Ring Around the Subsidiary

Embattled California utilities use controversial way to protect assets from bankruptcy.

Sometime 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.

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