United States: SEC Proposes New Rules Governing Investment In Foreign Utility Companies

The SEC recently proposed new rules dealing with the investment in "foreign utility companies" by registered holding companies under the Public Utility Holding Company Act of 1935 ("PUHCA"). The rules will require the SEC’s prior approval for specified FUCO investments. In general, the rules incorporate existing SEC practice, but there are some new requirements.

In 1992, Congress amended PUHCA to provide for two new types of entity – foreign utility companies ("FUCOs") and exempt wholesale generators ("EWGs"). The revision to the law was intended to facilitate investments in independent power production and non-U.S. utility operations by registered holding companies. Without the changes in the law, such activities would be very restricted.

The amended sections of PUHCA provide that registered holding companies may invest in EWGs and FUCOs without prior SEC approval and without limitation, except as provided in the statute. There is no direct limitation on the amount of investments in EWGs. The revised provision of PUHCA, however, provides that financing by a registered holding company for the purpose of investing in EWGs will remain subject to SEC jurisdiction. The law directs the SEC to adopt rules designed to ensure that such financing will have no substantial adverse impact on the financial integrity of the registered holding company system and no adverse impact on any utility subsidiary or its customers or on the ability of state regulators to protect such subsidiary or customers.

The revisions to PUHCA creating FUCOs have similar provisions. Registered holding companies may invest in FUCOs without SEC prior approval. However, the SEC is directed to adopt rules to provide for the protection of the customers of a public utility in the holding company system and the financial integrity of the registered system. Issuance of securities to finance the acquisition of FUCOs is subject to SEC jurisdiction.

In 1993, the SEC proposed rules to address EWGs and FUCOs. Final rules were adopted for EWGs; however, the SEC deferred taking action on the FUCO rules. The recent announcement re-proposes the 1993 rules regarding FUCOs with certain changes. Since 1993, the SEC has relied on the EWG rule – which aggregates registered holding companies’ investments in EWGs and FUCOs when considering the impact on the system – to govern acquisitions of EWGs and FUCOs. The new rules will impose for the first time specific requirements that must be met before a registered holding company can invest in a FUCO.

Proposed Rule 55 describes the conditions under which a registered holding company may acquire an interest in a FUCO without the need for prior SEC approval. It acts as a "safe harbor." If the terms of the rule are met, no approval is needed for an acquisition within those terms. If the conditions of the Rule cannot be met, the registered holding company may still seek specific SEC approval for its proposed acquisitions of FUCOs.

The SEC rejected calls for a rule that would require individual SEC approval for each separate FUCO investment, which some parties had suggested in 1993. The proposed rules will allow a blanket, general approval for FUCO investments up to a specified amount for a designated period and will not require identification of particular investments.

Under proposed Rule 55, no FUCO acquisition can be made, without express SEC approval, unless:

• the board of directors adopts procedures for analyzing risks associated with such investments (including, for example, operational, construction, commercial, management, political, legal, financial, and currency risks); and
• the board by resolution approves each FUCO investment based upon findings that
• the company’s investment analysis procedures have been followed;
• appropriate risk mitigation steps will be taken; and
• ratepayers of the system’s public utility companies are insulated from any adverse effects of the investment; and
• no more than 2 percent of the employees of U.S. public utilities render services to EWGs or FUCOs.
• In addition, the proposed Rule provides that SEC approval is required for any FUCO investment if:
• the holding company or any "significant" subsidiary has been the subject of a bankruptcy proceeding unless a plan of reorganization has been confirmed;
• the consolidated retained earnings of the holding company have declined by 10 percent over a one-year period and the amount invested in EWGs and FUCOs is more than 2 percent of the amount of capital invested in utility operations;
• existing EWGs and FUCOs have reported operating losses exceeding 5 percent of the holding company’s consolidated retained earnings in the prior year;
• any utility subsidiary has obtained a rate increase in the prior three years to recover losses or inadequate returns on FUCO investments;
• any public utility in the system has a less than investment-grade rating; or
• the holding company’s investment in EWGs and FUCOs exceeds 50 percent of consolidated retained earnings or such greater amount as has been authorized by an SEC order.

Several of these requirements are taken from SEC Rule 53, which establishes the conditions under which the SEC will find that a financing for the purposes of investing in an EWG will not have an adverse impact on the registered holding company system. In practice, most registered holding companies have aggregated their requests for financing authority to include both EWGs and FUCOs. Thus, the proposed Rule 55 largely codifies what has been the practice to date.

The proposed rule does eliminate one theoretical flexibility. Under the current rules, a registered holding company could take its own available funds, not derived from financing, and invest them in a FUCO even if that meant that it would exceed the 50 percent of retained earnings safe harbor. The "cost" of this move, however, would be to disqualify the system from engaging in any financing for EWGs and FUCOs. While this flexibility will be removed if the proposed rules are adopted, the practical effect is likely to be minimal.

Several features of Rule 55 are new. The proposed Rule imposes a requirement that a holding company’s board of directors adopt procedures for the identification and mitigation of the risks of FUCO investments. Most registered holding companies have such procedures, which will now have to be formally adopted by the board of directors if that has not already been done.

