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ALLEGHENY ENERGY v. DQE

December 3, 1999

ALLEGHENY ENERGY, INC., PLAINTIFF,
v.
DQE, INC., DEFENDANT.



The opinion of the court was delivered by: Cindrich, District Judge.

  TABLE OF CONTENTS
   I. Findings of Fact ....................................................... 485
      A. The Parties ......................................................... 485
      B. Jurisdiction and Venue .............................................. 485
      C. Deregulation of Electric Utilities in Pennsylvania .................. 485
      D. Background of the Merger ............................................ 487
      E. The Merger Agreement ................................................ 488
         1) Representations and Warranties ................................... 489
            a) Parties' Understanding of MAE Proviso ......................... 491
         2) Conditions to Consummation of the Merger ......................... 491
         3) Right of Termination ............................................. 492
      F. The Restructuring Proceedings ....................................... 492
         1) Background ....................................................... 492
         2) The PECO Decision ................................................ 493
         3) The January 12, 1998 Noia and Marshall Meeting ................... 495
         4) Allegheny's Reaction to DQE's Urging to Sale ..................... 496
         5) West Penn's and Duquesne's Restructuring Proceedings ............. 497
            a) Results of Duguesne's Restructuring Proceedings ............... 497
            b) Results of West Penn's Restructuring Proceeding ............... 497
      G. Allegheny and DQE Record The Results Of The Restructuring Orders .... 500
      H. The Effect Of The Restructuring Orders .............................. 502
      I. Results Of The Merger Filing ........................................ 503
      J. DQE Terminates The Merger Agreement ................................. 505
      K. Allegheny's Settlement With The PUC ................................. 510
      L. DQE's Asset Swap And Auction ........................................ 511
  II. Conclusions of Law ..................................................... 512
      A. Principles Of Contract Construction ................................. 512
      B. DQE's Termination Under Section 8.2(a) .............................. 513
         1) Measurement Of A Material Adverse Effect (MAE) Arising From
             Application Of Restructuring Legislation ........................ 513
         2) Definition Of "Materially Adverse Effect" ........................ 517
         3) Application Of MAE Provision ..................................... 518
         4) As Of October 5, 1998 ............................................ 518
      C. Availability Of Section 8.2(a) To DQE ............................... 520
  FINDINGS OF FACT AND CONCLUSIONS OF LAW

This case involves DQE, Inc.'s termination on October 5, 1998 of a merger agreement with Allegheny Energy, Inc. That same day, Allegheny filed the instant complaint seeking specific performance of the merger agreement arguing that DQE had breached the agreement. Beginning on October 20, 1999, the parties presented extensive testimony and other evidence during a six day bench trial, after which the parties submitted proposed findings of fact and conclusions of law. The case has been extensively and expertly briefed and argued. Based on the evidence, arguments, and authorities presented, the court makes the following findings of fact and conclusions of law pursuant to Federal Rule of Civil Procedure 52.

I. Findings of Fact

A. The Parties

1. This case involves the October 5, 1998 decision of DQE, Inc. ("DQE") to terminate a merger agreement with Allegheny Energy, Inc. ("Allegheny") that was announced on April 7, 1997 and approved by both DQE's and Allegheny's shareholders on August 7, 1997.

2. Allegheny is a Maryland corporation and a registered public utility holding company under the Public Utility Holding Company Act of 1935, 15 U.S.C. § 79 et seq. ("PUHCA"). Allegheny derives substantially all of its income from the electric utility operations of its subsidiaries Monongahela Power Company, The Potomac Edison Company, and West Penn Power Company ("West Penn"), which are engaged principally in the generation, transmission, distribution and sale of electric energy in Pennsylvania, West Virginia, Maryland, Virginia, and Ohio. West Penn, the Pennsylvania subsidiary, constitutes approximately 45% of Allegheny's total assets and revenues.

3. DQE, a Pennsylvania corporation, is an energy services holding company that owns various regulated and unregulated subsidiaries. DQE's regulated electric utility subsidiary, Duquesne Light Company ("Duquesne"), provides electric service to customers in southwestern Pennsylvania, including, principally, the City of Pittsburgh. Duquesne constitutes approximately 90% of DQE's assets and revenues.

