Reverse Morris Trust (ITC Transaction) Presentation Slides - ERG Consluting

REVERSE MORRIS TRUSTRATEPAYER VALUE

VS.SHAREHOLDER GAIN

A Review of The Failed Entergy – ITC Transaction

March 18, 2014NARUC Accounting and Finance Meeting

Victor Prep, P.E. & Byron Watson, CFA© 2014, Energy & Resource Consulting Group, LLC

Denver, Coloradowww.ergconsulting.com

INTRODUCTION

• Victor Prep, P.E. – Executive Consultant at ERG– BSME from OU, MBA from Wharton, Registered P.E. in PA, CO, and LA,

Retired Nuclear Submarine Naval Officer

• Byron Watson, CFA – Senior Consultant at ERG– BSEE from SMU, MBA in Finance from Emory University, Chartered

Financial Analyst (CFA®)

• The Council of the City of New Orleans Exercises Primary RetailJurisdiction Over two of Entergy Corporation Inc.’s (Entergy)Operating Subsidiaries in Orleans Parish, Louisiana– Entergy New Orleans, Inc. (ENO)– Entergy Louisiana, LLC (ELL)

• Members of ERG Serve as Regulatory Advisors to the Council of theCity of New Orleans– Directly Involved with the Entergy - ITC Transaction at Both the Local and

FERC Level

© 2014, Energy & Resource Consulting Group, LLC 2

ITC TRANSACTION OVERVIEW

• The Transaction was a Proposed Entergy Divestiture/Spin-offof its Six Operating Companies’ Transmission Assets & aMerger of the Spun-off Assets with International TransmissionCompany, Inc. of Novi, Michigan (ITC)

• The Transaction used a Merger & Acquisition (M&A)Technique Called a Reverse Morris Trust (RMT).

• The Proposed Transaction was the First Attempt to Use theRMT in Divesting Assets Within the US Electric and Gas UtilityIndustry.

3© 2014, Energy & Resource Consulting Group, LLC

SUMMARY OF REGULATORY CONCERNS

• FERC Regulatory Construct Increases Retail Revenue Requirement

• Loss of Jurisdictional Control by State Regulators of TransmissionRatemaking & Oversight of Transmission Function– Only Retail CCN Approval Preserved

– Section 206 Rate Challenge Only

• Transfer of Risk from Entergy and ITC Shareholders to Retail Ratepayers– FERC Forward Looking FRP Process

• Value and Ownership of Gains Monetized by Transaction– Ratepayers versus Shareholders

• Lack of Demonstrable Quantifiable Ratepayer Benefits

• Major Storm Restoration Concerns

• Transfer of Intellectual Capital

• Experience of ITC in Previous Acquisitions

• Shareholder Gain at the Expense of Ratepayers


THE PROPOSED TRANSACTION


PARTIES TO THE TRANSACTION

• Entergy Corporation– Six Vertically Structured Operating Companies

• ENO, ELL, Entergy Gulf States, LLC, Entergy Texas, Inc., Entergy Mississippi, Inc. & Entergy Arkansas, Inc.

– Four Mid-South States• Arkansas, Louisiana, Mississippi & Texas

– Five Retail Jurisdictions• Arkansas, Louisiana, Mississippi, New Orleans & Texas

• ITC Holdings Corp. – An Independent Transmission Focused Company– Created in 2003 Through Predecessor (Formally DTE Energy Transmission)

– Transmission Service in Seven Midwestern States Through Subsidiaries• ITC Transmission, ITC Midwest, ITC Great Plains & Michigan Electric

Transmission Company


STATED RATIONALE FOR THE TRANSACTION

7

• Improved Network Reliability

• Increased Investment in Transmission Network (Reduced Costs Through Less Congestion)

• Improved O&M Efficiency

• Singular Focus on Transmission

ITC

• Enhanced Financial Flexibility– Benefit to Other Ongoing

Required Investments

– Better Access to Capital

– Credit Quality Protection

• Improved Earnings and Dividend Growth

ENTERGY

© 2014, Energy & Resource Consulting Group, LLC

UNSTATED RATIONALE

• Entergy’s Concerns with an Ongoing DOJ Anti-TrustInvestigation Regarding Operation of Its Transmission System

• Creation of Enhanced Value for Entergy Shareholders– Failed Attempt to Divest Wholesale Nuclear Assets

