This is a suit in equity brought by the plaintiff, hereinafter called the company, under G. L. (Ter. Ed.) c. 25, § 5,
1
praying for the annulment of, or other relief from, an order of the department dated March 18, 1949, in a proceeding known as D. P. U. 8181, which disallowed a schedule of rates and charges filed by the company on April 21, 1948, cancelled certain rates previously approved by the department on July 24, 1947, and ordered the company to file on or before April 1, 1949, a new schedule of rates and charges which should be the same as those in effect before July 24, 1947, except for .certain specified changes designed to produce approximately the same revenue as the rates of July 24, 1947. This suit is the same suit in equity to which reference is made in
Department of Public Utilities
v.
New England Telephone & Telegraph Co.
Previous Rate Schedules.
There had been no increase in the company’s rates for many years prior to the approval by the department of the rates of July 24, 1947. Those rates increased the company’s earnings by approximately $5,000,000 and have been known as the $5,000,000 rates. The rates filed by the company April 21, 1948, and now disallowed by the department would have still further increased the earnings by approximately $10,000,000, making a total increase of $15,000,000. These have been known as the $15,000,000 rates. The rates substituted by the department in the order now sought to be annulled preserved the original
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$5,000,000 increase, largely by means of a surcharge of 5% upon customers’ bills, and have been called the 5% rates. A further surcharge of 4% allowed after the order now complained of to cover additional labor costs made the so called 9% rates, which are not directly involved in this proceeding except as the 5% rates are included in the 9% rates. The history of these successive rates more fully appears in
Department of Public Utilities
v.
New England Telephone & Telegraph Co.
The Stipulation, Reservation and Report.
When this present suit came on for hearing before the single justice of this court, the company and the department presented a stipulation wherein the company waived all issues except those relating to the adequacy of the return and the rate of return allowed by the department, including as still open the subsidiary issues (a) of adequate return upon stock capital, (b) of a safe ratio of debt capital to total capital, and (c) of the right of the company to earnings upon reinvested surplus. This stipulation included an agreement as to certain facts, among them being that the average 1949 Massachusetts intrastate rate base upon which the company was entitled to a fair return was $238,264,400, if the company was not entitled to earnings upon surplus reinvested in its plant, or $244,185,500, if the company was entitled to such earnings; that the company’s total capitalization, not including surplus, was $410,570,100, consisting of long term debt of $135,000,000, advances from the American Telephone and Telegraph Company of $120,000,000, and common stock amounting to $155,570,100, making a ratio of debt capital to total capital of 62.1%; that the surplus was $9,585,000; that the composite cost of existing long term debt was 3.613% as found by the department, which (according to the stipulation and the findings) could be reduced to 3.45% 1 upon the acquisition of new debt *85 capital at slightly lower cost; and that the composite return on the rate base resulting from the department’s order would be 4.887%* 1 if the company was not entitled to earnings on reinvested surplus and 4.768%1 if the company was so entitled. Reference will be made to other facts agreed in so far as becomes necessary. It was further agreed that the case should be presented to the single justice upon the pleadings, the facts agreed, and the evidence presented to the department bearing upon rate of return for the determination of the issues “by the court upon its own independent judgment as to both law and fact.”
In accordance with the stipulation, all the evidence bearing upon the rate of return, including a transcript of the voluminous testimony and including the exhibits, all of which had been received by the department, was presented to the single justice without additional evidence and, the evidence before him being entirely documentary, the single justice, at the request of the parties, reserved and reported the case for such relief, if any, as might be appropriate under G. L. (Ter. Ed.) c. 25, § 5. See
Boston & Albany Railroad
v.
New York Central Railroad,
Scope of Judicial Review.
It is elementary that the fixing of rates is not a proper judicial function. On the other hand, where a rate established by a public regulatory body is attacked as confiscatory the Constitution of this Commonwealth and seemingly still that of the United States require that there be a full opportunity for judicial review as to both fact and law. The cases are collected and discussed in the recent decision of
Lowell Gas Co.
v.
Department of Public Utilities,
The Factual Background of the Case.
