The Fine Print: How Big Companies Use Plain English to Rob You Blind

by David Cay Johnston

  The Bush appointees’ fealty to the pipeline industry ran deep. Once they had heard all they wanted from pipeline lobbyists and lawyers, they allowed only a brief opportunity for comments on the not-yet-issued “policy statement.” As for the customary practice of letting parties respond to what their opponents say, that went out the window. Each side was given only a few days to file, and no rebuttals were allowed before FERC adopted the policy statement. Then in 2007, Kelliher and the other commissioners relied on the policy statement in approving new rates for the SFPP, the same pipeline controlled by Kinder Morgan that had been the subject of the earlier federal appeals court decision. These new rates included the corporate tax even though, as a master limited partnership, SFPP was exempt from corporate income taxes.

  This decision on the added tax was more than a little odd because the second President Bush had pledged never to raise taxes. Bush signed a no-more-taxes pledge much stronger than what Grover Norquist of Americans for Tax Reform bullied many other politicians into signing. “If elected president,” Bush wrote to Norquist in 1999, “I will oppose and veto any increase in individual or corporate marginal income tax rates or individual or corporate income tax hikes.” Since no major news organization covered the FERC beat, the broken pledge went unreported. Even so, it’s a truism that even if a tax falls in the forest of Washington regulations and no one reports it, the tax is still there.

  Technically, one could argue that the pipeline rule that makes you pay other people’s income taxes does not violate the presidential pledge. That tortured reasoning runs this way: the rule does not raise your marginal tax rates or hike taxes, it just makes you pay a tax that the law does not impose.

  After the Bush administration put the “tax” back in place, ExxonMobil and other oil companies that shipped their products through the 2,700-mile SFPP pipeline filed new challenges. Based on the earlier decision, it looked like an open-and-shut case since nothing substantive had changed. A fake expense was still included in monopoly pipeline rates, and Judge Sentelle had said that was not allowed.

  This time Judge Sentelle, joined by judges Thomas Griffith and Brett Kavanaugh, took a different view. The decision made it clear that they disliked FERC’s new policy of imposing fake taxes, as the judges suggested that ignoring taxes altogether in setting rates might be a good idea, certainly a better idea than including nonexistent taxes in rates. They wrote that rates based on a fictional corporate income tax charge “and the policy statement upon which they are based incorporate some of the troubling elements of the phantom tax…disallowed in” the earlier SFPP pipeline case.

  But their decision then took an unexpected turn. Judge Sentelle and his colleagues ruled that chairman Kelliher and the rest of the commission had “justified its new policy with reasoning sufficient to survive our review.” How did the appeals court stand its earlier decision on its head? Judge Sentelle wrote that it was not the court’s place to decide what regulation was best or smart, but only to make sure it was “not arbitrary or capricious or contrary to law.” This was the same legal reasoning that permits monopoly railroads to charge customers like the Lafayette Utilities System in Louisiana a monopoly price for hauling coal 1,520 miles when there are parallel tracks for all but 20 miles of that journey. Whatever the flaws in the FERC’s reasoning, Judge Sentelle said, the fake tax could be charged to customers. He and his confreres made no mention of two obvious and essential questions: How can any fictional expense be fair to customers? And how can any fake cost be “just and reasonable”?

  In California, SFPP sought to impose the same corporate tax charge for oil it moves within the state. There, rates are regulated by the state Public Utilities Commission. An administrative law judge who heard evidence in that case, which began in 1997, issued a proposed ruling denying any allowance for a fake tax. But late in 2010 Commissioner Timothy Alan Simon put out an alternative decision that included the tax. Simon, who was appointed by Governor Arnold Schwarzenegger, is a securities lawyer who worked for investment firms engaged with energy businesses.

