Opinion ID: 372907
Heading Depth: 2
Heading Rank: 2

Heading: The Hypothetical Capital Structure

Text: 100 Even though COMSAT had not issued any debt securities, the Commission postulated that having passed its birth-pain years, COMSAT would by 1973 be able to sustain debt in its capital structure. (J.A. 60, 56 FCC2d at 1160). The Commission was not undertaking to restructure the capital of COMSAT on its own; that was for the COMSAT management to accomplish when it considered such a readjustment appropriate. The Commission's imputing of debt was an admittedly hypothetical construct, for the purpose of determining the allowable rate of return. COMSAT's maintenance of an all equity structure resulted in an inordinately high cost of capital, since the cost of equity is generally higher than the cost of debt, and almost all public utilities carry some debt. Indeed, some public utility commissions have held that it is the obligation of a public utility to offer as much debt as is consistent with the sound finance of the company. See, e. g., Re New York Telephone Company, 7 PUR4th 496, 506 (N.Y. Pub. Util. Comm'n 1974). Cf. AT&T, 9 FCC2d 30, 52 (1967). Rate-payers are subjected to an excessive burden when the revenues to be derived from the rates they pay have to be high enough to compensate the cost of a capital structure consisting entirely of equity financing; levering 33 a capital structure with lower-costing debt relieves some of that burden. 34 101 The authority of a public utility commission, like the FCC, to assume hypothetical debt for a company derives from its jurisdiction over rates charged by the company, that they be just and reasonable. The appropriate part of the COMSAT Act providing such power to the FCC is 47 U.S.C. § 721(c) (2): 102 (T)he Federal Communications Commission, in its administration of the provisions of the Communications Act of 1934, as amended, and as supplemented by this chapter, shall . . . insure that all present and future authorized carriers shall have nondiscriminatory use of, and equitable access to, the communications satellite system and satellite terminal stations under just and reasonable charges . . . . 103 We reject the Commission's allegation, made in its brief to this court, that the proper jurisdictional statutory provision in this rate-making proceeding is 47 U.S.C. § 721(c)(8), which provides: 104 721. In order to achieve the objectives and to carry out the purposes of this act . . . (c) the Federal Communications Commission in its administration of the provisions of the Communications Act of 1934, as amended, and as supplemented by this act, shall (8) authorize the corporation (Comsat) . . . to borrow any moneys . . . upon a finding that such . . . borrowing . . . is compatible with the public interest, convenience, and necessity and is necessary or appropriate for or consistent with carrying out the purposes and objectives of this act by the corporation. 105 This statute merely directs the Commission to Authorize the borrowing of moneys when a certain showing is made and the managerial decision as to whether the corporation should borrow money remains with COMSAT. However, it is well settled in public utility law that it is no interference with this management prerogative for a regulatory commission to impute a hypothetical capital structure, whether or not the regulated company increases its debt; for that is done merely in pursuance of the Commission's legitimate rate-making authority. 106 One of the clearest statements of this principle is afforded by the Supreme Court of New Hampshire, in New England Telephone & Telegraph Co. v. State, 98 N.H. 211, 220, 97 A.2d 213, 220 (1953): 107 Although the determination of whether bonds or stocks should be issued is for management, the matter of debt ratio is not exclusively within its province. Debt ratio substantially affects the manner and cost of obtaining new capital. It is therefore an important factor in the rate of return and must necessarily be considered by and come within the authority of the body charged by law with the duty of fixing a just and reasonable rate of return. 108 The same sentiment has been echoed by the Federal Communications Commission itself in a rate determination opinion: 109 We do not propose to require RCAC or any other carrier to incur any particular percentage of debt in meeting its capital requirements. However, it appears to us that in fixing a rate of return we must keep in mind the capital structure which a regulated carrier chooses to maintain in order to balance properly the requirements of safety of investment, stability of dividends, and availability of capital, and an obligation to maintain that rate structure which will, consistent with the foregoing, result in minimum requirements from the rate-paying public. 