Certain undisputed facts form the background of the case and will in large measure determine the outcome. They are established by a plenitude of figures, charts, and testimony, but their substance may be stated in simple language. The company is one of the associated companies of the Bell system. Of its stock 68.9% is held by the American Telephone and Telegraph Company. During and since World War II there has been an immense increase in the demand for the company’s telephone service. The company has greatly increased its facilities but nevertheless by the summer of 1948 shortly before the hearings began before. the department it had not yet been able to catch up with the accumulated applications for service. To enable the company to expand its plant to meet the vast public demand, and in accordance with a custom in the Bell system, the American Telephone and Telegraph Company has advanced to the company on unsecured demand notes at 2.75% the. sum of $120,000,000, which amounts to between a quarter and a third of the total capitalization of the company. This money was advanced in the expectation that it would be *87 repaid in accordance with the custom in the system out of new issues of securities by the company. The company is under an absolute obligation to repay these advances but can do so only by means of acquiring new permanent capital either in the form of additional debt .capital through bond issues or in the form of additional stock capital through stock issues. But the experts who testified were in agreement, and we suppose it is matter of common knowledge, that the proportion of debt capital cannot be extended indefinitely without adversely affecting the credit of the company, injuring the market for its stock, and to some degree that for its bonds also. It would seem that the company, with a ratio of 62.1% of debt capital to total capital, is already top heavy with debt, and that a substantial part of the new capital required must be raised by the sale of stock, how much will be a subject of discussion later in this opinion. And at this time, when it has become necessary to raise a substantial amount of new capital through an issue of stock, we are confronted with the further undoubted facts that high costs of operation since the war have greatly impaired the company’s earning capacity relative to the capital invested, 1 so that the dividends upon the stock have decreased from 6% to 4.25%, and as the hearing before the department approached its end the stock, of which the par value , is $100, had fallen in the market so that it was hovering around $80 to $85. Moreover, the company is a New York corporation and under New York law cannot issue new stock at less than par. N. Y. Stock Corp. Law, § 69. Compare G. L. (Ter. Ed.) c. 166, §§ 7, 8, 9. Such in rough outline was the situation with which the company and the department had to deal. The expert witness called by the Attorney General in behalf of the public conceded that the company was faced with a very serious financial problem to which he could see no answer except in some way to increase earnings.
*88 Theories of Rate Making.
The department approached the problem by way of its so called theory of "prudent investment" upon which it and its predecessor commissions have for many years relied in ascertaining the property "actually used or useful for the convenience of the public." See G. L. (Ter. Ed.) c. 159, § 26. As applied to this case the department describes its method in these words, “our method is to.ascertain, through appropriate steps, the valué of the company’s investment in gross intrastate plant in Massachusetts, to deduct therefrom the amount of the company’s corresponding depreciation reserve, and to add thereto the amount of working capital, if any, required by the company in its intrastate operations." Application of this method led to the finding of the rate base of $238,264,400, and as herein-before stated the parties have now agreed upon this figure, subject to an increase to $244,185,500, if the company is entitled to earnings upon its reinvested surplus.
In determining the fair rate of return upon the rate base the department adopted the “cost of capital" method. As to debt capital this means that the company is entitled to earnings which will pay its actual interest obligations as they accrue on existing debt capital and upon new debt capital required in the immediate future, and as to stock capital, according to a statement of the department in the early part of its decision, it means "the amount which the company would have to pay in order to ‘hire’ its equity capital under current conditions," subject to the important consequence, which the department apparently recognizes, that commonly a company cannot issue new stock which will have a preferred position over stock already outstanding, and that the rate must therefore be sufficient to pay the same dividends upon all the stock that are required to enable the company to sell new stock.
We pause here long enough to observe that this court has never yet passed upon the soundness of the department’s so called "prudent investment" theory of fixing the
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rate base or of its corollary the “cost of capital” theory of determining the rate. See, however,
Donham
v.
Public Service Commissioners,
Cost of Debt Capital.
In following the department’s theories, no particular difficulty is encountered in ascertaining the probable total cost of debt capital after the acquisition of $120,000,000 of required new capital. We understand the stipulation of the parties and the pleadings to mean that the total cost of debt capital would then be 3.45%, 2 if the debt ratio were reduced to 45%, and would be slightly higher if the debt ratio were reduced to 35%.
Cost of Stock Capital. Debt Ratio.
