Opinion ID: 785944
Heading Depth: 2
Heading Rank: 3

Heading: The Interest Rate Adopted by the District Court

Text: 45 The District Court, in arriving at its penalty assessment, adopted the economic analysis proffered by the government. In that submission, the alleged economic benefit stemming from each violation was computed forward from the date of violation to February 28, 2001 (roughly the date of the judgment) at a rate of 12.73% annually, to arrive at a $4,122,335 total economic benefit at the time of judgment. 46 The District Court derived this rate from the proffer of government witnesses Gary Amendola and Robert Harris who explained the three steps they took to calculate the WACC. First, they determined that ALC had a debt rating of A, as assigned by Standard & Poor's (S & P). Then, they researched what the typical monthly interest rate was for A-rated bonds in each relevant year and computed yearly averages. This rate was adjusted to account for the advantageous tax treatment of interest payments on corporate debt. Second, they calculated the cost of equity as follows: They started with a 30-year treasury bond as a baseline. They next looked up the company's beta, which is a measure used to evaluate the relative risk of a particular stock for an equity investor. Finally, they assumed a generic value for the market-risk premium-the premium that a person would demand to invest in stock rather than in a (risk free) treasury instrument. At that point, they multiplied the beta by the market-risk premium, and added an intermediate stock premium for the years before ALC merged with another entity and became a bigger, safer company. They then added this to the 30-year treasury bond rate to arrive at an equity cost by year. Third, they combined these cost of debt and cost of equity measures by taking a weighted average of them, based on the relative proportions of debt and equity in ALC's capital structure for that year. 7
47 ALC characterizes the 12.73% rate as a theoretical, risk-adjusted rate (denominated by EPA as the weighted average cost of capital or `WACC'), based on broad averages across the U.S. capital markets. As the foregoing explanation suggests, this characterization is generally accurate. ALC contends that using such a hypothetical rate of interest was an error of law because ALC had presented evidence of its actual rate of return on capital which, at the time of the penalty trial, showed that the average rate of return on capital for ALC and its parent company between 1990-2000 was 5.7%. This fact was uncontested, and thus ALC submits that the 12.73% rate did not achieve the legal purpose of leveling the economic playing field, but rather was used to exact a severe penalty reflecting not the time value of money nor ALC's benefits from retaining funds, but rather theoretical investment averages that indisputably were not achieved by ALC. 48 ALC submits that, instead of the 12.73% rate, one of four alternative rates should have been used: 49
50 (2) the risk-free rate represented by the short-term U.S. treasury rates during the relevant time period 51 (3) the actual average rate of ALC's return of capital from 1990-2000 52 (4) the actual average rate of ALC's return of capital from 1990-2001 53 Each of the rates suggested by ALC results in approximately the same interest rate, hovering between 5.2% and 6%, which is less than half the rate that the District Court actually used. 8 ALC adds that the theoretical WACC has been rejected consistently when applied to companies and industries that are not achieving such theoretical rates of return. 9 54 The government responds with a number of arguments. First, the government correctly notes that the economic benefit calculation need not be precise. In Dean Dairy, we recognized that economic benefit may not be capable of ready determination, and the Court gave the district court's award of a penalty wide discretion, even though it represents an approximation. 150 F.3d at 264 (citing Tull, 481 U.S. at 426-27, 107 S.Ct. 1831). The government couples this deference accorded to district court awards with the suggestion that, since the statutory maximum penalty for ALC's violations was $28.05 million, the District Court gave ALC a break. The government advocated taking other statutory factors into account and trebling the economic benefit to yield a penalty of approximately $12.3 million, see supra note 6, but the District Court only doubled the economic benefit and ordered ALC to pay $8,244,670. The government points to this discrepancy between what it asked for and what the Court actually did as proof that the District Court really does have, and should have, a great amount of discretion in determining these types of penalties. 55 The government also points to the decisions of other courts that have approved the use of WACC to discount economic benefit when calculating CWA penalties, particularly Smithfield Foods where the District Court, crediting expert testimony, used the WACC to discount the defendant's economic benefit. See United States v. Smithfield Foods, Inc., 972 F.Supp. 338, 349 & n. 17 (E.D.Va.1997), cited with approval in Dean Dairy, 150 F.3d at 266.