• Offload Significant Required Future Investments inTransmission

• Capture and Monetize Higher Rates Through FERC RegulatoryConstruct (Regulatory Forum Shopping)

• Approximate Doubling of Size of ITC


TRANSACTION APPROVALS

• The Six Entergy Operating Companies (OPCOS) and ITC Filed JointApplications in 2012 for Retail Regulator Approval of theTransaction– Louisiana Public Service Commission (LPSC)– Public Utility Commission of Texas (PUCT)– Arkansas Public Service Commission (APSC)– Mississippi Public Service Commission (MPSC)– Council of the City of New Orleans (CNO)

• Transaction Also Required Approval from– FERC– Department of Justice (DOJ)– Federal Trade Commission (FTC)– Internal Revenue Service (IRS)– ITC’s Shareholders


TRANSACTION STRUCTURE

• ITC Proposed to Establish an ITC Subsidiary in Each ofthe Four States to Provide Wholesale TransmissionService to Entergy OPCOS Under FERC Jurisdiction

• Creation of Wholly Owned ITC Subsidiary - ITC MidSouth, LLC With Four Operating Subsidiaries

– ITC Arkansas, LLC

– ITC Louisiana, LLC

– ITC Mississippi, LLC

– ITC Texas, LLC


WHAT IS A REVERSE MORRIS TRUST?


WHAT IS A REVERSE MORRIS TRUST?

• An M&A Technique to Avoid Corporate Taxes

– A Series of Transactions Whose End Result is theTransfer/Sale of a Portion of a Company’s Assets to a NewOwner

• In This Case - Transfer of Entergy OPCO TransmissionAssets to ITC

– Avoids Corporate Taxes on Gains

– Consideration Paid is the Acquirer’s Stock

– The Net Book Value of the Transmission Assets Remain theSame for Entergy and ITC as New Owner


SIMPLE REPRESENTATION OF RMT(Please See Appendix for Detailed Steps)


ITC TRANSACTION OVERVIEW


RMT HISTORICAL EVOLUTION

• Challenged by IRS (Commissioner vs. Mary Archer W.Morris Trust, 1966)– Morris Trust Received a Favorable Ruling – Creating a

Loophole for Companies to Avoid Taxes when DivestingAssets• Several IRS Published and Private Rulings Also Approved Morris

Trust Transactions

• Congress Sought to Limit the RMT in 1997– IRS Code Section 255(e) Resulted in the “50% Rule”

– Limits RMTs and the Degree of Leverage that Can be UsedRelated to the Majority Ownership Between the “Seller”and “Buyer” Entities in the Merger


LIMITATIONS IN MONETIZING A SPIN-OFF

• Debt/Equity and Debt/Debt Swaps are EquallyAvailable to the Seller

• A Monetizing Spin-Off Allows a Seller to Spin Off aSubsidiary on a Fully Tax-Free Basis While De-Leveraging to a Significant Extent

• The Tax Basis of the Subsidiary Determines UpstreamCash or Push Down Debt on a Tax-Free Basis

– Any Incremental Cash/Debt Would Trigger a Taxable Gain


THE “50% TEST”

• The Selling Company Must Own More than 50% ofthe Ultimate Merged Company

• Shareholders of Seller Must Receive Over 50% of theVote and Value of the Newly-Formed Entity in theMerger

– “Vote and Value” – Shares in the Newly-FormedEntity Owned by the Seller Shareholders by Virtueof Equity Positions in the Buyer


THE “50% TEST”

• Dilution of Seller Shareholders by Post-TransactionEquity Issuances Within Two Years of the Transactionby the Surviving Entity Will be Counted for Purposesof the “50% Test”

• Acquiring Company Usually Must be Smaller thanSeller

– In the End - Acquiring Company Must Own Less than 50%of the Merged Company


CORPORATE GOVERNANCE

• Notwithstanding the 50% Requirement – the Buyerin a Reverse Morris Trust Acquisition Can RetainEffective Control Over the Board of Directors andSenior Management of the Surviving Entity

• Proposed RMT Structures Should Receive an IRSRuling Confirming Tax-Free Treatment


WHY THE USE OF A RMT STRUCTURE?