4. Both Allegheny and DQE are publicly held companies. The shares of both companies are registered pursuant to Section 12 of the Securities Exchange Act of 1934 and are listed and traded on the New York Stock Exchange. (Direct Testimony of Dr. Gregg A. Jarrell ("Jarrell Direct"), at 10*fn1; Exhs. D98, D101)*fn2.

B. Jurisdiction and Venue

5. This Court has jurisdiction over this action pursuant to 28 U.S.C. § 1332. Venue is proper in this Court pursuant to 28 U.S.C. § 1391(a) and (c). (PTO ¶ 3).

C. Deregulation of Electric Utilities in Pennsylvania

7. The Restructuring Legislation gives each customer the right, over a phase-in period beginning January 1, 1999, to purchase electricity from any qualified supplier. 66 Pa. Cons.Stat. §§ 2802, 2806. Formerly, each Pennsylvania retail customer could purchase electricity solely from the utility that had been granted an exclusive franchise over the customer's service territory. But with the passage of the Restructuring Legislation, customers are now permitted to choose their own suppliers, a development that represents a major change for electric utilities, which for the first time will be required to sell the electricity they generate in a competitive market, with no guaranteed customers or revenue base and no assurance that market prices will be sufficient to cover the cost of generating electricity or to produce a profit. (Direct Testimony of David D. Marshall ("Marshall Direct"), at 4).

8. Under the Restructuring Legislation, two-thirds of Pennsylvania retail electricity customers are currently eligible to choose their supplier of electricity, or "shop," with the remainder becoming eligible on January 1, 2000. Although shopping has been permitted only since January 1, 1999, by October 1, 1999 over 14 percent of Allegheny's and over 20 percent of DQE's customer load had switched to new suppliers. (Exh. D218).

9. The Restructuring Legislation requires customers to continue to pay to their franchised utility a delivery charge that reflects the cost of transmission and delivery of power over the utility's existing power lines, plus a separate charge reflecting the price that each customer agrees to pay to the electricity supplier of its choice. (PTO ¶ 12).

10. Prior to the implementation of the Restructuring Legislation, the Pennsylvania Public Utility Commission ("PUC") traditionally prescribed the rates that utilities such as West Penn and Duquesne may charge for all of their services — generation, transmission and distribution. In order to ensure that rates were both stable and as low as possible, the PUC required utilities to defer recovery of certain obligations and investments, including investments in generation assets, in return for the assurance — or the so-called "regulatory compact" — that they would have an opportunity to recover such costs under regulation in the future. (Morrell Direct at ¶ 6.)

11. Because of the requirements imposed by the pervasive regulatory system, expenditures and investments (including investments in generation facilities) that were made and approved under the regulatory regime may not be recoverable in a competitive market. To the extent that recovery of these investments will be impeded or prevented by the advent of competition, some or all of these costs would become "stranded." (Morrell Direct at ¶ 7.)

12. The Restructuring Legislation requires customers to pay to their franchised utility during the period from January 1, 1999 through December 31, 2005 (the "Transition Period"), unless extended by the PUC, a competitive transition charge ("CTC") that provides for the recovery of the utility's stranded costs.

13. More specifically, the Restructuring Legislation directed the PUC to determine the level of transition or stranded costs and required each utility in Pennsylvania to file a "restructuring" application with the PUC. Thereafter, the PUC would hold a public proceeding to establish each utility's stranded costs and issue a restructuring order awarding such costs. The amount of stranded costs awarded is to be collected by each utility through the CTC which is paid by the utility's transmission and distribution customers during the Transition Period.

14. Thus, the CTC represents a stream of guaranteed future revenue that electric utilities are entitled to recover during the Transition Period regardless of whether future market prices of electricity go up or down (Marshall Direct, at 35). Accordingly, the restructuring proceedings were a matter of vital importance to electric utilities in Pennsylvania as the amount of CTC awarded by the PUC could substantially affect revenues and income during the Transition Period.

