Holding Company Act Release 27579
SECURITIES AND EXCHANGE COMMISSION
(Release No. 35- 27579; 70-9897)
Allegheny Energy, Inc., et al.
Supplemental Order Authorizing Issuance and Sale of Secured Debt and Reserving Jurisdiction
October 17, 2002
Allegheny Energy, Inc. ("Allegheny"), a registered public-utility holding company, and its direct wholly owned generating subsidiary company, Allegheny Energy Supply Company, LLC ("AE Supply," and together with Allegheny, "Applicants"), Hagerstown, Maryland, have filed with the Securities and Exchange Commission ("Commission") a post-effective amendment to an application-declaration ("Application") under sections 6(a), 7, 32 and 33 of the Public Utilities Holding Company Act of 1935, as amended ("Act"), and rules 44, 53 and 54. The Commission issued a notice of the Application on November 30, 2001 (Holding Co. Act Release No. 27471).
By order dated December 31, 2001 (Holding Co. Act Release No. 27486) ("Financing Order"), the Commission authorized Applicants, among other things, through December 31, 2005 ("Authorization Period"), to issue and sell an aggregate principal amount of up to $4 billion of short-term and/or long-term unsecured debt at any one time outstanding ("Financing Limit"). The Commission reserved jurisdiction in the Financing Order over, among other things, the issuance and sale of secured debt.
In the post-effective amendment, AE Supply now asks the Commission to release jurisdiction and to authorize it to issue and sell during the Authorization Period up to $2 billion of short-term and/or long-term debt at any one time outstanding, secured by substantially all of the assets of AE Supply, including its utility assets and securities of public-utility and other companies held by it, and all or substantially all of the assets of its subsidiaries, in each case to the extent permitted by, and consistent with, contractual restrictions and applicable law (the "AE Supply Collateral").1 Any debt securities issued under the requested order would be included in, and subject to, the Financing Limit.
A. The Allegheny System and AE Supply
Allegheny's primary operating subsidiaries are three state-regulated public-utility companies, West Penn Power Company ("West Penn"), The Potomac Edison Company ("Potomac Edison") and Monongahela Power Company ("Monongahela") (collectively, "Operating Companies") and AE Supply. The Operating Companies provide electric and natural gas service to about three million customers in Maryland, Ohio, Pennsylvania, Virginia and West Virginia.
During 1999 and 2000, in response to deregulation legislation in Maryland, West Virginia, Virginia and Pennsylvania, Potomac Edison and West Penn transferred generating assets totaling approximately 6,900 megawatts ("MW") to AE Supply. In 2001, Monongahela transferred generating assets totaling 352 MW to AE Supply. Pursuant to contracts, AE Supply provides power to West Penn, Potomac Edison and Monongahela to serve their customers in Pennsylvania, Maryland, Virginia and Ohio, and to serve the customers of Potomac Edison in West Virginia. These contracts represent a significant portion of the normal capacity of AE Supply's fleet of transferred generating assets. As a result, AE Supply's core business has been to provide power to the Operating Companies to serve their native load.
The Allegheny system entered the merchant trading business with the purchase of a 276 MW generating unit located at the Fort Martin Power Station in West Virginia, which was subsequently transferred to AE Supply. Beginning in 2000, the Allegheny system significantly expanded its merchant power business. In May 2001, AE Supply acquired three natural gas-fired generating facilities with total capacity of 1,710 MW in Illinois, Indiana and Tennessee for a purchase price of approximately $1.1 billion. In addition, AE Supply has acquired, constructed or obtained contractual control over 569 MW of capacity. Two generating plants totaling 1,080 MW of capacity are currently under construction.
Also, in 2001, AE Supply acquired Global Energy Markets, the energy commodity marketing and trading business of Merrill Lynch Capital Services, Inc. The acquired business included a long-term contractual right to call up to 1,000 MW of generating capacity in southern California. The acquisition provided AE Supply with expanded expertise in wholesale marketing, energy trading, fuel procurement, market analysis and risk management.
