Corporate Governance Failures Through Organizational Transformation: The Montana Power Company / Touch America Case

Julie Penner Primary Reader: Paul MacAvoy, Economics Second Reader: Dennis Michaud, Economics

Submitted in partial fulfillment of the requirements for the degree of Bachelor of Arts with Honors in Public and Private Sector Organizations at Brown University December 2004 1

Every eight-year old who learns to play monopoly knows the first rule is never to sell your utilities.

Jan Hulme

This project is dedicated to all the former employees, customers, and shareholders of the Montana Power Company.

Acknowledgements .. Chapter 1: Corporate Governance, Energy Deregulation, and the Telecommunications Industry Introduction Energy in Montana .. The Montana Power Company Deregulation and the Energy Industry . The Telecommunications Industry .. Theory . Objective .. Case Justification . Research Design .. Chapter Outline .. Chapter 2: Historical and Literature Review Speculative Bubbles The Growth of the Internet . The Capital Markets The Telecommunications Industry .. The Utility Industry . Table 1: Utility Prices in the Fifty States (1995) . Chapter 3: Theory Theoretical Framework for Analysis ... Theory of Competitive Advantage .. Competitive Strategy ... Generic Competitive Strategies Low-Cost Dominance .. Differentiation . Low-Cost and Differentiation Variations Industry Analysis Threat of New Entry ... Rivalry Amongst Firms ... Nature of Competition Within an Industry . Oligopolistic Competition ... Behavior Factors . Agency Theory Corporate Governance . Chapter 4: Analysis and Discussion of the Montana Power Case Chapter Outline Industry Analysis . Table 2: Industry Comparison; Regulated Utility vs. Telecom Montana Power as a Utility .. Exit From Power Generation Exit From Power Trading and Marketing . Exit From Remaining Energy Operations Montana Power / Touch America as a Telecommunications Company ..

5 6 7 7 9 10 11 12 12 13 13 15 17 18 21 23 26 29 29 31 33 34 35 36 38 39 40 41 41 42 44 45 50 51 52 53 56 60 61 63

The Growth of Fiber-Optics Telecom Bubble Bursts Legal Problems . Touch America Files for Bankruptcy .. Corporate Strategy ... Managing Risk in Strategic Decisions ..... The Growth Mentality . Strategy Analysis Low-Cost Strategy .. Corporate Governance and Strategy Formation .. Bounded Rationality The Board of Directors Executive and Director Compensation Change of Control Payments .. Capital Markets and Corporate Advisors Findings Montana Power in a Changing Industry .. Implications . Energy Deregulation Research Limitations ... Further Research .. Appendix A: Qualitative Data from Montana Power Company Table 3: Timeline of Events at Montana Power Company . Table 4: The Montana Power Company Board of Directors .. Appendix B: Historical Charts Chart 1: Montana Power / Touch Americas Historical Stock Chart .. Chart 2: The Stock Market Bubble . Chart 3: Industry Growth for Telecommunications and Energy . Graphs 1 & 2: The Energy Mix in Montana and Nationally Appendix C: Fiber-Optic Expansion Chart 4: Fiber-Optic Network Expansion by Route Miles*, 1992-2001 .. Chart 5: Fiber-Optic Network Expansion by Company, 1997-2001 Chart 6: Touch America Fiber-Optic Network Expansion, 1997-2002 Appendix D: Montana Power / Touch America Selected Financial Statistics Chart 7: Montana Power / Touch America Revenues Chart 8: Montana Power / Touch America Net Income . Chart 9: Montana Power / Touch America Earnings Per Share (EPS) Bibliography ..

64 67 68 71 73 76 76 78 79 82 82 84 87 90 91 93 96 97 98 99 99 101 104 106 107 108 109 110 111 112 113 114 115 116

Acknowledgements

Professor MacAvoy - I had no idea at the onset just how complex a puzzle I stepped into with this thesis. Luckily, your guidance helped me tackle such strange and bewildering topics as the retail deregulation, oligopolistic competition, dark fiber and so much more. Your questions and comments spurred me on and helped me find the path this story took. Ill never forget that mistakes arent very interesting to write about. I simply could not have done it without you, and for that I am forever grateful.

Professor Michaud - My interest in corporate governance started with your inspiration and instruction. In fact, the very idea for this thesis was yours, and without the foundation you laid, I never would have looked deeper into this case. Your work inspired the heart of this thesis, and I can never thank you enough. To My Theta sisters From Jocelyns thesis advice to my familys love and support and the continual progress checks from many of you, I want to thank all of you for taking an interest, for noticing when I disappeared, and more importantly, being glad to see me when I reappeared. A very lonely existence would have consumed me before I finished if not for all of you. To Matt The late night talks and coffee really made a difference. Thanks for your encouragement, occasionally tolerating my stress-induced behaviors, and pulling me away from work with late night reruns. Heres looking to next spring to be a little more relaxing. To Jason This semester was crazy, stressful, and sometimes lonely, it was you I turned to when I felt the most confused and the most over-whelmed because you understood. Weve been through a lot together at Brown, but this semester you really were the friend I could always lean on, and filled a whole in my life. Having you here this semester has been a true blessing to me. To my family, especially my parents Thank you for all the love, support, and encouragement during these four years, especially this last one, it was so much more than I ever expected. Youve given me everything I every wanted and so much more, and Im so grateful for my Brown experience and the opportunity to make you proud. I am so lucky to have you as parents.

Chapter 1: Corporate Governance, Energy Deregulation, and the Telecommunications Industry

Introduction In the last decade, some great corporate dramas have played out in the global marketplace. Not since the stock market collapse of the 1920s has the business community witnessed such meteoric climbs in stock prices only to have them fall apart under poor management and accounting scandals on this scale. Since the fall of Enron, the sixth largest company at the time of its demise, national attention has been focused on cases of mismanagement and corporate malfeasance. Approximately half of all Americans own some type of security1. With such a large percentage of individuals invested in the market, the effects of successive cases of corporate greed have rippled throughout our economy. Investor confidence was rattled by scandals at Enron, WorldCom, Global Crossing, Qwest, Tyco, Putnam, Arthur Andersen, and even the New York Stock Exchange. Investors watched as executives at Enron and Tyco and Martha Stewart were led away in handcuffs and became increasingly less tolerant of abuses of corporate power. Numerous executives exploited the inflated stock market opportunity and in doing so, walked away with millions while shareholders saw the value of their securities disappear leaving many to wonder about the role responsibility of the board of directors. The state of Montana and the case of the Montana Power Company offers a small but meaningful microcosm of the countrys ailing corporate governance system.

The nineties witnessed an influx of new investors through vehicles such as IRAs, 401(k)s, and mutual funds. Social Scientists have also noted the baby boomers generational effect on the growth of securities investment. (see Shiller)

Energy In Montana Although Montana is the fourth largest state in terms of area, it is home to just over 900,000 people or .3% of the national population2; making the state relatively sparsely inhabited by individuals and businesses alike. The sparse population in Montana makes infrastructure needs such as supplying energy a challenge, but luckily the state has a number of power resources. Wind energy operations, hydroelectric dams, coal deposits and natural gas assets have all been exploited and developed. In fact, due to the abundance of power generation and the low population, Montana is classified as an energy exporting state.3 Another ramification of Montanas low population density is the lack of businesses willing to provide services to such remote locations. Montana, like other states in the union, provided energy infrastructure and services for many years as a public good by publicly regulating the major supplier who held a monopoly over power generation and distribution throughout the state4. That supplier for almost ninety years was the Montana Power Company. Until recently, the Montana Power Company was the only Fortune 500 member in the state. The Montana Power Company Montana Power Company (MPC) incorporated in Montana in 1912 as a result of four merging electrical companies.5 For almost 90 years, MPC provided reliable energy and jobs. Additionally, the company declared dependable dividends to its

2 3

U.S Census Bureau, 2003 estimate Montana has the 7th lowest retail electricity prices in the nation. The 2000 state average rate of $50.30/MWh was 25 percent below the national average retail rate. Montana power rates are very low because of a high proportion of low cost coal (56 percent) and hydroelectric generation (42 percent). Its low cost structure has made Montana a large net power exporter. (see http://www.careenergy.com/powering_life/state_profiles/mt.asp) 4 with the exception of rural energy co-ops who bought and distributed their own power and MontanaDakota Utilities, who supply some power in the Eastern part of the state. 5 Malone, Roeder, and Lang; Montana: A History of Two Centuries

investors, two-thirds of whom were Montana residents. Although the company was regulated by the Public Service Commission, it was successful in turning a profit every year due to the low cost of energy generation. In the late nineties, Montana was ranked as having the seventh cheapest energy in the union, largely due to the majority of the power coming from efficient hydro-electric as well as coal-burning facilities and the fact that the state produced enough energy to power Montana with some excess. In the nineties, Montana Power Company and the State of Montana began to see serious changes in the energy industry as deregulation became a buzzword amongst policy makers. California was the first state to approve energy deregulation at the retail level with the hopes of increasing competition and lowering the cost of electricity. Montana and many other states followed suit, and in 1997, the passage of Senate Bill 390 (SB390) set in motion deregulation in Montana. In December of that year, MPC announced the sale of power generating assets, followed in 2000 by the announcement of the sale of their remaining energy operations. Montana Power then reinvested the majority of the proceeds from the sale of assets into their telecommunications subsidiary, Touch America. By the beginning of 2001 over $600 million dollars from the sale of assets had been invested into Touch Americas expansion of fiber-optic networks and voice and data transfer operations. Unfortunately, Montana Powers myopic investment strategy in the telecom industry came just in front of one of the largest investment bubbles in history. Saddled with lower than expected demand and poor cash flow, Touch America was quickly thrown into serious financial trouble. Facing poor investment returns and

burdened by the wave of collapsing telecom companies and lawsuits, Montana Power filed for bankruptcy on June 19th of 2003. Deregulation and the Energy Industry More than once in our 200 year history laissez-faire economics has come to be the dominant prescription of politicians and businessmen alike. The rationalization behind deregulation is based upon the now standardized economic principles of adding competition to the market in order to achieve lower prices for consumers and keep inefficiencies formed by monopolies such as disincentives to innovate and rents to a minimum. Without competition in the marketplace, companies with monopolies have little incentives to innovate or to be efficient due to their ability to lock in demand at a certain rate. In economic terms, monopolies do not produce at the market equilibrium price where supply meets demand. Rather, monopolies as the single supplier are able to extract a premium or rent above a competitive market price. Monopolies are sometimes designed to produce a public good, such is the case in the energy transmission and distribution industries, but these monopolies are regulated to protect consumers from uncontrolled price premiums. The bankruptcy of Montana Power Company could not have happened without the passage of Senate Bill 390, which deregulated the energy market in Montana. However, energy deregulation in Montana did not take place in a vacuum. The push for deregulation in last thirty years has been significant in a number of industries including railroads, airlines, telecom, and energy. In the late nineties, retail and wholesale energy deregulation became the latest sector to experience deregulation. Although deregulating the energy market has come before Congress in the past, to date

