Whither PUHCA?-[1]- Barry P. Barbash, Director Division of Investment Management U.S. Securities and Exchange Commission ---------FOOTNOTES---------- -[1]- Remarks from this speech were given before the Tenth Annual Utility M&A Symposium on February 4, 1997, at the Plaza Hotel, New York, New York. ==========================================START OF PAGE 1====== Whither PUHCA?-[2]- When I became Director of the SEC's Division of Investment Management in 1993, I was led to believe that the Office of Public Utility Regulation was a rather sleepy little corner of the Division overseeing a dormant industry. To me at the time, Southern was a type of hospitality, Entergy a name with a typo, and Enron, some sort of sweep run by a halfback. I quickly came to appreciate the vitality of the utility industry and the importance of the work done in the Office. I also came to understand more fully, and even enjoy, the intricacies of the Public Utility Holding Company Act of 1935 and the immense challenges involved in its administration. Some may question the judgment of anyone who says he enjoys the Act; perhaps my feelings about the Act are not entirely surprising, as I have spent most of my career seeking to decipher the equally complex Investment Company Act of 1940. The challenges we face in administering the '35 Act arise from the break-neck speed with which the gas and electric utility industries are moving from a monopoly structure into a more competitive energy marketplace with many diverse participants. In the process, the fibers of a 62 year old statute have been strained to the breaking point. Congress enacted the 1935 Act during the Depression, to eliminate evils existing at the time, and to prevent their recurrence. The Act worked smoothly and effectively within the framework of the old monopoly structure: sprawling holding companies were broken up; affiliate transactions were monitored and, if abusive, were not permitted; the rights of investors and consumers in multistate systems were protected against abuses inherent in the holding company structure; and the regulatory gaps that state utility regulation did not, or could not, reach were filled. The '35 Act worked in the past to accomplish its purposes, but it simply does not work well today. The solutions of the past have become barriers today. Congress could not have foreseen in 1935 the tremendous structural changes that are now occurring in the utility industry and are likely to continue to occur in the future. Often standing in the way of that change is the '35 Act, the most rigid of the federal securities laws. It provides for substantive review and monitoring of countless activities and transactions, and broad prophylactic relief in cases of noncompliance. ---------FOOTNOTES---------- -[2]- The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission. ==========================================START OF PAGE 2====== Applying its rigid provisions to a vibrant and developing industry is akin to putting on a suit that you wore in your younger days: it just doesn't fit the way it did before. Examples of the irresistible forces of industry change meeting the seemingly immovable object that is the '35 Act are numerous. Four industry trends show the tension in graphic detail -- the rise of new participants in the utility business using novel ways to provide energy to consumers; the fundamental restructuring of the electric industry now occurring; the trend toward internationalization of the energy business; and the ever- increasing degree of industry consolidation. I. New Participants and New Roles in the Energy Supply Business. Business publications are filled today with articles about new developments in the marketing of energy. Whether it is Southern convincing a large commercial customer in Boston to leave its traditional supplier of electric power,-[3]- or Enron's acquiring a local electric utility company in the Pacific Northwest,-[4]- the traditional and nontraditional players in the energy business are invading each other's turf and vying for customers through price competition, ancillary services, and other incentives.-[5]- Key to these developments are federal and state initiatives ---------FOOTNOTES---------- -[3]- "B[oston] Edison loses bid for Hancock," The Boston Globe, January 2, 1997, at p. E-1,col. 4 (reporting a 5-year energy supply contract between John Hancock Mutual LifeInsuranceCompany in Boston and Southern Energy, a nonutility subsidiary of Southern, to be effective when commercial customers have a choice of energy suppliers under Massachusetts law). Massachusetts has taken several steps toward retail competition, including obtaining the agreement of all electric utilities in the State to a timetable for phasing in retail competition, beginning as early as January 1, 1998. -[4]- See "The New Face of Competition: Enron Buys an Electric Utility," Energy Daily (July 23, 1996) (reporting proposed acquisition by an energy marketer of an electric utility company in Oregon). -[5]- See, e.g., "Power Struggle: Big Utilities Vie for Affections of Tiny New Hampshire Town," Houston Chronicle (Oct. 20, 1996) (describing incentives used to attract customers in New Hampshire retail pilot program, including balloon rides, bird feeders, and pints of Ben & Jerry's ice cream). ==========================================START OF PAGE 3====== that encourage development of independent power producers-[6]- and permit wholesale and retail customers a choice of energy suppliers.-[7]- So far, even after a short period, these initiatives have had nothing short of dramatic results. In the year ended December 31, 1995, approximately 76% of gas sold at retail to industrial customers and 23% of gas sold at retail to commercial customers was sold by a party other than the customers' local utility.