Letter from E. E. Bennett (Los Angeles) to William Reinhardt, December 4, 1951

Los Angeles December 4, 1951 Mr. Wm. Reinhardt: (cc - Mr. W . R. Rouse) For some time I have been giving thought to the advan- tages which would result from the transfer of the water pro- duction facilities of the Railroad Company to the distribu- tion company at Las Vegas. It appears to me that there are some decided advantages in making the transfer. There are also some problams. The most serious problem the Water Company and the Rall- road face is the oontinual demand for expansion of their facilities. The Railroad Company, either directly with respect to its own facilities or through non-interest bearing loans to the Water Company, has expended a very large amount of money in expanding the water production and distribution fa- cilities at Las Vegas in the last several years. At the same time it is apparently facing a politically minded Com- mission which is reluctant to permit the Water Company to make rates high enough to pay a fair return on the combined investment. I am certain that no Independent company could have borrowed money in the state of Nevada or elsewhere to make the capital expenditures which have been made by the Railroad Company and the Water Company in the face of the earnings, or rather deficits, which the Water Company has suffered in the past two or three years. If an independent company had been operating the water system in Las Vegas, I am certain that by the very force of circumstances the Com- mission would have been compelled to grant it rates which would have made the lending of money to the Company attrac- tive to investors. I think the Water Company would be in a much better bar- gaining position in dealing with the Commission with respect to rates if the Railroad Company were disassociated entirely from water production and distribution except as the owner of the Water Company. In such event the Railroad could refuse to loan money to the Water Company for expansion of plant un- til the earnings of the Water Company were brought up to the point which would Justify a loan from outside sources. With proper capital structure for the water distribution company the Railroad Company would be not only the owner of the equity capital but also of a loan large enough to make impossible the procuring of outside capital by the Water Company unless prop- er earnings were being realized. Mr. Willlam Reinhardt 2. December 4, 1951 Such a transfer would also have the advantage of be- ing very acceptable to the present Commission because the present Commission looks with suspicion upon the fact that the Railroad Company is the producer of water at Las Vegas. although we know that the Water Company has not been unfair- ly treated in charges made by the Railroad Company for wa- ter produced, it is difficult to make the present Chairman of the Commission accept this fact. If the transfer took place, all of the capital expenditures and all revenues and expenses would be reported to the Commission in one annual report and the Commission would not be able to assert that some secret profit was being hidden in the transactions be- tween the Railroad and the Water Company. There is another important reason why the Railroad Com- pany should disassociate Itself entirely from water produc- tion at Las Vegas. We all know that the water shortage is becoming more and more acute as the result of declining wa- ter tables and Increased population. It is problematical whether the District or the City will be able to finance the bringing of Lake Mead water to Las Vegas. If the present efforts of the District fail, it is entirely possible that the people of that area will look to the Railroad Company to furnish the capital to bring in a supplementary supply of water. There are many defenses which the Railroad Com- pany could assert if an attempt were made to compel it to furnish a supplementary water supply from such source, but I think It is highly desirable that the Railroad put itself in such position that no one could possibly assert that it had an obligation to supplement the present water supply. If it were not the producer of the domestic water supply at Las Vegas, no one would have any justification for asking the Railroad to furnish an additional supply. If the water distribution company were also the producer of water, it would be unable to finance the bringing in of an alterna- tive supply from Lake Mead unless the Railroad Company were willing to loan the money, which the Railroad Company would undoubtedly refuse to do. If anyone were to attempt to compel the Railroad Com- pany to furnish an alternate supply of water, they would un- doubtedly proceed by asking the Commission or courts to find Mr. Willlam Reinhardt 3. December 4, 1951 the Railroad Company to be a public utility. If they were successful in having the Railroad Company declared a public utility, they would then seek to obtain an order to compel the utility to expand its facilities to meet the demands for service made upon it. We have always maintained that the Railroad Company was not a public utility with respect to the production of water, but I believe that there is real danger that the Railroad Company might be declared a public utility with respect to such operations if a serious attempt was made to have it so declared. Section 6106 of the Nevada Compiled Laws provides in part that the term "public utility" shall "embrace every corporation . . . . that now or hereafter may own, operate or control . . . . directly or indirectly any plant or e- quipment within the state for production, delivery or fur- nishing for or to other persons, firms, associations or cor- porations, private or municipal, . . . . water for business, manufacturing, agriculture or household use." Section 6138 of the Nevada Compiled Laws provides as follows: "Whenever any person, company, corporation or association which is not engaged In business as a public utility as defined by this act, and which does not furnish, sell, produce or deliv- er to others, light, heat, power or water, under a franchise received