• Entergy and ITC Claimed That the Motivation forUsing an RMT was to Make the Transaction “TaxFree”

– Asset Value is Not Reset to Fair Market Value

– Accumulated Deferred Income Tax (ADIT) is Not Re-measured

• Other Benefits to Entergy and ITC Shareholders

– Escape State Regulation Except for CCN Requirements

– Retain All of the Gain of the Transaction


REGULATORY CONCERNS OVER ENTERGY - ITC TRANSACTION


CUSTOMER REVENUE REQUIREMENTS

• Transmission Cost of Service Changes with Assets Regulatedby the FERC– ROE Would Have Increased to 12.38%

– State Jurisdictional ROEs in Range of 10.2 – 11.1%

• Capital Structure and Rate of Return Changes with theTransaction– 60% Equity & 40% Debt Capital Structure

– Funded by Corporate Debt at 6.5% APR

– ITC Would Itself be Highly Levered

• Prospective Forward Test Year

• Reduced Regulatory Lag Especially with Large PlannedInvestment


LOSS OF RETAIL REGULATORY JURISDICTION

• Transfer of Risk From Entergy Shareholders to Ratepayers– Transmission Planning and Expansion

– Storm Operations and Restoration

– Rate Setting and Prudency of Investments Reviewed at FERC

• Lack of Enforceable Commitment to Improve Service Quality

• No Integrated Resource Planning With Transmission

• No Constraints on Aggressive Transmission Construction andSignificant Spending

• O&M Cost Concerns Based Upon Experiences with ITC in OtherJurisdictions

• Requirement to Challenge ITC’s Actions at FERC

• No Ability of Entergy OPCOS to Challenge ITC’s Rates for Five Years– Only Section 206 Challenges to Rates Available at FERC by State Regulators


NO QUANTIFIABLE DEMONSTRATION OF RATEPAYER BENEFITS

• No Supportable Analytical Cost Benefit Analysis was Providedto Retail Regulators

• No Incremental Benefit Ascertained - Above the BenefitsAnticipated from Entergy Transmission Ownership in theMidcontinent Independent Transmission System Operator(MISO) RTO

• Questionable Weighted Average Cost of Capital (WACC)Assumptions/Projections for Comparison Purposes

• Ignored Ability of OPCOS to Refinance Existing EmbeddedDebt at Lower Incremental Costs

• Increased Cost in Retail Revenue Requirements forTransmission Function

• Adopted Entergy’s Five Year Transmission Plan– Future Studies to Determine Additional Commitments


SHAREHOLDERS KEEP GAINS

• Entergy – ITC Transaction Essentially Monetized Value of FERCConstruct vs. Traditional Asset Recovery with Retail Regulation– All New Value is Created Through Regulatory Forum Shopping

– Funding Equity Return of 12.38% Through Debt Issuance at [6.5%]

• All Retail Regulators’ Staff Concluded That Transaction CreatedSignificant Gain to Entergy Shareholders– Estimated $2 to 4 billion Goodwill as Proxy for Step-up in Asset Value

• 1.8 to 4 Times Book Value of Assets Being Spun Off

• No Sharing of Gain With Ratepayers


TOO LITTLE TOO LATE

• Following Stiff Regulatory Opposition, Entergy & ITC Proposed aSeries of Rate Mitigation Plans– Insufficient to Offset Costs and Risks to Ratepayers– WACC & Incremental Cost of Debt Issues– Ill Defined Structure– Large Portion of Mitigation Plan Based on “Difficult to Quantify” Benefits

to Ratepayers• Green Jobs and Economic Stimulus• More Reliable Transmission Network

– Yet Entergy Consistently Maintained That its Existing Network Met All ReliabilityStandards

• Rewarded for Use of the Same Transmission Construction Plan as Entergy toBenchmark Benefits in MISO

– Ratepayers Would Bear all Risk of Insufficient Mitigation

• Regulator Staff & Intervenors Saw Each Plan as Failing toCompensate Ratepayers for Increased Costs and Risks


OBSERVATIONS

• Proposed Transaction Using the RMT Would EliminateCorporate Taxes and Maintain the Transmission Assets andADIT at Book Value

• Very Significant Gain to Entergy Shareholders not Shared WithRatepayers– The Very Structure and Basis for the Transaction Contrary to Such

