PG&E’s Bankruptcy — Fiddling While California Burns

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There’s probably no such thing as a “simple” Chapter 11 filing, but the bankruptcy proceeding for Pacific Gas & Electric (“PCG”) will be especially complex. The company already had significant liabilities on its balance sheet before it caused November’s Camp Fire in northern California, which charred 14,000 homes and 5,000 other buildings, enveloped 245,000 acres, and left 86 people dead with tens of billions of dollars in property damage.

I’ve been following PG&E since its last bankruptcy – dating back 18 years to 2001. Back then, the company’s utility operating subsidiary failed because it was largely a victim of Enron’s fraudulent market manipulation of the California state energy market. Ultimately, California’s regulators therefore allowed PG&E to pass on its losses to its more than 5 million ratepayers in the form of above-market rates. As a result, it emerged from bankruptcy in 2004 with its holding company shareholders retaining their stock ownership.

The BalanceTHE BALANCE

That kind of outcome is rare, partly because most businesses don’t have captive customer bases. But if you live in the area they serve and you want electricity, PG&E is the only game in town. Usually, when a publicly traded company declares bankruptcy creditors line up to get paid. And last in line to be paid are almost always common shareholders, who get some degree of recovery in less than one percent of all bankruptcies. That’s likely to be the case with the current PG&E bankruptcy as well.

After the 2001 bankruptcy, California regulators ultimately allowed PG&E to pass the costs on to its customers.  This time around it’s a much different story since PG&E is no longer a victim. The company has been found negligent in the management of safety with its infrastructure which led to the devastating loss of life and property. As such, it is much less likely to get sympathy from the California Public Utilities Commission, the Californian legislature or the general public. This isn’t the first disaster for which the company has been held responsible. In the aftermath of a natural gas pipeline explosion in San Bruno, California in 2010, the company paid a $300 million fine, refunded $400 million to customers and agreed to spend $850 million on gas safety improvements. The company was simultaneously placed on criminal probation as a result and a court is currently considering whether the latest events violated that probation.

Tens of Billions in Damages

A lot of reports on the damage have cited losses totaling $30 billion, but that figure is misleading and doesn’t reflect all potential losses. Company filings state that $30 billion is what the local insurance industry estimated as the monetary damage from the fires, but that only refers to the losses claimed so far by those who were insured and filed claims. It doesn’t include those who didn’t have insurance or who were under-insured. When you add in those additional losses, the final cost will likely be much higher. It also doesn’t include a long list of other costs — personal injury claims, fire remediation, relocation expenses for people moving away from burned out towns, medical bills, attorneys’ fees, class action securities fraud claims, and fines or penalties from regulators. When you take all of that into consideration, $30 billion could wind up being a best case estimate. Although the local regulator determined that PG&E didn’t cause the 2017 Tubbs fire, class action attorneys suing PG&E for recovery from their 2017 damages are not bound by that ruling and PG&E was found negligent in multiple other 2017 fires.

It’s also relevant to consider the effect that bankruptcy will have on the equity market. The top holders of this stock are big name passive investment funds who own it only because they must own anything in the S&P 500. Now that PG&E was booted out of S&P 500, they are forced sellers. Moreover, once it is delisted from a major stock exchange because of the bankruptcy, those investors will have even greater incentive to sell it. Investors who own the stock simply because it’s in an index are not sophisticated distressed security investors. They’ve likely never looked at the company’s balance sheet since they only own it due to their passive mandate to own any stock that’s in the index. As a result, there will likely continue to be significant supply of sellers as this distressed situation progresses.

In preparing for its Chapter 11 filing, PG&E secured debtor in possession (DIP) financing from JP Morgan for $5.5 billion. Prior to that DIP loan, the company had $3.3 billion of bank debt and about $18 billion worth of bonds outstanding.

Bondholders Left Holding the Bag

Even without their wildfire liabilities, that’s a lot of debt and the current situation has likely thrown the holders of that $18 billion in bonds into a panic. In these situations, behavioral finance has shown that investors often act irrationally. They know that they’ve got to get out but, as they watch the value of the debt drop further and further from 100 cents on the dollar, they keep hoping it will get better before they capitulate. However, once the company files for bankruptcy, reality will set in and they will likely become forced sellers in a market without buyers. It’s unlikely that Wall Street banks or distressed securities funds will step in to bail them out with a strong bid until the debt really drops in value and becomes compelling as a potential long investment. However, distressed funds usually seek to earn a considerable return on their investment in exchange for the associated risk at hand. In this case, their demand will take into consideration the fact that unsecured creditors will need to share their recovery with a huge and fast-growing pool of tort claimants. Moreover, their demand will certainly discount a long potential workout in light of the complexities and size of this case.

It’s no secret that investors don’t always act in their own best interest, but it’s not always their fault. By late November, it was obvious to anyone paying attention that the wildfires were going to mean big financial trouble for PG&E. Yet all three credit rating agencies—Fitch, Moody’s, and S&P—maintained an investment grade rating on PG&E bonds until mid-January, when everyone already knew that Chapter 11 was in the works. Passive investors who rely on these agencies for help in deciding whether or not to hold specific securities do not appear to be getting their money’s worth.

This is a subject best explored in more detail at another time, but there’s obviously a problem with this system. Investors rely on the “expert” opinions of the ratings agencies, but the agencies themselves are too slow to form an opinion and by the time they do, the damage has already been done. The situation for PG&E bondholders stuck holding this debt while California is burning is similar to what happened during the last credit crisis, but on a smaller scale. Back then, the ratings agencies all said that the subprime housing debt was fine and so investors around the globe bought it until the bottom fell out.

What Comes Next?

We’ve mentioned the debt on the PG&E balance sheet due to the wildfires and obligations to bondholders, but the company has other liabilities as well. There are also asset retirement obligations, regulatory liabilities, and existing power purchase agreements that may need to be restructured. Those things may add another $10-15 billion or more in debt to the company. Similarly, the costs of future forest fires (in 2019 or later) would add to these liabilities as well. All told, there could easily be somewhere between $60-80 billion in claims against the company, which means the bankruptcy court will have its work cut out for it with this giant case. Of course, attorneys, investment bankers and other advisors will be perfectly happy to keep it in court for as long as possible since their fees will grow fastest there and will be first in line for repayment.

In ancient times, the decadent and unpopular Emperor Nero fiddled while Rome burned. For PG&E, its CEO, state regulators and politicians all did the same while California burned. Fortunately, the company will benefit from well-settled bankruptcy laws and procedures in Federal Bankruptcy Court as this mess gets sorted. However, PG&E shareholders are last in line and they are therefore unlikely to get significant upside when the smoke and ashes disappear.

 

George Schultze is a hedge fund manager and the founder of Schultze Asset Management. He is the author of The Art of Vulture Investing: Adventures in Distressed Securities Management.

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