Takeaways for Private Placement Investors following PG&E’s Bankruptcy
By: Chiraag Kumar (MetLife)
Private placement investors that often negotiate “anti-Cookson clauses” and “Adelphia provisions” are reminded that bankruptcy proceedings (such as those of namesakes Cookson Group and Adelphia Communications) often lead investors to re-examine their financing agreements in order to address areas of risk that were otherwise thought to be covered-off.
The bankruptcy of Pacific Gas and Electric (PG&E) earlier this year has been no different. As the largest American utility by various measures, PG&E is the offtaker - and, therefore, ultimate credit source - for a large number of energy projects that have been financed through the private placement market. The bankruptcy proceedings are still on-going, yet investors have already learned new lessons, or been reminded as to the importance of old lessons, in diligencing and de-risking their infrastructure financings. The below takeaways will certainly be supplemented throughout PG&E’s restructuring, but they offer a glimpse as to the effect the bankruptcy has had on investors’ credit processes.
The headline item that investors have educated themselves on since PG&E’s bankruptcy filing has been the application of inverse condemnation laws generally, and California’s application of its version of the law on utilities specifically. Inverse condemnation laws provide land owners with a right to seek compensation when public bodies take or damage their property. California’s law is particularly interesting for two reasons.
First, California expands the group of entities that can be held liable for inverse condemnation beyond just governmental bodies to include investor-owned utilities.
Second, California’s law imposes strict liability. Thus, as PG&E has discovered, a private entity can be held liable for inverse condemnation despite their actions displaying no negligence or carelessness.
No fifty-state surveys have been prepared in the months since PG&E’s bankruptcy filing, but investors are now taking the opportunity as new transactions arise to ask questions about the applicable state’s inverse condemnation laws. Investors are now careful to ensure that California is unique among the States in how it imposes inverse condemnation.
Cross-Default to Offtaker PPA Breach
One documentation point that investors are focusing on in their financing agreements is whether a default by the offtaker under the relevant power purchase agreement (PPA) – including, specifically, filing for bankruptcy – would trigger an Event of Default under the financing agreement. The review would be a two-step process. First, investors would want to confirm that an offtaker bankruptcy is in-fact a default under the PPA. Second, investors would want to ensure that such a default would create a cross-default under the financing agreement and pay particular attention to any carve-outs that could weaken this provision. Borrowers are keen to soften such a cross-default by proposing to have it tripped only in instances such as the offtaker actually missing a payment under the PPA or if the bankruptcy could reasonably be expected to have a material adverse effect on the borrower (the latter raising the ever-present question of what constitutes an “MAE” – does the offtaker bankruptcy itself qualify or would the investors be forced to allow the borrower an opportunity to find a replacement offtake arrangement?). Investors must weigh how quick of a trigger they deem prudent once it is clear that their investment’s ultimate credit is experiencing financial difficulties.
Bankruptcy-remoteness of Utility Subsidiaries
In contrast to situations in which a utility is the offtaker and revenue source for a borrower, subsidiaries of utilities themselves are often also borrowers of private placement debt. PG&E’s bankruptcy has caused investors in these offerings to increase their focus on the extent such a subsidiary is “bankruptcy-remote” from its utility parent company. The concern with a subsidiary that may not be adequately “bankruptcy-remote” would be that the creditors of its distressed parent would argue for a substantive consolidation of the parent and the subsidiary in order to bring as many assets into the bankruptcy estate as possible. Investors would typically view it as credit-positive to have a strong utility at the top of a borrower’s organizational structure. The PG&E bankruptcy, though, has reminded investors that it is prudent to ensure that their borrowers are operated in a manner that is sufficiently separate from its parent entities so as to not be brought into any upper-tier insolvencies. A substantive consolidation analysis will always be a situation-specific and fact-based exercise, but investors will likely be more vigilant going forward in negotiating for traditional “separateness” covenants in their financing agreements. Examples include (but are in no way limited to) requirements that the borrower:
- be established for, and permitted to only operate with, a singular purpose,
- maintain its own books, records and bank accounts,
- conduct its business solely in its own name,
- not commingle its assets with any other entity’s and pay its liabilities from its own assets,
- observe all organizational formalities,
- not guarantee or assume the debts of any other entity or provide security over its assets for the benefit of any other entity’s creditors and
- generally operate in an arm’s-length manner with its affiliates.
Enforceability of PPA termination payments
PPAs often include a liquidated damages provision that provides for a termination payment in the event the PPA is terminated due to a breach by one of the parties. Such a provision would apply if the relevant offtaker filed for bankruptcy (assuming, as discussed above, that such a bankruptcy filing qualifies as a PPA Event of Default), and would require a payment to be made in favor of the power generating project company. From an investor’s point of view, a termination payment such as this would be used to pay off (at least in part) the loans they provided to the project company. Thus, PG&E’s bankruptcy has forced investors to re-familiarize themselves with the general considerations that are made when courts consider whether a liquidated damages provision should be sustained or held unenforceable. There is no bright-line rule to decide whether a liquidated damages provision is enforceable as courts typically weigh several factors. Primary among those is the consideration as to whether the liquidated damages provision provides for a reasonable payment amount when compared to the harm caused to the non-breaching party. In other words, does the provision seek to make the non-breaching party whole, or does it result in a payment that is so disproportionate to the harm caused that it should be viewed as punitive? It is common for a PPA’s termination payment to be calculated based on the net present value of the losses the non-breaching party will incur due to the PPA’s termination. A provision such as this is conceptually consistent with what is permissible, but investors will now be advised to pay closer attention to the details to ensure the likelihood of any termination payment being upheld. Important considerations will include the discount rate to be used, the types of losses that can be factored in and the level of mitigation required on the part of the project company.
This article has been prepared by the author solely for informational purposes and does not constitute a recommendation regarding any investments or the provision of any investment advice. The views expressed herein are solely those of the author and do not necessarily reflect, nor are they necessarily consistent with, the views held by, MetLife, Inc. or any of its affiliates.