15. In sum, rates have changed under the Restructuring Legislation from a single "bundled" rate for combined services to "unbundled" rates consisting of three major components: (i) a charge for "generation services" — that is, electric power supply; (ii) a charge for "delivery services" — that is, transmission and distribution services; and (iii) the CTC.

16. However, the incumbent local utility is permitted to continue to charge the bundled rate to any customer that remains on its system. By comparison, customers who shop for electricity from alternative suppliers receive a credit — the "shopping credit" — equal to the generation component of their bundled rate, while paying the CTC and delivery charges to the incumbent local utility and a market rate for generation to a third party. Thus, only customers who shop receive a market price for generation. (Morrell Direct at ¶ 10.)

D. Background of the Merger

17. Beginning in October 1996, senior representatives of Allegheny and DQE began discussing the possibility of pursuing a merger. (Noia Direct at ¶ 25.)

18. At the time, the electric utility industry was undergoing a wave of consolidation as the industry was, throughout the nation, moving away from traditional regulation towards a more competitive environment. (Marshall Direct, at 3; Direct Testimony of John W. Barr ("Barr Direct"), at 8).

19. In these early conversations, Allegheny's Chairman and Chief Executive Officer, Alan J. Noia ("Noia"), expressed to DQE's Chief Executive Officer, David D. Marshall ("Marshall"), how important the transaction was to Allegheny, in part because it would diversify Allegheny's business risk beyond the traditional regulated utility business to the unregulated businesses in which DQE clearly had experience and success. (See Id. at ¶ 26.) Mr. Noia told Mr. Marshall that he believed DQE's management skills in marketing and retail services would be critical in a competitive environment and particularly valuable when combined with Allegheny's historic strength in traditional electrical generation businesses. (See id.)

20. DQE believed that it would be too small to compete effectively on a stand-alone basis in the coming competitive environment in Pennsylvania. It was DQE's belief that the electric generation business would come to be dominated by a small number of very large, national and international players that would be able to reduce their risk and improve their margins by generating electricity through a system of plants located throughout the United States and diversified as to type of fuel and capacity. (Trial Tr., 10/26/99 (Marshall), at 125)*fn3. DQE believed that a combination with Allegheny could provide it with greater opportunities to compete in a deregulated market, and that a combined DQE/Allegheny itself would be an attractive acquisition candidate as competition ushered in the wave of consolidation expected to occur among electric utilities here and abroad. (Marshall Direct, at 45).

21. Following passage of the Restructuring Legislation, Allegheny wished to remain in the generation business. In contrast, DQE had considered selling its plants, but had made no final decision to do so. (Marshall Direct, at 5, 17). Nevertheless, after it began merger discussions with Allegheny, DQE recognized that a combined DQE/Allegheny could be a stronger competitor in the generation business than DQE on a stand-alone basis. (Marshall Direct, at 17). DQE and Allegheny agreed that they would try to remain in the generation business in the event they merged, but only if they could do so on a rational financial basis that would not expose their shareholders to undue risk. (Marshall Direct, at 17-18).

22. Both DQE and Allegheny were well aware that their Pennsylvania subsidiaries shortly would be required to commence restructuring proceedings in Pennsylvania pursuant to the Restructuring Legislation. (Marshall Direct, at 18). Both companies recognized that there was a danger that one or both subsidiaries might not be permitted by the PUC to recover enough of their stranded costs to protect their shareholders from undue risk. DQE was fully prepared to exit the generation business if, as a result of the PUC's rulings in the restructuring proceedings, a sale of generation appeared necessary to protect the interests of its shareholders, and it made this clear to Allegheny. Accordingly, DQE made no commitment to Allegheny to remain in the generation business. (Marshall Direct, at 18; Trial Tr., 10/26/99 (Marshall), at 101-02).

