5. Net Benefits Showing
Section §854 (b)(2) requires that, in order to warrant approval, merger transactions must produce both "short-term" and "long-term" economic benefits, and it requires the Commission to equitably allocate, where it has ratemaking authority, the total of such forecasted benefits between shareholders and ratepayers, with ratepayers receiving no loss than 50% of those benefits. To the extent that applicable benefits of the merger can be identified, we find that a 50% sharing of those savings between ratepayers and investors is reasonable and consistent with the requirements of § 854(b)(2).
Applicants claim that there are no savings from the merger specifically attributable to California retail customers, and that there should be no surcredits or other pass-through of savings to retail customers as a condition of approving the merger. Applicants claim that, to the extent that California retail customers realize any benefits from the merger, such benefits will be in the form of improvements in the range and quality of service, including provisioning of voice, data, and video services.
ORA argues that Applicants' claims of mere qualitative, or "soft," benefits are not the "economic benefits" required by § 854(b). ORA witness Selwyn testified that service quality improvements would not "constitute an `economic benefit' for California ratepayers" unless "existing service quality [from Applicants]. . . in California today is less than satisfactory."15 Applicants have not contended that existing service quality is unsatisfactory, nor have they provided specific details about how the merger would improve service quality in California.
We agree that "soft" benefits, as described by Applicants, do not satisfy the net benefits requirements of § 854(b). Most of Applicants' highlighted advantages of the merger, such as network integration and the ability to attract a larger number of large global customers, are essentially shareholder benefits. Such "soft" benefits would impact consumers only to the extent they manage to "find [their] way into consumer" segments of the market via a "ripple down" effect.16
Applicants' witnesses are vague about whether, or when, any consumer benefits might be realized. They testified that the intention of Applicants is to develop new products and apply them to the enterprise market, with the effect that at least some of these products will apply to the mass market as well. They further testified that details about new projects could not be stated at this time because Applicants do not know specifically what the new projects will be.
ORA witness Selwyn challenges Applicants claims' of innovation from the merger, arguing that competition, not the scale of operations, is the driver of innovation. Selwyn stated that firms with few or no rivals have little incentive to bring new products to market. He argued that academic literature corroborates that competition drives innovation.17 TURN and ORA maintain that the proposed merger is risky for ratepayers. Selwyn testified that the merger could lead to an overall increase in the rates consumers pay for services because of the initial costs of consolidation, even if in the aggregate the merger produces positive economic benefits for Applicants.
5.2. Applicants' Calculation of Savings
Regarding net customer benefits expected from the merger, Applicants sponsored the testimony of Stephen E. Smith, Verizon group vice president for business development of domestic telecommunications. Smith is responsible for developing estimates of the synergies resulting from the proposed merger.
Although Applicants dispute that § 854 (b) applies to the Verizon/MCI acquisition, in compliance with the Assigned Commissioner's Ruling they produced a calculation of certain merger-related savings that could theoretically be shared with California customers. These savings are generally referred to as "synergies." To calculate a California share of synergies, Applicants start with the base figure for merger-related savings derived from their National Synergy Model. This national model was created during the "due diligence" process prior to Verizon's signing the merger agreement with MCI to assist senior management and the board of directors in evaluating the transaction, and to assist in determining the price to pay for MCI.
The National Synergy Model estimates that the transaction will generate $7.3 billion of present value arising from new revenues and expense and capital savings, net of costs to achieve those benefits and net of related taxes. The Applicants attribute almost 50 percent of these synergies to network operations and IT functions, with substantial synergies from procurement cost savings and increased revenue opportunities. Applicants also expect synergies from the reduction in third party network expenses due to moving network traffic onto MCI's network, elimination of overlap between Verizon and MCI staff relating to national networks, enterprise sales and support, and headquarter operations (e.g., finance, accounting, human resources, and legal).
Applicants calculated operating synergies in California by deducting costs necessary to achieve those synergies, allocating the remaining net synergies to Verizon California, excluding MCI synergies and excluding synergies that Verizon will realize in operations where the Commission does not exercise direct ratemaking authority. The Applicants then discounted the forecasted synergies to present value to compute economic benefits to be $6.6 million (with a $3.3 million share going to ratepayers). The $6.6 million estimate represents about one-tenth of 1% of the total corporate synergies.
