KORNFIELD, PAUL & NYBERG Harrison Street, Suite 800 Oakland, California Telephone: (510) Facsimile: (510) or 8681

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1 KORNFIELD, PAUL & NYBERG 1999 Harrison Street, Suite 800 Oakland, California Telephone: (510) Facsimile: (510) or 8681 Memorandum TO: Frances Medema - League of California Cities DATE: March 19, 2012 FROM: RE: Aaron Paul Thinking The Unthinkable-Public Utility Bankruptcy: Impact On California City Revenues INTRODUCTION California Cities presently enjoy a revenue stream from public utilities in the form of franchise fees and utility users taxes. California Cities also sell power to electric utilities and receive substantial compensation in return. This paper examines the impact of a Chapter 7 bankruptcy liquidation or a Chapter 11 bankruptcy reorganization filing by utilities on these important revenue streams. A brief overview of the bankruptcy administrative process follows. OVERVIEW OF BANKRUPTCY PROCEDURES Upon the filing of a bankruptcy, whether under Chapter 7 or Chapter 11, the debtor receives the benefit of the automatic stay under 11 U.S.C The stay is automatic. It is self-executing and no court order is required. The purpose of the stay is (1) to provide the debtor with a breathing spell from creditor s actions; (2) to achieve an equality of distribution of the estate assets among claimants; and (3) to promote an orderly administration of the case. The effect of the stay is to invalidate certain post-petition action taken against the debtor, property of the debtor, or property of the bankruptcy estate. Relief from the automatic stay may be obtained upon written motion filed with the court or by appropriate stipulation between the parties. Any actions taken in violation of the stay are void. In re Gruntz, 202 F.3d 1074, 1082 (9 th Cir. 2000) 11 U.S.C Also In re Schwartz, 954 F.2d 569, 571 (9 th Cir. 1992). An exception to the automatic stay is the exercise of police power by a governmental unit under 11 U.S.C. 362(b)(4). Section 362(b)(4) is narrowly construed to apply to the enforcement of laws effecting health, welfare, morals and safety and should not permit the continuation of governmental action to protect its interest in property of the debtor or the estate.

2 See In re State of Missouri v. United State Bankruptcy Court for Eastern District of Arkansas, 647 F.2d 768 (8 th Cir. 1981), cert. denied, 454 U.S (1982). The exception to the automatic stay for police and regulatory actions does not permit an agency to enforce contractual rights against a debtor without first seeking relief from the automatic stay. In re University Medical Center, 973 F.2d 1065, 27 CBC.2d 800 (3 rd Cir. 1992). The public policy test distinguishes between governmental actions that effectuate public policy and those that adjudicate private rights. In re Universal Life Church, Inc., 128 F.3d 1294, 38 CBC.2d 1235 (9 th Cir. 1997), cert. denied, 524 U.S. 952, 118 Supreme Ct. 2367, 141 Lawyer s Ed.2d 736 (1998). In National Environmental Waste Corp., 129 F.3d 1052, the Ninth Circuit balanced the equities in granting relief from the stay retroactively when the City of Riverside terminated waste handling service contracts one week after the service provider filed for Chapter 11. What Is the Duration of the Stay and How and When Is it Automatically Lifted? The automatic stay continues until the bankruptcy case is closed, dismissed or until a discharge is granted or denied. (subsection 362(c)(2)). Under a Chapter 11, the debtor seeks confirmation of a Plan of Reorganization which usually includes a provision for discharge of indebtedness and prohibition against any contemplated action. All rights of creditors existing prior to the filing are replaced by those rights set forth under the Plan once it is confirmed by the Bankruptcy Court. PRIORITIES UNDER THE BANKRUPTCY CODE Priorities grant special rights to the holders of certain unsecured claims; thus, under the Code, they are to be narrowly construed. To be accorded priority status, a party must fit clearly within the requirements of the priority statute. The party seeking to establish a priority claim bears the burden of proof that the party s claim qualifies for priority status. (In re Tera Distribution, Inc., 148 Bkrptcy.Rptr. 598 (Bankr. R.I. 1992). Bonner v. Almond, In re Heritage Village Church and Missionary Fellowship, Inc., 22 CBC.2d 1093, 137 Bkrptcy.Rptr. 888 (Bankr.D.S.C. 1991)). Generally, Bankruptcy Code 507 establishes priorities in the payment of claims in cases where there are assets available for distribution to creditors. Section 507(a) creates nine categories of priority claims. Priority claim status affecting California Cities fall into several categories: 1. First Priority: Administrative Claims Administrative expenses are generally post-petition claims and involve not only the fees and costs of a Trustee, but also the cost and fees of the attorneys and other professionals. These fees and costs must, however, have been incurred in preserving the estate. See Bankruptcy Code section 303. Thus, any expenses arising from the sale by cities of power to an electric utility in bankruptcy would entitle the city to first priority status of administrative expenses. As administrative expenses, these claims would be granted higher priority and would be entitled to payment ahead of those with a lower priority. 2. Eighth Priority: Taxes And Custom Duties 507(a)(8) Under Bankruptcy Code 507(a)(8), an eighth priority is granted to allowed unsecured claims of a governmental unit for certain kinds of pre-petition taxes. Section 101 of the Code defines a governmental unit and includes taxes owed to federal, state, and local taxing 2