23. During early discussions, DQE representatives did not express concern about the amount of stranded cost recovery that Allegheny would seek or need heading into deregulation (Noia Direct at ¶ 29.) Instead, DQE, which believed that it had more stranded costs than Allegheny, was more concerned with addressing whether Allegheny would oppose generation-related stranded cost recovery for high cost utilities such as DQE. (See id.) Mr. Noia explained that Allegheny had taken this position at the time that the competition legislation was being formulated but now that legislation had passed, Allegheny believed that each company — including West Penn — had to do its best to recoup its stranded costs. (See id.)

E. The Merger Agreement

24. On April 5, 1997, Allegheny and DQE entered into a written Agreement and Plan of Merger (the "Merger Agreement" or "Agreement") contemplating a tax-free, stock-for-stock merger transaction (the "Merger"), pursuant to which DQE would become a wholly-owned subsidiary of Allegheny. Under the terms of the Merger Agreement, each share of DQE common stock was to be exchanged for 1.12 shares of Allegheny common stock (the "Exchange Ratio"). (PTO ¶¶ 4-5). The Exchange Ratio represented a 22 percent premium for DQE's shareholders based on the closing prices of DQE's and Allegheny's stock on April 4, 1997, the last trading day prior to announcement of the Merger. (Marshall Direct, at 3). If the Merger was consummated, DQE's shareholders would have owned approximately 42 percent of the combined company. (PTO ¶ 5).

25. The Merger Agreement also provided that Allegheny would select nine of the fifteen directors for the merged company and that Mr. Noia would serve as Chairman and Chief Executive Officer, with Mr. Marshall slated to be President and Chief Operating Officer. (Noia Direct at ¶ 31.) Mr. Marshall conceded that these terms ensured that Allegheny would control the combined company. (Marshall Direct at 44.)

1) Representations and Warranties

27. Section 5.1 of the Merger Agreement sets forth the express contractual representations and warranties made by both Allegheny and DQE in connection with the contemplated Merger.

  28. In Section 5.1(e) of the Merger Agreement, Allegheny and
DQE represented and warranted to each other that from and after
the "Audit Date" (December 31, 1996) their respective financial
statements would fairly present their financial position and
results of operations in accordance with generally accepted
accounting principles ("GAAP"), and that their filings with the
Securities and Exchange Commission (the "Reports"), including the
financial statements set forth in the Reports, would contain no
materially false or misleading statements of fact or omit to
state any material facts necessary to make the reports not
misleading. Section 5.1(e) provided in pertinent part that:

    . . [T]he Reports did not, and any Reports filed
  with the SEC subsequent to the date hereof will not
  contain any untrue statement of a material fact or
  omit to state a material fact required to be stated
  therein or necessary to make the statements made
  therein, in light of the circumstances under which
  they were made, not misleading. Each of the
  consolidated balance sheets included in or
  incorporated by reference into the Reports (including
  the related notes and schedules) fairly presents, or
  will fairly present, the consolidated financial
  position of it and its Subsidiaries as of its date
  and each of the consolidated statements of income and
  of changes in financial position included in or
  incorporated by reference into the Reports (including
  any related notes and schedules) fairly presents, or
  will fairly present, the results of operations,
  retained earnings and changes in financial position,
  as the case may be, of it and its Subsidiaries for
  the periods set forth therein . . . in each case in
  accordance with generally accepted accounting
  principles ("GAAP") consistently applied during the
  period involved, except as may be noted therein.

(Exh. D1, at § 5.1(e) (emphasis added)).

29. An objective of the parties in negotiating this Agreement, as expressed by Mr. Marshall in a March 25, 1999 letter to Mr. Noia, was that the contract make it "difficult to terminate [the Merger] since we both know the costs that termination would impose on each of our companies." (PX 35; see also 10/26/99 Trial Tr. at 129; Noia Direct ¶ 33.) As Mr. Noia phrased it, Allegheny's intention was "to maximize the chances of closing." (PX 29 at DQE 014215.)

