Energy and Appellate Alert
June 2008
Authors:
John L. Longstreth
john.longstreth@klgates.com
202.661.6271
Donald A. Kaplan
don.kaplan@klgates.com
202.661.6266
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Supreme Court Reaffirms The “Mobile-Sierra”
Presumption That Wholesale Electricity And
Gas Contracts Are Just And Reasonable
On June 26, 2008, the United States Supreme Court clarified in Morgan Stanley Capital
Group Inc. v. Public Utility District No. 1 of Snohomish County the standards that the
Federal Energy Regulatory Commission (FERC) must apply in determining whether to
abrogate or revise contracts entered into by wholesale purchasers and sellers of natural gas
or electricity. The case construed two Supreme Court decisions from 1956 that have come
to be known as the “Mobile-Sierra” doctrine, and that recognize the importance of contract
certainty under the Natural Gas Act (NGA) and the Federal Power Act (FPA). The Court
rejected two limitations on the Mobile-Sierra doctrine that had been applied by a federal
appeals court, holding that the doctrine applied: (1) to purchasers as well as sellers seeking
relief from a contract, and (2) even if FERC had not reviewed the terms of the contract at
the time it was made to determine if the terms were just and reasonable.
The Court thus determined that a single standard applied under the doctrine: FERC must
presume that the rate set out in a freely negotiated wholesale energy contract meets the
“just and reasonable” requirement imposed by law, and that presumption may be overcome
only if FERC concludes that the contract seriously harms the public interest. This strict
“public interest” test is extremely protective of contracts and prohibits a party from seeking
to avoid a contract simply because it determines that it made an improvident bargain or
claims it is not getting a fair return.
The Contracts at Issue
The Supreme Court was reviewing cases that arose out of the California energy crisis of
2000 and 2001, when prices in the electricity spot market spiked due to a combination of
natural, economic, and regulatory factors. Seeking relief from high spot market prices,
buyers entered into long-term contracts whose prices were high by historical standards, but
much lower than the prevailing spot market prices. When spot market prices came down,
the buyers argued they should be relieved of their bargains because the contract prices were
much higher than the subsequently prevailing market price or a reasonable measure of the
sellers’ marginal cost, and because the market in which the contracts were entered into was
“dysfunctional” as a result of the chaotic market conditions and manipulation of the spot
markets by some sellers. The Ninth Circuit largely agreed, holding that Mobile-Sierra
should not apply unless FERC makes an inquiry into “the market conditions in which the
contracts at issue were formed,” and that market “dysfunction” is a ground for finding a
contract not to be just and reasonable. The Ninth Circuit also held that a purchaser, as
opposed to a seller, need show only that the price is outside a “zone of reasonableness,”
and not that it is contrary to the public interest.
Energy and Appellate Alert
The Supreme Court Rejects the Ninth
Circuit’s Limitations on the Mobile-Sierra Presumption
The Supreme Court rejected the Ninth Circuit’s first
limitation that Mobile-Sierra should apply only when
FERC has made a prior review of market conditions.
The Court held that the doctrine applies “regardless of
when the contract is reviewed” because “sophisticated
businesses enjoying presumptively equal bargaining
power” could be expected to “negotiate a ‘just and
reasonable’ rate as between the two of them.” The
Court also noted that it would be anomalous to hold
that the doctrine should not be enforced when there is
volatility in the market, because that would discourage
parties from entering into long-term contracts that
could be expected to stabilize such volatility. Finally,
the Court noted that “a presumption of validity that
disappears when the rate is above marginal cost is no
presumption of validity at all, but a reinstitution of
cost-based rather than contract-based regulation.”
The Court also rejected the Ninth Circuit’s second
limitation – that a “zone of reasonableness” test rather
than the Mobile-Sierra presumption should apply to
a buyer’s challenge. In the Supreme Court’s view,
the “zone of reasonableness” concept “fails to accord
an adequate level of protection to contracts,” and the
“standard for a buyer’s challenge must be the same,
generally speaking, as the standard for a seller’s.” The
Court noted that the Ninth Circuit’s limitation on the
presumption gave short shrift to the fact that “contract
stability ultimately benefits consumers, even if shortterm rates for a subset of the public might be high by
historical standards.” The Court further found that the
Ninth Circuit’s rule would be unworkable, as it would
require FERC to determine the reasonableness, based
on cost and other factors, of filed contracts, rather than
limiting its review to the extraordinary circumstances
where the public interest is affected.
The Supreme Court Remands to FERC for
Consideration of Two Points
Although the Court disagreed with much of the
Ninth Circuit’s ruling, it did agree that FERC should
reconsider two points. First, it was unclear whether
FERC considered only the rate the buyers were paying
before the contracts went into effect, or also considered
the disparity between the contract rate and the rates
consumers would have paid (but for the contracts)
further down the line, when the open market was no
longer dysfunctional. If that disparity amounted to
an “excessive burden,” then the contract challenge
could be shown to have met the Mobile-Sierra public
interest test.
Second, FERC is to determine whether there was
unfair dealing at the contract formation stage – for
instance, considering traditional grounds for contract
abrogation such as fraud or duress. In addition, if the
“dysfunctional” market conditions under which the
contract was formed were caused by the illegal action
of one of the parties to the contract, the Supreme Court
indicated that FERC should not apply the MobileSierra presumption. However, “the mere fact of a
party’s engaging in unlawful activity in the spot market
does not deprive its forward contracts of the benefit
of the Mobile-Sierra presumption” – FERC must also
find “a causal connection between unlawful activity
and the contract rate.”
Implications of the Decision
The Morgan Stanley decision is striking in its
endorsement of the benefits of contract stability to
energy markets. The message is clear – while FERC
has a role in determining if contracts are just and
reasonable, its inquiry is limited to those circumstances
where the public interest is plainly affected, or where
one party to the contract engages in misconduct that
directly affects the bargaining between the buyer and
seller.
There is also no support in the decision for imposing
remedies against all sellers in a market based on the
misconduct of certain sellers. Rather, the Court has
made clear that it is the individual contracting parties’
conduct, not general market-wide conditions, that
should govern FERC’s determination. This view is
consistent with traditional rules of fault and liability
as well as with the concern for contract stability that
seemed of greatest importance to the Court.
A copy of the court’s opinions is attached at the link
below. The majority opinion was written by Justice
Scalia (joined by Justices Kennedy, Thomas, and Alito),
Justice Ginsburg concurred, and Justices Stevens and
Souter dissented.
http://www.supremecourtus.gov/opinions/07pdf/06-1457.pdf
June 2008 | 2
Energy and Appellate Alert
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