56 The methodology used by the District Court and those advanced by the parties do not exhaust the possible interpretations of economic benefit under § 1319(d). It will be helpful to analyze the options. There are, as we see it, two possible approaches. The first is the cost of obtaining capital-i.e., the interest rate necessary to acquire the capital with which to make the improvements (which were never made). The second is the use of the corporate offender's actual return on its capital, which, it is conclusively presumed, was not used to make the improvements. These are both highly variable factors, turning on the cost of money to the company (which depends not only on the general market forces but also on its financial strength and credit rating) or on the profitability of the company at a given time. 57 In view of this variability, we think that it would be inappropriate for us to decree which methodology should be used since in any given situation, leveling the playing field might be more readily achieved with one or the other. Therefore, we think that the choice of methodology should be left to the sound discretion of the District Court. 10 In this case, however, it is not clear that the District Court was aware of or considered the range of options available. 58
59 As noted above, economic benefit can be measured by an entity's cost of capital. In accepting the government's experts' position, the District Court adopted one such measure-WACC-but there are others. In commenting upon the cost-of-capital measure adopted by the District Court, we hope to provide some guidance as to what constitutes an appropriate cost-of-capital measure of economic benefit. 60 With respect to the cost-of-capital measure used by the District Court, we conclude that both the calculation and application are, at the very least, unsupported. The first problem is the government's calculation of the WACC. That calculation relied on values that were not ALC-specific. Instead of using the actual yield on bonds that ALC had issued, the government experts computed the WACC by using the yield on Standard & Poors A-rated bonds. While using the S & P figure might well have been a reasonable approximation of ALC's bonds' yield, a more accurate calculation could easily have been achieved by using figures specific to ALC's bonds. 11 61 The second problem is the government's application of the WACC. WACC averages are constructed on the basis of a company's existing capital structure (that is, the relative proportions of debt and equity). A WACC figure based on a company's existing capital structure at a given time is not, without further support, necessarily the same as a company's marginal or current cost of capital at that time (i.e., what it would cost to obtain additional capital) because new capital might come in a different mix of debt and equity. See Aswath Damodaran, Applied Corporate Finance 108 (1999) (In estimating [the current cost of capital using WACC], we have in a sense conceded the status quo in terms of financing mix, since we have estimated the cost of capital at the existing mix. It is entirely possible that a firm, by changing its mix, could lower its cost of capital.). Unless WACC is shown to be a good approximation for the marginal or current cost of capital, it sheds little light on how expensive it would have been for the company to go to the market for its capital, instead of diverting funds that should have gone to improving pollution controls. 62 As noted above, the government and the District Court relied on Smithfield Foods. But, upon closer analysis, Smithfield Foods does not help the government. There are reasons to suspect that in the food processing industry (in which Smithfield operated), the WACC may have been an entirely appropriate approximation of Smithfield's economic benefit, whereas conditions in the steel industry (in which ALC operates) are radically different. More precisely, it may have been that in Smithfield Foods that the WACC was a good approximation for the terms on which money could have currently been raised; the food processing industry is a stable industry where companies probably attract new capital on terms similar to their existing capital structure. The steel industry, in contrast, has been highly volatile and rife with stiff foreign competition, dislocations, and bankruptcies. Indeed, as the District Court noted, the industry is going through a brutal restructuring, and more than twenty-five United States steelmakers have sought bankruptcy protection since 1997. Thus, a company in ALC's position may not have, at the times in question, been able to raise capital on the same terms as its existing capital structure. We need not (indeed, cannot) resolve this; but for our purposes, it is enough that there was insufficient evidence for the District Court to say that ALC's existing capital structure was representative of the terms on which new capital would be raised. Thus, if the economic benefit to ALC is to be established by a cost-of-capital measure, the measure to use is ALC's marginal or current cost of new capital in the years in question. 12 Some courts appear to have endorsed this approach. See, e.g., Gwaltney of Smithfield, 611 F.Supp. at 1559 ([T]he actual rate Gwaltney itself paid on borrowed funds ... is a more accurate basis for determining Gwaltney's economic benefit from delay.). 