No. 80-99 

IN THE SUPREME COURT OF THE STATE OF MONTANA 

1981 

MOUNTAIN STATES TELEPHONE AND 

TELEGRAPH COMPANY, a Colorado 

corporation, 

Plaintiff and Appellant, 

VS. 

THE DEPARTMENT OF PUBLIC SERVICE 

REGULATION, MONTANA PUBLICE SERVICE 

COMMISSION et al., 

Defendants and Respondents. 

Appeal from: District Court of the First Judicial District, 

In and for the County of Lewis and Clark. 

Honorable Peter Meloy, Judge presiding. 

Counsel of Record: 

For Appellant: 

Hughes, Bennett, Kellner and Sullivan, Helena, Montana 

J. Walter Hyer argued, Denver, Colorado 

For Respondents: 

Calvin K. Simshaw argued, M.P.S.C., Helena, Montana 

James C. Paine Montana Consumer Counsel Counsel, Helena, 

Montana 

John Allen argued, Consumer Counsel, Helena, Montana 

Filed: 

Submitted: January 12, 1981 

Decided : FEB 5 - l9%l 
Mr. Chief Justice Frank I. Haswell delivered the Opinion of the 

Court. 

This is an appeal by Mountain States Telephone & Telegraph 

Company (Mountain Bell) from a judgment of the District Court in 

a utility rate case. The Montana Public Service Commission (PSC) 

granted Mountain Bell an annual rate increase totalling 

$3,097,000 as compared to the $11.83 million sought. The 

District Court concurred. We affirm. 

Mountain Bell petitioned the PSC for utility rate 

increases that would generate $11.83 million additional yearly 

revenues from its Montana customers. PSC granted interim rate 

increases of $2,326,000 pending its final decision which are not 

at issue in this appeal. PSC's final order granted Mountain Bell 

an annual revenue increase of $3,097,000 in increased charges for 

its services to its Montana customers. 

Mountain Bell petitioned the District Court of Lewis and 

Clark County for judicial review of PSC's final order pursuant to 

the Montana Administrative Procedures Act. Subsequently Mountain 

Bell elected to proceed under Montana Public Utilities Act 

(Section 69-3-401, MCA et seq). The District Court's pretrial 

order narrowed the issues to two: (1) PSC's application of the 

"double leverage" adjustment in determining the cost of capital 

in Mountain Bell's rate base, (2) PSC's "NARUC" tax adjustment. 

The District Court received the transcript of proceedings 

be£ ore the PSC, heard additional evidence, and remanded the case 

to the PSC for reconsideration on the basis of the additional 

evidence. The PSC reconsidered, a£ f irmed its previous final 

order, and returned the case to the District Court. The District 

Court affirmed PSC's final order holding (1) that the "double 

leverage" concept was lawful, was applied within the statutory 

authority of the PSC, and was supported by substantial evidence, 

and (2) that the "NARUC" tax adjustment was within the statutory 

authority of the PSC and was supported by substantial evidence. 
Mountain Bell appealed from the judgment of the District 

Court, abandoning the issue of the "NARUC" tax adjustment. 

The sole issue on appeal is the legality of PSC1s "double 

leverage'' adjustment in determining the cost of capital in 

Mountain Bell's rate base. 

Before considering the arguments of Mountain Bell, an 

understanding of the capital structure of Mountain Bell and its 

parent company, AT&T is necessary. The "double leverage" 

adjustment, as applied here, is premised on the PSC1s consideration of the parent-subsidiary financial relationship and 

its effect on the cost of capital in Mountain Bell's rate base. 

