United States: FERC Cracks Down on Violations of Interlocking Director Rules

The Federal Energy Regulatory Commission ("FERC") has strict rules regarding who can serve as an officer or director of a public utility while also serving in such a role with specified other types of company. Prior FERC approval is required if a utility officer or director wants to be an officer or director of another public utility, a company supplying electrical equipment to the utility, or a company authorized to underwrite utility securities. On April 14, 2004, FERC denied a request by the CEO of a utility to serve as outside director of a firm supplying electrical equipment to his company. This order represents a denial of a request that in the recent past might have been approved. Importantly, the case also drew sharp rebukes and calls for more vigorous enforcement from the FERC Commissioners.

Michael J. Chesser became CEO of Kansas City Power & Light ("KCPL"), a utility subject to FERC jurisdiction, in October 2003. He also served since 1999 as a director of Itron, Inc., a company that supplied electrical equipment to KCPL. His application for approval to hold both positions, as required by Section 305(b) of the Federal Power Act, was filed on December 30, 2003 — almost three months after the interlock first arose. FERC regulations note that it is unlawful to hold the proscribed interlocks without prior FERC approval. The regulations mandate that a filing be made no later than 30 days following election or appointment to the position that gives rise to the jurisdictional interlock.

Several FERC Commissioners reacted negatively to this request. They were particularly concerned by the late filing, noting that utilities and their officers and directors must be aware of the interlock rules and take appropriate steps to obtain necessary approvals prior to assuming the conflicting positions. Commissioner Brownell recommended sending an advisory letter to all utility CEOs reminding them of the rules. The Edison Electric Institute sent an alert to its membership regarding this issue.

On the merits of Mr. Chesser’s application, the FERC order noted that the purpose of the approval requirement is to eliminate the "lack of arm’s length dealings between public utilities and organizations furnishing financial services or electrical equipment." The order further notes that the law recognizes that "conflicts of interest stemming from the presence of the same few persons on boards of companies with intersecting interests generated subtle and difficult-to-prove failures in the arm’s length bargaining process."

In the past, FERC has approved interlocks between a utility and an electrical equipment supplier to that utility only if the amount of dealings between the entitles was de minimis — both regarding the percentage of total purchases of the utility, represented by purchases from the interlocked supplier, and the percentage of total sales of the supplier, represented by sales to the utility. These prior orders impose a condition that the officer or director involved report the total amount of these purchases annually to FERC so it can monitor the volume of sales to ensure that the de minimis requirement is not violated in the future.

In Mr. Chesser’s case, FERC found that existing and potential future purchases by KCPL from Itron would exceed a de minimis amount. FERC noted that existing transactions were small (0.6 percent of KCPL’s total non-fuel materials and supplies purchased in 2002 and 1.6 percent of such amount in 2003). However, the request indicated that Itron might win a competitive bid for services that would cost about $2.6 million over three years. FERC indicated this latter potential transaction would violate the de minimis requirement. Mr. Chesser’s position as a senior member of the utility’s management was also relevant to the decision in that he would be in a position to influence the utility’s purchasing practices. The order concludes that Mr. Chesser did not meet his burden of showing that holding the two positions would not adversely affect public or private interests.

This decision is also noteworthy in that Mr. Chesser had decided not to stand for re-election as a director of Itron following its May 2004 shareholders meeting. Thus, even in a situation where the interlock would be for a limited time period, FERC strongly rejected the request. Furthermore, Commissioner Kelliher requested FERC staff to investigate whether FERC has authority to require disgorgement of the compensation Mr. Chesser received during the period he held the unapproved positions. FERC general counsel Cynthia Marlette indicated that FERC had never assessed such a penalty but that the legal staff was investigating what options the commission would have to deal with such cases.

The interlocking officer and director restrictions are sometimes overlooked. In past years, many applications have been submitted, and approved, where the interlock was already in place — sometimes for many months or even years. The Chesser case signals a change in attitude by FERC regarding these cases. In addition to the embarrassment of having a request denied, with the requirement to resign one of the positions, officers and directors may also face monetary penalties, as indicated by the Commissioner’s comments, if the rules are not carefully followed.

In addition to electrical equipment suppliers, the other major category of proscribed interlocks is with firms authorized by law to underwrite utility securities. The statute and FERC rules and interpretations broadly define being "authorized to underwrite." Investment banks as well as commercial banks are usually authorized to underwrite utility securities. It is irrelevant whether the firm actually engages in underwriting — being authorized by law is sufficient. Importantly, if a utility has an interlocking officer or director of a conglomerate that includes financial services businesses, one of its subsidiaries may be authorized to underwrite, which is sufficient to make the interlock subject to approval.

A change to the Federal Power Act in 1999 significantly reduced the number of interlocks with underwriting firms that need to be approved. Under current law, if the utility takes one of four steps designed to reduce conflicts of interest between the utility and the interlocked underwriter, then no approval is required. For details on this change, including a discussion of the steps that will relieve the officer or director from the approval requirement, see Energy Bulletin, February 2001, Vol. 24 (available on Jones Day's Web site, www.jonesday.com).

While the burden of compliance with the Federal Power Act interlocking provisions falls on the individual officer or director, as a practical matter, the utility company involved should take steps to ensure that its officers and directors are in compliance with the law and FERC regulations. Commissioner Kelly asked FERC staff to investigate whether the utility companies could be penalized for violations of the interlock rules. Utilities may want to use the occasion of this recent harsh decision to prompt a review of all interlocking positions held by their officials and determine whether all required approvals are in place. Utilities should also ensure that there are procedures in place to determine whether nominees for the board of directors or candidates for officer positions already have proscribed interlocks. If they do, appropriate steps should be taken before that person assumes a role with the utility. Finally, utilities should have procedures to alert their current officers and directors to the restrictions on accepting new positions with other utilities, electrical equipment suppliers, and firms authorized to underwrite utility securities.