As a result of a recent decision of an Ontario court, boards of directors of local distribution companies can rest assured that their authority remains relatively unfettered from regulatory involvement, at least with respect to the payment of dividends.
The Decision, in short
On September 9, 2008, the Superior Court of Justice (Divisional Court, Ontario) (the Court) granted an appeal made by Toronto Hydro Electric System Limited (THESL) of part of a decision made by the Ontario Energy Board (OEB) in respect of a rate application by THESL. In decision EB-2005-0421 (OEB Decision), the OEB required that, as a condition of setting rates for the distribution of electricity, any dividend paid by THESL to the City of Toronto be approved by a majority of THESL's independent directors.1 THESL appealed the OEB Decision.
THESL argued that the OEB had no jurisdiction to impose such a condition, and that by doing so it restricted, unjustifiably, the authority of THESL's board of directors. The OEB argued that it acted within its authority in rendering its decision on payment of excessive dividends. The court found in favour of THESL.
The OEB Decision was made in response to THESL's 2006 rate application, one of the first applications to be made on a forward test year. As part of this rate application, THESL selected a 9% market based rate of return (MBRR), the maximum allowable. Various parties and intervenors to the proceeding made submissions on this rate of return. Ultimately, the OEB accepted the 9% MBBR.
As part of the background facts, it was noted that, prior to 2003, THESL did not pay any dividends. In 2003, THESL paid a dividend to THC of $5 million, and in 2004, $31.5 million. A significant part of the dividends paid by THC to the City was derived from the regulated business of THESL as compared to the unregulated businesses of THESL's affiliates. In addition, interest payments were being made by THC and THESL on promissory notes between the City and THC and; correspondingly, TCH and THESL.
An anticipated shortfall in the 2006 operating budget of the City led to a demand for a substantially higher dividend from THC to the City, which in turn triggered a demand from THC to THESL for a higher dividend payment.
A Shareholder Direction from the City to THC was in effect which required THC to pay a dividend equivalent to 50 per cent of THC's consolidated net income. However, the direction provided discretion not to declare a dividend.
THESL acknowledged that it could have invested the dividends paid to its shareholder to update THESL's infrastructure. However, this course of action was not analysed in detail and a plan of capital investment had not been completed.
At the time of the OEB Decision, THESL was not required to comply with the requirement in the Affiliate Relationships Code for Electricity Distributors and Transmitters (ARC) that at least one third of the board of an electricity distributor must be independent of any affiliate since the code had not yet come into effect. The ARC, however, would be in effect for part of the period that would be covered by the rate application. THESL confirmed its intention to comply with the ARC once it came into effect.
The OEB Decision
In arriving at its decision, it appears that the OEB placed significant emphasis on the non-arm's length relationships between the City of Toronto, THC and THESL. The OEB raised concerns regarding the interest payments that it found to be above market rate, payments for shared services and the dividend payments. The OEB characterized the dividend payments as extremely high and unusual. Consequently, the OEB found it appropriate to require that any dividend paid by the utility to the City of Toronto [sic] be approved by a majority of the independent directors that would soon be part of THESL's board. The OEB indicated this to be consistent with the policy intent of the ARC.
The Court's Decision on Appeal
In hearing the appeal, the Court considered whether, in setting rates that an electricity distributor may charge, the OEB has jurisdiction to impose conditions on the authority of the licensed distributor's directors to declare dividends. To arrive at its decision, the Court looked to principles of corporate law as well as to the Ontario Energy Board Act, 1998 (the Act).
In considering the Act, the Court noted as relevant the Act's objectives to protect the interests of consumers with respect to prices and reliability of service, and to promote economic efficiency and cost effectiveness in the electricity system and industry. The Court recognized the provisions that permit the OEB to impose conditions in an order that it sees as proper and the OEB's authority to make orders for just and reasonable rates for the distribution of electricity.
These latter provisions were central to the OEB's arguments that it had both express and implied authority to impose the conditions regarding dividend payments. The Court disagreed, stating that the Act contains no express power to dictate, as a condition of rate setting, how dividends are to be declared. The Court also found no such implied power for various reasons, including that it was not necessary to imply such authority for the achievement of the Act's objectives nor essential for the OEB to fulfil its mandate.
The Court also noted that it was unnecessary to imply such powers because of safeguards contained in the Ontario Business Corporations Act (OBCA), including the fiduciary duties of directors. The Court pointed out that the OEB accepted THESL's MBBR and, having done so, the distribution of the profit is a decision that belongs with the directors of THESL. The Court agreed that the effect of requiring a majority of the independent directors to approve such decisions would be the equivalent of delegating dividend payment decisions to the independent directors. This is contrary to the OBCA and long-standing corporate law principles.
The Court found in favour of THESL and its appeal was granted. The Court set aside the condition in the OEB Decision that a majority of THESL's independent directors approve decisions regarding dividend payments.
The Court's decision illustrates that the provisions of the Act, the OBCA and corporate law principles exist side by side for the regulated distributor. The OEB cannot simply ignore corporate law principles in rendering its decisions, even if in furtherance of its goal of protecting electricity distribution consumers.
Regardless of the Court's decision to set aside a portion of the OEB Decision, the decision may be worthwhile reading for any distributor in its future rate submissions. The OEB Decision is is useful in understanding the OEB's scrutiny of distributor rate applications, its focus on affiliate relationships, and its emphasis on consumer protection objectives. In the wake of this court decision, the OEB is concerned in any particular case about the adequacy of infrastructure investment or fairness of distribution rates, it may look to other, more definitive regulatory tools. It would not be farfetched to predict that, in the future, particularly if the maximum allowable market based rate of return is sought, the OEB will require enhanced rigour in distributor's rate applications.