ORA and TURN performed their own analyses of synergy savings attributable to California consumers, and presented testimony concluding that Applicants' calculation of the total merger synergies allocated to California consumers was significantly understated. As a basis for their calculations, ORA and TURN relied on the Applicants' synergy model as a starting point, and made adjustments to the Applicants' figures. On a net present value basis, taking into account adjustments for the alleged deficiencies, ORA estimates of the correct amount of synergies attributable to California is $206 million18, while TURN calculates the amount as $365.7 million.19 ORA and TURN propose applying 50% of these synergy savings to ratepayers pursuant to § 854(b).
The ORA and TURN figures differ from Applicants' estimate by a considerable amount due to several adjustments not contemplated by Applicants. In particular, ORA and TURN (1) include revenue synergies as well as expense synergies; (2) include benefits over the full long term; (3) include the full range of national synergies (and costs) for both Verizon and MCI, with the exception of categories of costs not attributable to the merger; (4) allocate transaction costs across synergy categories; (5) include an estimate of the savings due to a reduction in MCI's cost of capital; (6) correct a minor error in severance costs for corporate headcount reductions; (7) assume a different discount rate, and (8) apply different allocation factors per type of major market.
Applicants take issue with Intervenors' criticism of their calculation of synergies, characterizing it as "second guessing" the professional judgment of managers. We disagree with this characterization. Opposing parties are entitled to examine all relevant documentation in an effort to validate any part of Applicants' modeling methodology. To the extent that the development of national synergies estimates were developed through due diligence and the "best business judgment" of Verizon senior management, parties should be able to validate that due diligence and the methodology employed in developing specific estimates.
5.4. Short-Term and Long-Term Benefits
One of the largest factors accounting for the difference between the Applicants and ORA/TURN in measuring benefits subject to § 854(b) ratepayer sharing relates to the time period over which synergies forecasts are recognized. For purposes of their calculation of $6.6 million in California-specific synergies subject to ratepayer sharing, Applicants limited the time horizon to a four-year period. Applicants recognize no distinction in their calculation between the "short term" and the "long term" (pursuant to § 854(b)) for purposes of allocating benefits to ratepayers.
Section 854(b), however, requires calculation of both "short-term" and "long-term" consumer benefits from the merger. The statute does not provide a specific definition of what constitutes the short term versus the long term. TURN argues that the projected costs of implementing the merger are likely to result in little or no net benefit for customers in the short term, representing the initial years of the merger.
While Applicants have calculated the California-specific synergy benefits by limiting the forecast time horizon to four years, the National Synergy Model forecasts additional merger synergies through the year 2013 (or eight years), and also includes an additional terminal value for synergies anticipated into perpetuity. The National Synergy Model estimates were used as a basis to make representations to the financial community.
The estimated costs to achieve the merger occur in the initial years after the transaction, while offsetting savings are realized over a longer period. Using a four-year period for measuring California ratepayer synergies implies that most of the initial merger costs are incorporated in the estimate, while only a small percentage of the offsetting savings forecasted by the National Synergy Model is included. ORA and TURN argue that Applicants provide no valid reason to limit the California-specific forecast of benefits to a shorter period than the one used by Applicants to calculate merger benefits to justify the Federal Communications Commission (FCC) approval of the transaction.20 ORA argues that an economic definition of "long term" should refer to the period of time after merger implementation costs were incurred, allowing all permanent synergy and other efficiency gains to be included in the calculation of merger benefits. Applicants claim that if the Commission uses the same definition of long term used for Applicants' forecasts presented to the financial community, there will be an inordinate risk upon the companies' financial operations and shareholders.
ORA witness Selwyn testified that the merger poses virtually no investor risk, while ratepayers will confront a substantial risk that the merger will create a far less competitive market overall, with the likelihood that California ratepayers generally will see price increases. ORA argues that the Commission should not reduce ratepayer benefits to account for alleged shareholder risk by cutting off the calculation at four years and ignoring subsequent years projected benefits. Accordingly, ORA calculated the synergies attributable to California over the same time frame used by SBC for its shareholder and investor synergy disclosures.
Section 854(b)(2) requires that California ratepayers receive a minimum of 50% of the total short-term and long-term forecasted economic benefits of the merger, where the Commission has ratemaking authority. In reviewing the available material produced for this proposed merger, ORA and TURN allege deficiencies in the Applicants' California synergy calculation, and have corrected these to reach similar estimates of the amount of synergies attributable to California. ORA calculates that amount at $206 million, and thus recommends an allocation to ratepayers of 50% of this amount.
