Opinion ID: 2284798
Heading Depth: 2
Heading Rank: 2

Heading: Treatment of Gains Realized on Reacquisition of Long-Term Debt

Text: As part of a predetermined sinking fund obligation, WGL periodically repurchases some of its outstanding long-term debt. The Company is able to reacquire these obligations at less than their par value when their coupon rate is lower than the coupon rate in the current bond market. When a bond is repurchased at less than par, the company realizes a gain. From 1955 through 1977, WGL realized from such purchases gains totaling $3,747,000. Prior to the ratemaking proceeding in issue here, it was WGL's practice to account for these gains as below-the-line profits that is, net earnings accruing to the benefit of the company's stockholders, rather than its ratepayersin the year the applicable debt was retired. Thus, whenever WGL repurchased one of its debentures at less than face value, the resultant gain was treated as part of the Company's retained earnings and, presumably, was taken into account when the Company declared shareholder dividends. [38] Until the ratemaking proceeding presently before us, this accounting practice apparently was not challenged by the Commission. In the instant proceeding, however, the Commission ruled that this treatment of gains is unrealistic and inequitable, at least for ratemaking purposes. The Commission instead determined that the gain realized from each repurchase should be amortized over the remaining life of the particular debt retired, and that each year during that remaining life, the amounts so amortized should be used to offset the Company's overall cost of debt. The effect of this policy is to shift the benefits of these gains from the Company's shareholders to its ratepayers, since a utility's cost of debt is a factor considered by the Commission in setting the authorized overall rate of return. [39] The rationale behind this policy shift was described by the Commission as follows: Any reduction in or savings associated with the cost of debt should be passed on to the customers. This is the corollary of the principle that all legitimate costs incurred in financing or refinancing debt are part of the cost of debt and should be passed on to the consumer. [Order 6051, at 12.] The policy thus prescribed by the Commission is not a novel one. Rather, the Commission followed the decision of the Federal Power Commission (FPC) in Manufacturers Light and Heat Co., 44 F.P.C. 314, 319-26, 84 P.U.R.3d 511, 516-22 (1970), in which the FPC announced a policy virtually identical to that adopted in this proceeding. The FPC has reaffirmed its Manufacturers Light & Heat Co. ruling on several occasions. See, e.g., Columbia Gulf Transmission Co., 53 F.P.C. 2016, 2024-25, 10 P.U. R.4th 116, 122-23 (1975); Kansas-Nebraska Natural Gas Co., 53 F.P.C. 1691, 1708, 9 P.U.R.4th 481, 496-97 (1975), aff'd sub nom. Kansas-Nebraska Natural Gas Co. v. Federal Power Commission, 534 F.2d 227 (10th Cir. 1976); Consolidated Gas Supply Corp., 52 F.P.C. 454, 465, 5 P.U.R.4th 418, 427-28 (1974). See also Accounting for Premium, Discount and Expense of Issue, Gains and Losses on Refunding and Reacquisition of Long-Term Debt, and Interperiod Allocation of Income Taxes, Order No. 505, 51 F.P.C. 714, 39 Fed.Reg. 6,093 (1974), rehearing denied, 51 F.P.C. 1746 (1974), clarified & aff'd, 59 F.P.C. 591 (1977), aff'd mem. sub nom. Texas Eastern Transmission Corp. v. Federal Energy Regulatory Commission, 187 U.S.App.D.C. 426, 574 F.2d 637, cert. denied, 439 U.S. 836, 99 S.Ct. 119, 58 L.Ed.2d 132 (1978). In addition, a nearly unanimous consensus of state regulatory bodies agree that gains as well as losses resulting from the repurchase of debentures should be passed on to ratepayers. [40] WGL does not contest the Commission's decision to implement such a policy. The Company contends, however, that the Commission properly could consider only those gains realized on purchases in the test year and thereafter. Instead, the Commission adopted the approach followed by the Federal Power Commission in Manufacturers Light and Heat Co., supra: [T]he amount of gains to be used as an offset to interest costs should be the pro forma amount that would have been amortized during the test year had such gains been amortized over the remaining life of the debt from the date of realization to the date of maturity of the issues involved. [Order 6051, at 14-15 (citing Manufacturers Light and Heat Co., supra at 324-26, 84 P.U.R.3d at 520-21).] Put in simpler terms, the Commission announced that for ratemaking purposes it would look to all gains realized since the repurchasing scheme began in 1955; that it would treat those gains as if they had been amortized from the time of repurchase over the remaining lives of the bonds involved; and that it would offset the cost of long-term debt in the test year (1977) by the sum of the portions of these gains which would have been amortized in that year under such a system of accounting. WGL argues that by dipping back into gains realized prior to the test year, which were recorded by the Company as below-the-line earnings under the then-acceptable method of accounting, the Commission has engaged in a type of retroactive ratemaking proscribed in Board of Public Utility Commissioners v. New York Telephone Co., 271 U.S. 23, 46 S.Ct. 363, 70 L.Ed. 808 (1926). In that case, the Supreme Court struck down an order that the telephone company make up future earnings deficiencies out of excessive depreciation reserves accumulated in the past. The Court stated: The revenue paid by the customers for service belongs to the company. The amount, if any, remaining after paying taxes and operating expenses, including the expense of depreciation, is the company's compensation for the use of its property. If there is no return, or if the amount is less than a reasonable return, the company must bear the loss. Past losses cannot be used to enhance the value of the property or to support a claim that rates for the future are confiscatory.... And the law does not require the company to give