William K. Koska william.koska@wallerlaw Waller Lansden Dortch & Davis, LLP

1. THE EFFECT OF ENVIRONMENTAL LAWSUITSNational Association of Regulatory Utility CommissionersStaff Subcommittee on Accounting and FinanceSeptember 11-14, 2006Holiday Inn By-The-Bay, Portland, ME William K. Koska william.koska@wallerlaw.com Waller Lansden Dortch & Davis, LLP 511 Union Street, Suite 2700 520 South Grand Ave., Suite 800 Nashville, TN 37219 Los Angeles, CA 90071 (615) 850-8463 (213) 362-3484

2. RELATIONSHIP OF REGULATORS/REGULATED COMPANIES • The relationship between regulators and the companies they regulate can be fraught with peril. • When 3,000 individuals sue a regulated company in multi-million dollar litigation in 22 cases state-wide, the attitude of the regulators to defend the cases and support the utility, especially when the utility has complied with all regulations, is aggressive and supportive. This is especially true when insurance is involved. • But when that same utility sues the polluters directly, and litigation expenses are extremely high because of scorched-earth tactics of the polluters, passing those costs to the ratepayers becomes more complex.

3. The Journey Begins…

4. April 24, 1997 • A complaint containing a host of theories including wrongful death was filed in Los Angeles Superior Court on behalf of 140 plaintiffs naming only Southern California Water Company (SCWC). • No contaminators/polluters were named as defendants. • Two of the firms involved were participants in the case made famous by the film “Erin Brockovich.” • Case alleged contaminated water had been served to plaintiffs in San Gabriel Valley for some 20 years (Superfund Site).

5. WE WANT MONEY! $$ $$ $$ $$ $$

6. Over the next two years a total of 19 cases were filed naming only investor-owned water purveyors as defendants and some municipal water utilities (companies). • Total plaintiffs involved were approximately 2,800. Another firm also involved in the “Erin Brockovich” litigation joined on behalf of other plaintiffs.

7. The water companies involved (except the Municipals) were all Class A Regulated Utilities governed by the California Public Utilities Commission. • The California PUC is a state agency of constitutional origin with far-reaching duties, functions and powers. (California Constitution Article 12 §§ 1-6).

8. On August 1, 1997, Southern California Water Company applied for a Memorandum Account (memo) for litigation expenses for its San Gabriel District. The Public Utilities Commission (“PUC”) granted the application on January 21, 1998. • A memo account is an accounting device to track unanticipated significant expenses (usually), to allow for future recovery in a general rate case, subject to a prudency showing. • In California, utilities regulated by the PUC are regarded as a regulated monopolies, with an ability to recover their expenses from their ratepayers. But, their rate of return is also regulated.

9. PUC Resolution 4089 – Jan. 21, 1998 • “SCWC has incurred and expects to incur substantial costs in this defense, which costs may or may not be recoverable through insurance.” • Company was placed on notice that the PUC would “carefully scrutinize the amounts and types of expenses booked to the memorandum account.” • The PUC also pointed out that “we are particularly concerned with the possibility that this lawsuit may end up in a settlement and not go to trial. Should the commission allow settlement costs (less any insurance proceeds) in rates to be recovered from its rate payers? If SCWC settles, would that encourage additional suits yielding more settlements?”

10. Resolution 4089 – Jan. 21, 1998 • “We expect that SCWC will not be passive with the insurance companies to which it pays premiums funded by its rate payers, customers of the water company. • SCWC should actively and quickly pursue resolution of its rights under insurance policies currently enforced. • We would expect SCWC would aggressively pursue legal action for recompense from original polluters. • Reasonable legal expenses would be considered appropriate for inclusion in memorandum account.”

11. Though the PUC granted the memorandum account on January 21, 1998, it also added in its final order that it was the “Commission’s policy that litigation costs are not allowable for rate-making if the utility is found negligent or admits liability.”