policy makers are unwilling to dictate retail energy policy to the states6. It was California, however, that was first to approve statewide retail energy deregulation and created a model for other states to follow suit. The Telecommunications Industry The stock market bubble of the late nineties was fueled by a combination of factors including the growth of the internet and internet technologies, the expanding volume of trade, growth in stock ownership, optimistic predictions by analysts, the growth stock mentality, and other behavioral influences such as irrational exuberance. While the internet was growing extremely fast in the mid-nineties, by the later part of the decade, predictions about the growth of the internet and new technologies were inflated. Inaccurate future expectations led to an over-valuation of almost every technology or technology-related stock traded on the New York Stock Exchange or the NASDAQ including telecommunications companies. Telecommunications companies saw the profit potential in supplying the infrastructure for the internet and took steps to capitalize on the opportunity to utilize the enthusiasm of the capital markets to make the necessary investments. AT&T, Qwest, WorldCom, and MCI others began laying fiber-optic cable networks hoping to be the company to meet the information transfer needs of a growing base of internet users. The handful of well-established telecom companies were not the only firms trying to expand into the telecommunications industry, in fact a number of companies from other industries as well as a few start-ups entered the market as they sought to profit in the industry and also increase their share price by incorporating technology as a part of their image.
6

Mclean and Elkind, The Smartest Guys in the Room

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Telecommunications companies began laying fiber-optic cables with enormous capacities all across the country, literally burying billions of dollars of assets most of which is yet to be lit7. This scurry of activity was in part made possible by the passage of the Telecommunications Act of 1996 that changed the regulatory statutes regarding long-distance service. So much cable was laid that competing companies installed an

excess of fiber-optic capacity. When the economy started to slow down and the internet bubble burst, the price for information and internet services tumbled, and with it went many of the companies reliant upon those revenues. Theory Some key theories will be employed to understand and explain and link the downfall of Montana Power including competitive strategy, behavioral factors, and agency theory. Competitive strategy is the foundation for understanding the environment in which the company operated and provides a framework for examining the capacities of Montana Power so that the strategic decisions that were made by management and the board can be evaluated and critiqued. In addition to utilizing competitive and strategic theory, this thesis will explore behavioral factors including bounded rationality and irrational exuberance that affected the decision making process of management and the board and therefore had a profound impact on the outcome of the company. Finally, agency theory will be developed and applied in detail in order to explain the structures as well as the behaviors of the board of directors. The agentprincipal problem which agency theory is based upon is central to the idea of providing quality oversight through effective corporate governance. Therefore, agency theory will be invoked in an effort to explain why corporate governance and the creation of a
7

Lit fiber optic cable actively carries a signal. Cable that does not carry a signal is called dark fiber.

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system susceptible to corporate governance failure caused poor decision making at Montana Power Company. Objective This thesis will use the case study approach along with the analysis of pertinent theories to answer the question of who or what ultimately caused Montana Power Company to file for bankruptcy. The case study method is appropriate in order to focus on why certain decisions were made, who made them, how they were implemented and what outcomes they had.8 The paper also seeks to examine the relationships between various factors and events that led to the insolvency of Montana Power using organizational and behavioral theories. Lastly, the paper includes prescriptions for how similar events could be avoided in the future. Case Justification Only recently has research been undertaken that seeks to explain the link between corporate governance and strategic decision-making. This case is an interesting example of just such an intersection of theories. The effects of malfunctioning governance mechanisms in the economy are still being felt, and it is for that reason and many others that we seek to learn from the mistakes of the past and not repeat them in the future. Corporations, shareholders, and politicians are still looking for effective ways to prevent exactly the kind of outcome that resulted from strategic decisions made by Montana Power/Touch America. Thousands lost their savings, their jobs, their confidence in the stock market, or their faith in corporate leadership, and the Montana economy was adversely affected by the dissolution of the company, the rise in

Yin, Robert, Case Study Research, Design and Methods, 2nd Edition, page 12

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energy prices, and other effects.9 Finally, this thesis is needed to start answering the question so many Montanans have asked; Who (or what) killed Montana Power? Research Design The study of Montana Power/Touch America will employ the case study approach to examine what happened to the organization. The single-case method is useful in validating the theories it invokes to explain the phenomenon. In particular, this thesis represents an archetypal example of corporate governance failure using agency theory and its effects on corporate strategy decisions.10 The case will use various levels of analysis including the society, the organization, the sub-group (board of directors), and the individual levels in order to produce an accurate picture of the forces that influenced Montana Power as it transitioned through its final years. Chapter Outline Chapter 2 will be a combined historical review and literature review that serves as background for the rest of the thesis on subjects such as the utility and telecommunications industries to more intangible topics such as the capital markets and corporate governance. Chapter 3 will explore the theories used to explain events at Montana Power including competitive and strategic theory, behavioral theories such as bounded rationality and irrational exuberance, and agency theory. Chapter 4 will detail the events that took place at Montana Power focusing on the process that drove the decision-making at the firm. This chapter will also apply the pertinent theories to events in order to explain at the organizational and behavioral levels how the operational
9

Montanas economy suffered to the loss of corporate income tax at Montana Power and a number of businesses were suspended or cut back due to the higher prices for electricity to industrial users (which was not subject to a transition period). 10 Robert Yin calls them critical cases. See Yin, Robert K., Case Study Research, Design and Method Second Edition

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system at Montana Power failed. Chapter 4 will offer some thoughts on how the downfall at Montana Power Company might have been avoided and how similar bankruptcies might be avoided in the future. The chapter will also discuss possibilities for further research on this case and especially best practices and reform within the corporate governance area of study.

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Chapter 2: Historical and Literature Review

The case of Montana Power is complex and involves a range of driving forces, each of which played a role in affecting the chain of events at the company. A basic knowledge of each of the following topics will provide a base for understanding the impact of environmental and structural elements. The chapter will therefore provide a background in and discussion of relevant issues related to speculative bubbles, the growth of the internet, the role of the capital markets, and the telecommunications and utility industries. Speculative Bubbles Robert Shiller in Irrational Exuberance defined speculative bubbles as, an unsustainable increase in prices brought on by investors buying behavior rather than by genuine, fundamental information about value.11 Speculative bubbles occur in fixed patterns, the first one dating back to the tulip bulb craze of the 1630s in Holland. Prices rose to astronomical rates as demand for bulbs continued to grow. Some individuals were willing to pay such prices for rare tulip bulbs, but the majority of citizens perceived the bulb market as an easy profit opportunity. The speculation was based on the assumption that buyers would continue to pay higher and higher prices for bulbs, or according to Schiller, a feedback loop was created.12 As with all bubbles, at some point investors decided to protect their profits and sell their investments. A negative feedback loop was formed as confidence in the value of the speculative investment falls rapidly, so did share prices, until the per share price more accurately reflected the fundamental value of the security.
11 12

Shiller, Robert J., Irrational Exuberance, chapter 1 pp. 5, Shiller, Robert J., Irrational Exuberance, chapter 3 pp. 60

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The railroad boom in the mid 1800s was another speculative bubble, but with one important difference that would exemplify bubbles to come. The railroad industry was made possible by new technology that at the time promised greater productivity through increased communication and falling transportation costs. The promise of a technology that would revolutionize business became a prime attraction for investors who rushed to lend capital. The stock markets facilitated capitalization primarily through equity offerings of the various railroad companies, which fueled by enthusiasm caused a speculative bubble in the companies stock. In economic terms, the demand for investment opportunities increased greatly, causing the price of such investments to rise as the demand curve shifted to the left. A secondary result was an increase in the supply of railroad investment opportunities, some of which turned out to be fraudulent or financially unsound but managed to raise money through association of an industry with great investment demand. In 1891 after the burst of the bubble, financier Henry Clews wrote that the crisis was chiefly due to an excessive diversion of capital into the building of railroads, and also the fact that the new companies were organized upon a grossly speculative and inflated basis.13 In fact, many new technologies tend to cause speculative bubbles. Author Burton Malkiel points out the patterned nature of investments in new technologies asserting that there is a proven history of unrewarding investments in technology including the radio in the 1920s, the electronics boom of the 1950s and 1960s, biotechnology in the early 1980s, and most recently the internet bubble of the late 1990s. He also writes, The key to investing is not how much [the] industry will

13

Glassman, Cynthia A., Speech by SEC Commissioner: Sarbanes-Oxley and the Idea of Good Governance

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affect society or even how much it will grow, but rather its ability to make and sustain profits.14 It appears that market fundamentals are sometimes ignored by investors who translate rising stock prices as profit opportunities either through sale to other investors at higher prices or from the future revenues generated through new technologies. The Growth of the Internet While the foundations for what would become the internet began almost forty years ago as a defense department communications project, it wasnt until the midnineties that a sizeable portion of private citizens began taking advantage of the technology. By 1993, the World Wide Web was becoming more accessible to individuals other than computer scientists and academics thanks to a more user-friendly web-browser called mosaic X, the predecessor to Netscape Navigator.15 The increased usability of the internet spurred on the growth of websites and internet users; that is, improvements in software continued to make access to the internet easier for a growing population of computer users around the world. According to Business Week in early 1995, over 27,000 websites had already been created, and that number doubled every two months.16 From these high rates of growth of internet demand came the myth that, Internet traffic is doubling every 100 days, which was true for some period of time when Netscape first launched its web browser in 1995 and 1996, but by 1997 the rate had slowed to doubling about once a year.17 Its logical that a new technology like the internet would show explosive growth at its inception because its user base started virtually from zero, making extraordinarily high growth rates plausible, but not sustainable. This scenario is consistent with the
14 15

Malkiel, Burton G., A Random Walk Down Wall Street, chapter 4 pp. 102 Cassidy, John, Dot.Con, The Greatest Story Ever Sold, chapter 4 16 Cassidy, John, Dot.Con, The Greatest Story Ever Sold, chapter 4 pp.65 17 Malik, Om, Broadbandits, Inside the $750 Billion Telecom Heist, chapter 1, pp. 13-14

