United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT
Argued May 14, 1998 Decided July 21, 1998
No. 97-1276
Iroquois Gas Transmission System, L.P.,
Petitioner
v.
Federal Energy Regulatory Commission,
Respondent
Consolidated with
No. 97-1533
---------
On Petitions for Review of Orders of the
Federal Energy Regulatory Commission
Joseph S. Koury argued the cause for petitioner. With him
on the briefs were James T. McManus, Jeffrey A. Bruner
and Paul W. Diehl.
Samuel Soopper, Attorney, Federal Energy Regulatory
Commission, argued the cause for respondent. With him on
the brief were Jay L. Witkin, Solicitor, and Susan J. Court,
Special Counsel. John H. Conway, Deputy Solicitor, entered
an appearance.
Dennis Lane argued the cause for intervenors Public Ser-
vice Commission of the State of New York, et al. With him
on the brief were David W. D'Alessandro, Mary Ann Walker,
Neil L. Levy, Richard A. Rapp, Jr., Lillian S. Harris and
Kevin J. McKeon.
Before: Wald, Williams and Henderson, Circuit Judges.
Opinion for the Court filed by Circuit Judge Williams.
Concurring opinion filed by Circuit Judge Wald.
Williams, Circuit Judge: Iroquois Gas Transmission Sys-
tem, L.P., ran up substantial legal defense costs as a result of
federal investigations into environmental violations committed
in its construction of a natural gas pipeline. The Federal
Energy Regulatory Commission issued orders excluding
these legal costs from the rate base used to calculate Iro-
quois's permissible charges, explaining that Iroquois had
failed to carry the burden of proving that the costs were
prudently incurred. Iroquois says the orders were grounded
in an impermissible presumption of non-recoverability and
asks us to set them aside, relying primarily on our decisions
in Mountain States Telephone and Telegraph Co. v. FCC, 939
F.2d 1021 (D.C. Cir. 1991) ("Mountain States I") and Moun-
tain States Telephone and Telegraph Co. v. FCC, 939 F.2d
1035 (D.C. Cir. 1991) ("Mountain States II"). Because the
Commission has failed to come to grips with the questions
that Mountain States II said must be answered when ad-
dressing a utility's recovery of legal expenses, we remand the
case for a more reasoned decision.
* * *
In November 1990 the Commission granted Iroquois a
certificate of public convenience and necessity under Section 7
of the Natural Gas Act (the "Act"), authorizing the company
to build and operate a new pipeline stretching from the
Canadian border to Long Island. The pipeline went into full
service in January 1992. Before long, however, Iroquois
found itself in trouble for environmental violations. Around
November 1991 the U.S. Attorney's Office for the Northern
District of New York, in conjunction with the FBI and the
Environmental Protection Agency, began an investigation
into whether Iroquois's construction activities violated the
Clean Water Act. The record suggests that the investigation
focused on points where the pipeline crossed creeks and
streams in upstate New York, allegedly discharging silt and
sediment in violation of Iroquois's Clean Water Act permit,
and on Iroquois's alleged failure to build so-called trench
breakers, which control soil erosion and pipeline corrosion.
An Army Corps of Engineers inspection report from
early 1992 cited a potential overall penalty of more than
$115,000,000. Civil investigations, presumably closely relat-
ed, were also undertaken by the U.S. Attorney's offices for
the Northern, Eastern, and Southern Districts of New York.
In addition, FERC's own enforcement staff launched a sepa-
rate investigation to determine whether Iroquois had violated
the environment-related conditions of its Section 7 certificate.
Ultimately an Iroquois affiliate and four of its employees
entered into guilty pleas and a civil settlement costing $22
million in fines and penalties, and Iroquois consented to a
settlement with the Commission admitting violations of envi-
ronmental conditions in its certificate and agreeing not to
pass the fines and penalties on to its ratepayers. Iroquois
Gas Transmission System, L.P., 75 FERC p 61,205 (1996).