30. Consistent with this objective, DQE sought in the Agreement to minimize a party's ability to use legislative or regulatory developments and, in particular, the new legislation in Pennsylvania deregulating aspects of the electric generation business, as grounds to terminate the merger agreement. Like many merger agreements, the DQE/Allegheny agreement contains a provision requiring, as a condition to closing, that the parties represent to one another that no development has occurred from a specified date prior to the Merger Agreement being signed that is reasonably likely to have a material adverse effect ("MAE") on aspects of the company's business. This representation is embodied in Section 5.1(f) of the Merger Agreement and reads as follows:

  Except as disclosed in the Reports filed prior to the
  date hereof, or as expressly contemplated by this
  Agreement or as expressly contemplated by the DQE,
  Inc. 1997 Five Year Plan, a copy of which has been
  provided to, and accepted by, [Allegheny] (the
  "Company Budget") or the Allegheny Power Final
  Operating, Cash and Capital Budget for Year 1997 and
  Forecast Years 1998 through 2001, a copy of which has
  been provided to, and accepted by, [DQE] (the
  "Parent Budget" and collectively with the Company
  Budget, the "Budgets"), since the Audit Date it
  and its Subsidiaries have conducted their respective
  businesses only in, and have not engaged in any
  material transaction other than according to, the
  ordinary and usual course of such businesses and
  there has not been (i) any change in the financial
  condition, properties, business or results of
  operations of it and its Subsidiaries or any
  development or combination of developments affecting
  it of which its management has knowledge that,
  individually or in the aggregate, is reasonably
  likely to have a Material Adverse Effect on it.

(Exh. D1, at § 5.1(f)(i) (emphasis added)).

31. MAE is defined in Section 5.1(a) of the Merger Agreement, which states in pertinent part as follows:

  "Material Adverse Effect" means with respect to any
  Person, a material adverse effect on the financial
  condition, properties, operations, business or
  results of operations of such Person and its
  Subsidiaries taken as a whole;

32. The definition of MAE in Section 5.1(a) of the Merger Agreement was the subject of negotiations between Mr. Noia and Mr. Marshall. Mr. Noia urged that the existence of an MAE resulting from any regulatory proceeding or ruling prior to closing of the Merger be determined by reference to the effect of the proceeding or ruling solely on the particular company affected. Allegheny took this position because it was concerned with DQE's ownership interest in certain nuclear facilities and wanted to be able to terminate the Merger Agreement in the event DQE suffered an adverse ruling with respect to those plants. (Trial Tr., 10/21/99 (Noia), at 48; Exh. D125, at 1-2).

33. In contrast, Mr. Marshall urged that an MAE be determined by reference to the effect of any development on the "combined" company. He believed that Allegheny's proposal, i.e., "[l]ooking at impacts on one company" only, would make "it much easier to terminate the agreement." (Exh. D126, at 2).

34. In the drafting leading up to the Agreement, DQE suggested a proviso to this definition that would limit the extent to which a party could claim an MAE if the "effect" resulted from legislation or legislative activity. The proviso as initially proposed by DQE read as follows:

  provided, however, that any such effect resulting
  from any change in law, rule or regulation
  promulgated by (i) United States Congress, (ii) the
  Securities and Exchange Commission (the "SEC") with
  respect to the Public Utilities Holding Company Act
  (the "PUHCA"), (iii) the Pennsylvania State
  Legislature or the Pennsylvania Public Utilities
  Commission or (iv) the Federal Energy Regulatory
  Commission (the "FERC") or any interpretation of any
  such law which affects both [DQE] and its
  Subsidiaries taken as a whole and [Allegheny] and its
  Subsidiaries taken as a whole shall only be
  considered when determining if a Material Adverse
  Effect has occurred to the extent that such effect on
  one such party exceeds the effect on the other
  party[.]

(PX 3 at AE 118829-30.)

35. Also, DQE initially suggested that the effect on it of any action taken by the PUC be specifically excluded from the MAE definition:

  provided further that any such effect resulting
  from any action with respect to [DQE] taken by the
  Pennsylvania Public Utility Commission shall not be
  considered when determining whether a Material
  Adverse Effect has occurred.

36. DQE later amended this exclusionary language to specifically refer to the Restructuring Legislation:

  provided, further, that any such effect resulting
  from or caused by any Governmental Consents (as
  defined by Section 7.1(c)) or as a result of any
  restructuring plan of such person or any of its
  Subsidiaries pursuant to the Electricity Generation
  Customer Choice and Competition Act . . . shall not
  be considered when determining if a Material Adverse
  Effect has occurred.

