How to Keep the Lights On in a REP Bankruptcy A Case Study from Texas

Texas Commercial Energy (TCE) filed for bankruptcy protection on March 6, 2003 (Cause No. 03-20366-C-11; <i>In
re Texas Commercial Energy LLC,</i> debtor; in the U.S. Bankruptcy Court for the Southern District of Texas,
Corpus Christi Division), following a sudden and dramatic rise in the price of wholesale electricity. TCE is an
Allen, Texas-based retail electric provider (REP) serving commercial and light industrial customers in the region of
Texas administered by the Electric Reliability Council of Texas (ERCOT). TCE acquires electricity on the
wholesale market and then sells it on a retail basis to its customers. TCE typically enters into 12-, 24- or 36-month
contracts with its customers to supply electricity at a fixed price.

</p><p>During February 2003, the wholesale price of power in Texas increased dramatically and exceeded the price TCE
was charging its customers. Prior to filing for bankruptcy protection, TCE was purchasing almost its entire supply
of energy from ERCOT on the spot or "balancing energy" market rather than acquiring a steady long-term supply of
power at a fixed price. TCE lacked the financial resources at that time to hedge adequately its power supply costs
against price fluctuations in the market. ERCOT established the "balancing energy" market as a mechanism to allow
REPs to buy and sell small amounts of electricity for immediate delivery and thereby balance their fluctuating
obligations to supply and purchase power. The market also serves as the intermediary between REPs and generation
companies in order to provide a source of marginal amounts of additional power to compliment a REP's
fixed-price supply.

</p><p>ERCOT is the Independent System Operator (ISO) for the electric grid in the majority of Texas. It is a
member-owned, non-profit entity and is responsible for maintaining the integrity of the electric power market in the
majority of Texas. The traditional vertically integrated, regulated utility has not existed in Texas since the electricity
market was deregulated in January 2002. ERCOT has three categories of participants: generation companies
(generators), transmission and distribution service providers (TDSPs) and load serving entities (LSEs). REPs,
subgroups of the LSEs, purchase power from the generators and deliver that power over the TDSPs' power lines to
the end users. This economic model is roughly similar to that used by resellers of telephone service. REPs make
money just like any other retailer: They buy large volumes at wholesale prices and resell in smaller amounts to end
users.

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Recharacterization is usually a risk to equity investors since equity recovers only after all creditors are paid in any subsequent bankruptcy case. By contrast, LCs are a credit support, not a loan or other transfer of money into a company.
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<p>As a rule of thumb in the ERCOT market, short-term wholesale power delivered during the peak demand periods of
the day sells for an annual average of 10 times the price of natural gas. For example, if gas sells for $5/mmBtu,
then power will sell for $50 per megawatt-hour (MW-h). On Feb. 24 and 25, 2003, during an unusually severe cold
snap across the country, the price of natural gas on the spot market rose to $22/mmBtu and power followed suit
with prices rising to $220/MW-h. At the time, typical rates for retail power varied from $75-$85/MW-h. Due to a
variety of factors, including the extended period of extremely cold weather, trading issues and practices that are
currently in both dispute and litigation, transmission constraints and generation outages, spot prices for power
continued to increase, reaching the ERCOT-imposed $990/MW-h cap for several hours.

</p><h4>Managing Supply Costs</h4>

<p>A REP makes money by successfully managing its supply costs. There are several strategies for managing the risk
of sudden increases in the cost of wholesale power. Customary practice is to match the term of load requirements
with the term of supply agreements. Starting with the most expensive strategy, a REP could purchase all of its
requirements in the forward market under a Power Purchase Agreement—essentially paying today for power that
will be delivered in the future. Alternatively, it could enter into a tolling arrangement in which it delivers fuel to a
generator and, for a fixed price, receives power in return. It could also contract for power to be delivered over a
rolling three- or six-month basis. Finally, since there is not an options market for power in ERCOT, a REP could
indirectly hedge its supply costs by purchasing call options on natural gas. While no single strategy can remove all
of a REP's supply risk, an appropriate risk-management policy can minimize the volatility of a company's supply
costs.

</p><p>A well-established, investment-grade company would normally establish "pay-as-you-go" terms with its suppliers.
TCE had neither the capital nor the credit to qualify for these payment terms. More importantly, TCE did not have
the capital to implement any significant hedging program. TCE chose to manage its risk by purchasing all of its
supply on the spot market, betting that gas prices would stay low while the company used its limited capital to
aggressively pursue new customers and grow revenues. This strategy is perfectly reasonable—if a company has the
financial resources to withstand a sudden and sustained rise in supply costs. In TCE's case, however, this strategy
was a recipe for disaster. While an effective hedging program is not necessarily capital-intensive, it is certainly
credit-intensive. A company of TCE's size requires capital or access to credit roughly equal to three months of
supply costs in order to hedge effectively their supply risks. TCE, as a relatively young company that had
undergone a modest amount of management change, was not financially strong enough to withstand the pricing
volatility in the spot market.

</p><h4>Post-filing Strategies</h4>

<p>After TCE filed for bankruptcy protection, ERCOT required the company to shed 80 percent of its customers and to
begin hedging by buying power on a month-ahead basis. As an interim solution, TCE negotiated a deal with Coral
Energy to supply power and risk-management services. Coral required TCE to post letters of credit (LCs) for its
purchases. TCE's equity owners posted these LCs for TCE's benefit. The credit support provided was sufficient to
fund TCE's power purchases on a monthly basis, but not enough to hedge any supply costs for more than 30 days.