In the course of resolving these disputes Iroquois ran up a
legal bill of more than $15,000,000. While the various inves-
tigations were still under way, Iroquois filed with the Com-
mission for a general rate increase to recover its pipeline
construction costs. The rate proceeding culminated in a set-
tlement between Iroquois and its customers resolving all
issues except the rate and accounting treatment of the legal
defense costs. Hearings on these reserved issues were held
before an administrative law judge, who determined that the
legal costs were not unrecoverable per se, and observed that
"[t]he participants have presented nothing to rebut Iroquois's
position that the legal costs were incurred as an appropriate
and normal response to investigatory activities arising from
the construction undertaken to provide service to the rate-
payers." Iroquois Gas Transmission System, L.P., 72
FERC p 63,004, at 65,027 (1995).
The Commission reversed the ALJ's initial decision and
held that Iroquois's legal defense costs could not be included
in its rate base. Iroquois Gas Transmission System, L.P., 77
FERC p 61,288 (1996). "Allowing recovery of Iroquois' litiga-
tion expenses," the Commission concluded,
would fail to recognize the interests of Iroquois' ratepay-
ers, shared by the Commission, that emanate from Sec-
tion 7 of the NGA. These interests are to ensure that
the pipeline is built in compliance with all applicable
federal environmental and safety laws so as to prevent
any future personal injuries or environmental damage.
Id. at 62,280. The Commission based its disallowance of
recovery on Iroquois's failure to demonstrate any countervail-
ing economic or non-economic benefit to ratepayers from the
activities that gave rise to the investigations. The Commis-
sion denied Iroquois's request for rehearing, Iroquois Gas
Transmission System, L.P., 78 FERC p 61,216 (1997), and
later rejected similar claims in a second rate case filed by
Iroquois. Iroquois Gas Transmission System, L.P., 77
FERC p 61,352, at 62,538 (1996), rehearing denied, 80 FERC
p 61,199, at 61,797-98 (1997). Iroquois petitioned for review
in this court.
At the outset the Commission concedes two propositions,
one general and one specific to this case. First, the Commis-
sion admits that although the Act gives the natural gas
company the burden of showing that a proposed rate increase
is just and reasonable, 15 U.S.C. s 717c(e), as a matter of
FERC practice "a natural gas company is ordinarily not
required to show that all of its expenditures were prudent
unless serious doubts are raised regarding the prudence of
those costs." FERC Br. at 24. See, e.g., Trans World
Airlines, Inc. v. CAB, 385 F.2d 648, 657 (D.C. Cir. 1967);
Minnesota Power & Light Co., 11 FERC p 61,312, at 61,645
(1980). Second, the Commission does not seriously contest
that it effectively raised a presumption against recovery in
this case, putting the burden on Iroquois to demonstrate that
its expenditures were prudently incurred. See 78 FERC at
61,927 ("[S]ince [Iroquois] was seeking to recover the legal
defense costs in its rates, it had the burden of proving that
the costs were just and reasonable."). Indeed, at times the
Commission seemed to erect something close to an irrebutta-
ble presumption against recovery. See id. ("Iroquois placed
itself in the untenable position of arguing that its illegal
activities, supposedly taken to save time and money during
construction, were in the interests of its ratepayers, and,
therefore, just and reasonable.") (emphasis added).
The Commission contends, however, that it adequately
justified its decision to invert the normal presumption in this
case, because Iroquois's legal costs by their very nature
raised a serious doubt as to prudence (i.e., because they grew
out of civil and criminal violations).1 See FERC Br. at 24.
One immediate problem with this approach is that as of the
time the hearing was held before the ALJ no violations had
been proven or admitted; the investigations were still ongo-
ing and the precise contours of any eventual charges were
still uncertain. But even if that problem is put aside, the
Commission runs into another barrier: our decisions in the
Mountain States cases.