B. Requested Supplemental Order
As noted above, AE Supply now requests authorization to issue and sell during the Authorization Period up to $2 billion of short-term and/or long-term debt at any one time outstanding, secured by the AE Supply Collateral. Issuances of secured debt securities would be included in, and subject to, the Financing Limit, and would be subject to the following conditions through December 31, 2003:
- The common stock equity of Allegheny, on a consolidated basis, will not fall below 28% of its total capitalization; and the common stock equity of AE Supply, on a consolidated basis, will not fall below 20% of its total capitalization;2
- The effective cost of capital on any security will not exceed competitive market rates available at the time of issuance for securities having the same or reasonably similar terms and conditions issued by similar companies of reasonably comparable credit quality, provided that in no event will the interest rate on any secured debt exceed an interest rate per annum equal to the sum of 12% plus the prime rate as announced by a nationally recognized money center bank;
- The underwriting fees, commissions and other similar remuneration paid in connection with the non-competitive issuance of any security will not exceed the greater of (a) 5% of the principal or total amount of the securities being issued, or (b) issuance expenses that are paid at the time in respect of the issuance of securities having the same or reasonably similar terms and conditions issued by similar companies of reasonably comparable credit quality;
- The maturity of long-term debt will be not less than one year and will not exceed thirty years; and
- Short-term debt will have a maturity of not less than one day and not more than 364 days.
Applicants further request that the requested authorization for AE Supply to issue secured debt not be subject to the requirement that Allegheny and/or AE Supply maintain a common stock equity ratio above 30% or above the levels stated above. Rather, Applicants request that such authorization remain effective without regard to the common stock equity levels of Allegheny and/or AE Supply. Applicants request that the Commission reserve jurisdiction over the common stock equity to be maintained by Allegheny and AE Supply as a condition to the authorization for AE Supply to issue secured debt as described herein below the levels set forth above.
Applicants request authorization to issue secured debt at an interest rate not exceeding an interest rate per annum equal to the sum of 12% plus the prime rate as announced by a nationally recognized money center bank. The Applicants request that the Commission reserve jurisdiction over any other higher interest rate that would be applicable to any secured debt to be issued pursuant to this authorization.
The Applicants commit to file in a timely manner an application with the Commission if, or to the extent that, the Applicants will seek relief from the requirement that they maintain a common stock equity ratio of at least 30% after December 31, 2003.
Applicants state that the requested authority is required to meet their short-term liquidity needs, including payment of obligations arising in the operation of their businesses and the refinancing of borrowings. The proceeds of issuances will be used to (i) refinance all or a portion of existing indebtedness of AE Supply,3 (ii) finance the business of AE Supply and its subsidiaries, and (iii) fund the payment of dividends to Allegheny, as and to the extent permitted under the Act or by Commission order.4 Specifically, Applicants anticipate that up to $1,235 million of the proceeds of the proposed secured debt will be used to refinance the existing indebtedness described above. The proceeds of any additional secured debt will be used to meet the liquidity requirements of the Applicants and their subsidiaries.
C. Current Financial Situation of Applicants
The requested supplemental order is intended to address financial developments during 2002 that have brought about acute short-term liquidity needs for the Applicants.
Shortly after acquiring the energy trading business in 2001, AE Supply implemented a hedging strategy in view of the unusually high prices and volatility in the electricity and natural gas markets at the time. AE Supply entered into a power purchase agreement with the California Department of Water Resources (the "California DWR"). In 2002, in response to concern over the cost of natural gas and the prices for electricity in California, AE Supply entered into a series of forward purchases to hedge its risks. The prices paid for these forward purchases exceeded the contractual price of the California DWR contract. As a result, the contract and related forward purchase hedges have negatively affected AE Supply's cash flows since March 2001.5
Applicants state that, while the entry of AE Supply into the merchant power business was a reasonable business decision in view of the dynamics of the energy markets at the time, the business has suffered a number of setbacks. Some markets, most notably California, have experienced interruptions of supply and price volatility. The bankruptcy filing of Enron Corp. has negatively affected merchant trading. These events have caused state deregulation to be delayed, discontinued and/or reversed. As a result, the demand for merchant power has not developed as expected. Additional capacity, coupled with lower than expected loads and a relatively weak economy, have led to reduced wholesale prices in several regional markets in which AE Supply owns, operates or contractually controls generating assets.
