American Telephone & Telegraph Co. v. Federal Communications Commission

836 F.2d 1386, 267 U.S. App. D.C. 38, 64 Rad. Reg. 2d (P & F) 558, 1988 U.S. App. LEXIS 619

• Court: Court of Appeals for the D.C. Circuit
• Decided: January 22, 1988
• Docket: Nos. 85-1778, 85-1805, 85-1807, 86-1216, 86-1234, 86-1255, 86-1322 to 86-1324 and 87-1025
• Status: Published

Opinions

PER CURIAM:

Petitioners, numerous telephone companies and other carriers of telecommunications service, challenge the adoption of a rule by the Federal Communications Commission (the “Commission”) that requires the carriers to refund earnings they receive in excess of the expected rate of return on capital factored into their rates. Petitioners claim that the refund rule is arbitrary and capricious, exceeds the Commission’s statutory authority, and is an unconstitutional confiscation of their property. We agree that the refund rule is arbitrary and capricious and grant the petitions for review.

I.

Under the Communications Act of 1934, ch. 652, 48 Stat. 1064 (codified as amended at 47 U.S.C. §§ 151-611 (1982 & Supp. Ill 1985)) (the “Act”), the Commission regulates the rates a carrier may charge for interstate telecommunications service. 47 U.S.C. §§ 201-205 (1982). As part of that task, the Commission sets the rate of return on capital that the carrier may use in setting its rates. See, e.g., Nader v. FCC, 520 F.2d 182, 191-92 (D.C.Cir.1975); AT & T, 86 F.C.C.2d 221, 223 (1981). The carrier then calculates its rates so that projected revenues will cover projected operating expenses plus the authorized return on capital. If the projections that underlie this calculation thereafter prove correct — such as estimates of labor and tax expenses, and the level of customer demand — then the carrier’s net revenues will match precisely the carrier’s authorized return. Obviously, this will virtually never occur, although the gap between the actual return and the projected retum may more often than not be relatively small.

The Commission’s refund rule was announced in Authorized Rates of Return for Interstate Services of AT & T Communications and Exchange Telephone Carriers, 50 Fed.Reg. 41,350 (1985), reconsideration denied, FCC No. 86-114 (Mar. 24, 1986), further reconsideration denied, FCC No. 86-544 (Jan. 14, 1987). The refund rule extends the use of the rate of return beyond its role in prospectively determining a carrier’s rates. Specifically, the Commission would require a carrier to refund all revenues it ultimately collects that exceed the target rate of return by more than a specified amount.

Under the refund rule, the Commission will set a target rate of return, and will require carriers to file rates reflecting the target, for a subsequent two-year period. The Commission will review the filed rates to determine whether they are just and reasonable, and in particular whether the carrier has properly incorporated the target return the Commission has set. See 50 Fed.Reg. at 41,351. This process does not significantly differ from what the Commission and the carriers have done in the past. But the refund rule also requires each carrier to compare the revenue it actually received during the two-year period with the revenue that, all else being equal, achievement of the target return plus a “buffer” increment would have produced during that same period.¹ If the carrier received more revenue than the target with the buffer would have produced, it must refund the excess to its customers.² See id. at 41,354-55 & n. 30.

In addition, the Commission’s rule requires the carrier to apply this refund procedure not only to the revenue from its interstate operations taken as a whole, but also to the revenue from certain segments of the carrier’s operations. Each of the segments employs rates that, by Commission rule, incorporate the target return. An excess of revenues in any one of those segments triggers a refund; a revenue shortfall below the target return in one segment may not offset an excess in another segment. See 50 Fed.Reg. at 41,352-53.³

The Commission, in two opinions on reconsideration of the refund rule, modified the rule in various ways but rejected all challenges to the rule’s basic structure and operation. See Memorandum Opinion and Order, FCC No. 86-114 (Mar. 24, 1986) (order on reconsideration), summarized in 51 Fed.Reg. 11,033 (1986); Memorandum Opinion and Order, FCC No. 86-544 (Jan. 14, 1987) (order on further reconsideration). These petitions for review followed.

II.

Petitioners assert that the rule as a whole violates the Communications Act, the Constitution, and the Administrative Procedure Act’s prohibition of arbitrary and capricious agency action. See 47 U.S.C. § 402(g) (Supp. III 1985). They also challenge particular features and applications of the rule. We find one of these challenges dispositive. We agree that the Commission’s refund rule is arbitrary and capricious agency action under the Administrative Procedure Act. See 5 U.S.C. § 706(2)(A) (1982).

