United States: Energy Bulletin - SEC Creates New ´Temporary´ Exemption Under PUHCA
Also Clarifies How Large an ´Immaterial´ Subsidiary Can Be

In the latest in an increasingly long line of cases adapting the outdated Public Utility Holding Company Act ("PUHCA ")to current conditions in the U.S.electric and gas utility business,the SEC on March 23,2001 approved the acquisition of IPALCO Enterprises,Inc.by The AES Corporation. In 1999,the SEC approved AES ’s acquisition of Illinois-based electric and gas distribution company CILCORP on the basis that its utility operations were "small " relative to AES and also were "small " on an absolute basis,compared to other utilities in Illinois,the surrounding region,and nationwide.

In the most recent case,AES sought to add the vertically integrated Indiana electric utility IPALCO to its growing energy business.The SEC found that AES could not acquire IPALCO and remain exempt from PUHCA ’s strict regulation unless it agreed to sell the transmission and distribution business of CILCORP.It gave AES two years to accomplish this divestiture,thus affirming that a utility acquisition that disqualifies a holding company for an exemption under PUHCA can nevertheless take place without loss of the exemption as long as the problem under the statute is cured within a short period of time.Although AES will not satisfy all the requirements for an exemption,it will continue to enjoy its exemption from PUHCA on the condition that it divests the CILCORP utility properties.

AES is exempt from PUHCA regulation by virtue of Section 3(a)(5)of the statute,which grants an exemption to a holding company that does not derive any material part of its income from any public utility company operating in the United States.A previous Jones Day Energy Bulletin "Foreign Investment in U.S.Utilities Eased – With an Unexpected Bonus for U.S.-Based Investors " (September 1999,Vol.21),describes the basis for the SEC decision allowing AES to acquire CILCORP.AES sought to build upon the 1999 decision and acquire IPALCO on the same basis. In short,the exemption is available only if the utility subsidiary is "small." AES tried to show that even when combined,CILCORP and IPALCO together would satisfy the two-part smallness test of Section 3(a)(5)by being:

•small relative to AES and together not representing a "material part " of AES ’s consolidated revenues;and

•small on an absolute basis,compared to other utilities in the region and nationally.

The SEC first addressed the relative size requirement. A combined CILCORP and IPALCO would represent 16.94 percent,14.20 percent,15.99 percent,and 8.49 percent of AES ’s consolidated gross revenues,operating income,net income,and net assets,respectively.The SEC held that these percentages were too large to represent "no material part " of AES ’s income.Thus,AES would fail the first prong of the test necessary for it to continue to enjoy an exemption under Section 3(a)(5)if it retained both CILCORP and IPALCO.

The AES decision notes that the largest percentage of revenues the SEC has found to be immaterial was in NIPSCO Industries, Inc.where the subsidiary ’s contributions ranged from 10.8 percent to 11.2 percent over a three-year period. The SEC declined to take another step to increase the percentage of revenues that could be contributed by a subsidiary that would pass the relative smallness test.Older cases had drawn the line for a subsidiary ’s contribution at about 3 percent of consolidated gross revenues of the proposed acquiring holding company.The SEC in recent years has significantly liberalized its view of what satisfied the immaterial test as shown by the 1999 AES case approving a subsidiary that provided 10.3 percent of revenues. However,it now is clear that the SEC will not go any further.

Although AES failed the test considering both utility subsidiaries together,IPALCO,taken alone is small relative to AES based on the precedent. IPALCO alone would constitute about 10.06 percent of AES ’ gross revenues,,10.73 percent of its operating income,10.91 percent of its net income,and 5.49 percent of its net assets.This AES decision,therefore, clearly sets 11 percent as the upper limit for the contribution a utility subsidiary can make and still constitute an "immaterial " subsidiary..Industry speculation that the SEC might be willing to expand this test to allow contributions of 15 percent or even more can now be viewed as incorrect.

AES was unable to convince the SEC that a combined IPALCO and CILCORP would pass the first prong of the two-part test,i.e ,smallness relative to AES. Because the proposed acquisition failed this test,the SEC did not determine whether CILCORP and IPALCO together would satisfy the second prong of the Section 3(a)(5)exemption — the "absolute " smallness test.However,the SEC did find that IPALCO considered alone constitutes a "small " utility on an absolute basis.

Although IPALCO is somewhat larger than CILCORP,the SEC found that it satisfied the "smallness " test..For 2000,IPALCO ’s consolidated assets,revenues,and net income were $1.983 billion, $858 million,and $155 million,respectively. IPALCO engages primarily in the generation, transmission,distribution,and sale of electric energy in Indianapolis and neighboring cities,towns, communities,and adjacent rural areas.As of December 31,2000,it served approximately 438,933 retail electric customers.In 2000,IPALCO received $831 million in electric utility revenues.At the end of 2000,IPALCO had total assets,operating revenues,and net income of $1.9 billion,$858.5 million,and $80.2 million,respectively.

