Thomas C. Havens
Whitman Breed Abbott & Morgan LLP
The acquisitions of Pacificorp by ScottishPower plc and of the New England Electric System by National Grid Group plc mark the first takeovers of major U.S. electric utilities by foreign companies. In closing these transactions, the foreign buyers had to negotiate a maze of state and federal regulatory hurdles. Although approvals of local officials for the ScottishPower merger were secured only after lengthy hearings and rate concessions, merger proceedings at the federal level have been largely uneventful, with one exception. A real question exists as to how these new global utilities can be squared with the requirements of the Public Utility Holding Company Act of 1935 (PUHCA) which, until now, have virtually blocked foreign companies from acquiring U.S. utilities. However, in signaling its blessing for these mergers, the Securities and Exchange Commission (SEC) is clearing the way for completing transactions that did not seem possible under existing law.
SEC`s interpretations change
Foreign utilities are taking a more strategic interest in U.S. electric utilities for a number of reasons. Under a European Union (EU) directive issued in 1998, EU countries are gradually opening their electric systems to competition. For some European utilities, the influx of competitors is coupled with substantial rate reductions. The prospect of earnings erosion at home is prompting a search for investments abroad that offer a platform for stable earnings growth. Economic and political uncertainties in Asia and Latin America have made the U.S. electric market look increasingly more attractive for large infrastructure investments. In addition, some foreign utilities believe their experience with competitive market structures and incentive regulation will give them an edge in exploiting U.S. utility markets that are moving toward deregulation.
But the real catalyst for the recent move by foreign companies into the U.S. utility sector may be the momentum building in Congress to remove barriers to entry, particularly PUHCA. With PUHCA repeal likely within the next several years, SEC has been under enormous pressure to administer the statute in a manner that facilitates transactions that have been approved by local regulators and other key constituencies. Especially significant to prospective foreign acquirors is that SEC has shown willingness in recent years to read the “integration” standards of PUHCA much more liberally. Section 11 literally requires SEC to limit “registered” holding companies subject to PUHCA to “single integrated public-utility” systems, which traditionally have consisted of physically and operationally integrated electric (or gas) utility assets. However, SEC also is empowered to judge integration against the “state of the art” of the utility business, giving it broad discretion to consider the fundamental changes now taking place in the structure of the U.S. utility market. For example, SEC has eschewed traditional notions of integration in approving convergence mergers between electric and gas utilities and between non-contiguous utility systems.
Nonetheless, foreign utility takeovers have provided the toughest test of SEC`s resolve to flexibly administer PUHCA. To allow foreign acquisitions of U.S. utilities, SEC will have to reinterpret existing laws and regulations applicable to such transactions. PUHCA was enacted primarily to dismantle the far-flung public utility holding company systems that dominated the U.S. in the early 1930s, several of which owned substantial foreign utility properties. SEC ordered these foreign operations to be divested under Section 11 precisely because they were not integrated with the holding company`s domestic utility business.
A foreign company with minor U.S. utility subsidiaries escaped the divestiture mandate of Section 11 only if it qualified for an exemption from registration under PUHCA Section 3(a)(5). Pursuant to Section 3(a)(5), an “essentially foreign” company could acquire and own a U.S. utility subsidiary, without becoming subject to the integration requirements of PUHCA, if the U.S. utility: (a) would not make a material contribution to the income or revenues of the acquiring company, and (b) was small in size in both a relative and an absolute sense. Given the narrow scope of Section 3(a)(5), it is hardly surprising that few foreign acquisitions of U.S. utilities have been accomplished in reliance on this exemption. In the most recent case under Section 3(a)(5), SEC took nearly seven years before allowing a Canadian company to acquire a small Vermont gas utility with less than $35 million in assets.
EPAct opens foreign markets to U.S.
U.S. companies, on the other hand, have largely been free to purchase foreign utilities since the passage of the Energy Policy Act of 1992 (EPAct). EPAct amended PUHCA to exempt acquisitions by U.S. companies of foreign utilities and generating facilities from the integration and SEC approval requirements of PUHCA. Acquisitions of foreign utilities by registered holding companies are subject to SEC approval only if certain financings or affiliate transactions are involved. However, under SEC regulations mandated by EPAct, registered companies generally cannot make equity investments in foreign utilities or generating plants in excess of consolidated retained earnings.
While EPAct opened up foreign utility markets to U.S. utilities for the first time since the 1930s, it did not address the matter of inbound acquisitions of U.S. utilities by foreign companies. SEC opened the door a crack in a decision last summer concerning AES Corp.`s acquisition of CILCORP, an electric and gas utility in Illinois. SEC found that AES`s ownership of CILCORP qualified for an exemption under Section 3(a)(5), despite the fact that CILCORP had more than $1 billion in assets and would contribute (on a pro forma basis) over 10 percent of the revenues of the combined company. By expanding the parameters of Section 3(a)(5), SEC also, albeit inadvertently, increased the usefulness of this provision for potential foreign acquirors. After this ruling, a Section 3(a)(5) exemption could be obtained for acquisitions of a number of mid-sized U.S. utilities, meaning that the foreign purchaser would avoid registration and regulation under PUHCA.
As for the larger cross-border utility mergers for which Section 3(a)(5) is not available, such as the two British takeovers, SEC has tentatively concluded that these inbound transactions also should benefit from the exemptions set forth in EPAct. Strictly as a matter of comity, it would have been difficult for SEC to block European companies from buying U.S. utilities when the latter have been actively investing in utilities overseas, especially in the U.K. Nevertheless, SEC has clearly given new meaning to the legislative intent behind the EPAct amendments. Among the many policy and interpretive questions now being raised is how to reconcile these new, predominately foreign, registered systems with the rules limiting foreign investments by other registered companies. Ironically, as it stands now, the constraints on inbound acquisitions by foreign companies would be much more generous than those governing outbound acquisitions by registered holding companies of foreign utilities. SEC will likely need to address this and other issues through a rulemaking proceeding.
As many expected, SEC is seeking to craft a solution to accommodate an emerging class of global utility companies within the existing framework of PUHCA. In so doing, SEC will provide an antidote for what many perceived as a “poison pill” to foreign utility takeovers. Consequently, regardless of when PUHCA is repealed, it will no longer be an impediment to foreign acquisitions of U.S. utilities. Therefore, expect more cross-border utility mergers to be announced in the months ahead. Many believe these precedent-setting deals will open the floodgates to further foreign advances. There is no shortage of opportunities, with over 100 investor-owned electric utilities in the highly fragmented U.S. industry. Each transaction will bring its own set of legal, cultural and political challenges to potential acquirors. n
Editor`s note: At press time, SEC issued a concept release soliciting public comment on issues arising under PUHCA with respect to the acquisition of U.S. utilities by foreign companies that will register as holding companies under the Act following the acquisition. SEC requested comments by early February 2000.
Tom Havens is a partner in the Corporate Department and head of the Energy Practice Group at the New York office of Whitman Breed Abbott & Morgan LLP.