Question
December 21, 2006
Mr.B. Michael Verne
PremergerNotification Office
FederalTrade Commission
600 Pennsylvania Avenue, N.W.
Washington, D.C. 20580
Re:Advice Received on December 19, 2006
Dear Michael:
I am writing to confirm the advice Ireceived from you during our discussion Tuesday afternoon, December 19, 2006.I summarize below the facts and analysis that we discussed.
Facts
My client, Company W, is a regulatedelectric utility company that is proposing to purchase an 8% undivided interestin a coal-based generation facility, a facility in which it already owns an 84%undivided interest, from Company A. Many years ago Company A entered into asale-leaseback arrangement involving the bulk of its 8% undivided interest inthe facility. As a result, Company A now leases this portion of the facilityfrom the "owner trustee," a trust company, and thereby derives theright to 8% of the power generated by the facility. The lease expires in 2019.Under the proposed transaction, Company W would assume the lease and beobligated to make all payments required under the lease. In addition to thelease assumption, Company W is paying Company A approximately $20 million(subject to adjustment) for leasehold improvements and related assets, at cost,that are part of the 8% undivided interest but not covered under the lease.Company W is not paying any additional consideration for the assignment.
Asa condition of closing, Company W must enter into a power purchase (supply)agreement with Company M. Company M, an unrelated third party, is purchasingother electric utility assets from Company A. Historically, the power to whichCompany A is entitled pursuant to the 8% leasehold interest has been used tomeet the needs of the business that Company M is now purchasing from Company A.The power purchase agreement that is a condition to the closing of thistransaction requires that Company W sell 100% of the power to which it isentitled pursuant to the 8% leasehold interest (that is being assigned fromCompany A) to Company M at cost for the balance of the term of the lease. As wediscussed, the lease payments Company W is assuming could be considered farbelow market value; however, Company W receives no benefit from this arrangementbecause (a) it must sell the power generated by the leasehold interest atcost-based rates to Company M under the power purchase arrangement and (b)aside from the power purchase agreement, any benefit inuring to Company W fromselling that power at higher prices must be credited back to its ratepayersbecause it is a regulated utility. As an analogy, it is as if Company W isassuming a lease on a rent-controlled building where the lease payments arelow, but because there is a restriction against sub-leasing it for higherprices, there is no ability to benefit from the low rent-controlled prices.Consequently, Company W would never have assumed the lease with higher leasepayments reflecting what a party could sell the power generated by the leaseholdfor at market rates because of its inability to sell the power generated by theleasehold interest at above cost.
Likewise, the prices Company W isobligated to charge Company M for the power under the supply agreement could beconsidered far below market value. As a regulated entity, however, the pricesCompany W charges Company A for power under the power purchase agreement mustbe based on "cost-of-service". Moreover, aside from the power supplyagreement, any additional revenue Company W would gain from charging higherprices must be credited back to Company W's ratepayers. Thus, Company W wouldnever enter into a supply agreement charging higher prices in thesecircumstances.
Finally, for accounting purposes,Company W believes that Company A maintains the lease as an operating lease, asopposed to a capital lease, which would be considered an "asset."Company W intends to treat the lease as an operating lease for accountingpurposes.
Analysis
Pursuant to the facts outlined above,you advised me that my client would not have a reporting obligation. There weretwo stages to the analysis. First, you agreed that the assignment of the leaseshould be treated as such rather than the sale of an asset. In other words, youagreed that Company A, although it is a lessee under a previous sale-leasebacktransaction, does not have beneficial ownership of an asset that it is nowselling to Company W. As such, Company W is not purchasing an asset when itassumes the lease from Company A.
Second, you agreed that the fair market value of theassignment is zero. As I understand it, the Premerger Notification Office takesthe position that as long as there is no consideration paid to the assignor,and the lease payments are at market rates, the acquisition price for theleasehold interest is zero. See Premerger Notification Practice Manual(3`d ed. ABA) at Interpretations 28 and 104. As we discussed, myclient considers the lease payments to be equivalent to market rates because,as a regulated utility, it cannot charge above a certain amount for its power.Should it do so, any additional revenue it derives must be credited back itsratepayers. Moreover, as discussed above, as a condition of the transaction,Company W must sell the power generated by this leasehold interest to CompanyM, essentially at cost. Thus, while the lease payments would be consideredbelow market (and therefore the leasehold interest would have a positive value)for a hypothetical company that is neither regulated nor subject to a supplyagreement, that is not the case for my client. You agreed that my client's fairmarket value determination should be conducted considering the value of thelease to it. Because my client would not make leasehold payments in amountsgreater than the current obligations under the lease, given its regulatednature and obligations under the supply agreement, the acquisition price andfair market value for the leasehold interest is zero.
Because the acquisition of other assets amounts toapproximately $20 million dollars, you agreed that the transaction as outlinedabove would not be subject to the notification and reporting obligations underthe Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and theregulations promulgated thereunder.
If I havemisstated the advice you gave to me or if you believe that the analysis aboveis in any way incorrect, please let me know at your earliest convenience.