It is a basic principle of utility regulation that a utility is entitled to receive a fair and reasonable rate of return 

on its investment in plant and equipment used to provide its services to the public. In determining a fair and reasonable rate 

of return, it is necessary to determine what it costs the utility 

to secure the required capital to finance its operations. This 

"cost of capital" approach to utility ratemaking involves determining the composite cost of the several types of the utility's 

capital, properly weighted on the basis of an appropriate capital 

structure. New England Telephone & Telegraph Co. v. Public 

Utility Commission (1978 ), Me. , 390 A.2d 8, 32. The 

"cost of capital" involves not only the interest the utility must 

pay on its borrowed capital (debt), but also the cost of 

attracting purchasers of its common stock (equity). A regulatory 

commission such as the PSC must authorize utility rates sufficient 

to cover the utility's cost of debt and cost of equity, but no 

more, or the utility's customers will be paying excessive rates 

for the services the utility provides. 

In this case Mountain Bell's capital structure as 

reflected in its books indicates that it is funded 44.65% by 

borrowed funds (debt) and 55.35% by sale of its common stock 

(equity). Because Mountain Bell is partially financed by debt 
and partially financed by equity, Mountain Bell's common 

stockholders are said to be "leveraged" to the extent that the 

cost of its debt is less than the (weighted) cost of its capital. 

In other words, Mountain Bell 's common stockholders are 

"leveraged" because Mountain Bell is paying less interest on its 

borrowed funds than the return it makes on the use of its 

borrowed funds. This is leverage #l. 

But in this case there is a second or "double leverage" 

en joyed by the common stockholders of AT&T arising out of the 

parent-subsidiary relationship between AT&T and Mountain Bell. 

When this case was heard by the PSC, ATbT owned 88.55% of the 

common stock of Mountain Bell, with the balance being held by 

minority stockholders. Thus the common stockholders of AT&T are 

"double leveraged": first, because the cost of debt in AT&T1s 

capital structure is less than the return it makes on the use of 

its borrowed funds; and second because it derives the benefit of 

similar leverage in Mountain Bell's own capital structure by 

reason of its 88.55% ownership of Mountain Bell's common stock. 

The PSC found that if the "cost of capital" in Mountain 

Bell's rate base was considered in isolation without regard to 

the "double leverage" enjoyed by AT&T8s common stockholders, it 

would result in an excessive return to AT&T' s common stockholders 

at the expense of Montana utility ratepayers. To correct this 

inequity, the PSC applied a "double leverage" adjustment in 

determining the "cost of capital" in Mountain Bell's rate base. 

In summary form, the PSC applied the "double leverage" 

adjustment in this manner: 

(1) PSC determined that the capital structure of Mountain 

Bell was composed of 45.65% debt (borrowed funds) and 55.35% 

equity (common stock) as reflected in its books. 

(2) PSC determined that an 11.25% return on the capital 

invested in Mountain Bell was a fair and reasonable rate of 

return. 
(3) PSC determined that if ~ountain Bell had been funded 

in the open market the weighted cost of Mountain Bell Is capital 

would have been 9.473, figured as follows: 

Weighted 

-- Type of Capital % of Capitalization Cost -- Cost 

Debt 44.65% X 7.26% = 3.24% 

Common Stock 55.35% X 11.25% = 6.23% 

100.00% 9.47% 

(4) PSC determined that 88.55% of Mountain Bell's equity 

is owned by AT&T whose weighted cost of capital is 9.86% 

figured as follows: 

Weighted 

-- Type of Capital % of Capitalization Cost - - Cost 

Debt 23.1% X 6.47% = 1.49% 

Preferred Stock 8.0% X 7.82% = .63% 

Common Stock 

(5) PSC determined that 88.55% of Mountain Bell's equity 

should be sourced to AT&T because it owned 88.55% of Mountain 

Bell's stock; and AT&Tts cost of capital of 9.86% should be 

applied to such 88.55%. The remaining 11.45% of Mountain Bell's 

equity held by minority stockholders was allowed a capital cost 

(6) PSC determined that the composite weighted cost of 

capital to Mountain Bell was 8.78% based on the following 

computation : 

Weighted 

-- Type of Capital -- % of Capitalization Cost Cost 

Debt 44.65 X 7.26% = 3.24% 

Equity supplied by AT&T 49.01 X 9.86% = 4.83% 

(88.55% x 55.35%) 

