Latham & Watkins Finance Department

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1 Number 822 February 26, 2009 Client Alert Latham & Watkins Finance Department Financial Crisis Impacts on FERC Approval Requirements For Upstream Transfers of Energy Assets The current financial crisis has spurred a flurry of transactions in the energy and financial sectors, including direct and indirect dispositions of energy assets. While the focus and intent of these transactions may have little to do with the downstream energy assets, failure to obtain necessary FERC approvals may have serious consequences. Introduction The current economic crisis has had a significant effect on the energy industry, and many energy assets have already directly or indirectly changed hands, including as a result of the upstream ownership changes of many large financial institutions that have indirect energy holdings in the United States. This Client Alert focuses primarily on certain Federal Energy Regulatory Commission (FERC) approvals that may be required prior to such changes in ownership or control. As discussed in this Alert, Section 203 of the Federal Power Act (FPA) requires that owners of certain energy assets in the United States obtain prior approval of certain upstream transfers, unless blanket authorization is available or jurisdiction has been disclaimed. FERC has attempted to expedite approvals of upstream transfers to accommodate time-sensitive requests, and in one case, has granted retroactive approval of an upstream transfer of energy assets. Prior Approval Required for Transactions Under Section 203(a)(1) Section 203(a)(1) of the Federal Power Act (FPA) requires any person owning or operating a facility subject to FERC s jurisdiction to obtain FERC authorization prior to, inter alia, disposing of such facilities or any part thereof with a value in excess of $10 million. 1 FERC has broadly interpreted Section 203(a) (1) to apply to direct or indirect (i.e., upstream) transfers of ownership and/or control of a FERC-jurisdictional facility. FERC Interprets Control Broadly As previously stated, prior FERC authorization may be required for transfers of direct or indirect control of a FERC-jurisdictional facility. FERC interprets control broadly, often finding that Section 203 prior approval is necessary even for transfers of interests considered to be passive in many other contexts. As a general matter, FERC has found that the question of whether a change in control triggering Section 203 has occurred is a factintensive analysis. FERC generally considers a transfer of ownership or control to occur when there is a transfer of 10 percent or more of the interests in a FERC-jurisdictional facility. For example, FERC recently found that a hedge fund with a 21 percent ownership interest in a FERC-jurisdictional facility did indeed control that facility for purposes of FERC s Section 203 analysis, despite the fact that the hedge fund had made a Schedule 13G filing to the Securities and Exchange Commission Latham & Watkins operates as a limited liability partnership worldwide with affiliated limited liability partnerships conducting the practice in the United Kingdom, France and Italy. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2009 Latham & Watkins. All Rights Reserved.

2 (SEC). 2 In its Schedule 13G, the hedge fund stated that it had not acquired the securities with the intent of changing or influencing the control of the facility; FERC nevertheless found that because the facility s ownership was highly concentrated, the hedge fund could control the facility if it worked in concert with another minority owner. Passive Ownership Interests In the few instances in which FERC has disclaimed Section 203 jurisdiction over future transfers of so-called passive interests in an upstream owner of a FERC-jurisdictional facility, the rights attached to such interests have been extremely limited. FERC has only disclaimed Section 203 jurisdiction over future transfers of passive interests in a limited liability company, the indirect, wholly-owned subsidiary of which was a FERC-jurisdictional facility, because such interests included only limited rights to grant or withhold consent to certain actions of the limited liability company parent. Notably, the only rights attached to these interests were veto rights over the following actions: (a) material amendments to the limited liability company agreement of the parent under certain specified circumstances; (b) issuance of new interests senior to the then-existing member interests of the parent; (c) the adoption of new operative or constituent documentation in connection with mergers, consolidations, combinations or conversions in certain cases; (d) appointment of a liquidator for the parent, but only if the managing member did not do so; and (e) assignment of investment advisory contracts under certain circumstances. 