### No. 80-99 IN THE SUPREME COURT OF THE STATE OF MONTANA 1981

MOUNTAIN STATES TELEPHONEAND 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 JohnAllen argued,Consumer Counsel,Helena,Montana

Filed: Submitted: January 12, 1981 Decided: 

## FEB5

# -l9%lMr. Chief Justice Frank I. Haswell delivered the Opinion of the Court.

This is an appeal by Mountain StatesTelephone & Telegraph Company (MountainBell)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. Weaffirm. Mountain Bellpetitioned the PSC forutility 

### rate increases thatwould 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 arenot 

### at issue in thisappeal. 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 Bellpetitioned the District Court of Lewis and Clark County forjudicial review of PSC's final order pursuant 

### to the Montana Administrative Procedures Act. SubsequentlyMountain Bellelected 

### to proceed under Montana PublicUtilities Act (Section69-3-401, MCA etseq). The District Court's pretrial order narrowed the issues to two: (1)PSC's applicationof the "double leverage" adjustment in determining the cost of capital inMountain 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 tothe PSC for reconsideration on the basis of the additional evidence. The PSC reconsidered, a£firmed itsprevious final order, and returned the case to the District Court. The District Court affirmed PSC's finalorder holding (1)thatthe "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 indetermining 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&Tis necessary. The "double leverage" adjustment, 

### as applied here, 

### is premised on the PSC1s considerationof the parent-subsidiary financial relationship and its effecton the cost of capital inMountain Bell's rate base. It is a basic principle of utility regulation that a utilityis entitled to receive a fairand reasonable rate of return

on 

### its investment inplant and equipment used 

### to provide 

### its services to the public. In determining a fairand reasonable 

### rate of return, it 

### is necessary 

### to determine what it 

### costs the utility tosecure the required capital to finance 

### itsoperations. 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 interestthe utilitymust 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 tocover the utility's 

### cost of debt and 

### cost of equity, but no more, orthe utility's customers willbe paying excessive rates forthe services the utilityprovides. 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 debtand 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)costof its capital. Inother 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&Tarising out of the parent-subsidiary relationship between AT&Tand Mountain Bell. When this case was heard by the PSC, ATbT owned 88.55%of the

common stockof Mountain Bell, with the balance being held by minority stockholders. Thus the common stockholders of AT&Tare "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 inMountain 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&T8scommon stockholders, it would result in an excessive return 

### to AT&T's common stockholders atthe expense of Montana utility ratepayers. To 

### correct this inequity, the PSC applied a "double leverage" adjustment in determining the "cost of capital" inMountain Bell's ratebase. In summary form, the PSC applied the "double leverage" adjustment in thismanner: (1)PSC determined that the capital structure of Mountain Bell was composed of 45.65%debt (borrowed funds) and 55.35% equity (common stock) asreflected in its books. (2)PSC determined that an 11.25%return on the capital invested inMountain Bellwas a fair and reasonable rateof return.(3)PSC determined that if ~ountain Bell had been funded inthe open market the weighted cost of Mountain BellIscapital 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&Twhose 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&Tbecause 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 willresult 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 structureof AT&TandMountain Bellrather than the PSC's 

### rate order. The District Court pointed out that the PSC's function

### was fulfilled when it established a fairand reasonable 

### rate of return on the utility's investment regardless of how the utility's management distributed thatreturn among its stockholders. Mountain Bell advances threeprincipal arguments against thePSC1s applicationof the "double leverage" adjustment in determining the 

### cost of capital inMountain 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 inconsistentwithin itself, ignoring the very principles on which it is based, and (3)it is premised on a disregard of applicable 

### law inthat the minority stockholderswillnot receive the return on their investment found tobe fairand reasonable by thePSC. Atthe outset

### we note thatMountain 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 Bellcontends firstthatPSC's use of the "double leverage" adjustment must be set aside as unsupported by substantial evidence. Mountain Bell urges that the uncontradicted evidence shows thatMountain 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 inthe cost of equity, inorder to provide a return toequity 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 satisfactionof the districtjudge 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 thatportion 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&T1scapital structure--debt, preferred stock and common stock. Contrary to what Mountain Bell asserted, thisadjustment did not infuse additional debt into Mountain Bell's capital structure. The earnings of Mountain Bell

### willbe subject to the 

### same debt obligations regardless of the source of the equity investment. There 

### is no increase inthe financial risknor 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 greaterrate 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 BellSystemhas varying amounts of debt in the capital structure of both AT&Tand Mountain Bell, not because the "double leverage" adjustment has increased the risk to stockholders inMountain 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; ReHawkeye StateTelephone Co. (1974), 2 PUR4th 166, 180-181; Re United Telephone Co. of New Jersey (1974), 2 PUR4th 299, 307-310; Re MidstateTelephone Co., Inc. (1975), 10 PUR4th 88, 95-96; Re Continental Telephone Co. of Minnesota, Inc. (1976), 14PUR4th 310, 315-317; Re BlackstoneValley Electric Company (1978), 24 PUR4th 309, 321-323. It has been recognized but denied application in the only appellatedecision cited involving a parent 

