Opinion ID: 1224779
Heading Depth: 1
Heading Rank: 1

Heading: Deductions From Rate Base Due To Purchases From Automatic Electric Company

Text: Witnesses for General testified to the following effect: Both General and Automatic are wholly owned subsidiaries of GT&E. Automatic was acquired by GT&E in 1955. As of 31 December 1969, GT&E's investment in Automatic was $328,909,188 and the consolidated book net worth of Automatic and its own subsidiaries was $235,991,550, on which Automatic earned 18.06%. For many years prior to its acquisition by GT&E, Automatic was an independent manufacturer of telephone and electronic equipment and a major source thereof for telephone companies not affiliated with the Bell Telephone System, including all operating companies in the GT&E System. This business Automatic had secured on a competitive basis. Since such acquisition, the other affiliates of GT&E, including General, are not obligated by contract or otherwise to purchase equipment and supplies from Automatic. However, Automatic continues to be their principal, though not their sole supplier. Automatic continues to sell to telephone companies not affiliated with either the Bell System or the GT&E System. Most of its manufactured products are designed and engineered to the purchasing company's specifications. Since the acquisition of Automatic by GT&E, its prices to GT&E affiliates, including General, are the same as or lower than its prices to telephone companies not affiliated with GT&E. On items sold but not manufactured by it, Automatic obtains from its own supplier discounts by virtue of the volume of its purchases. These discounts Automatic passes on to its operating affiliates, such as General, irrespective of the size of the purchases made from time to time by such affiliated operating companies. [This is one distinguishing feature of the present case from State ex rel. Utilities Commission v. Morgan, Attorney General, supra, concerning transactions between affiliates.] Generally, on items not designed to meet the specific customer's specification, Automatic's prices to General, and to other GT&E operating affiliates, are lower than the prices charged by competing independent suppliers; i. e., suppliers other than Western Electric Company, which is the principal supplier of the Bell System operating companies. Since its acquisition by GT&E, Automatic has followed the same or similar pricing methods as prior to such affiliation. However, as a result of the affiliation, Automatic, under the Federal Internal Revenue Act, may disregard profits made by it on sales to affiliated companies, thus substantially reducing Automatic's income tax liability. This entire saving Automatic remits to GT&E, which, in turn, remits to its affiliated operating companies. In this way, General received in 1969 a total refund of $1,660,000 on account of its purchases from Automatic, totaling $17,802,000 (company-wide, not North Carolina alone). Also, since its affiliation with GT&E, Automatic has introduced an inventory stocking plan which allows the affiliated operating companies, including General, to minimize their own inventories and use invoicing and other procedures which are beneficial to them. Since its affiliation with GT&E in 1955, Automatic's sales to its nonaffiliated customers have increased from $37,000,000 to approximately $72,000,000, despite intervening acquisition by GT&E of a number of previously nonaffiliated customers of Automatic. The Commission's Director of Accounting, who testified concerning the relation between Automatic and General, did not controvert any of the above summarized testimony given by witnesses for General. His testimony was to the effect that Automatic's sales to nonaffiliated domestic companies have declined in relation to Automatic's total sales. (This would be a natural consequence of the acquisition by GT&E of some of Automatic's previously unaffiliated customers.) He further testified that the dominant position of Automatic in the telephone equipment market, other than the Bell System, leaves only a few smaller manufacturers in the market with little, if any, competitive forces at their command. On the other hand, Automatic's existence depends upon the business it receives from GT&E affiliates and its entire operations are geared to the service of such affiliates. For this reason, this witness recommended that the Commission permit General, for rate making purposes, to consider as the original cost of its purchases from Automatic, not the actual price paid to Automatic, but no more than a reasonable price, based on a fair return to Automatic upon its own net investment in properties required for the production of such commodities. He concluded that $1,417,000 should be subtracted from the original cost of General's properties, computed on the basis of prices actually paid by it, on the ground that this amount represented excess profits made by Automatic upon its sales to General for North Carolina intrastate service. Such excess he computed on the concept of permitting the supplier affiliate the same rate of return on net book investment as that allowed by the Commission to the affiliate operating telephone company, which, in the opinion of the witness, should be 12% (i. e., on the equity component of General's capital structure). This concept would further require, in the opinion of the witness, adjustments to the accumulated depreciation reserve and to operating expenses. In support of this concept, the witness cited the decision of the Court of Appeals of New York in General Telephone Co. of Upstate New York v. Lundy, supra, and orders of the New York, Pennsylvania and Wisconsin Commissions. The record does not indicate that Automatic carries on any operations in North Carolina. Furthermore, it is not a public utility within the definition contained in G.S. § 62-3(23)a. It is not the parent of or a subsidiary of General, as those terms are defined in G.S. § 55-2. Consequently, it is not brought within the definition of public utility by the provisions of G.S. § 62-3(23)c. Neither the Commission nor the courts may add to the types of business defined by the Legislature as public utilities. State ex rel. Utilities Commission v. Carolina Telephone & Telegraph Co., 267 N.C. 257, 268, 148 S.E. 2d 100. Consequently, the Commission may not fix or control prices which Automatic charges its customers for its products. The Commission may, however, in a proper case, refuse to allow General to include in its rate base, or in its operating expenses, the full