A.

Under the Communications Act, the Commission has the authority to prescribe rates for a carrier’s interstate telecommunications services. See 47 U.S.C. § 205(a) (1982). This court has held that the Commission also has the power to prescribe the rate of return to be incorporated into the carrier’s rates. Nader v. FCC, 520 F.2d at 203-04. The rate of return the Commission prescribes must be sufficient to cover the cost of capital the carrier must raise to do business. See United States v. FCC, 707 F.2d 610, 612 (D.C.Cir.1983). The rate of return accordingly embodies the Commission’s best estimate, in light of the evidence available to it, of the earnings needed to retain the carrier's capital investors and to attract additional required investment. See id.

Counsel for the Commission stated at oral argument that the rate of return the Commission prescribes “is the minimum that it can prescribe.” Transcript of Oral Argument (“Tr.”) at 29. This is consistent with the Commission’s past pronouncements and the way this court has understood those pronouncements. See United States v. FCC, 707 F.2d 610, 612 & n. 4 (D.C.Cir.1983); Nader, 520 F.2d at 202, 204; AT & T, 86 F.C.C.2d at 223; AT & T, 57 F.C.C.2d 960, 960-61 (1976); AT & T, 38 F.C.C.2d 213, 226, 240-41, 245 (1972); AT & T, 9 F.C.C.2d 30, 52 (1967). Since the determination of a carrier’s allowed rate of return requires a balance of investor and consumer interests, see AT & T, 86 F.C.C. 2d at 223; AT & T, 9 F.C.C.2d at 52; see generally FPC v. Hope Natural Gas Co., 320 U.S. 591, 603, 64 S.Ct. 281, 288, 88 L.Ed. 333 (1944), the rate of return, as a balance point, represents “at the same time a minimum and a maximum” allowable return. Tr. at 29. If the rate were higher, the balance would tip in favor of the investor; if lower, it would tip in favor of the consumer. According to the Commission, therefore, its selected rate of return is the proper balance between these interests and hence the minimum return the carrier requires. See United States v. FCC, 707 F.2d at 612 & n. 4; Nader, 520 F.2d at 204; AT & T, 9 F.C.C.2d at 52.

It is true of course that a reviewing court may not overturn the Commission's selected rate of return so long as it lies within a “zone of reasonableness.” Jersey Central Power & Light Co. v. FERC, 810 F.2d 1168, 1177 (D.C.Cir.1987) (en banc), quoting Washington Gas Light Co. v. Baker, 188 F.2d 11, 15 (D.C.Cir.1950). But it is the Commission’s understanding of its own task, and not our understanding of the court’s task, that is before us in this case. The Commission has indicated, at oral argument in this case and in the past, that it prescribes a carrier’s rate of return at what it considers to be the necessary minimum.

B.

We think the Commission’s refund rule cannot stand because it is inconsistent with the rate of return prescription it purports to enforce. See, e.g., City of Lawrence v. CAB, 343 F.2d 583, 588 (1st Cir.1965).

The refund rule requires the carrier to refund any earnings above the upper bound of target plus buffer, while the carrier may not recoup any shortfall in its earnings below the target. A carrier cannot be expected to receive earnings each year at precisely the prescribed rate of return, and from one two-year period to the next it must forfeit any excess in earnings while absorbing any deficiency. Thus, over the long run the carrier is virtually guaranteed to fall short of earning its required target rate of return on its combined operations for all such periods viewed together. The Commission itself acknowledged that the refund rule introduces a “systematic bias” that operates to depress carrier earnings below their target “over the long run.” 50 Fed.Reg. at 41,351.⁴ Indeed, since the Commission views the rate of return as a minimum, the refund rule under the Commission’s view would operate over the long run to put a carrier out of business. It should be stressed that this result does not reflect merely the business risk that a carrier is bound to accept under the accepted view that regulation does not guarantee the regulated company a profit. Rather, it is the Commission’s refund rule that seems to guarantee the regulated company an economic loss.

