Rock, Paper, Scissors

By Published On: April 16, 2005

Rock After a year of contracts law, I had no doubt about the utter importance of a well-thought-out and precisely worded contract. Once it is crossed, dotted, and signed, it is cast in stone. Thus, contracting parties had better be aware of what is, or is not, included in the document before the molten rock hardens. After the rigors of the first year of law school, I was exposed to an entirely different approach to contracts. In 1985, I spent the summer in Japan studying and working-and traveling-when possible. Paper My Japanese contracts professor at the University of Tokyo emphasized to us giajins (foreigners) the importance of the contracting parties’ relationship. The paper agreement in the Land of the Rising Sun is not fixed like a rock but akin to a live tree that grows and changes as the business relationship evolves. I was fascinated by the approach, so much so that I received the first and last A+ in my scholastic history. (In all honesty, I attribute the grade to a whopping hangover the morning of the final. The previous night I showed my group spirit by trying to keep up alcohol-wise with my office mates from the Nippon Telegraph & Telephone Co. international legal affairs department.) Since that summer, the U.S. notion of the sanctity of contracts has never looked quite the same. I was reminded of the issue when reviewing the briefs over which standard to apply to the long-term contracts the Department of Water Resources signed during the energy crisis. The rallying cry for those defending the agreements is “sanctity of contracts.” A decision from the Ninth Circuit Court of Appeals is expected soon on whether the Federal Energy Regulatory Commission application of the higher public interest standard will be upheld or whether California will have the opportunity to argue its case that the “just and reasonable” standard should be applied. On December 8, 2004, the court heard oral arguments on two cases involving the question of what standard to apply to long-term, market-based contracts signed during the energy crisis. One deal involved the California Public Utilities Commission and Electricity Oversight Board (EOB), the other the Snohomish Public Utilities District. In 2002, the CPUC and EOB appealed the federal commission’s ruling that the higher public interest standard as spelled out in the Mobile-Sierra cases governed the deals. Without fully vetting the issue, the feds denied considering refunds. Federal regulators concluded that the CPUC failed to show that DWR’s bilateral contracts “imposed an excessive burden on ratepayers,” as required by Mobile-Sierra. Much to the CPUC’s dismay, FERC found that DWR was not a victim of market manipulation but had “real bargaining power,” and the deals were “distinctly beyond the realm” of the California Independent System Operator or California Power Exchange centralized market operations. Attorneys from the state argued that the deals were both unjust and unreasonable and not in the “public interest.” The terms were claimed to be a result of the generators’ exercise of market power when the market was in chaos. The lawyers representing California also asserted that they were prohibited from proving that the dysfunctional spot market affected the terms of the market-based agreements. DWR signed 56 contracts worth about $42 billion. Since the CPUC filed its appeal, 34 of those deals have been renegotiated, 14 have expired, and 2 were terminated. Thus, from a narrow perspective, the legal fight involves half a dozen contracts, including the most costly one?Sempra?s $6 billion agreement. The refunds being sought by the state are separate and apart from the nearly $9 billion it has been pursuing for spot-market purchases, including the case argued in the Ninth Circuit Court of Appeals this weekBecause of the number of contracts at issue, the state refund claim has dropped from $12 billion in excess charges to $1.6 billion. The outcome of the standards case will affect how much ratepayers ultimately will pay for the deals former governor Gray Davis insisted be signed at breakneck speed regardless of the written terms. Price concerns, including expensive gas tolling provisions, were rammed through with no questions asked. The tolling issue is a major bone of contention in the Sempra contract because of the very high cost of gas used to feed the power plants to provide the contracted power. But for many others, much more than $1.6 billion is at stake. FERC, lenders, and independent power producers fear that cracking open the contracts will undermine the roots of the living and changing energy market tree. The fallout from the crisis caused lending for new power plants to virtually dry up, reducing merchant generators’ ability to secure financing. You may recall that numerous permits for new power plants were approved by the California Energy Commission, but financing the construction was nearly impossible without contracts, and there were few agreements to be had. FERC applied the Mobile-Sierra high bar because a deal is a deal, and this set-in-stone standard is the precedent where so-called competitive deals are involved. The rationale is that contracting parties in a capital-intensive business should not face undue regulatory interference. To do so could jeopardize repayments. The durability of a contract-paper or rock-is an even bigger deal in the tight lending market, and more so now that a number of banks own power plants. While the lenders will do all that they can to protect their financial interest, and generators have to do what they say to get their projects financed, there is a glaring omission in this myopic stance. Scissors Sure, FERC does not want to shake up the industry, but I have a real problem with its failure to factor in the insanity that prevailed during the crisis, and to consider who bears the burden of the mistakes made. In addition, it is highly unlikely that a Morgan Stanley or Goldman Sachs presumed that the contracts represented an attractive, stable investment when they were signed. According to Erik Saltmarsh, EOB director, “A contract is not a sanctified thing in the U.S.” Contracts outside the energy business, such as in construction, for instance, are governed by a code of law, the Uniform Commercial Code, which lays out rules governing contracting parties? rights and obligations under various circumstances. Saltmarsh added that the state does not want an “Alice in Wonderland regulatory world in which no one would want to be in the energy business. But factors were in place when the energy contracts were signed that caused them not to be fair.” Allowing contract flexibility in light of the changing world would be akin to cutting and pasting U.S. and Japanese contract principles together. No doubt the push for a change will send shivers down some people’s spines. Yet perhaps not, if the change is seen as akin to pruning a valuable bonsai.

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