price General actually paid Automatic for equipment and supplies. In its proper regulation of rates charged by General, the Commission is expressly authorized to inspect the books and records of affiliated corporations and to investigate contracts and practices between the operating utility company and its holding company. G.S. § 62-37 and G.S. § 62-51. G.S. § 62-153, which authorizes the Commission, after hearing, to disapprove and declare void contracts between a public utility and certain types of affiliated corporations is not before us in the present case and nothing herein may be deemed to limit the powers granted to the Commission by that statute. In fixing rates to be charged by a public utility to its own customers, the Commission is directed by G.S. § 62-133 to consider the reasonable original cost of the utility's property used and useful in providing the service. (Emphasis added.) Obviously, a utility may not inflate its rate base by extravagance in purchasing equipment or constructing its plant. In this connection, it is immaterial whether such extravagance be due to careless improvidence or to wilful payment of exorbitant prices to an affiliate. See: State ex rel. Utilities Commission v. Morgan, Attorney General, supra, 277 N.C. at pp. 271-272, 177 S.E.2d 405; Pacific Telephone & Telegraph Co. v. Public Utilities Commission, 34 Cal.2d 822, 215 P.2d 441. As Mr. Justice Brewer said, in Chicago & Grand Trunk Railway v. Wellman, 143 U.S. 339, 346, 12 S.Ct. 400, 402, 36 L.Ed. 176, 180, While the protection of vested rights of property is a supreme duty of the courts, it has not come to this: that the legislative power rests subservient to the discretion of any railroad corporation which may, by exorbitant and unreasonable salaries, or in some other improper way, transfer its earnings into what it is pleased to call `operating expenses'. On the other hand, the management of the business of a public utility, including the fixing of the prices which it pays for the construction and equipment of its plant and for its maintenance and operation, rests with its board of directors in the absence of clear mismanagement or abuse of discretion. State ex rel. North Carolina Utilities Commission v. Piedmont Natural Gas Co., 254 N.C. 536, 548, 119 S. E.2d 469; United Fuel Gas Co. v. Railroad Commission, 278 U.S. 300, 320, 49 S.Ct. 150, 73 L.Ed. 390; Southwestern Bell Telephone Co. v. Public Service Commission, 262 U.S. 276, 43 S.Ct. 544, 67 L.Ed. 981; Chambersburg Gas Co. v. Public Service Commission, 116 Pa.Super. 196, 176 A. 794, 806. As observed by Justice Traynor, later Chief Justice, in Pacific Telephone & Telegraph Co. v. Public Utilities Commission, supra, 34 Cal.2d at p. 826, 215 P.2d 405, the advent of the holding company, which both controls and provides, either directly or indirectly through another subsidiary, services for a network of operating utilities, has been the source of new problems in public utility rate regulation. As the Supreme Court of California there observed, and as we stated in State ex rel. Utilities Commission v. Morgan, Attorney General, supra, 277 N.C. at p. 272, 177 S. E.2d 405, the doctrine of the corporate entity may be disregarded where it is used to defeat the public interest and circumvent public policy in the regulation of utility rates. However, the fact that equipment or services are sold to the utility by an affiliated corporation does not alter the ultimate question for the Commission. That question is whether the prices paid by the utility are reasonable and, therefore, reflect the reasonable original cost of the properties. The only effect of the affiliation between the utility and its supplier is that such relationship calls for a close scrutiny by the Commission of the price paid by the utility. Dayton Power & Light Co. v. Public Utilities Commission of Ohio, 292 U.S. 290, 295, 308, 54 S.Ct. 647, 78 L.Ed. 1267; Lindheimer v. Illinois Bell Telephone Co., 292 U.S. 151, 156, 54 S.Ct. 658, 78 L.Ed. 1182; Western Distributing Co. v. Public Service Commission of Kansas, 285 U.S. 119, 124, 52 S.Ct. 283, 76 L.Ed. 655; Smith v. Illinois Bell Telephone Co., 282 U.S. 133, 152, 51 S.Ct. 65, 75 L.Ed. 255; Pacific Telephone & Telegraph Co. v. Public Utilities Commission, supra; General Telephone Co. of Upstate New York v. Lundy, supra; Solar Electric Co. v. Pennsylvania Public Utilities Commission, 137 Pa.Super. 325, 9 A.2d 447, 473. Where the purchase is made from an affiliated company, the bargaining is not at arm's length and when the transaction is called in question, the burden is upon the utility to show that the price it paid was reasonable. As was said in Solar Electric Co. v. Pennsylvania Public Utilities Commission, supra: Charges arising out of intercompany relationships between affiliated companies should be scrutinized with care [citations omitted] and if there is an absence of data and information from which the reasonableness and propriety of the services rendered and the reasonable cost of rendering such services by the servicing companies can be ascertained by the commission, allowance is properly refused.    Moreover, the record in this case is an illustration of the fact that effective and satisfactory State regulation of utilities is made increasingly difficult by the progressive integration of utility services under holding company domination. The desire of public utility management, evidenced by various methods, to secure the highest possible return to the ultimate owners is incompatible with the semi-public nature of the utility business, which the management directs. It therefore follows that the commission should scrutinize carefully charges by affiliates, as inflated charges to operating companies may be a means to improperly increase the allowable revenue and raise the cost to consumers of utility service as well as an unwarranted source of profit to the ultimate holding company. Similarly, the Court of Appeals of New York, in General Telephone Co. of Upstate New York v. Lundy, supra, observed: When such materials and services are obtained through contracts which are the result of arm's-length bargaining in the open market, the contract price is usually accepted as the proper cost. However, when a utility and its suppliers are both owned and controlled by the same holding company, the safeguards provided by arm's-length bargaining are absent, and ever present is the danger that the utility will be charged exorbitant prices which will, by inclusion in its operating costs, become the predicate for excessive rates.