-[8]- The '35 Act was not written with this type of activity in mind; it reflects a model of vertically-integrated monopolies, and its core definitions can operate in unexpected ways as the ---------FOOTNOTES---------- -[6]- See the Energy Policy Act of 1992, Pub. L. 102-486, 106 Stat. 2776 (1992) (exempting exempt wholesale generators, defined as anyone that owns or operates a facility for the generation of electric power for sale at wholesale, from the Act), and the Public Utility Regulatory Policies Act of 1978, 92 Stat. 3117 (1978) (providing that "qualifying facilities", predominantly cogenerators and small power producers, are not public utilities under the Act). -[7]- These initiatives require or permit owners of transmission and distribution facilities to provide equal access to any supplier wishing to use these facilities to deliver energy commodities to customers. At the wholesale level, recent FERC orders provide for open access to gas transportation and electric transmission facilities. See Regulation of Natural Gas Pipelines After Partial Wellhead Decontrol, Order No. 636, III FERC Stats. & Regs. 30,939 (Apr. 16, 1992); and Promoting Wholesale Competition Through Open Access Non-Discriminatory Transmission Services by Public Utilities and Recovery of Stranded Costs by Public Utilities and Transmitting Utilities, Order No. 888, FERC Stats. & Reg. 31,036 (1996). Nineteen states have implemented pilot programs for retail wheeling of electric power, and all 50 states have designed programs that allow retail customers to buy natural gas directly from suppliers other than the local distribution company (including 25 states that have pilot programs targeting residential customers). See, e.g., Order of the New Hampshire Public Utilities Commission on the Retail Competition Pilot Program Establishing Final Guidelines and Requiring Compliance Filings, Order No. 22,033 (Feb. 28, 1996) (implementing pilot program for retail electric competition); and California Public Utilities Commission Decision No. 86-03-057 (Mar. 19, 1986) (requiring California's large gas utilities to unbundle transportation and distribution services for large volume customers with long-term firm contracts for gas). -[8]- Retail electric and residential gas competition programs are of too recent a vintage to have generated statistics. ==========================================START OF PAGE 4====== industry departs from this model. A "public utility company" under the Act, includes any entity that owns or operates facilities for the distribution of gas at retail or facilities for the generation, transmission or distribution of electric energy for sale. A "holding company" is an entity with a 10% or more voting interest in a public utility. Under these definitions, the entity that holds title to the physical utility assets is technically a utility under the Act, even though it may not sell a single watt of electricity or cubic foot of gas, and its parent is technically a utility holding company. Both the parent and subsidiary would be potentially subject to the full panoply of regulation under the Act. The same result holds for an entity that does not even own the physical assets but instead merely operates them under a contract with the owners. At the same time, the actual seller of the energy commodity itself, if it owns or operates no facilities, may escape 1935 Act regulation. We have generally concluded that, despite its contracts for the sale of gas or electric power, an energy marketer is not a public utility under the Act.-[9]- Nonetheless, each day we are faced with a host of interpretive issues under the Act relating to novel energy marketing issues. Can a registered holding company system form a nonutility subsidiary to participate in energy markets outside the system's franchised service territory? Can the subsidiary deal in energy that is not produced by the system's utility companies? Can a marketer own limited incidental facilities, such as meters, related to distribution of electric power, and still be a nonutility for purposes of Act? Can a nonutility marketer build minor direct connections to commercial and institutional customers, bypassing the local distribution system and saving the customer money, and escape classification as a public utility under the Act? All of these questions would seem to reflect the proverbial square peg of today's industries trying to be squashed in the round hole of regulation under the '35 Act. Industry restructuring. Energy marketing is far from the only aspect of the utility industry that is calling into question the '35 Act and its underlying principles. In the wake of FERC Order No. 888, formation of "independent system operators" to operate transmission grids throughout the country is underway. Some states are encouraging separation of generation assets from other ---------FOOTNOTES---------- -[9]- See, e.g., Norstar Energy L.P., SEC No-Action Letter (Feb. 9, 1995); and Enron Power Marketing, Inc., SEC No-Action Letter (Jan. 5, 1994). ==========================================START OF PAGE 5====== utility property.-[10]- These developments, together with the general industry trend toward separating the regulated portion of the gas and electric utility industries from those portions that are moving more rapidly toward competition, show clearly that the monopoly structure of 1935 is on its way to becoming a dinosaur. This restructuring of the industry parallels in many respects the participation of new players in the energy supply business, and raises many of the same issues concerning the status of independent system operators or generating companies as utilities, and of their stockholders as holding companies. To date only a few preliminary questions relating to the industry restructuring have been raised with the Commission's staff, and none has been carried through by the inquirer to resolution. We expect these types of questions to be plentiful in the coming years. In resolving the issues raised by new market participants and industry restructuring, the Commission must consider developments in the industry and the equities of the situation against the backdrop of the Act and the purposes it was intended to achieve. What types of entities should the Act catch in its regulatory net? What activities and ownership structures raise issues under the Act? How far can we stray from a strict interpretation of the definitions in the Act? In addressing these questions we are faced with the stark regulatory