3 FERC has explicitly held that if an upstream (i.e., indirect) owner has the ability to exercise any control over the hiring and firing of the management of a FERC-jurisdictional facility, then that owner s transfer of its interests would constitute a transfer of control of the facility such that prior approval under Section 203 would be required. 4 Prior FERC Approval for Investment Advisers that Exercise Control The Commission recently has clarified that investment advisers also are subject to the prior authorization requirements of Section 203(a)(2), even where (a) the adviser is not itself a security account holder, and (b) the security account holders have delegated the power to vote securities to the financial adviser but the financial adviser generally defers to another entity that it engages to vote the securities. 5 Investment advisers may be able to obtain blanket authorization for subsequent investment activities. However, FERC emphasized recently that investment advisers must seek approval for such blanket authorizations prior to engaging in any investment activities giving rise to Section 203(a)(2) approval requirements. The Commission gave investment advisers who previously engaged in such acquisitions without obtaining Section 203 approval until February 17, 2009, to file an application requesting authorization for such acquisitions. Section 203 Standard of Review and FERC-Imposed Conditions Under Section 203(a)(4) of the FPA, FERC shall approve a proposed transaction if it determines that the transaction will be consistent with the public interest. The Commission generally considers the transaction s potential effect on the following three factors in this analysis: (a) competition; (b) rates; and (c) regulation of the facility in question at the federal or state level. The Commission must also find that the transaction will not result in cross-subsidization of a nonutility associate company or the pledge or encumbrance of utility assets for the benefit of an associate company, unless the Commission finds such cross-subsidization to be in the public interest. 6 2 Number 822 February 26, 2009

3 The Commission has the authority to impose conditions on its approval of transactions under Section 203. For example, FERC recently approved a transaction in which a hedge fund, which already owned or controlled a FERC-jurisdictional facility, was seeking to acquire percent of the outstanding voting securities in another FERC-jurisdictional facility. The Commission s conditions require the hedge fund to agree that it would not: (a) control the new facility; (b) seek representation nor hold any seat on the new facility s board of directors; (c) become the new facility s largest shareholder; (d) act in concert with any other minority shareholder to achieve (a) or (b); or (e) control or influence in any way the price at which power is sold from the new facility or when power generated by the new facility will be sold. The Commission also required the hedge fund to represent that it had not acquired the securities of the new facility for the purpose of changing or influencing the control of the new facility. 7 In addition, the Commission imposed various related reporting and certification requirements. Certain Blanket Authorizations Available FERC s regulations grant blanket authorization for certain securities acquisitions by a holding company, including, inter alia, (a) the acquisition of any amount of non-voting securities and (b) subject to certain conditions, the acquisition of up to 9.9 percent of the outstanding voting securities of an electric utility company or a transmitting utility. Additionally, for any entity that is a holding company solely based on its ownership of one or more exempt wholesale generators, qualifying facilities and foreign utility companies, FERC s regulations grant blanket authorization for such an entity to acquire the securities of additional exempt wholesale generators, qualifying facilities and foreign utility companies without prior Section 203(a)(2) authorization. Note, however, that FERC recently emphasized that even when this particular blanket authorization applies to a particular transaction, prior approval under Section 203(a)(1) nevertheless may be required if such transaction results in a change of control of an exempt wholesale generator that is a public utility owned by the holding company whose securities are being acquired. 