For the six months ended June 30, 2002, Allegheny had consolidated income of approximately $69 million before the cumulative effect of accounting changes. Applicants state that these results primarily reflect weak wholesale energy markets nationwide, reduced economic activity and unplanned generator outages. As a result of the current low wholesale market price, low volatility and excess capacity, the Midwest peaking units purchased by AE Supply in 2001 lost approximately $34 million in the first six months of 2002. In addition, a dramatic reduction in market liquidity has significantly affected trading and origination opportunities. More specifically, hedging transactions relating to the California DWR contract created negative cash flows in 2001 and 2002. In the first six months of 2002, AE Supply suffered trading losses of approximately $29 million. AE Supply also had higher than normal unplanned outages at its generating facilities. These outages resulted in lower net revenues as a result of increased operation expenses, including the purchase of higher priced replacement power, and reduced excess generation available for sale into the wholesale markets. Finally, Allegheny recorded as of June 30, 2002 an after-tax charge of approximately $28.8 million for cancellation of generation projects and an impairment charge.
Applicants state that the weakness in the wholesale power market is expected to continue into next year. In addition, many of the benefits of Allegheny's long-term strategy will not be realized immediately, but will be realized only over time as the strategy is implemented. As a result, Allegheny's financial forecasts continue to show weak financial performance through 2002. However, as reflected in the financial forecasts for 2003, Allegheny expects to realize benefit from these actions during 2003.
With the changed market environment, Allegheny has decided to reduce reliance on the wholesale energy trading business and to refocus on delivering energy to native load customers and operating the system's low-cost fleet of legacy generating assets. AE Supply will redirect its activities and will trade around its generating assets in regions and markets where it has a generating presence and will enter into new trades that lock in value and/or produce or enhance the value of its generating fleet and existing trading portfolio as it matures.
In a move to reduce costs and bolster financial performance, AE Supply has cancelled a number of generation projects. Applicants state that this action will reduce capital expenditures by approximately $700 million over the next several years. To increase liquidity, AE Supply has offered for sale certain of its generation assets.6 AE Supply is also working with the State of California to settle issues raised by the state at the Federal Energy Regulatory Commission with respect to the California DWR contract, and is evaluating options to monetize the value of the contract and related positions.
Allegheny has also undertaken a number of cost-cutting initiatives, including reducing pre-tax operating expenses in 2002 by an estimated $45 million. In addition, in 2002, Allegheny is reducing its workforce by approximately 10% through an early retirement option, normal attrition and selected staff reductions. This measure is projected to reduce expenses in 2002 by $5 million and to result in annualized savings of $40 to $50 million. To increase liquidity, Allegheny is committing that the dividend to be paid by the holding company in December 2002 and in 2003 will be between 0% and 50% of the current dividend level.7 Applicants expect this commitment will result in significant cash savings each quarter.
Allegheny believes that its underlying businesses remain fundamentally sound. Allegheny and AE Supply believe that they are taking the steps necessary to reduce operating expenses and to reduce the cash requirements of the energy trading business. Applicants project that each of Allegheny and AE Supply will have positive cash flow from operations in 2003. Applicants further project additional cash flow from asset sales by AE Supply.
In the short-term, however, Applicants have a critical liquidity need. As a result of the financial developments during 2002, Allegheny and AE Supply do not have sufficient liquidity to satisfy collateral requirements and otherwise satisfy their financial obligations unless they can obtain additional sources of credit. Allegheny announced on October 8, 2002 that technical defaults exist under its principal credit agreements and those of its subsidiaries, AE Supply and Allegheny Generating Company, after AE Supply declined to post additional collateral in favor of several trading counterparties. Those counterparties declared AE Supply in default under their respective trading agreements. This action triggered cross-default provisions under the credit agreements and other trading agreements. The collateral calls followed the downgrading by Moody's Investors' Service of the credit ratings of Allegheny and AE Supply below investment grade.
Allegheny is in discussions with its bank lenders with a view toward obtaining required waivers and additional funding. Applicants state that they have explored various options available to meet their funding requirements. Their financial advisor, Lazard LLC ("Lazard"), and prospective lenders have advised that, given current market conditions and Applicants' financial condition, Applicants will be required to provide collateral in order to obtain new funds.
