ARCHIVED -  Telecom Decision CRTC 98-3

On 20 December 1984, la Régie des services publics du Québec (later, la Régie des télécommunications du Québec) (the Régie)) held a public hearing to consider an application by Le Téléphone Guèvremont Inc. to purchase the shares of and amalgamate with Le Téléphone Bon-Conseil Inc. (Bon-Conseil). At the hearing, the Régie verbally approved the merger of Le Téléphone Guèvremont Inc. and Bon-Conseil which was to take effect 1 January 1985. The approval of the merger was subsequently reiterated in Decision R.S.P. 84-050-A, dated 6 September 1985 (Decision R.S.P. 84-050-A). The Régie ruled in that Decision that the newly merged company of Téléphone Guèvremont Inc. (Guèvremont) was to record the transaction for regulatory purposes at historical cost of Bon-Conseil’s assets.

Guèvremont disputed the Régie’s ruling to record the transaction at historical cost and recorded the acquisition of Bon-Conseil at market value. This dispute led to Guèvremont challenging the Régie’s jurisdiction in the Courts which resulted in the Supreme Court of Canada’s decision in Attorney-General of Quebec et al. v. Téléphone Guèvremont Inc., 26 April 1994, recognizing that jurisdiction over the independent telephone companies in Canada was with the Commission.

The purchase price negotiated for Bon-Conseil’s shares by Le Téléphone Guèvremont Inc. was $2.1 million, which was $1.3 million in excess of the net book value of $0.8 million. The write-up was allocated to Bon-Conseil’s capital assets and amortized over the life of the various categories of assets. As of 31 December 1995, the unamortized portion of the asset write-up in Guèvremont’s accounting records was approximately $0.4 million. The transaction was funded almost entirely through a preferred share offering which was then subsequently converted to common share equity.

In Regulatory Framework for the Independent Telephone Companies in Quebec and Ontario (Except Ontario Northland Transportation Commission, Québec-Téléphone and Télébec ltée), Telecom Decision CRTC 96-6, 7 August 1996 (Decision 96-6), the Commission directed Guèvremont, in light of the fact that the company is not a member of the Société d’administration des tarifs d’accès des télécommunicateurs (SATAT), to show cause within 30 days of that Decision, as to why the company’s 1995 and 1996 Carrier Access Tariffs (CATs) should not be finalized at the levels proposed by SATAT on behalf of participating Association des compagnies de téléphone du Québec Inc. (ACTQ) CAT members.

In its response dated 6 September 1996, Guèvremont requested that the company’s 1995 CAT remain at the then current interim level of $0.1791 per minute. The $0.1791 per minute rate was the interim 1994 CAT approved in Telecom Order CRTC 95-75, 26 January 1995, for the ACTQ CAT participating members based on the Commission and Line Haul Agreement between ACTQ members and Bell Canada (Bell), and subsequently approved in Telecom Order CRTC 95-558, 11 May 1995, on an interim basis for all small Quebec independent telephone companies, including Guèvremont, effective 1 June 1995.

Guèvremont further requested approval of a new 1996 interim CAT based on calculations that, among other things, assumed that the merger was accounted for at market value. Guèvremont stated that it did not participate in establishing the SATAT members’ 1995 and interim 1996 CATs and that implementing these rates would cause serious prejudice to Guèvremont. Furthermore, Guèvremont stated that the CAT methodology established in Decision 96-6 does not permit the company to recover from Bell, or any other interexchange carrier, the retroactive contribution due and necessary to obtain its authorized rate of return.

On 7 October 1996, in response to Guèvremont’s submission, Bell requested that the Commission finalize Guèvremont’s CATs based on the Régie’s decision. Bell submitted that the integration of an artificial value of the assets acquired from Bon-Conseil, in the CAT calculation, would only perpetuate the erroneous financial results.

On 18 October 1996, in reply comments, Guèvremont noted that the Commission had not explicitly or implicitly ratified the Régie’s decision. Guèvremont submitted that, should the Commission decide to re-examine the validity of the Régie’s decision, it should establish a public process to do so.

By letter dated 14 February 1997, the Commission noted that finalization of the CATs from 1995 onward would be directly affected, among other things, by the regulatory treatment of the asset write-up. The Commission determined that, until the issue of the asset write-up was resolved, Guèvremont’s 1995 CAT would remain interim at the then current level of $0.1791 per minute and the 1996 CAT would be set on an interim basis at $ 0.1014 per minute which is the interim 1996 CAT based on Phase III costs approved for the SATAT members in Decision 96-6. The interim 1996 CAT was to remain in effect on an interim basis for 1997. In a separate letter dated 14 February 1997, the Commission initiated a proceeding to determine the regulatory treatment relating to the amount paid over net book value resulting from the purchase of Bon-Conseil by Le Téléphone Guèvremont Inc.