The peaks-and-valleys problem also exists, of course, not merely in the long run but for each two-year period for which the Commission sets a target rate of return. A carrier with profitable and unprofitable business segments may easily find that making refunds on the profitable segments means that it earns less than the required minimum rate of return on its overall operations. The carriers’ submissions to this court demonstrate that such an outcome is not at all unlikely. See Brief of Petitioner AT & T at 28 & n. 33; Reply Brief for the Named Petitioners and Intervenors at 11; Tr. at 22. Indeed, the Commission itself acknowledged that requiring refunds by business segment “may prevent a carrier from earning its overall authorized return” within a single two-year period. 50 Fed. Reg. at 41,353.⁵

Finally, we have seen that the Commission defines the target return it prescribes as a return that, if exceeded, would tilt the investor-consumer balance in the investors’ favor and result in unjust and unreasonable prices for consumers. See, e.g., AT & T, 86 F.C.C.2d at 223. And it is undisputed that carriers must set their rates by reference to the prescribed return. But in its promulgation of the refund rule, the Commission rejected a suggestion that it eliminate any buffer and simply require the refund of all carrier earnings that exceed the target by saying that earnings within the buffer but above the target need not be refunded because “a target return is in reality a point within a zone of reasonableness. Returns that slightly exceed such a target have never been and should not be deemed unjust.” 50 Fed.Reg. at 41,355. This statement contradicts the Commission’s later explicit statement at oral argument before this court, and the Commission’s prior statements, that the prescribed rate of return represents at once both the carrier’s minimum and maximum necessary return. For this reason alone, we are constrained to invalidate the refund rule.

It may be that the Commission considers the rate of return for rate-setting purposes as something different from the rate of return for refund purposes (a question on which we take no position). It has not attempted to provide any such understanding to this court. On remand, if the Commission wishes to promulgate a new refund rule, it must clearly and specifically explain what it understands the rate of return to be and how that understanding is consistent with a refund rule.

We are convinced, therefore, that the Commission's own understanding of its rate of return prescription and of its refund rule constitutes a self-contradiction. Since we find that the refund rule as a whole is unreasonable agency action, it is not necessary for us to consider petitioners’ other arguments.

III.

For the guidance of the parties in case the Commission chooses to reformulate the refund rule, we offer comments on two of the issues raised by petitioners.

First, regarding petitioners’ constitutional argument that the refund mechanism is an unconstitutional taking of their property, the Commission should explain how an operation of the mechanism on business segments that would result in pushing the carriers’ total return below a reasonable level would be consistent with the constitutional doctrine that an agency rate order “viewed in its entirety” must produce a just and reasonable “total effect” on the regulated business. FPC v. Hope Natural Gas Co., 320 U.S. 591, 602, 64 S.Ct. 281, 287, 88 L.Ed. 333 (1944). Investors in a carrier, after all, must invest in the carrier as a whole, and not just in one or another of its business segments.

Second, we observe that a panel of this court has decided in New England Telephone & Telegraph Co. v. FCC, 826 F.2d 1101 (D.C.Cir.1987), that the Commission has statutory authority to employ a refund mechanism in conjunction with rate of return regulation.⁶ In New England Telephone, the Commission had attempted in an individual case to exercise the very authority to impose refunds that it now seeks to assert generically. The Commission had ordered a rate refund of one hundred million dollars to reimburse consumers for 1978 earnings by the AT & T system in excess of the then-outstanding rate-of-re-tum prescription. We determined that the Commission’s order was a valid exercise of its ratemaking authority under the Communications Act. Specifically, we reiterated our holding in Nader v. FCC, 520 F.2d 182 (D.C.Cir.1975), that the Commission has power under section 205 of the Act to prescribe rates of return as well as rates. We then determined that the Commission's refund order was a reasonably necessary enforcement mechanism for its rate-of-retum prescription and therefore was authorized under section 4(i) of the Act, which permits the Commission to “perform any and all acts, make such rules and regulations, and issue such orders, not inconsistent with this [Act], as may be necessary in the execution of its functions.” 47 U.S.C. § 154(i) (1982).

New England Telephone clearly defeats the claim that a refund scheme in conjunction with rate-of-retum regulation is necessarily incompatible with the regulatory scheme embodied in the Communications Act. A prescription of a rate of return was described in New England Telephone as representing a proclamation by the Commission that earnings in excess of the prescribed rate are unlawful and shall not occur. See New England Telephone, 826 F.2d at 1106. The Commission’s refund scheme was viewed therefore as simply forcing carriers to disgorge earnings they never had a right to collect. Although the enforcement mechanism that the Commission chose may not have been the only conceivable one, it was found to be within the range of reasonable remedies that the Commission may employ in its discretion under section 4(i). Id. at 1107-08. It should be noted, however, that the particular refund scheme at issue in New England Telephone was found by this court to provide “ample protection for the carriers’ interests,” and we went on to say, “[s]hould this state of affairs not hold in the future, the Commission and the courts can address the situation at that time.” Id. at 1109.

