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The once sleepy electric power industry, formerly known in the investment community for safety and predictable dividends, has become restructuring’s new stepchild. Today, utilities are facing defaults under existing bank credit agreements or bond indentures, and are entering into onerous restructuring arrangements and leveraging utility assets. Energy deregulation, an effort to offer choice and create diversity, has elevated the financial and market risk borne by regulated utilities. Ring-fencing and bankruptcy-remoteness protections that have been applied to nonregulated industries to protect subsidiaries against mass tort liability are being used to protect utilities from the financial risks of their holding companies and affiliates, and are being considered as a protective tool in federal regulations. Federal deregulation of the electric power industry began with the Public Utility Regulatory Policies Act of 1978 and was expanded with the Energy Policy Act of 1992. The Federal Energy Regulatory Commission’s 1996 orders 888 and 889 opened access to interstate transmission lines, facilitating competition from independent producers and other nontraditional power producers. By the end of 1999, more than half of the states followed this trend with state legislation. Deregulation at the state level allowed (and in some instances required) regulated investor-owned electric utilities that were vertically integrated (i.e., owning generation, transmission and distribution facilities) to separate or divest their generating assets. The generation assets were sold to third parties or transferred to separate affiliates. For example, the Electric Service Customer Choice and Rate Relief Law of 1997 enacted in Illinois permitted electric utilities to spin off generation assets. The goal was to keep pace with what was expected to be a deregulated environment, permitting the realization of full value for older fossil generation plants and repositioning utilities for competition. Utilities in the Allegheny Energy family and Dynegy’s Illinois Power Co. separated generation assets into nonregulated “Genco” subsidiaries, leaving the regulated utilities with transmission and distribution functions. Utility holding companies such as Westar Energy Inc. acquired unrelated businesses and bought and sold other businesses in an attempt to enhance shareholder return. These types of high-growth acquisitions made the sector sexier, but added a new level of risk to the utility industry. Additionally, in some cases, management made use of existing late 20th century first-mortgage indentures-a traditional utility financing technique-to finance growth into energy trading and for acquisitions. These first-mortgage indentures added significant leverage while diluting existing creditors through the issuance of additional series of secured bonds on an equal basis with existing first-mortgage bonds. Risks come home to roost As utilities gave up ownership and control of their electric generation assets, they added market risk and financial-leverage risk-much of which is coming to light in recent months. Investor-owned utilities must have a source of electricity supply for their customers. Utility-owned generation assets historically provided most of their supply requirements; once restructured utilities divested their generation, new arrangements were needed. These arrangements were either long-term power purchase agreements or spot- market purchases. To create price certainty and avoid subjecting many purchases to the daily fluctuations of the spot market, many utilities entered into long-term power purchase agreements. But these agreements have inherent risk. For example, regulated utilities purchasing from financially distressed suppliers may ultimately see their supply agreements rejected in bankruptcy. This was recently permitted by Judge Richard C. Casey’s order allowing NRG Energy Inc. to terminate an above-market power purchase agreement to supply power to Connecticut Light and Power Co. In re NRG Energy Inc., No. 03-13024 (Bankr. S.D.N.Y. June 2, 2003). Additionally, these agreements have a termination date and must be renegotiated at market rates. Spot-market sourcing of energy is not a viable strategic alternative. Recently, there has been testimony on Capitol Hill regarding the inclusion in �� 203 and 204 of the Federal Power Act of accounting and bankruptcy protections in future approval processes to protect utilities from the ravages of the unregulated world through the techniques of ring-fencing and bankruptcy remoteness. Such a protective amendment to the Federal Power Act would require the Federal Energy Regulatory Commission to establish and maintain standards for the corporate and financial separation of public utilities in accordance with certain guidelines. These standards are predicated upon techniques that are commonly referred to as ring-fencing. Ring-fencing is not a new concept to the industry. In fact, it has proven effective in insulating a wholly owned utility subsidiary from the financial woes of