One of the iron rules of competition and open markets is that there are winners and losers. Winners tend to win very big; losers tend to lose everything and disappear, through absorption or insolvency. As deregulation takes hold, high-cost producers and less adroit managers may find themselves steamrollered by emerging strongmen and entrepreneurial upstarts. These rivals may usurp segments of their business by bidding the job cheaper and still making money, leaving a rising tide of shareholder suits in their wake. Some of these will be derivative suits for mismanagement; some will be securities law suits for misstatements in prospectuses. Most likely, the majority of lawsuits will cover both these bases.
The targets of this litigation will be the company officers and directors, of course. So how will they defend themselves?
Senior management will either take early retirement or add defending these suits to the list of their daily duties. Their lives are unlikely to be affected to any large extent. Outside board members, however, may find the experience a substantial and expensive headache. In part, this will be because some outside utility directors have a level of knowledge and involvement in their companies that may well fall short of the easily defensible threshold of responsibility.
Many utility companies are run like quasi-governmental entities, whose obligations are first to management and employees, second to ratepayers, third to creditors, and last to shareholders, who are really regarded more as deeply subordinated debt holders than as owners of the enterprise. The real owners are management. So when shareholders' lawyers ask for evidence of management and board efforts to deliver returns for common shareholders, some records will be hard to defend.
Through the Looking Glass
The current state of affairs is not at all surprising. Over the years, management and regulators have frolicked together in a Wonderland of "regulatory assets" and "mirror" CWIP; rate structures where large, powerful customers paid more than small ones who were expensive to serve; and where DSM programs paid vendors to encourage their customers to buy less of the product. This world is peopled with exotic creatures such as "PURPA
machines" (em independent power producers that leveraged off utilities' balance sheets and customer bases while earning rates of return frequently in excess of 30 percent annually (em in an industry where 10 to 12 percent is the norm.
Small wonder that directors found their roles limited: What market should we enter? Not an issue; our service territory is defined and so is our function. What plants should we shut down because 90 percent of the industry makes the product cheaper? Nobody ever asked, and until very recently, if at all, management never thought it their duty to provide boards with data about comparative costs and prices and staffing levels. Comparisons to other utilities were beside the point.
What was there, indeed, for the board to involve itself in under the old regime? The public utility commission (PUC) staff, and then the commissioners, were arguably the de facto management and boards of these companies. What was the real necessary level of rates? The PUC decided. Was a new power plant needed? The PUC decided whether it was "used and useful," and what the right fuel should have been. What was the proper budget for construction? The PUC decided what cost level was prudent (remember that the famous business judgment rule that protects directors is couched in terms of what a "prudent" man would do).
There were areas where boards did get involved, but the artificiality imposed by the monopoly position of the utility and the substitution of the government regulator for genuine market forces left the board in the dugout more often than on the field. Until now there really was not much of a role for the board to play. Also, compared to similar-sized companies in other industries, utility directors' fees have been quite modest.
This world order will no longer be acceptable to the institutional shareholders who currently make up over 40 percent of the utility shareholder constituency, or to the courts, as the stakes of many shareholders dwindle.
Boards will need to educate themselves, rapidly, to the new paradigms of competition, and stop regarding the utility as a quasi-public entity that happens to pay dividends. They will also need to press their managements for the kinds of information a prudent man would need to protect and enhance his investment. This will protect the boards, and might even protect the shareholders. Finally, the management of these companies will need to build a new type of partnership with their boards.
The accompanying quiz covers elements that are, or soon will be, critical to the success or failure of electric utilities. Some are utility-specific; some relate to more general business issues that are becoming more important to utilities. The object is twofold. First, to sensitize managements and directors to the level of knowledge and concern for shareholder interests likely to be expected by shareholders, the marketplace, and the judicial system. And second, to alert directors to the kinds of questions and guidance that will test their managements and make the director/ management team function in fact as well as in name.
To make the test objective, there are no "Why" questions. However, "Why?" is a question your shareholders could properly assume that you, as a director, should be thinking about. And one that, sooner rather than later, you should have good answers to. t
J. Michael Parish is an attorney with the Washington, DC, law firm of Reid & Priest, LLP.
Truth ... or Consequences1. How efficient is your utility?
(Compare your company's heat rates for plants with similar fuels to others in your power pool or your state.)2. Does the wholesale market pose a threat?
(How will your prices look to your 10 largest customers after deregulation ... and can you afford not to care?)3. What major costs do you incur?
(How do you expect these components to change over the next five years?)4. What segments of your customer base are most profitable?
(Where do see your future profits: industrial, residential, commercial, government/nonprofit customers, offsystem sales?)5. How much of your business is wholesale?
(Will you sell more or less to other utilities and power brokers?)6. How competitive is your company?
(Where would you rank in terms of thermal efficiency, environmental emissions, capital and operating costs, and per-employee output?)7. What is your company's value to shareholders?
(Give three good reasons to buy your stock, as opposed to an S&P 500 index fund or 10-year Treasury bonds.)8. What is the financial condition of your company?
(How reliable have your internal financial projections been over the last five years?)9. Which parts of your company's business are most viable?
(Rank the profitability of the generation, transmission, and distribution segments of your business with an eye to future disaggregation.)10. How will you make money after deregulation?
(Banking, railroads, trucking, airlines ... many of those entities ran aground when government lifted monopoly rules. How will you avoid their mistakes?)
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