from the state or from any county or municipality within the state, shall be able from any surplus beyond the needs or re- quirements of its business, and shall desire to sell, produce, furnish and deliver to any other person, company, association or corporation, any light, heat, power or water, such person, company, association or corporation, shall apply to the public service commission for authority to sell, produce, furnish or deliver any such surplus light, heat, power or water, and shall submit to the commissilon the proposed contract, by which such light, heat, power or water Is to be sold, furnished, produced or delivered. Mr. Wm. Reinhardt 4. December 4, 1951 "The commission shall thereupon ascertain whether it is advisable in the public interest that such contract be executed and, if the com- mission shall approve such contract, then such person, company, corporation or association shall have the right to furnish, sell, produce and deliver such light, heat, power or water in accordance with the terms of such contract, and shall not thereby become a public utility within the meaning of this act, nor shall it be subject to the jurisdiction of the commission." The Railroad first engaged in producing water at Las Vegas for use in its own operations and the supplying of water to the City of Las Vegas was only incidental. For many years the Railroad itself used the bulk of the water which it produced, This has entirely changed, and the Water Company now distributes for domestic consumption at Las Vegas almost 98% of the water produced by the Railroad Com- pany. The balance is taken by the Railroad Company and, although I do not have the exact figures before me, it is my understanding that practically all of the water taken by the Railroad Company is sold by it to sevaral industri- al consumers in the City. It can thus be seen that the Railroad Company is no longer merely disposing of surplus water not required in Its operations. Practically its entire production goes - directly into domestic or industrial use. There is con- siderable authority in decided cases to the effect that a person or corporation, without being declared a public utility, can sell water or other products ordinarily distributed by public utilities which are surplus products. The theory behind these cases Is that the seller makes no firm commitment to its purchasers to continue to supply them with the water or other products and that it therefore does not ded- icate the surplus product not required in its own opera- tions to the public use. Section 6138 of the Nevada Com- piled Laws is a statutory recognition of this principle. The Railroad has never complied with Sectlon 6138 by obtaining the approval of the Public Service Commission Mr. illlam Reinhardt 5. Deoember 4, 1951 for lts contracts with the Water Company because we have never admltted that the Railroad Company sold water to the Water Company. The Water Company rather than the Railroad Company has always filed applications to appro- priate the water developed by wells upon the railroad lands, and the successive contracts between the Railroad Company and the Water Company have always been drawn up- on the theory that the Railroad Company was merely acting as a contractor for the Water Company in producing the wa- ter which the Water Company had appropriated and that the railroad Company was merely leasing to the Water Company the use of its reservoirs and transmission mains for the water taken by the Water Company. I think it is entire- ly possible if the matter were litigated that a court or commission might decide that the Railroad Company in ef- fect was selling water at wholesale to the Water Company. There is conflict in the decisions with respect to whether a wholesaler of a product distributed by a public service corporation is itself acting as a public utility. Under the facts of particular cases wholesalers have in some instances been held not to be public utilities. How- ever there are a number of decisions holding directly to the contrary. In the case of Acquacknonk Water Co. v. Board of public Utility Commissioners (New Jersey), 118 tl. 535, it was held that a company which sold water at wholesale to other water distribution companies was nevertheless a public utility subject to rate regulation by the Board of Public Utility Commissioners. In the case of Orndoff v. Public Utilities Commission (Ohio), 21 N. E. 2d 234, a producer of natural gas who sold gas to a gas company which as a utility distributed gas to consumers was held to be a public utility and required to make a report to the Public Utilities Commission. In the case of South Oklahoma Power Company v. Corporation Commission (Oklahoma) 220 Pac. 370, it was held that a corporation gen- erating electric power and selling it at the switchboard of lts plant to a distributing company which distributed it to the public was itself a public utility and required to file annual reports with the State Corporation Commis- sion. I the case of Gallatin Natural gas Co. v. Public Service Commision (Montana), 256 pac. 375, it was held Mr. Wm. Reinhardt 6. December 4, 1951 that a foreign corporation conveylng gas over the state line and delivering It to a distributing corporation which it con- trolled was, under the evidence in that cast, a public util- ity and subject to regulation as such. The mere fact that a product is sold at wholesale does not prevent the seller from being declared a public utility if the regulatory statute is broad enough to include whole- sale sellers. An example of the regulation of such business is the Federal Power Act, Title 16 U. S.C., Sec. 324 et seq., which provides for the regulation of the business of trans- mission of electric energy in interstate commerce and the sale of such energy at wholesale in interstate commerce for ultimate distribution to the public. The definition of a water utility in the Nevada statutes is quite broad, and it Is quite possible that a court might construe it as includ- ing the Railroad Company in view of the fact that the Rail- road Company is not furnishing surplus water incidental