Restructuring

Co-Authored by Debra A. Dandeneau and Victoria Vron
This was the question we analyzed in the below article, which was first published in the New York Law Journal on December 2, 2013.
Why do utilities enjoy greater protections under the Bankruptcy Code than other creditors? Not only do utilities benefit from adequate assurance and setoff provisions in §366, but, in certain circumstances, they also enjoy the safe harbor protections under §556 and administrative expense priority under §503(b)(9). With all the focus recently on how the Bankruptcy Code should be amended, it is surprising that the protections utilities receive, some of which are grounded in anachronistic notions of how utility services work, have not been subject to more scrutiny.

Section 366 of the Bankruptcy Code, as originally enacted in 1978, temporarily enjoined a utility from altering, refusing, or discontinuing services to, or discriminating against, a debtor solely on the basis of commencement of a bankruptcy case or the existence of an unpaid prepetition debt. The injunction was lifted if, within 20 days after the petition date, the debtor did not provide “adequate assurance” of payment to the utility for postpetition service (irrespective of whether adequate assurance was required under state law). Courts sometimes interpreted the adequate assurance requirement to include simply according administrative expense priority for postpetition utility services in cases in which the debtor had a prepetition history of timely payments or expected postpetition cash flows.
The congressional purpose behind §366 was to protect debtors from termination of postpetition service by utilities, while at the same time providing adequate assurances to utilities that debtors would continue paying for such services postpetition. This policy made sense in the 1970s when most utilities were regulated monopolies that provided services without a contract. The ability of a utility to terminate service upon a bankruptcy filing posed a real threat to debtors’ reorganization efforts because alternate providers of utility services were not readily available.
Is this still the case? Corporate debtors typically have access to multiple providers of utility services. Other than potentially water and sewer, what traditional providers of utility services truly remain monopolistic? A competitive market now exists for most utility services. Indeed, what is or should be a “utility” (a term not defined in the Bankruptcy Code) today? With increasing technology, the scope of “utility services” arguably has expanded, with no real attempt being made to limit the notion of what truly is a “utility” within the meaning of §366.
Moreover, corporate debtors often enter into contracts with utility providers. As a result, if utilities with contracts with debtors were treated the same as other contract counterparties, debtors would be protected by the automatic stay from the unilateral postpetition termination of executory contracts. Courts have held, though, that §366 still applies if a utility and a debtor are parties to an executory contract. See, e.g., Sharon Steel v. National Fuel Gas Distribution, 872 F.2d 36, 38 (3d Cir. 1989). Rather than protecting a debtor, §366 puts the onus on the debtor to prevent termination of a utility contract, whether or not the debtor was in default as of the petition date.
Despite the changing nature of utilities and utility services, in 2005, Congress amended the Bankruptcy Code to provide even greater protections to utilities. The 2005 amendments added a new §366(c), which permits utilities to alter, refuse or terminate service to a Chapter 11 debtor if, within 30 days after the petition date, the debtor does not provide the utility adequate assurance of payment that is satisfactory to the utility. Although this provision gave debtors an extra 10 days to provide adequate assurances, the new section arguably made provision of adequate assurances of payment more burdensome for debtors. For example, some courts have interpreted §366(c) to require that a debtor provide whatever assurances a utility determines is satisfactory to it, no matter how unreasonable or absurd, and only thereafter may the debtor seek a court order modifying this amount. See, e.g., In re Lucre, 333 B.R. 151, 154 (Bankr. W.D. Mich. 2005). But see Long Island Lighting v. Great Atl. & Pac. Tea (In re Great Atl. & Pac. Tea), 2011 U.S. Dist. LEXIS 131621, *13-16, No. 11-CV-1338 (CS) (S.D.N.Y. Nov. 14, 2011) (siding with majority of courts that allow the adequate assurance amount to be determined before a debtor has to provide adequate assurances on the ground that doing otherwise would be unworkable and would lead to absurd results). Even those courts that interpret §366(c) to allow a court to determine the amount of adequate assurances before they are provided, however, hold that such determination must occur before the 30-day temporary injunction expires. See, e.g., In re Beach House Prop., 2008 Bankr. LEXIS 1091, *4, No. 08-11761 (BKC) (Bankr. S.D. Fla. April 8, 2008). Local Rule 9013-1 of the Bankruptcy Court for the Southern District of Florida now requires that debtors make a good faith effort to reach an agreement with utilities as to adequate assurances prior to filing a motion seeking a court determination that the debtor’s adequate assurance provisions are satisfactory (which motion must be heard within the 30-day temporary injunction period).
