U.S. Bankruptcy Judge Dennis Montali recently ruled in the Chapter 11 case of Pacific Gas & Electric (“PG&E”) that the Federal Energy Regulatory Commission (“FERC”) has no jurisdiction to interfere with the ability of a bankrupt power utility company to reject power purchase agreements (“PPAs”). Although this question has divided courts which have considered it, Judge Montali made clear that he would not allow FERC to limit either PG&E’s rights under the U.S. Bankruptcy Code, or his own power to oversee PG&E’s bankruptcy case. (Kelley Drye & Warren LLP represents certain creditors in the PG&E case but took no part in the issues discussed here.)

The U.S. Bankruptcy Code provides an enterprise that is seeking to reorganize under chapter 11 with a number of tools to rehabilitate its business prospects. One of the most important is the ability, under Section 365, to reject burdensome executory contracts. An executory contract is generally considered to be any contract of the debtor for which there are material obligations to be performed by both parties. In considering a debtor’s request to reject a contract, courts typically defer to the debtor’s “reasonable business judgment” as to whether rejection would be in the best interest of its creditors and its bankruptcy estate — a very low standard to meet. The rejection of such a contract frees the debtor from any ongoing obligations under the contract, and is deemed to be a breach of such contract as of immediately prior to the filing of the bankruptcy petition. The non-debtor party to the contract is afforded a claim for damages arising from the breach, which is treated in the bankruptcy case as a general unsecured claim.

In the bankruptcy cases of power utility companies such as PG&E, the question of whether the debtor can reject its PPAs has become a crucial issue. PPAs are unquestionably executory in nature. Due to the volatile nature of power pricing, such agreements can often be significantly burdensome for the debtor. It would therefore appear that PPAs can readily be rejected by utility companies in bankruptcy.

Nevertheless, there is a significant split among courts on this issue. Some courts have determined that power utility companies do not have the unfettered ability to reject PPAs, under the rationale that, because the purchase and sale of energy for distribution to consumers “is affected with a public interest,” the Federal Power Act (“FPA”) requires the approval of FERC before a PPA can be terminated in a bankruptcy proceeding.

The dispute in the PG&E case arose last January when PG&E disclosed that it intended to file for protection under Chapter 11 of the Bankruptcy Code due to its potential massive liabilities for wildfire damage claims in California. PG&E is party to numerous PPAs for electricity generated by alternative sources such as solar and wind. The price for such energy sources has dropped considerably in the last few years. Two of PG&E’s power suppliers, anticipating that PG&E could want to extricate itself from having to pay above-market rates, petitioned FERC to rule that PG&E could only reject PPAs with FERC’s consent. In response, FERC issued a decision stating that it had “concurrent jurisdiction” with the bankruptcy court “to review and address the disposition of [PPAs] sought to be rejected through bankruptcy.” PG&E, immediately after filing its Chapter 11 petition, commenced an adversary proceeding in the bankruptcy case, seeking a declaratory judgment that the bankruptcy court has exclusive jurisdiction over this question.

Judge Montali noted the “unsettled” law regarding the rejection of PPAs in bankruptcy. Some courts have looked at the “filed rate doctrine,” which is FERC’s mandate under the FPA to certify contract rates for electricity as “just and reasonable,” and have determined that FERC has authority over PPAs in bankruptcy. In the chapter 11 case of NRG Energy, for example, a district court judge in New York ruled that FERC retained its regulatory authority over the debtor’s PPAs notwithstanding the bankruptcy filing, and that the FPA required deference to FERC. A few years later, in the chapter 11 case of Calpine Corp., another New York district court judge concluded that Congress had granted FERC substantial authority over energy contracts and found no evidence that it intended for the Bankruptcy Code to supersede such authority.

Judge Montali, however, dismissed the argument that FERC’s authority with respect to energy contract prices provided it with jurisdiction over the rejection of such contracts in a chapter 11 case. His starting point in the jurisdictional analysis was Section 1334(a) of the U.S. Judicial Code, which provides federal district courts (and by extension bankruptcy courts) with “exclusive” jurisdiction over all bankruptcy cases.

He observed that “[n]othing in the FPA or the Bankruptcy Code grants FERC concurrent jurisdiction with this court over Section 365 motions to reject executory contracts covering federal power matters. The issue here is Section 365 and not any of the permutations and applications of the filed rate doctrine.” He held that the matter before him did not arise under the FPA and he was not reviewing any decision by FERC regarding energy prices; instead he was considering only whether PG&E, a debtor in a Chapter 11 case, could exercise a statutory right to reject, i.e., effectively breach, a contract. He therefore determined that “[t]he rejection of an executory contract is solely within the power of the bankruptcy court, a core matter exclusively this court’s responsibility.”

Judge Montali agreed with the reasoning of the Fifth Circuit, the only circuit Court of Appeals that has considered the issue. In the case of Mirant Corp., the Fifth Circuit found no conflict between the FPA and Bankruptcy Code. The court determined that FERC’s authority under the FPA deals only with energy prices, and that a bankruptcy court’s decision to permit rejection of a PPA therefore does not interfere with such authority. Judge Montali also cited a recent decision in the FirstEnergy chapter 11 case in Ohio, which followed the Fifth Circuit in ruling that there is no inherent conflict between FERC’s jurisdiction under the FPA and the authority of a bankruptcy court to permit the rejection of a PPA under the Bankruptcy Code.

Judge Montali viewed FERC’s assertion of “concurrent jurisdiction” over PPAs as an improper encroachment by an executive branch agency on the authority of United States bankruptcy courts. He concluded, “Section 365(a) and 28 U.S.C. § 1334, taken together, clearly lead to the inescapable conclusion that only the bankruptcy court can decide whether a motion to reject should be granted or denied, and under what standards.”

The ruling is heading to the Ninth Circuit following Judge Montali’s certification for a direct appeal. With the Sixth Circuit also now considering the FirstEnergy decision on appeal, it appears likely that this issue will be before the Supreme Court in the near future.