CHAPTER XXXII PROPER BASIS OF CAPITALIZATION § 1080. Various theories as to proper capitalization. Topic A. The Original Cost as the Common-law Basis § 1081. Actual investment entitled to return. 1082. Argument for the rule of total investment. 1083. What is the actual cost. 1084. Cost enhanced by fraudulent contract. 1085. Plant built unnecessarily large. 1086. Plant adapted for a larger population. 1087. Construction now thought unwise. 1088. Proportion of plant not now utilized. 1089. Equipment long since superseded. 1090. Capital sunk in past operations. Topic B. Outstanding Capitalization 1091. Normal capitalization outstanding unconclusive. 1092. The problem of watered stock. 1093. Abandonment of par values. 1094. Bonded indebtedness beyond actual value. 1095. Stock issues based upon surplus earnings. 1096. Securities issued upon reorganization. 1097. State scrutiny of the issue of securities. 1098. Existing capitalization hardly excessive. Topic C. Present Value as the Constitutional Basis 1099. Protection of present values. 1100. Original cost as affecting present value. 1101. Value as a going concern. 1102. Whether return allowed on such value. 1103. Franchise value upon purchase. 1104. Franchise values not considered in rate regulation. 1105. Values returned for taxation inconclusive. 1106. Tax valuation does not estop the State. Topic D. Cost of Reproduction as the Basis § 1107. The Minnesota rule. 1108. The Federal courts opposed. 1109. Explanation of the California decisions. 1110. Factors disregarded by the reproduction rule. 1111. Abandonment of the investment test impolitic. 1112. Two principles still persist. § 1080. Various theories as to proper capitalization. In order to decide upon what principles the amount of capital devoted to a public service and therefore entitled to a return is to be estimated it is important to examine the various theories which have been brought forward for determining what amount is proper. There is as yet no real agreement among the authorities which have dealt with this problem; but it is desirable that some theory should be found with a sufficient preponderance to be taken as a working basis in a given situation. For without a basal theory as to proper capitalization, rate regulation is virtually impossible; since unless this is determined it cannot be told whether the receipts from any given business are excessive or not. Many theories as to proper capitalization have been advanced at different times, and, indeed, each of them still has some advocates at the present time. But, various as these are, they may be reduced to four. Thus (1) the outstanding capitalization is by a few still regarded as sacred; while at the other extreme are those who refer everything to what might be shown to be (2) the bare cost of substantial reproduction at the present moment. But to most persons both of these standards seem essentially unfair, either to the company concerned or to the public served. And the real controversy it is submitted is between the two remaining theories, (3) the original cost of the property in question to its owners, or (4) the fair value of the property at the present time. It will be seen that, although these amounts may sometimes nearly approximate each other, there is such an inherent difference between these cases that one or the other must ultimately be adopted in a particular case. Topic A. The Original Cost as the Common-Law Basis § 1081. Actual investment entitled to return. The doctrine that the company would be entitled to a fair return on the money actually invested, whether originally or during the operation of the company, is expressed in some cases. This view is substantially held by the Supreme Court of Pennsylvania in Brymer v. Butler Water Company1 where Mr. Justice Williams summed up the law relating to this matter thus: "The cost of the water to the company includes a fair return to the persons who furnished the capital for the construction of the plant, in addition to an allowance annually of a sum sufficient to keep the plant in good repair and to pay any fixed charges and operating expenses. A rate of water rents that enables the company to realize no more than this is reasonable and just.” 2 §1082. Argument for the rule of total investment. It is submitted that this rule that a return may be 1179 Pa. St. 231, 36 Atl. 249, 36 L. R. A. 260 (1897). In several jurisdictions the amount actually invested in good faith is given almost controlling weight. United States.