Related to this requirement is another new provision that requires a specific board of directors approval for each FUCO investment. Further, this approval must consider the three factors indicated above – that the risk assessment process was followed, that mitigation steps will be taken, and that the structure of the investment is adequate to insulate retail ratepayers of the affiliated utility companies from any risk from the FUCO investment.

Other new sections in proposed Rule 55 are those requiring SEC approval for FUCOs if there have been any utility rate increases in the prior three years resulting from FUCO investments and if any utility subsidiary has less than an investment-grade rating from rating agencies.

In addition to describing when SEC approval will be needed to acquire a FUCO, the SEC announcement proposes several other new rules or amendments to existing rules. The proposed rules will require that FUCOs maintain specified books and records and make these available to the SEC for inspection in the United States. Changes are proposed to the manner and timing of giving notice to the SEC and state commissions when FUCOs are acquired. Further, the SEC is proposing to adopt a clarification to its "affiliate" rules that would require SEC approval where an EWG or FUCO will either render services to, or receive services from, any other company in the holding company system.

The SEC has asked for comments on whether it should allow FUCOs to keep their books in conformity with local accounting rules rather than require all accounts be kept in accordance with U.S. generally accepted accounting principles.

The SEC announcement also includes new proposed Rule 56. This rule would make it clear that a subsidiary that is engaged exclusively in the direct or indirect ownership of interests in a FUCO can itself be considered a FUCO. This Rule will clarify a gap from the l992 legislation. PUHCA makes it clear that intermediate holding companies for EWGs can enjoy EWG status themselves even though they do not directly own qualifying facilities. The FUCO provisions of the statue do not provide the same relief. The SEC had noted in 1993, when it first proposed rules in this area, that the increased insulation provided by allowing intermediate companies to be considered FUCOs enhanced the protections for consumers intended by the law. Thus, under proposed Rule 56, so long as a company controls a company that has foreign utility facilities, it too can be a FUCO.

The SEC announcement invites public comments on the proposed rules. Comments are due by April 9, 2001.

In addition to comments on the proposed rules, the SEC is also asking for comments on the advisability of possible limitations on the ability of a holding company to qualify its foreign operations as a FUCO. Questions regarding the permissible activities of a FUCO have arisen in the context of three utilities from the United Kingdom – National Grid, Scottish Power, and PowerGen – that have each acquired a U.S. utility and have become registered holding companies. These acquisitions have relied on the ability of these U.K. companies to consider their utility and other activities outside the U.S. to be "FUCOs." The SEC asks whether there should be a limit on the types or size of non-utility businesses engaged in by a FUCO. The SEC asks whether it should be relevant that a FUCO is highly diversified or engages in diversified activities that are significantly larger than the utility operations. If the SEC were to conclude that a company cannot qualify as a FUCO if it also has significant non-utility businesses, many foreign energy companies could be effectively barred from acquiring U.S. utilities because of the restrictions of PUHCA.

Although PUHCA provides that registered holding companies can acquire EWGs and FUCOs without SEC approval, in practice the SEC’s existing rules often necessitate obtaining SEC approvals to allow a holding company sufficient flexibility to pursue these investments actively. The proposed rules will not change this general state of affairs. As noted, the proposed rules build on the rules applicable to EWGs and, if adopted, should not impose any significant practical new restrictions on FUCO investing.

The most meaningful restriction in currently effective rules is the requirement to get SEC approval for financing EWGs if the aggregate investment in EWGs and FUCOs exceeds 50 percent of the holding company’s consolidate retained earnings. Proposed Rule 55 imposes the same test – but in a slightly different context – and thus does not impose any meaningful new restriction. Under existing Rule 53, the 50 percent test limits only financing for EWGs and FUCOs. Under proposed Rule 55, if the 50 percent test is not met, a registered holding company may not acquire any additional FUCOs, even with its nonfinanced funds, without SEC approval.

The SEC has indicated in some recent orders approving financing for EWGs, where the aggregate investment exceeded the 50 percent limit, that it would consider many factors indicating financial strength in addition to just the retained earnings measurement. The discussion of the proposed rules by the SEC indicates that it will continue to be receptive to showings of financial strength and will not rely solely on the retained earnings measurement when called upon to approve investments.

Some state utility commissions and consumer groups sought stricter limitations on EWG and FUCO investments in 1993 when the SEC last considered rules on the subject. These parties may file comments renewing their requests. Registered holding companies may wish to examine the proposed rules to determine if any of its requirements will impose significant hardships on their ability effectively to grow their EWG or FUCO businesses and file comments accordingly. Finally, non-U.S.-based companies that may be interested in the U.S. utility markets should carefully consider the proposal. The ability of many foreign entities to invest effectively in the U.S. will depend on how flexible the SEC is in allowing a FUCO to engage in non-utility businesses. This inquiry will include an examination of both the type of businesses and the size of those businesses relative to utility operations. Interested foreign entities should also consider filing comments to be sure their views are considered by the SEC.

Jones Day is active in advising clients regarding PUHCA matters and will be happy to assist interest parties in preparing comments on the proposed rules for filing with the SEC. The SEC has considerable experience dealing with EWGs and FUCOs since 1992. The agency can be expected to act fairly quickly to adopt a final rule after the comment period expires. Of course, significant negative comments could delay the rule or require changes before adoption.