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John Papaspanos Energy Law and Climate Change LAW919-001-12C Professor Ken Kulak 15 January 2013 “I have spoken on several occasions of a "new deal" for the American people. I believe that the "new deal," as you and I know it, can be applied to a whole lot of things. It can be applied very definitely to the relationship between the electric utilities on the one side, and the consumer and the investor on the other.”1 Franklin Delano Roosevelt in his “Portland Speech” on September 21, 1932
During his famous “Portland Speech,” Franklin Delano Roosevelt addressed the question of electrical power in the United States in the context of his broader views of government and its role in regulating the relationship between powerful economic interests and individuals. FDR believed that both the government and economic actors should collaborate in developing an “economic constitutional order” in which individuals are accorded basic economic rights. Accordingly, if a group of economic actors with concentrated wealth decide to exercise their “collective power contrary to public welfare,” FDR’s political philosophy recommended that the government “must be swift” to intervene in order to protect the public interest.2 For this reason, FDR sought to 1 Franklin Delano Roosevelt, Commonwealth Club Address, AMERICAN RHETORIC: ONLINE SPEECH BANK (Sep. 23, 1932), http://www.americanrhetoric.com/speeches/fdrcommonwealth.htm. 2 Id.
establish a regulatory framework to impose restrictions on the utility holding companies of the early 20th century, which he described as “financial monstrosities” that “fleeced [the public] out of millions of dollars.”3
Over seventy years had passed since the Stock Market Crash of 1929, the onset of the Great Depression, and FDR’s activism in pushing reform in the electrical power industry. PUHCA performed the function of dismantling the utility holding companies, however, stakeholders were criticizing its function after the decades-long transformation of the political, economic, and regulatory spheres. Undoubtedly, the same themes and concerns that caused the enactment of PUHCA were also central to the debate surrounding its repeal. In the framework of FDR’s New Deal, the relationship between the electric utilities on the one side and the consumers and investors on the other was examined and the balancing of interests led to PUHCA’s repeal by Congress in the U.S. Energy Act of 2005. The verdict as to whether the repeal of PUHCA will result in favorable outcomes in the long term is difficult to predict at this time,4 but the analysis reveals several preliminary conclusions regarding recent developments. On the one hand, the proponents of PUHCA’s repeal put forth some potential benefits that have not been accrued. And on the other hand, some of the unfavorable consequences that were predicted to occur by the opponents of PUHCA’s repeal have not been borne out. 3 Franklin Delano Roosevelt, The “Portland Speech”, WORKS OF FRANKLIN D. ROOSEVELT (Sep. 21, 1932), http://newdeal.feri.org/speeches/1932a.htm. 4 The two major factors explaining the difficulty in predicting the implications of PUHCA’s repeal are 1) the economic crisis began shortly after the repeal became effective, 2) merger activity is highly cyclical and additional data may be required to make more definitive conclusions because the repeal has only been effective since 2006, amounting to nearly six years of available data.
Furthermore, other factors, perhaps even more powerful than PUHCA’s repeal, are affecting the M&A landscape—such as the motives for mergers today and the ability of state public utility commissions to safeguard the interests of ratepayers through the merger approval process, as evidenced by the role of the New Jersey Board of Public Utilities (NJBPU) in blocking the recent merger attempt between Exelon and PSEG.
Historical Development of the Utility Industry
In the early years of the industry’s development, utility companies “served individual municipalities or neighborhoods pursuant to a franchise agreement with the municipal government.5 By the early 20th century, the earlier regulatory regime consisting of franchise agreements was supplanted by municipal-level regulations, and ultimately, state legislatures passed laws creating public utility commissions with the authority to oversee the utilities operating within each state’s respective borders.6
With the growth of electricity demand, the number and size of the utility industry increased, however, the utilities faced significant legal and regulatory barriers to consolidation, which impeded the consummation of strategic acquisitions.7 Since the institutional barriers were often prohibitively expensive to overcome, the “simplest way to combine operating companies was for a single holding company to purchase control
5 Paul G. Mahoney, The Public Utility Pyramids, Vol. 41, No. 1 THE JOURNAL OF LEGAL STUDIES, 37, 40 (January 2012). 6 Id. 7 Id.
blocks in each operating company.”8 The holding companies would typically span wide
geographic areas and they were often purchased by even larger companies—the high-tier holding companies. The resulting corporate structures were immensely elaborate and sprawling. In addition, they were sometimes made even more complicated when the high-tier holding companies were purchased, controlled, and managed by construction companies or investment banks, thereby creating “super holding companies at the top of the [organizational] pyramids.”9 The equity ownership of the holding companies typically consisted of low-tier holding companies owning all or nearly all of the common equity of the operating companies (i.e. utilities), which represented the base of the pyramid. In the upper-tiers of the structure, the high-tier companies owned lower than a 100 percent stake in one or more low-tier holding companies.10 The potential on the upside was unlimited on the part of the promoter and the controllers of the holding companies, whereas the vast majority of the risk on the downside was shifted to the stakeholders. Coupled with the fact that the securities laws were not in force at that time (e.g. the Securities Act of 1933 and the Securities Exchange Act of 1934), the authorities and investors had immense difficulties in determining the accuracy of the books and records of the holding companies and their subsidiaries. The manipulative accounting and disclosure practices of many holding companies resulted in the lack of a rich information environment, which hindered the authorities and investors from accurately ascertaining the financial condition and performance of the companies. 8 Mahoney, supra note 5, at 40. 9 Id. at 37. 10 Id. at 41.
