The Narrowing Preemptive Power of Chapter 11

Journal Issue

Feb 2004

Column Name

Journal HTML Content

It has been a year in which the latest round of public utility and merchant power company bankruptcies has sparked
detailed examination by the courts of the relative powers of the bankruptcy courts and other state and federal
regulatory bodies. In the NRG and Mirant cases, the battleground has been over the relative powers of the
bankruptcy courts and the Federal Energy Regulatory Commission (FERC) with respect to electric power purchase
contracts rejected under the Code. Meanwhile, the Pacific Gas & Electric (PG&E) case provided its third year of
running conflicts with California authorities and agencies, ultimately resulting in a global settlement and a
confirmed plan at year end.

This column will focus on the latest decision by the Ninth Circuit in the PG&E case, Pac. Gas & Elec. Co. v.
California, 350 F.3d 932 (9th Cir. 2003), in which the Ninth Circuit interpreted §1123(a)(5) of the Code to
provide only the narrowest scope for preemption of state laws that might interfere with the confirmation of a chapter
11 plan. It held that the only applicable non-bankruptcy laws expressly preempted by §1123(a) are those relating to
financial condition.

The Ninth Circuit's decision had no impact on the PG&E case, as the reorganization plan and disclosure statement
it addressed were abandoned by PG&E five months before the appeal was decided. PG&E's original plan had called
for, among other things, the "disaggregation" of PG&E's business into four separate companies. Three of the new
companies, those responsible for generation and transmission, would have shifted to regulation by the FERC after a
century of being regulated by the California state utility commission. To reach that end, PG&E's plan called for the
bankruptcy court to approve the requisite corporate transfers without approval of the California Public Utility
Commission (CPUC) and without interference from numerous other state statutes and commission rules.

Bankruptcy Judge Dennis Montali rejected the "across-the-board, take-no-prisoners preemption strategy" theory on
which the plan was premised and refused to approve the disclosure statement. In re Pac. Gas & Elec. Co., No.
01-30923 (Bankr. N.D. Cal. Feb 7, 2002) at 46. He offered PG&E options of amending the plan or proceeding with
its plan by appeal. PG&E appealed to the district court, which reversed in June 2002. In re Pac. Gas & Elec. Co.,

283 B.R. 41 (N.D. Cal. 2002). The district court engaged in a thorough analysis of the Code, caselaw and
legislative history to evaluate the preemption arguments raised by the parties. Relying heavily on In re Public
Service Co. of New Hampshire, 108 B.R. 854 (Bankr. D. N.H. 1989), the district court reasoned that the absence of
any requirement in §1129 for approval by public utility regulators, except as to rate increases, evidenced Congress's
intent to preempt state law by doing away with the state regulators' approval rights for transactions contemplated
by a plan. That requirement had been part of the former Bankruptcy Act, and the exclusion of this requirement in
the Code was seen as probative of Congress's intent to override state utility laws and regulations that would give a
veto to the states over transactions proposed as part of a chapter 11 plan. The respondents appealed to the Ninth
Circuit. While the appeal to the Ninth Circuit was pending, though, a mediated settlement process resulted in the
announcement of a proposed settlement in June 2003 and the filing of a consensual plan at the end of July. The new
plan no longer sought to disaggregate the businesses or to shift regulatory control away from the CPUC. Instead, it
proposed the reorganization of PG&E as a vertically integrated utility subject to state regulation.

For bankruptcy lawyers accustomed to thinking that the Supremacy Clause and the broad equitable powers of the
bankruptcy courts are all that are needed to overcome state law restrictions in structuring a plan, the Ninth Circuit's
PG&E decision serves as a wake-up call that the Code may not be as powerful a tool as previously thought, and
that principles of federalism embodied in a long history of Supreme Court decisions may require a more subtle
analysis.

<h3>Express and Implied Preemption</h3>

Express preemption exists where Congress preempts state law by so stating in express terms. The term
"notwithstanding" is often used in a statute to express this kind of broad preemptive intent. The Code uses the
"notwithstanding" formulation in several places to indicate express preemption. Examples cited by the Ninth Circuit
include §365(e)(1) (barring termination or modification of executory contracts notwithstanding provisions in the
contracts or in applicable law relating to insolvency or bankruptcy), §365(f)(1) (permitting assignment of contracts
and leases notwithstanding contractual provisions or applicable law restricting assignment) and §365(f)(3)
(prohibiting termination of contracts or leases based on assumption or assignment by a trustee notwithstanding
contractual provisions or applicable law to the contrary).

Implied preemption of state law can exist where state law "stands as an obstacle to the accomplishment and
execution of the full purposes and objectives of Congress." Baker & Drake Inc. v. Pub. Serv. Commission of
Nevada (In re Baker & Drake Inc.), 35 F.3d 1348 (9th Cir. 1994). Thus, even where the Code is silent,
congressional intent to preempt state law can be implied from the overall structure and purposes of the bankruptcy
laws. As the district court observed in a prior ruling on procedural issues related to the appeal, a higher burden is
imposed on a debtor seeking to establish implied preemption. The purposes of the state law must be considered in
conjunction with the purposes of the Code so that the bankruptcy court can apply a balancing test in which federal
preemption will be more likely when the challenged state law involves economic regulation rather than health or
safety. In re Pac. Gas & Elec. Co., 280 B.R. 506, 513 (N.D. Cal. 2002). For example, the Ninth Circuit refused to
find implied preemption in Baker & Drake where the challenged state statute was promulgated as part of a safety
measure regulating taxi companies.

