Opposition — Western Coal Traffic League v. United States

No. 82-1369

——

Iu the Supreme Cowt of the United States

OCTOBER TERM, 1982

WESTERN COAL TRAFFIC LEAGUE, ET AL., PETITIONERS

VU:

UNITED STATES OF AMERICA, ET AL.

ON PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

BRIEF FOR THE FEDERAL RESPONDENTS

IN OPPOSITION

REX E. LEE

Solicitor General

Department of Justice

Washington, D.C. 20530

(202) 633-2217

JOHN BROADLEY

General Counsel

LAWRENCE H. RICHMOND

Deputy Associate General Counsel

ERNEST B. ABBOTT

Attorney

Interstate Commerce Commission

Washington, D.C, 20480

——- -—-— -— —— —-- ~~ —— ——————

QUESTIONS PRESENTED

1. Whether the Interstate Commerce Commission’s

adoption, as the standard for railroad revenue ade-

quacy, of a rate of return on net investment equal to

the current cost of capital was consistent with 49

U.S.C, 10704(a) (2) and constituted a reasonable ex-

ercise of discretion.

2. Whether the Commission’s definitions of cost of

capital and net investment base were arbitrary and

capricious.

(1)

TABLE OF CONTENTS

Page

Opinions below spect cahcuaes ae 1

Jurisdiction ; . ideeeatat 1

Statement . . 2

REESE EE eR OS I eA TI SR SITET EN eas %

Conclusion 22

TABLE OF AUTHORITIES

Cases:

Adequacy of Railroad Revenue, 361 1.C.C, 79, 362

L.C.C, 198, petition for reopening denied, 362

1.C.C, 794 (Ex Parte No, 3538) 3,4, 11, 13, 15-16

Atchison T. & S.F. R, Co. v. Wichita Board of

Trade, 412 U.S, 800 15-16

Chesapeake & Ohio Ry., Docket No, 38793, petition

for review (served Mar. 18, 1982), appeal dock-

eted, No, 82-3122 (3d Cir.), Wheeling Pittsburgh

Steel Co. v. ICC : : 10

Cleveland-Cliffs Iron Co. Vv, ICC, 664 F.2d 568 ..... 20

Establishment of Adequate Railroad Revenue

Levels, 858 1.C.C, 844, modified, 359 I.C.C, 270

(Ex Parte No, 338) ae HH Be eS

Iowa Public Service Co. v. ICC, 643 F.2d 542 20

San Antonio v. United States, 631 F.2d 831, modi-

fied, 655 F.2d 1341, rev'd on other grounds

sub nom, Burlington Northern, Ine. v. United

States, No, 81-1008 (Dec, 13, 1980) . 13, 20

Standards for Railroad Revenue Adequacy, 364

L.C.C, 803 (Fx Parte No, 393) rite 6, 8

Ex parte, No, 347 (Sub-No, 1), Coal Rate Guide-

lines—Nationwide, 364 1.C.C, 360 . 10, 20

Ex parte, No, 393 (Sub-No, 1), Standard for Rail-

road Revenue Adequacy (Mar, 9, 1983) . 17, 19, 21

Statutes:

Act of Oct, 17, 1978, Pub. L, No, 95-473, 92 Stat.

1337 2

(111)

IV

Statutes :—Continued Page

Economic Recovery Tax Act of 1981, Pub. L. No.

97-34, 95 Stat. 172 a 21

Milwaukee Railroad Restructuring Act, Pub. L.

No, 96-101, 93 Stat. 736 . 4

Railroad Revitalization and Regulatory Reform

Act of 1976, Pub. L. No, 94-210, 90 Stat, 31

(49 U.S.C. (& Supp. IV) et seq.) 2

Section 101(a), 90 Stat, 33 9

Section 202 (b) and (e), 90 Stat. 25, 36-38 2

49 U.S.C. (Supp. 1V), 10101a, note 5

49 U.S.C. (Supp. IV) 10701a(a) (3) 5

49 U.S.C. (Supp. IV) 10701a(b) (3) 9

49 U.S.C. (Supp. [V) 10704(a) 12,17

49 U.S.C. (Supp. IV) 10704(a) (2) 2, 11, 13, 18

49 U.S.C. (Supp. IV) 10704(a) (2) (A) 7,18

49 U.S.C. (Supp. IV) 10704(a) (2) (B) 11,17

49 U.S.C. (Supp. 1V) 10704(a) (3) and (4) 5

49 U.S.C. (Supp. IV) 10705a(a) and (b) 5

49 U.S.C. (Supp. 1V) 10707a(d) (3) and (e) 5

Rock Island Transition and Employee Assistance

Act, Pub, L. No, 96-254, 94 Stat. 399 4

Stagwers Rail Act of 1980, Pub, L. No, 96-448,

94 Stat. 1895 8 4

Section 2, 94 Stat. 1896 11

Section 3, 94 Stat. 1897 5,9

Section 201(a), 94 Stat. 1898 5

Section 203(a), 94 Stat. 1901 5

Section 205, 94 Stat. 1905 5

Section 205(b) (2), 94 Stat. 1906 h

Section 217(a) (1), 94 Stat. 1917 5

AM TS.C, Mal) 2

Miscellaneous:

Ex parte, No, 392, Standards for Railroad Revenue

Adequacy (Notice), 45 Fed. Reg. (1980) :

p. 80150-80155 5-6

p. 80151-80152 6

p. 80152 19

H.R. Rep. No. 95-1395, 95th Cong., 2d Sess,

(1978) . era -

Sk Se ee

Miscellaneous—Continued Page

H.R. Rep. No. 96-1430, 96th Cong., 2d Sess.

ce 5

S. Rep. No. 94-499, 94th Cong., 2d Sess. (1975). 13

S. Rep. No. 94-595, 94th Cong., 2d Sess. (1976). 2

U.S. Railway Ass’n, Conrail at the Crossroads:

The Future of Rail Service in the Northeast

| Nee AE ape paateanhs 4

Iu the Supreme Court of the United States

OCTOBER TERM, 1982

No. 82-1369

WESTERN COAL TRAFFIC LEAGUE, ET AL., PETITIONERS

Ge

UNITED STATES OF AMERICA, ET AL.

ON PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

BRIEF FOR THE FEDERAL RESPONDENTS

IN OPPOSITION

OPINIONS BELOW

The opinion of the court of appeals (Pet. App. la-

35a) is reported at 691 F.2d 1104. The decision of

the Interstate Commerce Commission (Pet. App. 1b-

24b) is reported at 364 I.C.C. 803.

JURISDICTION

The judgment of the court of appeals was entered

on October 19, 1982 (Pet. App. 1d-2d), and petitions

for rehearine were denied on November 15, 1982

(1)

2

(Pet. App. le-2c). The petition for a writ of cer-

tiorari was filed on February 14, 1983. The jurisdic-

tion of this Court is invoked under 28 U.S.C. 1254/1).

STATEMENT

1. Congress enacted the Railroad Revitalization

and Regulatory Reform Act of 1976, Pub. L. No. 94-

210, 90 Stat. 31 (the “4R Act’’), in the face of a sea

of bankruptcies involving most railroads serving the

northeastern United States. Intervention by the In-

terstate Commerce Commission into railroad rate-

making was perceived as a major contributor to the

carriers’ weakened financial position, and Congress

sought to restore stability by reducing regulatory re-

straints on rail carrier pricing decisions. See S. Rep.

No. 94-595, 94th Cong., 2d Sess. 124 (1976). Thus,

the 4R Act substantially limited the power of the

Commission to find rates unreasonably high or low,

and restricted the Commission’s power to suspend

rate changes. 4R Act, Section 202(b) and (e), 90

Stat. 35, 36-38.

The 4R Act also directed the Commission to de-

velop and promulgate reasonable standards for the

establishment of adequate railroad revenue levels,

and then to make “an adequate and continuing effort

to assist those [rail] carriers in attaining [the] rev-

enue levels prescribed * * *.” 4R Act, Section 205, 49

U.S.C. (Supp. IV) 10704(a)(2) * * *.' The Act

' The provision enacted by the 4R Act was originally codi-

fied at 49 U.S.C. 15a(4). That provision was restated with-

out substantive change as 49 U.S.C. (Supp. IV) 10704 (a) (2)

by the Act of Oct. 17, 1978, Pub. L. No. 95-473, 92 Stat. 1337.

See H.R. Rep. No. 95-1395, 95th Cong., 2d Sess. 70, 72 (1978).

The excerpt quoted above is from the restated provision as it

appears in 49 U.S.C. (Supp. IV) 10704 (a) (2).

carefully specified that the revenue levels established

by the Commission as adequate must be sufficient to

“support prudent capital outlays, assure the repay-

ment of a reasonable level of debt, permit the rais-

ing of needed equity capital, *~ * * cover the effects

of inflation * * * [and] attract and retain capital in

amounts adequate to provide a sound transportation

system in the United States.” /bid. Congress did not,

however, give carriers whose revenues were deter-

mined to be inadequate any regulatory freedoms un-

available to “revenue adequate” carriers, or specify

how the Commission was to use its revenue adequacy

findings in individual rate proceedings.

Pursuant to the 4R Act, the Commission began an

extensive rulemaking proceeding to devise standards

of revenue adequacy. /stablishment of Adequate

Railroad Revenue Levels, 358 1.C.C. 844, modified,

359 1.C.C. 270 (1978) (Kx Parte No. 338). Upon

promulgation of generic standards, the Commission

conducted a proceeding to make revenue adequacy

determinations for individual railroads. See Ade-

quacy of Railroad Revenue, 361 L.C.C. 79 (1978),

and 362 I.C.C. 198 (1979), petition for reopening

denied, 262 1.C.C. 794 (1980) (Ex Parte No. 353).