Equity supplied by 

minority stockholders 

The use of 8.78% as the weighted cost of capital of 

Mountain Bell will result in a return of 10.01% to its minority 

stockholders rather than the 11.25% found to be a fair and 

reasonable return by the PSC. The District Court held this inequity was the result of the capital structure of AT&T and 
Mountain Bell rather than the PSC's rate order. The District 

Court pointed out that the PSC's function was fulfilled when it 

established a fair and reasonable rate of return on the utility's 

investment regardless of how the utility's management distributed 

that return among its stockholders. 

Mountain Bell advances three principal arguments against 

the PSC1s application of the "double leverage" adjustment in 

determining the cost of capital in Mountain Bell's rate base: 

(1) that it is not supported by substantial evidence, (2) that 

the "double leverage" adjustment as applied by the PSC is inconsistent within itself, ignoring the very principles on which it 

is based, and (3) it is premised on a disregard of applicable law 

in that the minority stockholders will not receive the return on 

their investment found to be fair and reasonable by the PSC. 

At the outset we note that Mountain Bell's third argument 

is now moot. The minority stockholder's interests in Mountain 

Bell have been purchased by AT&T. Mountain Bell is now a whollyowned subsidiary of AT&T. 

Mountain Bell contends first that PSC's use of the "double 

leverage" adjustment must be set aside as unsupported by substantial evidence. Mountain Bell urges that the uncontradicted evidence shows that Mountain Bell's capital structure appropriately 

consists of 44.65% debt, but by use of the "double leverage" 

adjustment, the PSC raised Mountain Bell's debt ratio to 55.99%, 

without an analysis of the effect on the cost of equity. The 

addition of 11.34% debt into the capital structure must be accmpanied by a change in the cost of equity, in order to provide a 

return to equity reflecting the increased risk. The result is a 

substantial understatement of Mountain Bell's revenue 

requirements--a result which is contrary to the financial principles relied on by the parties, according to Mountain Bell. 

The evidence presented by the PSC established to the 

satisfaction of the district judge that the "double leverage" 
adjustment was based on substantial evidence. The District Court 

found that the double leverage adjustment simply established the 

true cost of that portion of Mountain Bell's equity (common 

stock) attributable to AT&T's financing (88.55%). The PSC 

established 9.86% as the true cost by weighing the three associated costs making up AT&T1s capital structure--debt, preferred 

stock and common stock. Contrary to what Mountain Bell asserted, 

this adjustment did not infuse additional debt into Mountain 

Bell's capital structure. The earnings of Mountain Bell will be 

subject to the same debt obligations regardless of the source of 

the equity investment. There is no increase in the financial 

risk nor any change in the priority of the Mountain Bell stockholders' claim to the assets or income of Mountain Bell. 

Therefore, the Mountain Bell stockholders are not entitled to a 

greater rate of return because the risk of the stockholders has 

not been increased. Here the return to the stockholders of 

Mountain Bell capital is in£ luenced because the capital structure 

of the consolidated Bell System has varying amounts of debt in 

the capital structure of both AT&T and Mountain Bell, not because 

the "double leverage" adjustment has increased the risk to 

stockholders in Mountain Bell. 

We note that the "double leverage" adjustment has previously been recognized by regulatory commissions in situations 

involving a parent and a wholly-owned subsidiary: Re General 

Telephone Company of Wisconsin (1960), 34 PUR3d 497, 515-519; 

Re Hawkeye State Telephone Co. (1974), 2 PUR4th 166, 180-181; Re 

United Telephone Co. of New Jersey (1974), 2 PUR4th 299, 307-310; 