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characteristics of speculative bubbles. In late 1999, the number of internet users was estimated at about 100 million, and it was expected to grow to 177 million users by 2003. Likewise, the number of World Wide Web users was expected to grow from 142 million in 1998 to 502 million in 2003.18 By my calculations, these numbers represent approximately 15% and 29% compound annual growth rates, which represents a fastgrowing industry but certainly does not support the assumption of limitless growth. The Capital Markets In the American business model, the capital markets are primarily utilized to transfer excess wealth from investors to companies needing capital to take advantage of profit opportunities. A byproduct of the capital markets is that they respond to changes within a company and in its environment that has the potential to affect future earnings. Therefore, the markets can act as a signal for approving or disapproving of corporate strategies and decisions. The capital markets have historically also facilitated the spectacular gains in prices characteristic of speculative bubbles. Such transfers of wealth are often fueled by the publics perception that new technologies are synonymous with limitless returns. As Burton Malkiel writes, Part of the genius of financial markets is that when there is a real demand for a method to enhance speculative opportunities, the market will surely provide it.19 Such was the case in the bubbles of the South Sea Company20, the railroads, the biotech boom, and of course the Internet bubble.
18 19

Shiller, Robert J., Irrational Exuberance, chapter 11 pp. 205 Malkiel, Burton G., A Random Walk Down Wall Street, chapter 1 pp. 36 20 The South Sea Company was granted a monopoly over trade to the South Seas by the British government and funded the national debt in 1719, which increased its value amongst investors so much so that it created a speculative craze for the stock. Other investment opportunities sprung up to meet the demand for stock ownership, but many were fraudulent or ill-founded and lasted only a short time. From this time period comes the analogy of a bubble due to the ephemeral nature of such investments and their tendency to pop. See Malkiel, Burton G, A Random Walk Down Wall Street, chapter 2

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The late nineties saw many investors attempt to profit on new technology, mainly the internet and telecommunications, but also companies who built their businesses around supporting high-tech companies. Venture capitalists, hedge funds, and private investors alike swarmed to take advantage new companies initial stock offerings (IPOs) with the aspirations of instant wealth. The excitement over new technology, especially the creation of new applications for computers and the transition to digital processes, and the prolonged bull market prompted many to call the period of the late nineties the new economy or the new era, despite the historical tendency for this nomenclature to be false.21 Such euphoric buying created a market bubble as evidenced by inflated stock prices. The market moved away from traditional means of valuing companies such as earnings multiples, revenue growth, and other financial statistics, and investors continued to bid up the price of various start-ups and technology companies, most of whom had never produced a profit. The effects of the upsurge in prices in the high-tech sector spilled into the rest of the market to a lesser degree as share prices of the S&P 500 index rose dramatically above earnings levels. 22 This opportunity to gain access to large amounts of capital through the capital markets did not escape the notice of many telecommunications companies who were at the same time looking for funding to build their costly telecommunications networks. The stock market willingly supplied the capital needed to create the fiber-optic infrastructure we have today, but not without a cost. Speculatory pricing of internet companies spilled over into related industries because investors believed those firms would grow in proportion. Therefore,

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Shiller, Robert J., Irrational Exuberance, chapter 5 See Appendix A, Chart 2

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companies providing a wide range of goods and services to the computer and internet industries also saw speculation in their own stock prices. Furthermore, expansion in the telecom industry after the Telecommunications Act of 1996 prompted others to invest in the industry as expectations for high profit potential grew. The buying euphoria of the late nineties began to dissipate in early 2001 as many of the internet-based firms began to file bankruptcy proceedings. It became increasingly apparent that technology ventures were not profitable as previously assumed. Additionally, the national economy began to show signs of slowing. Pension fund and wealth managers accountable to investors began withdrawing funds from the market, effectively tightening the funds available to the corporate sector. The result was a collapse in investor confidence combined with a significant economic pullback, which led many stocks to plummet in price. The drops in equity added pressure to companies on the verge of bankruptcy. For a variety of factors including speculation as well as fraud, a number of major of companies throughout the internet and telecommunications industry were forced to file bankruptcy including Worldcom, Enron, GlobalCrossings, McLeod, and many others. The economy slowed dramatically, especially after September 11th, which continued to severely affect the telecommunications industry. The stock market bubble of the nineties contributed to the incidence of corporate fraud by creating incentives for executives to inflate earnings and projections in order to take advantage of inflated stock prices by selling shares out of their portfolios or compensation schemes. Stock options became a popular compensation tool for many boards of directors looking for ways to create incentives for management

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to align their goals with those of the shareholders. The use of stock options, however, created incentives fro executives to increase the stock price through any means possible including inflating earnings and other accounting fraud and pursuing high-growth strategies. The fact that senior managers were able to achieve such levels of malfeasance and in some cases fraud indicates significant failures in corporate governance, a subject that will be further explored. The Telecommunications Industry Changes to the nature and structure of the telecommunications industry came when Congress passed the Telecommunications Act of 1996. The act, which was the widest reaching in the industry since the divestiture of AT&T in 1984, sought to restructure competition in the communications marketplace. The act was partially motivated by the fact that long-distance rates and other communications services remained well above competitive levels despite new entrants in the industry since 1984.23 Indeed, many telecommunications service providers, carriers, and equipment manufacturers formulated and executed new business plans in an effort to capitalize on industry profit opportunities. Of particular interest to the industry was the growth of the internet and the growing demand for the ability to transfer data over phone lines. At the time of the Telecommunications Act, demand for internet capacity was growing at high rates. Many companies looked at the growth of Silicon Valley and the increase of dot-com companies as an indicator of growth and profit potential in the telecom industry. As the demand for internet capacity grew, the need for efficient data transmission grew proportionally, a service that the telecom industry sought to provide. It was perceived that to meet the demand needs of the growing base of consumers of
23

Peltzman and Winston eds., Deregulation of Network Industries Whats Next?, pp.74

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internet and communications capacity, additional phone lines, mainly fiber-optic cables, would have to be laid in a network, despite the considerable costs of doing so. Believing in the new era economics, many telecommunications companies began laying fiber-optic cables across the country, literally burying billions of dollars of assets. Economically speaking, it made sense for companies making investments in fiber-optic networks to lay enough to create capacity beyond the currently demanded level because the cost of adding cable in the future was very high. This tendency amongst telecom companies to lay more cable than was currently demanded contributed to a gross over-production of capacity for data and voice transmission. KMI Research found that between the beginning of 1996 and the end of 2001, about 80.2 million miles of fiber-optic cable was laid in the US alone.24 In 1990, seven companies owned some part of a national network, including the big three of AT&T, MCI, and Sprint, who together had the vast majority of market share, and made the industry oligopolistic in nature. By 1997, just one year after the passage of the Telecommunications Act, eleven companies had entered the national market. By 1999, seventeen firms were pursing nation-wide fiber optic networks, and by 2001 the market reached its peak of nineteen different providers, only one of whom was Touch America (Montana Power Company). In fact, the market was outpacing demand and creating an unprofitable scenario for all companies involved. The first articles appeared in 2001 concerning the overcapacity in the fiberoptics networks. So much cable was laid that an excess of capacity was installed by competing companies. Some estimates say as much as six times the needed amount of cable has been laid, most of which remains unused (known as dark fiber) to this day.
24

Malik, Om, Broadbandits, Inside the $750 Billion Telecom Heist, Prologue, pp. xi,

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When the economy started to slow down and the dot-com bubble burst, the demand for data transmission decreased suddenly. The shift in demand caused the price for communication services to diminish and with it went many of the companies reliant upon those revenues. The failure of many Internet start-ups sent ripples through the telecommunications industry. At the same time the capital markets soured on technology and telecommunications companies, which caused a massive reversal in the valuation and share price of related companies. Enrons broadband venture failed, as did WorldCom-MCI, Global Crossing, McLoed, and finally Touch America. The Utility Industry The regulated utility industry has remained fairly stable over the past decades. With the exception of PG&E who went bankrupt due to the post-deregulation California energy crisis, no electric utility company has ever filed for bankruptcy. The industry is characterized by controlled entry for competitors, predictable prices, and more often than not, a monopoly on the market. Due to these market characteristics, the regulated utility industry has a very low risk profile. The lack of volatility in the industry stems in part from the inelasticity of demand for energy, and partly from the stability of a vertically integrated platform that characterizes most regulated utility companies. Vertically integrated utilities control the three major components of the energy delivery process including generation, transmission, and retail distribution. With only a few exceptions, public service offices in each state regulate electric utility companies. Such a utility company would not typically encounter competition, and in fact, many have guaranteed rates which are adjusted to provide a rate of return to the company as

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provided by legal statues like the filed rate doctrine25. As a mature industry, most companies in the utility industry were showing 3-4% growth, primarily as a result of increasing energy demands within their geographical regions. These utilities produced consistent earnings and a rate of return that was highly predictable but relatively moderate compared to more growth-oriented companies. This finding is consistent with the risk-return performance expected from a company taking on minimum levels of risk. By contrast, many telecommunications companies in the late nineties were growth at the rate of 20-30%, but that industry was characterized by much greater risk. In the late nineties, the atmosphere in the utility industry began to shift. Deregulation became a serious topic of discussion at the state and national levels. The price of energy is a key factor in businesses ability to compete internationally, especially in the manufacturing industry. Therefore, it made sense theoretically that freeing the energy market would spur competition and lower prices in addition to creating incentives to operate efficiently. The long-run goal of a deregulated system was to help businesses compete more efficiently by forcing production inputs such as energy to be priced at the market equilibrium. Professor and author Paul L. Joskow said it plainly, The U.S. electric power sector is in the midst of major changes in its structure, the way it is regulated, and the role that competition plays in allocating
25

The doctrine originates in the rule that a utility may only charge its customers pursuant to a "filed rate" -- that is, a rate that has been filed and approved by the regulatory agency. Traditionally, the doctrine was cited when utilities filed a rate, experienced unanticipated higher costs, and tried to surcharge their customers for the increase. In recent years, a variant of the doctrine has arisen when the Federal Energy Regulatory Commission (which regulates wholesale power rates) has reviewed and approved a rate under which a utility purchased power and then the utility's state PUC (which regulates retail rates) refused to let the utility pass the costs of that purchased power through to the ratepayer. In those cases, federal courts have said that the supremacy of federal law compels the state to allow the utility to pass through the rates it paid under the federally-approved filed rate. However, those cases all involved state regulatory action taken after the federal approval of a specific rate, where the state clearly was attempting to undermine a federal order finding the wholesale rate "just and reasonable." See http://www.consumerwatchdog.org/utilities/fs/fs001098.php3

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resources to and within the sector.26 Although deregulating the energy market came before Congress in the past, to date policy makers like the Federal Energy Regulatory Commission (FERC) have presided over wholesale and transmission costs, but have been unwilling to dictate retail energy policy to the states27. California was the first state to boldly initiate utility deregulation, or the unbundling of services, in the hopes of lowering the above-average energy prices in the state. A number of states followed Californias example in the hopes of lowering their own energy prices, including the state of Montana28. In the case of Montana, who had the seventh cheapest energy in the country when deregulation was passed in 1997, politicians and industrialists believed that cheaper energy in the neighboring states of Washington, Oregon, and Idaho would put downward pressure on the price of energy in Montana if the retail market deregulated.