Rather than adopting a single standard of revenue

adequacy in these proceedings, the Commission de-

fined a range between a minimum and a maximum

standard. The minimum standard was determined

by using the “flow of funds” approach, advocated by

shipper groups (including several of the petition-

ers herein). This method was designed to measure

the revenues required to (1) pay all operating ex-

penses and contractual debt obligations, and (2) pro-

vide enough equity capital from retained earnings to

permit financing of all necessary future investments

at the current cost of capital for debt and equity. Ex

4

Parte No, 338, supra, 358 LC.C, at 859-860; Ex Parte

No. 353, supra, 362 1.C.C, at 204, 227-242. The maxi-

mum standard for revenue adequacy was defined as

the “fair return level”—i.e., a rate of return equal

to the cost of capital multiplied by the net invest-

ment base. Kw Parte No, 338, supra, 358 LC.C, at

896; 359 LC.C. at 273; Ex Parte No, 353, supra, 362

L.C.C, at 223-224. In addition, the Commission pro-

posed to give weight to a number of financial indi-

cators in determining the revenue adequacy of indi-

vidual carriers; where a carrier’s revenues fell

within the range, these indicators would be used in

making a judgment regarding revenue adequacy, 358

LC.C. at 858-860."

The railroad industry continued to struggle finan-

cially despite the 4R Act reforms, prompting Con-

gress to enact the Staggers Rail Act of 1980,’ Pub. L.

No, 96-448, 94 Stat. 1895 (“Staggers Act”). The

* Using these standards, the Commission found 15 carriers

with rates of return ranging from 4.02 to 11.70 percent to be

revenue adequate, and 23 carriers with rates of return rang-

ing from —40, to 4.65°7 to be revenue inadequate, 362 1.C.C.

at 297-341.

"For example, during this period, two major midwestern

rail carriers—the Chicago, Rock Island & Pacific Railroad and

the Chicajyro, Milwaukee, St. Paul and Pacific Railroad—not

only declared bankruptcy, but ceased providing service over

the major parts of their systems, forcing congressional inter-

vention, See Rock Island Transition and Employee Assistance

Act, Pub, L. No, 96-254, 94 Stat. 399; Milwaukee Railroad

Restructuring Act, Pub, L. No, 96-101, 93 Stat. 736. Two

other major carriers—Consolidated Reil Corporation and the

Delaware & Hudson Railroad—required major government

subsidies. U.S. Railway Ass'n, Conrail at the Crossroads:

The Future of Rail Service in the Northeast 2, 39 (1981).

See also the Commission's initial revenue adequacy determina-

tions in Ex Parte No, 353, 362 1.C.C. at 257.

5

express purpose of the new legislation was “to pro-

vide for the restoration, maintenance, and improve-

ment of the physical facilities and financial stability

of the rail system of the United States.” Section 3,

94 Stat. 1897, 49 U.S.C. (Supp. IV) 10101a, note.

This financial and physical improvement was to be

accomplished primarily through further limiting of

federal regulation of railroad ratemaking and

through encouraging the earnings levels necessary to

attract needed capital. H.R. Rep. No. 96-1430, 96th

Cong., 2d Sess, 79-80 (1980).

In the Staggers Act, the Commission once more

was directed to complete a proceeding—this time

within 180 days—to establish standards of revenue

adequacy and to determine which railroads were

meeting those standards. Section 205(b)(2), 49

U.S.C, (Supp. IV) 10704(a) (3) and (4). Addi-

tional such proceedings were to be conducted in sub-

sequent years. The Staggers Act also directed the

Commission to consider revenue adequacy in any pro-

ceeding involving the reasonableness of a railroad

rate. Section 201(a), 49 U.S.C. (Supp. IV) 10701a

(a) (3). Only railroads not earning adequate rev-

enues would have the right, after 1984, to increase

rates by 4% per year without those increases being

subject to suspension (Section 205(a), 49 U.S.C.

(Supp. IV) 10707a(d) (3) and (e)), and only rail-

roads not earning adequate revenues would have the

right to impose surcharges on all traffic moving under

joint rates (Section 217(a) (1), 49 U.S.C. (Supp. IV)

10705a(a) and (b)). Under this statutory scheme,

then, a finding of revenue adequacy would narrow the

ratemaking flexibility of the carrier involved.

2. a. Faced with these congressional directives,

the Comniission instituted the proceeding that is the

subject of the instant petition. Ka Parte No, 398,

6

Standards for Railroad Revenue Adequacy, 45 Fed.

Reg. 80150-80155 (1980). The Commission proposed

that, in light of the emphasis of the Staggers Act on

revenue adequacy, the then-existing standards should

be replaced. Under the proposed standards, revenues

would be deemed adequate if a railroad earned a rate

of return on investi ent equal to the current cost of

capital, and if the railroad achieved certain financial

ratios consistent with a sound financial condition. The

Commission proposed to withdraw the “funds-flow”

standard. 45 Fed, Reg. 80151-80152 (1980).

After consideration of voluminous comments filed

by railroad and shipper interests, the Conimission

promulgated its current revenue adequacy standards.

Standards for Railroad Revenue Adequacy, 364 LC.C,

803 (1981) (Pet. App. 1b-24b) (“He Parte No.

393”). The Commission found (Pet. App. 7b-8b)

that the most appropriate standard for determining

if a railroad has adequate revenues is whether it re-

ceives a rate of return equal to the current cost of

capital. This rate of return was deemed the minimum

rate of return that would allow railroads to obtain

investment funds, because, in the Commission’s

judgment, “investments earning less than the cost of

capital will, in general, not maintain existing fund-

ing nor obtain new funding” (id. at 8b).