Thus, as we previously have concluded, the Commission has authority under the Act to order refunds where a carrier has violated an outstanding rate-of-retum prescription. That authority must, however, be exercised in a way that does not contradict the Commission’s own theory of rate of return regulation. See supra pp. 1389-1392. An obvious example of a scheme that would be consistent with the Commission’s view of the rate of return prescription as a minimum, is one in which the carrier, in addition to being required to return amounts that exceeded the target return, would be permitted to recover amounts by which it fell short of the target. We are confident that the Commission can imagine other schemes that would not tend to prevent carriers from earning the return needed to enable them to attract necessary capital. It is of course the Commission, not this court, that is empowered to exercise its judgment in choosing a course of action. We do not mean to suggest that any one valid course of action is preferable to any other. If the Commission’s choice is to survive judicial scrutiny, however, it must conform to the Commission’s understanding of its task. If the Commission wishes to reformulate that understanding, then to the extent that it is “changing its course[, it] must supply a reasoned analysis indicating that prior policies and standards are being deliberately changed, not casually ignored....” Greater Boston Television Corp. v. FCC, 444 F.2d 841, 852 (D.C.Cir.1970), cert. denied, 403 U.S. 923, 91 S.Ct. 2229, 29 L.Ed.2d 701 (1971).

We grant the petitions for review and remand the case to the Commission so that it may fashion, if it wishes, a refund mechanism that does not contradict the Commission's understanding of its rate of return prescription.

It is so ordered.

1 . The Commission also indicated that each carrier may during the two-year period file tariffs that change the carriers’ rates to narrow any anticipated gap between actual and targeted revenues at the end of the period. See 50 Fed.Reg. at 41,353 & n. 21. But see infra note 6.

2 . The Commission determined that the buffer increment above the target would be 50 basis points (.50%) for AT & T. 50 Fed.Reg. at 41,-351. For the local exchange companies, the increment is 25 basis points (.25%) for the target return covering all operations, and 40 basis points (.40%) for a segment of operations’ target return. Id. at 41,353. While the Commission indicated that it would review these increments periodically, their review would not coincide with the biennial revision of the rate of return. Id. at 41,351.

3 .For this purpose, AT & Ts interstate business is divided into two segments, switched services and private line services. The Commission derives the allocation of rates and earnings for the divisions from the Commission’s Interim Cost Allocation Manual, which the Commission also employs to allocate AT & Ts costs and target its rate levels prospectively. See 50 Fed.Reg. at 41,350-52. Pertinent business of the local exchange carriers is divided into three categories —common line, special access, and switched traffic sensitive. See Reconsideration Order, slip op. at 19, FCC No. 86-114 (Mar. 24, 1986).

4 . This comment occurs in the Commission’s discussion of the “buffer" increment. The Commission seems to have thought that the buffer disposed of this problem, but it does not. The carriers' submissions indicate that in recent years they have consistently deviated from the authorized return by far more than the buffer amount. See, e.g.. Joint Appendix at 136-37. But the carriers do admit, as they must, that if the buffer were large enough for a “careful carrier ... invariably [to] meet the target, this would be a different case." Tr. at 19.

5 . The Commission also stated that the impact of the refund rule on the carriers would be blunted by each carrier's ability to adjust its rates during the two-year period if it believes that its earnings will miss the target. See 50 Fed.Reg. at 41,353. But the Commission has refused to say whether it will accept corrective rate filings that incorporate a return higher than the target, see Brief of Respondent at 33 n. 45, which is the filing that a carrier whose earnings fell short of the target during the first year of the period would have to make. Even apart from the practical barriers to making corrective adjustments, see Tr. at 18-19, we will not rely on the ability to adjust when the Commission itself refuses to say whether it would permit all the adjustments that carriers would need to make.

6 . The opinion in New England Telephone issued after oral argument in this case, and a suggestion for rehearing New England Telephone en banc is currently pending before this court.