In Mountain States I we held that the Federal Communi-
cations Commission had failed to provide a reasoned justifica-
tion for its presumption that antitrust litigation expenses
incurred by AT&T could not be recovered from ratepayers.
939 F.2d at 1029-35. "Illegality of carrier conduct from
which an antitrust litigation expense stems," we concluded,
"does not inexorably compel or warrant either rejection or
stigmatization of the expense as a factor in rate calculations."
Id. at 1031. We noted that in two tax decisions the Supreme
Court had described litigation expenses--even those incurred
in a losing cause--as ordinary and legitimate costs of doing
business. Id. at 1031-32 (citing Commissioner v. Heininger,
__________
1 When asked by the ALJ to come forward with evidence raising
doubts about the prudence of the costs, FERC's staff counsel
answered, "[I]t is our belief that the recoverability issue is simply a
matter of fairness, and there wasn't a whole lot to say about it."
Similarly, counsel for the Public Service Commission of the State of
New York responded, "It's our view that these are not the typical
costs that are incurred to provide service by a utility and we cannot
conceive of a scenario under which they would be recoverable."
320 U.S. 467 (1943), and Commissioner v. Tellier, 383 U.S.
687 (1966)).
In Mountain States II, issued the same day as Mountain
States I, we reviewed a new FCC regulation governing the
accounting treatment of litigation expenses generally. The
new rule attached a presumption of non-recoverability to all
litigation expenses that resulted in an adverse final judgment
or post-judgment settlement in any federal statutory case,
unless the regulated company could show that ratepayers
benefited from the underlying activity. 939 F.2d at 1039.
Holding that "the FCC may disallow any expense incurred as
a result of carrier conduct that cannot reasonably be expected
to benefit ratepayers," id. at 1043, we found the new rule
quite sensible in the context of antitrust violations, since the
effect of such violations is typically to injure consumers. But
we went on to say that the FCC had inadequately justified its
application of the new rule to statutory violations beyond
antitrust, where an absence of ratepayer benefit "is neither
self-evident, as it is in the antitrust context, nor bolstered by
either analytical or empirical support." Id. at 1044. By the
same token we rejected the FCC's "terse assertion" that
violations of federal statutory law "raise public policy implica-
tions" sufficient to justify presumptive disallowance of associ-
ated litigation costs. Id. at 1045.2
We emphasized in Mountain States II that the FCC had
not taken sufficient account of the perverse incentive effects
set in motion by a presumption against recovery of litigation
expenses. Such a presumption, we observed, was likely to
induce excessive caution in carriers, causing them to shun
activities that might conceivably be found to violate federal
law, even when those activities promise benefits to ratepay-
ers. Id. at 1046. We illustrated the point in a passage whose
uncanny relevance to the instant case calls for full quotation:
__________
2 On remand the FCC decided to retain its special accounting
rules with respect to antitrust judgments and settlements, but
abandoned them with respect to antitrust litigation expenses and all
costs arising from other types of litigation. In the Matter of
Accounting for Judgments and Other Costs Associated With Litiga-
tion, 12 FCC Rcd. 5112 (1997).
Consider the following example: A carrier has to choose
between instituting a strict pollution monitoring policy or
a lax policy that is arguably sufficient under the law and
would cost $50,000 less than the strict policy. The
carrier will surely be sued under a federal statute if it
adopts the lax policy, and there is a 10% chance that it
will lose; if it does, the plaintiff would recover $100,000,
making the expected or ex ante cost of the lawsuit
($100,000 x .10 =) $10,000. Thus the carrier reasonably
determines that adopting the lax policy will produce a net
benefit of $40,000 to the ratepayers, who would otherwise
have to pay the cost of the strict monitoring policy. It
would be misleading to say that requiring ratepayers to
bear the cost of the resulting judgment, if any, causes
them to subsidize the carrier's illegal activity. The carri-
er made the "right" decision, i.e., what the ratepayers
would have decided in their own economic self-interest;
it just turned out to be the "wrong" decision as a matter
of how the law was finally interpreted. Perhaps the
agency has a more capacious notion of ratepayer benefit
than merely paying lower rates. If it does, however, it
has neither said as much nor indicated why ratepayers
are generally harmed in some non-economic way by the
violation of federal statutes.