At the height of consolidation, the concentrated ownership in the industry reached a point where “almost half of all electricity generated in the U.S. was controlled by three
huge holding companies, and more than 100 other holding companies existed.”11 In fact, the ten largest holding company systems in the U.S. sold 75% of the electricity generation in the U.S.12
Dangers of Ownership Consolidation in the Utility Industry
While some holding companies were formed and managed in good faith with the aim of generating a reasonable level of profits and to facilitate the operation of the lower tiers of corporate entities, a subset of other holding companies were created on the basis of speculation and the pursuit of “promotional profits.” According to a report published by the Department of Energy, a promoter could structure a group of companies and sell preferred stocks and bonds to the public to pay for the assets. Then he or she could withhold a generous commission and also maintain control of the company by purchasing all or most of its common stock (voting shares), thereby remaining in control without having paid a cent into the business.” Such financial opportunities provided a wide avenue for speculative investors to engage in risky behavior. On some occasions, the holding companies would “bid against each other to buy operating companies to put into the holding companies” in pursuit of higher levels of profit.13 Such a “frenzied” investment climate encouraged the use of high levels of debt to finance these purchases, 11 Department of Energy, The Changing Structure of the Electric Power Industry: An Update, DOE REPORT, DEC. 1996, at 25, ftp://ftp.eia.doe.gov/electricity/056296.pdf. 12 Mahoney, supra note 5, at 41. 13 Department of Energy, supra note 11, at 25.
resulting in highly-leveraged holding companies that were highly vulnerable to risk in the credit markets and fluctuations in the broader economy. According to Paul G. Mahoney, a law professor of the University of Virginia, the membership in a utility holding company was beneficial to their subsidiaries and their shareholders and the breakup of the holding company was viewed as negative news to investors. He stated that holding companies conferred benefits to subsidiaries “in the form of financial, managerial, or operating efficiencies.”14 Such benefits could have been realized given the synergies and economies of scale that could be captured with consolidation. If the holding companies were in fact managed appropriately with sufficient care and loyalty to shareholders’ interests, there is no doubt that the utility holding companies could be preferable corporate entities, especially in light of the extensive growth experienced by the utility industry at the time. However, the possible gains were likely outweighed by the risk (and actual incurrence) of losses, as evidenced by the damning evidence of the federal investigations that were conducted at the time. Moreover, the holding companies and their investments generated systemic risks not only within the utility industry, but also for the wider economy, subjecting all the relevant stakeholders to the substantial possibility of various harms to their interests. For example, the employees could receive less compensation and even lose their jobs if the utility became bankrupt or underwent financial difficulties. The implosion of a utility not only affected those who worked under its employ, but also the suppliers who relied on their orders for goods and services and investors who relied on their stock valuations for income or even for their retirement. 14 Mahoney, supra note 5, at 40.
But the gravest danger was the prospect of rate hikes for the electricity consumers.
Households were vulnerable to monopoly pricing due to the state-sanctioned monopolies of utility companies and businesses required a constant supply of electricity at reasonable prices for their operations. The cross-subsidization of costs between regulated utility and unregulated activities of its parent company represents the major activity by which holding companies exploited their captive markets. In doing so, the holding company exploited the utility as a “cash cow to support unregulated ventures.”15 Another source of rate increases can be the increase in borrowing costs caused by the additional risk imputed to utility companies if its parent company (i.e. a highly leveraged holding company) used the utility assets to incur debt and then proceeded to invest the cash in high-risk business endeavors.16 Because the additional risk required a higher premium for potential lenders in the capital markets, the utilities would pay a higher cost of capital and such costs would be passed onto their consumers.
The Enactment of PUHCA
In 1928, following the financial failure of several utility holding companies, the U.S. Senate ordered the Federal Trade Commission (FTC) to investigate the corporate misdeeds perpetrated by utility holding companies,17 “after which it criticized the many abuses that tended to raise the cost of electricity to consumers.” In addition, the Securities and Exchange Commission (SEC) also examined the matter and concluded that 15 S&P says PUHCA repeal could damage utilities’ credit, Gas Daily, WLNR. 16 S&P says PUHCA repeal could damage utilities’ credit, Gas Daily, WLNR. 17 Mahoney, supra note 5, at 43.
the holding companies committed many abuses which deprived “existing investors of the returns to which they were entitled, including “ . . . stock watering and capital inflation, manipulation of subsidies, and improper accounting practices.”18 The damning findings of the federal investigators, in combination with the implosion of several holding companies and the intense public criticism of corporate excesses, empowered FDR’s push for reform, culminating in the passage of the Public Utility Holding Company Act of 1935 (PUHCA). Touted as a landmark consumer protection law, PUHCA was “designed to ‘integrate and simplify” the structure of utility holding companies”19 for the benefit of customers and investors. The major features of PUHCA include: 1) limits on the size and geographical scope of utility holding companies, the types of businesses they may engage in, the number of holding companies over a utility in a corporate structure, and their capital structure; 2) regulations regarding the amount of debt, dividends, loans, and guarantees based on utility subsidiaries, 3) controls on selfdealing between affiliate businesses; 4) overseeing acquisitions of other utilities and other business types; and 5) limiting common ownership of both electric and natural gas utilities.20 PUHCA achieved its objective of “breaking up the unconstrained and excessively large trusts that then controlled the Nation’s electric and gas distribution networks.”21 Within twenty years, the number of holding companies declined from more than 200 to
18 Mahoney, supra note 5, 42-43. 19 Geddes, Time to Repeal the Public Utility Holding Company Act, Vol. 16, No. 1, THE CATO JOURNAL 63 (Spring/Summer 1996) 20 Lynn Hargis, PUHCA for Dummies, Sept. 2003, at 2, http://www.citizen.org/documents/puhcafordummies.pdf. 21 Department of Energy, supra note 11, at 24.
