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FERC’s Hold Harmless Proposal To Impact M&A
Reprinted from Power Finance & Risk
The current energy crisis and the various major changes affecting the electric
industry including the introduction of open access to transmission facilities, major
utility reforms, environmental challenges together with large turnover of state
public utility commissioners expected across the country, has had or will continue
to have a significant impact on the sector. As a result, many energy companies
have engaged in mergers or other energy asset transactions. On January 22,
2015, the U.S. Federal Energy Regulatory Commission issued a proposed
policy statement to clarify FERC’s allowance on “hold-harmless” commitments for
determining whether such proposed mergers or other asset transfers subject to its
jurisdiction would have an adverse effect on cost-based rates for transmission
service or wholesale electric service. As discussed below, FERC’s policy
statement, if adopted, may have a significant impact on valuations of large
regulated utility mergers and swaps of generation asset portfolios.
The Law-Standard of Review
Generally, Section 203 of the Federal Power Act requires owners of certain
energy assets in the U.S. to obtain prior approval of certain acquisitions,
dispositions and mergers transfers from FERC unless blanket authorization is
available or jurisdiction has been disclaimed. Failure by such owners of electric
energy to obtain FERC’s approval for a transfer to an acquiring entity could lead
to FERC’s assessment of civil penalties. As discussed below, in light of the
issuance of the Revised Policy Statement on Penalty Guidelines (Revised Policy
Statement on Penalty Guidelines, 132 FERC ¶ 61,216 (2010) in the Sept. 17th
order and the recent more aggressive role of FERC’s Office of Enforcement
auditing the activities of energy companies subject to FERC regulation, failure to
comply with the requirements of Section 203 of the FPA may have serious
consequences, including sanctions and possible civil penalties.
At heart, FERC is a consumer protection agency whose primary task since the
1930s has been to protect the consumer ratepayers (including protection against
inappropriate cross-subsidization), precluding harm to competition, but also
removing unnecessary transaction burdens on the much needed infrastructure
investment in the utility industry. Simplified, FERC’s approach to merger analysis
under Section 203 of the FPA is to determine if the transaction “will be consistent
with the public interest,” (i.e. does not raise market power concerns and does not
have adverse effects on rates). If so, the statute requires FERC to approve the
transaction. Applicants do not have to demonstrate that the proposed transaction
positively benefits the public interest, but rather the proposed transaction does not
harm the public interest. FERC generally analyzes the public interest issue by
considering the effect of the transaction on electric power competition, rates and
regulation in the relevant geographic and product markets. The Energy Policy Act
of 2005 amended Section 203 to expressly require FERC to also find that the transaction “will not result in cross subsidization of a non-utility associate company or the pledge or encumbrance of utility assets for the benefit of an associate company,” unless FERC determines that such a result of the transaction “will be consistent with the public interest.” 16 U.S.C. § 824b(a)(4).
Section 203 applicants commonly are able to satisfy FERC’s concern on adverse effect on rates by demonstrating and utilizing rate freezes, rate reductions, open seasons or other ‘hold harmless commitments.” In connection with such hold harmless commitments, the applicant typically covenants for a period of five years after the transaction closes, not to seek to recover transactional related costs or transition costs in jurisdictional rates except to the extent that there are demonstrable merger-related savings in a separate rate filing. Specifically, the applicants commit for a period of five years to hold ratepayers harmless from the rate effects of a proposed merger. Common protests around the hold harmless commitment usually center on the requests for a full evidentiary hearing, what constitutes merger-related costs including acquisition premiums (or acquisition adjustments), misunderstanding of savings and the procedures for how such costs and savings are verified and enforced together with the absence of satisfactory assurances that the accrual of merger related costs during the commitment period will not prevent recovery of such costs after the commitment period expires.
FERC’s Proposed Policy Statement
In the Policy Statement, FERC proposes four new changes as set forth below:
1. To clarify the scope and definition of the costs that should be subject to hold harmless commitments;
2. To clarify the controls and procedures applicants offering hold harmless commitments must implement to track the costs from which customers will be held harmless;
3. To impose no time limitation on hold harmless commitments; and
4. To clarify that applicants may demonstrate that, under certain circumstances, a hold harmless commitment is unnecessary.
It is also important to note that the if the proposal is adopted, FERC would apply the new policies on a prospective basis.
Key Takeaways on the Policy Statement
1. Just as the FERC has done since 1935, it will continue to be vigilant to protect ratepayers against mergers or other jurisdictional corporate transactions that are not consistent with the public interest.
2. The unlimited duration of the hold-harmless commitment may make the anticipated value of the merger or other electric asset transactions more uncertain because the facts and circumstances of future cost-recovery will be more difficult to predict. From the transactional side, utilities look to merge to increase their valuation multiples, and reduce their cost of capital. A key metric in valuations is how quickly utility companies can earn back the funds that it will spend on capital expenditures. If the Proposal is adopted, we expect to see variations of existing methodologies for valuations for utility companies which may be more attractive to strategic buyers versus financial sponsors.
3. If the Proposal is adopted, the FPA 203 application will need to be significantly more detailed with supporting data, calculations and witness testimony together with post-transaction accounting entries to demonstrate proper compliance with the hold harmless commitments. This means the applicants will likely need to track separately merger-related costs, including costs incurred to effectuate the proposed transaction and costs incurred to integrate.
4. To gain more regulatory and financial certainty, the merger agreement or principle agreement between the parties in the merger or electric asset transaction will need to include carefully drafted provisions to address the uncertainties of cost recovery. We would suggest provisions such as detailed condition precedents, risk shifting covenants, reverse termination fees, cooperation covenants together with strong indemnities and representations with survival.
5. The scope and definition of transaction-related costs are critical. Disputes may arise before FERC over what costs may be recoverable in rates.
6. Failure to comply with Section 203 to obtain prior authorization of disposition is a violation of federal law and may also be a violation of various contractual obligations of the parties. FERC has also indicated that a disposition implemented without prior authorization may be voidable in court by the affected party and that FERC has the authority to revoke market-based rate authority or order refunds for violating Section 203.
Comments on the Policy Statement are due March 30, 2015.