Who Will Pay for Buffett’s Rail Premium?

For several years, the Surface Transportation Board has been confronted with issues surrounding merger and acquisition premiums paid in most of the recent major transactions involving railroads. The STB generally has looked the other way, but its policies have only encouraged the payment of such premiums.

Yet the STB’s job is to protect the public interest in such transactions. To do so, it must change its approach to conform to that of other federal regulatory agencies, and, thanks to one recently announced transaction, the agency has an opportunity to do that.

On Nov. 3, Berkshire Hathaway announced the proposed acquisition of BNSF Railway in a transaction worth $44 billion. BNSF had a market value of approximately $26 billion before the transaction was announced. As a result, the acquisition premium will be approximately $18 billion.

The BNSF acquisition apparently does not require STB approval. That does not mean the STB does not have an important role to play regarding the premium paid by Berkshire.

Under STB policy, an acquisition premium therefore results in an increase in the book value of the targeted company. No other regulatory agency allows this approach. These higher book values are built into the STB’s Uniform Railroad Costing System in which costs are used to calculate the STB’s jurisdictional threshold for rate regulation and to determine railroad “revenue adequacy.”

In 2008, BNSF was deemed “revenue inadequate” by the STB. The $18 billion acquisition premium will dramatically increase BNSF’s investment base, thereby reducing its return on investment and likely making BNSF “revenue inadequate” for years to come.

This is preposterous. Under the statute, the STB is supposed to determine if BNSF (and the other railroads) are able to “attract” capital. The best demonstration of the ability to satisfy the statutory “revenue adequacy” standard is Berkshire’s acquisition of BNSF.

Professor Alfred E. Kahn tried to convince the STB more than 10 years ago, in the Conrail acquisition proceeding, that it should not permit Conrail’s assets to be “written up” by the amount of the premium paid there. He warned a policy of allowing such premiums to write up asset valuations would only encourage the payment of more such premiums in future transactions.

The acquisition premium being paid by Berkshire will have a deleterious effect on STB jurisdiction and, very likely, on rates paid by BNSF’s customers. The reason is that the premium, by raising BNSF’s URCS costs, will in effect raise the 180 percent “jurisdictional threshold” below which the STB may not even consider whether a rate is unreasonably high. This will permit BNSF to raise rates for a significant amount of currently regulated traffic up to the jurisdictional threshold. Congress could not have intended to let Warren Buffett and the BNSF board of directors have the power to effectively raise the STB’s jurisdictional threshold.

The STB’s position has essentially been that any potential adverse impact on rates from merger premiums will be more than offset by merger benefits to shippers. Other agencies, such as the Federal Energy Regulatory Commission, require merging entities to provide benefits (such as rate reductions) to obtain approval of any premiums paid. The STB does not.

Because the proposed Berkshire-BNSF acquisition is not a merger, there are no transportation synergies or other merger benefits to be passed on to shippers. Therefore, absent congressional or regulatory relief, the BNSF premium could flow directly through to shippers in the form of higher rates and an elevated jurisdictional threshold that will deprive the STB of the authority even to consider requiring a lower rate.

There is a solution. The STB, or Congress, could simply say merger and acquisition premiums will not affect the STB’s return-on-investment calculations for determining railroad “revenue adequacy,” and will not affect the calculation of URCS costs for individual railroads. This would simply mean any premiums paid would be the responsibility of the acquiring or merging entity rather than the customers of the railroad.

Customers should not be responsible for paying such premiums when neither they nor the government has any say in the amount of such premiums. In this way, such transactions could proceed with the risk placed where it belongs — on the acquiring or merging entity, and not on its captive customers.

Those buying regulated entities do so with the understanding that they are regulated in the public interest. Therefore, the acquiring entities should not expect to, in effect, take the law into their own hands and to be able to effectively deregulate rates and then raise prices to pay for the arbitrary premiums paid without governmental scrutiny.

Michael F. McBride is an attorney with Van Ness Feldman in Washington. He represents railroad customers before the STB. Gerald F. Fauth is president of G.W. Fauth & Associates, a transportation consulting firm in Alexandria, Va. The views expressed are those of McBride and Fauth, and not necessarily those of their clients.