its parent. For example, Portland General Electric Co., a subsidiary of Enron Corp., managed to avoid bankruptcy in the wake of Enron’s Chapter 11 filing, in large part through ring-fencing. A closer look at ring-fencing The term ring fencing includes an array of methods that a wholly owned subsidiary may use to insulate itself from the financial condition of its parent. To understand their operation, first we will examine how the financial distress of a parent can have a negative impact on the credit ratings and overall financial condition of its wholly owned subsidiary. The negative impact of a distressed parent on the credit ratings and overall financial condition of an otherwise financially healthy wholly owned subsidiary is principally attributable to three risk factors. First, a financially distressed parent may have the ability and the incentive to deplete the assets of its subsidiary or to encumber it with liabilities. Second, a financially distressed parent that is forced into bankruptcy might have an economic incentive-and the ability-to cause its subsidiary to file for bankruptcy protection regardless of the subsidiary’s financial health. Finally, in the event that the distressed parent files for bankruptcy, a bankruptcy court might find it appropriate to substantively consolidate the assets and liabilities of the financially healthy subsidiary with those of its insolvent parent and treat them as if all such assets and liabilities belong to one entity. See In re Bonham, 229 F.3d 750, 764 (9th Cir. 2000). With regard to the last risk factor, substantive consolidation is normally appropriate only if, first, the proponent establishes a substantial identity between the entities by showing, among other things, consolidated financial statements; a unity of interest and ownership between the debtor-entities, parent and intercorporate loans; difficulty in segregating and ascertaining individual assets; commingling of assets; transfers of assets without observance of corporate formalities; and profitability of consolidating at a single physical location. Second, the proponent must show that, in balancing the equities for and against consolidation, the economic prejudice of continued debtor separateness outweighs the economic prejudice of consolidation. See, e.g., Union Savings Bank v. Augie/Restivo Baking Co. Ltd., 860 F.2d 515, 518 (2d Cir. 1988); In re Auto-Train Corp., 810 F.2d 270, 276 (D.C. Cir. 1987). The goal of ring-fencing is to eliminate the three aforementioned risk factors through the implementation of certain protective covenants, structural safeguards and separateness provisions. To alleviate the first risk factor-the parent’s access to the assets and credit of the subsidiary-protective covenants are normally included in the subsidiary’s charter. Such protective covenants will include a prohibition on any declaration of dividends or asset transfers unless certain financial ratios are maintained. These covenants may also set forth requirements that the subsidiary not guarantee or otherwise become obligated for the debts of any other entity, not make loans to any person or entity, not hold indebtedness other than investment-grade securities and not pledge its assets for the benefit of another person or entity. And further risks To address the second risk factor-a parent’s ability to cause its subsidiary to file for bankruptcy-structural safeguards are usually implemented that effectively give the subsidiary and its creditors a voice independent from the directives of the parent. The most common structural safeguard is a provision in the subsidiary’s charter that requires that the subsidiary’s board of directors include one independent director, an individual who is not affiliated with the parent. The charter will provide that an affirmative vote of the independent director is required for the subsidiary to file a voluntary petition for bankruptcy. Moreover, Standard & Poor’s recommends that the charter also provide that the independent director must consider the interests of the creditors of the subsidiary in determining whether to file for bankruptcy protection. A similar structural safeguard that a subsidiary might also implement is the issuance to an independent shareholder of limited voting junior preferred stock, which limits the subsidiary’s right to commence any voluntary bankruptcy without the consent of that shareholder. Finally, to counter the last risk factor-threat of substantive consolidation-separateness provisions are generally included in the subsidiary’s charter to ensure that the subsidiary remains a distinct entity from its parent. These provisions may require, inter alia, that the subsidiary ensure that its capitalization is adequate in light of its business and purpose; maintain an arm’s length relationship with its parent and its other affiliates; pay its liabilities out of its own funds; not become liable for the debts of, or make loans or advances to or acquire the securities of, its parent or its affiliates (other than its own securities); conduct business in its own name; maintain its separate identity; and