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Acquiring Bankrupt Energy Assets Clear of Compliance Obligations

By Ken W. Irvin and David E. Kronenberg
Sidley Austin, LLP

In one of the first decisions of its kind, the Bankruptcy Court for the District of Delaware held in In re La Paloma Generating Company, LLC that a power plant can be sold under Section 363 of the bankruptcy code free and clear of the debtor’s pre-sale obligations under California’s cap-and-trade program.

Although the decision, which is the subject of an ongoing appeal, is based on the particular language of the applicable California cap-and-trade regulations, it has laid the groundwork for further challenges to other market-based environmental programs, which, as demonstrated by the recently filed case of In re Philadelphia Energy Solutions, have already begun in earnest.

Background

La Paloma Generating Company, LLC, the owner of a natural gas-fired electricity generation facility in McKittrick, California, in December 2016 filed for bankruptcy protection in the Delaware backruptcy court. La Paloma attributed the filing to several factors, including substantial debt service, a challenging regulatory environment, and most notably, “mounting compliance obligations under California’s ‘cap and trade’ scheme.”

The cap-and-trade scheme to which La Paloma referred is a greenhouse gas emissions reduction program instituted by the California Air Resources Board (CARB) and authorized under the California Global Warming Solutions Act of 2006.  Under the program, the rules of which are set forth in the Regulation for the California Cap on Greenhouse Gas Emissions Market-Based Compliance Mechanisms, La Paloma was required to surrender to CARB a “compliance instrument” for each metric ton of carbon dioxide equivalent (CO2e) that the facility emitted.

The compliance instruments can be purchased at auction from CARB or purchased bilaterally from other parties and maintained in a holding account. When it comes time to surrender the applicable compliance instruments, they must be transferred from the holding account to a compliance account, where they are extinguished by CARB in satisfaction of the compliance obligations due at such time.

The program operates on three-year cycles. In each of the first two years, compliance instruments covering 30% of the prior year’s emissions must be surrendered by November 1 of the following year.  Then, on November 1 of the year following the end of the three-year compliance period, compliance instruments covering all remaining emissions for the cycle must be surrendered.

La Paloma filed for bankruptcy protection toward the end of the 2015-2017 compliance period.  On November 1, 2017, two days after La Paloma’s chapter 11 plan was confirmed, La Paloma was required to surrender to CARB approximately $7 million in compliance instruments equaling 30% of the facility’s emissions in 2016. La Paloma estimated during its bankruptcy case that it would be obligated to surrender another $63 million in compliance instruments by November 1, 2018 in order to cover its remaining obligations for the 2015-2017 period (70% for 2015, 70% for 2016 and 100% for 2017).

The La Paloma Generating Facility in Kern County, California. Courtesy: LPGF
The La Paloma Generating Facility in Kern County, California. Courtesy: LPGF

La Paloma’s principal strategy for the case was to auction the facility to the highest bidder, but the $63 million obligation that would be due in 2018 hung like a black cloud over the sales process. La Paloma received just two expressions of interest from third parties to purchase the facility—one for $25 million and another for $75 million—and each was conditioned upon a determination by the bankruptcy Court that the purchaser would not be liable for the $63 million obligation. CARB, not surprisingly, took the position that any buyer would be on the hook for the full $63 million obligation, plus have ongoing liability for future compliance periods.

Due to insufficient interest from third parties, La Paloma ultimately agreed to sell the facility to LNV Corp.—La Paloma’s senior pre-petition lender—in exchange for a $150 million credit bid of LNV’s pre-petition debt. In conjunction, La Paloma, LNV, and CARB entered into a stipulation whereby CARB and LNV agreed to submit the $63 million successor liability issue to the bankruptcy court for resolution, in connection with the confirmation of La Paloma’s chapter 11 plan and the closing of the facility acquisition.

LNV indicated that it would close on its purchase regardless of the outcome of the dispute with CARB, but said it needed to resolve the dispute and “know the extent of its successor liability (if any) prior to acquiring the Facility in order to make intelligent business decisions concerning the acquisition of the Facility.”

LNV and CARB’s Litigation Arguments

The litigation between LNV and CARB focused on Bankruptcy Code § 363(f), which permits a sale of property free and clear of any “interest” in the property if, among other things, applicable non-bankruptcy law permits a sale of such property free and clear of the applicable interest.

