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Bankruptcy Court Authorizes Sale of Power Plant Without Environmental Cap-and-Trade Obligations

The Delaware Bankruptcy Court recently authorized the sale of La Paloma’s electricity-generating assets “free and clear” of any obligations to surrender compliance certificates under California’s Cap-and-Trade Program. The ruling confirms the viability of Bankruptcy Code section 363 sales as a mechanism to release energy-related assets from certain ongoing environmental obligations.

At issue in the La Paloma case is the scope of Bankruptcy Code section 363(f)(1), which allows a debtor in bankruptcy to sell property “free and clear of any such interests in such property” if permitted under applicable non-bankruptcy law. So-called “363 sales” have become a very popular tool for buyers to acquire assets out of bankruptcy cleansed of unwanted liabilities in a relatively streamlined and expeditious process. At the height of the financial crisis, Chrysler, General Motors, and Lehman Brothers were just some of the big-name companies to utilize section 363(f) to facilitate quick sales in order to preserve value and shed unwanted liabilities.

But what constitutes an “interest in such property,” and whether non-bankruptcy law (typically, state law) allows for a “free and clear” sale, is still litigated with some regularity in bankruptcy cases. In the case of La Paloma, the bankruptcy court found that section 363 permitted a buyer to acquire the company’s principal asset—a natural-gas-fired-electric-generation facility—free and clear of La Paloma’s obligation to surrender compliance instruments for greenhouse gas emissions under the California Cap-and-Trade Program.

In 2006, the California legislature gave the California Air Resources Board (or “CARB”) authority to create a cap-and-trade program for the emission of greenhouse gases in California. CARB, in turn, enacted regulations that limited the number of “compliance instruments” available per year, a number that is reduced annually. The Compliance Instruments were freely tradable among “Covered Entities” (like La Paloma). This structure—an aggregate limit on instruments, which are tradable among market participants—gives the regulation its “cap and trade” name. Every year on November 1, Covered Entities must surrender compliance instruments to CARB. This obligation is calculated based on either (i) 30 percent of the Covered Entity’s greenhouse gas emissions in the preceding calendar year; or (ii) all greenhouse gas emissions within the preceding three calendar years as to which surrender was not made on an annual basis.

La Paloma filed for bankruptcy in December 2016 and, in October 2017, the bankruptcy court confirmed La Paloma’s plan of reorganization in which it agreed to sell substantially all of its assets under section 363 to LNV Corporation “free and clear” of La Paloma’s obligation to surrender its compliance instruments. La Paloma estimated that the surrender obligation (which would be due in November 2018) would be valued at approximately $63 million. CARB objected to the sale and argued that LNV should be responsible for the full amount of the surrender obligation when due in November 2018 because Bankruptcy Code section 363(f) does not authorize the sale of these assets free and clear of the surrender obligation.

The bankruptcy court rejected CARB’s argument, reaching two conclusions that could have wide ramifications in the energy-restructuring space:

• First, closely analyzing the applicable California regulations, the bankruptcy court concluded that only entities—and not assets—qualify as “covered entities” and thus must comply with the compliance-instrument surrender obligation. Here, LNV could become a Covered Entity only after the sale closed and it operated the facility long enough to satisfy the regulatory thresholds for emitting greenhouse gases. Thus, because LNV would not be a covered entity until after the sale closed, LNV would not assume the obligation to acquire compliance instruments corresponding to pre-sale greenhouse gas emissions.

• Second, the bankruptcy court found that the surrender obligation is an “interest” under Bankruptcy Code section 363(f), observing that environmental liabilities are generally not excepted by section 363(f). In addition, because the CARB regulations do not permit successor liability, the obligation to surrender compliance instruments qualifies as an “interest” that is cleansed by section 363.

CARB recently appealed the decision to the Delaware District Court, so the bankruptcy court may not yet have the last word on this important issue. In the meantime, section 363 sales remain a viable path for maximizing the value of energy-related assets while shedding unwanted liabilities.