Guèvremont, Bell and Télébec ltée (Télébec) were made parties to this proceeding. Guèvremont and Bell filed comments. Guèvremont filed reply comments.

In Newfoundland Telephone Company Limited - Revenue Requirement for the Years 1990 and 1991 and Attachment of Customer-Provided Multi-Line Terminal Equipment, Telecom Decision CRTC 90-15, 12 July 1990 (Decision 90-15), the Commission concluded that allowing any excess of purchase price over the original cost in the rate base with the resulting impact on the revenue requirement could only be justified if it was found to be in the public interest to do so. As part of this proceeding, in order to assess whether it was in the public interest to include the asset write-up in the rate base, the Commission requested Guèvremont to address the following factors enunciated in Decision 90-15:

Guèvremont submitted that the transaction between Le Téléphone Guèvremont Inc. and Bon-Conseil was negotiated on an arm’s length basis, as none of the shareholders of Bon-Conseil, directly or through a holding company, at the time of purchase, were shareholders, administrators or officers of Le Téléphone Guèvremont Inc. and vice versa. Guèvremont argued that its position is supported by the definitions of associate and affiliate as set out in subsections 2(1) and (2) of the Canada Business Corporations Act, R.S.C., 1985, c. C-44 and the Securities Act, L.R.Q., c. V-1.1.

Further, Guèvremont submitted that, notwithstanding that the transaction was performed between related parties as the principal shareholder of Le Téléphone Guèvremont Inc. and the principal shareholder of Bon-Conseil are brothers, the transaction was deemed, pursuant to subparagraph 251(2)(c)(ii) and section 69 of the Income Tax Act to have been negotiated on an arm’s length basis as it was performed at fair market value and did not confer undue privileges on the parties.

Guèvremont stated that it was requesting the same treatment as that given to other telephone companies in similar situations noting that the Commission has never refused to recognize the purchase price paid by a company for the acquisition of another company merely because a transaction was completed by related parties. In that regard, Guèvremont noted that in British Columbia Telephone Company - Proposed Acquisition of GTE Automatic Electric (Canada) Ltd. and of Microtel Pacific Research Limited, Telecom Decision CRTC 79-17, 18 September 1979, the Commission assessed the proposed acquisition by the related parties. Guèvremont stated that the Commission refused to recognize the purchase price for regulatory purposes, not because the transaction was negotiated on a non-arm’s length basis or that the price paid exceeded historical costs, but rather that there was no reliable data to establish the true value of GTE Automatic Electric (Canada) Ltd.

In support of the fair market value incurred for Bon-Conseil’s shares, Guèvremont submitted that the fair market value of Bon-Conseil’s fixed assets had been previously established through a similar offer submitted by Télébec and a similar offer submitted by Sogetel inc. (Sogetel). Guèvremont noted that an offer by Télébec in 1984 to purchase Bon-Conseil’s assets for $4 million (with a corresponding asset write-up of about $1.3 million) was supported by an independent technical and economic study conducted by Bell to determine the reasonableness of the price sought by the principal shareholder, Mr. Jean-Marie Guèvremont, for the sale of Bon-Conseil’s assets.

In addition, Guèvremont stated that, given the fair market value of the transaction was not disputed by Bell, the non-arm’s length issue was moot.

Bell confirmed that, based on the offers from Télébec and Sogetel to purchase Bon-Conseil, it did not dispute the fair market value of the transaction which led to the merger of Bon-Conseil and Le Téléphone Guèvremont Inc. However, Bell submitted that the purchase of Bon-Conseil by Le Téléphone Guèvremont Inc. was a non-arm’s length transaction as the two brothers that owned the two predecessor companies are the same ones that now own the merged company and therefore the asset write-up should not be allowed for regulatory purposes.

The purpose of assessing whether the transaction was concluded on an arm’s length basis is to ensure that the value attributed to the assets was not artificially inflated and that the objectives of the transaction itself were not distorted.

Based on the previous offers by Télébec and Sogetel to purchase Bon-Conseil and on Bell’s submission that it did not dispute the fair market value, the Commission notes that the transaction value is not a contentious issue in this proceeding.