LNV, in its opening brief, argued that the emissions obligations were “interests” and that California law, which was the “applicable non-bankruptcy law” in the case, permitted a sale of the Facility free and clear of the emissions obligations.

LNV noted that under California law, the purchaser of an asset generally does not assume the seller’s liabilities with respect to such asset, and that “[a]bsent a specific statutory requirement, successor liability arises only where ‘(1) there is an express or implied assumption of liability; (2) the transaction amounts to a consolidation or merger of the two corporations; (3) the purchasing corporation is a mere continuation of the sellers; or (4) the transfer of assets to the purchaser is for the fraudulent purpose of escaping liability for the seller’s debts.’”

LNV argued that because none of these exceptions applied and because the Regulation does not expressly impose successor liability on purchasers, LNV could not be held liable for La Paloma’s prior emissions obligations.

In support of this conclusion, LNV noted that the Regulation only imposes liability on an entity-specific basis rather than on an asset-specific basis.  In particular, the Regulation only imposes obligations on a “Covered Entity” for “its emissions”. In order to become a Covered Entity, a party must engage in certain enumerated activities, such as owning and operating an electricity generation facility, and operating such a facility in a manner that exceeds the applicable annual emission threshold, which is 25,000 metric tons of CO2e per year.

In LNV’s view, La Paloma was a Covered Entity, but LNV would not become a Covered Entity until some point after the closing of the acquisition.  Because a Covered Entity is only required to surrender instruments with respect to “its emissions,” LNV would only be liable for its emissions once it became a Covered Entity and thus would not be responsible for La Paloma’s prior emissions.  LNV emphasized that “there is simply no provision of the Regulation that obligates a purchaser of an Electricity Generation Facility in California to surrender compliance instruments for a different Covered Entity, even a predecessor owner of the facility at which the emissions are produced.”

In a shot at CARB for failing to properly address the issue of successor liability in its Regulation, LNV argued that “[h]ad CARB wanted to impose successor liability, it could have used plain language to achieve that purpose.  It did not.  It cannot rewrite its regulations in these Chapter 11 Cases.”

In CARB’s opening brief in the litigation, it argued that the Regulation did in fact address successor liability and prevented La Paloma from transferring the Facility to LNV free and clear of its obligation to surrender compliance instruments for emissions generated during the pre-transfer period. In support of this position, it noted that Section 95835(b)(8) of the Regulation provides that:

“… [i]t is the responsibility of the parties participating in the change of ownership to transfer any compliance instruments from tracking system holding accounts that they control prior to closure.  Prior to closure, the Executive Officer may transfer compliance instruments from an entity’s compliance account to its holding account upon request by the entity.  If a covered entity no longer owns or operates any active facility in its tracking account due to a change of facility ownership, then that covered entity may exit the Program and close its tracking system accounts within five business days after the facility or facilities are transferred in the tracking system of the purchasing entity.”

CARB noted that this section of the Regulation allows a Covered Entity to exit the Program within five days after it has transferred ownership of the relevant facility to another party, even though the transferor may have generated compliance obligations requiring the surrender of emissions instruments after it exits the Program.  CARB indicated that the “necessary implication . . . is that the purchasing entity is responsible for the compliance obligation after the change of ownership, even with respect to emissions generated before the change in ownership.”   As support for this conclusion, CARB referenced its Change of Ownership or Operational Control Guidance (the “Guidance”), which was issued in 2014 and indicated that CARB will assign “the current and future compliance obligation of the covered or opt-in facility to the new owner’s account . . .”

CARB argued that its interpretation of its own regulations, including the Regulation, was entitled to substantial deference and that its interpretation was the only reasonable one.   According to CARB, LNV’s interpretation would mean that any Covered Entity responsible for outstanding compliance obligations could simply change ownership and neither it nor the purchaser would be responsible for the obligations.  In CARB’s view, such an interpretation would “render CARB’s Cap-and-Trade Program unworkable.”

In its reply, LNV argued that CARB’s reliance on Section 95835(b)(8) of the Regulation was misplaced.  It noted that Section 95835(b)(8), which had been enacted on a special expedited basis on October 1, 2017, days before the opening briefs were filed in the case, only delineated the procedures for transitioning accounts between a seller and a purchaser.  In LNV’s view, this section did not expressly provide for successor liability and that CARB tacitly acknowledged as much when it stated in its brief that the “implication” of the section was that a purchaser would be responsible for the seller’s emissions obligations.   LNV also argued that the Guidance should be disregarded given that it had no force of law, as CARB freely admitted.  LNV acknowledged that CARB was entitled to deference in its interpretation of the Regulation, but that it was “not entitled to rewrite it or ignore its plain meaning.”