3 authorities. Section 507(a)(8) specifies seven categories of tax obligations that are entitled to priority: a. taxes measured by income or gross receipts; b. property taxes; c. trust fund taxes; d. employment taxes; e. excise taxes; and f. custom duties. DISTINGUISHING A TAX FROM A FEE If the claim held by a governmental entity for an obligation constitutes collection of a fee rather than collection of tax, then it will not be entitled to priority status. Therefore, it is important to distinguish between obligations that are fees from those that are taxes. The Supreme Court has held that a fee is a charge levied by a governmental unit on something that bestows a benefit on the particular party that is not shared generally by other members of society. It is incident to a voluntary act and the amount is related in some fashion to the benefit conferred upon the recipient. It has been noted that the chief distinction is that a tax is an exaction for public purposes while fees relate to an individual privilege or benefit to the payer. [The determination of] whether an exaction is a fee or a tax is a functional test not dependent upon whether the statute creating the obligation denominates it to be a fee or a tax. While the distinction between a tax and a fee is easy to state, it has proven quite difficult to apply in practice and is some times based on subtle nuances in the statutory scheme giving rise to the obligation. See Collier on Bankruptcy, 15 th Ed. Revised, Pgs See also National Cable Television Assn. v. United States, 415 U.S. 336, 94 Sup.Ct. 1146, 39 Lawyers Ed. 370 (1974). What Is A Franchise Fee? FRANCHISE FEES The revenue paid to a municipality from a franchisee is considered to be rent or a toll for the use of its streets. San Francisco - Oakland Terminal Railway v. Alameda County, 66 Cal.App. 77, 82, 225 P 304, 306 (1924). The Broughton Act, Cal. Pub.Util.Co et. seq., allows franchise payments of 2% of the franchisee s gross annual receipts arising from the use, operation or possession of the franchise. Cal. Public Utility Co This section applies to intrastate utilities (electric and telephone poles and wires, as well as gas pipes). The California Supreme Court has upheld the statute, and has established a methodology for allocating the franchise payments. See Tulare County v. City of Dinuba, 188 Cal. 664, 680, 681, 206 P. 983 (1922) (holding the percentages as calculated on miles of distribution system in franchise area). The California Municipal Law Handbook, 2000 Edition In addition, in place of franchise fees, a transportation customer which is a person, firm or corporation purchasing gas or electricity from a third person, but receiving transportation services from a utility or non-utility natural gas or electricity energy transporter which is subject to a franchise, is required to pay a municipal surcharge for the use of public lands. See Cal.Pub.Util.Code 6350 et. seq. 3