Applicants further state that, as a result of business developments and steps being taken to address the financial situation of AE Supply, that company may be required to record certain write-downs and other adjustments that would reduce the common equity
of Allegheny and AE Supply to a level below 30% of total capitalization.8 Factors that could require such write-downs and adjustments under generally accepted accounting principles ("GAAP") include asset impairments; losses in connection with asset sales; project cancellations and cost-cutting measures; and trading book reevaluations resulting from changes in market conditions, valuation methodology and parameters.
Applicants state that the timing and amount of any write-downs or adjustments cannot be determined at this time. Any write-downs or adjustments with respect to asset sales will necessarily depend upon the progress and pricing of potential asset sales. As noted above, AE Supply is currently marketing several assets for sale. If it is able to negotiate the sale of all or a portion of these assets, it may be required to record a substantial loss. AE Supply is also undertaking an assessment of certain of its assets, including its trading book. AE Supply cannot at this time predict the amount, if any, of the adjustments that may be recorded as a result of this process. In accordance with GAAP, however, AE Supply may be required to record adjustments, which may be material.
Applicants anticipate that any, or a combination, of the factors requiring the recording of impairment charges or other adjustments could result in a reduction of the common equity ratio of Allegheny and/or AE Supply below 30%. Any such write-down by AE Supply would have a more significant impact upon AE Supply than upon the holding company. But such actions would not adversely affect the underlying strength of the assets of AE Supply and Allegheny, or the future financial performance of AE Supply and Allegheny. Rather, the write-downs would result from the actions being taken by the companies to improve their liquidity positions and to address the changes that have occurred and are occurring in the merchant energy market.
In summary, Allegheny and AE Supply have confronted a drastically changing merchant power market. In this environment, Applicants have experienced declining financial performance and tightened liquidity. Applicants believe that the underlying assets remain strong and will provide improved financial performance in the long term. In the short term, however, Applicants have been advised, as noted above, that they will be required to provide collateral in order to obtain new funds.
Also, to address the deterioration in the merchant energy market and the decline in their financial performance, Applicants have aggressively taken action to reduce their expenses, raise cash and refocus their business. These actions have resulted, and are expected to result in the future, in write-downs of assets that will have a negative impact upon the Applicants' common equity ratios.
To address the current situation, Applicants request the supplemental order described in section I.B., supra. The issuance of secured debt by AE Supply will meet the urgent and necessary cash requirements of AE Supply and will allow it to pay a dividend to Allegheny.9 As described above, Applicants anticipate that up to $1.235 million of the secured debt will be used to refinance existing indebtedness and the additional proceeds of the secured debt will be used for general corporate purposes.
The proposed issuance of secured debt by AE Supply is subject to sections 6(a), 7, 12(d), 32 and 33 of the Act and rules 44, 53 and 54. Of these provisions, the most important for purposes of the analysis is section 7(d) of the Act. Among other things, section 7(d) authorizes the Commission to authorize the issuance of a security unless it finds that (1) "the security is not reasonably adapted to the security structure of the declarant and other companies in the same holding company system; or (2) the security is not reasonably adapted to the earning power of the declarant."10
In this matter, Applicants do not seek authorization to increase the amount of debt authorized to be issued and outstanding under the Financing Order. Rather, AE Supply seeks authorization to issue a different type of debt, specifically, secured debt. In issuing the Financing Order, the Commission determined, among other things, that the Allegheny system is financially able to sustain the burden of having a particular amount of outstanding debt securities. The current request does not call that finding into question.
In addition, in the past the Commission has routinely granted other registered system companies the ability to engage in various types of secured financings.11 In addition, on at least one occasion in the past, the Commission has permitted a registered system to establish a secured credit facility analogous to the type of facility proposed by Allegheny for the purpose of maintaining liquidity during a financial crisis as part of an effort to return to a more secure financial footing.12 The decision was largely based on the Commission's recognition of the "urgent and necessary cash requirements of applicants' operations as public utility companies, or . . . as the parent."13
The question for consideration in this matter is whether it is inappropriate, in light of the current financial condition of Allegheny and AE Supply, to authorize the subsidiary to issue secured debt. The Commission does not believe that this is the case. In this regard, the record contains evidence in support of the following:
- Unlike many companies facing bankruptcy, the value of AE Supply's assets exceeds the value of its liabilities. The problems faced by AE Supply are more closely related to its need to post collateral with respect to open trading positions than to an inability to pay its debts.