However, the Commission notes that the overall objectives of the related parties’ transaction raise concerns, as there was minimal new capital funding. Further, a similar offer by Sogetel to purchase the shares of Bon-Conseil had been earlier denied by the Régie whereby the regulator noted the possible impact on rates of allowing the proposed asset write-up for regulatory purposes.

Guèvremont submitted that productivity gains and efficiency improvements have been realized as a result of the merger, including the modernization of the networks, centralization of accounting and informatics activities, consolidation of equipment and more efficient use of the work force.

To support its position, Guèvremont filed an analysis of the net operating expense (excluding depreciation other than depreciation associated with the asset write-up and interest expenses) reductions for the years 1985 to 1987. Based on this analysis, Guèvremont indicated that total net savings of $237,323 in constant 1984 dollars, or $51,756 in actual dollars, were realized as a result of the merger in the form of reduced operating expenses for the years 1985, 1986 and 1987. Guèvremont argued that these savings reduced the impact of rate increases for subscribers and provided a direct advantage for Bell, as each dollar saved by Guèvremont increased its net income, thereby reducing the settlement owed by Bell.

Guèvremont also submitted that, as a result of the merger, the company’s operating expenses per network access service (NAS) decreased by more than 10% in 1985 and remained below its 1984 level in 1986. The company also provided a comparison of operating expenditures per NAS, over the period 1984 to 1989, for Guèvremont and other telephone companies with comparable NAS growth rates, particularly Téléphone Milot inc. (Milot) and La Compagnie de Téléphone de Warwick (Warwick). Guèvremont noted that its operating expenditures had increased at a slower rate than operating expenditures for Warwick and Milot. Based on this comparison, Guèvremont concluded that its level of efficiency was superior to that of Warwick and Milot.

Bell stated that, in justifying cost savings, Guèvremont excluded the expenses associated with depreciation and interest from its operating expense analysis. Bell recalculated Guèvremont’s cost savings and estimated the reduction of operating expenses. Bell found that comparing total expenses (including all depreciation and interest expenses) from 1984 to total expenses in 1985, resulted in cost savings of only $17,081 in the first year following the amalgamation as opposed to Guèvremont’s estimation of $55,547. In addition, Bell submitted that, over the eleven-year period (1984-1994), Guèvremont’s operating expenses had increased by 72%, which is comparable to an average increase of 73.6% for other Quebec independent telephone companies.

Bell further submitted that including the asset write-up of $1.3 million in Guèvremont’s rate base would not only increase the yearly depreciation expense, but would also increase the revenue requirement due to the impact of the class G preferred shares used to finance this transaction. Bell stated that these preferred shares earn a dividend of 13.55% before tax each year. Bell noted that, in addition, dividends have been paid in the form of stock dividends which require dividend payments on top of the dividends, year over year.

In reply, Guèvremont questioned the relevance of Bell’s submission comparing operating expenses for Guèvremont to those of all other Quebec independents which may have NAS levels that are different from Guèvremont. In addition, Guèvremont submitted that it is unfair to include in this comparison all the depreciation and interest charges as the company undertook, as early as 1986, substantial investment in its network through bank loans which resulted in a large increase in depreciation and interest charges.

Guèvremont disagreed with Bell’s calculation of the company’s operating expenses and provided further analysis of its operating expenses trend. Based on Bell’s calculations over the period of 1984 to 1994, Guèvremont amended the calculated yearly reduction in operating expenses to reflect the following downward operating expenses adjustments: (1) lower depreciation expenses and interest charges relating to its modernization program; (2) elimination of the professional and legal costs relating to the dispute with the Régie and Bell; and (3) a deduction for the additional interest expense due to Bell’s non-payment of compensation. With these adjustments, Guèvremont concluded that over the eleven-year period its operating expenses calculated in actual dollars grew by 11% (corresponding to a 21% decrease calculated in 1984 constant dollars) as opposed to the 72% increase stated by Bell. In addition, in comparing its expenses with other independent telephone companies, Guèvremont argued that only Milot and Warwick could be used for benchmarking as these two companies had NAS levels comparable to Guèvremont. On this basis, Guèvremont concluded that the growth in its operating expenses, adjusted for (2) and (3) above, over the eleven-year period, was 29% calculated in actual dollars which was still much lower than the growth rate experienced by Milot and Warwick of 108% and 88%, respectively.

The purpose of assessing whether there are productivity gains, efficiency improvements and reduction of operating expenses, from the merger, is to ensure that subscribers do not incur the additional costs arising from recording the assets above their historical cost.