fewer than 20.22 During the 70 years of PUHCA’s existence, many commentators attribute the financial strength and reliability of the U.S. electric utility industry to the protections set in place by PUHCA.
Debate over PUHCA: Proponents of Repeal
A confluence of factors, including record oil prices, the 2003 blackouts, and intense lobbying efforts, pushed Congress to reconsider PUHCA as a relevant and effective means of regulating the utility industry. The camp of PUHCA critics who sought its repeal included primarily the utilities, large corporations, and financial institutions. On the other side of the debate, the opponents of PUHCA’s repeal included consumer protection groups, state regulators, credit rating agencies, and several prominent Democratic Congressmen. The strongest argument put forth by the proponents of PUHCA’s repeal was that the law was obsolete and even redundant in light of the current regulatory regime. According to Jason Cuevas, a spokesman for Edison Electric Institute, PUHCA was created over 70 years ago when there were no regulatory oversights from the FERC or SEC which exist today.”23 Many argued that since the utility holding companies have been dismantled and the U.S. utility industry has become fragmented, the purpose of PUHCA has been achieved. But the pertinent question was whether the FERC could effectively take over the role of the SEC as the overseer of mergers after PUHCA would 22 The Energy Policy Act of 2005: The Repeal of PUHCA Paves the Way for New Investments, MORRISON FOERSTER (Aug. 31, 2005), http://www.mofo.com/pubs/xpqPublicationDetail.aspx?xpST=PubDetail&pub=7643. 23 Daily Deal, 2005 WLNR 5939724.
be repealed or would it fail to fulfill the role of “federal referee” and create a regulatory “vacuum?”24 Some argue that the FERC and the broader regulatory framework cannot sufficiently protect consumers and shareholders from the maladies which led to Congress’ action in the first place. For example, during the discussions in Congress, former Representatives John Dingell (D-Mich.) and Edward Markey (D-Mass.) sent a letter to then SEC Chairman Harvey Pitt, stating that they “found ‘troubling’ the fact that the SEC offers only ‘modest books and records requirements’ as substitute for the current act (referring to PUHCA).”25 They were extremely suspicious of the potential for state utility regulators to have the “level of staffing, resources, and technical expertise to fully comprehend potential risks to utility ratepayers.”26 The proponents may counter with the fact that PUHCA was enacted in response to corporate abuses committed without the robust presence of financial intermediaries and proper accounting standards in the economy, which now provide assurances to the accuracy of financial records. However, even though the modern-day auditing industry and the disclosure requirements of securities regulation are reasonably effective in ensuring the integrity of the markets, the opportunities for corporate abuses still exist, as evidenced by the Enron scandal. The gravest concern involves the use of interstate transactions between subsidiaries. For example, Clint Vince, the managing partner of Sullivan and Worcester’s Energy Practice Group, pointed out the fact that state regulators will not have the jurisdiction 24 Electric Utility Week, 2003 WLNR 3197704. 25 Inside FERC, 2002 WLNR 2389614. 26 Inside FERC, 2002 WLNR 2389614.
over interstate transactions, and therefore, holding companies could simply bypass state public utility commissions by causing interstate transactions among the affiliates.27 The other sources of regulatory review that could serve as protectors of the public interest would be the Department of Justice (DOJ), the FERC, and most importantly, the state public utility commissions. Given the recent transactions of post-PUHCA mergers in the utility industry, there is a strong indication that states will step forward and protect the interests of their ratepayers (as will be discussed in the Exelon-PSEG merger). With respect to investor protection, it is likely that the combination of Sarbanes Oxley regulations, the threat of a hostile takeover of management, or the prospect of derivative suits by shareholders, perhaps filing a “piercing the veil” claim, would sufficiently deter mismanagement and corporate abuses. Another powerful argument was that PUHCA was also unfair and harmful to the utility industry. Since the electrical industry was evolving quickly, given the movement for deregulation and other factors, proponents of repeal contended that there were restraints imposed on the 14 PUHCA parent companies that existed at that time, which did not allow them to implement strategies to evolve within their changing environment.”28 The restraints were primarily the geographical restriction, the limits to the types of businesses that they could own, and the additional compliance costs imposed on the utility holding companies which were not imposed on their competitors. Commentators argued that these compliance costs were unfairly harmful to the existing parent companies, but more importantly, they acted as barriers to expansion for companies to increase their size and to make the large investments necessary to build 27 Electric Utility Week, 2003 WLNR 3197704. 28 Cleveland Plain Dealer, 1996 WLNR 5723273.