- AE Supply is in the process of unwinding most of its long-term trading positions. In the future, it plans to trade only in the day-ahead market (with the exception of certain long-term agreements to sell power from plants that it owns).
- Allegheny states that, apart from the problems in its trading operations, its core businesses (the distribution of electricity through the state-regulated utilities and the sale of power from owned generation) are sound and will both make money and produce positive cash flow next year.
- AE Supply is also in the process of selling various assets to raise cash, as discussed previously. However, these sales will take time. In particular, AE Supply must settle ongoing litigation with the State of California before it sells its West Coast trading book. Again, in Allegheny's view, the ability to issue secured debt will give AE Supply time to reduce its debt and to improve its financial situation by completing the sale of these assets.
- Finally, Applicants have provided cash flow projections based on the various cash conservation measures and asset sales previously discussed. The projections show improvement in Applicants' financial situation throughout 2003. The assumptions underlying the projections, particularly those related to asset sales and reduced cash needs in the trading business, appear to be reasonable.
Although the issuance of secured debt does not address every risk that the Allegheny system companies may face at present, the Commission believes that, based on the Applicants' representations, it represents a reasonable measure whereby AE Supply can obtain the liquidity needed to satisfy collateral requirements and to meet other financial obligations. Further, it does not appear that this measure would be detrimental to the public interest or the interest of investors and consumers.
For the same reasons, the Commission believes that the relief requested from the 30% common equity test is reasonable and appropriate under the circumstances. The 30% common equity standard is a benchmark rather than an absolute requirement for the capital structures of holding-company systems. The Commission has, in fact, permitted capital structures with less than 30% common equity when mitigating circumstances are present, particularly those involving market conditions.14
Allegheny states, for purposes of rule 54, that the conditions specified in rule 53(a) are satisfied and that none of the adverse conditions specified in rule 53(b) exist. As a result, the Commission will not consider the effect on the Allegheny system of the capitalization or earnings of any Allegheny subsidiary that is an exempt wholesale generator or foreign utility company, as each is defined in sections 32 and 33 of the Act, respectively, in determining whether to approve the proposed transactions.
Applicants state that the fees, commissions and expenses to be incurred in connection with the proposed transactions are estimated to be $50,000. These estimates do not include the underwriting fees, commissions or other similar remuneration paid in consummating the proposed financings. Applicants state that no state or federal commission, other than this Commission, has jurisdiction over the proposed transactions.
Due notice of the filing of the Application has been given in the manner prescribed by rule 23 under the Act, and no hearing has been requested of or ordered by the Commission. Based on the facts in the record, the Commission finds that the applicable standards of the Act are satisfied and that no adverse findings are necessary.
IT IS ORDERED, that the post-effective amendment to the Application be permitted to become effective immediately, subject to the terms and conditions
prescribed in rule 24 under the Act.
IT IS FURTHER ORDERED, that Applicants will file a report with the Commission within two business days after the occurrence of any of the following:
1. Any further downgrade by a nationally recognized statistical rating organization of the debt securities of any of Allegheny, AE Supply or any of the operating company subsidiaries of Allegheny; and
2. Any event that would have a material adverse effect on the ability of Allegheny or AE Supply to comply with any conditions or requirements of an order of the Commission in this proceeding, or that Allegheny otherwise determines would be of material interest to the Commission.
IT IS FURTHER ORDERED, that, in addition to those matters over which jurisdiction was reserved in the Financing Order, jurisdiction is reserved over: (1) the common stock equity to be maintained by Allegheny and AE Supply as a condition to the authorization for AE Supply to issue secured debt below the levels set forth in section I.B. of this supplemental order, and (2) any interest rate per annum that is higher than the sum of 12% plus the prime rate as announced by a nationally recognized money center bank that would be applicable to any secured debt to be issued pursuant to this authorization.
By the Commission.
Margaret H. McFarland
1 The debt will not be secured by any securities or utility assets of the operating utility subsidiaries of Allegheny.
2 Because AE Supply is a limited liability company, "common stock equity" means for this purpose the membership interests of AE Supply.