Id. at 1044-45.
The Commission quoted this passage in its initial order, see
77 FERC at 62,279-80, acknowledging its relevance but
claiming to find refuge in its final two sentences. While the
FCC in Mountain States II had failed to articulate any non-
economic harm flowing from violations of federal statute law,
the Commission said, here Iroquois's ratepayers have a gen-
eral interest in compliance with federal environmental and
safety laws, and thus are harmed whenever those laws are
violated. 77 FERC at 62,280. The inclusion of environmen-
tal compliance requirements in Iroquois's Section 7 certifi-
cate, according to the Commission, represented an "implicit
recognition that it would be appropriate for ratepayers to pay
costs that may be incurred to build a pipeline in an environ-
mentally responsible manner. It is not reasonable then to
elevate the ratepayer interest in saving time and money to
such a preeminent position in the interests to be considered
when deciding whether costs are recoverable in the rates."
Id.
We pause here to note that the Commission correctly
placed its initial focus on the prospect of ratepayer benefits
from the underlying activity rather than from the litigation.
Even though it is commonly prudent (in the conventional
sense of the term) to incur legal expenses in defending
conduct that turns out to have been illegal, there appears no
reason why ratepayers should bear the expense of defending
conduct that had no ex ante prospect of benefiting them. See
Mountain States II, 939 F.2d at 1043.
Nonetheless, we find the Commission's treatment of Moun-
tain States II unconvincing. The asserted ratepayer interest
in compliance with environmental and safety laws is virtually
as generic as the amorphous "public policy implications" we
found inadequate to justify the presumption of non-
recoverability in Mountain States II. 939 F.2d at 1045.
Because all citizens share an interest in widespread compli-
ance, not just with environmental or safety laws but with laws
of any kind, the Commission's approach would result in the
presumptive disallowance of all litigation expenses leading to
anything short of outright triumph for the regulated entity.
More important, the Commission's approach utterly fails to
respond to the problem of incentives posed in Mountain
States II. Iroquois's ratepayers, in common with the general
population of upstate New York, undoubtedly share an inter-
est in maintaining the purity of the region's creeks and
streams. But the same ratepayers have a unique and concen-
trated interest in timely and efficient pipeline construction.3
__________
3 In fact, Iroquois's customers evidently had a special interest in
speedy construction. In Iroquois's certificate proceeding the Com-
mission found as a general matter that the pipeline's proposed
customers "have an urgent and significant need for additional
natural gas supplies during the 1991-1992 winter season." Iroquois
Gas Transmission System, L.P., 52 FERC p 61,091, at 61,343
(1990). In a later order denying a stay of Iroquois's construction
certificate, the Commission noted the dangers of "delay[ing] further
the badly needed entry of the Iroquois-supplied gas into the North-
Although our concurring colleague asserts that some ratepay-
ers would willingly pay higher rates in exchange for assur-
ances of environmental compliance, see Concurring Op. at 1-
2, laws obligating firms to satisfy environmental standards
are necessary precisely because most consumers, if given a
choice, appear unwilling to pay the full cost of satisfying
higher standards. If consumer demand were actually enough
to cause ordinary firms in competitive industries to incur the
costs of protecting the environment, there would be little
need for environmental regulation.
Indeed, because of the limitation of the utility's rates to
recovery of cost under the statute's "just and reasonable"
formula, the ratepayers have the same interest in optimizing
environmental compliance costs as they would if they built the
pipeline themselves through a cooperative or a partnership.