PX 4 at p. 10 (Rider 10.1); PX 5 at p. 10 (Rider 10.1).)

37. The final definition of MAE as contained in the Merger Agreement reads as follows:

  "Material Adverse Effect" means with respect to any
  Person, a material adverse effect on the financial
  condition, properties, operations, business or
  results of operations of such Person and its
  Subsidiaries taken as a whole; provided, however,
  that any such effect resulting from . . . the
  application of the Pennsylvania Restructuring
  Legislation . . . which affects both [DQE] and its
  Subsidiaries, taken as a whole, and [Allegheny] and
  its Subsidiaries, taken as a whole, shall only be
  considered when determining if a Material Adverse
  Effect has occurred to the extent that such effect on
  one such party exceeds such effect on the other
  party.

(emphasis added).

a) Parties' Understanding of MAE Proviso

38. DQE and Allegheny both testified at trial that prior to the execution of the Merger Agreement, both parties anticipated presenting its restructuring case before the PUC in the alternative — one case to be applied in the event that the Merger was consummated and one to be applied if the Merger was not consummated. (Noia Direct at ¶ 47; Morrell Direct at ¶ 33-36; Marshall Direct at 16.)

39. Mr. Noia and Michael Morrell ("Morrell"), Allegheny's Chief Financial Officer, testified that they understood that the proviso, where applicable, required that the MAE test would only be applied to the amount that represented the extent to which the effect was greater on one party than the other (i.e. the "differential effect"). (See PX 294 at AE 118504 ("Effects of Pa. restructuring legislation — take difference of effect on [companies] and apply it to MAE"); Noia Direct at ¶ 32; Morrell Direct at ¶ 69.)

40. Moreover, Mr. Morrell testified that in his "view [] a sophisticated merger partner like DQE would take into account what any particular [thing] that has occurred would have an affect on the future earning power of its merger partner. . . . You look at what happened to its value, what happened to its earning potential. . . . But those words in my view mean looking at the financial capabilities of the Company and how they have or have not been impacted since the day the representation was originally made." (10/20/99 Trial Tr. at 124-25.)

2) Conditions to Consummation of the Merger

41. Section 7.3 of the Merger Agreement set forth the conditions to the parties' obligation to consummate the Merger. One such condition, found in Section 7.3(a), required all of the representations and warranties made by Allegheny in the Merger Agreement, including the MAE Representation, to be:

  true and correct as of the date of this Agreement and
  as of the Closing Date as though made on and as of
  the Closing Date (except to the extent any such

  representation and warranty expressly speaks as of an
  earlier date), and [DQE] shall have received a
  certificate signed on behalf of [Allegheny] by an
  executive officer of [Allegheny] to such effect.

(Exh. D1, at § 7.3(a)).

3) Right of Termination

42. Article VIII of the Merger Agreement specified the circumstances in which one or both parties could terminate the contract prior to consummation of the Merger (the "Effective Time"). Subsection (a) of section 8.2 of the Merger Agreement provided in pertinent part that:

  [The] Agreement may be terminated and the Merger may
  be abandoned at any time prior to the Effective Time
  by action of the board of directors of either
  [Allegheny] or [DQE] if (a) the Merger shall not have
  been consummated by October 5, 1998 . . . (the
  "Termination Date"); provided that the Termination
  Date shall automatically be extended for six months
  if, on October 5, 1998:(i) any of the conditions set
  forth in Section 7.1(c) [requiring receipt of
  required governmental approvals of the Merger] has
  not been satisfied or waived, (ii) each of the other
  conditions to consummation of the Merger set forth in
  Article VII [conditions to each party's obligation to
  effect the merger including representations and
  warranties] has been satisfied or waived or can
  readily be satisfied, and (iii) any Governmental
  Consent that has not yet been obtained is being
  pursued diligently and in good faith[.]. . . .