110 Re Western Union Telegraph Co., 25 F.C.C. 535, 600-01, 25 PUR3d 385, 464-65 (1958). Many state public utility commissions have also followed this method of imputing a hypothetical amount of debt. For example, the Idaho Public Utilities Commission has stated: 111 The function of this commission is regulatory and not managerial. The determination of debt-equity ratios of capital is for management, but when a policy adopted by management results in the payment by subscribers of rates higher than might be required under another policy available to management, then this commission must take note. 112 Re Mountain States Telephone & Telegraph Co., 6 PUR3d 428, 438 (Idaho Pub. Util. Comm'n 1954). The Public Service Commissions of Louisiana and Wyoming are on record to the same effect. See Louisiana Public Service Commission v. Southern Bell Telephone & Telegraph Co., 14 PUR3d 146, 165 (La.Pub.Serv.Comm'n 1956); Re Mountain States Telephone & Telegraph Co., 14 PUR3d 231, 237 (Wyo. Pub. Serv. Comm'n 1956). 113 Perhaps the ultimate authority for imputing debt when necessary to protect rate-payers from excessive capital charges is the Supreme Court's statement in Hope Natural Gas, that The rate-making process under the Act, i. e., the fixing of 'just and reasonable' rates, involves a balancing of the investor and the consumer interests. 320 U.S. at 603, 64 S.Ct. at 288. The equity investor's stake is made less secure as the company's debt rises, but the consumer rate-payer's burden is alleviated. It is these conflicting interests that the Commission is to reconcile. 114 The FCC cannot be faulted for considering consumer interests in the COMSAT proceeding, and deciding that COMSAT could reasonably have levered its capital structure with debt. In so doing, it not only was true to its statutory obligation, but was also following a practice quite commonplace among public commissions charged with reviewing and setting reasonable rates for service. The practice of imputing a hypothetical amount of debt has been explicitly approved by the public utility commissions or courts of at least twenty-two states and the District of Columbia. Over the course of the last two decades, the following jurisdictions have hypothetically altered the actual capital structure of a regulated corporation for purposes of setting rates that were more equitable to consumers: Alabama, 35 Connecticut, 36 Delaware, 37 District of Columbia, 38 Idaho, 39 Illinois, 40 Louisiana, 41 Maryland, 42 Massachusetts, 43 Michigan, 44 Mississippi, 45 Montana, 46 Nebraska, 47 New Hampshire, 48 New Mexico, 49 Pennsylvania, 50 South Dakota, 51 Tennessee, 52 Texas, 53 Utah, 54 Vermont, 55 Washington, 56 and Wyoming. 57 Minnesota 58 and California 59 have expressed some reservation to imputing a hypothetical amount of debt when the regulated company's outstanding debt was not improper. 60 But the term improper could have referred to the perspective of a rate-payer, in which case those courts would not be in disagreement with the others cited. The Supreme Judicial Court of Massachusetts has most directly addressed the problem of when debt may be imputed, and has on some occasions refused to do so. See, e. g., Boston Gas Co. v. Department of Public Utilities, 359 Mass. 292, 269 N.E.2d 248 (1971); Mystic Valley Gas Co. v. Department of Public Utilities, 359 Mass. 420, 269 N.E.2d 233 (1971). 61 A reconciliation of that state's case law on this point is offered in New England Telephone & Telegraph Co. v. Department of Public Utilities, 360 Mass. 443, 275 N.E.2d 493 (1971). The distinction drawn by the Supreme Judicial Court between cases where hypothetical debt would be imputed, and where it would not be, was one of degree; where the company's debt structure was already close to what the regulatory commission was proposing for rate-making purposes, or soon would be, the court held the Commission ought not interfere. The court stated: It is now clear that in certain circumstances the Department may disregard the actual capital structure of a regulated utility company and attribute to it a hypothetical capital structure for the purpose of rate making. . . . 