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.

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.”

So Craver created another entity, Mission Energy Holding Co., in June. The new, ring-fenced entity could raise the needed capital because it was bankruptcy-remote from its troubled parent and sister utility, and secured entirely with stock from the already ring-fenced Edison Mission Energy.

The strategy paid off. On June 11, Standard & Poor’s Corp. assigned a double-B-minus rating to Mission Energy Holding’s offering of $1.2 billion in senior secured notes. “I wouldn’t have minded a slightly cheaper rate on the financing,” says Craver, “but we were pleased with that.” He should be thrilled — both subsidiaries have higher ratings than the parent they are working to save. “Ring-fenced subsidiaries rarely achieve ratings appreciably higher than their parents,” S&P’s analysts noted at the time.

Craver says he avoided challenges from the administration by explaining ahead of time how ring fencing would help avoid a bankruptcy filing. Thanks to the new financing, he explains, “Edison International and all of its unregulated subsidiaries have met all our obligations, debt and otherwise, in full and on time.”

Unbreakable?

Of course, that still leaves the principal subsidiary, SoCalEdison, deep in the red. Craver estimates that the utility, California’s second largest, will have $3.9 billion in unpaid wholesale energy costs by the end of this year. “SoCalEdison is clearly in severe financial stress,” he says.

State legislators have been slow to develop the governor’s promised rescue plan. But even if the utility succumbs to bankruptcy, Craver says he isn’t worried about creditors breaking the ring fence. To do so, he says, they would have to petition the judge for a “substantive consolidation” of the various entities on the grounds that there is no true distinction between the utility and its sister subsidiaries. “That’s extremely rare,” says Craver, “especially in the context of large corporations where typical separation formalities are observed.” Moreover, he notes, Mission Energy Holding is a secured borrowing, so unsecured creditors would not improve their position by breaking through the ring fence.

S&P analysts cautiously agree, although they note that “the economic disincentives that create barriers to filing [for bankruptcy against] Mission Energy Holding are considerably less compelling than those that exist for Edison Mission Energy.”

The next few months will be crucial for ring fences at both PG&E Corp. and Edison International. For PG&E Corp., the goal is for its utility to emerge from Chapter 11, its ring fence intact. For Edison, the goal is to avoid Chapter 11, and any test of its ring fence. See you in court. [/p>

SO WHY RING FENCE?

Protecting one corporate entity from the financial woes of another is an old game. Corporate raider Carl Icahn, for example, spent years trying to separate Nabisco from litigation-prone tobacco unit R.J. Reynolds. But ring fencing, which seeks to do the same without a corporate spin-off, can be a mixed blessing.

“Ring fencing costs a lot of money. It restricts the way you can do business. And there’s a negative overtone to it,” says Dan Streek, interim CFO of Kansas City, Missouri-based energy firm UtiliCorp United and CFO of its unregulated subsidiary Aquila Inc.

Streek says he considered a ring fence while planning an April initial public offering that took 20 percent of Aquila public. “I thought perhaps I should ring fence the trading operation from the rest of Aquila to get an investment-grade rating,” he says. But when it became clear that Aquila as a whole would make investment grade, the move no longer made sense. In fact, even without a ring fence, and despite UtiliCorp’s 80 percent ownership stake, Aquila has a higher credit rating than its parent. “Generally, a ring-fence strategy is a defensive move or a survival move,” says Streek.

UCLA law professor Lynn LoPucki agrees. “The only time it matters whether you have ring fenced is when you are in financial trouble, or a creditor is anticipating the possibility that you may be” in trouble, he says.

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