keep its own funds, accounts, assets, records and books of account. The charter might also provide that the affirmative vote of an independent director is necessary for the subsidiary to engage in transactions with its affiliates. Moreover, the parent might also obtain a nonconsolidation opinion, a common practice in structured finance, which specifically addresses the risk of substantive consolidation in light of the particular separateness provisions that have been implemented. The protections instituted by Portland General Electric Co., referenced above, provide an excellent example of what appears to be a successful implementation of a ring-fencing strategy in the utility sector. Portland General took the following steps to separate itself from Enron and reduce the risk that an Enron bankruptcy would force Portland General to file for bankruptcy protection. First, although Enron owns all of Portland General’s common stock, Portland General, as a separate corporation, owns or leases the assets used in its business, and Portland General’s management, separate from Enron, is responsible for the company’s day-to-day operations. Second, regulatory and contractual protections restrict Enron’s access to Portland General assets. Under Oregon law and the specific conditions imposed on Enron and Portland General by the Oregon Public Utilities Commission in connection with Enron’s acquisition of Portland General in 1997, Enron’s access to Portland General’s cash or assets (through dividends or otherwise) is limited. Under the merger conditions, Portland General cannot make any distribution to Enron that would cause Portland General’s equity capital to fall below 48% of its total capitalization (excluding short-term borrowings) without commission approval. The merger conditions also include notification requirements regarding dividends and retained earnings transfers to Enron. Third, Portland General is required to maintain its own accounting system as well as separate debt and preferred stock ratings. Fourth, Portland General maintains its own cash-management system and finances its operations separately from Enron, on both a short-term and long-term basis. Lastly, Portland General issued to an independent shareholder a single share of a new $1 par value class of limited voting junior preferred stock that limits, subject to certain exceptions, Portland General’s right to commence any voluntary bankruptcy, liquidation, receivership or similar proceedings without the consent of that shareholder. Indianapolis Power & Light Co. (IPL) has also implemented what appears to be a successful ring-fencing strategy in an effort to insulate itself from the negative business developments of its parent, The AES Corp., and protect its credit ratings. IPL’s articles of incorporation provide that its board of directors must at all times include an independent director whose consent is required to take certain actions relating to creditor rights and bankruptcy laws. The articles also include both protective covenants, which provide that IPL cannot make any distribution to AES that would cause IPL’s leverage ratio to exceed 0.67 to 1, and separateness provisions. Moreover, the Indiana Utility Regulatory Commission recently issued an order regarding IPL’s dividend policy. The order, expiring in 2006, stipulates that, in advance of any dividend disbursement, IPL must file a notice with the commission which must include: the amount of the proposed dividend; the amount of dividends distributed over the past 12 months; an income statement for the same period; the most recent balance sheet; IPL’s capitalization as of the close of the preceding month; and a pro-forma capitalization giving the effect of the proposed dividend with sufficient detail to indicate the amount of retained earnings following distribution. On July 16, Fitch Ratings upgraded certain of IPL’s bond ratings based in part on this order as well as IPL’s ring-fencing protections. Energy deregulation has exposed the once stable utility industry to various new risks, which, in turn, have led to lower credit ratings and financial insecurity for many utility companies. This trend is beginning to garner the attention of state and federal regulatory agencies that are searching for a tool to manage and minimize these new risks. Ring-fencing techniques may provide such a tool. As indicated above, these techniques have been effectively employed to insulate utility companies from the financial woes of their affiliates. While ring-fencing is not a panacea for all of the difficulties currently facing the utility industry, it is likely that the uniform implementation of certain ring-fencing standards at a regulatory level will have the effect of reviving investor confidence in this industry and protecting the public’s interest in affordable energy. Gary A. Saunders is counsel to the New York office of Atlanta’s King & Spalding, where he practices in the financial restructuring practice group. Kevin J. Biron, an associate at the firm, assisted with this article.

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