The assessment of any revenue requirement impact is based on an actual, not constant, dollar basis. Therefore, in determining the net benefits to subscribers of the merger, the Commission finds that Guèvremont’s analysis of its operating expenses in 1984 constant dollars is not appropriate.

Further, the Commission considers that, as Guèvremont did not undertake any detailed studies to isolate and quantify productivity gains and efficiency improvements relating directly to the merger, Guèvremont’s suggestion that changes to its operating expenses over the years 1985 to 1987 resulted solely from the merger is unfounded. Moreover, even if Guèvremont’s approach were used, extending its expense reduction analysis beyond 1987 would demonstrate additional costs, as the reductions in operating expenses would not offset the additional depreciation expenses related to the asset write-up during those years.

In addition, the Commission notes that, in its approach to quantify the net benefits over the years 1985 to 1987, Guèvremont excluded the cost associated with funding the asset write-up through preferred shares. After incorporating the cost of funding associated with the asset write-up into Guèvremont’s methodology of estimating the net benefits, the Commission considers that there would have been net costs to subscribers for the three years following the merger. Furthermore, starting in 1988, the financing expenses related to the asset write-up would have increased since the company declared common stock dividends on the shares used to fund the transaction.

Considering the size of Guèvremont’s asset base relative to the magnitude of the asset write-up, the Commission is of the view that it is highly improbable that Guèvremont could have achieved productivity gains or efficiency improvements sufficient to cover the additional costs associated with the asset write-up over the life of the assets.

The Commission concludes that Guèvremont’s assessment of the benefits and costs associated with the asset write-up is incomplete and that the company has not demonstrated that any reduction in operating expenses due to the merger would outweigh the additional costs to Guèvremont’s subscribers through rate increases or increases in Bell’s revenue settlement payments.

Guèvremont submitted that there were tangible benefits that accrued to subscribers as a result of the productivity gains and efficiency improvements due to the merger, which included customer service improvements, lower rates than otherwise if Bon-Conseil had been purchased by Télébec, integration of discount and bonus plans offered by Bell and the offering of the new services.

Bell submitted that, while the Régie approved the merger for the expected benefits that would accrue to subscribers, it denied in Decision R.S.P. 84-050-A the inclusion of the asset write-up for regulatory purposes. Bell further noted that this denial was confirmed years later in Decision RT 88-045-C/90-006-C.

The purpose of the tangible benefits criterion is to evaluate whether there has been any net productivity gains and efficiency improvements, as elaborated in the previous Section, or any other result from the transaction that have been beneficial to subscribers.

In approving the merger in Decision R.S.P. 84-050-A, the Régie expected that benefits from the transaction would accrue to subscribers. The Commission notes that some benefits may have accrued to subscribers from the merger but finds, as discussed in the previous Section, that any expense reductions resulting from the merger do not outweigh the additional expenses from including the asset write-up in the rate base. In addition, as stated in Part III, Section B, any funding of the asset write-up by subsidy flows from outside the company would be unfair and inappropriate.

The Commission notes that, prior to amalgamation, both Bon-Conseil and Le Téléphone Guèvremont Inc. were subject to earnings regulation using historical cost and it was on that basis that the Régie established whether each company’s rates were just and reasonable. This situation is different from the circumstances with respect to the asset write-up relating to Teleglobe Canada Inc. (Teleglobe), as discussed below in Part III, Section A, whereby prior to privatization Teleglobe was not subject to the statutory requirement that rates be just and reasonable.

Guèvremont submitted that there are unique circumstances which warrant special consideration in assessing the public interest. In that regard, the company noted that, prior to the amalgamation, both Le Téléphone Guèvremont Inc. and Bon-Conseil required extensive modernization of their networks. Guèvremont stated, however, that since both companies had high debt ratios and weak liquidity, the individual companies could not foresee obtaining financing from the banks to modernize their respective networks. With the merger and the revaluation of Bon-Conseil’s assets at market value, Guèvremont stated that the new company was able to improve its capital structure and obtain the necessary financing to modernize the network. The company further stated that the purchase of Bon-Conseil by Le Téléphone Guèvremont inc. through the transfer of preferred shares of the merged company, payable at a later date, permitted the acquisition without affecting Guèvremont’s liquidity.

Guèvremont argued that the company would not have proceeded with the transaction without expecting to recover its investment, receive a return on Bon-Conseil’s fair market value and concurrently improve its debt ratio.

Bell noted that, should the Commission approve Guèvremont’s application, other independent telephone companies in similar situations may also wish to increase their asset base artificially, for regulatory purposes, to Bell’s detriment.