Opinion ID: 372907
Heading Depth: 3
Heading Rank: 1

Heading: Return Deficiencies

Text: 47 In the case-law development of the reasonable rate of return concept, a great variety of methodologies have been allowed by courts. This has been in keeping with the Supreme Court's governing rule established in Hope Natural Gas as detailed above. However, one proposal for rate-base inclusion has met with almost uniform rejection across more than half a century of Supreme Court precedent, and that is the notion that the losses of a utility sustained in previous years must be capitalized into a rate base so that the payments of utility users in future years can help alleviate the earlier deficiencies. 48 In arguing for its return deficiencies concept, COMSAT has placed great reliance on the wisdom of Justice Brandeis, in Galveston Electric Co. v. Galveston, 258 U.S. 388, 395, 42 S.Ct. 351, 66 L.Ed. 678 (1922). It is an appropriate starting place, accordingly, to refer to the opinion for the Court of Mr. Justice Brandeis on the question of capitalizing past losses: 49 The fact that a utility may reach financial success only in time or not at all, is a reason for allowing a liberal return on the money invested in the enterprise; but it does not make past losses an element to be considered in deciding what the base value is and whether the rate is confiscatory. A company which has failed to secure from year to year sufficient earnings to keep the investment unimpaired and to pay a fair return, whether its failure was the result of imprudence in engaging in the enterprise, or of errors in management, or of omission to exact proper prices for its output, cannot erect out of past deficits a legal basis for holding confiscatory for the future, rates which would, on the basis of present reproduction value, otherwise be compensatory. 50 258 U.S. at 395, 42 S.Ct. at 354. 17 The Southwestern Bell dissent of Mr. Justice Brandeis, on which COMSAT premises its claim that a rate base consists of capital embarked upon an enterprise, was concurred in by Mr. Justice Holmes. However, Justice Holmes was also quite clear in his belief, expressed for the Court in San Diego Land & Town Co. v. Jasper, 189 U.S. 439, 23 S.Ct. 571, 47 L.Ed. 892 (1903), that (i)f a plant is built . . . for a larger area than it finds itself able to supply, or . . . if it does not, as yet, have the customers contemplated, neither justice nor the Constitution requires that, say, two thirds of the contemplated number should pay a full return. 189 U.S. at 446-47, 23 S.Ct. at 574. Whatever their ideas on a proper rate base, both of these jurists were unequivocal in their rejection of the capitalization of past deficiencies. 51 The two foregoing authorities were relied upon in what has become, perhaps, the clearest statement of the Supreme Court's refusal to require that previous losses be capitalized, FPC v. Natural Gas Pipeline Co., 315 U.S. 575, 62 S.Ct. 736, 86 L.Ed. 1037 (1942): 52 But regulation does not insure that the business shall produce net revenues, nor does the Constitution require that the losses of the business in one year shall be restored from future earnings by the device of capitalizing the losses and adding them to the rate base on which a fair return and depreciation allowance is to be earned. . . . The deficiency may not be thus added to the rate base, for the obvious reason that the hazard that the property will not earn a profit remains on the company in the case of a regulated, as well as an unregulated, business. 53 315 U.S. at 590, 62 S.Ct. at 745. It is important to observe that the foregoing statement was in the context of the Court's holding that excess capacity Might be defended as part of the rate base as a part of the utility's equipment used and useful in the regulated business . . . . When so included, the utility gets its return . . . provided the business is capable of earning it. 315 U.S. at 590, 62 S.Ct. at 745. That holding is directly applicable to the COMSAT situation. COMSAT makes claim to sustaining capital to be included in its rate base. That is principally constituted by the reserve for launch failures and other catastrophes. It may be analogized to the excess capacity in Natural Gas Pipeline ; both are investments deemed necessary at the start but not actually put into use. Without deciding the question, we can assume for present purposes that the sustaining capital was used and useful in the regulated business in some sense. Where the return on the rate base including such an item as sustaining capital is alleged to be deficient, however, the clear holding of Natural Gas Pipeline is that the amount of the deficiency may Not be capitalized into the rate base for future years. To do so would unfairly privilege the ratepayers of previous years at the expense of the ratepayers of future years. One or the other must bear the loss, and in the mandate that rates be reasonable there is no justification for shifting that burden. 