LNV also countered CARB’s assertion that if CARB’s interpretation were not adopted, the Program would become unworkable because Covered Entities would game the system and free themselves of liability by transferring assets away.  LNV argued that such fears were overblown because closing a Covered Entity’s account does not absolve it of obligations that are due to be satisfied in the future.  According to LNV, Section 95853(a) provides that a Covered Entity remains a Covered Entity for at least one full compliance period after it ceases to generate emissions.

Based on this, LNV reasoned that in a typical arms-length sale, a seller likely would insist that its emissions obligations transfer with the assets being sold and become the responsibility of the purchaser.  The parties would then adjust the purchase price accordingly.

LNV argued that the risk to CARB only arises in the bankruptcy context, where a bankrupt debtor can sell its assets free and clear of its liabilities.  Although left unsaid by LNV, a bankrupt debtor is also, presumably, less likely to insist that its liabilities transfer to a purchaser if such liabilities can be discharged in the bankruptcy proceeding, an issue that, as detailed below, CARB appears to have attempted to address in a curious manner.

On June 5, 2017, CARB filed a proof of claim in La Paloma’s bankruptcy case asserting that it was entitled to receive compliance instruments covering La Paloma’s remaining emissions obligations during the 2015-2017 compliance cycle when the respective obligations come due on November 1, 2017 and November 1, 2018.  CARB stated that it filed the claim “in a protective fashion with respect to such obligations and requirements should the Debtor, or any other party, contend that such obligations are claims under section 101(5)(A) of the Bankruptcy Code and there is a final court order upholding that position.”   However, in the Stipulation among it, La Paloma and LNV, in which the parties agreed to litigate the successor liability issue, CARB also agreed that La Paloma’s emissions obligations were “not a ‘claim’ under 11 U.S.C. § 101(5) and do not constitute debts that can be discharged pursuant to section 1141(d) of the Bankruptcy Code.”   Accordingly, CARB agreed to withdraw its proof of claim against La Paloma with respect to such obligations.

CARB, in its reply to LNV’s opening brief, explained its position by stating that the parties “have stipulated that the obligation to surrender compliance instruments is not a claim . . . – it is a provision of state law that limits . . . emissions by requiring entities to surrender compliance instruments for such emissions.”   CARB sought to leverage this argument by then stating that, Section 363(f), which allows a purchaser to acquire a debtor’s assets free and clear of any “interests” in the assets, was inapplicable because just as emissions obligations are not “claims,” they are also not “interests” given that “no court has held that the obligation to comply with state environmental laws transforms into an interest any time such laws regulate specific property.”

CARB further argued that an adverse ruling would incentivize other Covered Entities “to sell facilities before the next Full Compliance Period Surrender Event on November 1, 2018” and that CARB wouldn’t be able to counter this through a rule change given that “CARB’s rulemaking process is subject to the California Administrative Procedure Act and can take at least a year for a rule amendment to become effective.”

The Bankruptcy Court’s Decision

On November 9, 2017, the Bankruptcy Court issued its decision (the “Decision”), in which it acknowledged that it was required to defer to CARB’s interpretation of the Regulation, but only if such interpretation was not contradicted by the clear language of the relevant provision of the Regulation.

The Bankruptcy Court found that the Regulation was clear and only imposed the obligation to surrender compliance instruments on a Covered Entity on account of “its emissions”.  The Bankruptcy Court agreed with LNV’s position that LNV would only become a Covered Entity when it acquired the facility in the upcoming sale and operated the facility in a manner that exceeded the applicable emissions threshold, which would not occur until some point after closing.  As to Section 95835(b)(8) of the Regulation, which permits a Covered Entity to exit the Program within five business day after a facility is transferred to a purchaser even though compliance instruments for past emissions do not need to be surrendered until later, the Bankruptcy Court found that this section did not necessarily imply that the acquirer of the facility would take over the requirements of the former-Covered Entity, as asserted by CARB.