Section 366(c)(3)(B) also expressly forbids courts from taking into consideration the absence of a security deposit before the petition date, the debtor’s timely payment for services prior to the petition date, or the availability of an administrative expense priority when determining what constitutes adequate assurance.
The result of the new §366(c)(1)-(3) is that debtors now have to lay out more cash in the crucial first month of their Chapter 11 cases and expend more resources during that time negotiating with utilities. For energy-dependent debtors or debtors with many locations, this can be onerous.
New §366(c)(4) provides that, without notice or order of the court, a utility may recover prepetition amounts owed to it by setting off any prepetition security deposit it may hold from the debtor. With the exception of counterparties to certain derivative contracts, the Bankruptcy Code does not afford any other creditors a similar right and instead requires other creditors to seek relief from the automatic stay to offset mutual obligations.
Because of the changing nature of the delivery of energy, the benefits to “utilities” did not stop with the changes to §366. Increasingly, energy-dependent debtors contract with energy suppliers to provide for the physical delivery of energy through the use of forward contracts. The 2005 amendments effected significant changes to provisions relating to derivative contracts, including forward contracts, to allow the markets to continue to function efficiently notwithstanding a debtor’s bankruptcy filing. Among other things, §556 was revised to allow the non-debtor counterparty to terminate a forward contract by reason of commencement of a case under the Bankruptcy Code or a debtor’s financial condition. Debtors have not succeeded in convincing courts that contracts providing for the physical delivery of energy should be outside the scope of a “forward contract” subject to §556. See, e.g., MBS Mgmt. Serv. v. MXEnergy Elect., 690 F.3d 352, 357 (5th Cir. 2012) (electricity requirements contract was a forward contract); Hutson v. E.I. du Pont de Nemours (In re Nat’l Gas Distribs.), 556 F.3d 247, 258 (4th Cir. 2009) (a forward contract may provide for actual physical delivery of a commodity, such as gas). When combined with §366, §556 gives utilities with forward supply contracts the option of determining whether they want to terminate (and potentially negotiate an entirely new arrangement) or push for additional security. It is hard to understand, though, what public policy supports such a favorable treatment of utilities or what “market disruption” would occur if forward contract merchants under contracts for physical delivery of energy were prevented from terminating such contracts as a result of the mere fact of the occurrence of the debtor’s bankruptcy filing.
Utilities also have attempted to use new §503(b)(9), which provides an administrative expense priority for the value of any “goods” received by the debtor within 20 days prior to the petition date that were sold to the debtor in the ordinary course of business, to improve their position. Although §503(b)(9) ostensibly was intended to provide relief to trade vendors that failed to give an effective notice of reclamation, utilities have seized upon §503(b)(9) to argue that electricity and natural gas are “goods” for purposes of §503(b)(9). See, e.g., In re NE OPCO, 2013 Bankr. LEXIS 4569, *64-66, No. 13-11483 (CSS) (Bankr. D. Del. Nov. 1, 2013) (holding that gas is, but electricity is not, a good for purposes of §503(b)(9)); Hudson Energy Servs. v. Great Atl. & Pac. Tea (In re Great Atl. & Pac. Tea), 2013 U.S. Dist. LEXIS 132775, *35-36, No. 12-CV-7629 (CS) (S.D.N.Y. Sept. 16, 2013) (remanding for further evidentiary proceedings to determine whether electricity supplied was a “good”); GFI Wis. v. Reedsburg Util. Comm’n, 440 B.R. 791, 798-99 (W.D. Wis. 2010) (holding that electricity is a “good” for purposes of §503(b)(9), but acknowledging that courts differ on this issue); In re Pilgrim’s Pride, 421 B.R. 231, 240-42 (Bankr. N.D. Tex. 2009) (extending administrative expense priority under §503(b)(9) to suppliers of water and gas).
Now that eight years have passed since the 2005 amendments, it is time to reflect on the revised §366 and ask the following questions: (1) Is the temporary injunction in §366(a) still necessary, (2) are the protections for utilities in §366 still necessary and are they fair, and (3) should utilities have the additional protections provided by §§556 and 503(b)(9)?