54 The fairness of not permitting the capitalization of previous earnings shortfalls is further emphasized by the fact that COMSAT in determining its rate base and as special items for recoupment was allowed liberal expense allowances for many of the factors that contributed to the overall earnings deficiency, including interest during construction, satellite incentive payments, depreciation, and amortization. (J.A. 74; 56 FCC2d at 1174). In all, $91,596,300 of the claimed $91,605,000 losses were allowed. Id. at 75; 1175. Compare FPC v. Hope Natural Gas Co., 320 U.S. at 598-99, 64 S.Ct. 281. 55 In recent years, the Supreme Court has not retreated from its opposition to any requirement that past losses be capitalized. See, e. g., FPC v. Tennessee Gas Transmission Co., 371 U.S. 145, 152, 83 S.Ct. 211, 9 L.Ed.2d 199 (1962). And this court has explicitly endorsed that view as settled law. 18 See, e. g., Payne v. Washington Metropolitan Area Transit Commission, 134 U.S.App.D.C. 321, 330 & n. 39, 415 F.2d 901, 910 & n. 39. We reaffirm that principle today. 19 2. Interest During Construction 56 Several methods are available to take account of the costs incurred by a regulated industry during its start-up period. The most common alternatives are either to include the plant under construction in the rate base even before it is completed, 20 or to keep account of the interest payable on the funds tied up in construction, and capitalize that account at the end of construction. 21 COMSAT proposed a third approach involving a current expensing of interest, inclusion of plant under construction in the rate base, and the capitalization of the interest account; while recognizing COMSAT's more complicated proposal as theoretically acceptable, the Commission chose not to follow it. (J.A. 33; 56 FCC2d at 1133). Instead, it decided on the method of capitalizing interest during construction at the time the new plant was brought into service. This choice was entirely proper for the Commission to make and is not challenged by COMSAT. 57 It is objected, however, that the Commission did not correctly apply the method it chose. The advantage of the interest during construction method is that by capitalizing such an account, the future rate-payers will be obliged to subsidize the construction of plant that benefits them; and present rate-payers are not burdened with that cost. 22 The question arises, however, as to what interest rate should be used in computing the total, compounded sum which will be added to the rate base at the time the new plant is ready. 58 The theory behind compensating for interest during construction is that the cost of an addition to the existing plant structure includes payments not only for physical materials but for the finance charges of borrowed money as well. The only question is the means by which, in this theoretical framework, the regulated company is assumed to have borrowed the money: by loans from commercial banks, or by floating debt obligations of its own in the bond market. Each method has its advantages, and the Commission is free to exercise its own judgment as to the most realistic assumption for COMSAT. 59 The most relevant portion of the Commission's holding on this question is as follows: 60 We are . . . impressed with the argument that the risk associated with these (construction funds) tends to be lower than the investment in plant in service by virtue of Comsat having the benefit of collateral contractual protection from its hardware suppliers. Accordingly, we view the prevailing annual average (a 13-point average) prime interest rate as the most appropriate rate for Comsat's IDC (Interest During Construction) account commencing 1974. Clearly, considering Comsat's minimal business risks . . . the prime rate should invariably exceed the interest rate on Future issues of Comsat corporate bonds. (footnote in original: We anticipate that Comsat should readily be regarded as a low risk, prime Borrower in the corporate bond markets. See note 117, Infra.) We regard application of this prime rate concept as fair to both future authorized users and Comsat alike. 