Reverse Morris Trust Transaction

REVERSE MORRIS TRUST
RATEPAYER VALUE
VS.
SHAREHOLDER GAIN
A Review of The Failed Entergy – ITC Transaction
March 18, 2014
NARUC Accounting and Finance Meeting
Victor Prep, P.E. & Byron Watson, CFA
Energy & Resource Consulting Group, LLC
Denver, Colorado
www.ergconsulting.com
INTRODUCTION
• Victor Prep, P.E. – Executive Consultant at ERG
– BSME from OU, MBA from Wharton, Registered P.E. in PA, CO, and LA,
Retired Nuclear Submarine Naval Officer
• Byron Watson, CFA – Senior Consultant at ERG
– BSEE from SMU, MBA in Finance from Emory University, Chartered
Financial Analyst (CFA®)
• The Council of the City of New Orleans Exercises Primary Retail
Jurisdiction Over two of Entergy Corporation Inc.’s (Entergy)
Operating Subsidiaries in Orleans Parish, Louisiana
– Entergy New Orleans, Inc. (ENO)
– Entergy Louisiana, LLC (ELL)
• Members of ERG Serve as Regulatory Advisors to the Council of the
City of New Orleans
– Directly Involved with the Entergy - ITC Transaction at Both the Local and
FERC Level
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ITC TRANSACTION OVERVIEW
• The Transaction was a Proposed Entergy Divestiture/Spin-off
of its Six Operating Companies’ Transmission Assets & a
Merger of the Spun-off Assets with International Transmission
Company, Inc. of Novi, Michigan (ITC)
• The Transaction used a Merger & Acquisition (M&A)
Technique Called a Reverse Morris Trust (RMT).
• The Proposed Transaction was the First Attempt to Use the
RMT in Divesting Assets Within the US Electric and Gas Utility
Industry.
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SUMMARY OF REGULATORY
CONCERNS
• FERC Regulatory Construct Increases Retail Revenue Requirement
• Loss of Jurisdictional Control by State Regulators of Transmission
Ratemaking & Oversight of Transmission Function
– Only Retail CCN Approval Preserved
– Section 206 Rate Challenge Only
• Transfer of Risk from Entergy and ITC Shareholders to Retail Ratepayers
– FERC Forward Looking FRP Process
• Value and Ownership of Gains Monetized by Transaction
– Ratepayers versus Shareholders
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•
•
•
•
Lack of Demonstrable Quantifiable Ratepayer Benefits
Major Storm Restoration Concerns
Transfer of Intellectual Capital
Experience of ITC in Previous Acquisitions
Shareholder Gain at the Expense of Ratepayers
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THE PROPOSED TRANSACTION
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PARTIES TO THE TRANSACTION
• Entergy Corporation
– Six Vertically Structured Operating Companies
• ENO, ELL, Entergy Gulf States, LLC, Entergy Texas, Inc., Entergy Mississippi, Inc.
& Entergy Arkansas, Inc.
– Four Mid-South States
• Arkansas, Louisiana, Mississippi & Texas
– Five Retail Jurisdictions
• Arkansas, Louisiana, Mississippi, New Orleans & Texas
• ITC Holdings Corp. – An Independent Transmission Focused
Company
– Created in 2003 Through Predecessor (Formally DTE Energy Transmission)
– Transmission Service in Seven Midwestern States Through Subsidiaries
• ITC Transmission, ITC Midwest, ITC Great Plains & Michigan Electric
Transmission Company
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STATED RATIONALE
FOR THE TRANSACTION
ITC
• Improved Network
Reliability
• Increased Investment in
Transmission Network
(Reduced Costs Through
Less Congestion)
• Improved O&M Efficiency
• Singular Focus on
Transmission
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ENTERGY
• Enhanced Financial
Flexibility
– Benefit to Other Ongoing
Required Investments
– Better Access to Capital
– Credit Quality Protection
• Improved Earnings and
Dividend Growth
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UNSTATED RATIONALE
• Entergy’s Concerns with an Ongoing DOJ Anti-Trust
Investigation Regarding Operation of Its Transmission System
• Creation of Enhanced Value for Entergy Shareholders
– Failed Attempt to Divest Wholesale Nuclear Assets
• Offload Significant Required Future Investments in
Transmission
• Capture and Monetize Higher Rates Through FERC Regulatory
Construct (Regulatory Forum Shopping)
• Approximate Doubling of Size of ITC
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TRANSACTION APPROVALS
• The Six Entergy Operating Companies (OPCOS) and ITC Filed Joint
Applications in 2012 for Retail Regulator Approval of the
Transaction
–
–
–
–
–
Louisiana Public Service Commission (LPSC)
Public Utility Commission of Texas (PUCT)
Arkansas Public Service Commission (APSC)
Mississippi Public Service Commission (MPSC)
Council of the City of New Orleans (CNO)
• Transaction Also Required Approval from
–
–
–
–
–
FERC
Department of Justice (DOJ)
Federal Trade Commission (FTC)
Internal Revenue Service (IRS)
ITC’s Shareholders
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TRANSACTION STRUCTURE
• ITC Proposed to Establish an ITC Subsidiary in Each of
the Four States to Provide Wholesale Transmission
Service to Entergy OPCOS Under FERC Jurisdiction
• Creation of Wholly Owned ITC Subsidiary - ITC
MidSouth, LLC With Four Operating Subsidiaries
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–
–
–
ITC Arkansas, LLC
ITC Louisiana, LLC
ITC Mississippi, LLC
ITC Texas, LLC
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WHAT IS A REVERSE MORRIS TRUST?