63 It is of course possible that this approach might make an offender worse off than under the government's WACC proposal. For example, a company in dire financial straits may well have a marginal cost of capital (offered by lenders who see it as a high-risk investment) that exceeds its WACC. This is no anomaly. For companies that are hard up for capital and cannot afford to raise it in the market, it is doubtless all too tempting to forego the sometimes costly improvements and pollution controls that are required by the CWA and EPA regulations. But such companies must still be held to the law. To do otherwise is, in essence, to allow capital-strapped polluters to take out low-interest loans against the environment. 64 We of course intimate no view on what a remand may develop respecting ALC's situation in the 1990s. The government's experts' proffer shows debt costs for S & P A-rated bonds were in the 6.68% — 10.06% range in the 1990s. That is significantly lower than the 12.73% WACC figure relied on by the District Court. Moreover, in recent years, which would also figure in the calculations, interest rates have been very low. The record does not reflect ALC's actual financial strength, and it may (or may not) also have (or have had) a good credit rating throughout the relevant period. 65
66 We have so far been talking about measuring the economic benefit of additional capital by the cost to obtain that capital elsewhere. But the other option is to use actual rates of return on capital to compute economic benefit. The government's experts cited the importance of leveling the economic playing field in the same industry. It is obvious, for example, that ALC and the steel industry were not, at times relevant, enjoying stellar returns. Indeed, as noted above, it was uncontested at trial that ALC had a return on capital that was less than half the 12.73% rate used by the District Court. On this view, any advantage that ALC enjoyed over its competitors by avoiding the cost of CWA compliance is measured by the return that ALC actually realized on its retained funds or the risk-free return it might have enjoyed using those funds. We think that the return on capital is a quite viable means of leveling the playing field, along with the marginal or (then) current cost of capital. 67
68 There are other potential problems with the District Court's calculation, which relied on the methodology provided by the government's experts. It appears that the government's experts computed annual estimates of WACC for each of the years 1990-1998, and came up with the 12.73% figure by taking the arithmetic mean. 13 Since the savings from different violations accrued on different dates over a several year period, it is questionable whether an average interest rate is appropriate, when year-to-year interest rate estimates are known and could be used with only minimal additional effort by the experts. 14 The potentially problematic practice of using a mean interest rate over a large time span is present in the government's experts' report. 15 As it happens, this wound up hurting ALC: The theoretical WACC figures from the early 1990s (15.85% in 1990 and 1991, and 13.95% in 1992) are the highest of the group, but really have no bearing on the economic benefit conferred by post-1992 violations. Thus, the average WACC was biased toward the less-relevant higher WACC estimates from the early 1990s. 69 Finally, we note that the government is unquestionably correct in its assertion at oral argument that any computation must use the same discount rate for both forward and backward computations during the same period. For example, it would be clearly inappropriate to discount all economic benefit backwards to a uniform date using one rate, and then use a different rate to carry the value forward to the date of judgment.
70 We are, of course, acutely aware that we review the District Court's interest rate determination for abuse of discretion, and that its determination need not be exact. See Dean Dairy, 150 F.3d at 264-65. Our deferential scope of review does not mean, however, that we cannot intervene when a District Court makes a finding that is methodologically flawed, even if, under such theory, the penalty figure it ultimately arrives at is plausible. 71 In the dissent's view given our highly deferential standard of review, the District Court did not clearly err in crediting the government's witness over ALC's witness and adopting the WACC to calculate economic benefit. Of course, when presented with two sound but conflicting expert opinions, a district court has discretion to credit one over the other. But this discretion is not a license to adopt an opinion based on unsound methodology, whatever its source. 72 Based upon our analysis of the government's expert's methodology, we are unconvinced that the use of the 12.73% interest rate achieves the stated purpose of leveling the economic playing field, nor are we sure that it bears much connection to a meaningful measure of ALC's cost of capital (much less its return on capital). We therefore must set aside the penalty calculation and remand for further proceedings with respect to the interest rate, fully open to the possibilities that the record on remand will support a higher, lower, or substantially similar penalty. We will not choose among the alternatives we have suggested (or those suggested by ALC) in the discussion above; rather we shall leave it to the District Court, after receipt of further submissions by both parties, to decide what alternative rate is best applied to the circumstances developed in the record on remand. 16 73