to the production of water for its own business, but is en- gaged in furnishing to the Water Company at Las Vegas the entire domestic supply for the City and also is furnishing water directly to a number of industrial consumers at Las Vegas. In view of the foregoing circumstances I believe that the Railroad should not continue to expose itself to the danger of being determined to be a public utility with respect to the production of water. By transferring its water production facilities to Las Vegas Land and Water Company without making any change in that corporation the Railroad would fortify itself against a demand that it, as a public utility, expand its water supply at Las Vegas. however the distribution company would not have a capital structure best designed to facil- itate the presentation of Its earning problems at rate hearings. The distribution company would still have the problem of sep- arating its accounts between water production and distribu- tion operations and the other operations. It seems to me that the best plan would be to have a distribution company at Las Vegas entirely separated from any other business ac- tivity so that there could be no claim on the part of the Commission that there had been an improper separation of the revenues and expenses of the company. This could be accomplished by creating a new corporation and transfer- ring the distribution and water production facilities to Mr. Wm. Reinhardt 7. December 4, 1951 that company, it could also be accomplished by transfer- ring the distribution facilities of the Railroad Company to the Las Vegas Land and Water Company and have that com- pany transfer all other assets except water production and distribution assets to a new corporation. I think the lat- ter plan has advantages. The Las Vegas Land and Water Company is now acting as a public utility in the distribution of water and It need not obtain the approval of the Nevada Public Service Com- mission for the purchase of the water production facilities of the Railroad Company and the continuance of oper- ations as a public utility. new corporation acquiring both the production and distribution facilities would have to comply with Sectlon 6137 of the Nevada Compiled Laws, which requires every public utility before beginning oper- ations to obtain from the Public Service Commission a cer- tificate that the present or future public convenience or necessity requires the commencement of such operations. In considering such an application the Commission might At- tempt to control the capital structure and organizational setup of the new company. By continuing to use the Las Vegas Land and Water Company as a distribution company we would be reasonably free from interference by the Commis- sion. I am certain that the Commission would approve of a transfer of the production facilities to a distribution company, but I do not believe we should give the Commis- slon an opportunity to impose conditions on that transfer. A suggested plan is that we transfer the water produc- tion facilities to the Las Vegas Land and Water Company, change its corporate name to Las Vegas Water Company and have the company transfer all of its assets other than wa- ter production and distribution to a new land company hav- ing an appropriate corporate name. There are certain prob- lems to be considered in making such a transfer. I do not haive the final answer on many of them and I think the en- tire problem should be given careful consideration by all interested parties before a definite determination is made to go ahead with the plan which I have been discussing. Mr. Renwick recently wrote Mr. Wehe advising him that we intended to make a recommendation to you concerning the transfer of the water production facilities and asking him Mr. Wm Reinhardt 8. December 4, 1951 for his comments with respect to the capital structure which he would consider advantageous for the distribu- tion company to have from a rate standpoint. I attach for your information copy of Mr. Wehe's letter of No- vember 23, 1951. I have some comments in edition to those made by Mr. Wehe with respect to some of the prob- lems involved. One of the important problems is whether there will be an income tax disadvantage in making the transfer. I agree with Mr. Wehe that the water production facilities of the Railroad Company should be transferred to the water Company at their depreciated book cost so that pre- sumably there would be no capital gain Involved in the transfer. If it were decided to transfer the production facilities at their so-called original cost as determined in the Wehe report, there probably would be some capital gain Involved. However it is my understanding that under Section 112(b)(5) of the Internal Revenue Code no gain or loss is recognized if property is transferred to a corpo- ration which is controlled by the transferror immediately after the transfer. I also believe that a transfer of the assets of Las Vegas Land and Water Company, other than water production and distribution facilities, to another sub- sidiary corporation could be accomplished without income tax consequences under Section 112(g) of the Internal Rev- enue Code. Mr. Wehe points out that if the water utility operations were conducted by a separate corporation, it would lose the benefit of offsetting its losses in poor years against income from the other operations formerly conducted by Las Vegas Land and Water Company. This is probably true except in years when the Railroad system as a whole would decide to file consolidated returns. The income tax problem should be given careful consideration by others more familiar with tax matters than I am before a definite conclusion is reached. It would be advantageous from a rate standpoint for the reorganized water company to have a capital structure which would enable It to demonstrate in the usual manner the rate of return to which that company is entitled. One of the tests is the cost of money test, which is deter- mined by the cost of interest on borrowed capital and a Mr. Wm. Relnhardt 9. December 4, 1951 fair return on the