</p><p>In order to successfully reorganize, TCE needed a source of both exit financing and long-term financing. Manti
Resources, an independent oil and gas exploration and production company and the majority owner of TCE, was
unwilling to inject any fresh capital directly into TCE. As a solution, Manti established Magnus Energy Marketing
to procure power for TCE and manage the associated supply risks. Magnus markets all of Manti's gas production
and uses that in addition to letters of credit as collateral for power purchases. With the approval of the court,
Magnus entered into a 12-month contract with TCE to provide a revolving-credit facility that will be used to fund
the purchase of up to $25 million of power. As collateral for this line of credit, Magnus was granted by the
bankruptcy court a first lien on TCE's cash and accounts receivable along with other protections typically provided
to a post-petition lender.

</p><p>At the inception of the case, the view of the creditors' committee and its counsel was that a liquidation of TCE was
likely to be the only workable alternative for creditors. After much consultation with financial advisors, analysis and
review, the committee determined that a liquidation of TCE would provide a modest recovery at best for unsecured
creditors. TCE's main assets were cash on hand, accounts receivable and the portfolio of customer contracts. At this
point during the proceedings, the contracts had an average remaining term of eight months. The committee's
financial advisor used two different approaches to value these contracts. First, recent transactions involving the sale
of a similar mix of customer contracts showed that the market value of a customer contract was approximately $100.
This benchmark, applied to TCE's 1,200 customers, valued the business at $120,000. The second approach was to
take a market-to-market approach and evaluate the gross margin that could be earned by retaining the existing terms
of the contracts. This approach, after applying a discount for selling the contracts at auction, valued the portfolio at
$1.2 million. After collecting the accounts receivable and paying administrative expenses, the estate was projected
to have $2.7 million in cash available to repay $34 million in claims. The creditors' best hope for a reasonable
recovery was repayment over a period of time from the debtor's continued operations.

</p><p>TCE's initial reorganization plan called for the creditors to receive full repayment of their claims out of a share of
future profits over an extended and indefinite period of time. The financial advisors to the committee tested the
assumptions underlying the initial proposal and believed the debtor's proposal to be inherently risky for the
unsecured creditors of the estate. The challenge was to structure the proposed plan to provide the highest, most
secure return to the unsecured creditors while not burdening the reorganized company to such an extent that it could
not continue to grow and generate sufficient income from operations to repay the creditors in accordance with the
plan.

</p><p>The goal of the committee and its financial advisors was to negotiate a repayment plan that was feasible and
realistic, and to simultaneously convince TCE's equity owners to provide some level of credit support for the
promised payments. The final agreement separated TCE's payments into three different streams. TCE agreed to
make fixed payments to ERCOT and the unsecured creditors on a quarterly basis. The unsecured creditors will also
get a 25 percent net profits interest. The fixed payments were structured as a note rather than a profits interest to
give the creditors more certainty of the timing, likelihood of delivery and a means of enforcing their rights in the
event of a default. TCE agreed to a number of covenants, including minimum debt coverage and liquidity ratios and
capital expenditure limits that provide the unsecured creditors with a mechanism to monitor and measure the
debtor's post-confirmation financial condition and compliance with the terms of the reorganization plan. Finally, the
debtor's equity-holders agreed to provide a letter of credit in the amount of $1.3 million for the benefit of the
unsecured creditors. The amount of the letter of credit was equal to the value Manti, TCE and the committee agreed
was likely to be recovered in an actual liquidation sale. The plan structure provided a workable mechanism for TCE
to repay its creditors from operations and continue its business fully hedged.

</p><h4>Use of Letters of Credit</h4>

<p>Letters of credit are a very effective way to capitalize a business like TCE. The use of LCs can accomplish two
things for an actively involved equity investor. First, they amplify the value of an investment. Depending on the
investor's relationship with the issuing bank, $1 held as security can support $4-$8 in letters of credit. (Of course,
the investor still remains liable on a guaranty usually given to the issuer for the total amount of the letter of credit.)
Credit-intensive businesses like REPs need a modest level of initial cash but a much larger level of credit to support
the purchase of the energy supply for their operations. Second, LCs protect against subsequent recharacterization in
the event of a bankruptcy. A traditional loan or preferred stock investment can sometimes be recharacterized as an
equity investment depending on the presence of certain other factors. Recharacterization is usually a risk to equity
investors since equity recovers only after all creditors are paid in any subsequent bankruptcy case. By contrast, LCs
are a credit support, not a loan or other transfer of money into a company.

</p><p>In Texas, the financial requirements for establishing a REP are minimal. While this policy encourages start-up
companies to become involved in the ERCOT market and to further the goal of deregulation of the retail power
market, it does nothing to mitigate the risk that a company will become vulnerable to market fluctuations if it lacks
the financial ability to appropriately hedge its supply risks. Letters of credit are one way to provide such credit
support and can be used effectively in a bankruptcy case to provide additional financing and equity-type capital for a
debtor.

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<h3>Footnotes</h3>

<p><small>^{<a name="1">1</a>}</small> Board Certified in Business Bankruptcy Law by the American Board of Certification. <a href="#1a">Return to article</a>