275 N.E.2d at 507. In the case before it, however, where the utility had demonstrated it would imminently have a debt structure of 45%, the court ruled that the regulatory commission erred in imputing a debt percentage of 50%. That rationale clearly has no application here, where the regulated company, COMSAT, has a debt ratio of 0%, and the FCC proposes to impute a 45% Debt. 115 Hence, we hold that the Commission acted consistently with settled regulatory law and acted well within its own jurisdiction as the reviewer of rates proposed by COMSAT, when it hypothesized some debt in COMSAT's capital structure. The question next arises whether there was substantial evidence for the Commission's choice of 45% As the level of debt to be assumed. 116 The Commission based its determination of a 45% Level of imputed debt on comparative evidence from other communication companies and AT&T in particular. The Commission's decision states: 117 Comsat's peculiar 100% Equity capital structure was noted by Dr. Carleton and, of course by Dr. Brigham who acknowledged that the absence of debt resulted in less risk for Comsat's stockholders. Dr. Brigham also indicated that the average debt ratio for utilities was 61%. Currently AT&T's debt ratio is approximately 50%. We also take notice from our 1974 compilation of Statistics of Communications Common Carriers that the weighted average (arithmetic mean) ratios of long-term debt to total capital for 87 telephone and 7 telegraph carriers was 49.1% And 40.4% Respectively. On the basis of the foregoing we believe it conservative to impute debt at a 45% Level in our determination of Comsat's 1975 rate of return allowance. 118 (J.A. 58; 56 FCC2d at 1158) (footnotes omitted). The 1973 Annual Report of AT& T (the 10K Report on file with the Securities and Exchange Commission) shows that AT&T had a 47.6% Debt ratio. 62 Hence, the Commission's reference to an approximate debt ratio of 50% Was more generous than accurate; and a proper reference indicates that the Commission's imputation of 45% Debt was even closer to that of AT&T than the Commission claimed. 119 A great assortment of hypothesized rates can be found among the decisions of the various courts and public utility commissions that have adjusted capital structures for rate of return purposes. In most cases, the hypothesized percentage of debt is defended merely on the ground that the regulated company has been shown to be able to sustain that amount of debt without jeopardizing the integrity of its equity. 63 When comparisons are made, the more common approaches are to refer to like utilities in the area, 64 similar companies in the industry, 65 or future trends predicted for the company itself. 66 Viewing the grand display of public utility commissions' statements on this question, the rationale proffered by the FCC in this case certainly ranks among the more complete: it refers to the general industry, to a particular competitor, and to the financial ability of the company in question. 120 In addition to the foregoing sufficient justifications for the choice of 45%, it should be noted that many public utility commissions and courts have chosen 45% In the absence of alternative evidence. The Supreme Court of Louisiana has stated: 121 Since the decision of the United States Supreme Court in the case of Federal Power Commission v. Hope Natural Gas Co., supra, the hypothetical 45% Debt ratio rule has been almost universally adopted in those states where there is no formula prescribed by constitutional provisions or statutes for the determination of a rate base. 122 Southern Bell Telephone & Telegraph Co. v. Public Service Commission, 239 La. 175, 199, 118 So.2d 372, 381 (1960). 67 Cases which have applied the 45% Rule almost automatically have involved a wide assortment of actual debt ratios that ranged from zero to just under 45%. 68 Other target debt ratios have also been used in their own appropriate context: adjustments have been made from 27% To 38%, 69 from 39.4% To 47.5%, 70 from 7% To 35%, 71 and so on. Of most interest here are those cases that have imputed a high debt percentage for a company with no debt at all. In Pennsylvania Public Utilities Commission v. Johnstown Water Co., 19 PUR3d 433, 443-44 (Pa. Pub. Util. Comm'n 1957), the Commission imputed a debt of 59% To an all-equity company, although the subject company had recently begun to borrow small amounts on the short-term market. In Re Lawrence Gas Co., 12 PUR3d 64 (Mass. Dept. of Pub. Util. 1955), a 45% Level of debt was assumed, although once again the creation of debt was not completely an assumption because the subject company was a subsidiary of another which had a 57% Debt ratio. In Lower Paxton Township v. Commonwealth, 13 Pa.Cmwlth. 135, 144-45, 317 A.2d 917, 921-22 (1974), a company with an all equity capital structure was hypothesized to have 55% Of its capital subsumed by debt, for purposes of rate-making. 