4 Under the test established by the National Cable Television Association case, revenue paid to a municipality from a franchisee as a rental or toll for the use of its streets is not a tax but merely a fee. Under these circumstances, any revenue due from a public utility prior to the bankruptcy filing would not entitle the City to a priority claim. Instead, this claim would be deemed to be a general unsecured claim, and would be treated like general trade debt. UTILITY USERS TAX Charter cities which are granted the constitutional power to tax are allowed the corollary power to use reasonable means to effect collection, including having others to collect the tax and remit it to the city. See City of Modesto v. Modesto Irrigation District, 34 Cal.App.3d 504, 110 Cal.Rptr. 111 (1973). Thus, the utility users tax on utilities such as gas, electricity, telephone, water and cable television now collected by the power utilities for remittence to the cities, falls in the category of a trust fund tax under Bankruptcy Code 507(a)(8)(C). Section 507(8)(C) provides for priority to the extent that such claims are for a tax required to be collected or withheld and for which the debtor is liable in whatever capacity. In determining whether a claim falls within this category, a court must determine that (i) the claim is held by a governmental unit, (ii) the claim is for a tax, (iii) the tax is owed by a party other than the debtor, (iv) the tax must be collected or withheld from that party and transmitted to the governmental unit, and (v) the debtor must be liable for payment of the tax in some capacity. All five elements are necessary for the claim to achieve priority under 507(a)(8)(C). In particular, the tax at issue must be owed by a party other than the debtor and then collected or withheld by the debtor from the other party. If the tax at issue is a tax owed by the debtor in the first instance, it is not a trust fund tax and not within the scope of 507(a)(8)(C). (See In re Official Comm. of Unsecured Creditors of White Farm Equip. Co., 943 F.2d 752 (7 th Cir. 1991, cert. denied 503 U.S. 919, 112 Sup.Ct. 1292, 117 Lawyer Ed. 2d 513. See also Collier on Bankruptcy, supra, pg ). Since the charter cities have the power to use reasonable means to effect collection, including electric utilities which collect the tax and remit it to the city, this would appear to fall within the trust fund taxes category for priority under 507(a)(8)(C). However, it should be noted that some of the taxes covered by 507(a)(8)(C), such as sales taxes, may also be considered excise taxes and entitled to priority under 507(a)(8)(E). These priority categories may not, then, be mutually exclusive. If a tax claim fits within both categories, it may be entitled to priority under both categories. The following excise taxes hold priority status: 1. Those occurring before the date of the filing of the petition for which a return, if required, is last due, including any extensions, within three years prior to the petition date; and 2. Transactions occurring within three years preceding the petition, if the transaction is such that a return is not required to be filed. The Bankruptcy Code does not define either excise or excise tax. Legislative history suggests that sale taxes, estate and gift taxes, gasoline and special fuel taxes, wagering and truck taxes are examples of excise taxes. Excise taxes have been defined as an indirect tax that is not directly imposed upon persons or property, but is one that is imposed on the performance of an act, the engaging in any occupation, or the enjoyment of a privilege. However, it is this writer s opinion that the utility users tax falls more closely into the definition of a trust tax and would be entitled to priority under 507(a)(8)(C). TAX PENALTIES 507(a)(8)(G) 4

5 Section 507(a)(8)(G) adds an allowed unsecured claim for a penalty that is related to a claim of a kind specified in 507(a)(8)(A) through 507(a)(8)(F), but only if the claim is in compensation of actual pecuniary loss. Thus, in the event that a city would be entitled to seek a penalty for any unpaid portion of the utility user s tax, it would be entitled to priority status for the unpaid penalty as well. In summary, if a penalty tax claim is considered to be in compensation for actual pecuniary loss, it will be entitled to priority so long as it is related to a claim of a kind specified in 507(a)(8)(A) through 507(a)(8)(F) ahead of general unsecured claims. If it is not, it will be subordinate to general unsecured claims. See Collier on Bankruptcy supra, pg CLAIMS ARISING FROM SALE OF POWER TO ELECTRIC UTILITIES If a California City holds an unpaid claim for power sold to an electric utility, the city s claim in the utility s bankruptcy will be treated as a general unsecured claim along with all other vendors of goods or services who were unpaid prior to the bankruptcy. EXECUTORY CONTRACT Section 365 provides fro the assumption or rejection of executory contracts. The legislative history refers to the Countryman definition ( generally includes contracts on which performance remains due to some extent on both sides ). Countryman, Executory Contracts in Bankruptcy 57 Minn.L.Rev 439. Section 365 empowers the trustee (in a Chapter 7 case) on a debtor in possession (in a Chapter 11 case) to assume or reject executory contracts. The decision must be approved by the court. If the contract is rejected, the estate will lose any benefit from the contract and will be liable fro damages for the breach; in this situation, the claim for damages is treated as a pre-petition claim. If the claim is assumed, any liability thereafter will be an expense of administration. Collier on Bankruptcy, supra, P If the claim is to be assumed, all pre-filing and post-filing arrearages must be cured as a condition to assumption. Therefore, if a California City sells power to an electric utility which files for Chapter 11, the debtor will have an opportunity to consider whether to assume or reject the contract under which the power was sold. The decision by the debtor is subject to the business judgment test. 5

UNITED STATES BANKRUPTCY COURT FOR THE EASTERN DISTRICT OF KENTUCKY DIVISION IN RE: CASE NO. Original Amended Date:

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