Although Applicants propose a four-year "long-term" definition for determining the synergies attributable to California, the national synergy figure they presented to investors and shareholders, and which was reported in their 8-K filing with the SEC, calculates merger synergies for eight years and into perpetuity. Using a four-year definition of long term ensures that most of the expected one-time merger costs are incorporated, while only a smaller percentage of expected merger savings is included. All of the merger costs-to-achieve occur in the first several years after the transaction, while benefits increase over time. As a result, the costs-to-achieve become a larger proportion of the total synergies over the first four years than when considered relative to total synergies as disclosed to investors, which creates an unjustified disparity in the manner in which costs-to-achieve and the resulting synergy gains are allocated to ratepayers. California ratepayers will have to fund the costs-to-achieve while enjoying few of the synergies the financial community expects shareholders to realize. Applicants have provided no viable basis for presuming that synergy benefits associated with California intrastate services will end any sooner for ratepayers than for shareholders. Nor have they provided a policy reason for the Commission to limit the California-specific forecast of benefits to a shorter period than the one used by Applicants to calculate merger benefits used to justify the FCC and shareholder approval of the transaction.
We conclude that all MCI and Verizon California activities "where the Commission has ratemaking authority" (whether that authority is exercised or not) should form the basis for the § 845(b)(2) allocation of benefits to California ratepayers. Applicants understate the California-specific synergies by creating a factor that considers only Verizon California synergies, ignoring the intrastate operations of MCI activities in California, which form the bulk of the merger synergies related to Applicants' combined post-merger California operations.
Applicants justify their approach as being consistent with the approach for evaluating synergies adopted by the Commission in the GTE/Bell Atlantic merger. However, prior to that merger, Bell Atlantic did not have any meaningful operations in California, so there were no Bell Atlantic "California synergies." This was also the case with the SBC/Pacific Telesis merger, where SBC had no California operations going in, and neither of those merger proceedings presented the Commission with the question as to how to identify California-specific merger benefits when both the acquired and the acquiring company have substantial assets and operations in California and where they compete with one another in the California market. In both of those proceedings, it made sense to limit the analysis of California specific synergies solely to the operating company being acquired, precisely because the company being acquired was the only entity with significant California-regulated operations. Neither of those decisions serves as precedent for excluding MCI's California operations from the California-specific merger synergies of a merger between Verizon and MCI.
Section 854(b)(2) does not suggest that one company in a merger should be excluded in determining economic benefits. The subsection clearly requires the Commission to "[e]quitably allocate[], where the Commission has ratemaking authority, the total short-term and long-term forecasted economic benefits ... of the proposed merger, acquisition, or control, between shareholders and ratepayers." The only limitations are that the Commission must have ratemaking authority, and that the allocation must assign a minimum of 50% of the economic benefits with ratepayers. It is clear that there is a duty to include all forecasted economic benefits, and not just those to be realized only within the first four years and only by Verizon California.
For these reasons, we conclude that MCI's California intrastate operations should be included in calculating the California synergies allocated to California ratepayers. ORA presented synergy figures including both Verizon and MCI California intrastate operations synergies. This adjustment results in California specific synergies of $206 million if taken in perpetuity as assumed by Joint Applicants.
This Commission must evaluate the proposed transaction in light of the risk it entails. The soft benefits claimed by Joint Applicants are at best suppositions and speculations. They have not been economically quantified and have not been compared to the risks this transaction poses to ratepayers. Applicants do not give any firm assurances that these benefits will actually arise, let alone flow to ratepayers; they only suggest that the soft benefits might find their way to ratepayers at an unspecified time in the future.
Section 854(b) requires that ratepayers receive benefits over both the short-term and long- term, but does not specifically define a duration for either period. In prior decisions analyzing § 854(b), we have held that the definition of long-term may vary with the circumstances of each individual case. We conclude that, in this case, ORA and TURN have made the stronger showing that the merger portends risk to ratepayers that must be ameliorated to some extent by an equitable sharing of merger synergies. We further conclude that Applicants have not demonstrated by a preponderance of evidence that a sharing of one-tenth of 1% of their anticipated total synergies will adequately compensate Verizon and MCI ratepayers for the risks they are about to undertake. We will adopt ORA's estimate of California synergies that must be shared on a 50% basis with ratepayers. This figure is a reasonable and well-supported estimate of the value of merger synergies attributable to California, and these benefits will offset the risks to which this proposed transaction may subject ratepayers . We note also that the ORA calculation is somewhat less than but roughly equivalent to TURN's synergy estimate for the period between eight and nine years after the merger takes place. In this case, we believe that a period of approximately eight years is a fair assessment of the "long-term" benefits of this merger.
We note that Applicants have entered into a settlement with Greenlining and LIF in which stipulated amounts of philanthropic contributions would be designated as the sole § 854(b) benefits to be adopted in this proceeding.21 Yet, the settlement does not purport to represent any quantitative analysis of actual synergies that would actually be realized through the merger. For reasons discussed below, we decline to limit § 854(b) benefits solely to those identified in the settlement.