Concept

• Significant Increased Costs to Ratepayers WithoutDemonstrable Benefits

• Complete Loss of Retail Jurisdiction

• Shifting of Risks from Shareholders to Ratepayers


REGULATORY OUTCOMES OF PROPOSED TRANSACTION

• All Retail Regulators’ Staff Recommended Against Finding theTransaction in the Public Interest

• Substantially all Intervenors Recommended Against theTransaction– Stakeholders

– Large Industrial Customers

– Trade Groups

• Outcome– MPSC Found the Transaction “Not in the Public Interest” on December

10, 2013 in Well Reasoned & Supported Decision

– Entergy & ITC Withdrew Joint Application Before all Retail Regulators &FERC in December 2013


OBSERVATIONS – QUOTES

• The evidence indicates that the applicants have downplayed the significantbenefits to shareholders and overplayed any benefits to ratepayers. . . . Thereis also conclusive evidence that ETI’s shareholders, not customers, are theprimary beneficiaries of the transaction. - PUCT Docket 41223, ProposedFindings of Facts.

• …the value of Entergy’s shareholders stock would be enhanced significantlywith the proposed transaction. . . .There is no benefit to retail customers fromincreasing the cost of service related to the transmission function bytransferring the regulatory oversight to FERC and significantly increasing Texascustomers’ cost for the same transmission service. - Michael P. Gorman onBehalf of Texas Industrial Energy Consumers.

• ITC Holdings is building a house of cards that is constructed with high leverageand inflated FERC-approved ROEs. - William B. Marcus, on Behalf of TheArkansas Attorney General.

• The effect of ITC’s use of double leverage financing coupled with its proposedrate construct is to charge customers more than the actual financing costs andto inflate the returns accruing to stockholders. - J. Bertram Solomon on Behalfof Arkansas Electric Energy Consumers, Inc.


OBSERVATIONS – QUOTES

• What is the magic that’s being done here that takes an asset -- a sleepy utility asset andturns it into something that's so much sexier and more valuable? It's things like higherROEs on a uniform basis. It's things like incentives for doing the things to push certainpolicies that are pushed by the federal government. It's routine awards of CWIP,construction work in progress, awards for abandoned plant. If they don't actually finisha project, they get to recover the costs they spent trying to do it; fictional capitalstructures; capital structures that don't have anything to do with what's real forratemaking purposes, and back-leverage of the parent company, which you will seelater, that actually takes what looks to be already a high ROE and turns them intorecoveries north of 20 percent.– Philip Oldham, Counsel for Occidental ChemicalCorporation.

• We're talking about the use of this mechanism in order to transfer money to the Entergyshareholders and create a larger platform with ITC who has a particular vision. And Iwill say that vision will be presented to you in great detail in this case, a vision of anational super highway grid [that] pushes certain policies that are not consistent withthe public interest in Texas . . . .– Id.

Q&A


APPENDIX

DETAILED RMT STEPS OF THE ENTERGY ITC TRANSACTION


ITC TRANSACTION – STEP 1LLC IS CREATED


ITC TRANSACTION – STEP 2ENTERGY ISSUES DEBT


ITC TRANSACTION – STEP 3ENTERGY PAYS OFF EXISTING DEBT


ITC TRANSACTION – STEP 4ENTERGY REDEEMS PREFERRED STOCK


ITC TRANSACTION – STEP 5ENTERGY CREATES WIRES SUBSIDIARY


ITC TRANSACTION – STEP 6WIRE SUBS ISSUE DEBT


ITC TRANSACTION – STEP 7OPERATING COMPANIES BECOME LLC


ITC TRANSACTION – STEP 7ACONTRIBUTION OF TRANSMISSION COMPANIES


ITC TRANSACTION – STEP 8OPERATING COS PAY EXISTING DEBT


ITC TRANSACTION – STEP 9WIRE SUBS TO ENTERGY


ITC TRANSACTION – STEP 10LLC RECEIVES TRANSMISSION ASSETS


ITC TRANSACTION – STEP 11WIRE SUBS TO ENTERGY


ITC TRANSACTION – STEP 12SPIN OFF LLC


ITC TRANSACTION – STEP 13REDEEM ENTERGY NOTES


ITC TRANSACTION – STEP 14MERGE LLC AND WIRE SUBS


Documents

Reverse Morris Trust (ITC Transaction) Presentation Slides - ERG Consluting