26 27

Peltzman and Winston eds., Deregulation of Network Industries Whats Next? Edison Electric Institute, Section Two: The regulation of Shareholder-Owned Electric Utility Companies , page 1 28 Twenty-three states and the District of Columbia have adopted retail competition. The states are: Arizona, Arkansas, California, Connecticut, Delaware, Illinois, Maine, Maryland, Massachusetts, Michigan, Montana, New Hampshire, New Jersey, New Mexico, New York, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Texas, Virginia, and West Virginia. Source: Edison Electric Institute, Section Two: The regulation of Shareholder-Owned Electric Utility Companies , page 4, http://www.eei.org/industry_issues/industry_overview_and_statistics/nonav_key_facts/section2.pdf

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Table 1: Utility Prices in the Fifty States (1995) State Washington Idaho Oregon+ Kentucky Tennessee Montana+ Wyoming N. Dakota Nebraska W. Virginia Alabama Indiana Oklahoma+ Utah Mississippi Wisconsin Nevada+ S. Dakota Minnesota Louisiana Missouri Colorado S. Carolina Washington DC+ Texas+ Florida Utility Price* 5 5.3 5.5 5.6 5.9 6.1 6.1 6.2 6.4 6.5 6.7 6.7 6.8 6.9 7 7 7.1 7.1 7.2 7.3 7.3 7.4 7.5 7.6 7.7 7.8 State Georgia Virginia+ Kansas Arkansas+ N. Carolina Iowa Michigan+ Maryland+ Ohio+ New Mexico+ Arizona+ Delaware+ Pennsylvania+ Illinois+ Vermont Arkansas Massachusetts+ Rhode Island+ California+ Connecticut+ New Jersey+ Maine+ Hawaii New Hampshire+ New York+ Utility Price* 7.8 7.8 7.9 8 8.1 8.2 8.3 8.4 8.6 8.9 9.1 9.1 9.7 10.4 10.5 11.2 11.3 11.5 11.6 12 12 12.5 13.3 13.5 13.9

Source Energy Information Administration, U.S. Department of Energy * - energy prices in cents per kilowatt hour + - adopted some sort of retail energy deregulation As the table shows, about half of all state adopted some type of deregulation, the majority of which had energy prices above the market average unlike Montana. Deregulation has the potential to drive energy prices to the median, which can help lower prices in above-average cost states, but what policy makers failed to realize was how unreliable the deregulated system really was. It is true that deregulation can lower

26

prices in competitive markets, but it can also make prices spike if a good without substitutes is suddenly scarce. This is exactly what happened in California when a drought in the Northwest and a jump in the cost of natural gas along with other factors led to a shortage of power. The result was a tremendous increase in the cost of energy for retail distributors like PG&E. To compound difficulties, retail distributors were required to sell their generating facilities and abandon the vertically integrated power company platform that prevailed for the majority of the twentieth century. Furthermore, they were not allowed to hedge their risk against changes in energy prices and instead were forced to buy their power in the spot market where they were beholden to the prevailing energy prices. At the same time, retail prices for consumers were capped as part of the deregulation transition process. The difference between the cost of energy in the spot market and the capped rate for customers had to be paid by retail distributors like PG&E until the company depleted its cash reserves completely. The deregulated system was doomed to fail at some point because no protection was built in to guard against the fluctuations producers and distributors faced in the energy market. In Montana, the lack of population density also brings a unique aspect to deregulation in the fact that most companies left to their own devices will not pursue sparsely populated regions because the profit opportunities in such areas are limited. Deregulation in Montana therefore exposes the possibility that no energy companies will be willing to serve a significant part of the state or only serve the state at a price premium. In Montana, small and private customers had their rates capped as a part of the transition to a deregulated market, and Montana Power and its successor were

27

obligated to distribute power at a regulated rate independent of the market price for electricity. The long-term impact of deregulation in Montana is still unknown, but the short-term impact of deregulation was Montana Power Companys exit of the utility industry through the sale of its energy generating and then distributing and transmission capacities.

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Chapter 3: Theory
Theoretical Framework for Analysis To understand what caused Touch America to end in bankruptcy, it is necessary to develop a framework to analyze what makes some companies successful and others unsuccessful. Additionally, theory will help explain the actions and behaviors of successful companies as they diverge from their less fortunate counterparts. In this chapter, I will briefly discuss the theory of competitive advantage and how it relates to industry analysis and competitive strategy in private sector companies. Additionally, I will discuss theories of behavior such as bounded rationality and irrational exuberance, which also affects the companies and the decision-making process. Finally, agency theory and its effects on the actions and behaviors of management and the board of directors will also be explored. Theory of Competitive Advantage We can consider competitive capacities on a spectrum, ranging from competitive advantages on one end, competitive disadvantages on the other, and competitive parity in the middle. In other words, companies are able to achieve advantages over their rivals with varying degrees of success. Unless otherwise stated in the corporate charter, the objective of every publicly held company is to maximize returns to the owners, or in general to maximize profits. To that end, companies seek to outperform their competition and garner the largest possible revenues consistent with profit maximization. In an effort to surpass the competition, companies seek strategic advantages, which are behaviors, policies, processes, and products that differentiate one

29

company from another in a way that makes the differentiated firm more successful. Jay Barney defines competitive advantage as, When its [the firms] actions in an industry or market create economic value and when few competing firms are engaging in similar actions. Firms gain competitive advantages when their theory of how to compete in an industry or market is consistent with the underlying economic processes in that industry or market and when few other firms share this theory or are able to act upon it as completely.29 Competitive advantage is used to consistently attract customers to a particular firms products or services, which allows that firm better than average prospects for winning in the marketplace and achieving above-average profitability.30 More common than creating competitive advantages is the process of developing strategic parity, which is defined as a set of actions that create economic value but are easily employed by rivals within the industry.31 Simply stated, companies experiencing parity have successful but commonly adopted strategies. Parity often occurs because competitive advantages are difficult to maintain, and developing a new competitive advantage is untested and can be associated with tremendous risk. Successful strategies and advantages are often duplicated which also creates parity amongst companies within the industry. This is not to say that it is not sufficient to sustain a company. Many industries, especially those with high barriers to entry, are able to sustain a number of firms with near identical capacities and strategies. A

firms actions and strategy should never have as its goal anything less than parity (with advantage as the ideal goal), because anything less than parity calls into question the

29 30

Barney, Jay B., Gaining and Sustaining Competitive Advantage, pp.9 Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.7 31 Barney, Jay B., Gaining and Sustaining Competitive Advantage, pp.9

30

ability for a company to compete successfully in the capital markets for sufficient resources and therefore has doubtful prospects for long-term survival. Companies are not always fortunate enough to find their strategies and actions creating positive economic value, in which case the company creates a competitive disadvantage. Under those circumstances, a firm actually destroys economic value in the company, and managements theory about how to succeed in the marketplace is inconsistent with actual conditions.32 Part of competing in business is taking risk, but those risks should be well assessed, and if competitive disadvantages are created through poor strategic choices, the direction of the firm should change quickly or the long-term survival of the company is in jeopardy. Competitive Strategy Strategy can be defined in many ways33, but it consists of the planned course of action a firm creates in order to achieve its goals and objectives. It follows that part of achieving a firms goals is competing successfully, or it will go out of business and fail to achieve any of its other objectives. Strategy and competition are therefore inextricably linked, strategy being the firms theory of how to compete successfully in the market, which can lead to the creation of competitive advantage, parity, or disadvantage depending on the success of the strategy.34 First and foremost, a firms strategy must be profitable or have the potential to be profitable at the onset. Without profitability, a firm is wasting its resources achieving a goal that does not create value for the owners of the company. Therefore,
32 33

Barney, Jay B., Gaining and Sustaining Competitive Advantage, pp.10 For a listing of alternative definitions see Barney, Jay B., Gaining and Sustaining Competitive Advantage, pp.6. See also Porter, Michael E., Competitive Strategy; Techniques For Analyzing Industries and Competitors, pp.34 34 Barney, Jay B., Gaining and Sustaining Competitive Advantage, pp.6-7

31

when a strategy is unprofitable or the potential for profit is low, it the duty of management to adapt the strategy or develop a new one. A firms strategy is also the over-arching guide for the actions and behavior of the company. In other words, the strategy is coherent when the larger goals and objectives of the strategy are reinforced and achieved through decisions and actions at every level that are consistent with the overall strategy.35 Good strategies fail if not implemented throughout the company. For example, if a firm decides to compete on the basis of low cost, it is inconsistent that the firm would spend a large portion of their resources on marketing or packaging, which is more consistent with a differentiation strategy because it increases costs. It should also be noted that once top management has formulated a strategy, it is their job to assure that lower level managers and employees execute that strategy. A change in strategic vision isnt adopted overnight throughout the firm; on the contrary, change might be obstructed by vested interests, habits and expectations, ingrained attitudes, and inertia.36 Management is responsible for communicating the new strategy; figuring out how to implement that strategy, including assessing what new structures and processes are necessary; and making the necessary internal changes as quickly as possible. One final note about competitive strategies is that they are a combination of proactive and reactive measures that seek not only to move ahead of the competition, but also to find a best response to other firms in the market and changing economic conditions.37 Anticipating what competitors next moves might be and how best to respond to them is the essence of interactive firm behavior in a competitive industry
35 36

McAfee, Preston R., Competitive Solutions, pp. 48-50 Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.317-319 37 Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.8