As our opinion in Mountain States II made clear, a firm
incurring optimal environmental compliance costs will on
occasion take measures that are ultimately found illegal. In
Mountain States II 's example, where a saving of $50,000
runs a 10% risk of triggering $100,000 in additional costs, the
ex ante expected benefit for the ratepayers is $40,000. Con-
trary to our concurring colleague's suggestion, see Concur-
ring Op. at 2, Mountain States II does not establish a
ratemaking principle that affirmatively encourages regulated
companies to violate environment-related certificate condi-
tions. It does, however, recognize that ratepayers often
benefit from activities that tack reasonably close to the wind,
and that policies inducing management to pursue absolutely
risk-free environmental compliance measures are therefore
not, on their face, in the ratepayers' interest.
Yet the Commission's approach seems sure to chill some
lawful activity beneficial to ratepayers; indeed, it would seem
calculated to encourage regulated firms to avoid any and all
litigation risks. "[L]awsuits are a recurring fact of life in
operating a business," Mountain States I, 939 F.2d at 1034,
and in the area of federal environmental regulation the line
between permissible and impermissible conduct is often
drawn in (muddy) water. Compare United States v. Mango,
__________
east market." Iroquois Gas Transmission System, L.P., 54 FERC
p 61,103, at 61,342 (1991).
997 F. Supp. 264, 285 (N.D.N.Y. 1998) (holding that CWA
authorized Army Corps of Engineers to regulate Iroquois's
"backfilling of trenches excavated in waterways and wetland
areas") with id. at 283-87, 295-98 (holding that CWA does not
authorize Corps to impose permit conditions not related to
discharge of dredged or fill material, such as those designed
to prevent wetland drainage). Thus the Commission must do
a better job of explaining why all activities that turn out to
violate environmental laws should be presumed unlikely "to
benefit ratepayers," as required for presumptive disallowance
under Mountain States II. 939 F.2d at 1043.4
The Commission's attempted distinction of Appalachian
Electric Power Co. v. FPC, 218 F.2d 773 (4th Cir.1955), is also
insubstantial. There the Fourth Circuit held that legal costs
incurred by a regulated utility in an unsuccessful challenge to
the Commission's jurisdiction over a proposed power plant
were recoverable from ratepayers as expenses necessary to
the development of the project. According to the Commis-
sion, the costs of the jurisdictional challenge in Appalachian
were an example of "normal civil litigation" costs; other
examples given by the Commission were the "cost of attor-
neys hired to secure any state or federal permits, or litigation
to perfect eminent domain rights or to establish property
values." 77 FERC at 62,281. Iroquois's case is different, the
Commission said, because it "is not the type of case where a
regulated company, interpreting the law in a manner most
favorable to the company, loses a court case." Id. In fact
that description seems, at least at first glance, to fit Iroquois's
case quite snugly. Beyond offering a few conclusory state-
ments ("there is no punitive aspect associated with the loss of
a challenge [to] the agency's regulatory jurisdiction," id.), the
__________
4 The Commission mystifyingly asserted that Iroquois's agree-
ment not to recover any of the $22 million in fines and penalties
from its ratepayers "impl[ied] that the pipeline itself recognized
that the ratepayers did not benefit from the illegal activities." 77
FERC at 62,281. Given that the same agreement explicitly re-
served the issue of recoverability of legal expenses, see id. at 62,277
n.11, we can see no basis for the supposed inference.
Commission never explains why action based on a legal
interpretation "most favorable to the company" should have
been presumptively beneficial to ratepayers in Appalachian
but presumptively harmful here.5
In short, the Commission has not made clear which types of
legal defense costs are presumed recoverable for ratemaking
purposes and which not, or why the costs here belong on the
nonrecoverable side of the line. Particularly in light of the
explicit discussion of pollution laws in Mountain States II, the
Commission's burden here requires more than the making of
general allusions to the public interest in compliance with
environmental statutes or with Section 7 certificate require-
ments. Of course, we do not reach the ultimate question
whether Iroquois's legal defense costs were in fact prudently
or imprudently incurred, and thus whether they may or may
not be borne by the ratepayers. We hold only that the
Commission has not adequately justified its apparent decision
to impose upon Iroquois the burden of proving that its
activities benefited ratepayers.