In response to CARB’s argument that its interpretation of Section 95835(b)(8) was reasonable and that the Bankruptcy Court must defer to CARB’s interpretation, the Bankruptcy Court clarified that it is only required to defer to CARB if the Regulation contains an “unresolved ambiguity”.  The Bankruptcy Court, however, found that no such ambiguity existed with regard to the issue of successor liability.  It found that CARB “ignore[d] the provisions of the Regulation that explicitly set forth and limit the surrender obligations [to an entity’s own emissions], and instead relie[d] on reporting provisions and provisions that are specifically made subject to the surrender obligation provisions it ignore[d].”

With regard to whether obligations to surrender compliance instruments constitute interests for the purposes of Section 363(f) of the Bankruptcy Code, the Bankruptcy Court found, with little discussion, that they do and that neither the Regulation nor Section 363(f) of the Bankruptcy Code imposes successor liability on LNV.

The Appeals Process

On November 20, 2017, CARB appealed the Decision to the U.S. District Court for the District of Delaware (the “District Court”).   The next day, it also filed a motion in the bankruptcy case for a stay of the Decision pending its appeal.  It requested that for the duration of the appeal, LNV be required to comply with the Regulation as “though no transfer took place”.   It argued that this would not interfere with or delay the effectiveness or consummation of La Paloma’s chapter 11 plan or LNV’s expectations as purchaser of the Facility because LNV agreed, prior to plan confirmation, that it would acquire the facility regardless of the outcome of its dispute with CARB.

In the Third Circuit, courts consider the following factors in determining whether a stay pending appeal should be granted:

  • Whether the stay applicant has made a strong showing that it is likely to succeed on the merits;
  • Whether the stay applicant will be irreparably injured if a stay isn’t issued;
  • Whether the stay would substantially injure other parties in the proceeding; and
  • Where the public interest lies.

CARB noted that precedent in the Third Circuit indicated, with respect to the first prong, that the stay applicant merely has to demonstrate a reasonable chance of success and that “the likelihood of winning on appeal need not be more likely than not . . .”   CARB argued that its interpretation of the Regulation was reasonable because it was consistent with the Act, which directed that a regulation be adopted that reduces the aggregate amount of emissions each year through a market-based system.  CARB argued that LNV, in fact, put forward an “absurd interpretation” as it would permit “emissions in excess of annual aggregate limits so long as the source of such excess emissions is transferred to an entity that is liquidating in the final year of a full compliance period.”

As to the second and third prongs in the stay analysis, CARB argued that if the Decision is not stayed, LNV would not surrender the applicable compliance instruments and that CO2e emissions will go accounted for in the Program, which would affect California’s ability to reduce C02e emissions.  CARB also argued that such an outcome would distort the price for compliance instruments and thus undermine the program, potentially for years to come.  In contrast, other parties in the proceeding would not be negatively affected by a stay, in CARB’s view, because the stay would not affect the chapter 11 plan or distributions to creditors.  Lastly, with respect to the public interest, CARB argued that the public has an interest in maintaining the integrity of the Program and reducing C02e emissions.

On November 28, 2017, LNV objected to CARB’s motion for a stay pending appeal.  LNV argued that it would be improper to stay the Decision without also staying the chapter 11 plan and the closing of the sale, which was now final with respect to CARB. LNV reasoned that under Section 363(m) of the Bankruptcy Code, “CARB cannot consent to the closing of the Sale while simultaneously attacking a material economic aspect of that Sale.” Further, it argued that CARB had not shown a meaningful chance of success on the merits and that the potential harm to LNV from a stay, which would require it to submit $63 million in compliance instruments in 2018, would outweigh any potential harm to CARB or the public interest.

On January 9, 2018, at a hearing in the Bankruptcy Court on CARB’s motion for a stay pending appeal, the Bankruptcy Court noted that in the Third Circuit, the primary issues to be examined in determining whether a stay pending appeal should be issued are the likelihood of success on the merits and irreparable harm.   The Bankruptcy Court found that CARB failed to demonstrate a likelihood of success on the merits based on the plain language of the Regulation.   Further, on the issue or irreparable harm, the Bankruptcy Court found that LNV would be subject to irreparable harm if the stay was issued because it would have to pay $63 million to submit the compliance instruments by November 1, 2018, without an ability to get a refund if CARB’s appeal is ultimately unsuccessful.  Based on this, the Bankruptcy Court issued an order denying CARB’s motion for a stay pending appeal.