12. In January 1998, two more cases were filed, this time in Sacramento. • The allegations were the same as those made in the Los Angeles/San Gabriel Basin area. • Approximately 800 plaintiffs were named and, again, one of the Los Angeles firms involved in the “Erin Brockovich” case was the lead for one group of plaintiffs. • The cases continued to name only water companies as defendants. • The chief consequence of which was that each water company would be forced to file cross-complaints against polluters and prove contamination was caused by them – an extremely costly process.

13. Settlement costs recovery? • If settled, will there be additional suits? • If tried, what if we lose? • If tried and won, will we recover expenses? Mr. Dilemma, CEO SCWC

14. Despite the caveats in the PUC’s resolution, the company determined to move forward aggressively and defend itself against all of the allegations in all of the cases. • The company appointed one lawyer to be the “quarterback” to lead the defense of all the cases in both locations, select and lead appropriate counsel in both locations, select appropriate insurance coverage counsel, deal with the agencies, political and PR issues when asked, and generally, WIN.

15. PUC ACTION • On March 12, 1998, the PUC issued an Order Instituting Investigation (OII). • Required each of the 25 Class A water purveyors in California to give a history of each well in its state-wide system for past 25 years, exercising its ongoing jurisdiction of water companies. • On March 26, 1998, the PUC through Resolution No. W-4094 authorized memorandum accounts to be established by each of the utilities that were defendants in the litigation.

16. COURTS REACT TO PUC’S OII • Beginning in June 1998, Superior Courts in Los Angeles and Sacramento stayed or halted all legal proceedings against the water companies, pending outcome of the PUC’s OII. • The judge in Ventura County (where one of the cases had been transferred) dismissed the water companies on jurisdictional grounds. • Plaintiffs also began serving the polluters/contaminators with suit in both Los Angeles and Sacramento. • Approximately 80-90 polluters/contaminators in Los Angeles, but only 2 in Sacramento. • Plaintiffs appeal both sets of rulings.

17. Cases remain stayed as the appellate briefs were written and oral argument was scheduled for Summer of 1999. • All the while, each of the 25 utilities were immersed in filing their compliance reports with the PUC for the OII. • For SCWC, this involved tracking history of 300 wells over 25 years. • Project was costly and enormously time consuming of company resources and attorney time.

18. The PUC’s inquiry was to determine: • (1) whether current drinking water standards adequately protect the public health and safety; • (2) whether the regulated water utilities have complied with those standards; • (3) what remedies should apply for non-compliance with safe drinking water standards; and • (4) whether the occurrence of temporary excursions of contaminant levels above regulatory thresholds are acceptable “taking into consideration economic, technological and public health and safety issues, and compliance with Public Utilities Code §770.

19. PUC concluded, some 18 months later, that: • Existing DHS drinking water quality standards adequately protect the public health and safety • Over the past 25 years regulated utilities, including defendants in these lawsuits, had provided water that was “in no way harmful or dangerous to health” • Utilities satisfactorily complied with DHS drinking water quality requirements

20. In September 1999, the California Court of Appeal ruled unanimously that the cases were preempted insofar as they seek remedies against regulated utilities. • The victory, however, was short-lived. • On December 15, 1999, the California Supreme Court granted review of Court of Appeal decision.

21. While the defense cases in Los Angeles and Sacramento were winding their way through the court system, SCWC was losing wells in the Sacramento basin as a result of contamination from rocket fuel by Aerojet General Corporation (Aerojet), and a poor clean-up plan approved by the State of California. • Beginning in February 1997, the company lost 8 wells of its 23 well system through January 2000. • By July 2002, 12 wells were shut down.

22. SCWC approached the Governor and Attorney General for a tolling agreement so that statute of limitations issues would not force a suit to be filed against the State of California, but SCWC was rejected. • Aerojet sent a late response to the request for a tolling agreement which was unacceptable. • On October 25, 1999, a suit was filed in the Sacramento Superior Court against the State of California on theories of inverse condemnation, nuisance and trespass. • On the same date, a second suit was filed against Aerojet for negligence, nuisance and trespass theories.

