Stick to the 'Plain Meaning'

Rockport 2, completed in 1989, has a useful life expectancy estimated at 45 to 65 years, meaning that it should be economically functional until some time between 2034 and 2049. It was financed by a sale and leaseback arrangement with several investor-owned trusts (known here as “the owners” or plaintiffs). As the Sixth Circuit explained, the financing arrangement worked like this: “[E]ach investor formed a pair of trusts (one for each defendant); each trust purchased a portion of defendants' interest in Rockport 2; and each trust leased the interest back to defendants for a period of thirty-three years — through December 7, 2022. As a result, the owners receive annual rent payments, tax and accounting benefits, and, as important here, the value of Rockport 2 after the lease expires (what the parties call its 'residual value').”

Problems arose for the defendants in 1999 when the U.S. Environmental Protection Agency (EPA), several states, and a number of private environmental organizations all brought actions against AEP for modifying some of its power plants nationwide without installing pollution controls that are required by the Clean Air Act. The suits, which concerned 13 of AEP affiliates' plants, were consolidated in the Southern District of Ohio. Neither of the Rockport plants was the subject of any of these allegations, however, and the owners of the plants were not involved in the lawsuits.

To settle the lawsuits, AEP agreed in 2007 to modify its plants — including the Rockport plants, even though these had not been the subject of the suits. For Rockport 2, AEP agreed to install emissions-limiting devices by Dec. 31, 2019, including a scrubber device that would cost in the neighborhood of $1.4 billion. AEP later sought permission to install a less expensive device, but the plaintiffs in the consolidated action objected. The parties to the emissions suit instead agreed in 2013 to modify the 2007 consent decree to allow AEP to install a less expensive system by 2015, under one condition: AEP must also “Retrofit, Retire, Re-power, or Refuel” Rockport 2 by Dec. 31, 2028 — six years after AEP's lease to operate the plant had expired. For purposes of this modified consent decree,”Retrofit” means to install a new scrubber; “Retire” means to permanently shut down Rockport 2,” “Re-power” means replacing the plant's coal-burning technology, and “Refuel” means to convert it to natural gas.

As explained by the Sixth Circuit in the lease-terms dispute action, “The effect of the modification [to the consent decree] is substantial. By pushing the 'Retrofit, Retire, Re-power, or Refuel' requirement to 2028 (six years after the expiration of the Facility Lease), the owners are now responsible for the costs associated with either upgrading Rockport 2 or shutting it down.”

Could AEP do this? The owners thought not, and their trustee soon brought suit against AEP, alleging: 1) breach of the Facility Lease by imposing an impermissible Lien; 2) breach of Section 6.01(j) of the Participation Agreement by taking an action that materially adversely affected the economic useful life of Rockport 2; and 3) breach of the covenant of good faith and fair dealing by interfering with Rockport 2's economic useful life. The case was filed in New York, but later transferred to the Southern District of Ohio. The district court sided with AEP in determining that the costs of the delayed requirement to 'Retrofit, Retire, Re-power, or Refuel” could be pushed onto the owners. The owners appealed to the Sixth Circuit.

Who's on the Hook?

The dispute at the trial court level and on appeal to the Sixth Circuit (which applied de novo review) centered on the terms of the contracts between the owners and AEP. The contracts themselves called for application of New York law, which holds that “the intent of the parties controls and if an agreement is complete, clear and unambiguous on its face, it must be enforced according to the plain meaning of its terms.” Beardslee v. Inflection Energy, LLC, 25 N.Y.3d 150, 8 N.Y.S.3d 618, 31 N.E.3d 80, 84 (N.Y. 2015) (internal quotations and brackets omitted). Further, as explained in S. Rd. Assocs., LLC v. Int'l Bus. Machines Corp., 4 N.Y.3d 272, 826 N.E.2d 806, 809, 793 N.Y.S.2d 835 (N.Y. 2005), this principle of adhering to the plain meaning of a contract's terms as evidencing the parties' intents “is particularly important in the context of real property transactions, where commercial certainty is a paramount concern, and where the instrument was negotiated between sophisticated, counseled business people negotiating at arm's length.”