reality of certain inescapable 1935 Act principles: ownership or unlimited operation of utility facilities almost certainly brings an entity within the definition of "public utility"; integration is an issue whenever physical assets are owned or operated by a company in a registered system; ownership of 10% or more of a utility's voting securities imposes on a security holder that wants to escape holding company status a significant burden to show it does not control the utility; and regulation under the Act cannot easily be avoided if consumer interests are implicated and are not protected in other quarters. Issues in this area will continue to be complicated and intensely fact-specific. It is difficult to predict how '35 Act regulation will work as restructuring proceeds, which participants in the energy market will be subject to its regulation, and which will escape. Unhappily, a strong ---------FOOTNOTES---------- -[10]- See Rhode Island Utility Restructuring Act of 1996, discussed in "R.I. Gov. Almond Signs Nation's First Bill Establishing Retail Wheeling," Electric Utility Week (Aug. 12, 1996) (legislation calls for "corporate unbundling to create a firewall between utility affiliates"). ==========================================START OF PAGE 6====== possibility is that the end result may be inconsistent with not only the realities of the utility industry, but also the energy policies of the individual states and the FERC. Foreign acquisitions, and acquisitions by foreigners. With the rapid advances in communication and technology since 1935, the insular nature of the U.S. utility business is becoming a thing of the past. U.S. utilities want to expand their businesses by investing overseas and, conversely, foreign companies are interested in U.S. utilities. The Energy Policy Act of 1992 eliminated a number of '35 Act barriers to acquisition of foreign utility interests,-[11]- and since its enactment, registered holding company systems have invested approximately $3.5 billion in foreign utility companies and foreign exempt wholesale generators, as defined in sections 32 and 33 of the Act. Exempt holding companies and free-standing utilities have invested approximately $4.9 billion in these entities over the same period. Yet, the Act remains out of step with industry developments in many ways, and significant issues relating to internationalization of the industry rear their heads every day. Perhaps the most significant of these issues have been raised by attempts by holding companies to use the proceeds of financing transactions to invest in foreign utility companies and exempt wholesale generators, when the aggregate amount of the investments exceeds the safe harbor limitations of rule 53 under the Act (i.e., 50% of the system's consolidated retained earnings). The Commission has granted requests by Southern and CSW to double their permitted investments, and a similar application filed by GPU is still pending. These filings are controversial, engendering opposition from consumer groups, and strong, but mixed, responses from various members of Congress. We expect that registered holding companies will continue to seek authorization to increase the amount of these types of investments, and that the Commission will continue to grant these requests when the applicable standards of the Act and rules are satisfied. Expansion of the utility industry into foreign markets has also raised a number of questions involving foreign nonutility activities. In some cases, the issue involves status as a foreign utility company; the statutory definition of a FUCO does not make clear the extent to which an entity may engage in ---------FOOTNOTES---------- -[11]- For holding companies, the question was whether the foreign properties were required to integrate with the system's domestic utility operations. For others, the question was whether the acquisition would trigger holding company status, and whether an exemption was available. ==========================================START OF PAGE 7====== nonutility activities and retain FUCO status.-[12]- In other cases, a company in a registered system may want to engage in nonutility activities overseas, completely unrelated to a FUCO. The potential risks of these activities can be significant, and the '35 Act's limits on nonutility activities-[13]- can be strict. When a FUCO is involved, or where the acquiror is a gas registered holding company and the activity is subject to the Gas-Related Activities Act of 1990,-[14]- the acquisition may be permissible. Outside the area of FUCOs and GRAA, it may be very difficult, if not impossible, to comply with the requirements of the Act. To date, the Commission has only approved limited cases, primarily involving consulting activities. Worldwide expansion of the energy business has not been one-sided. In recent months, we have started to receive a number of inquiries from foreign entities interested in acquiring interests in domestic utilities. The primary issues involve whether the resulting holding company is exempt from the registration requirements of the Act and, in cases in which the acquiror is a utility or has other utility interests, integration of the resulting system's utility properties. Unless expansion of the utility business beyond national borders comes to an expectedly abrupt halt, questions such as these will become a greater part of the staff's agenda. Merger activity. The current merger mania would not likely have pleased the ---------FOOTNOTES---------- -[12]- The definition of "foreign utility company" in section 33 of the Act does not require that the entity be engaged exclusively in the utility business, but does not specify the extent to which a FUCO may engage in other, nonutility, activities without losing its status. -[13]- The Commission must determine whether the new business satisfies the requirements of section 11(b)(1), that, is "functionally related" to the system's utility operations. -[14]- Pub. L. No. 101-572, 104 Stat. 2810 (1990) (codified as a note to section 11 of the Act). The Gas-Related Activities Act permits gas registered holding companies to acquire interests