The Commission also stressed that a rate of re-

turn equal to the current cost of capital would sat-

isfy all of the statutory criteria, because it would give

carriers a “ ‘flow of net income sufficient to support

prudent capital outlays, assure the repayment of a

reasonable level of debt, permit the raising of needed

equity capital, cover the effect of inflation’ and other-

wise meet the requirements of the statute” (Pet.

7

App. 8b, quoting 49 U.S.C. (Supp. IV) 10704(a) (2)

(A)).

b. Having adopted this standard for determining

revenue adequacy, the Commission next defined the

relevant cost of capital as a weighted average of the

current cost of debt and equity. The Commission re-

jected the shippers’ contentions that the embedded

cost of debt, reflecting the historical cost of prior in-

vestment, should be used. The Commission explained,

repeating the analysis provided in the Notice of Pro-

posed Rulemaking (Pet. App. 13b):

A sound transportation system should return the

cost of capital to investors and reflect that cost

of capital in prices paid by users. These are

forward-looking concepts. The year and the rate

at which past debt was raised are not sevelant

for these purposes. The more relevant consider-

ation is the cost to the railroad of raising (or

not losing) capital for current and future

investment.

The Commission did not exclude unused and non-

useful assets from the initial calculation of the net

investment base, finding that to do so would be im-

practical in the 180-day period available to complete

the initial proceeding and that only minimal distor-

tions would result in any event (Pet. App. 10b). The

Commission also determined that reserves for de-

ferred taxes that would have been due had the rail-

roads not used the accelerated rather than straight-

line depreciation method for tax purposes should not

be subtracted from the investment base.

3. The court of appeals affirmed the Commission’s

decision in all respects.‘ The court held that the “over-

4A cross-petition filed by several railroads, objecting to

the Commission’s statement that it would, in 4 future pro-

p¢leum™

8

all policy pursued by the agency [in adopting a single

rate-of-return standard] is entirely consistent with

Congressional directives,” and that the “[r]easons for

departure from the ICC’s prior position with respect

to use of financial ratios and flow of funds analysis,

and for refraining from incorporating productivity

standards * * *, have been carefully explained” (Pet.

App. 26a). The court further concluded that the

agency’s use of the current (rather than embedded)

cost of debt was consistent with the statute (id. at

28a-29a), and that the agency had adequately ex-

plained the inclusion of both unused and unuseful

assets and the reserve for deferred taxes in the in-

vestment base (id. at 3la, 38a).

ARGUMENT

The court of appeals correctly determined that the

Commission’s revenue adequacy standards are con-

sistent with the statutory scheme and supported by

the Commission’s analysis. The decision conflicts with

no decision of this Court or of any court of appeals,

and does not warrant further review.

1. Petitioners urge (Pet. 9-13) that the revenue

adequacy standards adopted in Ew Purte No, 393

raise important questions concerning the Commis-

sion’s regulation of rail rates, because, in petitioners’

view, the standards deprive captive rail shippers of

the maximum rate protections provided in the Inter-

state Commerce Act. This arguinent confuses the dis-

tinct issues of defining revenue adequacy, on the one

hand, and utilizing the concept of revenue adequacy

in ratemaking decisions, on the other. Only the Com-

ceeding, consider excluding ‘unused and nonuseful assets”

from the investment base, was denied as not ripe for judicial

review (Pet. App. 33a-34a).

9

mission’s definition of revenue adequacy is at issue in

this case.

The purpose of both the 4R Act and the Staggers

Act was to help rehabilitate and maintain the physical

facilities of the railroad industry and to restore its

financial integrity. 4R Act, Section 101(a), Pub. L.

No. 94-210, 90 Stat. 33; Staggers Act, Section 4, Pub.

L. No. 96-448, 94 Stat. 1897. Thus, because revenue

adequacy findings must be considered in rate proceed-

ings and can limit a carrier’s access to several Stag-

gers Act reforms, revenue adequacy must be carefully

defined to ensure that no carrier is labeled revenue

adequate unless its revenues are “adequate” for the

purposes Congress sought to achieve: the obtaining of

long-term financing for the rehabilitation and mainte-

nance of that carrier’s physical plant.

Contrary to petitioners’ contention, however, the

Commission’s definition of revenue adequacy does not

have the effect of “depriving captive rail shippers of

the maximum rate protections which Congress in-

tended them to have” (Pet. 9). Individual rates, or

methods that may be used to determine individual

rates, are not at issue here. Although the Commis-

sion is required to “consider” revenue adequacy in

individual rate cases (49 U.S.C. (Supp. IV) 10701a

(b) (3) ), the Commission’s decision in this case does

not determine or even discuss what form that con-

sideration might take. Accordingly, the decision be-

low does not preclude shippers from seeking relief

from unreasonable rates charged by carriers even if

those carriers are determined to be revenue inade-

quate. Indeed, both the Commission and the court of

appeals stressed that “a revenue adequacy determina-

tion is no guarantee that any carrier will attain any

level of revenue” (Pet. App. 6b, 7b, 27a).

10

Petitioners apparently believe that the Commission

has given undue weight to carrier revenue needs in

the concededly “few” individual rate cases decided

after the Commission rendered the decision at issue

here. They point (Pet. 11) to several individual rate

cases in which revenue inadequacy was considered.’