energy infrastructure. Some argued that PUHCA’s repeal could effectuate a massive investment flow, placing nearly a trillion dollars in play. For example, Warren Buffet
expressed his desire to allocate 10 to 15 billion dollars of capital to energy infrastructure. When a massive blackout struck the northeastern U.S. in August of 2003, many commentators attempted to attribute the power failure to the lack of infrastructure investment that could be remedied by PUHCA’s repeal. Last, proponents of PUHCA’s repeal focused on the anti-competitive nature of PUHCA’s regulations that restrained holding companies to operate within a specific geographic area where they could establish a high level of market power. They compared the utility industry and its dispersed economic units to other capital-intensive industries, such as the oil industry, where the concentration of ownership is high.29 The argument states that large companies with more efficient access to capital are more costeffective entities to finance the long construction lead times and high upfront costs associated with the building of power plants, transmission lines, and other types of infrastructure.30 Some commentators even claim that a more consolidated industry would lead to less volatility in prices because the major players would be less willing to undercut the other companies’ sales in competing for more market share. These arguments would be more plausible if electricity was a typical consumer product. On the contrary, electricity holds unique characteristics that create an additional risk factor in the utility industry and engender particularly dangerous conditions for corporate abuse. The five major characteristics that differentiate electricity from other products are as follows: 1) the supply of electricity must be equivalent to demand at every second and each 29 M&A, Boom or Bust?, 2005 WLNR 23165196. 30 Id.
location in the network, 2) any electricity generated must be transported through a transmission network that has a limited capacity, 3) the generation of electricity is
restricted to the number of generators operating at that time producing a limited amount of energy, 4) electricity is very expensive to store and impracticable at a large scale with current technology, and 5) the real-time demand for electricity is close to perfectly priceinelastic because the retail price charged to virtually all final consumers does not change with the hourly wholesale price.31 The potential to manipulate supply and prices is greater due to the abovementioned characteristics of electricity, and thus, weakens the argument that high consolidation of the utility industry may be a favorable objective.
Debate over PUHCA: Opponents of Repeal
In the other camp of the debate, the opponents of PUHCA’s repeal, which included an eclectic coalition of stakeholders, expressed their concerns with respect to the implications of repealing PUHCA. First, they were fearful of consolidation and the return of the corporate abuses which prompted Congress to act in the first place. As of now, the utility industry has not demonstrated such a trend. Although several high profile mergers have taken place in recent years, the market remains relatively fragmented. Second, the opponents of PUHCA repeal were fearful that “non-industry players, such as private equity or other financial companies, [would] increase their investments in the sector.”32 The two major issues concerning that development would be that such nonutility companies do not have the necessary management expertise to operate in the 31 Wolak and McRae, supra note 31, at 12. 32 Natural Gas Week, 2003 WLNR 17456591.
industry and their primary objectives would be to maximize value for the short term, perhaps without a sensitivity to the long term interests of utilities and stakeholders.
Likewise, this concern has also not been borne out. On the contrary, Oregon and Arizona recently denied two merger proposals by private equity firms. Therefore, the merger review process on the state level can effectively impose a defense against takeover attempts of utilities by private equity firms. Furthermore, credit rating agencies were particularly persuasive in pointing out that the parent companies of utilities would be allowed to pursue investment options that would generate higher rates of return, but also lead to the “deterioration in credit quality for utilities” if the decisions resulted in unfavorable outcomes.33 According to a S&P report, “if regulated utilities choose to pursue those options (i.e. invest in unwise investments in unregulated entities), we could see deterioration in credit quality for utilities whose corporate parents have an appetite for greater risk if PUHCA is repealed.”34 PUHCA was meant to limit the unregulated investments of holding companies and their ownership of large nonutility investors to one utility,” with certain exceptions.”35 PUHCA achieved these limits on investment activity largely through the use of a single provision: Section 11(b)(1). With respect to nonutility acquisitions, Section 11(b)(1) of PUHCA stated that, “a registered system can retain a nonutility system only if it is ‘reasonably incidental or economically necessary or appropriate’ to the operations of [an]
33 S&P says PUHCA Repeal could Damage Utilities’ Credit, Gas Daily, WLNR. 34 Id. 35 Gas Daily, supra note 33.
integrated public-utility system.”36 Based on the SEC’s interpretation of this provision, the nonutility systems allowed under this rule include “businesses that supply or serve the utility system, such as coal mines or rail lines.”37 In addition, Section 11(b)(1) obligates each registered system to be a “single integrated public-utility system,” which the SEC interpreted as imposing a “virtual ban on the acquisition of geographically distant utility assets through holding companies.”38 As a result, the registered holding companies were limited to a single geographical area, which “greatly limited” merger activity among utilities.39 Finally, one of the strongest arguments by opponents of repeal emerged in the wake of Enron’s collapse. The debate surrounding PUHCA and its repeal was made more complicated by the accounting scandals and other corporate abuses that led to the collapse of Enron in the early 2000s (2001-2002). Through the misuse of special purpose vehicles, Enron concealed large amounts of debt through its manipulative accounting methods and caused significant harms to investors and ratepayers after its bankruptcy. While many proponents of PUHCA’s repeal argued that PUHCA was an ineffective regulatory regime, as proven by Enron’s bankruptcy, the opponents of repeal rebutted, arguing that PUHCA was instrumental in reducing potential harms because Enron was prohibited from purchasing regulated utilities across the country. The issue of whether Enron could have been avoided if there was stricter SEC enforcement of PUHCA is open to debate, but what is more important is the role of ringfencing as a regulatory tool in controlling interstate transactions among subsidiaries 36 Geddes, supra note 19, at 64. 37 Geddes, supra note 36, at 65. 38 Id. 39 Id.