Two sections of two of the series of documents memorializing the financing and leasing arrangement between AEP and the owners were important to this case, as both protected the plant's residual value following the lease term. The first of these was Section 6.01(j) of the Participation Agreement, which prohibits AEP from “tak[ing] any action … which will materially adversely affect the operation, safety, capacity, economic useful life or any other aspect of Unit 2.” The second is Section 7 of the Facility Lease, which provides that AEP “shall not directly or indirectly create, incur or suffer to exist any Lien” on Rockport 2, “except Permitted Liens.” The Facility Lease also defines “liens,” and all parties in this action agreed that the encumbrance imposed on Rockport 2 by the modified consent decree constitutes such a “lien.”

The next question, then, was what constituted a “Permitted Lien.” In clause (x) of Section 7 of the Facility Lease was one such permitted lien, allowing “any Governmental Authority to condemn or appropriate the Undivided Interest, Unit 2, any Modification, the Unit 2 Site, the Unit 2 Site Interest, the Common Facilities, the Easements, the Rockport Plant Site or the Rockport Plant, or to control or regulate any of the foregoing or the use thereof in any manner.” This is what the defendants contended had happened when AEP and the state and federal government entities entered into the modified consent decree, and it was this argument that the district court had accepted in dismissing the owners' claims seeking relief from the obligation to “Retrofit, Retire, Re-power, or Refuel” Rockport 2 by six years after the expiration of the Facility Lease. But was this encumbrance actually a “Permitted Lien” within the meaning of the parties' contract?

To fit within this contractual definition, the Sixth Circuit found, the scrubber mandate must: 1) be a right “reserved to or vested in any Governmental Authority”; that 2) involves the power “to condemn or appropriate” or “to control or regulate” Rockport 2 “in any manner.” But whereas the district court interpreted the word “vested” to include rights obtained by the government — by any means and at any time — to exercise power to regulate Rockport 2, the appellate court was not convinced. It held a more restrictive view of this term because doing otherwise would set up a conflict with the plain meaning of clause (x) and with the Facility Lease as a whole.

Parsing the language of these contract sections, the court determined that the rights “reserved to or vested in” the government had to have existed at the time of contracting for the owners to be bound by them. Rights that vested at some future time — like in 2013, when the modified consent decree was entered into — would not be covered. “Based on this plain language reading,” stated the court, “we look to what rights the EPA (as a Governmental Authority) had to condemn, appropriate, control, or regulate Rockport 2 when the parties finalized the sale and leaseback arrangement. At that time, the EPA had the general power to commence proceedings to enforce the Clean Air Act and to settle such proceedings through a consent decree. 42 U.S.C. § 7413(b), (g). And it exercised this power by initiating and ultimately settling enforcement litigation against various AEP affiliates for alleged Clean Air Act violations at other coal-burning power plants. But it did not do so with respect to Rockport 2. Rather, having made no allegations regarding the owners' plant, the EPA gained the ability to impose the scrubber requirement only by virtue of the consent decree agreed to by its lessees — one whereby AEP traded away Rockport 2's long-term value in exchange for a more favorable settlement of claims against their other interests.”

For the defendants to prevail, therefore, the Sixth Circuit concluded that they must show that the Facility Lease expressly allowed them to “create” a right for the EPA to condemn, appropriate, control, or regulate Rockport 2 independent of its abilities under the Clean Air Act. The district court had found support for AEP to create such a right in Section 7's prefatory language, which states: “The Lessee shall not directly or indirectly create, incur or suffer to exist any Lien … except Permitted Liens.” With this language, the district court had reasoned that AEP had done only what it was entitled to do: to “create” a “permitted lien.” Not so fast, said the Sixth Circuit in response to that argument:

This is only half-right. True enough, the Permitted Lien's definition allows AEP to create Liens, like those arising during the normal course of regular operations. This would include, for example, those Liens made “in connection with any Modification or arising in the ordinary course of business” under Permitted Lien clause (v) or replacement parts under Permitted Lien clauses (xv) and (xvi). However, the district court's untethered interpretation ignores Section 7's “suffer to exist” preface and the “reserved to or vested in” clause. Given the latter's plain meaning, AEP cannot create clause (x) liens and instead may allow them only to suffer to exist; to read “create” as an all-encompassing right, as the district court did, renders these other phrases superfluous.