Petitioners’ argument regarding the methods used

in individual rate cases has no relevance here. None

of these cases is now before the Court, and petitioners’

objections with respect to them may be raised in ac-

tions seeking judicial review in those cases. This case,

as we have said, concerns only the Commission’s defi-

nition of revenue adequacy.”

Petitioners also contend (Pet. 13) that the standard

adopted by the Commission must be erroneous because

it results in a finding of revenue inadequacy for many

railroads and, hence, no “meaningful distinction” is

made between financially strong and weak railroads.

5 All but one of these cases involved carriers whose revenues

were inadequate under both the new standards adopted by the

Commission in the instant proceedings and the old standards.

The exception is the Chesapeake & Ohio Ry., Docket No. 38793,

petition for review of a decision of the Public Service Comm'n

of West Virginia (served Mar. 18, 1982), appeal docketed,

No. 82-3122 (3d Cir.), Wheeling Pittsburgh Steel Co. v. ICC.

6 Similarly, the Commission’s proposed guidelines for taking

revenue adequacy into account in ratemaking proceedings, set

forth in a notice in Ex Parte No. 347 (Sub-No. 1), Coal Rate

Guidelines—Nationwide (served Feb. 24, 1983), discussed

in the Brief Amicus Curiae filed by the Consumer Owned

Power Coalition (at 18-22), may be contested in an action

challenging those guidelines if they are finally adopted by the

Commission or in an action contesting individual rates deter-

mined by reference to the proposed or final guidelines. Those

guidelines do not furnish a basis for reviewing the revenue

adequacy standards themselves in this case.

11

The purpose of the Staggers Act, however, was not

to require the Commission to determine which car-

riers have more adequate or less adequate revenues

on a relative basis. Rather, it required the Commis-

sion to define revenue adequacy at levels sufficient to

“attract and retain capital in amounts adequate to

provide a sound transportation system.” 49 U.S.C.

(Supp. IV) 10704(a)(2)(B). Further, Congress

made explicit findings in the Staggers Act that earn-

ings of the railroad industry as a whole were “insuf-

ficient to generate funds for necessary capital im-

provements” and that “by 1985, there will be a capi-

tal shortfall within the railroad industry of between

$16,000,000,000 and $20,000,000,000.” Staggers Act,

Section 2, 94 Stat. 1896. Given these findings, Con-

gress could not have anticipated that the Commission

would find large numbers of carriers to be revenue

adequate, See Pet. App. 15b-16b.’

2. The court of appeals correctly rejected peti-

tioners’ contention (Pet, 14-18) that 49 U.S.C. (Supp.

IV) 10704(a) (2) “expressly precluded” the Commis-

sion from adopting return on investment as the sole

measure of revenue adequacy. As its terms make

clear, 49 U.S.C. (Supp. IV) 10704(a) (2) does not re-

quire the Commission either to adopt or to avoid any

particular method for determining revenue adequacy.

Rather, the statute lists several performance tests for

7 Petitioners cite (Pet. 13) the Burlington Northern Rail-

road (BN) as an example of a strong railroad that should be

considered revenue adequate, because it had the resources

recently to acquire control of E] Paso Natural Gas Company.

Contrary to petitioners’ contention, however, BN’s decision

to invest internally generated funds outside the rail industry

in fact does not speak well for the profitability of BN’s rail

operations. Moreover, BN was considered revenue inadequate

even under the old standards that petitioners now seek to have

reinstated. See Ex Parte No. 358, supra, 362 1.C.C. at 303.

12

carrier revenue adequacy, and requires the Commis-

sion to design standards that would enable railroads

to satisfy those tests. Thus, Section 10704(a) pro-

vides:

The Commission shall maintain and revise as nec-

essary standards and procedures for establishing

revenue levels for rail carriers “ “ © that are

adequate, under honest, economical, and efficient

management, to cover tctal operating expenses,

including depreciation and obsolescence, plus a

reasonable and economic profit or return (or

both) on capital employed in the business.

Further, the revenue levels established by the Com-

mission must—

(A) provide a flow of net income plus deprecia-

tion adequate to support prudent capital outlays,

assure the repayment of a reasonable level of

debt, permit the raising of needed equity capital,

and cover the effects of inflation; and (B) attract

and retain capital in amounts adequate to pro-

vide a sound transportation system in the United

States.

The Commission found that a rate of return on in-

vestment equal to the current cost of capital would

satisfy all of these performance criteria (Pet. App.

7b-9b). The Commission credited the testimony of a

witness in the proceedings, Professor Baumol, that

any decision which precluded a compensatory return

on a railroad’s cost of capital would result in dis-

investment from the railroad industry, because in-

vestors would choose to invest their funds elsewhere

at a higher rate of return (Pet. App. 7b-8b). Such

disinvestment in turn would lead to deterioration of

plant and equipment, avoidance of replacement of

equipment, neglect of opportunities for moderniza-

13

tion, and withdrawal of railroad services valued by

customers. In contrast, the Commission concluded

that the rate-of-return standard would prevent these

results, and thus was entirely consistent with con-

gressional directives."