32

and a necessary component of strategic planning since very few firms in industries relevant to this study have the option of ignoring the actions of their competition. Additionally, internal and external changes can force a company to adapt its strategy to new and unanticipated conditions. It is useful to think about a companys strategy as an evolving operating manual that adapts the prior strategy to meet changing conditions based on new information about competitors, the market environment, and the effectiveness of the former strategy. It is common for firms to review their strategies annually, although they may make small changes more frequently. Strategic planning is a process that starts with evaluating the current strategy, making appropriate changes, and then implementing them. Generic Competitive Strategies Competitive strategy has been broken down into two generic approaches that can be modified to meet the specific objectives and goals of a firm. The generic strategies are low cost dominance (or overall cost leadership), and differentiation (value-added strategy). These strategies can be implemented in different ways including a broad or narrow focus (market segmentation), or strategies can be combined so that lower prices and some differentiation provide the consumer with the best economic value (best-cost provider).38 Each strategy has advantages and disadvantages including specific risks associated with each approach. It is also worth noting that these strategies represent only the building blocks of more complex corporate strategies and only rarely fully describe a firms tactics. However, these basic strategies are useful in

38

Porter, Michael E., Competitive Strategy; Techniques For Analyzing Industries and Competitors, pp.34. See also Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.116

33

analyzing the basic elements of a companys strategy and allow for greater insight into the choices that make a firm successful or unsuccessful. Low-Cost Dominance The strategy of low-cost dominance is exactly what the name implies. Companies pursuing overall cost leadership, as this strategy is also called, seek competitive strategies that achieve cost advantages that enable a reduction in price by the advantaged producer. In order for firms to achieve a low-cost position and remain profitable, they must have policies, resources, and processes consistent with low production costs including economies of scale, tight cost control, and minimal expenditures on R&D, advertising, distribution, and other marginal costs.39 Firms with overall cost leadership display an ability to minimize costs wherever possible throughout all units of the company. The low cost strategy is advisable in a few distinct situations including; highly competitive rivals (industries prone to price wars for example), industries with commodity-like goods and services (where it is difficult to differentiate the product or service), and when buyers are price sensitive (especially if they incur low switching costs).40 The primary risk of pursuing a low-cost strategy is that it is difficult to defend, especially over a period of time. Rivals are likely to imitate price leaders, and they may even adapt new technologies that help them achieve greater efficiency than the cost leader, thereby undercutting any competitive advantage. Another pitfall of the low-cost strategy is that cost leaders may cut prices to marginal costs so that they are no longer able to sustain the flow of capital or produce at a profit, which defeats the point of

39 40

Porter, Michael E., Competitive Strategy; Techniques For Analyzing Industries and Competitors, pp.35 Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.125

34

operating a business if it continues over a long enough period of time. The most notable risk with this strategy is that low-cost producers can become so focused on cost reduction that they distort a vital production process41 such as safety, quality control, or customer service and in the process corrupt the economic value of the product or service the firm was producing.42 Differentiation The second generic strategy is known as differentiation or the value-added approach, implying a strategy that seeks to create a unique product or service, or at least the perception of such. Firms seek to differentiate themselves from their competition in order to achieve above average shares of demand in the relevant markets. The differentiation strategy requires that the company achieve its unique status by using one or many different factors including brand, quality, service, design, distribution, technology, and many others to set itself apart from its rivals. The objective of this strategy is to create value in the minds of consumers greater than what a low-cost product or service might provide in order to justify a higher price level. In many instances, buyers are willing to pay the premium for a differentiated product for convenience, lack of suitable substitutes, or higher quality. Companies who successfully pursue this strategy often have some organizational resource that allows them to create a unique product. These resources might include strong R&D or marketing, well-built networks or alliances, or a tradition of creativity,

41

An extreme example is the case of Northeast Utilities who pursued a low-cost strategy that included reduced funding for safety procedures designed to prevent accidents at its nuclear facilities. The end result was a shutdown of a number of its nuclear power generating facilities which was detrimental to the companys ability to produce a positive rate of return on their investments. 42 Porter, Michael E., Competitive Strategy; Techniques For Analyzing Industries and Competitors, pp.44-46. See also Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.126

35

groundbreaking technology, or highly skilled employees.43 The differentiation strategy is especially applicable if the market has a number of segments, when buyers perceive differentiated products as having greater value, or when technological change creates competition around features.44 One of the major risks involved with pursuing a differentiation strategy is the potential to produce at a price point that is too high for customers to justify the added cost. Additionally, if imitators begin producing a similar good or service, the necessary differentiation may not be sufficient to retain a sizeable and loyal client base. Finally, if the need (or the perceived need) for a differentiated product or service declines, the strategy has the potential to fail in the absence of those who previously believed the higher price to be justifiable.45 Low-Cost and Differentiation Variations The two generic strategies can be employed in a number of ways. Every firm has to decide how to serve consumers. Either strategy can be applied in a broad or narrow sense, depending on how the market is segmented, or they can seek a middle ground between the two strategies. In the area of market segmentation, firms have the option to produce in a low-cost or differentiated way for a broad or a focused set of consumers. The focused approach involves targeting a narrower base of customers to meet the needs of one or more market segments while a broad approach seeks to appeal to a wider set of consumers. As with the two strategies described before it, the focused and broad approach also carries some risks. The potential for a mainstream producer to

43 44

Porter, Michael E., Competitive Strategy; Techniques For Analyzing Industries and Competitors, pp.41 Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.129-130, 134 45 Porter, Michael E., Competitive Strategy; Techniques For Analyzing Industries and Competitors, pp.44-46. See also Thompson, Strickland, and Gamble, Crafting and Executing Strategy,.130

36

out compete the focused firm or for a niche firm to cut into a broad producers profits46 are very real threats. Additionally, if the difference between the market segment or niche and the mainstream changes, the value added by the focused or broad firm will likewise suffer. Finally, if the focused producer achieves substantial profit levels, it may induce other firms to enter the niche market, either as new entrants to the industry or as a rival broadening its product offerings, in an effort to capture some of the focused firms financial success. Another approach is to pursue a middle ground between the two strategies in the hopes of creating the best value. Best value producers can be described as those firms seeking the highest economic value for the money. In industries where differentiation is commonplace but customers are still price and value sensitive, for example the car industry, a product in the middle range of cost and value can be very profitable.47 Best value firms risk either being squeezed by both high and low end producers, or they could become stuck in the middle. Pursuing a median strategy means that a best value strategy must produce significantly more value from low cost producers and significantly less cost than differentiated producers in order to capture a sizeable share of the market. If the firm fails on either end the result will be a poorly differentiated product with little potential for attracting a large customer base. The second problem is what Michael Porter calls getting stuck in the middle, by which he refers to firms unable to achieve a low-cost dominance or substantial differentiation. He defines these firms as either having inadequate resources to obtain one of the two generic strategies

46

When firms enter a profitable niche market to compete against broad producers it is sometimes referred to as cream-skipping. 47 Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.131

37

or attempting to achieve conflicting strategies.48 Porters point is simply that firms need to adopt competitive strategies that are coherent and well-structured or they run the risk of limiting the profitability and potentially the sustainability of the firm. Industry Analysis A crucial skill for any company in a competitive industry is the ability to critically evaluate and analyze the industry of which it is a member in order to delineate the most appropriate strategic course of action. A companys strategy should seek not only to provide maximum insulation from competitive pressures but also take steps to create competitive advantages.49 It is nearly impossible to create a strategy that will achieve these goals without a thorough understanding of the industry. Every industry has unique economic features that make competing in that industry different from any other. It is therefore necessary to evaluate the basic components as well as the driving forces of the industry before any strategy is contemplated, evaluated, or attempted. Examples of basic industry information include the size of the market (as measured through revenue and other metrics), the projected growth of the industry, the market segmentations, any patterns in sales, number of producers/providers, the degree of product differentiation, and any economies of scales that are attainable.50 Some examples of driving forces which can have serious effects on an industry include the growing use of the internet, product innovation or technology, changes in the industrys long-term growth rate, changes in regulation, changes in uncertainty and business risk, and changes in general economic conditions

48

Porter, Michael E., Competitive Strategy; Techniques For Analyzing Industries and Competitors, pp.41-44 49 Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.67-68 50 Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.45-49

38

to name a few.51 All of these elements impact the industry and the strategies of the firms within the industry, and are useful in representing the major components of an industry for more thorough analysis. Most analysis also utilizes a framework for breaking down the complex interactions within an industry. The most commonly used and often adapted framework is the five forces model developed by Michael Porter52. In his model, Porter outlines five main forces that drive industry competition including the threat of potential entrants, the bargaining power of buyers, the threat of substitute products and services, the bargaining power of suppliers, and finally the rivalry amongst existing firms.53 For our purposes, a more complete description of the threat of new entry and industry rivalry is needed. Threat of New Entrants New entrants in an industry can affect the nature of competition amongst firms for long periods of time. New firms have the potential to steal market share and revenues from existing companies and likely add to the complexity of strategic decisions within the industry. Existing firms would like to limit the possibility of new entrants, which is easier to do in some industries than in others. New entrants are more attracted to some industries than others, usually because of a perceived profit opportunity. Other factors that tend to attract new firms are significant growth in buyer

51 52

Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.68-74 Porter, Michael E., Competitive Strategy; Techniques For Analyzing Industries and Competitors, chapter 3 53 Porter, Michael E., Competitive Strategy; Techniques For Analyzing Industries and Competitors, pp.4, see also Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.50-51. See also McAfee, Preston R., Competitive Solutions, pp. 9-11. See also Barney, Jay B., Gaining and Sustaining Competitive Advantage, pp.78-79

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demand for a product or service, low entry barriers, and industries with firms unable or unwilling to contest the entry of new firms. Rivalry Amongst Firms It is common for competition amongst firms in an industry be the strongest of the five forces; in fact, it is customary to expect rivals to use every strategy and resource they can to out-compete other firms in a perpetual quest for better position, increased sales and market share, and competitive advantages.54 Some examples of tactics a firm might use in competing with rival companies include lowering prices, adding new or different features, increasing quality, expanding a product line, increasing marketing and branding efforts, or creating better customer service. Firms use these actions as part of their strategies to help them compete in the industry, hopefully to a more successful degree than the competition. Some factors within an industry tend to intensify rivalry while others tend to reduce it.55 Rivalry tends to be intense when buyers switching costs are low, when exit barriers are high, when growth in demand is slow, or when a good or service is not easily differentiated and acts like a commodity. The number of firms in an industry also contributes to the degree of rivalry. Industries with less than five firms typically experience less rivalry, unless all firms are of approximately equal size and capacity. As the number of firms increases, rivalry becomes more intense, especially if smaller firms are struggling to compete profitably. Other forces can intensify rivalry within an industry, but for these purposes, the aforementioned list will suffice.