Is the temporary injunction in §366(a) still necessary? Whether §366(a) is still necessary may depend upon whether the utility service is being provided to a debtor pursuant to an executory contract. If yes, then §362’s automatic stay and §365(e)’s prohibition on enforcement of ipso facto clauses should protect debtors from utilities’ unilateral termination or modification of services postpetition, making §366(a)’s temporary injunction unnecessary. (This would also resolve an open issue in the case law as to whether a utility that is providing a commodity to a debtor for resale to end users pursuant to an executory contract is a “utility” for purpose of §366.)
In the case of debtors who are not parties to executory contracts with utilities, the answer likely is yes. These debtors are typically end-users of utility services, which in most instances are essential to the operations of their businesses. Even though alternate providers may now exist, a debtor’s business could still be significantly disrupted if it had to change utility providers in the first month of the case, especially if a debtor has multiple locations and multiple utility providers.
Are the protections for utilities in §366 necessary and fair? In light of the above, are the protections for utilities in §366 necessary and fair? On the one hand, shouldn’t utilities be protected if they are “forced” to provide services to a debtor and face the potential risk that the debtor will be administratively insolvent? On the other hand, why treat utilities differently than other contract counterparties? Contract counterparties also have to provide goods and services to debtors postpetition notwithstanding the typical ipso facto provisions in their contracts, and yet they receive no adequate assurances other than administrative expense priority for their postpetition claims and take the risk that a debtor will be administratively insolvent. Fairness considerations tip the scale towards treating utilities just like any other trade creditor. Just because utilities historically have not provided services pursuant to contracts should not make them any different than other trade creditors.
Thus, §366(b)-(c) should be repealed altogether, and the injunction in §366(a) should be extended for the duration of the case and limited only to utilities without contracts. Utilities still would have the ability to claim administrative expense priority for postpetition services, consistent with other trade creditors. Utilities, however, should be allowed to seek relief from the §366(a) injunction for cause, similar to contract counterparties who have the right, pursuant to §362(d), to seek relief from the automatic stay for cause to compel a debtor to assume or reject, or to terminate, their contracts. Cause may include, for example, the debtor not paying its postpetition bills or being administratively insolvent. This approach would sufficiently protect a utility from an unreasonable risk of nonpayment while being fair to other creditors and without unduly impeding the debtor’s reorganization efforts.
At the very least, §366(c) should be repealed. The adequate assurance requirements pre-2005 amendments were more than sufficient to protect utilities. The pre-2005 §366 provided a more objective standard for determining what is an adequate assurance of payment in a particular case. As courts have stated, Congress never intended adequate assurance of payment to be a guaranty of payment, but protection from any unreasonable risk of non-payment for postpetition services. See, e.g., Steinebach v. Tucson Elec. Power (In re Steinebach), 303 B.R. 634, 642 (Bankr. D. Ariz. 2003). Return to the pre-2005 adequate assurance standard would give courts back the discretion to determine whether any adequate assurances beyond an administrative expense priority are necessary in a given situation, while protecting those utilities that are truly at risk of nonpayment for their postpetition services.
Should utilities receive the benefits of §§556 and 503(b)(9)? Finally, Congress should examine whether it is appropriate for utilities to benefit from the favorable treatment of forward contracts when the debtor has contracted with the utility for physical delivery of a commodity as part of its day-to-day business operations. Allowing a utility to terminate a contract because it is structured as a forward contract runs directly contrary to the original purpose of §366—to protect a debtor from interruption in utility services. Moreover, should utilities continue to receive the benefits of §503(b)(9)’s administrative expense priority? Courts have been divided on this issue and have fallen back on the vagaries of state law under the Uniform Commercial Code to address the issue. When §503(b)(9) was enacted, it generally was recognized as a provision that was enacted to protect creditors from the possibility that debtors would stockpile goods prior to a Chapter 11 filing and then leave the vendor with a prepetition claim for payment of such goods. By its nature, electricity and gas are generally used and consumed by a debtor, and the typical debtor does not have the ability to hoard electricity or gas in the days leading up to its Chapter 11 filing. Congress needs to address the scope of §503(b)(9) and should make it clear that utilities do not have yet another arrow in their bankruptcy quiver by creating a federal definition of “good” that does not include energy.
Debra A. Dandeneau is a partner and Victoria Vron is a senior associate in the business finance and restructuring department at Weil, Gotshal & Manges.
Reprinted with permission from the December 2, 2013 edition of the New York Law Journal © 2013 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.