23. NECESSITY FOR SUIT(Sacramento) • The causes of the contamination were essentially two-fold: • The contamination caused by Aerojet by rocket fuel additives, Perchlorate and NDMA, which migrated through the soil and into the groundwater, and were continuing to be injected (re-pumped back) into the groundwater supply as a part of the “Cleanup Plan.” • An ineffective cleanup plan mandated and/or agreed to by the State of California, which perpetuated the contamination and overseeing Aerojet as part of a CERCLA cleanup action begun in 1986 against Aerojet by California and Federal EPA. (Superfund Site)

24. MEMO ACCOUNT FOR SACRAMENTO CASES • On November 23, 1999, SCWC filed an advice letter requesting authority to establish a NEW memorandum account for the Sacramento cases (Arden-Cordova). • TO THIS POINT, PUC HAD NEVER ALLOWED UTILITIES TO ESTABLISH MEMO ACCOUNTS FOR CAPITAL PROJECTS AND INCREASED OPERATING AND MAINTENANCE COSTS. • IT WAS ALSO RARE TO HAVE PUC PERMIT A MEMO ACCOUNT WHERE THE UTILITY IS A PLAINTIFF. • Annual operating revenues for the Arden-Cordova district were $6 million and the rate base was less than $14 million. This is a small district that was facing catastrophic losses. • On February 3, 2000, the PUC, pursuant to Resolution W-4181, authorized a memorandum account to record costs associated with the two cases.

25. RESOLUTION • The PUC’s resolution specifically authorized SCWC to “use every means possible to maximize its insurance proceeds and to seek restitution from the polluters of the basin so as to lessen any possible regulatory burden on its customers.” • SCWC agreed to credit its memorandum account by all amounts, including punitive damages it receives from defendants. • SCWC was authorized to keep 10% of all punitive damages, net of expenses it obtains from the pending litigation.

26. In February 2001, SCWC sought an increase in gross annual revenues to amortize the accumulative balance of the water quality memorandum account involving the two cases in Sacramento against the State of California and Aerojet. • In its order of April 19, 2001, the PUC refused to allow any amortization of the memorandum accounts where the company was a defendant, only because the cases were still open and the companies might still be culpable.

27. In the Sacramento lawsuits where the company was a plaintiff, the Commission permitted the memorandum costs, at that point in time to be passed on to the Arden-Cordova (Sacramento) customers. • REMARKABLY, it was recommended that “the Commission should approve recovery subject to refund as A MESSAGE OF SUPPORT TO THE UTILITY.”

28. SUPREME COURT ACTION(Defense Cases) • On February 4, 2002, the California Supreme Court issued its unanimous ruling in the case of Hartwell v. Superior Court. • The Court did reaffirm that DHS and the EPA have exclusive authority to set standards and enforce laws related to state and federal Safe Drinking Water Act provisions. • The Court also affirmed that PUC has general and specific powers to ensure the health, safety and availability of the public’s drinking water in conjunction with DHS enforcement authority. • The Court agreed that the two agencies have concurrent jurisdiction over water quality safety.

29. The only thing the plaintiffs did win was the right to replead their claims in the Superior Court on the theory that the water failed to meet federal and state Safe Drinking Water Act standards. • The cases were thereafter assigned to Superior Court judges in Los Angeles and Sacramento respectively to restart the litigation process in the Spring of 2002.

30. Supreme Court (kinda won) Court of Appeal (won) Superior Court L.A./Sacramento Superior Court (won) L.A./Sacramento

31. STATUS OF DEFENSE CASES • From the Spring of 2002 over the course of the next 2 ½ years, the 22 contamination cases in which SCWC was a defendant in Los Angeles and Sacramento proceeded. • In August 2004, the Los Angeles cases were DISMISSED as to all of the CPUC-Regulated Utilities on jurisdictional grounds. These cases are STILL PENDING APPEAL and an argument date is expected shortly. • In the Fall of 2004, the cases against the CPUC-Regulated Utilities in Sacramento were also DISMISSED on jurisdictional grounds. Those cases were NOT appealed.