  What happened next shows how a spotlight, even a small one, focused on government can produce positive change. I wrote a column about Simon’s proposal to impose this tax in State Tax Notes, a small public policy magazine; the column was also posted at tax.com, its sister Web site. That prompted several people to notify the commission that they wanted to speak about it during the next public comment period. Rather than hear them, the commission put off the vote. Six months later, with Simon gone, the commission rejected the proposed fake tax.

  The amount of money at stake was small, about $9 million per year or twenty-five cents per resident. But that one brief article and the action of readers who asked that their voices be heard will save Californians that $9 million, inflation adjusted, which should give heart to those trying to make government more responsive to people and less friendly to corporations.

  The money taken from you by all of America’s pipelines together is too small to be worth any individual putting up a fight. I estimate the charge for this nonexistent tax comes to about $3 billion a year, which is about $20 annually per American household, something like a nickel a day. But to the two hundred monopoly pipelines that stand to benefit, it is a lot of money, enough to justify huge spending on campaign contributions, lobbyists and litigation.

  Unless consumers rise up and fight this, one thing is certain: unelected officials, backed by judges with lifetime appointments, will authorize and then approve more ways to pick your pocket because of what judges Sentelle, Griffith and Kavanaugh did. In a clear miscarriage of economic justice, they destroyed the legal principle that “just and reasonable” rates rest on actual costs, at least for pipelines. This fake tax may be extended to other utilities and to the railroads. Achieving this requires only a simple change in federal law. All that would be required is the insertion of a list of industries that can be owned through publicly traded master limited partnerships without being subject to the corporate income tax.

  A prominent regulatory lawyer and former chief counsel for FERC told me he expects that is what will happen. Gordon Gooch joined FERC as a young lawyer, after clerking for a Supreme Court justice, and rose to become FERC’s general counsel. Later, as a private lawyer representing ExxonMobil, he lost the case in which Judge Sentelle allowed fake taxes to be added as a cost in pipeline rates.

  Gooch says that corporate-owned electric utilities are salivating at the prospect of getting out of paying corporate income tax while pocketing the money. Their trade association has already defended collecting income taxes from customers, monies that are never turned over to government. The industry trade association Edison Electric Institute basically said its members just do what the law allows. “The electric utilities would be master limited partnerships now,” Gooch said, “except that when the law was changed in 1986 the Edison Electric Institute was uncharacteristically asleep at the switch.”

  If Congress amends the law, or some creative judicial interpretation effects such a change, then the cost to consumers of this fake tax would soar. Instead of being a nickel per day, each family of four could be hit for more than a dollar a day, and $400 annually for a family of four is real money. It is the weekly after-tax pay for a single worker at the median wage in 2010.

  How many other rules like this one benefit the heavily subsidized energy industry but lie buried beneath layers of legalese? The answer is: plenty. Just ask Calvin Johnson, a professor of tax law at the University of Texas, who has devoted years to uncovering hidden tax favors. Hidden in the legal and regulatory fine print Johnson found an astonishing profits booster for independent oil and gas companies. They get extra dollop after extra dollop of tax breaks on top of the thick layers of official favors the energy industry already enjoys.

  Consider two companies, each of which earns a 10 percent pretax return in the market, but one of which is an independent oil and gas company. Johnson showed how energy industry tax rules create an additional profit o
f 41 percent. The independent oil and gas company investors will earn 14.1 percent instead of the market profit of 10 percent.

  Johnson and others disclosed their findings through the Shelf Project, which is published in State Tax Notes. Its goal is to show ways that Congress could raise more money just by closing loopholes, fixing flaws in tax laws, and undoing unjust decisions like Judge Sentelle’s shameless gift to pipeline MLPs. So far Johnson and his colleagues have shown how Congress, by closing loopholes, could raise $1 trillion each year without any new taxes or tax rate increases. That would be enough to nearly balance the federal budget in 2013.