of utility holding companies. In the 1990s, Enron was granted permission under PUHCA to purchase Portland General Electric (PGE) after establishing its state of incorporation in Oregon although the majority of the company’s operating activities were conducted in geographical areas that were far away from Oregon. Some commenters argued that PUHCA was useful in preventing Enron from skimming PGE earnings out of Portland for investments in other businesses. More importantly, when Enron collapsed (20012002), Portland’s ratepayers did not receive a heavy blow in the form of rate hikes because of the prudent regulatory action by Oregon in which the assets of the utility were “ringfenced.” Ringfencing occurs when regulators raise “barriers on the state level between the regulated utility and the parent and its unregulated companies.”40 Therefore, the regulatory tools of ringfencing and the use of “mini-PUHCA” laws can be employed by states for the purpose of enhancing protections for their utilities. Tools such as ringfencing and mini-PUHCA laws are supplemental to the strongest bulwark on the state level against unfavorable mergers—the state utility commission. In conclusion, after a lengthy debate, intensified by the Enron debacle, Congress ultimately passed the Energy Policy Act of 2005 and President George W. Bush signed it into law on August 8, 2005. Essentially, the SEC was replaced by the FERC as the supervisor over utility holding companies. The major features of PUHCA’s repeal is that 1) it allows non-utility entities to invest in or merge with utility holding companies and public utilities, 2) existing utilities can now merge with or acquire other utilities that operate in noncontiguous territories and non-utility companies, and 3) the FERC was 40 PUHCA Repeal: A Door Opens, ELECTRIC PERSPECTIVES, Jan. 1, 2006, 32-34, http://www.eei.org/magazine/EEI%20Electric%20Perspectives%20Article%20Listing/20 06-01-01-PUHCA.pdf.
granted greater authority to review and approve investments and mergers in the utility industry.41
The Motives Driving Recent Merger Activity
Many commentators believed that PUHCA’s repeal would open the floodgates for mergers, resulting in a highly consolidated industry in which a select few utilities could exercise market power to the detriment of ratepayers and possibly commit corporate abuses at the expense of investors. Keith Boyfield, a Fellow of the Institute of Economic Affairs, expressed his views about the potential for mergers in his prognosis: “Expect a feeding frenzy.”42 However, since PUHCA’s repeal in 2006, the utility industry has not seen the level of merger activity that was anticipated. One can argue that the repeal of PUHCA represents a door that opens: an obstacle is removed and an incentive is created to enter through the door. However, to continue the analogy, the conditions outside must still be favorable to proceed in exiting out the door. Likewise, even though PUHCA was repealed, there are other factors, namely motives to merge during various points in the business cycle for different reasons, that can explain the merger activity of the utility industry in the present day. Unlike other sectors of the economy, mergers and acquisitions (M&A) in the utility industry follow a cyclical pattern of activity in which various factors not only affect the number and value of deals consummated, but also the strategies employed by the merging companies and their rationales for pursing a business combination. The provisions of 41 MORRISON FOERSTER, supra note 22. 42 Utility Week, 2005, WLNR 16273803.
PUHCA have been a powerful force in shaping the M&A landscape in the utility industry, as evidenced by its highly fragmented nature, with “more than 3,000 utilities providing power to the country’s energy consumers and more than 240 publicly listed companies generating 75% of the sector’s power.”43 Since the early 1990s, the utility industry has completed three waves of M&A activity44 and it is currently undergoing a fourth wave.45 The early 1990s saw a “period of strategic mergers, aimed at
opportunities to build out regional markets and exploit cost synergies.”46 Thereafter, in the mid- to late- 1990s, the underlying rationale for many of the deals during the next active period of mergers was to prepare for deregulation and competitive positioning. Deal making reached its acme during 1999-2000 when companies reconfigured the industry in response to the deregulation of the wholesale markets.47 And then from 2005 to 20007, earnings growth became the main purpose of M&A. According to Gregory Aliff, a vice chairman of energy and resources at Deloitte, the M&A activity was “more offensive—companies were seeking growth.”48 By providing a steady stream of cash flows, equity ownership of utilities served as an attractive investment that yielded rates of return in the median range of the spectrum of possible investment options. Utility stocks did not provide the returns of riskier equity on the one end of possibilities, but they did 43 Economist Intelligence Unit, 2006 WLNR 24815254. 44 The first wave of mergers lasted from 1999 to 2000 and the second wave occurred between 2005-2007. 45 Alan Feibelman, Today’s Utility Mergers: The Search for Financial Strength, OLIVER WYMAN (2011), http://www.oliverwyman.com/media/20110923_EGY_Todays_Utility_Mergers.pdf. 46 M&A, Boom or Bust?, 2005 WLNR 23165196. 47 M&A, Boom or Bust?, 2005 WLNR 23165196. 48 Adam Aston, Utilities Turn to Mergers as Demand for Power Slows, DEALB%K (Jun. 16, 2011), http://dealbook.nytimes.com/2011/06/16/utilities-turn-to-mergers-as-demandfor-power-wanes/.