32. Supreme Court (kinda won) Court of Appeal (won) Court of Appeal (L.A. pending) Superior Court L.A (pending) Sacramento (won) Superior Court (won) L.A./Sacramento

33. LITIGATION COSTS OF DEFENDING THE 22 CONTAMINATION CASES • $5,389,509.80 were expended defending the cases in Los Angles and Sacramento. Of this amount, $5,048,354.77 was paid for by insurance. • Thus, 93.6% of the defense costs were paid for by insurance. • This is particularly good news because the cases in Los Angeles are on appeal, totaling 19. All other parties in Los Angeles and Sacramento have settled with other defendants, except for SCWC and the other Class A regulated utilities. • Should the appeal be unsuccessful, approximately 1,500 persons would remain as plaintiffs. (give or take a few hundred)

34. CASE AGAINST STATE(Sacramento) • In an attempt at settlement, a mediation was held in the Spring of 2002. • Following the mediation, a settlement was arrived at with the State and its various entities. • The total settlement number of $2,475,000 was LESS than the legal fees and costs incurred. • The terms of the settlement, however, were extremely favorable to SCWC.

35. SCWC SETTLMENT WITH THE STATE • The settlement provided the company with a monetary payment, and a critical, powerful ally in its effort to obtain replacement water supplies from Aerojet. The settlement required: • The State to pay SCWC $2,475,000 toward incurred costs; • Cause Aerojet to provide SCWC with a secure replacement source of potable water available within 24 hours, actually deliverable to the area served by the lost wells.

36. SCWC Settlement With the State (cont.) • The State assist in developing a plan for Aerojet to provide SCWC with a permanent source of replacement water. • The total legal fees incurred in the action against the state were $5,548,507. • PUC, pursuant to the memorandum account, permitted $502,793 to be amortized over 6 years to make up the $3 million difference between funds spent and received.

37. CASE AGAINST AEROJET(Sacramento) • In October of 2003, the day before trial was to begin, a settlement was reached with Aerojet. • Aerojet later attempted to reconstruct some terms and conditions of the settlement. • Additional motions in court confirmed that the partially typewritten, partially handwritten settlement was binding upon the terms as stated.

38. FACTUAL BACKGROUND OF SETTLEMENT • Aerojet owns in excess of 8,000 acres of land in Sacramento. • Land is slated for development according to Aerojet. • Aerojet needs water in order to gain development rights. • SCWC had its service area contiguous to some of the land to be developed. • SCWC has applied to the PUC to be the service provider as development takes place. • As land is developed, Aerojet will assess a Water Availability Fee (WAF) of approximately $6,000 on each equivalent development unit (EDU) of new housing, collected from the builder/developer by the city of Rancho Cordova, and transmitted to SCWC.

39. TERMS OF AEROJET SETTLEMENT • SCWC would be paid $8,734,964 as reimbursement for capital expenditures necessary to continue delivery of short term replacement water. • $8 million in reimbursement for additional capital costs (guaranteed) and $17.5 million in reimbursement for litigation costs (not guaranteed). • 100% of SCWC’s costs (if any), IF Aerojet’s groundwater remediation plans do not succeed and other wells go down. • The source of the $8 million and $17.5 million payments is water supply availability fee (WAF).

40. ADDITIONAL BENEFITS OF THE SETTLEMENT • If litigation had been avoided altogether, SCWC’s RATEPAYERS WOULD HAVE FACED COSTS WITH A PRESENT VALUE OF $274 MILLION (2004) OR ABOUT $18,400 PER THE CONNECTIONS in the Cordova system in July 2003, to convert to a surface water system, with less reliable water service and no guarantee of success • This service area is unique because there is a guaranteed supply of water for customers. • With a reliable total supply of 20,200 acre feet, which includes replacement water from the settlement, SCWC will have total build out of its current service area.

41. If SCWC had litigated through trial, there would have been additional litigation costs, in the face of some degree of uncertainty and risk, but with the potential prospect of not recovering the litigation costs themselves. LITIGATION MAY HAVE PROVIDED MONEY, BUT NO GUARANTEE OF A REPLACEMENT SUPPLY at the cost of groundwater without contamination. • SCWC spent $20 million in the 5 years after the authorization of memorandum account, on capital projects to replace lost water supplies. Aerojet reimbursed all but $8 million of this sum and under terms of the agreement will reimburse the remainder in equal installments with interest at 5% compounded monthly accruing from January 1, 2004.