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WHAT IS A REVERSE MORRIS TRUST?
• An M&A Technique to Avoid Corporate Taxes
– A Series of Transactions Whose End Result is the
Transfer/Sale of a Portion of a Company’s Assets to a New
Owner
• In This Case - Transfer of Entergy OPCO Transmission
Assets to ITC
– Avoids Corporate Taxes on Gains
– Consideration Paid is the Acquirer’s Stock
– The Net Book Value of the Transmission Assets Remain the
Same for Entergy and ITC as New Owner
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SIMPLE REPRESENTATION OF RMT
(Please See Appendix for Detailed Steps)
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ITC TRANSACTION OVERVIEW
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RMT HISTORICAL EVOLUTION
• Challenged by IRS (Commissioner vs. Mary Archer W.
Morris Trust, 1966)
– Morris Trust Received a Favorable Ruling – Creating a
Loophole for Companies to Avoid Taxes when Divesting
Assets
• Several IRS Published and Private Rulings Also Approved Morris
Trust Transactions
• Congress Sought to Limit the RMT in 1997
– IRS Code Section 255(e) Resulted in the “50% Rule”
– Limits RMTs and the Degree of Leverage that Can be Used
Related to the Majority Ownership Between the “Seller”
and “Buyer” Entities in the Merger
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LIMITATIONS IN MONETIZING A SPIN-OFF
• Debt/Equity and Debt/Debt Swaps are Equally
Available to the Seller
• A Monetizing Spin-Off Allows a Seller to Spin Off a
Subsidiary on a Fully Tax-Free Basis While DeLeveraging to a Significant Extent
• The Tax Basis of the Subsidiary Determines Upstream
Cash or Push Down Debt on a Tax-Free Basis
– Any Incremental Cash/Debt Would Trigger a Taxable Gain
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THE “50% TEST”
• The Selling Company Must Own More than 50% of
the Ultimate Merged Company
• Shareholders of Seller Must Receive Over 50% of the
Vote and Value of the Newly-Formed Entity in the
Merger
– “Vote and Value” – Shares in the Newly-Formed
Entity Owned by the Seller Shareholders by Virtue
of Equity Positions in the Buyer
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THE “50% TEST”
• Dilution of Seller Shareholders by Post-Transaction
Equity Issuances Within Two Years of the Transaction
by the Surviving Entity Will be Counted for Purposes
of the “50% Test”
• Acquiring Company Usually Must be Smaller than
Seller
– In the End - Acquiring Company Must Own Less than 50%
of the Merged Company
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CORPORATE GOVERNANCE
• Notwithstanding the 50% Requirement – the Buyer
in a Reverse Morris Trust Acquisition Can Retain
Effective Control Over the Board of Directors and
Senior Management of the Surviving Entity
• Proposed RMT Structures Should Receive an IRS
Ruling Confirming Tax-Free Treatment
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WHY THE USE OF A RMT STRUCTURE?