pay out more than bonds. Accordingly, some commentators attribute Wall Street call for higher earnings growth during those boom years as the likely “forcing function.”49 Such a push for more earnings may have reflected a stronger appetite for risk on the part of investors who either held stocks in utility companies (or their parent companies) or those who were interested in purchasing them. In the present, the M&A landscape is different than the other periods when merger activity was also considered “hot.” The motives driving the mergers of today can be characterized as “defensive” in the sense that electricity demand is growing at a very low rate and the only way for companies to increase their earnings is through consolidation.50 Since the peak of electricity growth rate in the 1950s at 9.8% per year, the demand for electricity has “decelerated” in the last sixty years.51 To date, the total U.S. retail electricity consumption is growing only about 2% per year, and thus, the utilities are pursuing mergers with the aim of growing their profits. Specifically, the current M&A wave is fueled by the desire on the part of utilities to strengthen their balance sheets and achieve financial stability as a means of improving their quality of credit and gaining better access to capital.52 In addition, there are strong pressures for the utility industry to make massive investments in the country’s ageing infrastructure. Accordingly, utilities are seeking to merge for the purpose of enhancing their ability to secure the necessary capital to rebuild generation, modernize infrastructure, construct large transmission projects, and replace or upgrade transmission
49 M&A, Boom or Bust?, 2005 WLNR 23165196. 50 Aston, supra note 49. 51 Id. 52 Feibelman, supra note 46.
and distribution assets.53 Similarly, the prospect of more burdensome environmental
regulations also creates a need for capital expenditures. The calls to design “smart grid” technology to increase efficiencies and to reduce the environmental footprint of electricity generation to combat climate change require massive amounts of capital that may not be as readily available to utilities as stand-alone entities. In conclusion, the M&A landscape is shaped by the economic cycle and strategic motives on the part of merging companies. Even though PUHCA’s repeal did increase the number of mergers in the utility industry, that particular regulatory regime may have been deemed as a secondary concern. As explained above, the M&A landscape is shaped by the economic cycle and strategic motives on the part of merging companies. It is more likely that PUHCA’s repeal has served to facilitate mergers by increasing the flexibility of merging companies and reducing the compliance costs of mergers. In addition, energy analyst, Maurice May, believes that PUHCA’s repeal has accelerated the consolidation process, “but only modestly.”54 Therefore, it can be concluded that PUHCA’s repeal was important, but there are relatively more significant factors at play, such as the aforementioned motives of merging companies and the role of state public utilities explained below.
VIII. Exelon-PSEG Merger
In the context of these historical, regulatory, and economic developments, the Chicago-based Exelon corporation (Exelon), sought to purchase the Newark, NJ-based 53 Feibelman, supra note 46. 54 Daily Deal, 2005 WLNR 5939724.
Public Service Enterprise Group Incorporated (PSEG), through a $15.2 billion stock swap. The proposed Exelon-PSEG merger was announced in December of 2004 and after almost 19 months of negotiations, the two companies terminated their merger agreement in September of 2006. Therefore, PUHCA was in force at the beginning of
the negotiations, but it was repealed by the end of the negotiations period when the U.S. Energy Act of 2005 became effective on February 8, 2006. Among other assets, Exelon owns Pennsylvania’s largest utility, PECO, which provides services to about 1.6 million electricity customers in Philadelphia and the wider area while PSEG owns Public Service Electric and Gas Company (PSEG), which serves 2.1 million electricity customers in New Jersey. If the two companies had merged as intended into Exelon Electric and Gas, the combined entity would have been the largest utility in the U.S. The entity would have served almost seven million electricity customers and two million natural gas customers in Illinois, New Jersey, and Pennsylvania, with the use of approximately 51,000 megawatts (MW) in generation capacity, including 40% of it provided by nuclear power plants.55 Within the PJM Interconnection,56 the service territories of the two entities or their subsidiaries are adjoining: the eastern border of PECO’s service territory is adjacent to the western border of PSEG’s territory. The PJM Interconnection is an independent system operator and it has gained approval by the FERC as a Regional Transmission Organization (“RTO”) largely for the Mid-Atlantic region. The fact that both companies are members of PJM was a positive input for the decision making process at the FERC. 55 Wolak and McRae, supra note 31, at 2. 56 The wholesale market that includes some or all of the state of Pennsylvania, New Jersey, Maryland, Delaware, North Carolina, Michigan, Ohio Virginia, West Virginia, Indiana, and Illinois. Id. at 3.