123 Our conclusion must be that there is adequate authority, both in the factual administrative record here, and in prior decision law of courts and public utility commissions, to support the imputation by the FCC of 45% Debt to the all-equity structured COMSAT for rate-making purposes. 124 Nevertheless, we are not insensitive to the adjustment problems that are involved in the 45% Imputation, particularly in light of the fact that COMSAT was in no respect negligent in business sense for using an all-equity structure. There were many good, conservative reasons for that capital structure. 125 The Commission chose to impute a 45% Level of debt for 1975, and future years, in its decision that was issued in December of 1975. (J.A. 60, 56 FCC2d at 1160). Admittedly, the FCC was not ordering a restructuring of COMSAT's capital structure, so the shock of actually going from zero to 45% Debt was not necessarily imposed. However, when the Commission imposed the 45% Assumption it was fully aware that unless COMSAT did adopt a level of debt at least that high, the stockholders would not receive an 11.3% Rate of return on equity which, as noted elsewhere in this appeal, is at the lower limit of what could be approved as compensatory. 72 (J.A. 73, 56 FCC2d at 1173). 126 Under the assumptions most favorable to the position of the Commission, 1973 was the year in which COMSAT reached a level of maturity able to sustain debt in its capital structure. (J.A. 58, n. 92; 56 FCC2d at 1158, n. 92). The Commission's warning did not come until December of 1975, however; and then it could not fault COMSAT for maintaining an all-equity structure as late as 1973. The result is that, no matter what COMSAT might have done to increase debt earlier, it is a stretch of the Commission's finding to rule that COMSAT should have begun to lever its capital structure in 1973. COMSAT was not made aware of the consequences for rate-making of not obtaining debt financing until late 1975. Accordingly, it was an abuse of discretion for the Commission to treat COMSAT as though it had 45% Debt all at once (indeed, retroactively, since the 45% Assumption applied to the entire 1975 year, while the Commission's opinion did not issue until December of 1975). 127 COMSAT, of course, is free not to alter its capital structure at all. 73 If it chooses not to do so in the face of the now-apparent FCC rate-making policy, then it is consciously accepting a lower rate of return for its stockholders, possibly in the interest of preserving for them a low level of risk. The fault of the Commission's action in this opinion is to deny COMSAT even the opportunity to make that choice and begin to phase in debt. As of the moment the opinion was issued, COMSAT shareholders were subjected to a less than adequate rate of return. If the level of hypothesized debt were only a small increase over the amount of debt already in COMSAT's capital structure, then, perhaps, no time period would necessarily have been required before the hypothetical debt structure could be applied. That was the case in the vast majority of hypothesized debt decisions cited previously. But the jump from zero to 45% Is not a small one, particularly for a company totally inexperienced theretofore in raising funds in the debt market. The Commission has elsewhere in this opinion expressed a sensitivity to the transitional problems as COMSAT matures; for example, it afforded a five-year amortization period phase-out for laboratory investment considered no longer appropriate as COMSAT developed past the experimental stage. (J.A. 26; 56 FCC2d at 1126). And that phase-out was scheduled to begin in 1976, the year Following the Commission's decision. We hold that similar consideration should have been afforded to COMSAT's infusion of debt. The 45% Debt ratio assumption should be phased in gradually, and be scheduled to commence in the future, not retroactively. The precise details of the formula are for the Commission to develop upon remand. 74 128 The general effect of what we order can be described, however. COMSAT will be allowed to charge rate sufficient to earn at least an 11.3% Return on its rate base during the first year after the Commission's order if COMSAT still has no debt. Thereafter, over a period of years to be set by the Commission, the allowed rates should be lowered, corresponding to that level which would return 11.3% On the COMSAT equity if COMSAT had a certain percentage of debt. That assumed percentage of debt will rise (and the allowable rates will fall) until the hypothetical level of debt reaches 45% Of the capital structure.