54 55

Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.50-51 Porter, Michael E., Competitive Strategy; Techniques For Analyzing Industries and Competitors, pp.1723. See also Thompson, Strickland, and Gamble, Crafting and Executing Strategy, pp.50-55. See also Barney, Jay B., Gaining and Sustaining Competitive Advantage, pp.92-94

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Nature of Competition Within an Industry The final part of industry analysis is the discovery of the output and pricing structures that characterize the particular market. In other words, it is important to understand if the industry operates under a monopolistic, an oligopolistic, monopolistic competitive, or a competitive model. Each model will provide different conclusions on the ability of a firm to set prices and make a profit.56 Oligopolistic industries, for example, have less power to set prices than monopolies57, although their ability to set output and maximize rents depends on the particular pricing model. Competitive industries, on the other hand, are characterized by price taking firms who produce at a competitive level of output. For the purpose of this thesis, the nature of an oligopolistic industry is especially pertinent. Oligopolistic Competition By definition, oligopolistic industries are dominated by a small number of firms. These firms can interact in cooperative and non-cooperative ways that have considerable effects on each firms profitability. On one end of the spectrum of cooperation is tacit collusion in which firms do not fully cooperate with one another but use implicit market signals in order to charge a rate higher than a competitive price but less than a monopoly price. This type of price setting is called a Cournot oligopoly; firms non-verbally coordinating production are practicing tacit collusion, which may or may not be viewed as legal, depending on the circumstances. On the other end of the spectrum are Bertrand oligopolies, which are non-cooperative firms who compete on price and produce an output much closer to the competitive level. In between the two
56 57

Perloff, Jeffrey M., Microeconomics; Third Edition, pp. 424-426 Monopolistic firms are able to exert power in the marketplace by setting output at a profit maximizing level.

41

extremes lies another price and output setting possibility called the Stackelberg model. The Stackelberg model posits that a leader within an industry can set the price ahead of all other firms which leads to greater output than if all firms choose their level of output at the same time but also allows for greater profits to the leading firm.58 Behavioral Factors Behavioral factors such as bounded rationality and irrational exuberance have the potential to influence the decision-making processes of otherwise rational individuals. These influences become particularly important with regards to strategy formation because the decision-making of a few individuals can have dramatic effects on the performance of the company. Bounded rationality refers to the theory that states that decisions made within organizations are rational, but there are limits to said rationality. Bounded rationality is used to explain a decision-making tendency called satisficing.59 Satisficing is described as the practice of using the first acceptable decision rather than the best decision which in turn can be the result of bounded rationality when information is incomplete, imperfect, or otherwise not holistically and thoroughly evaluated. Such decision-making processes can contribute to policy myopia that can have lasting effects on individuals as well as organizations. Irrational exuberance is a term first used in 1996 by Federal Reserve Chairman Alan Greenspan to describe the fundamentally unfounded increase in stock market prices. Robert Shiller chose to explore the phenomenon further in his 2000 book60 where he came to the conclusion that irrational exuberance as experienced in the later part of the nineties was caused by a confluence of forces including structural, cultural,
58 59

Perloff, Jeffrey M., Microeconomics; Third Edition, pp. 424, 450-454 March and Simon, Organizations. See also Handel, Michael ed., The Sociology of Organizations; Classic, Contemporary, and Critical Readings, part V 60 Shiller, Robert, Irrational Exuberance

42

and psychological forces. A variety of factors Shiller argues helped create irrational exuberance and inflate capital markets in the last decade including the growth in the internet, the looming retirement of the baby boomers, herd behavior, new era thinking, and other amplifying effects. The notable increase in the value of the stock market had the effect of influencing the behaviors of many analysts, investors, and corporate executives. The capital markets are sometimes a valid source of feedback for corporations who see the rise and fall of the stock price as interpretations by speculators and investors of the well being of the company. Higher than expected earnings or a timely acquisition are rewarded by gains in the share price while disappointing news often causes dramatic decreases. In the late nineties, investors, analysts, speculators, and executives became fixated on the growth achieved in the market place. Growth and technology companies experienced a disproportionately large share of the growth during the period, while general enthusiasm for the market caused a swelling of price to earnings ratios amongst almost all stocks. Some executives looked at this bull market as an opportunity to profit on the growth mentality and started various technology firms with expectations of lucrative compensation61. The result was a proliferation of companies with inflated earnings projections and unstable business models, many of which collapsed when the economy slowed and the stock market euphoria evaporated. The capital markets unduly served as a positive feedback device for many companies seeking to produce innovative products or services though much of the positive signaling was due to a speculative bubble in the stock market rather than well-founded affirmation of various business models, strategic
61

See discussion of stock options below.

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choices, or other product innovations. Many irrevocable decisions were in part due to the conscious or unconscious drive to profit from the growth in the stock market. Agency Theory In the American business model, as the number of owners increase, the owners become more distant from control of the organization. It follows that sole proprietorships have the least separation of ownership and control while public corporations have the most. Therefore, shareholders as owners of the corporations utilize a board of directors as a mechanism for assuring that managements interests are aligned with those of the shareholders. The link between ownership and control provides the basis for agency theory. The scholarly foundation for American corporate governance today rests in agency theory, which postulates the type of relationship that exists between the principles (shareholders) and the agents (management)62. Corporate governance acts as a mechanism to prevent agents from pursuing their own interests instead of the interests of the owners, who are diffuse and not closely involved with the control of the company. Known as fiduciary duty, directors serve as knowledgeable and objective individuals with the capacity not only to support but also to override managements decisions in the event the board finds them inconsistent with the interests of shareholders. The boards of directors of public companies today are therefore entrusted with the tasks of hiring, monitoring, advising, evaluating, and occasionally firing senior management on behalf of the shareholders. In the nineties, a particular kind of compensation scheme became popular amongst companies in the United States. The awarding of stock options as part of a
62

Jensen, Michael, Foundations of Organizational Strategy

44

compensation package became standard practice in part due to the belief that these vehicles would align the interests of the executives with those of the shareholders because most of the options were structured to vest only after a specified period of time. In reality, stock options had the effect of amplifying the incentives for management to attempt to raise, sometimes artificially, the value of the shares through the vesting period to take full advantage of the compensation opportunity. Stock options drove management at many companies to pursue strategies, some well founded and some not, they thought would elevate the price of the stock. The incentives of senior management were not aligned with the time horizons of investors but rather in the time frame of their next vesting period. Corporate Governance Corporate governance is defined in many ways, but put simply, it is the mechanism designed to ensure that resources and capacities of an organization are harnessed for the agreed upon purposes. When resources are diverted from such endeavors, it is seen as a governance failure. With many companies filing for bankruptcy and continuing corporate scandals, the shortcomings of the American corporate governance structure have never been clearer than in the last four years. Boards of directors are set in place to prevent exactly the kind of activities that bring about circumstances leading to poor decision-making, fraud, and other types of mismanagement. As a direct result, recent actions have lead to a renewed interest in the issue of corporate governance, and the role of the board of directors has been under intense scrutiny. Research and reform are necessary steps before taking actions in

45

order to restore the confidence of investors and secure the investment capital that corporations rely on through the sale of their stock. The expectations for directors of public companies changed in the early nineties to emphasize the need for board members to be more active and balance the power of the CEO. Poor performance at a few major firms including General Motors and Westinghouse prompted those boards to develop and adopt so-called best practices for corporate governance. Early reformers set off a wave of change amongst directors hoping to improve their ability to uphold their fiduciary duty. These best practices included annual evaluations of the CEO and senior management as well as the board itself.63 The actions of the board of General Motors were widely discussed and even appeared in the Wall Street Journal and Business Week.64 Within their published guidelines in 1994; in one section it reads, The Committee on Director Affairs is responsible for reviewing with the Board, on an annual basis, the appropriate skills and characteristics required of Board members in the context of the current make-up of the Board. This assessment should include issues of diversity, age, skills such as understanding of manufacturing technologies, international background, etc. -- all in a context of an assessment of the perceived needs of the Board at that point in time. Other guidelines included increased board leadership from an outside director, regular meetings of outside directors unattended by management, and the determination of governance structures and processes by outside directors.65 Corporate governance has come into focus again in the wake of bankruptcies and other corporate scandals at corporations like Enron, Global Crossing, Tyco, and others. Corporations, investors, and lawmakers are all searching for explanations and
63 64

Lipton and Lorsch, A Modest Proposal for Improved Corporate Governance Simison, Robert, GM Board Adopts Formal Guidelines on Stronger Control Over Management, and Dobrzynski, Judith, At GM, A Magna Carta of Directors 65 MacAvoy and Millstein, The Recurrent Crisis in Corporate Governance

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ways to prevent further cases of corporate malfeasance. In response to the wave of corporate governance failures, Congress passed the Sarbanes-Oxley Act (SOX) that put in place strict compliance measures for all public companies but focused on a few areas. They included providing greater transparency to investors through additional and timely disclosures, reducing conflicts of interest related to hiring external auditors, increasing director accountability in cases of malfeasance, and requiring other board structures that will hopefully prevent further malfeasance. The act was designed to primarily address fraud and therefore did not include other best practice ideas including rigorous evaluations. The important note is that regulation does not exist prescribing such evaluations, however, the board best practices guidelines existed and were adopted by many long before the stock market, internet, and telecom bubbles of the late nineties. The effectiveness of legislation like Sarbanes-Oxley is debated amongst the business community. Governance experts prescribe two different kinds of solutions, structural and behavioral, to prevent failures of corporate governance. Structuralists argue that structural weaknesses in the corporate governance system prevail. The rights of shareholders in the United States make it very difficult for institutional and private investors alike to depose poor managers and directors. Proxy voting is structured heavily in favor of incumbent board members, and staging hostile takeovers is typically very costly and not always successful. The American model has a weak system of oversight that results in the continued existence of poor quality boards of directors. Board members have become over-reliant on information provided to them by senior management thus negating the boards ability to minimize agency conflicts.