8 FERC has granted blanket Section 203 authorization for (a) internal corporate reorganizations that do not result in reorganization of a traditional public utility that has captive customers and that do not present cross-subsidization issues and (b) a FERC-jurisdictional facility to transfer a wholesale marketbased rate contract to any other FERCjurisdictional facility affiliate that has the same ultimate upstream ownership. The Commission has expressly confirmed that flexibility in the structuring of a proposed transaction is permissible based on these blanket authorizations. However, certain transfers of jurisdictional facilities between affiliated companies, including direct asset transfers, may require prior approval. FERC also recently clarified that neither a FERC-jurisdictional facility nor its upstream owner has an obligation to obtain prior approval for a disposition of its securities in a secondary market transaction in which: a) The securities in question are common stock and are publicly traded; b) Large volumes are traded daily between third-party investors in arm s-length transactions; c) Neither the jurisdictional facility nor its upstream owner has any control over the transfer of the common stock; and d) Neither the facility nor the upstream owner is required to be given prior notice of these transactions. 9 In addition, FERC has proposed a limited blanket authorization under Section 203(a)(1) under which a public 3 Number 822 February 26, 2009

4 utility would not be obligated to seek prior approval to dispose of less than 10 percent of its securities to a public utility holding company, but only if, after the disposition, the interests directly or indirectly held by the holding company and any associate or affiliated company would not equal or exceed 10 percent of the public utility. FERC has indicated a willingness to consider broader, ex ante requests from applicants, including joint requests from multiple, similarly situated applicants, for blanket authorizations under Section 203(a)(1), on a case-specific basis, but has made clear that these requests must clearly demonstrate on the record that such blanket authorizations, if granted, would have no adverse impact on captive customers or the public interest. At the time, FERC stated that granting such case-specific blanket authorizations may be able to provide some of the certainty that is sought by the industry and investors. 10 For instance, the Commission recently granted to investment adviser Horizon Asset Management, Inc. a three-year blanket authorization for (a) Horizon to engage in account management activities involving the acquisition of the voting securities of FERC-jurisdictional entities and (b) utilities or holders of utility voting securities to sell such securities to Horizon in transactions falling within the scope of Horizon s account management activities. This blanket authorization included several conditions, including (i) that each individual Horizon account must at all times hold less than 10 percent of the issued voting securities of a FERCjurisdictional facility; (ii) the firm must maintain and enforce its internal corporate policy against exercising control over companies whose securities are acquired for account holders; and (iii) the firm must maintain its eligibility to file a Schedule 13G with the SEC. 11 FERC Section 203 Reaction to Financial Crisis The current financial crisis has spurred a flurry of transactions in the energy and financial sectors, including direct and indirect dispositions of energy assets. While the focus and intent of these transactions may have little to do with the downstream energy assets, failure to obtain necessary FERC approvals may have serious consequences. FERC authorization is required for a large number of transactions involving FERCjurisdictional energy assets, but FERC has shown flexibility with respect to such authorizations. For example, FERC regulations state that the Commission must act on a completed application under Section 203 within 180 days or the application will be deemed granted. FERC approval may often be obtained in significantly less time, and in recent months, FERC has approved transactions involving financial institutions in as little as 21 days from the date of filing of the application. 12 FERC has explicitly acknowledged the need to act quickly in granting authorizations in the current economic climate, stating that [t]he Commission stands ready to act in processing urgent FPA section 203 filings in response to the current financial market turmoil. As in other recent orders, the Commission will act promptly to provide regulatory certainty to those jurisdictional entities adversely affected by the unprecedented, ongoing market conditions. We recognize that stabilizing the global financial market is a goal consistent with the public interest. 13 Notably, in late November 2008, FERC refused to grant Section 203(a) (2) authorization retroactively to an investment adviser which had acquired more than 10 percent of the voting shares of several FERC-jurisdictional facilities. However, FERC declined to impose sanctions due to its lack of clarity regarding its interpretation of 4 Number 822 February 26, 2009