equity stock. Mr. Wehe has discussed this somewhat in his letter and has suggested that a pos- sible structure would call for 55% stock, 45% bonds. This relationship of course is not inflexible. However I think that the water utility should have a substantial amount of borrowed capital from the Union Pacific so that It could demonstrate its inability to borrow money on the outside under junior issues when earnings are unfavorable. If so a financial structure similar to that referred to by Mr. Wehe were dopted, the water utility would have to is- sue additional stock having a par value equivalent to ap- proximately 55% of the depreciated book value of its total assets. The manner in which the borrowed capital would be ev- idenced is something which could be handled in a number of ways. It seems to me that such borrowed capital could be evidenced by an open book account instead of bonds. This would seem to be preferrable because it would entail no cost of issuance of bonds and would enable the lender to drain off accumulated cash when available in payment on the book account. However I do believe that Interest e- quivalent to the rate which would be paid upon capital borrowed from outside sources should be charged by the Railroad Company upon the amount in the loan account. It is my understanding that in the past the Las Ve- gas Land and Water Company at no time has had a cash ac- count, but that all revenues have been deposited to the credit of the Railroad Company, which has paid all ex- penses, and that the loan account haa been merely an ac- count which balances the difference between the reciepts and expenditures made by the Railroad Company on behalf of the Water Company. It appears to me that it would be desirable for the reorganized Water Company to maintain a small working cash account and for transfers to be made periodically from this account in payment of balances due on the loan account. Such handling would make plain to a regulatory commission the need for a working cash allow- ance in the rate base, and If interest were paid on the balance in the loan account from time to time, the cost of borrowed money to the water utility could be readily dem- onstrated. 4 Mr. Willlam Reinhardt 10. December 4, 1951 Another Important factor to consider in a transfer of the water production facilities to the distribution company is the manner in which the comblned facilities would be maintained and operated. Mr. Wehe's discussion is based on the assumption that an almost self-sufficient organization would be created. I do not believe that such a complete separation Is necessary or desirable although I do agree that It would be looked upon with the most favor by the Publio Servlce Commission. For Instance I do not believe that it would be desirable for all of the accounting work relating to the water utility to be performed at Las Ve- gas. I seems to me that the accounting work and the hand- ling of funds should be handled by the Omaha forces as in the past and an appropriate charge made upon the Water Com- pany therefor. The Railroad forces would also continue to provide legal, valuation, tax and executive services for the Water utility at an appropriate charge. The real problem, as I see it, is whether the con- struction of new water production facilities, engineer- ing incidental thereto and the maintenance and operation of the water production facilities should continue to be performed by Railroad forces or by forces on the payroll of the Water Company. To relieve the railroad Company of the necessity of furnishing engineering services In con- nection with maintenance and addition and betterment work it would be necessary to have someone on the payroll of the Water Company qualified to do this work. At present most of the design work is furnished by the engineering staff of the Manager of Industrial Development and I be- lieve that Mr. Ritter would be glad to have his staff re- lieved of the necessity of performing such work. The su- - pervision of construction work and maintenance work is performed by the Division Engineer and the actual opera- tion and maintenance work Is performed by the Division Engineer's forces. From the standpoint of the water dis- tribution company alone it might be more economical and more efficient to have all of this work performed by a small force on the payroll of the Water Company and un- der the direct supervision of lts manager. However I am not certain that from the over-all standpoint the hand- ling of the work in the water production field by such an organization would be more economical than the manner in which the work is now performed. At present the Railroad Mr. William Reinhardt 11. December 4, 1951 forces, which spend most of their time on Railroad work, devote a small portion of their time to maintenance and operation work in the water production field. If this work was taken away from the railroad forces, the expense of the Railroad forces might not be diminished so that any personnel added to the forces of the Water Company would mean in the aggravate added expense. I think the problem of operating the water production field most ef- ficiently and economically should be studied by all of the departments who are now participating in that vork. If the water production facilities were transferred to the water company, the distribution company would have to take over the service to industries now served by the Railroad Company. On the theory that it has not been serving these industries as a utility the Railroad Com- pany has ignored the law prohibiting the use of meters and has sold them water on a metered basis. The contract rates with all of the industries except the P.F.E. are in- tended to return a profit, but I understand that it is in- tended to furnish water to the P.F.E. at cost. The water distribution company would be required to furnish water to these industries on a flat rate, and some study of the amounts actually received for water under our contracts should be made in comparison with the charges which might be received from them on a flat rate basis. E.E. Bennett ECR:MSB Encl.