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Behavioralists on the other hand believe that structural solutions like those required by SOX cannot eliminate corporate malfeasance. They argue that there are always bad apples in the marketplace. In other words, regardless of consequences, these individuals assume that corporate executives will perpetually commit corporate crimes for their own benefit. For these theorists, corporate malfeasance is a byproduct of the downfall of human nature, and therefore only boards with a strong tendency to question management and uphold their fiduciary duty with great care will have a chance at preventing corporate wrong doing. Many believe that board behavior has digressed in the last forty years from vigilant overseer to passive supporter. Furthermore, they postulate that the balance of power in the boardroom has slowly shifted from outside directors to internal management thus negating the boards ability facilitate effective oversight.66 Behavioral social scientists also point to the disconnect in the American corporate system between investors who are invested long-term and executives who tend to emphasize short-term changes in valuation. Part of the pressure on short-term performance comes from speculators and stock analysts as well as the media, who have considerable influence on stock prices. Adding to the focus on share price are certain management compensation schemes that reward key executives with stock options. While outwardly stock options seem to align managements interests with those of the shareholders, the time horizons do not align perfectly and in fact can create incentives for management to inflate the share price long enough to have their shares vest only to see the share price subsequently drop. Furthermore, because of the short-term pressures on stock prices, management and the board can become fixated on the stock
66

MacAvoy and Millstein, Recurrent Crisis in Corporate Governance, pp. 7-10

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price and may attempt various courses of action they believe will raise analysts projections and ultimately the share price.

Chapter 4: Analysis and Discussion of the Montana Power Case

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Chapter Outline Montana Power made a number of critical strategic decisions starting in 1997 that changed the course of the company. This chapter explores the intersection of the companys strategy with various influences, including corporate governance and others. The strategic decision to exit the electric generation industry set in motion a course of actions that led to the complete exit from the energy business. Two points are critical with regards to subsequent decisions to leave the energy industry. First, the company decided to leave its core business. Exiting the remaining energy operations meant that Montana Power would cease to be a power company and redefined the companys business model. Stated simply, Montana Powers core competencies were in the energy business so that an exit from that business meant dissolution of the majority of the companys expertise. Despite the fact that Touch America as a telecommunications subsidiary existed within Montana Power since 1983, energy related operations accounted almost exclusively for the companys revenues and profits as reported by the companys annual report.67 Second, regardless of the merit of the decision to exit the energy industry, Montana Power had many options for how to return value to the shareholder with the proceeds of those sales. Montana Power chose to refund some long-term debt, repurchase some common stock, and invest in the telecommunications industry with those proceeds, but a variety of additional alternatives were feasible, a subject which will also be explored in the this chapter.

67

See Montana Power Company 1999 Form 10-K, Item 1: Business, table of percentage of revenue contributed by any class of similar products or services that accounted for 10 percent of more of consolidated revenues.

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In this chapter, the theoretical foundation built in chapter 3 will be utilized to examine the case of Montana Power/Touch America in three parts. In an effort to understand the strategic choices of the company, this chapter will first explore the composition of the industries in which Montana Power and Touch America sought to compete; the regulated energy and the telecommunications markets. The next section will seek to determine what was driving management and the company. Based on the industry analysis and an evaluation of the resources and capacities of the company, the strategic decisions of the firm will first be identified and then evaluated. In other words, the value of the strategic decisions will be determined by their suitability given the prevailing set of circumstances. The third part of the chapter seeks to explain what is driving the strategy process including behavioral influences. This section also explores the link between compensation, the board of directors, senior management, and the strategic decisions of the two groups with special emphasis on the applicability of agency problems. Industry Analysis For the majority of its existence, Montana Power (the predecessor of Touch America) operated in the regulated utility industry, which through most of the last century included generation, transmission, and retail operations. In the final years of its existence, Montana Power Company transitioned from a utility company into a telecommunications corporation called Touch America. Both industries have unique components and forces, which impact successful strategy choices. Therefore, the examination of each industry is necessary in order to evaluate the transition of the company from competing primarily in one industry or the other.

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Table 2: Industry Comparison; Regulated Utility vs. Telecom Service Provider Utility Monopoly Stagnate Demand Growth Tested Business Model Regulated Prices Controlled Entry Low Volatility Low-Changing Technology Few/No New Entrants Low Risk Telecom Oligopoly Explosive Demand Growth Untested Business Model Unregulated Prices Uncontrolled Entry High Volatility Fast-Changing Technology Many New Entrants High Risk

The characteristics of the telecommunications industry are very different than that of the energy and utility businesses. In the short-run, energy has a highly inelastic demand curve. In other words, there are very few substitutes for energy and consumers are not highly price sensitive when the cost of the good rises. Although consumers will develop alternatives and practice greater energy conservation when the price of energy rises, the industry is not nearly as vulnerable to market risk as telecommunications. Demand for telecommunications service is much more dependent on general market conditions for two reasons. First, expenditure on long distance and Internet are secondary for individual consumers when spending is constrained which also means that wholesale telecommunications diminishes as large carriers face less demand. Second, communications services are a byproduct of conducting business, therefore when transactions decline in a market downturn, businesses and other large customers need less telecom services. The telecommunications industry is not only more prone to business cycle volatility but also to price elasticity within individual companies because energy as a factor of production is a higher priority than telecommunications capacities.

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Montana Power as a Utility Montana Power Company (MPC) operated for more than eighty years as a utility in the state of Montana, and served roughly 130,000 natural gas customers and 265,000 electricity users as of 1995. MPC had grown to be the source of three distinct business groups. Each business group expanded through growth and acquisition so that by 1995, the company claimed $2.5 billion in assets. The three segments included the regulated utility, the independent power group, and non-utility endeavors in coal mining, oil, natural gas, and telecommunications.68 The company owned and maintained generation assets including twelve hydroelectric dams with 508,000 kW of capacity and four coal-fired thermal generation plants, which provided 689,000 kW of capacity.69 The total capacity of the company made MPC a small utility on the national scale, providing approximately 1% of power nationally, but it was nevertheless the largest operator in Montana and an important energy provider in the Northwest. MPC was able to operate at a relatively low generation cost at approximately 3 cents per kilowatt-hour,70 which contributed to the state achieving the seventh lowest energy costs in the union (refer to Table 1: Utility Prices in the Fifty States (1995)). Montana Power was able to deliver relatively low cost energy to its customers in part because of its vertically integrated structure. While the integrated nature of the company was a successful format for Montana Power and other utility companies for decades, the nineties ushered in changes in the regulated utility industry that had marked effects on MPC. Beginning with the Federal Energy Regulatory Committees (FERC) decision in 1992 to open transmission lines to competing energy providers,
68 69

Billings, Erin, MPC gears for uncertainty Montana Power Company 1996 Form 10-K, Item 2: Electrical Properties 70 Power, T.M., The Importance of the Incentives Built into Utility Regulation

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Montana Power realized they would have to become more competitive in an industry with less regulation.71 The federal government has generally presided over wholesale prices and transmission rates, but the states have the authority to control retail rates. At the time, the country seemed to be moving toward deregulation in the retail market, which in Montana meant an end to the virtual monopoly of MPC in the state. California became the first state to adopt retail deregulation in 1996 and subsequently developed a model for other states to follow. A number of articles were printed in Montana newspapers between 1995 and 1997 predicting a rise in competitive forces for utilities like Montana Power72. The companys 1996 10-K reiterated the changing regulatory conditions stating, The electric and natural gas utilities are in transition as competition to provide energy commodity and related services to wholesale and retail customers intensifies.73 MPC was well aware of the industry changes as they started to affect utilities. In anticipation of greater competition, Montana Power Company reorganized their three divisions into just two, utility and non-utility, of which slightly more than half of their revenues came from the utility businesses. The non-utility portion of the company included the independent power group as well as coal mining operations and also the telecommunications subsidiary Touch America. They stated in their 1996 10K, The Company has taken a proactive approach to these industry changes and has restructured to better align its business functions with markets.74 MPC also made some smaller cost-driven cutbacks on personnel and services by consolidating service
71

Stucke, John, Utilitys Future in Diversity. See also Sshwennesen, Don, Montana Power Gears up for an Unfettered Industry. See also Billings, Erin, MPC gears for uncertainty 72 Stucke, John, Utilitys Future in Diversity. See also Sshwennesen, Don, Montana Power Gears up for an Unfettered Industry. See also Billings, Erin, MPC gears for uncertainty 73 Montana Power Company 1996 Form 10-K, Item 7 74 Montana Power Company 1996 Form 10-K, Item 7

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locations in rural areas and offering retirement incentives. In 1997, the Montana State Legislature passed Senate Bill 390 to restructure and deregulate retail energy in Montana. The bill was backed by both Montana Power Company and the large industrial users who felt it was the best way to deal with the coming tide of deregulation that threatened to attract large energy users away from regulated prices. At the time, it seemed plausible if not likely that if regulation continued, large users would shop the market for cheaper energy and use their leverage to obtain prices lower than those contracted by MPC that were set by the Montana Public Service Commission. Large users and other utilities acting as buyers were the first to put additional pressure on Montana Power, which presented a challenge for the company because energy is a commodity and MPC would therefore have to compete on price alone in order to attract or even retain those important power customers. If large users discontinued energy purchases from Montana Power, the company would seek to spread its cost amongst a smaller user base, mainly residential and small users, who would be left with higher rates per kilowatt-hour. Large users were given consumer choice immediately under the terms of the bill while residential and smaller users transitioned to unregulated prices over four years75. Importantly, the nature of the market had changed for Montana Power from an isolated monopoly to a potentially competitive market with the threat of new entrants in previously protected markets. This important difference should have prompted the board of directors to do a critical evaluation of the skills and capacities not only top management but also of the board itself, a point which will be discussed in greater

75

Four years was the transition period originally drafted and adopted in Senate Bill 390, however, the Montana Legislature has since extended the transition period past its expiration in 2001 until 2007.