5 the scope of Section 203(a)(2). In that order, FERC cautioned investment advisers that they may face possible monetary or other sanctions if they fail to obtain advance approval.... under Section Just weeks later, in December 2008, FERC authorized two transactions in which the Belgian government collectively acquired percent of the interests of Fortis Bank in the span of a week to prevent that bank s failure. Authorization was sought approximately one month after these transactions had occurred, even though Section 203 requires FERC approval before acquiring a jurisdictional interest. Citing the extraordinary circumstances of the transaction, FERC retroactively authorized the transactions as of the date on which each of them occurred. In its order, FERC acknowledged that the value of stock shares in the parent company of Fortis plummeted, and it was clear that Fortis would become insolvent if immediate action was not taken. 15 Potential liability under Section 203 Failure to comply with the requirements of Section 203 of the FPA may have a number of significant consequences. Failure to comply with Section 203 to obtain prior authorization of a disposition is a violation of federal law and may also be a violation of various contractual obligations of the parties. Under the FPA, FERC has the authority to impose penalties for noncompliance with the FPA of up to $1,000,000 per day that a violation exists. FERC has also indicated that a disposition implemented without prior authorization may be voidable in court by the affected party and that FERC has the authority to revoke market-based rate authority or order refunds for violating Section 203. Endnotes 1 Section 203(a)(1) also requires an owner or operator of a FERC-jurisdictional facility to obtain prior FERC approval for (a) any merger or consolidation, direct or indirect, of its FERC-jurisdictional facility with a FERCjurisdictional facility owned by another person; (b) any acquisition of an existing generating facility that (i) has a value of more than $10 million, (ii) is used for interstate wholesale sales of electricity and (iii) over which FERC has ratemaking jurisdiction; and/or (c) any purchase or acquisition of the securities of another public utility with a value more than $10 million. 2 Entegra Power Group LLC, 125 FERC 61,143 (2008). 3 D.E. Shaw Plasma Power, L.L.C., 102 FERC 61,265 (2003). 4 See, e.g., D.E. Shaw Plasma Power, L.L.C., 104 FERC 61,150 (2003); Central Mississippi Generating Co., LLC, 106 FERC 61,006 (2004). 5 Horizon Asset Mgmt., Inc., 125 FERC 61,209 (2008) U.S.C. 824b(a)(4). 7 Entegra Power Group LLC, 125 FERC 61, Harbinger Capital Partners Master Fund I, Ltd., 125 FERC 61,145 at P31 (2008); see also Transactions Subject to FPA Section 203, Order No. 669-A, FERC Stats. & Regs. 31,214, order on reh g, Order No. 669-B, FERC Stats. & Regs. 31,225 (2006). 9 FPA Section 203 Supplemental Policy Statement, 122 FERC 61,157 at PP3-4 (2008). Also note that over the last decade, it has become standard industry practice not to seek FERC authorization under Section 203(a) for the disposition of less than 5 percent of the jurisdictional facilities (i.e., an asset transfer) of an exempt wholesale generator. 10 FPA Section 203 Supplemental Policy Statement, 120 FERC 61,060 at P35 (2007). 11 Horizon Asset Mgmt., Inc., 125 FERC 61, U.S.C. 824b(a)(4). 12 Lehman Bros. Commodity Servs. Inc., 125 FERC 61,122 (2008). 13 Fortis Energy Mktg. & Trading GP, 125 FERC 61,246 (2008) (internal citation omitted). 14 Horizon Asset Mgmt., Inc., 125 FERC 61,209 at P3. 15 Fortis Energy Mktg. & Trading GP, 125 FERC 61,246 at P23. 5 Number 822 February 26, 2009

6 If you have any questions about this Client Alert, please contact one of the authors listed below: David L. Schwartz Natasha Gianvecchio Suzanne M. Logan Or any of the following attorneys listed to the right. Office locations: Abu Dhabi Barcelona Brussels Chicago Doha Dubai Frankfurt Hamburg Hong Kong London Los Angeles Madrid Milan Moscow Munich New Jersey New York Northern Virginia Orange County Paris Rome San Diego San Francisco Shanghai Silicon Valley Singapore Tokyo Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorneys listed below or the attorney whom you normally consult. A complete list of our Client Alerts can be found on our Web site at If you wish to update your contact details or customize the information you receive from Latham & Watkins, please visit to subscribe to our global client mailings program. Abu Dhabi Bryant B. Edwards Barcelona José Luis Blanco Brussels Howard Rosenblatt Chicago David S. Heller Bradley E. Kotler Jeffrey G. Moran Doha Bryant B. Edwards Dubai Bryant B. Edwards Frankfurt Uwe Eyles Hamburg Holger Iversen Hong Kong Joseph B. Bevash London James Chesterman Christopher Hall Los Angeles Jeffrey B. Greenberg Dominic K. L. Yoong Madrid José Luis Blanco Milan Andrea Novarese Moscow Mark M. Banovich Munich Andreas Diem New Jersey David J. McLean New York Daniel C. Seale Northern Virginia Eric L. Bernthal Orange County David C. Meckler Paris Etienne Gentil Rome Fabio Coppola San Diego Kelley M. Gale San Francisco Jared W. Johnson Shanghai Rowland Cheng Silicon Valley Ora T. Fisher Singapore Stephen P. McWilliams Tokyo Hisao Hirose David L. Schwartz Natasha Gianvecchio Number 822 February 26, 2009