3 AE Supply's existing bank borrowings currently total approximately $900 million. Other indebtedness at AE Supply includes $1,050 million in bonds issued to institutional investors in 2001 and 2002 (the "144A Debt"), $80 million of medium-term notes and approximately $347 million of pollution control bonds, substantially all of which are secured by the pollution control equipment that they were used to finance. Substantially all of the pollution control bond debt is guaranteed by either West Penn or Potomac Edison Company. The indenture pursuant to which the 144A Debt was issued includes a covenant that limits issues of secured indebtedness of AE Supply, but only to the extent that the incurrence of secured indebtedness exceeds 30% of the consolidated assets of AE Supply. Thus, the possibility of the issuance of secured debt was expressly contemplated by the indenture pursuant to which the 144A Debt was issued. In addition, for a discussion of certain lease transactions, reference is made to pages M-116 through M-117 of Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, in the Applicants' respective Annual Reports on Form 10-K for the year ended December 31, 2001, as amended.
4 Applicants are not seeking authority to declare or pay dividends out of capital or unearned surplus. Applicants agree that if the amount of dividends to be declared and/or paid by AE Supply exceeds the retained earnings of AE Supply, AE Supply will not declare or pay any dividends out of capital or unearned surplus without filing a separate application with the Commission seeking this authority under section 12(c) of the Act and rule 46 under the Act.
5 Applicants state that, although this hedging strategy will result in short-term cash outflows through 2002, the total projected cash flows related to the contract remain significantly positive nonetheless over the life of the contract.
6 To the extent that sales of generation assets by AE Supply require Commission approval, Applicants will be required to file a separate application under section 12(d) and rule 44.
7 Applicants state that the Board of Directors has not determined the actual future dividend level within this range.
8 As discussed further infra, the current financing authorization of Allegheny and AE Supply requires both companies to maintain common equity at a level of 30% of total capitalization.
9 See supra note 5.
10 In addition, section 6(a)(2) of the Act requires a registered holding company to seek Commission authorization prior to "exercis[ing] any privilege or right to alter the priorities, preferences, voting power, or other rights of the holders of an outstanding security of such company." Section 7(e) generally states that the Commission should permit such an alteration unless it finds that the alteration "will result in an unfair or inequitable distribution of voting power among holders of the securities of the declarant or is otherwise detrimental to the public interest or the interest of investors or consumers." AE Supply's request is subject to this section because any borrowings secured by the company's assets will have a priority over AE Supply's unsecured creditors to the extent of those assets. The Commission notes, however, that AE Supply's outstanding debt instruments contain specific provisions governing its ability to issue secured debt. In addition, Applicants believe that the value of AE Supply's assets exceeds the amount of its total indebtedness and other liabilities; and that the granting of a security interest in its assets to some bank creditors would not prevent the full payment of other creditors of AE Supply. For these reasons, the Commission does not believe that permitting AE Supply to establish a secured facility will harm the interests of existing debtholders. All such creditors would have to be paid in full before value is made available to AE Supply's parent in any bankruptcy or liquidation of AE Supply. Because Allegheny does not seek to increase the amount of debt that it is authorized to issue under the Financing Order, permitting AE Supply to issue secured debt will not harm the holders of Allegheny's common stock.
11 See, e.g., Interstate Power Co., Holding Co. Act Release No. 26946 (Nov. 25, 1998), as modified by Interstate Power Co., Holding Co. Act Release No. 27305 (Dec. 15, 2000).
12 See General Public Utilities Corp., Holding Co. Act Release No. 21107 (June 19, 1979). See also Holding Co. Act Release Nos. 21276 (Oct. 30, 1979), 21410 (Jan. 28, 1980), 22211 (Sept. 30, 1981), 22790 (Dec. 21, 1982), 23072 (Sept. 26, 1983) and 23079 (Sept. 30, 1983) (authorizing amendments, extensions, renewals and replacements of the secured bank facilities through 1983). These orders were issued in response to the financial damage GPU suffered as a result of the Three Mile Island incident.
13 General Public Utilities Corp., Holding Co. Act Release No. 21107, supra note 12.
14 See, e.g., Eastern Utilities Associates, Holding Co. Act Release No. 24879 (May 5, 1989), n.49 ("The Commission under appropriate circumstances has applied capitalization ratio standards flexibly where, for example, there was assurance that capitalization ratios would improve over the foreseeable future, and where it was in the public interest and the interest of investors and consumers that a proposed financing should be permitted to go forward.")