This being so, the “create” language of Section 7 did not, in the appeals court's opinion, support AEP's position that the Facility Lease permitted the defendants to “vest” — that is, create after the fact — additional governmental powers that were not in existence at the time the contract was signed.

Additionally, other sections of the Facility Lease contradicted such an interpretation, and the Sixth Circuit pointed to New York's mandate that courts review the “entire contract,” considering “particular words … not as if isolated from the context, but in the light of the obligation as a whole and the intention of the parties as manifested thereby.” Riverside S. Planning Corp. v. CRP/Extell Riverside, L.P., 13 N.Y.3d 398, 920 N.E.2d 359, 363, 892 N.Y.S.2d 303 (N.Y. 2009) (brackets omitted). Further, New York law declares that, in reading a contract as a whole, a court must not render any provision meaningless. Beal Sav. Bank v. Sommer, 8 N.Y.3d 318 (N.Y. 2007).

One example of how the district court had done this was when it relied on a clause in the Facility Lease that specifically contemplated allowing AEP to pass a judgment lien on to the owners. The Sixth Circuit pointed out, however, that in order to do this, the Facility Lease also required AEP to appeal any such judgment in good faith, set aside adequate reserves, and ensure that the lien did not “involve any danger of the foreclosure, forfeiture or loss” of Rockport 2. If this language protected the owners of Rockport 2 when encumbrances flowed from a judgment against Rockport 2 itself, how could the parties have intended that these owner protections would not apply if AEP was passing on the burden of satisfying a judgment not related to Rockport 2?

An Alternative Tack Fails

The Sixth Circuit rejected one more AEP argument — that the lack of a need for a scrubber at Rockport 2 for many years to come served to benefit not only AEP, but also the owners. The defendants reasoned that operating without it was economically advantageous at this time, and that having until 2028 to alter or shut down the plant gave the owners many years in which to decide which option would be best in light of any changed regulatory or market conditions at that time.

The court agreed that it was possible the terms of the modified consent agreement could prove profitable for the owners; however, stated the court, that did not change the fact that the consent agreement “is a different agreement — one the owners were not a part of, and one that is outside the four corners of the Facility Lease.” In sum, it did not matter that the consent agreement between the government and AEP might benefit the owners because the owners could not be bound, absent their agreement, by anything outside their own contract with AEP.

Conclusion

The Sixth Circuit, having determined that the district court had erred in holding that the modified consent decree constituted a “Permissible Lien” under Section 7 of the Facility Lease, concluded that there was no way within the contract for AEP to push the burden of complying with the government's requirements onto the owners. It thus reversed and remanded for entry of summary judgment in favor of the trustee representing the owners' interests.

The case illustrates how even parties and courts versed in interpreting contract terms can get lost in the details. But, as the Sixth Circuit explained in its opinion in Wilmington Trust Co. v. AEP Generating Co., “New York contract law focuses both on the forest and the trees when determining a contract's meaning.” The “trees” might have looked like one thing, but the “forest” — the meaning of all the contract terms, when read together — told a slightly different story.

*****
Janice G. Inman is Editor-in-Chief of Commercial Leasing Law & Strategy.

The complications that can and do arise in the field of commercial leasing come in all shapes and sizes, and not all can be anticipated. The best-written lease can fall short when an unusual situation arises. However, with careful planning, and if the stars align, lease terms sometimes cover even an abnormal future event, preserving the agreement that the parties undoubtedly contemplated at signing. Such was the case in Wilmington Trust Co. v. AEP Generating Co., 2017 U.S. App. LEXIS 6426, *; 2017 FED App. 0084P (6th Cir. 4/14/17), in which the U.S. Court of Appeals for the Sixth Circuit reversed a lower court ruling to prevent the lessee from passing off unanticipated expenses to the owners.