Petitioners contend (Pet. 17), however, that the

Commission did not explain its departure from its

prior position, expressed in Ew Parte No, 338, that it

would look to factors beyond the rate of return in

determining revenue adequacy. See Ex Parte No, 338,

supra, 358 I.C.C. at 858-860; Ex Parte No. 358,

supra, 362 I.C.C. at 216. This contention is without

*Contrary to petitioners’ contention (Pet. 16-17), the

opinion of the District of Columbia Circuit in San Antonio

v. United States, 631 F.2d 831, 850 n.104 (D.C. Cir. 1980),

modified, 655 F.2d 1341 (1981), rev’d on other grounds sub

nom. Burlington Northern, Inc. v. United States, No, 81-1008

(Dec. 13, 1982), supports rather than undermines the Com-

mission’s and court of appeals’ decision. The court there

stated that although 49 U.S.C. (Supp. IV) 10704(a) (2) re-

veals that revenue levels must provide net income adequate to

support prudent capital outlays, assure the repayment of a

reasonable level of debt, and permit the raising of needed

equity capital, “that language specifies not at all the exact

methodology that the Commission shall use in accomplishing

the mandate.” 631 F.2d at 850 n.104. The court likewise re-

jected the city’s reliance upon the same Senate Report relied

upon by petitioners herein (Pet. 15, quoting S. Rep. No. 94-

499, 94th Cong., 2d Sess. 51-52 (1975) ); it noted that although

the Report indicates that the Commission should not focus

solely on rate-of-return analysis and should adopt a prospec-

tive view of revenue needs, the Report does not prescribe the

specific standards by which to determine the adequacy of

revenue levels. 631 F.2d at 850 n.104. Here, the Commission

did not focus solely on rate of return. It explicitly considered

the other statutory criteria of adequacy and determined that

a rate-of-return standard would assure sufficient income to

meet those criteria (Pet. App. 86-96).

14

merit. The Commission explained that in Ex Parte

No. 338 and Ex Parte No. 353, it had established a

range of revenue adequacy, with a high value to be

determined by looking to the cost of capital and a low

value to be determined by using a flow of funds model.

The Commission stated that flow of funds determina-

tions “represent minimum target levels to be

achieved” and “are appropriate as indicators only of

the short-term viability of railroads” (Pet. App. 6b

(emphasis added) ). These indicators, the Commis-

sion explained, were “never intended to define a long-

term level of adequate revenue” (id. at 5b), and “are

especially inappropriate as measures to limit rail pric-

ing flexibility which is one of the roles the [Staggers]

Rail Act accords revenue adequacy findings” (id. at

6b). The Commission continued (ibid.) :

If we adopted the Ex Parte No. 353 minimum or

short-term standard for use here, we would likely

in the next few years find ourselves denying a

railroad the pricing flexibility necessary to ob-

tain long-term revenue adequacy simply because

that railroad was making some progress toward

achieving that goal. In short, we would be as-

signing the railroads the Sisyphean task of work-

ing toward revenue adequacy, and every time it

came close robbing it of the very means it had

used to get there. We do not believe this is de-

sirable nor do we believe it was intended by

Congress. Thus, our adoption of a rate of return

standard is not a radical departure from our

previous standards. Ex Parte No. 353 clearly

accepted rate of return as a proper standard for

ascertaining if a railroad has actually earned

adequate revenues, In adopting such a standard

here, we are only adapting our earlier findings

to the mandate and policy of the [Staggers] Rail

Act.

15

Finally, the Commission stressed that a finding of

revenue inadequacy does not give a railroad license

to set rates at unreasonable levels, because “revenue

need is not the only factor to be considered when the

reasonableness of a rate is determined” (id. at 7b).

As a result, “the computation of an adequate revenue

level for the carrier does not represent a guarantee

that the carrier will attain such a revenue level”

(ibid.).

The court of appeals held that the “[rJeasons for

departure from the ICC’s prior position with respect

to use of financial ratios and flow of funds analysis

* * * have been carefully explained” (Pet. App. 26a).”

The Commission therefore satisfied its responsibility

to explain its change of policy. Cf. Atchison T. &

® Petitioners contend (Pet. 17) that the Commission had

taken the position in its decisions in Ex Parte No, 338 and

Ex Parte No, 353 that 49 U.S.C. (Supp. IV) 10704 (a) (2) pro-

hibited the Commission from adopting a single standard of

revenue adequacy and that the Commission therefore erred in

not explaining why its legal position on this question of statu-

tory construction had changed. However, as a reference to the

pages of the Commission’s decisions relied upon by petitioners

makes clear, the Commission did not rest its decisions on a

conclusion that the statute precluded it from settling on one

measure of revenue adequacy; it simply described why it de-

termined that consideration of other factors was appropriate.

See 358 I.C.C. at 858-859; 362 I.C.C. at 216. The Notice of

Proposed Rulemaking in Ex Parte No. 328 did state that what

is now Section 10704(a) (2) does not envision that rate of re-

turn will be the sole factor to be considered in judging revenue

adequacy. See 358 1.C.C. at 904. But the Commission did not

take a contrary view here; it considered the other statutory

factors and determined that they would be satisfied by using

rate of return as a measure of the revenues that would be

necessary to accomplish the statutory purpose.

16

S.F. R. v. Wichita Board of Trade, 412 U.S. 800, 808-

809 (1973) (plurality opinion of Marshall, J.).