### corporation owning 86%of the stockof the subsidiary. New EnglandTelephone & Telegraph Co. v. Public Utilities Commission, supra, 

### Me. 

## ,389 A.2d at39-43. That case 

### is clearly distinguishable, inthat 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 inconsistentwith the Commission's own declaration concerning the "double leverage" concept. None of these factors is present inthe instant case. The District Court found that "the applicationof 'double leverage' does not cause an increase infinancial risk and there is, therefore, no increase in the costof equity" and "there being no change inpriorities [thepriority of claims of Mountain Bell stockholders to the assets and income of Mountain Bell] there is no change in financial risk and no change inthe 

### cost of equity.

### " (Bracketed material inserted.) Wehold that the PSC's order 

### was lawful and 

### was supported by substantial evidence. Accordingly, 

### we af f

### irmthe District Court on this issue mindful of our 

### role in reviewing 

### cases under theMontana 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), 144Mont. 169, 192, 394 P.2d 856, 868. The Commission is the judge of the facts and the court onlydecides questions of 

### law. New England Telephone & Telegraph Co. v. Public UtilitiesCommission, supra, Me. I 390 A.2d at 15. In deciding questions of 

### law, thisCourt may determine whether the PSC acted arbitrarily and unreasonably without sufficientevidence 

### to support its findings, 

### or exercised its authority unreasonably, or 

### set the utility 

### rates so 

### lowthatthey 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. Statev. Public Service Comm. (1957), 131Mont. 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 inpart by ignoring the principles on which the "double leverage" adjustment 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 toretained earnings aswell

### 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&Tbut the assets, income, and capital structureof Mountain Bell; in so doing PSC sourced 88.55%of Mountain Bell's retained earnings 

### to AT&Tand applied AT&TVs overall cost of capital to those retained earnings. This 

### is inconsistentwith the principle that the source of funds determines its cost, is unsupported by any evidence, and is totally arbitraryand 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% (thecost of capital toAT&T)because that is the cost of capital associated with that portion of Mountain BellIsoperating assets thatgenerated those retained earnings. If Mountain Bellretains a portion of its earnings these are no less the capital of AT&Tthanpaid-in capital. PSC further emphasized that no court orcommission has accepted Mountain Bell's argument that the source of retained 

### earnings is the subsidiary and not the parent which controls itsstock, orthat 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 (controlledby AT&Tby reason of 

### its majority stockownership) 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 inthe equity investment of AT&TinMountain Bell and applied AT&T1scost of capital to its entire equity investment inMountain Bell. The District Court adopted the reasoning of Basil L. Copeland, Jr. inhis 

### 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 inthe capital market or exists in the form of retained earnings. If a subsidiaryretains 

### 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 thatbecause retained earnings 

### are the property of the equity owner (AT&Tto the extentof 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 inorder to reflect the true cost of capital associated with thatportion of Mountain Bell's retained earnings attributable to the parent

The record inthis

### case shows substantial, thoughcon£licting, evidence supporting the PSC's application of the "double leverage" adjustment. The districtjudge based his findings on that evidence, and 

### we willnot overturn him. In sum, the District Court held thatPSC1s concernwas 

### to determine a 

### rate base which represents the total investment in property used and useful inrendering utility services and to multiply that by a rate of return sufficientto generate enough earnings tomake the return on investment fair and reasonable. The District Court further held thatPSC function is fulfilled when it determines such 

### total investment and a rate of return which willafford 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. Itwould appear that the PSC applied the "double leverage" adjustment in order toprotect Montana ratepayers from paying excessive utility 

### rates. A fairoverall rateof return 

### to all stockholders on their investment 

### was fixed and determined, but because the capital structureof AT&Tafforded double leverage to the common stockholders of AT&Ttheir rate of return on their investment inMountain Bellwould always be greater than the minority stockholders inMountain Bell regardless of what rate of returnmight be adopted by the PSC. This discrepancy is inherent in the capital structure of the parent AT&Tvis-a-vis the capital structure of the subsidiaryMountain 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 inplant and equipment used and useful infurnishing its services to the public. It is a function of management to distribute that return to its stockholders and if Mountain Bell's capital structureprevents an equitable distribution, this is not the faultof the PSC. To guarantee the minority stockholders the 11.25%return found 

### to be fair andreasonable by the PSC would result in an unconscionable and excessive return of 14.26%toAT&Tcommon stockholders at the expense of Montana ratepayers, all because of the capital structure of the two companies. This inequity willnot recur in the future as Mountain Bell is now a wholly-owned subsidiary of AT&T with no minority stockholders inMountain Bell. Affirmed.

Chief Justice

Hon. %ark Sullivan, sitting in place of Mr. JusticeShea who deems himself disqualified.