Merger Menace: Holding Companies and Overcapitalization
States remain as powerless to control holding companies as they were
in 1935, when PUHCA was passed.
During the 1970s and 1980s, diversification swept the gas and electric utility industries. One byproduct of this craze was the formation of a large number of new public utility holding companies, exempt not only from regulation by the Securities and Exchange Commission (SEC), but from state regulation over security issues. The new generation of unregulated public utility holding companies has created a constituency for complete deregulation of the public utility holding company.
Since 1982, in every session of Congress, legislators have introduced bills seeking repeal of the Public Utility Holding Company Act of 1935 (PUHCA). Even the SEC has joined the chorus in favor of repeal. So far, Congress has only loosened some restrictions under the Energy Policy Act of 1992. In October 1995, Sen. Alfonse M. D'Amato (R-NY) sponsored a bill that would effectively repeal PUHCA one year after passage.1 Even if the bill does not become law in this session of Congress, the pressure will remain for full repeal or, as one author recently suggested, a "re-deal."2
The primary argument for repeal or re-deal is that PUHCA is an anachronism that only serves as a "second belt over two sets of suspenders" to existing state and federal regulation.3 This argument completely disregards the problem of overcapitalization. While proponents of repeal dismiss the threat of overcapitalization as unreal, the experience of a merger approved by the Minnesota Public Utilities Commission (MPUC) suggests otherwise. In fact, the MPUC's experience reveals that state commissions remain as powerless to deal with the problem of holding companies engaged in interstate commerce as they were in 1935, when PUHCA was passed.
The Problem of Overcapitalization
Overcapitalization is a menace because it creates an irresistible pressure for rate increases to fulfill the expectations of increased revenues. PUHCA expressly recognizes the relationship between the abuse of overcapitalization by holding companies and public utility subsidiaries:
"when such securities are issued [by a public utility holding company or its utility subsidiary] on the basis of fictitious or unsound asset values having no fair relation to the sums invested in or the earning capacity of the properties and upon the basis of paper profits from intercompany transactions, or in anticipation of excessive revenues from subsidiary public utility companies."4
State regulators claim that state regulation of utility securities is adequate to prevent overcapitalization. They only demand access to affiliate books and records to ensure the continued protection of the public interest. D'Amato's bill to repeal PUHCA pays lip service to this concern by guaranteeing "access to affiliate books and records" to both states and the Federal Energy Regulatory Commission (FERC). Congress was presented with these same arguments in 1935 and rejected them on the advice of disinterested observers such as the National Power Policy Committee, which concluded that, "[e]ven if such [holding company] books and records are obtainable, however, such books and records will be comparatively unintelligible and even misleading until uniform accounting methods are made compulsory." That Committee found:
"The only practical control over public utility holding companies will be one [that] can directly reach the holding company itself and supervise its security structure and its use of capital and make possible over a period of time the elimination of the holding company where it serves no demonstrably useful purpose."5
The Arkla-DEI-Minnegasco Merger
The MPUC's handling of a merger between a Minnesota gas utility, its holding company, and an interstate gas utility and pipeline demonstrates how state regulation alone is inadequate to deal with the problem of overcapitalization effected by manipulation of utility securities. Minnegasco was a gas distribution company serving Minneapolis, one of the country's largest natural gas distribution markets. Its holding company, Diversified Energies, Inc. (DEI) was one of the new generation of exempt holding companies, formed in 1982 to enable Minnegasco executives to explore diversification opportunities. The only condition the MPUC imposed upon the creation of the DEI holding company was approval of a contract between the two affiliates, DEI and Minnegasco.
In 1990, DEI entered into an agreement with Arkla (em a natural gas pipeline, distribution, and production company (em to sell Minnegasco. The merger agreement presented DEI shareholders with a pure "stock-for stock" conversion: DEI stock for Arkla stock. Although the merger was presented for stockholder and regulatory purposes as an integrated transaction, the merger agreement described the transaction in several steps: 1) DEI stock would be transferred to Arkla, 2) DEI would be dissolved, 3) Minnegasco would be formally merged into Arkla, and 4) dissenters or nonvoting shares would be "converted" into Arkla shares "by operation of law" after shareholder approval. The exchange valuation announced by the companies promised that DEI shareholders would receive Arkla shares valued at over twice their value prior to closing before the merger was announced. In other words, regardless of how a person might vote on the merger, a DEI shareholder with stock valued at $29.60 would receive 1.752 shares of Arkla stock if a majority of his or her fellow shareholders approved.6 There was no guarantee that the shareholder could actually receive cash for the post-merger value of Arkla stock in the amount of $36.354.