Sale and Leaseback Agreements

The story began in the 1980s when Affiliates American Electric Power and Indiana Michigan Power Company (collectively, AEP or defendants) built two efficient and low-cost coal-burning power plants in Rockport, IN, known as “Rockport 1″ and “Rockport 2.”

Rockport 2, completed in 1989, has a useful life expectancy estimated at 45 to 65 years, meaning that it should be economically functional until some time between 2034 and 2049. It was financed by a sale and leaseback arrangement with several investor-owned trusts (known here as “the owners” or plaintiffs). As the Sixth Circuit explained, the financing arrangement worked like this: “[E]ach investor formed a pair of trusts (one for each defendant); each trust purchased a portion of defendants' interest in Rockport 2; and each trust leased the interest back to defendants for a period of thirty-three years — through December 7, 2022. As a result, the owners receive annual rent payments, tax and accounting benefits, and, as important here, the value of Rockport 2 after the lease expires (what the parties call its 'residual value').”

Problems arose for the defendants in 1999 when the U.S. Environmental Protection Agency (EPA), several states, and a number of private environmental organizations all brought actions against AEP for modifying some of its power plants nationwide without installing pollution controls that are required by the Clean Air Act. The suits, which concerned 13 of AEP affiliates' plants, were consolidated in the Southern District of Ohio. Neither of the Rockport plants was the subject of any of these allegations, however, and the owners of the plants were not involved in the lawsuits.

To settle the lawsuits, AEP agreed in 2007 to modify its plants — including the Rockport plants, even though these had not been the subject of the suits. For Rockport 2, AEP agreed to install emissions-limiting devices by Dec. 31, 2019, including a scrubber device that would cost in the neighborhood of $1.4 billion. AEP later sought permission to install a less expensive device, but the plaintiffs in the consolidated action objected. The parties to the emissions suit instead agreed in 2013 to modify the 2007 consent decree to allow AEP to install a less expensive system by 2015, under one condition: AEP must also “Retrofit, Retire, Re-power, or Refuel” Rockport 2 by Dec. 31, 2028 — six years after AEP's lease to operate the plant had expired. For purposes of this modified consent decree,”Retrofit” means to install a new scrubber; “Retire” means to permanently shut down Rockport 2,” “Re-power” means replacing the plant's coal-burning technology, and “Refuel” means to convert it to natural gas.

As explained by the Sixth Circuit in the lease-terms dispute action, “The effect of the modification [to the consent decree] is substantial. By pushing the 'Retrofit, Retire, Re-power, or Refuel' requirement to 2028 (six years after the expiration of the Facility Lease), the owners are now responsible for the costs associated with either upgrading Rockport 2 or shutting it down.”

Could AEP do this? The owners thought not, and their trustee soon brought suit against AEP, alleging: 1) breach of the Facility Lease by imposing an impermissible Lien; 2) breach of Section 6.01(j) of the Participation Agreement by taking an action that materially adversely affected the economic useful life of Rockport 2; and 3) breach of the covenant of good faith and fair dealing by interfering with Rockport 2's economic useful life. The case was filed in New York, but later transferred to the Southern District of Ohio. The district court sided with AEP in determining that the costs of the delayed requirement to 'Retrofit, Retire, Re-power, or Refuel” could be pushed onto the owners. The owners appealed to the Sixth Circuit.

Who's on the Hook?