• Entergy and ITC Claimed That the Motivation for
Using an RMT was to Make the Transaction “Tax
Free”
– Asset Value is Not Reset to Fair Market Value
– Accumulated Deferred Income Tax (ADIT) is Not Remeasured
• Other Benefits to Entergy and ITC Shareholders
– Escape State Regulation Except for CCN Requirements
– Retain All of the Gain of the Transaction
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REGULATORY CONCERNS OVER
ENTERGY - ITC TRANSACTION
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CUSTOMER REVENUE REQUIREMENTS
• Transmission Cost of Service Changes with Assets Regulated
by the FERC
– ROE Would Have Increased to 12.38%
– State Jurisdictional ROEs in Range of 10.2 – 11.1%
• Capital Structure and Rate of Return Changes with the
Transaction
– 60% Equity & 40% Debt Capital Structure
– Funded by Corporate Debt at 6.5% APR
– ITC Would Itself be Highly Levered
• Prospective Forward Test Year
• Reduced Regulatory Lag Especially with Large Planned
Investment
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LOSS OF RETAIL REGULATORY
JURISDICTION
• Transfer of Risk From Entergy Shareholders to Ratepayers
– Transmission Planning and Expansion
– Storm Operations and Restoration
– Rate Setting and Prudency of Investments Reviewed at FERC
• Lack of Enforceable Commitment to Improve Service Quality
• No Integrated Resource Planning With Transmission
• No Constraints on Aggressive Transmission Construction and
Significant Spending
• O&M Cost Concerns Based Upon Experiences with ITC in Other
Jurisdictions
• Requirement to Challenge ITC’s Actions at FERC
• No Ability of Entergy OPCOS to Challenge ITC’s Rates for Five Years
– Only Section 206 Challenges to Rates Available at FERC by State Regulators
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NO QUANTIFIABLE DEMONSTRATION
OF RATEPAYER BENEFITS
• No Supportable Analytical Cost Benefit Analysis was Provided
to Retail Regulators
• No Incremental Benefit Ascertained - Above the Benefits
Anticipated from Entergy Transmission Ownership in the
Midcontinent Independent Transmission System Operator
(MISO) RTO
• Questionable Weighted Average Cost of Capital (WACC)
Assumptions/Projections for Comparison Purposes
• Ignored Ability of OPCOS to Refinance Existing Embedded
Debt at Lower Incremental Costs
• Increased Cost in Retail Revenue Requirements for
Transmission Function
• Adopted Entergy’s Five Year Transmission Plan
– Future Studies to Determine Additional Commitments
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SHAREHOLDERS KEEP GAINS
• Entergy – ITC Transaction Essentially Monetized Value of FERC
Construct vs. Traditional Asset Recovery with Retail Regulation
– All New Value is Created Through Regulatory Forum Shopping
– Funding Equity Return of 12.38% Through Debt Issuance at [6.5%]
• All Retail Regulators’ Staff Concluded That Transaction Created
Significant Gain to Entergy Shareholders
– Estimated $2 to 4 billion Goodwill as Proxy for Step-up in Asset Value
• 1.8 to 4 Times Book Value of Assets Being Spun Off
• No Sharing of Gain With Ratepayers
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TOO LITTLE TOO LATE
• Following Stiff Regulatory Opposition, Entergy & ITC Proposed a
Series of Rate Mitigation Plans
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–
–
–
Insufficient to Offset Costs and Risks to Ratepayers
WACC & Incremental Cost of Debt Issues
Ill Defined Structure
Large Portion of Mitigation Plan Based on “Difficult to Quantify” Benefits
to Ratepayers
• Green Jobs and Economic Stimulus
• More Reliable Transmission Network
– Yet Entergy Consistently Maintained That its Existing Network Met All Reliability
Standards
• Rewarded for Use of the Same Transmission Construction Plan as Entergy to
Benchmark Benefits in MISO
– Ratepayers Would Bear all Risk of Insufficient Mitigation
• Regulator Staff & Intervenors Saw Each Plan as Failing to
Compensate Ratepayers for Increased Costs and Risks
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OBSERVATIONS
• Proposed Transaction Using the RMT Would Eliminate
Corporate Taxes and Maintain the Transmission Assets and
ADIT at Book Value
• Very Significant Gain to Entergy Shareholders not Shared With
Ratepayers
– The Very Structure and Basis for the Transaction Contrary to Such
Concept
• Significant Increased Costs to Ratepayers
Demonstrable Benefits
• Complete Loss of Retail Jurisdiction
• Shifting of Risks from Shareholders to Ratepayers
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REGULATORY OUTCOMES OF
PROPOSED TRANSACTION
• All Retail Regulators’ Staff Recommended Against Finding the
Transaction in the Public Interest
• Substantially all Intervenors Recommended Against the
Transaction
– Stakeholders
– Large Industrial Customers
– Trade Groups
• Outcome
– MPSC Found the Transaction “Not in the Public Interest” on December
10, 2013 in Well Reasoned & Supported Decision
– Entergy & ITC Withdrew Joint Application Before all Retail Regulators &
FERC in December 2013
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OBSERVATIONS – QUOTES
•
•
•
•
The evidence indicates that the applicants have downplayed the significant
benefits to shareholders and overplayed any benefits to ratepayers. . . . There
is also conclusive evidence that ETI’s shareholders, not customers, are the
primary beneficiaries of the transaction. - PUCT Docket 41223, Proposed
Findings of Facts.