In order to find that this merger is in compliance with § 854(b), we require that 50% of the $206 million net synergies be shared with California consumers, resulting in an allocation of $103 million on a discounted net present value basis. We address the allocation of these consumer benefits in the sections that follow.
5.4.1.2. Ratemaking Authority
Applicants argue that regardless of whatever level of merger savings may be attributable to California utility operations, the Commission should not impose a mandatory sharing of such benefits because the Commission does not have "ratemaking authority." Since MCI and its affiliates are classified as CLECs and NDIECs, they are not subject to cost-of-service rate regulation. Accordingly, Applicants argue that because the utilities being acquired are not subject to rate regulation, the merger transaction, itself, is not subject to the purview of § 854(b)(2). Applicants assert that the legislative history of Assembly Bill 119 of the 1995-1996 legislative session (AB 119) demonstrates that NDIECs and CLECs are exempt from § 854(b)(2)'s requirements.
We disagree. The language of the statute does not specifically refer to NDIECs and CLECs. California courts rightfully express "skepticism about looking beyond the statutory language when trying to discern the legislature's meaning." (Pacific Bell v. Public Utilities Com. (2000) 79 Cal.App.4th 269, 280.) The fact that the regulatory status of a company is relevant to whether or not an exemption should be granted does not show that the statute automatically excludes NDIECs and CLECs from §§ 854(b) and (c) review. In any event, this transaction involves the acquisition-and removal from the market-of a very significant NDIEC and CLEC. It also involves an acquisition by California's second largest ILEC. Thus, this transaction is not analogous to past proceedings where NDIECs and CLECs continued to participate in the market after the merger closed, and where no dominant ILEC was involved in the acquisition.
5.4.1.3. Implementing Pass-Through
Because there were no hearings in this case, and because an Assigned Commissioner's Ruling held (erroneously, we believe) that § 854(b) did not apply, we have an incomplete record as to how identified net benefits should be passed through to consumers.
ORA and TURN did not formulate specific proposals concerning how the net benefits should be allocated among different groups of consumers. ORA and TURN do agree, however, that merger savings to be shared with ratepayers need not all necessarily flow through as rate surcredits. ORA witness Selwyn characterized ratepayer benefits as "currency" to "spend" on various mitigation measures. ORA believes that proposals for the uses of shared benefits should be subject to examination and further comments. ORA and TURN propose that the specific allocation of the net benefits among different consumer groups and interests be addressed in a separate phase of this proceeding.
Various other parties and individuals at the public participation hearings have urged that any net benefits be earmarked for designated purposes, such as funding programs to help bridge the "digital divide" experienced by various underserved elements of the communities in which Verizon provides service. In this regard, we are also separately adopting certain conditions pursuant to § 854(c) relating to philanthropy commitments by Verizon, as discussed in a subsequent part of this decision.
In order to provide a proper basis upon which to determine how net consumer benefits from the merger should be distributed, we will adopt the ORA/TURN proposal to take further comments on this issue. Before determining the specific allocation of net benefits adopted herein, we solicit comments to be filed 20 calendar days following the effective date of this decision concerning proposals for the specific allocation of the net benefits among consumer groups and/or other programs for the benefit of consumers. Following receipt and review of comments, we shall proceed with further steps to implement the distribution of net benefits to consumers as adopted in this decision.
15 Ex. ORA 1 (Selwyn).
16 Ex. Verizon/MCI 25 (Smith/McCallion) at 2 ("The Applicants will be subject to competitive forces that will force them to flow through an equitable share of the synergies to customers.")
17 . See, e.g., Wendy Carlin, et al., A Minimum of Rivalry: Evidence from Transition Economies on the Importance of Competition for Innovation and Growth, Contributions to Economic Analysis & Policy, Vol. 3, Number 1, 2004, Article 17, cited in Ex. 126C, ORA/Selwyn.
18 Selwyn Testimony, Ex. ORA 1.
19 Murray/Kientzle Testimony, Ex. TURN 1.
20 Murray/Kientzle Reply Testimony, Ex. TURN 1.
21 Section 1.2.3 of the proposed settlement provides: "in the event the Commission were to determine that Section 854(b) obligations apply to the Application, the Parties will support a Commission determination that the terms and conditions of this Agreement shall be considered as a means of allocating benefits under Section 854(b)(2). Greenling and LIF will advocate that this Agreement constitutes satisfaction of Section 854 requirements."
