Restructuring

Contributed by Sara Coelho
When a debtor files for bankruptcy protection, one of most important and least appreciated tasks is keeping the lights on.  Like many creditors, once the debtor files its petition for bankruptcy protection, utilities can be stuck with a prepetition claim, and like all creditors they are not happy about it.  Utilities provide an essential service however, and so they have unusual power to wreak havoc on a debtor’s operations if their claim is not paid.  To protect debtors from disruptions in service following a bankruptcy filing, section 366 the Bankruptcy Code requires utilities to continue service without disruption, so long as the debtor provides “adequate” assurance (typically in the form of a deposit) that it will pay its bills postpetition.  This system has protected debtors entering bankruptcy while also providing utilities with protection from further payment failures.

With the increasing use of forward contracts, however, more suppliers of natural gas and electricity are avoiding this bargain by arguing that they operate under Bankruptcy Code safe harbors applicable to forward contracts that allow, among other things, exercise of contractual termination rights upon a debtor’s bankruptcy filing.  They also typically argue that because they provide only the commodity supply, and not the service of transporting it to the debtor, that they do not operate as traditional, monopolistic utilities, and should not be subject to section 366 of the Bankruptcy Code.
With respect to any given forward contract merchant, it is typically not worthwhile for the debtor to invest in going to court, and so often termination threats are resolved by either allowing the termination to occur, or providing accommodations to the vendor.  Where energy consumption is a key part of the debtors’ operations however, negotiating with forward contract merchants and dealing with contract terminations can require substantial investments of attorney time — particularly at the outset of the case when the debtor is most vulnerable to all sorts of other operational disruption, lead to threatened or actual disruptions to a debtor’s operations, and allow vendors to extract valuable concessions not available to other creditors.
The Bankruptcy Code’s definition of a forward contract is here.  If you have no idea what a forward contract is from reading this definition, you would not be alone.  The poor definition in both the statute and case law of exactly what a forward contract is could be the subject of its own posting.  Suffice it to say here, that arguing about forward contract status is complicated and typically debtors are better off devoting their energies to finding alternate sources of supply, even where the assertion of forward contract status may be dubious.  For their part, natural gas and electricity suppliers have capitalized on the vague standard to argue that just about any commodity supply contract with small print comes within the definition.
Utility suppliers will argue that termination of their contracts with a debtor should not disrupt service because municipal utilities will be required by law to provide service.  Experience tells us this is generally true, though without a survey of every jurisdiction it is impossible to know if this is true everywhere.  In any event, municipal utilities may further the cause of service disruptions by making gigantic deposit demands before they will begin service.  The debtor can appeal to the Bankruptcy Court to set a reasonable deposit, but because the forward contract merchant may terminate swiftly, the debtor may have difficulty getting to court in time and will be more apt to make concessions to the utility.
The sort of brinkmanship in which energy suppliers have engaged in order to gain an advantage at the outset of the case is precisely what section 366 is supposed to prevent, and there is no principled reason to exempt one category of suppliers from the orderly, court-monitored process of providing assurance to utility providers.  The legislative history of the derivatives safe harbors indicates the provisions were created to safe guard financial markets from disruptions caused by the bankruptcy of large institutions.  It is difficult to imagine how exempting certain energy suppliers from the traditional requirements of the Bankruptcy Code has any benefit for financial markets, but it is easy to see how these special rights can be wielded as a sword to gain advantages at the expense of the estate and other creditors.  The ability of natural gas and electricity providers to use termination rights to threaten a debtor with damage far in excess of the supplier’s claims, coupled with special rights conferred by the Bankruptcy Code, provides these entities a unique ability to extract concessions that are not consistent with the traditional bankruptcy principle of treating creditors equally.  Congress should reassess the costs of favoring one group of creditors and clarify the Bankruptcy Code to make clear that all providers of utility supplies and services are bound by section 366 of the Bankruptcy Code.