Regulators in the Bankruptcy Arena Who Has the Power

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Jul/Aug 2003

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What goes on in the mega-cases can seem far from everyday practice, but two huge cases
that are up this year put one of the most fundamental bankruptcy policy
considerations directly on the table: Nextwave<a href="#1" name="1a">1</a> and PG&E.<a href="#2" name="2a">2</a> The
issue is the role of regulatory agencies once a debtor declares bankruptcy. And
for anyone who thinks this is an issue that crosses the desks only of people
who handle multi-billion dollar reorganizations, think again. Every business
reorganization that involves a debtor with a license or a business that depends
on some government agency's approval for ongoing work can be affected by
these two opinions.

The basic contours of
the policy are familiar to everyone: Regulators (like police) continue to
exercise their regulatory functions after bankruptcy, but they cannot engage
in debt collection. This distinction receives the most attention in the
context of exceptions to the automatic stay. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §362(b)(4)</a>. But there is a deeper, more subtle question that
lurks behind that fundamental distinction: When a regulated company fails, what
is the role for the regulatory agency and what is the role for private parties
acting collectively through the bankruptcy court? The answer to that question
will determine the success or failure of some businesses and will affect the
post-reorganization shape of others.

<h3>Nextwave</h3>

We've
heard the facts of Nextwave before: When
the FCC auctioned off spectrum licenses, a start-up company made the winning
bid of $4.7 billion. The FCC took a down payment, note and security interest.
The market collapsed, Nextwave filed for bankruptcy, and the bankruptcy court
declared the bid to be a fraudulent conveyance (peculiar FCC rules declared the
sale wasn't final until long after the auction, by which time the market
had dropped). The district court affirmed, but the Second Circuit reversed. It
didn't hold that the fraudulent conveyance analysis was wrong, but that
the bankruptcy court had no jurisdiction to decide it. The FCC would determine
the fate of the Nextwave license, said the court, not the bankruptcy court. In
the meantime, the market recovered, so Nextwave offered to pay the full $4.7
billion—early. The FCC said "too bad," the license already
cancelled "automatically" back when Nextwave missed a post-petition
payment. The bankruptcy court said that violates the automatic stay, and the
case bounced back up to the Second Circuit, which once again held that the
bankruptcy court had no jurisdiction to supervise the regulatory activities of
the FCC. But it said Nextwave could ask the D.C. Circuit Court to review the
case because they had jurisdiction over the FCC. The D.C. Circuit said it
didn't need to reach §362(b), which was now law of the case anyway,
but it ruled that the FCC had stepped out of line by canceling the license
solely for the reason that the debtor had not made payment on a debt that was
dischargeable in bankruptcy, relying on §525.

That's where the
case stood when it went to the Supreme Court. The issue the court focused on
was whether the FCC could cancel its license notwithstanding the
debtor's bankruptcy. For those of us schooled in bankruptcy, the efforts
of the FCC (aided by the Second Circuit) to end-run the bankruptcy laws seems
pretty shocking. But for those of our cousins who grew up in the area of
regulatory agency law, the idea that some bankruptcy court could tell the
regulators how to regulate is equally shocking. And therein lies the rub.

The FCC argued its case honestly: They claimed that the distribution of licenses
for money payments, on whatever terms the FCC decides, is a fundamentally
regulatory action. According to the FCC's worldview, Congress told the
FCC to distribute them and that the FCC has a regulatory purpose when it
distributes the licenses to those who can pay the most in full and who can make
those payments on time.

Nextwave
and its other creditors (it is always fun to see the alliances that form in
bankruptcy) said, in effect: Hold on a minute. There is a regulatory function
that survives bankruptcy (such as the FCC rules on how long a company has to
build out and use its spectrum), but there is an ordinary creditor function as
well. The FCC acted like any other creditor, and it must abide by the rules
applicable to any other creditor when it comes to collecting money. It
doesn't matter whether the FCC brings a foreclosure action or cancels the
license. Both are collection efforts that follow whenever a party misses a
payment.