It is in determining the cost of stock capital that serious difficulty arises. In this connection debt ratio becomes a
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matter of more importance and has greater effect upon the cost of obtaining new capital. The company contended that in order to restore a sound capital structure it was necessary that enough of the required new capital should be in the form of stock capital to reduce the debt ratio to not more than 35%. The department, while recognizing the necessity of reducing the present debt ratio, was of opinion that a reduction to 45% would be safe. The company further contends that debt ratio is a matter for the exclusive determination of the management of the company. As to this last contention, we agree of course that a public regulatory board cannot assume the management of the company and cannot under the guise of rate making' interfere in matters-of business detail with the judgment of its officers reached in good faith and within the limits of a reasonable discretion.
State
v.
Public Service Commission of Missouri,
In reaching this conclusion we have not overlooked the persuasive effect of G. L. (Ter. Ed.) c. 166, § 2, which in substance limits Massachusetts telephone and telegraph companies to a 33-|% debt ratio. But this statute does not apply to a New York corporation, and its weight as indicating sound policy is greatly weakened by the facts that it was enacted approximately a century ago when the disparity in availability and in cost between debt capital and stock capital could not have been anticipated, and that Massachusetts companies have generally been so few in *92 number and small in size that there has been little occasion to amend the statute to meet changed conditions.
We are unable, however, to follow the finding of the department that a 6% return on stock capital is adequate. We find no evidence to support the proposition that under the prevailing conditions new stock capital could be had at all unless the rate of return thereon was substantially increased above this figure. Several expert witnesses of undoubted competency testified upon the point most elaborately and after careful study and research. They differed somewhat as to the rate of return on stock capital necessary to sell new stock. The lowest estimate was that of the witness called by the Attorney General in the interest of the public, who testified that 8% would be required at a 45% debt ratio. Estimates of experienced witnesses called by the company, some of them, so far as appears, wholly disinterested, were somewhat higher and were based upon a debt ratio of only 35%. All witnesses agreed that the price of the stock must go substantially above par in the market before an issue of new stock could be sold. At the time this testimony was given the stock was selling substantially below par. Even the witness called in behalf of the public testified in substance that in order to float an issue of new stock the intrinsic worth of the stock ought to approach $120 a share, and that increased earnings were necessary. Indeed, the department itself did not attempt to find in the face of this evidence that new stock capital could be obtained at a 6% return. Its finding was that such return was “fair, reasonable, adequate for the company’s needs, and likely under normal and representative conditions to maintain the price of the common stock at or above its par of 100.” This may or may not be true, but it does not reach to the real point. The question was not what return might maintain the stock at par in some hoped for representative period. The question was a much more immediate and practical one. Here is one of our greatest and most necessary public utilities. It cannot be permitted to fail in its service to the *93 public. It was legally and morally bound to increase its service to meet an insistent public demand. It did so by borrowing $120,000,000 on demand notes from a source which fortunately was available to it. It must repay this money in the near future. It cannot expect to retain this borrowed money indefinitely as part of its capital structure. Its only means of repayment is by obtaining new capital. Concededly it must not increase its debt ratio. It must therefore sell a substantial amount of stock. On the evidence it can do this only if it is allowed a return on stock capital substantially larger than the 6% allowed by the department. On this part of the case we agree with the following two paragraphs taken from the opinion of the dissenting member of the department.
“The fact is, that the investors of New England have apparently lost confidence in these securities. This is indeed unfortunate, but it is true. The stock, which is listed in Boston and New York, is currently selling at about 82, and has not been above 90 in a year or more. The majority has adopted a so-called 'historical basis’ of arriving at the cost of equity capital, losing sight of the fact that this company is going to be compelled to float new issues, not in the period of from 1938 to 1946, and certainly not in 1925, but now and on the present market. No witness anywhere in the record, including the Commonwealth’s own witness, Whiteside, testified that the company could acquire new equity capital at less than 8 per cent. . . .
“The company has been receiving revenues under an emergency rate increase since July, 1947, of about $5,000,000 in excess of its prior ' 1946 ’ rates. We are now informed that this emergency increase is to be cancelled but that, on the other hand, an increase of almost exactly the same amount over the prior ‘ 1946 ’ rates will restore the company’s earnings to the point where its stock will go up some twenty points on the market. I feel this is a peculiar logic and one which is lacking in realism. Neither my own observations nor the testimony before us cause me to believe that any such result will follow.”