…the value of Entergy’s shareholders stock would be enhanced significantly
with the proposed transaction. . . .There is no benefit to retail customers from
increasing the cost of service related to the transmission function by
transferring the regulatory oversight to FERC and significantly increasing Texas
customers’ cost for the same transmission service. - Michael P. Gorman on
Behalf of Texas Industrial Energy Consumers.
ITC Holdings is building a house of cards that is constructed with high leverage
and inflated FERC-approved ROEs. - William B. Marcus, on Behalf of The
Arkansas Attorney General.
The effect of ITC’s use of double leverage financing coupled with its proposed
rate construct is to charge customers more than the actual financing costs and
to inflate the returns accruing to stockholders. - J. Bertram Solomon on Behalf
of Arkansas Electric Energy Consumers, Inc.
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OBSERVATIONS – QUOTES
•
What is the magic that’s being done here that takes an asset -- a sleepy utility asset and
turns it into something that's so much sexier and more valuable? It's things like higher
ROEs on a uniform basis. It's things like incentives for doing the things to push certain
policies that are pushed by the federal government. It's routine awards of CWIP,
construction work in progress, awards for abandoned plant. If they don't actually finish
a project, they get to recover the costs they spent trying to do it; fictional capital
structures; capital structures that don't have anything to do with what's real for
ratemaking purposes, and back-leverage of the parent company, which you will see
later, that actually takes what looks to be already a high ROE and turns them into
recoveries north of 20 percent.– Philip Oldham, Counsel for Occidental Chemical
Corporation.
•
We're talking about the use of this mechanism in order to transfer money to the Entergy
shareholders and create a larger platform with ITC who has a particular vision. And I
will say that vision will be presented to you in great detail in this case, a vision of a
national super highway grid [that] pushes certain policies that are not consistent with
the public interest in Texas . . . .– Id.
Q&A
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APPENDIX
DETAILED RMT STEPS OF THE ENTERGY
ITC TRANSACTION
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ITC TRANSACTION – STEP 1
LLC IS CREATED
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ITC TRANSACTION – STEP 2
ENTERGY ISSUES DEBT
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ITC TRANSACTION – STEP 3
ENTERGY PAYS OFF EXISTING DEBT
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ITC TRANSACTION – STEP 4
ENTERGY REDEEMS PREFERRED STOCK
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ITC TRANSACTION – STEP 5
ENTERGY CREATES WIRES SUBSIDIARY
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ITC TRANSACTION – STEP 6
WIRE SUBS ISSUE DEBT
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ITC TRANSACTION – STEP 7
OPERATING COMPANIES BECOME LLC
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ITC TRANSACTION – STEP 7A
CONTRIBUTION OF TRANSMISSION COMPANIES
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ITC TRANSACTION – STEP 8
OPERATING COS PAY EXISTING DEBT
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ITC TRANSACTION – STEP 9
WIRE SUBS TO ENTERGY
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ITC TRANSACTION – STEP 10
LLC RECEIVES TRANSMISSION ASSETS
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ITC TRANSACTION – STEP 11
WIRE SUBS TO ENTERGY
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ITC TRANSACTION – STEP 12
SPIN OFF LLC
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ITC TRANSACTION – STEP 13
REDEEM ENTERGY NOTES
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ITC TRANSACTION – STEP 14
MERGE LLC AND WIRE SUBS
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