The resolution of this case is powerfully important to the bankruptcy system
because it sets the terms of the deal for everyone who invests in a business
that relies on a license or some other regulatory approval to survive. If any
agency in the country could think up some regulatory purpose to be served by
the agency's getting paid in full and on time, then there would truly be
a regulatory exception to the Bankruptcy Code; businesses can reorganize in
chapter 11 if—and only if—it pleases their regulators. But if the
rule is that regulatory agencies must observe the pecuniary/ regulatory
distinction no matter how the license is constructed, then start-ups and their
lenders will know that they can count on the license staying put so long as the
only defaults are monetary. If that is the rule, they can take the risk of
investing in regulated businesses without fear that the regulators will shut
the business down as soon as the company misses a payment.

We confess to being dyed-in-the-wool bankrupt-centric scholars (we've been
teaching this stuff for too long to masquerade in any other costume anyway),
but we think Justice Scalia got this one just right: Congress made a good
policy choice, leaving the financial decisions, in all their many
manifestations, to the bankruptcy system. This permits companies that need a
license to operate to compete on an equal footing for credit and investment
dollars.

A
closely related issue comes up in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Pacific Gas & Electric, 283 B.R. 41
(N.D. Cal. 2002)</a>, only this time we move to a more deeply
regulated industry: the power company. Following the terrible shocks in the
California energy market a couple of years ago, PG&E ended up in chapter
11. Management stabilized the operations of the utility, but they ended up with
a surfeit of plans for reorganization. PG&E's plan would cut the
company back up into four entities, one to be governed by the California Public
Utilities Commission and three to be governed by the federal government through
the Federal Energy Regulatory Commission. The resulting four companies would
all comply with the extant regulatory laws, but to get to that point, PG&E
would bypass Commission approval for the breakup. Under current law, if
PG&E wanted to break its pieces apart, the PUC would have to
agree—something that is about as likely as a Californian sitting in the
smoking section of the restaurant and ordering the extra-fatty short ribs with
a side of pork rinds. The PUC has its own plan on the table, one that keeps all
parts of PG&E under its thumb—and that chomps a big hunk out of
equity. Both plans are 100 percent payment plans, so this is really a fight
between the owners of PG&E and the Commission. At stake is the question of
how much reorganization authority rests with the bankruptcy court and how much
discretion remains lodged with the Commission.

Bankruptcy
Judge Dennis Montali had already decided that the utility customers had no seat
at the table in the bankruptcy, saying he could count on the Commission to
protect consumers' interests. He threw out the committee of consumer
representatives formed by Assistant U.S. Trustee Linda Stanley. When both
PG&E and the PUC proposed plans of reorganization, he reposed even more
confidence in the Commission. Judge Montali refused to approve the PG&E
disclosure statement, holding that the company could not propose a plan to
restructure its organization if the process of restructuring (the breakup of
the company) required PUC approval and the PUC was opposed. The district court
reversed, holding that the federal bankruptcy law preempted the PUC's
supervision over the structure of the company as it emerged from chapter 11,
which would give the bankruptcy judge power to approve either plan. The
bankruptcy court might be left to choose between two competing plans, but it
could not give the Commission an automatic veto over the reorganization
structure. Relying heavily on Public Service of New Hampshire, the district court found that the bankruptcy court
failed to distinguish between permitting a plan to authorize ongoing illegality
under state law (which the bankruptcy court would not have the power to
approve) vs. preemption of state law for the sole purpose of validation of the
transactions that permit the reorganization to occur (which the bankruptcy
court would have the power to approve). The Commission took strong exception,
arguing that the latter sort of preemption would permit, for example, a
reorganization merger that violated antitrust laws. The court said that might
sometimes be a good idea! But we (and they) digress.