up for the benefit of future subscribers any part of its accumulations from past operations. Profits of the past cannot be used to sustain confiscatory rates for the future. [ Id. at 31-32, 46 S.Ct. at 366 (citations omitted).] In the proceedings below, the Commission acknowledged that past excessive earnings belong to the regulated utility just as past losses must be borne by it. A course of action which would violate this doctrine is commonly referred to as retroactive ratemaking. Order 6060, at 7. The Commission, however, went on to rule: We were very careful not to indulge in retroactive ratemaking. The Commission's decision does not deprive stockholders of any past gains to which they were entitled prior to our decision in this case. They are permitted to keep all those gains which would have been amortized prior to the test year had the Commission instituted a policy of passing on the gains to the customers at the time the gains were realized. The customers get only the remaining pro forma unamortized gains which fall within the test period and in successive years. Under these circumstances, we do not think that it can be fairly said that we have engaged in retroactive ratemaking. [ Id. ] WGL contends on appeal that the Commission did not go far enough to avoid retroactivity. The Company argues, in effect, that because the Commission until now has tolerated the utility's practice of accounting for these gains as below-the-line earnings, its stockholders acquired a vested entitlement to the entire amounts of all gains realized prior to the 1977 test year. The Commission and People's Counsel urge, on the other hand, that since it is the ratepayers who ultimately bear the cost of the utility's debt, any gains arising from reacquisitions of long-term debt should inure to the ratepayers' benefit in the form of a reduction in current debt cost. People's Counsel contends that it is no more an act of retroactivity to use these past gains as offsets to present debt cost than it is to permit WGL to charge present ratepayers for the current cost of debt securities issued in years past. We agree with the Commission and People's Counsel that the Company's argument denies the realitiesas well as the equitiesof long-term debt financing. When a utility repurchases a debenture in the open market at a discount, the effect of such a transaction is to reduce the company's embedded cost of debt. This is true regardless of whether the discount is treated for accounting purposes as a reduction in debt expense or, as has been WGL's practice, as retained earnings. In other words, gains on reacquired debt reduce the company's embedded cost of debt, irrespective of the utility's accounting practices. As the Federal Power Commission noted in Manufacturers Light and Heat Co., supra at 323-24, 84 P.U.R.3d at 519-20: [T]he discounts on repurchased debt under consideration here represent a savings which is virtually automatic. [The utility] is required to repurchase its debentures for sinking fund purposes. So long as interest rates continue above the levels of the early 1950's, such repurchases will continue to be made at discounts each year. Unless amortization of these amounts is required, the cumulative effect will be to add large sums to retained earnings, with no benefit to consumers. Yet consumers will continue to pay the cost of debt, including new debt issued at higher rates to replace that retired.       Patently, all legitimate costs incurred in financing or refinancing debt are part of the cost of debt, and should be passed on to the consumer. Conversely, any reduction in or savings associated with cost of debt also should be passed on to the consumer.       Since management is required ... to incur both premiums and discounts associated with prudent retirement of debt, it is neither accurate nor equitable to describe such charges and credits as fortuitous. Instead, sound principle requires that they be treated as a normal and recurring part of utility financing and given appropriate recognition in determining the true cost of debt. The question of retroactive ratemaking was not discussed as such in Manufacturers Light and Heat Co. In that case, however, the FPC amortized gains over the remaining lives of debentures retired from 1956 through the test year, 1969, even though it apparently had never before announced such a ratemaking policy. Later, in Columbia Gulf Transmission Co., 53 F.P.C. 2016, 2024-25, 10 P.U.R.4th 116, 122-23 (1975), the FPC rejected a utility's argument that the agency properly could amortize only those gains realized since the date the utility began amortizing such gains for accounting purposes. Cf. Washington Public Interest Organization v. Public Service Commission, supra at 82-85 (PSC is not bound to conform ratemaking policies with accounting method used by utility even where system of accounting was prescribed by the Commission). We think that the ratemaking policy announced in the federal precedents and adopted by the Commission here is soundly supported by the realities of long-term debt financing. As the FPC noted in Manufacturers Light and Heat Co., the savings in debt cost associated with the repurchase of debentures at a discount are virtually automatic. 44 F.P.C. at 323, 84 P.U.R.4th at 519. Furthermore, it is the ratepayers, rather than the stockholders, who are burdened with payment of income taxes on the gains realized, as well as with the cost of financing new debt issued by the Company to replace the retired debt. [41] Accordingly, we find that the Commission's amortization of all gains realized since 1955 did not constitute illegal retroactive ratemaking. The fact that the Commission until now has acquiesced in the Company's use of a method of accounting that did not reflect the actualities or the equities of debt financing provides an insufficient basis to hold that WGL's stockholders acquired an immediate vested interest in all gains realized prior to the 1977 test year. We therefore affirm the Commission's treatment of gains realized on the reacquisition of long-term debt.