<h3>Scope of Express Preemption Under §1123(a)(5)</h3>

Section 1123 lists several mandatory requirements for chapter 11 plans. As amended in 1984, it provides, in
relevant part, as follows:

<blockquote>
§1123. Contents of Plan. 
(a) Notwithstanding any otherwise applicable non-bankruptcy law, a plan shall: 
(5) Provide adequate means for the plan's implementation, such as— 
(B) Transfer of all or part of the property of the estate to one or more entities whether organized
before or after confirmation of the plan,... 
(D) The sale of all or any part of the property of the estate, either subject to or free of any lien...
</blockquote>

The 1984 amendment to §1123(a) added the introductory "notwithstanding" clause. The meaning of these words,
coupled with authority to transfer property to one or more entities, is central to the express preemption analysis in

PG&E, as they appear on their face to follow the formulation used elsewhere in the Code to indicate broad express
preemption. Not so, according to the bankruptcy court, which described §1123(a)(5) as "directive" rather than
"empowering." Slip op. at 17. The Ninth Circuit also rejected the broad preemption claim, but had a different take
on the statutory language. It acknowledged that the "notwithstanding" clause indicated some form of express
preemption, but ruled that it was one that was extremely limited in scope. The Ninth Circuit focused on the scant
legislative history of the amendments to §1123, which included such elements as floor statements on failed
technical corrections bills in the early '80s to divine congressional purpose, rather than on the wording used in the
amendment. Despite the seemingly plain language of §1123's "notwithstanding" clause, the Ninth Circuit, citing a
general presumption against preemption, found that Congress did not intend to make a substantive change by the
1984 amendments to §1123(a) because it could find no clear indication of such intent in the legislative history. 350
F.3d at 943.

The Ninth Circuit held that the express preemption in §1123(a) is limited to the carve-out in §1142(a)
concerning implementation of a confirmed plan. That subsection provides that:

<blockquote>
Notwithstanding any otherwise applicable non-bankruptcy law, rule, or regulation relating to financial condition, the
debtor and any entity organized or to be organized for the purpose of carrying out the plan shall carry out the plan
and shall comply with any orders of the court.
</blockquote>

The Ninth Circuit ruled that the two sections must be read together and that, despite the absence of §1142(a)'s
qualifying language in §1123(a), the express preemption worked by §1123(a) is no broader than the scope of
§1142(a).

The Ninth Circuit did not provide any examples of applicable non-bankruptcy laws that would be preempted under
its announced standard. The bankruptcy court identified examples of hypothetical state laws that would be
preempted by its narrow reading of §1123(a), citing laws that would require shareholder approval or good-faith
negotiations with labor unions as prerequisites to the submission of a plan. Slip. Op. at 18. However, as the
district court pointed out, those hypothetical laws would have no bearing on the plan itself (283 B.R. at 49-50).
The CPUC's only example of a law that would be preempted under its proposed narrow reading of §1123(a) was
one requiring a dissolving corporation's plan of distribution to include certain mandatory elements that would be
inconsistent with §1123(a). None of these state laws would be ones "relating to financial condition." Therefore, one
is hard-pressed to identify any state laws or regulations that would be expressly preempted under the Ninth Circuit's
standard. Is the express preemption any broader than §525(a), which protects debtors from discrimination by
governmental units based on a debtor's filing for bankruptcy protection, the insolvency of a debtor at the
commencement of a case or the discharge of its debts in bankruptcy? Since §525(a) addresses the denial, revocation,
suspension or granting of a license, permit, charter, franchise or other similar grant based on financial condition,
there would seem to be little else for §1123 to preempt under the Ninth Circuit's narrow standard. Moreover, it is
not clear that the Ninth Circuit would permit a plan to override future application of financial responsibility laws
where the state law requirement was part of a police power statute to assure public health or safety. As the district
court pointed out, §1123(a) does not grant an exemption from compliance with applicable state or federal laws on an
ongoing basis. Instead, it should effect a temporary suspension of such laws solely for the implementation of the
restructuring proposals embodied in the plan, such as asset sales, mergers or the creation of new entities.

<h3>Implications for the Future</h3>

As a practical matter, debtors in the Ninth Circuit are left with implied preemption, which the district court
described as a blunt tool for the important task of rehabilitating a corporate debtor. Whenever state laws, rules or
regulations are to be overridden in structuring a plan, the bankruptcy court will need to engage in a balancing test to
evaluate the competing federal and state policies and determine whether application of the offending state law will
stand as an obstacle to the reorganization. Under this analysis, implied preemption may not be effective to override
state law unless compliance would make the reorganization impossible. Outside the Ninth Circuit, debtors will
press for a broader standard of express preemption under §1123, but they should be prepared to address the policy
questions inherent it trying to reconcile federal bankruptcy law and competing state regulation.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Board-certified in business bankruptcy by the American Board of Certification.

Journal Authors

Daniel J. Carragher

Journal Date

Sunday, February 1, 2004 - 12:00

Bankruptcy Rule

2004