(Exh. D1, at § 8.2(a) (emphasis added)).

43. Thus, under Section 8.2(a), DQE was permitted to terminate the Agreement on October 5, 1998 if the Merger had not been consummated by that date, unless "on October 5, 1998," each of the conditions to the Merger (other than those relating to receipt of required governmental approvals) had been satisfied — including the condition in Section 7.3(a) that the MAE Representation in Section 5.1(f) be true and correct.

44. Section 8.2 further provided, however, that

  the right to terminate this Agreement pursuant to
  clause (a) . . . shall not be available to any party
  that has breached in any material respect its
  obligations under this Agreement in any manner that
  shall have proximately contributed to the occurrence
  of the failure of the Merger to be consummated.

(Dx 1).

45. Section 6.5(c) of the Agreement required both parties "to cooperate with each other and use . . . all commercially reasonable efforts . . . to obtain as promptly as practicable all . . . approvals" necessary to consummate the Merger. (Dx 1).

46. Section 8.3(b)(ii) of the Merger Agreement also permitted DQE to terminate the Merger Agreement at any time, either before or after October 5, 1998, in the event Allegheny committed, but failed to promptly cure, any material breach of the contract. Specifically, Section 8.3(b)(ii) states as follows:

    [The] Agreement may be terminated and the Merger
  may be abandoned at any time prior to the Effective
  Time, whether before or after the approval by
  stockholders of [DQE] . . . by action of the board of
  directors of [DQE]:
    (b) if . . . (ii) there has been a material breach
  by [Allegheny] of any representation, warranty,
  covenant or agreement contained in [the] Agreement
  that is not curable or, if curable, is not cured
  within 30 days after written notice of such breach is
  given by [DQE] to [Allegheny]. . . .

(Exh. D1, at § 8.3(b)(ii)).

F. The Restructuring Proceedings

1) Background

47. The Restructuring Legislation defines stranded costs as "known and measurable net electric generation costs . . . which traditionally would be recoverable under a regulated environment but which may not be recoverable in a competitive electric generation market." One method for determining stranded costs for generation assets would be to sell those assets in an arm's length market transaction. Stranded costs could then be measured by the difference between the book value, representing the undepreciated historical cost of the plant, and the sale-determined market value of the plant.*fn4 An alternative to selling generation to determine stranded costs is an administrative determination of stranded costs, which relies on computer-generated market price and cost forecasts and application of discount rates that extend well into the future to establish stranded costs.

48. At the time they agreed to merge, both Allegheny and DQE recognized that the proposed Merger could take a year or more to close after the Merger Agreement was signed. (Marshall Direct, at 7-8). They also knew that there was a significant risk that the Merger might not be consummated at all, either due to a failure to obtain required regulatory approvals or because any regulatory approval might contain conditions that were unacceptable to the parties or that could not be satisfied. (Marshall Direct at 7-8).

49. Because both DQE and Allegheny understood there was no guarantee that the Merger would be consummated, they expected and agreed that each would be responsible for conducting its respective subsidiary's restructuring proceedings before the PUC in accordance with the best interests of its own shareholders. (Marshall Direct, at 8, 16-17).

50. Initially, however, both Allegheny and DQE agreed on a common strategy and approach. Both determined to ask the PUC to make a "market-based" determination of stranded costs, where actual market prices of electricity would be used to determine how much of West Penn's and Duquesne's costs were recoverable and how much were stranded. Allegheny and DQE agreed that such a determination would be superior to, and more likely to protect the interests of their shareholders than, the forecast approach, where the PUC would decide what future electricity prices were likely to be after considering testimony and forecasts offered by the utilities and the various intervenors in the restructuring proceedings. (Marshall Direct, at 8-9).

51. Consequently, both Allegheny and DQE proposed that the PUC employ a "multi-phase" approach, in which a CTC would be set initially by the PUC and then periodically adjusted in separate proceedings at intervals over the course of the Transition Period. (Marshall Direct, at 8). Although the initial CTC would be awarded based on expert forecasts of market prices, the CTC would be adjusted (or "trued up") at the end of the Transition Period to reflect actual market prices, with future credit to be given to, or additional charges imposed on, customers to accomplish the adjustment. (Marshall Direct, at 10).