61 J.A. 36, 56 FCC2d at 1136 (emphasis added). Footnote 117 referred to in the foregoing states: 62 We are confident that given Comsat's present all equity capital structure and its level of performance it would qualify for AA-rated utility bonds, possibly even AAA. Thus we presume that Comsat's actual cost of debt would in fact be lower than that imputed. 63 J.A. 73, 56 FCC2d at 1173. 64 From these references, it is unmistakable that the Commission was hypothesizing that COMSAT would go to the bond market to raise the funds needed for construction of more plant. The reference to the prime rate in the first quotation indicates that COMSAT would have to pay in the bond market. The immediately following sentence stating the Commission's belief that the prime rate should invariably exceed the interest rate on future issues of Comsat corporate bonds would be meaningless if the Commission were assuming that COMSAT was to raise funds by borrowing from lending institutions. There was no discussion in the Commission's opinion of COMSAT's credit-worthiness with lending institutions. Both footnotes confirm that COMSAT's qualifications as a borrower in the Bond market were at issue. The prime rate was serving simply as a reference point. 65 The difficulty that has arisen as a result of this approach is that the Commission's prediction about the future prime rate has proven inaccurate. COMSAT's brief to this court states the matter most clearly: 66 The Commission's justification for requiring Comsat to use the prime rate is simply wrong. The prime interest rate is now 7.25%; during 1975 the yield on new issues of Aaa utility bonds ranged from 8.97% To 9.68%; and the Commission elsewhere in its Decision finds that Comsat's cost of debt is 10.2%. Thus, the prime interest rate does not exceed even the interest rate on Aaa utility bonds and certainly could not invariably exceed the interest rate on Comsat corporate bonds. (Aaa is a rating by Moody's that corresponds to Standard and Poor's AAA). 67 Brief of Petitioner at 39 (footnote omitted). 68 The Commission's response to this miscalculation has been to attempt to justify the choice of the prime rate in its own right, rather than as a ceiling estimate of COMSAT's future debt service cost. The Commission offers no response to the error it made in predicting the future relationship of the prime rate vis-a-vis the rate at which high grade utility bonds would be issued. Instead it asserted that such error was harmless in light of the Commission's available alternative reliance on the theory that COMSAT would borrow from financial institutions rather than in the bond market. See Brief of Respondent at 41, n. 65. But that is not an adequate response. It is the Commission's own rationale for its decision, not the justification posited by appellate counsel, that must control our consideration. Securities and Exchange Commission v. Chenery Corp., 318 U.S. 80, 95, 63 S.Ct. 454, 87 L.Ed. 626 (1943). Nor is this merely a formalistic insistence. The Commission has given attention to COMSAT's ability to borrow in the debt market; there is no indication that it has given attention to COMSAT's ability to borrow from lending institutions. If it gave attention to the latter matter, it might determine that COMSAT did not qualify for the prime rate, or might uncover a wealth of other information potentially applicable to COMSAT's commercial borrowing capability. We cannot extrapolate from the Commission's finding that COMSAT could float high-rated bonds to the conclusion that the record supports the conclusion that COMSAT could borrow freely at the prime rate. 69 Accordingly, we remand the question of interest during construction to the Commission. The Commission must first determine what the most realistic borrowing assumption for COMSAT was. It might reassess its implicit decision on this record that COMSAT would go to the bond market rather than to commercial banks or institutional lenders. If it decides that the bond market is appropriate, it would have to apply the figure reached elsewhere in the opinion as to what interest COMSAT bonds would have to bear. Reference to corporate bond yields in general is not adequate when the Commission has already estimated the likely cost to COMSAT of issuing its own bonds. If, however, the Commission decides that the lending institution market is appropriate, then it must base its conclusion concerning the interest COMSAT would have to pay on record evidence specifically directed to that issue. 