  After the election of Barack Obama, FERC chairman Kelliher decided it was time to leave. But before going, he found one more way to gouge our wallets. During the first week of 2009 Kelliher announced that on Inauguration Day he would step down as chairman of FERC but stay on as a commissioner. He also announced that he would recuse himself from FERC business because he would be meeting with energy companies the commission regulates to “explore other career opportunities.” In other words, Kelliher hung around for two months doing no work, but collecting a paycheck until he got a new job. Kelliher’s new post? He became an executive in charge of the regulatory team at what is now NextEra Energy, a holding company that owns Florida Power & Light and, yes—you guessed it—pipelines.

  9…

  Investors Beware

  How long can such schemes last before there is an implosion that will make Samuel Insull and his pyramid holding companies’ implosion look innocuous by comparison?

  —Gordon Gooch, former Federal Energy Regulatory Commission general counsel

  9. Caveat emptor. Even if pipelines held by master limited partnerships, the subject of the last chapter, sound like a wonderful investment, there’s a flip side—a dangerous downside, you might say—to MLPs.

  Yes, cover stories in Barron’s, Forbes, Investor’s Business Daily, Money and other publications tout the lucrative returns. And, indeed, these pipelines “operate in areas where there is little to no competition,” which, Barron’s notes, means large profit margins.

  Where else, these investment publications ask, can investors get annual returns of 6, 8 or even 10 percent on their investment while paying little or no income tax? During an era when government has driven interest rates on savings to nearly zero and many companies pay no dividends, the promise of such high yields is certainly seductive. But those fat distributions of tax-free money are illusory. MLPs may well turn out to be disastrous for individual investors.

  If you, a relative or a friend has been taken in by the siren call of fat returns by investing in pipeline MLPs, read what follows very carefully. What is often overlooked is the reason why MLP payouts are tax-free. So look at the flow of cash and what happens to pipeline assets. They’re crucial to knowing the real value of pipeline partnership shares.

  WHAT’S THE PROBLEM?

  In short, those fat MLP payout checks sent to limited partners are not a share of profits. Rather than a return on capital, they are a return of capital. That is why the limited partners pay little or no tax: mostly they get their own money back.

  Pipeline partnerships are part of a multilayered legal structure so complex it would make Rube Goldberg proud. The partnerships themselves are mostly paper enterprises, as Gordon Gooch, the former Federal Energy Regulatory Commission general counsel, tells anyone who will listen. Sure, there is that pipeline lying in the ground. But many of the partnerships have no employees. Many have no cash, either, except what they borrow. And the general partner controls the whole deal. Typically the general partner is not a person, but a big corporation like, say, Kinder Morgan, which was started by a former Enron president. Starting to get the picture?

  I promise you it’s a real chore to figure out who gets those fake taxes the FERC and Judge Sentelle let the pipelines collect. Usually securities disclosure statements bunch all the information about an issue, say for executive compensation, in one place. Not so MLP pipelines. Gooch figured out what happens at one pipeline company by connecting language on one page with a passage dozens of pages deeper in the document and then another still deeper in, and then to a fourth page near the end of the thousand-page document. These legal breadcrumbs mark the path the general partner takes as he sweeps up the fake taxes, something missed entirely by the investor magazines.

  Where do the pipeline partnerships get the money to write checks to those who buy shares? A 2007 report by the investment bank Morgan Stanley revealed that for each dollar in new capital the MLPs need to develop and expand their pipelines, they pay out $10 to earlier investors. By following that creaky equation, pipelines take on ever more debt, in the form of bonds, and sell ever more partnership share units, diluting the interests of earlier investors.

  If one or more pipelines get squeezed in the future, as happens now and then to all businesses, the logical action for the people who control the pipelines would be to put the partnership into bankruptcy proceedings. It would be easy for the parent company to reorganize a bankrupt MLP in a way that lets the general partner remain as debtor in possession, which would wipe out the individual investors in the master limited partnership and force lenders to take a haircut. This happens all the time in corporate reorganizations under Chapter 11 of the federal bankruptcy code. In other words, the general partner probably remains whole and you get wiped out.