The merger proxy statement (which complied with the Securities and Exchange Act of 1934) indicated that Arkla's balance sheet would be "written up" by approximately $397 million to reflect goodwill and an "acquisition adjustment" gained by the merger with DEI.7 A "writeup" is an inflation of the balance sheet by an arbitrary amount that is unrelated to the earning capacity of the issuers. The proxy did not specifically state so, but since the purpose of the merger was to capture the strong Minneapolis retail natural gas market, the average shareholder would assume that the DEI/Minnegasco stock was undervalued and that the value would improve once future rate increases were obtained.
The MPUC asserted jurisdiction over the merger under Minnesota law.8 The Minnesota commissioners learned that under the "consistent with the public interest" standard of Minnesota law, they could only disapprove a merger or acquisition if they found such a transaction contrary to the public interest. By contrast, the PUHCA standard would have required the proponents of the merger to establish affirmatively that the merger would "serve the public interest by tending towards the economic and efficient development of an integrated public utility system."9 While DEI, Arkla, and Minnegasco conceded that the proposed merger could not meet that standard, they had entered into a stipulation with various parties, such as the Minnesota Attorney General's Office, which guaranteed, among other things, access to Arkla's books and records.
On November 9, 1990, the commissioners voted 2 to 1 to disapprove the merger. But within hours, after word of the vote reached Wall Street, the commissioners came under heavy political pressure to reconsider their vote. Confronted by some of the leading investment banking and law firms on Wall Street, as well as leading businessmen, attorneys, and politicians from Minnesota and Arkansas, the commissioners reconsidered and voted 4 to 1 to approve the merger. While they were advised that they could formally request an investigation by the SEC, the commissioners declined that course of action. Although the MPUC was unable to find the merger contrary to the public interest, it did note that its finding did not imply that the merger would produce any benefits to ratepayers or shareholders.10
Thus sanctioned, the merger produced big winners and big losers. The big winners: the investment bankers and DEI. Morgan Stanley received $1.3 million; First Boston received $3.7 million; Lehman Brothers received $600,000. The legal fees incurred were not disclosed. DEI, which was dissolved in the merger, received a fee of $4.75 million,11 which was distributed among the seven DEI executives whose positions were dissolved along with the holding company.12
The shareholders and ratepayers emerged as the big losers in the merger. DEI share values dropped from $29.60 per share to $6 to $8 per share. Likewise, the price of Arkla's stocks sank from a premerger high of $23.75 per share to below $8 per share, where it remains today as NorAm Energy. Ratepayers fared no better. After over 10 years without a rate increase, Arkla's Minnegasco division has sought and obtained several rate increases since the merger.
To be sure, the MPUC imposed a condition: The "writeup" denominated as an "acquisition adjustment" could not be recovered in rates from Minnesota ratepayers. But we know from experience with escalator and "take-or-pay" provisions in gas
producer-pipeline contracts that such orders are meaningless when enforcement threatens to impair service. One premise of PUHCA holds that state rate regulation will prove ineffective against the power of a utility company to seek and obtain revenue increases to improve earnings for an overcapitalized balance sheet. Consistent with that premise, the MPUC's condition has failed to prevent Arkla from increasing retail rates in either Minnesota, where the MPUC has jurisdiction, or in Arkansas, Texas, Kansas, Louisiana, Oklahoma, or at the FERC, where it does not.
A Second Re-Deal?