In the wake of this ruling, on January 19, 2018, LNV filed a motion in the District Court to dismiss CARB’s appeal as moot under Section 363(m) of the Bankruptcy Code, given that CARB was attempting to affect the validity of the Facility sale and was prohibited from doing so without a stay of the relevant orders.  On January 30, 2018, CARB opposed the motion to dismiss and reiterated that a reversal of the Decision would simply require LNV to pay for the requisite amount of compliance instruments and would not, in any way, undo the validity of the Facility sale, which LNV agreed to close regardless of the outcome of the CARB dispute.  As of this writing, the motion to dismiss is pending in the District Court.

The Effect of the La Paloma Litigation and Philadelphia Energy Solutions

The outcome of the La Paloma litigation has undoubtedly been dire for CARB.  Not only is its opportunity to force LNV’s compliance with pre-sale obligations now vanishingly slim, but it has also stridently taken the position that a Covered Entity’s obligation to surrender compliance instruments to CARB does not give rise to a “claim,” as that term is defined under the Bankruptcy Code.  Perhaps CARB believes that this representation ensures that such obligations cannot be discharged in a bankruptcy proceeding, but it is just as likely that other debtors will exploit this representation in an attempt to free themselves of such obligations in the future.

The La Paloma litigation also appears to have inspired similar litigation under the Clean Air Act, which, to CARB’s credit, it predicted could be a consequence of an adverse ruling in La Paloma.

On January 21, 2018, Philadelphia Energy Solutions (“PES”) filed for bankruptcy protection in the same court as La Paloma, citing, as the direct cause of its travails, “unpredictable, escalating, and unintended compliance burden[s]” under the Clean Air Act’s renewable fuel standard program.   This program requires oil refiners, such as PES, to blend a certain quantity of biofuels into the fuels they produce and sell in the U.S., or purchase compliance credits called Renewable Identification Numbers (“RINs”) if they are unable to do so.  PES asserted that its ability to blend biofuels is restricted due to its position in the fuel distribution system, forcing it to purchase $832 million in compliance credits in the last 5 years to remain in compliance with the Clean Air Act.

Seeking to replicate the result in La Paloma, PES has filed a pre-packaged chapter 11 plan in the Bankruptcy Court, pursuant to which it seeks to transfer its refinery business to a parent entity and its lenders free and clear of PES’s obligations under federal renewable fuel standards, which are satisfied by minting or purchasing RINs under the Clean Air Act.  Although the case is in its infancy, the U.S. government has already previewed its lines of attack. A representative of the U.S. Department of Justice’s Environmental and Natural Resources Division indicated, at PES’ first-day hearing in the case, that the U.S. government would be examining whether it was legal and appropriate for PES’s plan to fail to provide for even minimal compliance with the RINs obligations, whether the proposed sale free and clear of the RINs obligations qualifies as a “true sale” or a “disguised organization,” and whether the plan’s discharge provisions rendered it unconfirmable.  Also, recently the Environmental Protection Agency and the U.S. Department of Justice agreed to forbear from an enforcement action relating to PES’ RINs until May 1, 2018, and in exchange PES moved its plan confirmation hearing from February 23 to March 26, which will allow the parties more time to evaluate the RIN issue.

It remains to be seen whether PES will be successful and if the Clean Air Act will be interpreted by the Bankruptcy Court in a manner similar to the Regulation, but it goes without saying that a pattern is starting to emerge and that other energy companies may follow the path forged by La Paloma and PES.

If La Paloma and PES are able to transfer substantially all estate assets via a bankruptcy sale free and clear, it will mark a substantial threat to all carbon and environmental compliance programs, which depend on certificated compliance offsetting, discharge or blending requirements. Recognizing this threat and its declining fortunes in the litigation, CARB recently announced that a public hearing will be held in California on March 22, 2018 to consider a proposed amendment to the Regulation clarifying that the Regulation “requires a successor entity after a change in ownership to be responsible for the outstanding, pre-transfer compliance obligation of the predecessor covered entity.”  As the La Paloma and PES cases progress and gain more notoriety, other regulators and legislatures will no doubt take similar actions in an effort to protect their respective market-based environmental programs from adverse bankruptcy rulings in the future.

—Ken W. Irvin is a partner at Sidley Austin LLP, and co-chair of the Energy Practice. He specializes in energy, mergers and acquisitions (M&A), and securities and derivatives enforcement and regulatory. David E. Kronenberg is a counsel in the Energy group, specializing in corporate reorganization and bankruptcy, energy, and M&A.