-Milwaukee El. Ry. Co. v. Milwaukee, 87 Fed. 577 (1898). California. San Diego Water Co. v. San Diego, 118 Cal. 556, 50 Pac. 633, 62 Am. St. Rep. 261 (1897). Pennsylvania.-Pennsylvania R. R. Co. v. Philadelphia County, 220 Pa. St. 100, 68 Atl. 676, 15 L. R. A. N. S. 108 (1908). West Virginia.-Coal & Coke Ry. Co. v. Conley (W. Va.) 67 But as in most cases the rule of present value is now favored, it is pointed out that original cost can only be important data in estimating what is the present value. This point is made most strongly in: United States.-Seaboard Air L. Ry. Co. v. Florida, 203 U. S. 261, 51 L. ed. 175, 27 Sup. Ct. 109 (1906). Minnesota.-State 1 based upon the total investment sunk in the construction of the plant from first to last, with certain limitations, may be adopted not improperly by a public service company in making up its own schedule of rates. The advantages of this rule, and the disadvantages of any other, are well dealt with in the Pennsylvania cases 1 brought under the peculiar statute which gives the court power to say whether the rates fixed by the water company in its schedule are unreasonable or not. In one of the fullest of these cases, the court found that allowing only one per cent for depreciation, the net income available for dividends was five per cent upon the total cost of construction of the water works. The Justice before whom the case was brought, held the schedule reasonable; he said, in part: "The primary basis of any calculator as to the value of a water plant must be the money actually invested by the owners. If the earnings of the company have been used to improve the property, it is counted as so much more cash invested. In a case in another State, the market value of the plant was suggested as the proper basis of calculation. This is open to two objections. The plant, for many reasons, may have depreciated in value and the consumers of water may have decreased in their number, thus working an injustice to the owners, or the plant, owing to favorable natural conditions and the rapid growth of the territory supplied, may have greatly enhanced in value, thus increasing the rates beyond reason and equity." 1 Wilkes-Barre v. Spring Brook Water Co., 4 Lack. (Pa.) Leg. News, 367 (1899). This is based upon Brymer v. Butler Water Co., 179 Pa. St. 231, 36 Atl. 249, 36 L. R. A. 260 (1897), cited in the last paragraph. 2 See further the still more ex treme case of Metropolitan Trust Co. v. Houston & T. C. R. R. Co., 90 Fed. 683 (1898); and the almost equally extreme case of Pennsylvania R. R. Co. v. Philadelphia County, 220 Pa. St. 100, 68 Atl. 676, 15 L. R. A. (N. S.) 108 (1908). §1083. What is the actual cost. The question of what constitutes the actual cost of the plant was raised and much discussed in the case of the Town of Falmouth v. Falmouth Water Company.1 A statute gave the plaintiff town a right to take the corporate property of the defendant company on payment of the actual cost with interest. The town exercised the right, and this suit was brought to determine the actual cost. The court held in the litigation which followed that the actual cost mentioned in the statute was the actual cost of the plant to the water company; and this cost they held to be the amount actually paid to the contractor by the water company, although the contractor had done the work under a rather peculiar contract which yielded him a somewhat unusual profit. Mr. Justice Loring said in part: "It is argued by the town that this result amounts to substituting market value for actual cost, and actual cost excludes everything in the nature of a profit. It is true that actual cost excludes everything in the nature of a profit; but what is actual cost to the company includes a profit to the contractor, just as what is actual cost to the contractor includes a profit to the merchants of whom he buys his material." 2 § 1084. Cost enhanced by fraudulent contract. It should be clear, however, that if the contract under which the works are constructed is collusively made, the company cannot later rely upon the contract price as the true measure of actual cost. For instance, it has not been uncommon, in the past at least, for the promoters of a public service company to organize a construction group, which was thereafter paid extravagant prices. If such were shown to be the facts, a court to-day would have no 1180 Mass. 325, 62 N. E. 255 ter Water Co. v. Gloucester, 179 (1902). Mass. 365, 60 N. E. 977 (1901). See to the same effect: Glouces |