United States: Foreign Takeovers Of U.S. Utilities - The British Are Coming Again

By Thomas C. Havens

Last December, two proposed trans-Atlantic mergers were announced which could lead to profound changes in the U.S. electric utility industry. The acquisitions of Pacificorp by Scottish Power plc and of the New England Electric System by National Grid Group plc, if approved, would mark the first takeovers of major domestic public utilities by foreign companies. Considering the enormous opportunities presented by the opening of the $200 billion U.S. electric market to competition, many analysts believe that the successful completion of these deals will "open the floodgates" to further foreign advances. Reportedly, a number of other large European utilities are poised to enter the lucrative U.S. electric utility market. But before these transactions can close, foreign buyers will have to resolve uncertainties created by numerous Federal and state regulatory approvals, evolving energy policies, (please see endnote 1) political risks, (please see endnote 2) and consumer anxiety (please see endnote 3).

Foreign utilities are taking a more strategic interest in U.S. electric utilities for a number of reasons. Under a recent European Union directive, EU countries will be required to open up a portion of their state-owned electric systems to competition. The prospect of earnings erosion at home is prompting some European utilities to search overseas for investments that could provide a basis for stable earnings growth and asset diversification.

Moreover, economic turmoil in other parts of the world is making the U.S. electric market look increasingly more desirable for large infrastructure investments. Regions like New England also are attractive to foreign investors because the New England states have been at the leading edge of electric deregulation (please see endnote 4). Foreign utilities already operating in liberalized, competitive environments, like the U.K., are particularly interested in these regions because they believe their experience can help them to exploit deregulating utility markets.

On December 7, Scottish Power, an energy conglomerate headquartered in Glasgow, (please see endnote 5) and Pacificorp, an electric utility based in Portland, Oregon serving 1.4 million customers in five Western states, announced an agreement to merge in a transaction valued at approximately $11.7 billion. Scottish Power's acquisition is structured as a stock-for-stock transaction, with Pacificorp becoming a wholly-owned subsidiary of a newly-formed holding company. In addition to approvals from the Federal Energy Regulatory Commission (the "FERC") (please see endnote 6) and the Federal Trade Commission, (please see end note 7) the Scottish Power/Pacificorp merger likely will need the sanction of utility regulators in Oregon, Utah and Wyoming.

National Grid's $4.6 billion acquisition of NEES, announced on December 14, is an all-cash transaction that will be funded by a new National Grid credit facility. NEES is an electric utility holding company with over 1.3 million customers in Massachusetts, Rhode Island and New Hampshire. National Grid was formed in 1991 when the U.K. restructured its state-owned electric system into separate generation, transmission and regional distribution companies. National Grid, with a market capitalization of over $12 billion, owns and manages the entire electric transmission system in the U.K., through which it delivers energy to 23 million customers in England and Wales. The National Grid/NEES merger will need approvals from the FERC, state utility regulators in New England, and the Securities and Exchange Commission (the "SEC") under the Public Utility Holding Company Act of 1935 ("PUHCA" or the "Act") (please see endnote 8).

Of all the regulatory hurdles facing foreign buyers of U.S. utilities, perhaps the least understood, and potentially the most difficult to overcome, are the requirements of PUHCA. Simply put, existing law and precedent under the Act would not permit these foreign utility acquisitions to occur, or allow the existence of the global utility systems that these transactions will create.

PUHCA is one of the Federal securities laws, enacted primarily to break up and more effectively regulate the far-flung utility holding company systems that controlled the U.S. utility industry in the early 1930s. At that time, many of these holding companies owned substantial foreign utility properties. Because the operations of these foreign facilities were not physically "integrated" with the holding company's domestic utility businesses, as required under the Act, the SEC ordered these foreign interests to be divested during the 1940s and 1950s.

The statutory basis for the SEC's divestiture authority is contained in Section 11, which has been called "the heart of the Act". Section 11 compels the SEC to limit the operations of multi-state utility holding companies subject to PUHCA to "single integrated public-utility" systems, consisting of physically and operationally integrated electric (or gas) utility assets. The integration requirement of PUHCA is the principal reason why today's U.S. utility industry is so fragmented, and why most companies, to avoid pervasive regulation under PUHCA, confine their utility operations to single states or regions (please see endnote 9).

In a similar fashion, PUHCA's integration requirements until now have virtually blocked foreign companies from acquiring and owning U.S. utilities (please see endnote 10). The only exception in the Act to this prohibition is if an investment in a domestic utility would be "immaterial" to the acquiring company. Specifically, Section 3(a)(5) of PUHCA exempts from regulation under the Act any holding company that "...is not, and derives no material part of its income...from any one or more subsidiaries which are...companies the principal business of which within the United States is that of a public-utility company." (please see endnote 11) The legislative history of Section 3(a)(5) indicates that it was intended to exempt from PUHCA regulation holding companies whose interests are "essentially foreign" in nature (please see endnote 12). Considering the limited scope of this exemption, it is not surprising that only a handful of foreign acquisitions of U.S. utilities have been accomplished under Section 3(a)(5). The last such transaction, in fact, took over six years to complete, due in part to delays in obtaining SEC approval under PUHCA (please see endnote 13).

Foreign utility takeovers will provide the truest test of the SEC's resolve to enforce PUHCA while unprecedented structural changes are taking place in the U.S. utility industry. Under a literal reading of the standards and policies of Section 11, neither of the pending merger transactions would seem permissible. In fact, the "single integrated" utility system mandate of Section 11 actually compels the SEC to dismantle, much less sanction, such global utility holding companies. However, the SEC recently has shown a tendency to interpret the integration requirements of PUHCA more flexibly, especially where state regulators are unopposed and consumer interests are protected. In addition, though the exact timing is uncertain, the prospect of PUHCA repeal within the next several years will place enormous pressure on the SEC not to use the Act to block transactions that have been blessed by other key constituencies.