Re Midstate Telephone Co., Inc. (1975), 10 PUR4th 88, 95-96; Re 

Continental Telephone Co. of Minnesota, Inc. (1976), 14 PUR4th 

310, 315-317; Re Blackstone Valley Electric Company ( 1978), 24 

PUR4th 309, 321-323. It has been recognized but denied application in the only appellate decision cited involving a parent corporation owning 86% of the stock of the subsidiary. New England 
Telephone & Telegraph Co. v. Public Utilities Commission, supra, 

Me. , 389 A.2d at 39-43. That case is clearly 

distinguishable, in that the MaiwCommission failed to adequately consider the effect of "double leverage" on both the 

majority and minority shareholders so as to enable the court to 

determine the reasonableness of the result; additionally the 

method of applying double leverage by the MaineCommission was not 

supported by substantial evidence and was inconsistent with the 

Commission's own declaration concerning the "double leverage" 

concept. None of these factors is present in the instant case. 

The District Court found that "the application of 'double 

leverage' does not cause an increase in financial risk and there 

is, therefore, no increase in the cost of equity" and "there 

being no change in priorities [the priority of claims of Mountain 

Bell stockholders to the assets and income of Mountain Bell] 

there is no change in financial risk and no change in the cost of 

equity. " (Bracketed material inserted. ) 

We hold that the PSC's order was lawful and was supported 

by substantial evidence. Accordingly, we af f irm the District 

Court on this issue mindful of our role in reviewing cases under 

the Montana Public Utilities Act (sections 69-3-401, MCA et 

seq. ). 

Our review in utility rate cases is limited to determining 

whether the PSC order (1) exceeds the constitutional or statutory 

powers of the PSC or (2) is based upon a mistake of law. Cascade 

County Consumer's Ass'n v. PSC (1964), 144 Mont. 169, 192, 394 

P.2d 856, 868. The Commission is the judge of the facts and the 

court only decides questions of law. New England Telephone & 

Telegraph Co. v. Public Utilities Commission, supra, Me. I 

390 A.2d at 15. In deciding questions of law, this Court may 

determine whether the PSC acted arbitrarily and unreasonably 

without sufficient evidence to support its findings, or exercised 

its authority unreasonably, or set the utility rates so low that 
they are con£ iscatory and deprive the utility of its property 

without due process of law. Cascade County Consumers Ass'n v. 

PSC, supra. This Court on appeal cannot substitute its judgment 

for that of the PSC. State v. Public Service Comm. (1957), 

131 Mont. 272, 280-281, 309 P.2d 1035, 1040. 

Mountain Bell next contends that the "double leverage" 

adjustment applied by the PSC is inconsistent with itself and 

understates Mountain Bell's revenue requirements in part by 

ignoring the principles on which the "double leverage" ad j ustment 

is based. Mountain Bell argues that the principle on which the 

"double leverage" adjustment is based is that the source of funds 

determines its cost; that the PSC applied its "double leverage" 

adjustment to retained earnings as well as to paid-in capital of 

Mountain Bell; that PSC misapplied the principle on which the 

"double leverage" adjustment is based because the source of the 

retained earnings is not AT&T but the assets, income, and capital 

structure of Mountain Bell; in so doing PSC sourced 88.55% of 

Mountain Bell's retained earnings to AT&T and applied AT&TVs 

overall cost of capital to those retained earnings. This is 

inconsistent with the principle that the source of funds determines its cost, is unsupported by any evidence, and is totally 

arbitrary and illogical, according to Mountain Bell. 

The PSC argued to the District Court that the true source 

and ultimate destination of 88.55% of Mountain Bell's retained 

earnings is AT&T. The cost of capital associated with 88.55% of 

Mountain Bell's retained earnings is 9.86% (the cost of capital 

to AT&T) because that is the cost of capital associated with that 

portion of Mountain Bell Is operating assets that generated those 

retained earnings. If Mountain Bell retains a portion of its 

earnings these are no less the capital of AT&T than paid-in 

capital. PSC further emphasized that no court or commission has 

accepted Mountain Bell's argument that the source of retained earnings is the subsidiary and not the parent which controls its 
stock, or that a distinction should be made between cost of capital attributable to paid-in capital and that attributable to 

retained earnings. 