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It is repeatedly stated or implied in the decided cases, so far as we know without contradiction, that one of the constitutional rights of a regulated utility is the right to earn a sufficient return to maintain its credit and to obtain additional capital when needed to enable it to serve its public.
Bluefield Water Works & Improvement Co.
v.
Public Service Commission of West Virginia,
Although it is beyond our power to fix rates and we certainly have no desire to attempt that task, yet it is our duty to draw to the best of our ability the line where confiscation begins, and in the circumstances of this case, in order to make our decision as useful as possible and not merely the starting point of a series of attempts to ascertain by the method of trial and error just what figure this court would allow to stand, it seems that we should state where in our judgment on the evidence before us that line must be drawn. The Supreme Court of the United States did this in
United Railways & Electric Co. of Baltimore
v.
West,
45% debt capital x 3.45% net return = 1.55% net return on whole capital 55% stock capital x 8.5% net return =4.68% net return on whole capital Composite net return on total of both kinds of capital . . . 6.23%
In our opinion therefore a net return of less than 8.5% on stock capital or less than 6.23% on the sum of both kinds of capital is below the level where confiscation begins. It does not follow that a, considerably higher return might not fall within the range of reason and might not have been allowed by the department, but our duty is performed by marking the line of confiscation.
Return on Reinvested Surplus.
But we are of opinion that the company is entitled to a fair return on its surplus which it has reinvested in its business and thus devoted to the public service. This money belongs to the company and not to its customers. The money could have been paid out in dividends to the stockholders. Instead, it has been put into the plant for the benefit of the public, thus obviating the necessity of acquiring capital in some other manner upon which the company would have been entitled to a fair return. We are not impressed by the argument that this surplus must have been wrongfully exacted from past customers through excessively high rates and so should now be devoted to the public service without compensation. Apart from the obvious impossibility of restoring the money to a past generation of customers, there is not a scintilla of evidence that the money was wrongfully exacted in the first place. As hereinbefore stated good authority supports the proposition that a public utility has a constitutional right to a sufficient return to enable it to accumulate a reasonable surplus. There is no
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reason to doubt that the rates of the company in past years have been fair and in accordance with the filed schedules which it was obliged to observe and which could have been reduced by the department or its predecessor commission if they were excessive. The allowance of a fair return on reinvested surplus is not the same as a stock dividend, which is forbidden to Massachusetts telephone companies by G. L. (Ter. Ed.) c. 166, §§ 9, 10. The question of the company’s right to a fair return on surplus devoted to the public service so long as it remains so devoted is practically settled by what was said in
Fall River Gas Works Co.
v.
Gas & Electric Light Commissioners,
This brings us at once to the question as to what rate of return the company is entitled to receive on reinvested surplus, which is neither debt capital nor stock capital, but has been derived from both kinds of capital. In a case tried, as this case has been, on the theory of “cost of capital” it seems to us that the line of confiscation in the return on reinvested surplus is the same as that established' for the composite return on debt and stock capital, to wit, 6.23%, and that a lower rate of return would be confiscatory, and we so hold.
*98 Methods of disposing of the Case.
Upon the foregoing conclusions serious questions arise as to the proper disposition of the case. According to the statute under which the case is before us we have
“
jurisdiction in equity to review, modify, amend or annul any ruling or order of the commission [department] . . . but only to the extent of the unlawfulness of such ruling or order." Obviously it was the intent of the Legislature, and it is our duty, to preserve the order of the department to the extent that it is possible to do so without violation of law. The order of March 18, 1949, to which this suit relates, was in three parts.
1
The first part disallowed the company’s $15,000,000 rates. Taken by itself, there was nothing unlawful in this, since those rates were considerably above the level of confiscation, and so the department was not obliged as matter of law to allow them. Whether they might properly have been allowed is not for us to say. This part of the order should be preserved if possible. The second part of the order cancelled the $5,000,000 rates authorized by the department July 24, 1947. Taken by itself, there seems to have been nothing unlawful in this, since these rates were below the confiscation level, and so ought not to stand. This part of the order should be preserved if possible. The third part of the order set up the 5% rates, which are confiscatory and cannot stand. This is the focal point of the difficulty. If this part of the order is simply annulled, while the first and second parts stand, either the company will be left without any rates, which is inadmissible (G. L. [Ter. Ed.] c. 159, § 19;
Department of Public Utilities
v.