The case is remanded to the Commission for further pro-
ceedings consistent with this opinion.
So ordered.
__________
5 The Commission suggests in passing that the present case
differs from Appalachian in that "Iroquois admitted to knowingly
violating federal laws." 77 FERC at 62,281. Litigation costs
incurred in defense of knowing or willful violations might indeed call
for more stringent treatment under the Mountain States II frame-
work, though "willful" and "knowing" are of course "word[s] of
many meanings" depending upon context, see Bryan v. United
States, 1998 WL 309067, *4 (U.S. June 15, 1998), and the settlement
context suggests the presence of tradeoffs whose implications are
unclear. In any event, the Commission nowhere else relies on or
develops the argument that Iroquois committed knowing violations,
and we can find no support in the record before us to support such
an assertion.
Wald, Circuit Judge, concurring in the judgment: Al-
though I agree that this case must be remanded for further
consideration, I write separately to emphasize the breadth of
the analysis FERC should undertake on remand. Although
the ultimate issue in this case is who is to bear Iroquois's
litigation costs, not whether Iroquois's conduct was legal or
illegal, the latter consideration is certainly relevant, in my
view. It is worth noting, therefore, that Iroquois admitted
violating several environmental-related conditions of its sec-
tion 7 certificate, and our discussion of whether it is "just and
reasonable" for the company to then shift the litigation costs
related to those violations to its ratepayers should in no way
be read as directing FERC to ignore the harm to the
environment that has been suffered as a result of those
violations. Rather, I think it important that the calculus of
whether a rate is reasonable take into consideration noneco-
nomic benefit as well as economic benefit. It may well be
true that a thoroughly informed ratepayer will prefer a
cheaper product obtained by way of environmental violations
over a more expensive product produced legally. But I'm not
sure that this can be presumed to be the case, as the majority
opinion appears to assume. In an antitrust case, as Moun-
tain States II recognized, the analysis is easier: A presump-
tion that litigation expenses associated with a violation of the
antitrust laws are disallowed is reasonable because we can
assume that consumers would prefer to buy products in a
competitive market, since competition is presumed to make
products both cheaper and better. Thus, it would be difficult
to show that anticompetitive conduct would be beneficial to
ratepayers in any way. Here, however, the equation is not so
simple: We cannot presume that noncompliance with environ-
mental regulations would be a benefit to ratepayers if the
economic costs of compliance outweigh the economic costs of
noncompliance, since the noneconomic benefit of compliance
must also enter the calculus. It may well be the case, for
example, that a ratepayer would prefer to pay higher rates in
exchange for the assurance that the pipeline from which it
obtains its gas is in compliance with environmental laws. (I
can imagine several reasons for this preference: for the
goodwill benefits compliance confers, to aid in thwarting
litigation, or even because the ratepayer lives in the geo-
graphic area for which noncompliance is proposed and will
suffer as a citizen.) I agree that under our precedent
FERC's simple assertion that ratepayers have an interest in
compliance with the law is insufficient to disallow recovery of
Iroquois's litigation costs. As Mountain States II holds,
FERC must also take into consideration the economic bene-
fits noncompliance may confer, though I must admit I have a
good deal of trouble with the proposition that FERC can
validly attach an environmental condition on a section 7
permit, but the company is simultaneously encouraged by
ratemaking principles to violate it if it can build the pipeline
cheaper or faster by doing so. That kind of law makes no
sense to me. But I also believe that even the Mountain
States II calculus is far more expansive than the majority
opinion suggests. By seeming to give priority to economic
over noneconomic considerations, I fear that the majority will
dissuade FERC from adequately considering the environmen-
tal costs of Iroquois's conduct, costs that may well affect the
decision about whether forcing ratepayers to bear its litiga-
tion costs is indeed "just and reasonable."