Consumer Counsel agreed that the retained earnings are 

a reinvestment by the stockholders of Mountain Bell in the 

company. Consumer Counsel pointed out that before Mountain Bell's 

board of directors (controlled by AT&T by reason of its majority 

stock ownership) ever retained part of its earnings they were 

available to Mountain Bell 's stockholders as dividends. Thus the 

source of 88.55% of Mountain Bell's retained earnings is AT&T 

which has complete control over Mountain Bell 's board of 

directors and thus complete control over whether its earnings are 

retained by Mountain Bell or paid out as dividends. Accordingly, 

the PSC properly included retained earnings in the equity investment of AT&T in Mountain Bell and applied AT&T1s cost of capital 

to its entire equity investment in Mountain Bell. 

The District Court adopted the reasoning of Basil L. 

Copeland, Jr. in his article "Double Leverage One More Time," 

100 Public Utilities Fortnightly 19, in finding in favor of the 

PSC: 

" . . . the cost of equity is the same whether 

the equity was raised in the capital market or 

exists in the form of retained earnings. If a 

subsidiary retains a portion of its earnings, 

the earnings it retains are no less the capital 

of the parent than the capital recorded on its 

accounts as 'paid in'!" 

The District Court held that because retained earnings are the 

property of the equity owner (AT&T to the extent of its 88.55% 

ownership of Mountain Bell's common stock) it had a claim against 

88.55% of Mountain Bell's retained earnings. Therefore the PSC 

correctly applied its "double leverage" adjustment in order to 

reflect the true cost of capital associated with that portion of 

Mountain Bell's retained earnings attributable to the parent 

The record in this case shows substantial, though 
con£ licting, evidence supporting the PSC's application of the 

"double leverage" adjustment. The district judge based his findings on that evidence, and we will not overturn him. 

In sum, the District Court held that PSC1s concern was to 

determine a rate base which represents the total investment in 

property used and useful in rendering utility services and to 

multiply that by a rate of return sufficient to generate enough 

earnings to make the return on investment fair and reasonable. 

The District Court further held that PSC function is fulfilled 

when it determines such total investment and a rate of return 

which will af ford a reasonable return on that investment . This is a correct statement and the evidence shows that 

the PSC acted reasonably and within the bounds of the law. 

It would appear that the PSC applied the "double leverage" 

adjustment in order to protect Montana ratepayers from paying 

excessive utility rates. A fair overall rate of return to all 

stockholders on their investment was fixed and determined, but 

because the capital structure of AT&T afforded double leverage to 

the common stockholders of AT&T their rate of return on their 

investment in Mountain Bell would always be greater than the 

minority stockholders in Mountain Bell regardless of what rate of 

return might be adopted by the PSC. This discrepancy is 

inherent in the capital structure of the parent AT&T vis-a-vis 

the capital structure of the subsidiary Mountain Bell. This 

capital structure was determined by the management of the two 

companies, not by the rate order of the PSC. The PSC1s function 

was fulfilled when it established a fair and reasonable return on 

Mountain Bell's investment in plant and equipment used and useful 

in furnishing its services to the public. It is a function of 

management to distribute that return to its stockholders and if 

Mountain Bell's capital structure prevents an equitable 

distribution, this is not the fault of the PSC. To guarantee the 

minority stockholders the 11.25% return found to be fair and 
reasonable by the PSC would result in an unconscionable and 

excessive return of 14.26% to AT&T common stockholders at the 

expense of Montana ratepayers, all because of the capital structure of the two companies. This inequity will not recur in the 

future as Mountain Bell is now a wholly-owned subsidiary of AT&T 

with no minority stockholders in Mountain Bell. 

Affirmed. 

Chief Justice 

Hon. %ark Sullivan, sitting in 

place of Mr. Justice Shea who deems 

himself disqualified.