42. The initial development of Aerojet involves 1,500 acres targeted for 4,500 EDU’s. The assumption is that approximately 300 dwelling units will be built per year beginning in 2009. • The source of much of this long-term replacement water will be treated groundwater discharged by Aerojet into the American River. • Payment of the $8 million earmarked to complete reimbursement for capital expenditures is guaranteed in five installments. If the WAF funds available on each installment date are insufficient, Aerojet will make up the difference.

43. SCWC’s REQUEST TO THE COMMISSION • SCWC asked the Commission to order: • Amortization of the $22,100,000 over 20 years as a rate surcharge (about $1.28 million per year) with “true-ups” every three years in Arden Cordova’s general rate case. • This would amount to a $5.68 per month increase in customer’s monthly billing. For commercial customers, it would amount to approximately a $16.70 per month increase. • SCWC, as a part of the request, would shorten the amortization period and step down the amortization rate in subsequent general rate case cycles as development increased. • The worst case scenario for SCWC ratepayers would be paying roughly $6.2 million, with the amortization rate running for approximately 8 ½ years, not 20.

44. It was the view of the outside accounting/auditors that much of the $22.1 million would have to be written off if the Commission approval for the total sum involved was not allowed to be amortized. • Writing off such a sum would have virtually wiped out most of the profit of the company with all of the expected dire consequences in such a situation.

45. On October 30, 2003, SCWC filed an advice letter with the PUC for amortization of part of the current balance of the memorandum account authorized by prior Resolution W-4181 (Sacramento cases). We Don’t Pay! Don’t write off the bottom line! Ratepayer Shareholder

46. Though original application was filed October 30, 2003 the final decision was not handed down until July 21, 2005. • In the ensuing 21 months, SCWC’s outside accountants became increasingly concerned about potential contingency nature of settlement. • SCWC was forced by their accountants to move the PUC for amortization of the current balance, before trial was even commenced. Motion was denied on December 14, 2004, but SCWC was assured a speedy resolution of the entire issue.

47. OFFICE OF RATEPAYER ADVOCATES VIEW (our adversary) • ORA began review of all documents in Summer of 2004. Constant series of meetings, document production and review, countless e-mails, company and attorney time. • The ORA view was quite simple: • From a rate-making standpoint, shareholders, not ratepayers should bear the risk of recovery under a settlement fashioned by utility management and its lawyers. • The entire sum should be entered into the memorandum account as an offset against costs. • No consideration should be given to the contingent nature of the payment.

48. PUC PROCEDURE • Pre-hearing conference • Scoping memo • Direct testimony submitted in writing beginning in the Summer of 2004. • Rebuttal testimony submitted in writing in December 2004. • One week trial in March 2005. • Opening briefs submitted in April 20, 2005; reply briefs submitted May 5, 2005.

49. MAJOR ISSUE FACING CPUC • The CPUC needed to resolve how to handle the shortfall between costs of the groundwater contamination, and what the settlements offer in monetary recovery. • The interplay of ratemaking and accounting issues involved several factors: • The likelihood of receipt of the $17.5 million, and the implications of excluding it from amortization and customer rates.

50. CPUC EVIDENCE ANALYSIS • The likelihood of receipt of $17.5 million: • The PUC noted from the testimony that Aerojet is notorious for not agreeing to pay attorneys’ fees. Aerojet had a unique arrangement whereby the US Government picked up a large percentage of its defense costs (88 cents on the dollar). Aerojet was thus never exposed for its attorneys fees and typically took a scorched earth policy, not only in the handling of their cases, but in regard to the payment of attorneys’ fees. • Because the $17.5 million was coming in the form of a WAF, the settlement agreement does not call it a payment for attorneys fees. • Aerojet as a company has transformed itself into a development company with its biggest asset being land.