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Fair Return
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

Used principally in connection with earnings of railroad and public utility corporations.  It developed out of the notion that such public service corporations, by serving the public interest and in many cases being granted monopolistic franchises, should be allowed to charge only such rates for their services as would yield a reasonable return on the fair value of the assets devoted to providing the service.  A fair return, therefore, involves two variables:  (1) fair valuation of the property required for the services, and (2) fair rate of return thereon.

For years, the 1898 case of Smyth v. Ames (169 U.S. 466) was the leading case in valuation cases involving the necessary elements in fair value.  The comprehensive role of that case read as follows:  "And in order to ascertain that value, the original cost of construction, the amount expended in permanent improvements, the amount and market value of its bonds and stocks, the present as compared with the original cost of construction, the probable earning capacity of the property under particular rates prescribed by statute, and the sum required to meet operating expenses, are all matters for consideration, and are to be given such weight as may be just and right in each case.  We do not say that there may not be other matters to be regarded in estimating the value of the property."

Both the original cost and reproduction cost bases for fair valuation were recognized in the above, as well as capitalization and market value thereof.  The Supreme Court, however, did not indicate the basis to be used, or even combination of bases, and as a result the courts became involved in a series of valuation cases over the years.  By 1933, the Supreme Court was ready to leave the determination of fair valuation and fair rates to the administrative agency concerned, "so long as constitutional limitations are not transgressed"  (Los Angeles Gas & Electric Corp. v. Railroad Commission of California, 289 U.S. 287).  Emphasis on any single formula or combination of formulas was finally abandoned in the landmark case of Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591 (1944), in which the doctrine of end result was enunciated, as follows:  "Under the statutory standard of "just and reasonable" it is the result reached not the impact of the rate order which counts.  If the total effect of the rate order cannot be said to be unjust and unreasonable, judicial inquiry under the Act is at an end.  The fact that the method employed to reach that result may contain infirmities is not them important."

Thus emphasis has shifted from the valuation formula to the earnings result of rates allowed.  The Hope case indicated that fair rates would be those "which enable the company to operate successfully, to maintain its financial integrity, to attract capital, and to compensate its investors for the risks assumed "  At the federal level, the Federal Power Commission used to standardize rates of return as 6% for all electric companies and 6.5% for all natural gas companies under its jurisdiction, but in recent years it has abandoned such generalization and passes on rates on an individual basis.  The Federal Communications Commission prescribes just and reasonable rates for interstate of foreign communications companies.  State regulatory commissions operate under varying statutory conditions, some states providing no rate regulatory powers at all over specified types of utilities.

In the case of railroads, the VALUATION ACT OF 1913 provided for valuation of all railroad properties in the U.S.  The Interstate Commerce Commission (ICC) finally completed practically all of the work by mid-1934.  Then the TRANSPORTATION ACT OF 1920 enacted among other things the concept of fair return on fair value of the railway property providing the service, setting up the recapture clause.  If net railway operating income exceeded 6% of the value of the railway property held for and used by the railroad in the service of transportation, one-half of the excess was to be placed in a reserve fund by the railroad, and the remaining half was to be paid into a general railroad contingent fund, to be maintained for the benefit of railroads generally by the ICC.  Many railroads opposed this provision as unconstitutional, many not paying and other paying under protest, but the issue was never upset in a test case.  Finally, it was repealed by the Transportation Act of 1933.  The ICC therefore follows no precise formulas in deciding on just and reasonable rates for all common carriers (railroad, highway, water, and pipeline) and reasonable minimum rates for contract water and highway carriers.

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