According to Christine Tezak, senior vice president of Stanford Washington Research
Group, the “deal would have raised market power concerns at the FERC if the companies had not already joined PJM.”57 She predicted that the companies’ inclusion in PJM would “likely mitigate the vast majority of the transaction’s possible anticompetitive data” due to the advanced nature of the regional transmission organization.58 However, even if the companies’ membership in PJM alleviated some concerns about anti-competitiveness, the merger would have owned or controlled over 20% of the . . . PJM system.59 With PSEG controlling a large portion of capacity in PJM East, the merger would create an even higher concentration of ownership in PJM and ratepayers would be subject to risks associated with the merged company’s potential exercise of market power. The dealmakers on each side of the transaction had to “jump through many hoops” en route to the goal of closing the deal. And although the market power issue was the biggest obstacle that the companies faced during the long negotiating process with regulators, it was not the first.60 Undoubtedly, the management and the Board of Directors of Exelon were likely tracking the developments of the PUHCA debate and assessing the implications of a potential repeal during the earlier phases of the strategic planning of the merger. Under PUHCA, a utility holding company could either be registered or a company could attempt to receive an exemption if it met certain criteria. The two most common exemptions were granted if: 1) the utility’s operations were predominately in a single 57 Energy Trader, 2004 WLNR 21471860. 58 Energy Trader, 2004 WLNR 21471860. 59 Energy Trader, 2004 WLNR 21471860. 60 Daily Deal, 2005 WLNR 5939724.
state or 2) the utility is predominately an operating utility.61 Even though a company was eligible for exempt status, the company would still be required to abide by the “two-bite rule,” which “prohibited any firm that owns 5 percent or more of the voting securities of any public utility from acquiring 5 percent or more of the voting securities of another public utility without SEC approval.”62 In addition, the exempt holding company would be banned from merging with a non-utility parent company. Exelon was incorporated in Pennsylvania in February of 1999 and it was listed as a registered public utility holding company under PUHCA, as amended, due to its organizational structure and its asset holdings. In fact, in Exelon’s filing under PUHCA on December 30, 2005, Exelon stated that it “would continue to be a registered public utility holding company under the Act until the Energy Policy Act of 2005 became effective.”63 However, the fact that Exelon was a utility holding company did not pose a problem to the merger. According to Christine Tezak, senior VP of Stanford Washington Research Group, the merger did not face any major hurdles related to PUHCA. Exelon has underwent a similar process with respect to other acquisitions (i.e. the Commonwealth Edison and PECO deals) and “it does not appear to be an impediment to [the] current operational success” of the company.64 PSEG was incorporated in New Jersey in 1985 and it was an exempt public utility holding company under PUHCA primarily because of its predominantly NJ-based operations. The merger was feasible on the PSEG’s side of the merger as well. There 61 Geddes, supra note 19, at 64. 62 Geddes, supra note 19, at 64. 63 Exelon’s Filing under the PUHCA, as Amended, GOVPLUS, Jan.10, 2006, 1569-1580, http://govpulse.us/entries/2006/01/10/E6-84/filing-under-the-public-utility-holdingcompany-act-of-1935-as-amended-act-. 64 Energy Trader, 2004 WLNR 21471860.
were no issues raised as to any PUHCA violations. In fact, Patrick Wood, a former chairman of the FERC stated, “the only people you can merge with under [PUHCA] without triggering a lot of trouble is your next door neighbors."65 With the potential of
creating a larger service territory within a contingent and integrated area, the merger was consistent with the incentive structure as set forth by former chairman Wood. Therefore, PUHCA (or its absence) would not (and did not) substantially affect the merger of Exelon with PSEG. The role of PUHCA was eclipsed by other factors that contributed more to the failure of negotiations and the ultimate termination of the merger agreement. The major gatekeepers that reviewed the merger were the FERC, the Department of Justice (DOJ), and the state public utility commissioners of Pennsylvania and New Jersey. In the Energy Policy Act of 2008, Congress expanded the FERC’s merger authority in two major respects. First, the FERC’s merger authority under Section 203 of the Federal Power Act was increased to “cover more types of transactions” and it imposed an additional requirement that mergers do not result in the cross-subsidization of non-utility subsidiaries.66 For example, the Energy Policy Act mandates any public utility to secure the FERC’s consent before they can, among other things, purchase, sell, lease, or merge its jurisdictional facilities valued in excess of $10 million, including generation facilities.67 In addition, any holding company seeking, among other things, to purchase, acquire, or merge with a transmitting company, an electric utility company, or certain 65 Stephanie Cohen, Exelon, PSEG Seek Merger Approval, CBS MARKETWATCH, Jan. 12, 2005, http://www.marketwatch.com/story/exelon-pseg-to-meet-with-federalregulators-on-merger. 66 Inside FERC, 2005 WLNR 15581344 67 MORRISON FOERSTER, supra note 22.
other holding companies must be reviewed by the FERC using the “public interest”
standard.68 Secondly, the Energy Policy Act required utility holding companies to keep and make available to the FERC any books and records that are necessary to protect the interests of customers regarding jurisdictional rates.69 Based on this statutory authority, the FERC examined the merger by applying the “public interest” standard, which takes into account the effects of the merger on competition, rates, and regulation. According to Frank A. Wolak, who assisted the DOJ in analyzing the Exelon-PSEG merger, the FERC uses the Horizontal Merger Guidelines to determine the effect on competition, as does the DOJ. The effect on rates element involves the effect of the merger on any wholesale power or transmission customer. Last, the effect on regulation evaluates the effectiveness of federal or state regulations that will be adversely affected by the merger. In the final analysis, the FERC laid down one major barrier for the companies: the issue of divestiture. In the merger review process, the FERC assessed the representations of the companies and noticed several errors in the assumptions and conclusions in the filings relating to divestiture. As a result, the companies increased the amount of divestiture to 4,000 MW in May of 2005. In January of 2006, the Pennsylvania Public Utility Commission approved the merger with the proposed divestiture package. The “public interest” standard was used whereby the companies offered concessions to PA ratepayers in order to persuade the regulators that the merger was aligned with the interest of the public. Some benefits included a promise by PECO to not increase retail prices until 2010 and to assist the low-income 68 MORRISON FOERSTER, supra note 22. 69 Id.
