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: Nextwave¹ and PG&E.² 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. 11 U.S.C. §362(b)(4). 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.

Nextwave

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.

PG&E

A closely related issue comes up in In re Pacific Gas & Electric, 283 B.R. 41 (N.D. Cal. 2002), 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.³

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.⁴ 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.

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Footnotes

¹ Federal Communications Commission v. Nextwave Personal Communications Inc., 123 Sup. Ct. 832 (2003). One of us (Warren) participated in Nextwave in the U.S. Supreme Court. Return to article

² In re Pacific Gas & Electric, 283 B.R. 41 (C.D.C.A. 2002). Return to article

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

⁴ D.J. Newswires, June 26, 2003. Return to article