The dispute at the trial court level and on appeal to the Sixth Circuit (which applied de novo review) centered on the terms of the contracts between the owners and AEP. The contracts themselves called for application of New York law, which holds that “the intent of the parties controls and if an agreement is complete, clear and unambiguous on its face, it must be enforced according to the plain meaning of its terms.” Beardslee v. Inflection Energy, LLC , 25 N.Y.3d 150, 8 N.Y.S.3d 618, 31 N.E.3d 80, 84 (N.Y. 2015) (internal quotations and brackets omitted). Further, as explained in S. Rd. Assocs., LLC v. Int'l Bus. Machines Corp. , 4 N.Y.3d 272, 826 N.E.2d 806, 809, 793 N.Y.S.2d 835 (N.Y. 2005), this principle of adhering to the plain meaning of a contract's terms as evidencing the parties' intents “is particularly important in the context of real property transactions, where commercial certainty is a paramount concern, and where the instrument was negotiated between sophisticated, counseled business people negotiating at arm's length.”

Two sections of two of the series of documents memorializing the financing and leasing arrangement between AEP and the owners were important to this case, as both protected the plant's residual value following the lease term. The first of these was Section 6.01(j) of the Participation Agreement, which prohibits AEP from “tak[ing] any action … which will materially adversely affect the operation, safety, capacity, economic useful life or any other aspect of Unit 2.” The second is Section 7 of the Facility Lease, which provides that AEP “shall not directly or indirectly create, incur or suffer to exist any Lien” on Rockport 2, “except Permitted Liens.” The Facility Lease also defines “liens,” and all parties in this action agreed that the encumbrance imposed on Rockport 2 by the modified consent decree constitutes such a “lien.”

The next question, then, was what constituted a “Permitted Lien.” In clause (x) of Section 7 of the Facility Lease was one such permitted lien, allowing “any Governmental Authority to condemn or appropriate the Undivided Interest, Unit 2, any Modification, the Unit 2 Site, the Unit 2 Site Interest, the Common Facilities, the Easements, the Rockport Plant Site or the Rockport Plant, or to control or regulate any of the foregoing or the use thereof in any manner.” This is what the defendants contended had happened when AEP and the state and federal government entities entered into the modified consent decree, and it was this argument that the district court had accepted in dismissing the owners' claims seeking relief from the obligation to “Retrofit, Retire, Re-power, or Refuel” Rockport 2 by six years after the expiration of the Facility Lease. But was this encumbrance actually a “Permitted Lien” within the meaning of the parties' contract?

To fit within this contractual definition, the Sixth Circuit found, the scrubber mandate must: 1) be a right “reserved to or vested in any Governmental Authority”; that 2) involves the power “to condemn or appropriate” or “to control or regulate” Rockport 2 “in any manner.” But whereas the district court interpreted the word “vested” to include rights obtained by the government — by any means and at any time — to exercise power to regulate Rockport 2, the appellate court was not convinced. It held a more restrictive view of this term because doing otherwise would set up a conflict with the plain meaning of clause (x) and with the Facility Lease as a whole.

Parsing the language of these contract sections, the court determined that the rights “reserved to or vested in” the government had to have existed at the time of contracting for the owners to be bound by them. Rights that vested at some future time — like in 2013, when the modified consent decree was entered into — would not be covered. “Based on this plain language reading,” stated the court, “we look to what rights the EPA (as a Governmental Authority) had to condemn, appropriate, control, or regulate Rockport 2 when the parties finalized the sale and leaseback arrangement. At that time, the EPA had the general power to commence proceedings to enforce the Clean Air Act and to settle such proceedings through a consent decree. 42 U.S.C. § 7413(b), (g). And it exercised this power by initiating and ultimately settling enforcement litigation against various AEP affiliates for alleged Clean Air Act violations at other coal-burning power plants. But it did not do so with respect to Rockport 2. Rather, having made no allegations regarding the owners' plant, the EPA gained the ability to impose the scrubber requirement only by virtue of the consent decree agreed to by its lessees — one whereby AEP traded away Rockport 2's long-term value in exchange for a more favorable settlement of claims against their other interests.”