New England Telephone & Telegraph Co.
If the words of G. L. (Ter. Ed.) c. 25, § 5, “The supreme judicial court shall have jurisdiction in equity to review, modify, amend or annul any ruling or order of the commission [department] . . . but only to .the extent of the unlawfulness of such ruling or order” are to be interpreted narrowly and literally, and if the word “modify” refers only to such verbal changes in the order as this court can itself make in express words, there would seem to be no means of escape from one or another of the undesirable consequences enumerated above, which it is difficult to suppose the Legislature intended to leave possible. If, however, the word “modify” includes in a proper instance a direction to the department to change its order in certain specified respects definitely stated and capable of being readily followed so as to eliminate all illegality, those consequences can be avoided, and the interference of the court with the action of the department can be strictly
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confined “to the extent of the unlawfulness of such ruling or order.” Where the “unlawfulness” consists in confiscation the “extent of the unlawfulness” would seem to be measured by the degree of confiscation. We have already sufficiently indicated what degree of confiscation was involved in the department’s order of March 18, 1949. We cannot ourselves correct the order by amendments which would cure the difficulty, because we are not in a position to determine which schedules would best be changed and in what amounts to produce the necessary result. Moreover, any attempt on our part to do this would lead us into the forbidden area of rate making.
American Employers’ Ins. Co.
v.
Commissioner of Insurance,
We are hopeful that by the interpretation we have placed upon G. L. (Ter. Ed.) c. 25, § 5, that statute will prove an efficient means through which this court can perform the duty laid upon it without leaving the department and the utilities in doubt as to what is deemed confiscatory, and so without the necessity of repeated suits. This course could not have been taken in
Lowell Gas Co.
v.
Department of Public Utilities,
Effect of this Decision upon the 9% Bates.
A word should be said about the 9% rates which are not directly involved in this proceeding. These rates were ordered by the department on May 13, 1949, to cover additional labor costs incurred by the company after it had filed the $15,000,000 rates on April 21, 1948, and because the department did not allow anything for the additional labor item in its decision upon those rates of March 18, 1949.
Department of Public Utilities
v.
New England Telephone & Telegraph Co.
Conclusion,
The result is that the first part of the order of the department of March 18, 1949, disallowing the $15,000,000 rates is to stand; that the second part of the order cancelling the $5,000,000 rates is to stand; but that the third part of the order setting up the 5% rates is to be so modified as to provide for a net return of at least 8.5% on stock capital and 6.23% on reinvested surplus, the department to determine the detailed schedules required to produce that result, and in so doing to include the increased labor cost in operating expenses. A final decree to that effect is to be entered by the single justice. In order, however, that there may be rates in force while the modified schedules are being prepared, the decree shall provide that this suit be retained in this court ; that that part of the decree which sustains the department in disallowing the $15,000,000 rates shall not become effective; and that the interlocutory decrees of May 23, 1949, and May 25, 1949, staying respectively the enforcement of the department’s order of March 18, 1949, relative to the $15,000,000 rates and its order of May 13, 1949, relative to the 9% rates be continued in effect, so that the company can continue to charge the $15,000,000 rates subject to the bond — all until it shall be made to appear to the court that the department’s 5% rates have been modified as required by the decree, when a supplemental decree shall be entered, reciting that fact and declaring this suit at an end.
So ordered.
Notes
This statute provides that the Supreme Judicial Court “shall have jurisdiction in equity to review, modify, amend or annul any ruling or order of the commission [department] . . . but only to the extent of the unlawfulness of such ruling or order.”
This percentage assumes a debt ratio of approximately 45% which the department found to be safe, as hereinafter appears.
These figures are on the basis of the full year 1949, and do not take into consideration the wage increase with which the department dealt in a separate order (the 9% rates) after the decision from which the present appeal was taken.
The department finds that, although gross revenues in 1948 exceeded those in 1940 by nearly $51,000,000, the net earnings in 1948 exceeded those in 1940 by only $126,000.
See Opinion of the Justices,
The actual finding of the department was 3.448% at a debt ratio of 44.5%.
We are leaving out of consideration incidental parts of the order relating to termination of the investigation and similar matters.