ratepayers in paying more affordable rates for their electricity.70 Another interesting
outcome was the fact that PECO ensured that its headquarters will remain in Philadelphia until at least 2010. The next relevant agency to consider the proposed merger was the DOJ, which conditioned its approval of the merger with the divesture of 6 power plants amounting to 5,600 MW of fossil-fuel generation capacity, but did not obligate them to divest the nuclear power plants.71 The DOJ reviews utility mergers under Section 7 of the Clayton Act, which bans mergers that are “likely to lessen substantially competition in any relevant market.”72 Using the Horizontal Merger Guidelines, the DOJ makes decisions that are designed to prevent the formation of monopolies and to ensure robust competition within various industries. Given its responsibility of examining the effect of the merger on competition, the DOJ’s approval provided the companies the opportunity to substantiate their claim that the DOJ has shown that any market power issues will be resolved. The theory behind the divestiture was to mandate the companies to sell off certain power plants in order to reduce their ability to manipulate the price of wholesale electricity by exercising market power. Essentially, with greater ownership of electricity generation, the companies could employ various mechanisms to reduce output, and thus, increase prices. Finally, the New Jersey Board of Public Utilities (NJBPU) was the final agency where the merging companies had to secure approval. Although the current economic downturn may represent a reason for regulators to be more amenable to approving 70 Wolak and McRae, supra note 31, at 36. 71 Energy Daily, 2006 WLNR 12763542 72 Comments of the Department of Justice, HEARING BEFORE THE FERC, http://www.justice.gov/atr/public/comments/200542.pdf.
mergers in order to promote investment, the considerations of tangible benefits to
ratepayers, market power issues, and the prospect of labor synergies (i.e. savings realized by reducing labor costs) may have been even more important in the decision making process. NJBPU issued an order on June 20, 2005 that required the merging companies to show that PSEG customers and NJ would “benefit from the merger and the merger would not lead to adverse effects on competition, employees of PSEG, and reliability of electricity supply to the state.”73 From the perspective of the merging companies, the most attractive benefit that would be accrued in the deal was the use of Exelon’s expertise in the management of PSEG’s nuclear facilities beyond a service agreement that was in place at the time. PSEG was running several nuclear plants below optimal efficiency, and given Exelon’s experience and know-how, the PSEG facilities could have been operated at a higher profit, and thus, possibly reduce the wholesale cost of electricity for ratepayers. Another source of benefits would accrue from labor synergies because the combined entity would have eliminated jobs, particularly among PSEG employees in NJ. However, the public interest standard was focused on the magnitude of benefits and synergies that would be passed onto the ratepayers. In the final analysis, the major contention between NJBPU and the merging parties was the issue of tangible net benefits accrued by NJ and its stakeholders and the issue of wholesale market competitiveness. For a total of nearly 19 months, the parties primarily negotiated over these two issues, even three months after the DOJ provided its approval. The NJBPU demanded higher concessions than the merging companies provided to the 73 Wolak and McRae, supra note 31, at 38.
other regulatory agencies. During the regulatory review process, the NJ legislature applied pressure by pushing a resolution that opposed the acquisition. Non-binding Resolution No. 185 “urged the NJBPU to reject the merger” because it would be more difficult for the regulators to oversee the combined entity that was based beyond the
state’s borders and that the newly formed company could exercise market power over NJ ratepayers.74 Many other opposition groups vociferously attacked the proposed merger. As a last-ditch effort, the merging companies offered an enhanced cash settlement to the NJBPU that could be distributed to NJ ratepayers, which could be used to reduce the electricity rates for PSEG customers (or at least offset their increases). Apparently, the benefits package was not sufficient from the perspective of the NJ regulators, and as a result, the merging companies ultimately terminated the merger agreement in September of 2006. The value of the benefits package to NJ customers was likely excessive in relation to the value of the merger, and thus, the merging companies ended the process.
As detailed in the description of the historical, regulatory, and economical analysis above, the enactment of PUHCA was done at a time when the utility holding companies dominated the industry and committed many abuses. PUHCA was successful in addressing the issues facing the utility industry at that time. But after many decades of political and economical advancements and the creation of new regulatory regimes, the
74 Electric Utility Week, 2006 WLNR 12278793.
relevance of PUHCA was rightfully challenged. However, even more legitimate were the concerns raised by stakeholders about the implications of PUHCA’s repeal. For this reason, the PUHCA debate was highly important and in the coming years, the wisdom or imprudence of that decision will become more apparent. Based on the analysis, the proponents of PUHCA’s repeal have put forth claims that have not emerged whereas the opponents of PUHCA’s repeal have predicted bad outcomes that have not been borne out as of yet. Rather, there are other factors, unrelated to PUHCA’s repeal, that are more powerful in shaping the M&A landscape—most importantly, the role of the state utility commissions. For these reasons, it is likely that the regulatory regime without PUHCA will probably succeed in preventing the corporate abuses committed by the utility holding companies of earlier eras and that the states will fill in the SEC’s role of the “federal referee” and effectively “defend their turf.”
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