There
is a structural consideration lurking in the resolution of the problem. The
Code specifically excludes the bankruptcy courts from reorganizing banks and
insurance companies, leaving those entities to their own regulators. It also
specifically leaves rate changes with the regulatory commissions under §1129(a)(6).
The question is, what happens in the middle? Does §1123 express
congressional intent to preempt wherever necessary? Do vestiges remain of the
pre-Code requirement that regulatory permission be obtained before a regulated
industry is reorganized? The statutory arguments are thin on both sides,
although the narrowness of the requirement for regulatory approval of rate
changes in §1129(a)(6), and the legislative history making it clear that
regulatory approval was not necessary to confirm a chapter 11 plan, certainly
favor the reading of the district court.<a href="#3" name="3a">3</a>

The
policy argument is where it gets fun. The argument in favor of the Commission
is that regulatory agencies must have control over financial matters relating
to their regulatory role. This view slides around Nextwave because in that case the FCC was protecting itself
as creditor rather than imposing a regulatory financial standard, like a
debt/equity ratio or a certain bond rating, that would apply to all such
spectrum users—making Nextwave a much easier case. By contrast, the California commission was making a
regulatory decision to prevent PG&E from spiriting assets from a regulated
company to entities outside the reach of state regulation. As a matter of
investor/creditor expectations, the debtor's stockholders and creditors
cannot complain of the regulatory regime because they accepted the benefits and
burdens of investment in a regulated monopoly (although a similar kind of
argument could have been made in Nextwave).

The
counterview rests on markets as well. PG&E is now in an industry in a
quasi-deregulated environment. If regulated industries are to continue to
attract private capital and if they are now to face the kinds of business risks
that can drive them into bankruptcy, then it may be that the capital markets
will demand a bankruptcy court resolution, applying the same rules that apply
to all businesses—regulated and not. That rule helps insure the flow of
capital to all the regulated industries, long before bankruptcy is on the horizon.

The
purest policy question is right on the table in PG&E: Who should be making these
regulatory/reorganization decisions? The choice is between courts with a lot of
experience in reorganizing failing businesses or agencies with a lot of
experience in the specific industry. Will the public be better served if the
reorganization is treated like an ordinary business or if there are special
financial rules and veto powers whenever regulators are involved? The most
recent case involves NRG, which rejected its contract to supply power under
§365 and refuses to obey an overriding order from the FERC that it must
supply the power.<a href="#4" name="4a">4</a>
Is this financial good sense vs. keeping the lights on? We are guessing these
are hard issues, because the two of us cannot agree on the right policy answer.

And
one last point (a reward for those who read articles all the way to the end):
Why did the Justice Department come in on the side of the FCC? Doesn't
the federal government have as much stake in the preservation of the bankruptcy
system as in the autonomy of its regulatory agencies? They are both creatures
of federal statute and they both have powerful ramifications throughout the
economy. Perhaps the Justice Department thought the FCC had the better end of
the argument on the interpretation of the bankruptcy laws. But we confess to
wondering whether the government acted reflexively, assuming its duty was defined
by regulatory law and that its stake in the bankruptcy system was minimal. We
hope not, because we are convinced that the policy issues that lurk in
bankruptcy are every bit as important as those expressed elsewhere in federal
law.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Communications Commission v. Nextwave Personal Communications Inc., 123 Sup. Ct. 832 (2003)</a>. One of us
(Warren) participated in Nextwave in the
U.S. Supreme Court. <a href="#1a">Return to article</a>

<a name="2">2</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Pacific Gas & Electric, 283 B.R. 41
(C.D.C.A. 2002)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> The
PUC has now settled the case, exchanging a hefty rate increase for the
maintenance of state regulatory authority. WSJ 6/20/03. <a href="#3a">Return to article</a>

<a name="4">4</a> D.J.
Newswires, June 26, 2003. <a href="#4a">Return to article</a>

Journal Authors

Elizabeth Warren

Jay L. Westbrook

Journal Date

Tuesday, July 1, 2003 - 12:00

Bankruptcy Rule

2003