52. The Pennsylvania Office of Consumer Advocate ("OCA") and various intervenors objected to these proposals, arguing that the only acceptable way to make a market-based determination of stranded costs would be to immediately auction the generation assets of each utility, which would establish the current fair market value of those assets. To the extent that the utility realized less than book value at the auction, the PUC would permit the utility to recover the difference through collection of a CTC from its customers. (Marshall Direct, at 10).

2) The PECO Decision

54. The PUC's order in the PECO restructuring case made clear that it intended to conduct a single, one-time determination of stranded costs for each Pennsylvania utility and, consequently, that the PUC would not agree to any form of phased, market-based determination as proposed by Duquesne and West Penn. (Marshall Direct, at 11).

55. Additionally, the PUC adopted the forecast of future market prices for electricity submitted by the OCA, which projected prices substantially above those forecast by West Penn and Duquesne. (Marshall Direct, at 11).

56. From the PUC's PECO decision, it became apparent that the OCA price forecast would also be applied by the PUC in any administrative determination of the stranded costs in the West Penn and Duquesne restructuring cases, and, in such event, would result in a significant disallowance of each utility's stranded cost request. (Marshall Direct, at 11).

57. The PUC's PECO decision was a watershed event, and one to which DQE and Allegheny reacted in very different ways.

58. DQE believed that in a competitive environment, the business of generating electricity would be a commodity business characterized by high volatility and low margins, and would through consolidation come to be dominated by a relatively small number of large national companies. (Marshall Direct, at 4-5). Given its perception of the coming competitive environment, DQE believed that full recovery of stranded costs in Duquesne's restructuring proceeding would be vital to its ability to compete, and that anything less than full recovery of its stranded costs would expose its shareholders to the risks of a highly volatile, low margin commodity business. (Marshall Direct, at 11-12).

59. The PECO decision demonstrated to DQE that, since the PUC would adopt the OCA's price projections, which were substantially higher than those of DQE and Allegheny, full recovery of Duquesne's stranded costs could not be obtained in an administrative determination of stranded costs, but could only be assured through the offer of an auction of its generation assets. (Marshall Direct, at 11).

60. Allegheny does not dispute that the generation business in a competitive environment will be more volatile and riskier and dominated by large national players. (Exhs. D 182, D183). Allegheny believes, however, that it is well-positioned to meet these challenges in light of its claimed expertise in the generation business. In addition, Allegheny emphasizes that it is a relatively low-cost generator of power given its lack of nuclear generation, its rural customer base and the location of its fossil fuel plants near sources of fuel. (Direct Testimony of Alan J. Noia ("Noia Direct"), at 12, 16, 27). Given these factors, Allegheny believes that it can — and would like to try to — survive in the coming competitive environment by retaining its generation assets and continuing to operate, as it has in the past, as an "independent" generator of electricity. (Noia Direct, at 24-29; Marshall Direct, at 25-26).

61. Allegheny has argued that its status as a low-cost generator with a low shopping credit under deregulation will deter most of West Penn's customers from shopping for alternative suppliers of power. Since customers who do not shop will continue to pay the old, pre-deregulation price for electricity, Allegheny believes that West Penn will be able to maintain its pre-competition revenue stream. (Direct Testimony of John G. Graham ("Graham Direct"), at 17-18). DQE presented evidence, however, showing that West Penn faces a substantial threat of competition. (Exhs. D204, D216, D217).

62. As previously noted, after just nine months of competition, and with only two-thirds of retail customers in Pennsylvania being allowed to shop, over 14 percent of West Penn's customer load had already "shopped away" from West Penn and was purchasing power from alternate suppliers as of October 1, 1999. (Exh. D218).

63. In light of the PECO decision, DQE determined that it could assure full recovery of its stranded costs only by offering in Duquesne's restructuring proceeding to auction all of Duquesne's generation assets for sale to the highest bidder. (Marshall Direct, at 11-12). Having decided ...


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