Nevertheless, in addressing these unprecedented foreign acquisitions of U.S. utilities, the SEC will have to create new standards under PUHCA for regulating multinational utility holding companies. Since neither new holding company is able to qualify for exemption under Section 3(a)(5), each will have to "register" with the SEC and become subject to regulation under PUHCA (please see endnote 14). The nature and scope of SEC regulation of these new registered holding companies have yet to be determined. Among the many novel questions for the SEC to consider is how to reconcile these predominately foreign utility systems with SEC rules that limit foreign utility investments by registered companies (please see endnote 15). The SEC likely will carefully weigh the views of state regulators in deciding these matters.

In this regard, the outcome of state regulatory proceedings will greatly influence whether and when foreign utility acquisitions will close. Some state utility commissions (most notably, in Oregon) have a statutory duty to find that a utility merger will benefit consumers. This requirement often has been interpreted to mean that local electric rates should be reduced, or at least frozen for a period of time. However, rate reductions may be difficult for foreign acquirors to achieve without adversely affecting earnings, because cross-border mergers are unlikely to produce significant off-setting cost savings through operating synergies or other efficiency gains. State commissions may also want a foreign acquiror to agree to conditions designed to protect consumers and ensure continued reliability of service, including commitments not to sell utility assets and to "hold harmless" ratepayers from any increased costs (including the utility's capital costs) that result from the merger. Negotiating these rate concessions and other conditions can be a significant hurdle to closing these transactions, especially if the utility operates in multiple jurisdictions with differing or competing concerns. The complexities of this process should not be underestimated by foreign firms seeking to acquire U.S. utilities.

It is generally expected that the SEC will craft an approach to roughly fit these emerging global energy companies within the existing framework of PUHCA. Consequently, regardless of whether Congress decides to repeal PUHCA, the Act may no longer be an impediment to foreign acquisitions of U.S. utilities, no more than the Glass-Steagall Act, another Depression-era law, is a barrier to mergers between U.S. banks and insurance companies (as evidenced by the recent Citigroup/Travelers combination). If that is indeed the case, we can expect more of these cross-border utility mergers to be announced in the coming months. Each transaction will present its own unique challenges to utility companies and their legal advisors as they navigate through complex and changing energy laws and policies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

1. 1 Congress is weighing several different bills that would deregulate, and promote the restructuring of, the electric utility industry, though it is far from achieving a consensus on how to do so. Sixteen states have already acted on utility restructuring, and nearly all the remaining states are considering regulatory or structural reforms.
2. 2 Following the Pacificorp merger announcement, lawmakers in Oregon and Utah considered introducing bills that would have required the legislature or the governor to approve the transaction. However, these bills are not expected to be moved.
3. 3 Many consumer advocates, including Ralph Nader's Public Citizen, are opposing the mergers, with some questioning whether foreign ownership of essential U.S. infrastructure is in the national interest.
4. 4 In addition, nearly every utility in the region, including NEES, either has sold or is in the process of selling its generation assets -- their most risky investments -- giving these utilities more stable earnings prospects.
5. 5 Scottish Power, the largest power company in Scotland, also is involved in telecommunications, natural gas, water and waste water businesses.
6. 6 Neither of these mergers is expected to run into difficulty obtaining FERC approval under the Federal Power Act, since a foreign acquisition should not raise market power issues, alter wholesale power rates or affect FERC or state regulatory authority over the jurisdictional utilities involved.
7. 7 Scottish Power was granted an early termination of the 30-day waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. Such clearances are typical in cross-border mergers where the parties do not have overlapping or competing businesses.
8. 8 Pacificorp conducts its utility business through separate operating "divisions" rather than subsidiaries. Therefore, Pacificorp is not a utility "holding company" under PUHCA and the Scottish Power takeover will not need SEC approval under Section 9(a)(2) of the Act.
9. 9 There are over 125 investor-owned public utilities in the U.S.; in the New York metropolitan area alone there are 13.
10. 10 PUHCA distinguishes between acquisitions by foreign companies of U.S. public utilities, and foreign acquisitions of U.S. generating facilities. The latter have been permissible to some extent since the enactment of the Public Utility Regulatory Policies Act of 1978 ("PURPA"), and to a greater extent since the adoption of the Energy Policy Act of 1992 ("EPAct"). PURPA and EPAct exempted most electric generating facilities -- and the owners of such assets -- from regulation under PUHCA. However, such exemptions do not extend to the ownership of electric distribution or transmission facilities in the U.S.
11. 11 15 U.S.C. 79c(a)(5).
12. 12 S. Rep. No. 621, 74th Cong., 1st Sess. 24 (1935). The SEC has further interpreted Section 3(a)(5) as requiring the domestic utility operations to be "small in size", thus applying both a relative and an absolute measure of the size of the acquired company. See Electric Bond and Share Company, 33 S.E.C. 21, 51 (1952).
13. 13 See In the Matter of Gaz Metropolitan and Company, Limited Partnership, Holding Company Act Release No. 26170 (November 23, 1994).
14. 14 NEES is already a registered holding company, and both NEES and National Grid will continue as such after the merger.
15. 15 The SEC generally has limited such investments to no more than 100% of a registered holding company's consolidated retained earnings.