  Some experts on utility regulation describe MLPs as a variation of a Ponzi scheme. These are not cynical observations made in casual conversations, but in writing in formal regulatory proceedings. It is an argument to which FERC, the Securities and Exchange Commission and other regulators have paid no more heed than they did to the whispers that Bernard Madoff was running an actual Ponzi scheme. What distinguishes pipeline partnerships from Ponzi schemes is that pipelines are real businesses with steady streams of income from customers who want their natural gas or petroleum moved. What makes pipeline MLPs like Ponzi schemes is that those checks to investors come in large part from new investors, not from profits.

  On their face, pipeline master limited partnerships do not appear to be capitalism, at least not classic capitalism, in which owners try to maximize their profits and build wealth. Capitalism is about making profits and building up assets by retaining earnings for reinvestment. Not so with master limited partnerships. They are about stripping capital out of the enterprise, while raising new money from new investors.

  Kurt Wulff, who runs mcdep.com, a Web site that examines the finances of energy companies with a critical eye, described one pipeline deal not as a takeover, but a “take under” because the price paid was $29 a unit, far below the $40 per unit investors could have gotten by selling their shares on an exchange. Anyone reading just the press releases, though, would have thought this was a fabulous deal for the limited partners.

  Wulff has shown that many pipelines pay enormous “performance” fees to the general partner, typically more than the pipeline profits and often even greater than the pipeline’s cash flow. Wulff analyzed one pipeline deal by the Williams Companies and concluded that it was based entirely on borrowing more and more money. “All the GP [general partner] has to do is borrow to finance the acquisition of another asset,” Wulff explains. “Then like a Ponzi scheme, the distribution would be paid from future financing.” And like a Ponzi scheme perpetrator, Wulff notes, the general partner would be paid oodles of money “for little fundamental contribution” to the business.

  What if the pipeline had trouble paying off loans whose proceeds had been siphoned off by the general partner? Wulff noted that fine-print contract terms provide that the general partner “would have almost no liability for debt repayment.” In other words, if a pipeline company borrows until it collapses, it likely will be the lenders and the little investors who take the losses, while the corporate parent keeps control of the pipeline and the borrowed cash.

  Another warning comes from Gooch, the former FERC general counsel. Gooch wrote to FERC in 2007 that
, since master limited partnerships extract capital from their pipelines rather than building up capital, they are at risk of collapse if the flow of cash slows from customers or new investors. He pointed to the collapse of the Insull Trust—the Enron of the 1930s—and warned of dire consequences. It was the Insull Trust’s collapse that plunged the economy into its darkest days in 1932, three years after the stock market crash of 1929.

  We met Sam Insull earlier. He bought a small electric utility in Chicago at a time when multiple electric companies served neighborhoods, not cities or regions. Insull created an intricate legal structure through which he controlled electric utilities in thirty-two states. He financed it all with layer upon layer of debt that tied seemingly unrelated utilities together in a financial web that no one, perhaps not even he himself, understood. While today’s electric utilities are typically half shareholder equity and half debt, Insull had just 6 percent equity and 94 percent debt, making his company highly vulnerable because it had to spend most of its profits paying interest on loans. With the stock market collapse in 1929, many people struggled to pay their electric bills; three years later enough of them failed to pay Insull’s companies that he lacked the cash to pay his six hundred thousand bondholders their interest, plunging the entire nation further into the depths of the Depression. Insull became the most hated man in America, the Ken Lay of his day.

  Gooch warned FERC that such a disaster could recur. The money paid out to pipeline master limited partnership investors, he wrote, is “raised by higher rates (and perhaps skimping on maintenance), by extensive borrowing, and by sales” of new partnership shares that dilute the interests of existing shares.

  “How long can such schemes last before there is an implosion that will make Samuel Insull and his pyramid holding companies’ implosion look innocuous by comparison?” Gooch asked the commissioners. His letter went unanswered.