in certain gas-related assets and activities without satisfying the requirements of section 11(b)(1). The Commission recently determined that the Gas-Related Activities Act covers foreign activities and authorized a gas registered holding company to acquire interests in pipelines in South America and Australia, without a showing of functional relationship. Consolidated Natural Gas Co. et al., Holding Co. Act Release Nos. 26608 (Nov. 19, 1996) and 26595 (Oct. 25, 1996). ==========================================START OF PAGE 8====== drafters of the '35 Act, whose goal was breakup, rather than combination, of utilities. The industry is experiencing unprecedented activity in mergers and acquisitions, and the workload of the Office of Public Utility Regulation reflects this trend. We are at this time considering seven formally filed and pending applications relating to mergers, five which would result in new registered holding companies upon consummation of the proposed transactions.-[15]- The pending merger applications involve companies with aggregate assets in excess of $92 billion as of June 30, 1996, and for the twelve months ended on that date, operating revenues of approximately $32 billion and net income of approximately $3 billion. These applications raise significant issues under the Act's provisions relating to integration of utility properties, retention of nonutility businesses, and exemption from the reach of the Act. The most significant of the matters currently under consideration include: whether both gas and electric utility systems can be retained; whether nonutility businesses that are not directly energy-related can continue to be held; the limits of exemption under section 3(a)(2) of the Act, including, specifically, the point at which a holding company ceases to be "predominantly" a utility; the interaction between FERC and SEC requirements with respect to pricing of transactions between affiliated companies; and the policies of the Act concerning competition issues. We are working diligently to address these issues and hope to resolve them quickly. We recognize, though, that the number of inquiries raised by industry consolidation is likely to increase rather than abate at any time soon. The overriding regulatory question raised by the rapid and widespread changes occurring today in the energy landscape is what to do with the '35 Act. The question has certainly been asked before; the Commission has long recognized the tension created by industry developments and the Act's rigidity, and tried to deal with it for a number of years. Most recently, in June 1995 my Division prepared, and the Commission endorsed, a report on the status and future of regulation of public utility holding companies. The report was a comprehensive study of the history of utility holding company regulation, the development of administration of the Act, and recommendations for the future. Our primary recommendation was for legislative action to bring holding company regulation into the nineties. Our legislative remedy of choice was repeal of the Act, conditioned on transferring to the FERC certain limited powers and functions ---------FOOTNOTES---------- -[15]- That companies are willing, to subject themselves to registration under the Act as an out growth of these business combinations indicates the importance of mergers in the utility industry of today. In the recent past, the draconian threat of regulation may have been enough to defeat a proposed transaction. ==========================================START OF PAGE 9====== that would provide consumer protections where they are still needed. The report also proposed changes in the way the Commission administers the Act to provide interim relief, wherever possible, from some of the Act's more onerous limitations. A number of the Report's proposals have been pursued, including various legislative initiatives that are pending in Congress.-[16]- At the same time, the Division has pursued many interim solutions. I can assure you that we are trying to be as responsive as possible to new industry forces, consistent with the purposes and limitations of the Act. When we percieve flexibility in the Act, we have sought to use it. Perhaps as a result, the demands of the industry for further administrative change are increasingly aggressive, and the tension of applying an antiquated statute to a modern industry becomes ever more intense. As a further difficulty, the limited resources of the Office of Public Utility Regulation are already strained and will become even more so as the number of complex and novel applications increases. In the short time since the issuance of the June 1995 Report, industry developments have only underscored in heavy ink that the Report's conclusions and recommendations were correct. The '35 Act, more and more, is a weight that is holding back the utility industry and preventing it from moving as fast and as far as it might. In the past, we called certain cases, involving ownership of independent power projects, "PUHCA pretzels," because they required us to twist and turn the Act to conform to the needs of the industry. The Energy Policy Act provided a legislative fix for the problem, and these types of contortions are no longer needed. Today, however, more and more of our applications entail and twisting and turning of the provisions of the Act, and the appellation "pretzel" could be used to cover most matters we handle. The solution now, as it was then, is consistent with the basic premise of the report: administrative reform can provide no more than a limited measure of relief. We cannot administratively repeal the '35 Act, and legislative reform is crucial. We envy New York Yankee and Green Bay Packer fans and hope that 1997 is the year that the '35 Act reform becomes a reality. Thank you. ---------FOOTNOTES---------- -[16]- These initiative include Senate Bill 1317, which has been reported out of the Senate Banking Committee, and which would largely implement the Commission's conditional repeal recommendation. Other legislative proposals involve repeal as part of comprehensive restructuring of the energy industry.