3. Petitioners object (Pet. 19-20) because the

Commission included “unused and non-useful” assets

in the net investment base. This objection is insub-

stantial, especially in this case. Throughout these

proceedings the Commission actually has agreed that

it should seek to eliminate unused and unuseful assets

from the investment base when it is feasible to do so.

But the Commission also recognized that the identifi-

cation of unused and unuseful assets is a complex and

controversial task that could not be performed within

the 180-day period allowed by Congress for comple-

tion of the initial revenue adequacy determination

(ibid.). Further, the Commission found that includ-

ing unused and unuseful assets in the initial invest-

ment base would cause only a “minor distortion,”

because these assets amount to significantly less than

1% of total net investment and because the rail-

roads with the highest percentage of unused and

unuseful assets are the least profitable and therefore

are the least likely to be found revenue adequate in

any event (id. at 10b). The court of appeals found

evidence in the record to support these findings, and

on this basis correctly concluded that “no adjustment

to the book values of the investment base [to reflect

unused and unuseful assets] was necessary at this

10 Petitioners attempt to show the significance of this issue

by referring (Pet. 20 n.14) to a railroad witness’ estimate

that there are $225 million in unused and unuseful property.

This figure was derived using the generous and questionable

assumption that the book value per mile of unuseful property

is equal to the average book value per mile of all railroad

property. Even so, this estimated total amounted to only

.79% of railroad net investment.

17

time, because no likelihood of substantial over-valua-

tion was established” (id. at 3la).

This issue may soon be mooted in any event, be-

cause the Commission recently proposed a number of

substantial changes to improve the accuracy of its

initial revenue adequacy standards. One of these pro-

posals is “Elimination of Assets that are not used and

useful from the investment base.” Ex Parte No. 393

(Sub-No. 1), Standard for Railroad Revenue Ade-

quacy (Mar. 9, 1983), slip op. 2. In these circum-

stances, the Commission’s inclusion of these assets

presents no issue warranting this Court’s review.

4. Petitioners attack (Pet. at 20-21) the Commis-

sion’s decision to use the current cost of debt, rather

than the embedded cost of debt, in computing the ade-

quate rate of return on carrier net. investment. Peti-

tioners claim that the Commission’s approach over-

states debt costs because, at the present time, the cur-

rent cost of debt substantially exceeds the carrier’s

contractual interest and principal repayment require-

ments.

Contrary to the premises underlying petitioners’

contention, however, “revenue adequacy” for purposes

of 49 U.S.C. (Supp. IV) 10704(a) is a long-run and

forward-looking concept. The Commission must es-

tablish revenue levels adequate to “attract and retain

capital in amounts adequate to provide a sound trans-

portation system” in the future (49 U.S.C. (Supp.

IV) 10704(a)(2)(B)), rather than merely measure

the historical profitability of a carrier or that car-

rier’s ability to repay the debt associated with past

investments. Moreover, as the Commission found

(Pet. App. 13b), if a railroad attempts to raise capi-

tal today, either to rebuild worn-out facilities or to

expand existing facilities, it must compete for scarce

investment funds. To do so, it must offer a rate of

18

return equal to the cost of capital, where the cost of

capital is the weighted average of the current cost of

debt and the current cost of equity capital. Con-

versely, and as noted by the court of appeals, “[ijf

the railroads could not gain a rate of return on invest-

ment represented by old debt in excess of the old in-

terest rates on such debt, they would be unlikely to

attract new equity capital, and their shareholders

would insist on investment of internally generated

funds outside the rail industry” (id. at 28a).

The Commission’s choice of the current cost of capi-

tal also cannot be divorced from its choice of an origi-

nal cost investment base or its obligation to promul-

gate standards that “cover the effects of inflation.”

49 U.S.C. (Supp. IV) 10704(a)(2)(A). The Com-

mission was aware that the current and embedded

cost of debt differ largely because the inflation rates

anticipated by current and past investors differ.”

Similarly, the Commission was aware that, in times

of inflation, historical cost accounting systems using

actual “embedded” costs fail to reflect the impact of

changing prices on asset values and expenses. As a

result, such systems tend to understate operating ex-

penses (especially depreciation) and result in the re-

porting of illusory profits.’* In the instant proceeding,

“The nominal cost of capital is the sum of the real cost

of capital and the expected rate of inflation” (Pet. App. 12b).

% The Commission recently elaborated:

Historical cost depreciation is viewed as a systematic

method for allocating asset costs over useful lives, How-

ever, during periods of inflation, this cost does not re-

flect the economic cost consumed. Thus, while reported

earnings of a company often increase during periods of

inflation, the increases are not necessarily real. To main-

tain operating capability, for example, a railroad must

19

the Commission was forced to use an original cost

valuation of the investment base because replacement

data were unavailable (Pet. App. 17b). The Commis-

sion then selected the current nominal cost of capital

as the proper rate of return standard, noting wide

acceptance for the proposition that “the nominal cost

of capital must be applied to an original cost-based

asset valuation if the railroads are to be compensated

for inflation” (id. at 12b); see Ex Parte No. 398

(Notice), 45 Fed, Reg. 80152 (1980). This was a

rational respynse to the general problem of properly

accountine for inflation.”

