VideoSometime this month, a judge in the bankruptcy case of Pacific Gas and Electric Co. is expected to decide whether to approve the San Francisco-based utility's reorganization plan, the third-largest Chapter 11 proceeding in U.S. history. That case is being closely watched by not only the utility industry and residents of California, but also bankruptcy experts and the larger business community. At its heart is a little- known but widely used technique for protecting assets from creditors in a bankruptcy — ring fencing.
Broadly speaking, ring fencing involves an effort to wall off certain assets or liabilities within a corporation — by creating a new subsidiary, for instance, or cutting off internal financing to an existing subsidiary. The technique has been popular for years among businesses with large liability exposures, such as tobacco and taxicab companies. Ring fencing is a term of art, not of law, notes UCLA law professor and bankruptcy expert Lynn LoPucki, and as such "is often synonymous with judgment proofing."
That's what's causing an outcry in the Golden State. California attorney general Bill Lockyer has charged that Pacific Gas and Electric's holding company, PG&E Corp., is wrongfully using ring fencing to shield billions of dollars from the utility's creditors — thus shifting more of the massive cost of the bailout to taxpayers. PG&E Corp. says it's using ring fencing simply to protect the credit rating of one of its subsidiaries.
Regardless of whether a company's goal is to improve credit or protect assets from creditors, ring fences are less secure when erected under public scrutiny. "This stuff does not play very well with the public," says LoPucki. "And that means it won't play very well with the judges, once it is exposed for what it is."
An Investment-Grade Fence
PG&E Corp. erected its ring fence last January, when sky-high power prices threatened both the utility and the holding company with bankruptcy. In a hurried filing approved by the Federal Energy Regulatory Commission (FERC), PG&E Corp. built a financial wall around PG&E National Energy Group LLC (NEG), which cannot build power plants or trade power without an investment-grade credit rating.
"When the corporation's credit rating was dragged down by the utility, it became difficult for NEG to borrow money," says PG&E Corp. spokesman Shawn Cooper. "Ring fencing allowed NEG to go out and get its own credit rating so it could continue to do business." In fact, he notes, the move gave NEG the credit it needed to purchase turbines for new power plants, "including one in Bakersfield, California, that is greatly needed."
That contribution to the power-hungry state did little to mollify California governor Gray Davis, whose bailout negotiations with the utility were rapidly escalating into a public feud. Lockyer tried unsuccessfully to block FERC approval of the filing. "Given all the talk about potential bankruptcy, we are concerned that PG&E used a stealth move to shield assets," he said at the time.
PG&E Corp. has steadfastly denied any subterfuge, but in April, Pacific Gas and Electric Co. filed for bankruptcy. Although the utility is responsible for 80 percent of PG&E Corp.'s revenues, neither the holding company nor the ring-fenced NEG joined the filing. "What we did has been audited by the California Public Utilities Commission and the State Senate Oversight Committee, and every audit has reported back that we have done everything legally and above board," says Cooper. "We feel very comfortable that [ring fencing] was the right thing to do."
Lockyer clearly didn't agree. In July, he appealed to a higher power, asking the Securities and Exchange Commission to review PG&E Corp. "for potential holding-company abuses in the transfer of billions of dollars from its now bankrupt California subsidiary, Pacific Gas and Electric Co."
"There is a lot of political positioning going on in California now," responds Cooper. "A lot of political people are pointing fingers. We are pretty confident on legal grounds that we did everything correctly." In fact, if Pacific Gas and Electric Co. enlists the support of its creditors for its reorganization plan and wins approval from the judge, Lockyer may be forced to drop his effort to break the ring fence.
Doing a Deal
Was it financial engineering or political ham-handedness that got PG&E Corp. in trouble? Lockyer has made no move against the two ring-fenced subsidiaries of Rosemead, California-based Edison International, which has had much better relations with the governor. Just one day after Pacific Gas and Electric Co. officials declared bankruptcy and blamed it on stalled negotiations with Davis, Edison officials signed a memorandum of understanding with him to participate in a state-led bailout.
Edison International also put up its first ring fence, around its Edison Mission Energy subsidiary, in January, just four days before Lockyer tried to block FERC approval of the ring fence around NEG. Like the PG&E Corp. subsidiary, Edison Mission builds, owns, and operates power plants, and also trades power.
The ring fence protected Edison Mission from the danger threatening the parent company and its utility subsidiary, Southern California Edison. The parent had $1.2 billion in maturing debt, explains CFO Ted Craver, and unless he could find a way to pay off that debt, it was likely to tip it and SoCalEdison into Chapter 11 when it came due. Says Craver, "Our ability to go out and raise $1.2 billion with a double-C credit rating was nil."
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