3. Laboratory Costs 70 In establishing the communications satellite system pursuant to the congressional mandate, COMSAT made a rather sizable investment in laboratory plant and equipment. In 1973, over 16 million dollars in the claimed rate base was accounted for by laboratories. This was in keeping with the explicit instruction of the Act: Included in the activities authorized to the corporation for accomplishment of the purposes indicated . . . are, among others not specifically named . . . to conduct or contract for research and development related to its mission. 47 U.S.C. § 735(b)(1) (1970), 76 Stat. 425 (Aug. 31, 1962). 71 The Commission has ordered COMSAT to amortize its laboratory investment over the next five years. Costs of operating the laboratories will still be permitted as operating expenses in each year, but the intent of the Commission's order is to remove the investment in laboratories as a permanent rate-base fixture upon which a return would be earned each year. 72 As a reason for requiring the phase-out of laboratory capital, the Commission took note of the fact that (n)either The Bell Telephone Laboratories nor the R&D laboratories of any other carrier are given rate base treatment, but expenses are allowed. (J.A. 25; 56 FCC2d at 1125). COMSAT vigorously contests this, citing the Commission's decision in American Telephone & Telegraph, 9 FCC2d 30, 39 (1967), wherein Bell Telephone Laboratories, Inc., is included in the list of subsidiaries not consolidated in the statement of capital stocks owned by AT&T. However that dispute may be resolved, the Commission does not base its phase-out decision upon a comparison with AT&T. 73 Rather, the Commission's order to remove laboratories from the rate base does not rest on any assessment of the value of Comsat's R&D efforts to the INTELSAT system, but it does lay to rest problems we have noticed in the record, namely that R&D has been allocated to the international ratepayer, when it is clear that the fruits of the R&D are applicable to satellite technology generally. (J.A. 25; 56 FCC2d at 1125). At the start of COMSAT's development, international satellite operations were its only concern, so at that time there was no difficulty in including laboratories in the rate base. Whatever the laboratories produced redounded to the benefit of the jurisdictional enterprise. Now that COMSAT General and foreign subscribers as well as COMSAT's INTELSAT operations benefit from the laboratory research, it cannot be said that all the benefits go to INTELSAT. Unwilling to attempt an appropriate estimated allocation of the laboratory plant, the FCC has chosen to remove it entirely. 74 In light of the explicit statutory authorization for research and development, and the necessary reliance by COMSAT on innovative technology, it is not inappropriate that COMSAT maintain laboratory plant and equipment in its rate base. It is an inadequate response to refuse inclusion of so expectible an element of plant and equipment merely because of accounting difficulty in estimating a reasonable allocation formula. The Commission has often had to develop such separation estimates where communications companies were involved in both intrastate and interstate operations. See, e. g., American Telephone & Telegraph Co., 9 FCC2d 30, 88 (1967) (discussing separation formulae developed in 1947, 1952, 1956, 1962, 1965, and for 1967). 75 These two factors, COMSAT's statutory justification and the Commission's demonstrated expertise, combine to defeat the Commission's weak suggestion that determining a proper allocation would be administratively burdensome. The FCC's staff did not object to allocating the cost of COMSAT's laboratory plant between the various beneficiaries of its activities on the grounds some of the recipients were not involved in this proceeding; and they have made no suggestion that an appropriate allocation formula could not be developed. As we have held in American Smelting & Refining Co. v. FPC, 161 U.S.App.D.C. 6, 24, 494 F.2d 925, 943, Cert. denied, 419 U.S. 882, 95 S.Ct. 148, 42 L.Ed.2d 122 (1974), and recently reaffirmed in City of Willcox v. FPC (June 30, 1977), 185 U.S.App.D.C. 288 at 306, 567 F.2d 394, at 413, The mere fact that the solution is complicated cannot justify the Commission in refusing to provide just and reasonable . . . procedures. 76 On remand, the Commission will be required to develop an appropriate allocation formula, or base its decision to require the rapid amortization of laboratory investments on a rationale, supported by substantial evidence, other than its own inconvenience.