5. Finally, petitioners argue (Pet. 22-24) that the

Commission should have excluded deferred taxes from

the railroad’s net investment base and that the court

of appeals created a conflict among the circuits when

it affirmed the Commission’s treatment of deferred

taxes,

Contrary to petitioners’ contention, however, there

is no conflict among the circuits regarding the validity

of the Commission’s current position. Each of the

continually replace productive assets at present costs, In

periods of inflation, each replacement of an asset is more

costly than its predecessor, Business continuity is not

assured, therefore, merely because current revenues ex-

ceed past costs. While sales, earnings and dividends in-

crease during inflationary periods, those increases do not

necessarily represent gains in net worth in real terms.

Er Parte No, 893 (Sub-No. 1) (Mar. 9, 1983), slip op. 7 (foot-

note omitted).

' The Commission reopened the entire issue of inflation

accounting, including the choice of cost of capital and invest-

ment hase, in Ex Parte No. 398 (Sub-No, 1), supra. The

Commission there proposed to withdraw the standards now

under review and to replace them with a current cost valua-

tion of the railroads’ investment base and a “real” (adjusted

for inflation) cost of capital rate of return.

20

three cases cited by petitioners ' arose at a time when

the Commission’s revenue adequacy policy, as ex-

pressed in Ex Parte No. 338, supra, 358 LC.C, at

889-894, required deduction of the deferred tax ac-

count from the net investment base. In each of the

cited cases, the Commission apparently had failed to

follow its own policy, and the courts simply re-

manded the cases to the Commission to “clarify

whether this [deferred tax] adjustment was indeed

appropriate and in fact performed.” See, e.g., Cleve-

land-Cliffs Iron Co. v. ICC, 664 F.2d 568, 586 (1981)."”

In a notice issued in Ex Parte No, 347 (Sub-No. 1),

Coal Rate Guidelines—Nationwide, 364 1.C.C, 360,

371 (1980), however, the Commission suggested that

its Ex Parte No. 338 policy should be changed, be-

cause it substantially reduced the incentive of rail-

roads to undertake railroad investments, and thus

thwarted “the intent of Congress in passing the Reve-

nue Acts of 1954 and 1962, to provide business enter-

prise with tax benefits as a means of spurring capital

spending.”

The Commission adopted this reasoning in the in-

stant proceeding, finding that “[i]f we exclude in-

4 San Antonio Vv. United States, supra, 621 F.2d at 847;

Iowa Public Service Co. v. ICC, 643 F.2d 542, 546-547 (8th

Cir. 1981); and Cleveland-Cliffs Iron Co. v. ICC, 664 F.2d

568, 586 (6th Cir. 1981).

In San Antonio v. United States, the court of appeals ex-

pressed the view that under principles expressed in certain

public utility rate cases, the deferred tax account should be

deducted from the net investment base once normalization of

taxes is elected. 631 F.2d at 847. As the court itself noted

(ibid.), however, the Commission’s policy at that time was to

deduct deferred taxes, and the Commission had simply failed

to follow that policy in the case under review. The D.C. court

therefore had no occasion to review the Commission's revised

policy, at issue in this case.

= |

21

ternally generated funds, whether stemming from ae-

celerated depreciation or any other railroad activity,

from the investment base, the effect will be to estab-

lish a rate of return below the cost of capital’? and

“result in incentives to railroads to invest these funds

in nonrail operations” (Pet. App. 11b). Against this

background, the Commission adopted its new policy

of including deferred taxes in the net investment

base, accompanied by a careful explanation of its

change from the prior policy.’* The court of appeals

correctly recognized that the cases decided under the

Commission’s old policy no longer apply (Pet. App.

33a & n.8), and found the Commission’s new policy

“rationally supported” and “consistent with the Con-

gressional directive” (ibid.). The court of appeals’

decision affirming the Commission’s treatment of the

deferred tax acount—the first decision addressing the

Commission’s new policy—does not warrant review

by this Court."

16 Petitioners claim the Commission’s treatment of deferred

taxes is inequitable because it permits the railroads to earn a

return on investment capital “provided by the ratepayers”

(Pet. 24) and not by railroad investors. The deferred tax

account is not contributed by the ratepayers, however; if

contributed by anyone, it is by the federal government,

through authorization of accelerated depreciation for tax

purposes. The Commission determined that its treatment of

deferred taxes was consistent with the congressional purpose

underlying accelerated depreciation of encouraging capital

spending—a policy that also is consistent with the goals of the

4R and Staggers Acts.

17 The Commission is again considering how tax benefits

should be treated in computing revenue adequacy in order to

reflect the impact of the Economic Recovery Tax Act of 1981,

Pub. L. No. 97-34, 95 Stat. 172. See Ex Parte 393 (Sub-No. 1),

supra, slip op. 18.

22

CONCLUSION

The petition for a writ of certiorari should be

denied.

Respectfully submitted.

Rex E. LEE

Solicitor General

JOHN BROADLEY

General Counsel

LAWRENCE H. RICHMOND

Deputy Associate General Counsel

ERNEST B. ABBOTT

Attorney

tr oU. 8. GOVERNMENT PRINTING Office 1669 408744 1944