Congress characterized the holding company in 1935 as "an agency which, unless regulated, is injurious to investors, consumers and the general public."13 The Arkla-Minnegasco merger proves that the old-fashioned problem of overcapitalization remains a prime area of abuse. The use of the holding company in the Arkla-Minnegasco merger also undermines the claims in the preamble to S. 1317 that "changes in regulation and in the industry itself, have called into question the continued relevance of the model of regulation established" by PUHCA. If the issue is the manipulation of utility securities by holding companies to effect overcapitalization of
underlying utility companies, rather than the "model of regulation," the Arkla-DEI-Minnegasco merger suggests that the unregulated holding company is still an agency capable of injury to public, consumer, and investor interests that requires special regulation. Neither the states nor federal agencies acting under other legislation find themselves in a position to act as even a first set of suspenders to prevent utility overcapitalization by unregulated holding companies.14
How then should Congress or the SEC respond to calls for a "re-deal" of PUHCA? In most respects, as the Arkla-Minnegasco merger shows, the event has already occurred. Any further reform would mark a "second re-deal" for public utility holding companies. Neither Congress nor the SEC is in any position to consider a "second re-deal" when they
remain totally ignorant of the consequences of the first. The most important thing Congress could do, therefore, would be to inform itself about the consequences of its policies over the past 25 to 30 years. PUHCA instructed the SEC to study the problems of public utility companies and to make recommendations to Congress from time to time about the type and size of companies that would be best integrated and best promote and harmonize the interests of the public, the investor, and the consumer. The SEC has never conducted such studies.
Before Congress takes any further steps, it must confirm any resurgence of those abuses so carefully delineated in PUHCA and prior studies. As long as either Congress or the SEC chooses to ignore facts that do not coincide with a predetermined view of policy, any further "re-deal" would come from the bottom of the deck. t
Jon Erik Kingstad is a former assistant chief counsel to the Wisconsin Public Service Commission and a former legal counsel to the Minnesota Public Utilities Commission. He is presently in private practice in the Minneapolis/St. Paul, MN, area, providing legal and consulting services to the independent and public power industries.
1 S. 1317.
2 See Douglas Hawes, "Whither PUHCA: Repeal or Re-Deal," Public Utilities Fortnightly, July 15, 1995, p. 34.
4 15 U.S.C. 79a(b)(1).
5 Report of National Power Policy Committee on Public Utility Holding Companies, S. Rep. No. 621, 74th Cong., 1st Sess. at 57-58.
6 DEI Proxy Statement dated Oct. 25, 1990.
7 In the Matter of Proposed Merger of Minnegasco, Inc. with and into Arkla, Inc., MPUC Docket No. G-008/PA-90-604, Nov. 27, 1990.
8 Id. citing Minn.Stat. 261B.50 (1990).
9 15 U.S.C. 79j(c)(2). Wisconsin's Environmental Decade, Inc. v. SEC, 882 F.2d 523, 528 (D.C.Cir.1989).
10 In the Matter of the Proposed Merger of Minnegasco, Inc. with and into Arkla, Inc., MPUC Docket No. G-008/PA-90-605, Nov. 27, 1990.
11 DEI Proxy Statement dated Oct. 25, 1990.
13 The National Power Policy Committee observed in 1935 that "Fundamentally, the holding company problem has been, and still is, as much a problem of regulating investment bankers as a problem of regulating the power industry." If further recommended that holding companies not be allowed to derive fees or commissions from security transactions, noting that "[t]he holding company in the role of banker is in dangerous conflict with the interests of its investors and consumers." S.Rep. No. 621,74th Cong., 1st Sess. at 56-57.
14 Both the FTC and the FERC declined review or enforcement of the merger under the antitrust laws or the Natural Gas Act, Mr. Haws seems to believe that the SEC's deferral of several major hostile utility takeovers to the FERC proves his point about duplication of regulation. The FERC does regulate mergers between interstate public utilities, but PUHCA overrides the Federal Power Act with respect to mergers and acquisitions. 16 U.S.C. 825q; Arcadia v. Ohio Power Co., 112 L.Ed.2d 374 (1990). The SEC's deference to FERC jurisdiction with respect to these takeovers--to the extent they involved holding company manipulation, integration, and size standards, however--is consistent with its abdication of responsibility elsewhere under PUHCA.
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