The SEC compared IPALCO ’s size based on revenues,assets,and customers to its neighboring utilities in Indiana,in the bordering state region, and nationwide.IPALCO had a less than 6 percent "market share " in Indiana,,less than 2 percent in the eight-state region,and less than a 0.5 percent share nationwide.IPALCO ranks 61 st in the list of the largest U.S.electric utilities.The decision confirms the findings of the 1999 AES decision that only a very small U.S.utility can be held by a holding company seeking a Section 3(a)(5)exemption.

The 1999 AES decision and the 2001 decision show that AES could retain either CILCORP or IPALCO separately but could not hold them both while maintaining its exemption.Thus,AES was faced with a decision.It could acquire IPALCO only if CILCORP were no longer its "public utility " subsidiary.AES agreed,therefore,that it would divest CILCORP ’s transmission and distribution facilities,in which case CILCORP would no longer be a "public utility " as defined by PUHCA¹ With only one,immaterial public utility subsidiary – IPALCO – AES would then satisfy the requirements for an exemption.

PUHCA does not include any provision expressly allowing a holding company to enjoy a "temporary " exemption from its regulation – that is,permitting a company to be exempt notwithstanding that it does not qualify for one of the limited exemptions as long as it cures the condition that would disqualify it within a specified time frame.Nevertheless,the SEC has in effect created a "temporary " exemption for AES..The commission cited to older decisions where it "relaxed the strict requirements of the Act and granted temporary relief,where the overall consequence ... is to make nearer the ultimate goal of compliance." This concept had not been used in recent years, however.Given the high level of merger and acquisition activity in the electric utility industry today,acquiring companies may find this concept to be very helpful in allowing a proposed deal to close without becoming subject to SEC regulation.

Importantly,the decision determined that the acquisition of IPALCO by AES – as distinguished from the exemption – did satisfy all the requirements of PUHCA.The evidence submitted by AES suggested that IPALCO and CILCORP could be considered an "integrated public utility company " or,alternatively,that IPALCO would satisfy the so- called "ABC Test," which would allow it to be retained as an additional system to AES ’s principal system of CILCORP.Further,the SEC found that AES ’s acquisition of IPALCO would result in the type of "economies and efficiencies " that are required in order to approve an acquisition of a utility company under PUHCA.None of these conclusions would be adversely affected by AES ’s divestiture of the CILCORP transmission and distribution facilities.In fact,the transaction would satisfy the acquisition requirements of PUHCA even more easily if CILCORP were divested.

The SEC found that allowing AES to acquire IPALCO while retaining CILCORP for a limited time would not threaten the effectiveness of state regulation or otherwise foster the abuses that PUHCA was intended to prevent.The acquisition did not receive express support from the utility regulatory commissions in Illinois or Indiana.The SEC noted merely that "the Illinois and Indiana Commissions have expressed no position concerning the Transaction." The SEC concluded,,therefore, that the acquisition would not be detrimental to the public interest or the interest of investors or consumers.The SEC also took note of the fact that if AES lost its Section 3(a)(5)exemption,it would have to divest much of its considerable interests in "qualifying facilities " (("QF ")electric generating projects² The serious negative impact on AES from losing the exemption may have been an important practical consideration for the SEC in making its decision.

This case affirms that a holding company with utility operations outside the United States,or a foreign-based utility holding company,can acquire a small,vertically integrated U.S.utility company, and enjoy the Section 3(a)(5)exemption from PUHCA,if:

•the target ’s revenues would represent less than 11 percent of the holding company ’s pro-forma consolidated revenues;and

•the target is no larger than IPALCO – about 400,000 customers with total utility revenues of about $800 million.

Importantly,the decision does not provide any new relief for a U.S.-based industrial or commercial concern to enter the electric or gas distribution business on a PUHCA-exempt basis.In the 1999 AES decision,the SEC made it clear that an industrial or commercial company can rely only on another exemptive section – Section 3((a)(3)– which imposes a condition that the utility subsidiary be "functionally related " to the industrial or commercial enterprise ’s other businesses.³ Only a company in the "utility " business – either non--U.S.or electric generation activities in the U.S.that are exempt under PUHCA – can use the Section 3((a)(5) exemption.

It remains to be seen whether the "temporary " exemption will be expanded.However,this decision could provide a basis for an important "bridge " for utility merger and acquisition activity in the U.S. under the right circumstances.For example,what if a company in a utility-related business acquired a PUHCA public utility that was small relative to the acquiring company but not small on an absolute basis?Under this situation,the acquiring company could not satisfy the "absolute smallness " test of Section 3(a)(5).Would the SEC allow this deal to go forward and grant the acquiror an exemption if it committed to splitting up the target within two years so that it would no longer be a PUHCA jurisdictional public utility?This would be essentially the same circumstance as the AES case. There might be other scenarios where the acquiring company could seek a "temporary " exemption while it split the target into its transmission,distribution, and generation parts.The utility industry is seeing the dissaggregation of the traditional vertical utility in various situations,so such a scenario is not implausible.

This Energy Bulletin is a publication of Jones,Day, Reavis &Pogue and should not be construed as legal advice on any specific facts or circumstances.The contents are intended for general informational purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm,to be given or withheld at its discretion.The mailing of this publication is not intended to create,and receipt of it does not constitute,an attorney-client relationship.

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