For the defendants to prevail, therefore, the Sixth Circuit concluded that they must show that the Facility Lease expressly allowed them to “create” a right for the EPA to condemn, appropriate, control, or regulate Rockport 2 independent of its abilities under the Clean Air Act. The district court had found support for AEP to create such a right in Section 7's prefatory language, which states: “The Lessee shall not directly or indirectly create, incur or suffer to exist any Lien … except Permitted Liens.” With this language, the district court had reasoned that AEP had done only what it was entitled to do: to “create” a “permitted lien.” Not so fast, said the Sixth Circuit in response to that argument:

This is only half-right. True enough, the Permitted Lien's definition allows AEP to create Liens, like those arising during the normal course of regular operations. This would include, for example, those Liens made “in connection with any Modification or arising in the ordinary course of business” under Permitted Lien clause (v) or replacement parts under Permitted Lien clauses (xv) and (xvi). However, the district court's untethered interpretation ignores Section 7's “suffer to exist” preface and the “reserved to or vested in” clause. Given the latter's plain meaning, AEP cannot create clause (x) liens and instead may allow them only to suffer to exist; to read “create” as an all-encompassing right, as the district court did, renders these other phrases superfluous.

This being so, the “create” language of Section 7 did not, in the appeals court's opinion, support AEP's position that the Facility Lease permitted the defendants to “vest” — that is, create after the fact — additional governmental powers that were not in existence at the time the contract was signed.

Additionally, other sections of the Facility Lease contradicted such an interpretation, and the Sixth Circuit pointed to New York's mandate that courts review the “entire contract,” considering “particular words … not as if isolated from the context, but in the light of the obligation as a whole and the intention of the parties as manifested thereby.” Riverside S. Planning Corp. v. CRP/Extell Riverside, L.P. , 13 N.Y.3d 398, 920 N.E.2d 359, 363, 892 N.Y.S.2d 303 (N.Y. 2009) (brackets omitted). Further, New York law declares that, in reading a contract as a whole, a court must not render any provision meaningless. Beal Sav. Bank v. Sommer , 8 N.Y.3d 318 (N.Y. 2007).

One example of how the district court had done this was when it relied on a clause in the Facility Lease that specifically contemplated allowing AEP to pass a judgment lien on to the owners. The Sixth Circuit pointed out, however, that in order to do this, the Facility Lease also required AEP to appeal any such judgment in good faith, set aside adequate reserves, and ensure that the lien did not “involve any danger of the foreclosure, forfeiture or loss” of Rockport 2. If this language protected the owners of Rockport 2 when encumbrances flowed from a judgment against Rockport 2 itself, how could the parties have intended that these owner protections would not apply if AEP was passing on the burden of satisfying a judgment not related to Rockport 2?

An Alternative Tack Fails

The Sixth Circuit rejected one more AEP argument — that the lack of a need for a scrubber at Rockport 2 for many years to come served to benefit not only AEP, but also the owners. The defendants reasoned that operating without it was economically advantageous at this time, and that having until 2028 to alter or shut down the plant gave the owners many years in which to decide which option would be best in light of any changed regulatory or market conditions at that time.

The court agreed that it was possible the terms of the modified consent agreement could prove profitable for the owners; however, stated the court, that did not change the fact that the consent agreement “is a different agreement — one the owners were not a part of, and one that is outside the four corners of the Facility Lease.” In sum, it did not matter that the consent agreement between the government and AEP might benefit the owners because the owners could not be bound, absent their agreement, by anything outside their own contract with AEP.

Conclusion

The Sixth Circuit, having determined that the district court had erred in holding that the modified consent decree constituted a “Permissible Lien” under Section 7 of the Facility Lease, concluded that there was no way within the contract for AEP to push the burden of complying with the government's requirements onto the owners. It thus reversed and remanded for entry of summary judgment in favor of the trustee representing the owners' interests.

The case illustrates how even parties and courts versed in interpreting contract terms can get lost in the details. But, as the Sixth Circuit explained in its opinion in Wilmington Trust Co. v. AEP Generating Co., “New York contract law focuses both on the forest and the trees when determining a contract's meaning.” The “trees” might have looked like one thing, but the “forest” — the meaning of all the contract terms, when read together — told a slightly different story.

*****
Janice G. Inman is Editor-in-Chief of Commercial Leasing Law & Strategy.