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detail later in the chapter. Rivalry between firms was a competitive force with which Montana Power had no previous experience, and it was at this point that the company made a number of crucial decisions that determined its fate. Additionally, the industry characterized by regulated prices and controlled entry was nearly erased. These major changes should have been accompanied by structural changes amongst management and the board of directors. Decisions in the new competitive environment had a profound impact on the company, the first of which was the decision to sell the companys electricity generating assets. Exit from Power Generation The decision to sell energy generating assets was most likely motivated by several factors76. First, deregulation in California, which was the model for retail deregulation in states to follow, called for utilities to sell their generating assets in order to increase the number of power producers. It was believed that by increasing the competition amongst power producers, the price of energy would be driven to competitive levels thus lowering the cost of energy for purchasers who then distributed the energy to retail customers. If deregulation followed in Montana as it did in California, Montana Power might at some point be asked to sell its generating assets in a similar move to create competition. The companys 1997 annual report stated, [Our decision to sell our generating assets] is a reflection of the changes in the electric utility industry, which is moving unevenly but inevitably toward competition and customer choice of suppliers, with different opportunities and risk/reward characteristics.77

76

Only the board of directors can attest to the actual motivations behind selling generating assets, outsiders can only speculate on factors that motivated the decision. 77 Montana Power Company 1997 Annual Report, page 5

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Another motivation for MPC to sell its generating assets was its relatively small size in the energy generation industry, producing approximately 1% of the nations power78. The company was concerned with large electric companies who were focusing on becoming generating companies. MPC did not have a strong market position to defend itself in a price war situation, nor did it have the resources to handle large fluctuations in the price of energy. These points were clear in MPCs 1997 annual report, We are a relatively small company, and trying to compete against the industry giants puts us up against larger balance sheets, which provide greater staying power when market prices are less than the cost of production, and when there is accelerating industry consolidation.79 In December of 1997, the CEO Robert Gannon made this statement; We believe that the size and geographic presence necessary to compete successfully in the dynamic, evolving competitive generation market means that only the larger companies will have a sustainable competitive advantage, despite our earned reputation as a relatively low-cost generator of electricity. So Montana Power will focus even more on its core strength of customer service.80 Clearly management and the board were worried about the long-term outlook for Montana Power in the new deregulated environment. Unfortunately, there was no significant evidence that larger power producers would be willing or able to undercut Montana Powers prices. While it was not the lowest cost producer in the country, MPC did produce power at considerably less cost than other power companies, which would allow it to continue to compete effectively against larger but less efficient firms. The utility that bought Montana Powers generating facilities, PP&L Corp., proved that

78 79

Montana Power Company 1998 Annual Report, page 3 Montana Power Company 1997 Annual Report, page 6 80 Kelly, Nancy, 1998 PSC Reports to the Legislative Task Force, Comments on market Power

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fact when they sold almost one third of the facilities generation capacity out of state at premium prices.81 Finally, the issue of stranded costs undoubtedly played a role in MPCs decision to exit the industry. Stranded costs are generally defined as expenses incurred by a regulated public utility specifically used to build facilities, subsidize social programs, or purchase power from renewable generation facilities called qualified facilities (QFs). These expenses can be recovered from the customer base over a long period of time, but when a utility is deregulated, it attempts to recover so called stranded costs in the retail energy rate it offers. The Montana Powers annual statement admitted that proceedings with the Public Service Commission over the issue of stranded costs had become increasingly contentious, concluding that selling the generating assets would be a preferable method of deriving their fair market value for some of the facilities thought to have stranded costs.82 The companys fixation on the stranded cost issue is an example of bounded rationality affecting the decision-making process. Selling the generating assets was the first satisfactory decision that solved the stranded cost problem, but as the future would bear out, it was certainly not the best decision. The bill that deregulated energy in Montana did not specify an amount for stranded cost recovery, but it allowed for the Public Service Commission to determine an appropriate recovery amount. Naturally, any costs recovered by Montana Power would be shifted to energy users in the state, which meant that large industrial users who had backed deregulation with MPC had good reason to oppose stranded cost recovery.83 It is also noteworthy that stranded costs have generally been recovered for
81 82

Richards, Bill, Utilitys Telecom Gamble Becomes a Big Loss, Montana Power Company 1997 Annual Report, page 6 83 David Ewer Interview, member of the 1997 Montana Legislature

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power plants that are worth less than book value, as is the case in California and its nuclear facilities. Montana Powers power plants were hydroelectric and coal burning, neither of which would be associated with a valuation at less than book. Montana Power claimed that upwards of $1 billion dollars were due to the company when in reality there were actually minimal stranded costs associated with deregulation in Montana.84 While the company legitimately had the legal right under the filed rate doctrine to recover cost incurred from purchasing power from qualified facilities (QFs) as well the costs of other social and environmental policy programs, the size of the stranded costs compensation Montana Power sought exceeded reasonable estimates by the PSC and other concerned groups. While some of the companys reason for selling assets was justified by the movement toward a new model for utilities, the many additional motivations were somewhat flawed in their logic. Although Montana Power was smaller in terms of generation capacity, it had a competitive advantage over a number of firms in its ability to produce low-cost energy. When Montana Power focused on the fact that producers in their region could generate power at lower costs, they failed to consider opportunities to out compete many high-cost power suppliers in other markets. Also, the prospect of a newcomer coming into Montana and undercutting the companys prices was very low, 85 and that scenario is yet to happen under any circumstance. Any new market entrants would have to use Montana Powers transmission system, which only provides a small margin for the competitor, even if they can distribute power more efficiently than the incumbent, Montana Power.
84

Baxter, L. and Hirst, E., Estimating Potential Stranded Commitments for US Investor-Owned Electric Utilities 85 See insights by Justice Stephan Bryer.

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The decision to sell generating assets was unsupported on the part of Montana Power because unlike deregulation in California, the Montana legislature did not require divestiture of generating assets. Furthermore, the deregulation of the retail market was untested and called for a prudent course of action. On the point of stranded costs, Montana Power was undoubtedly frustrated with attempts to settle the issue. Additionally, although the company pointed to price risk as a reason for exiting the industry, the generation industry has as one of its advantages a relatively inelastic demand curve. Utilities like MPC were insulated from large swings in demand that are common in other industries which is reflected in the low volatility in annual returns that are common in the industry. The company seemed determined to stay independent. President and future CEO of Montana Power Company Bob Gannon stated as early as 1995, Were trying to position ourselves in the best way we can so we have an ability to control our destiny.86 This statement could be interpreted as the companys objective to avoid being acquired. However, if another company were to purchase Montana Power and its assets at a share price above book value, the shareholders would have been compensated with a positive return on their investment. Exit from Power Trading and Marketing The year following the sale of generating assets, Montana Power Company discontinued their electricity trading and marketing operations. The Company reasoned that without generating capacity, the operation would be exposed to much greater market risk. What is noteworthy in this evolution of Montana Power is not the fact that they exited the market, a prudent choice given the situation; rather it is important to consider that the sale of generating assets caused the company to exit another operation.
86

Billings, Erin, MPC gears for uncertainty

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In other words, its key to differentiate this decision because it was not independent of other operations. The pattern that would continue in the future was started when one strategic choice was the cause of subsequent strategic decisions that had profound impacts on the company. Exit From Remaining Energy Operations Montana Power continued to make business-altering decisions over the course of the following years. In early January of 2000, MPC engaged Goldman Sachs as their financial advisor in an effort to separate their energy business from the telecommunications subsidiary called Touch America. In the words of then CEO Bob Gannon, I am committed to unlocking any unrealized value in Touch America consistent with the best interests of shareholders.87 On March 28 of the same year, the board of directors announced their intent to divest the energy assets of the company to achieve the desired separation of energy and telecommunications.88 According to

the company, the decision was based on a belief that the divestiture would allow a focus on Touch America's fast-growing telecommunications business, while enabling the energy companies to grow and add value under new ownership.89 To that end, Montana Power and their financial advisors decided on the following course of action for the restructuring of their businesses. The utility business merged into Montana Power LLC, a wholly owned subsidiary of Touch America Holdings Inc. Once the utility was formed into a subsidiary, it could be sold to another company. Finally, shareholders of Montana Power Company would become shareholders of Touch America Holdings as part of the transformation to a
87 88

Montana Power Company 1999 Annual Report, page 3-4 Montana Power Company 2000 Form 10-K, Item 1: Business 89 Montana Power Company 2000 Form 10-K, Item 1: Business

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telecommunications company. NorthWestern Corporation, a South Dakota-based energy company, purchased Montana Power LLC immediately upon the completion of the corporate structure transformation.90 Additionally, the company utilized the competitive bidding process to sell off remaining energy operations including oil and natural gas businesses, coal production facilities, and independent power production. Agreements to sell all remaining energy interests were entered in 2000 with sales of those businesses concluding in either 2000 or in some cases 2001. Some agreements, commitments, and assets remained with the company through the transition to a telecommunications company, but these were inconsequential. The sale of assets gave Montana Power approximately $2.1 billion dollars in proceeds for the sale used to invest in order to pursue other projects including the expansion of its network.91 When all was contracted for sale, Montana Power recorded assets of market value greater than book, meaning there were no stranded costs in the state for Montana Power to collect or for rate payers to pay. Montana Power decided not to refund the state or its ratepayers with any of the excess of book value, but the Public Service Commission had its own leverage during the transition period.92 As part of deregulation, 288,000 small businesses and private households were guaranteed electric rates set by the commission. The obligation fell on Montana Power to provide retail service at those rates despite the fact that the company no longer owned generation assets. At any point the market price exceeded that regulated rate, Montana Power had to take a loss on the transaction. The burden was finally lifted from the company when

90 91

Montana Power Company 2000 Form 10-K, Item 1: Business Richards, Bill, Utilitys Telecom Gamble Becomes a Big Loss 92 Richards, Bill, Utilitys Telecom Gamble Becomes a Big Loss

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NorthWestern Energy completed the purchase of its transmission and distribution operations in 2002, but not without significant costs to the Montana Power Company. Montana Power / Touch America as a Telecommunications Company Montana Power operated an internal communications system since 1939 for the purposes of coordinating power generation and transmission systems. When the process became more automated in 1983, MPC reorganized the division under the name Telecommunication Resources, Incorporated (TRI) rather than dismantling the unit. Its services expanded into fiber optics and digital microwave technologies. In 1990, the company acquired Touch America, a small long distance reseller based in Montana.93 While the subsidiary existed for many years inside the company providing long-distance service and internal communications capacity, it wasnt until the late nineties that growth in the business began to be of interest to the larger corporation. In fact, in a review of financial and operating statistics prepared by the company covering the period from 1985 to 1995, telecommunications revenues are not broken down separately anywhere in the document.94 In 1997, Touch America began utilizing its fiber optic network, which reached from Seattle to Minneapolis in the East-West direction and from Canada to Denver in the North-South direction for a total of 3,015 route miles.95 Clearly the company was moving in a new direction, away from energy and toward a future in telecommunications. The companys 1998 annual report stated the new emphasis on telecommunications very clearly; Telecommunications, a relatively quiet part of Montana Power, became a top priority. We realized this business offered
93 94

History of Touch America outlined in Montana Power Company 1998 Annual Report, pages 8-10 The Montana Power Company Financial and Operating Statistics 1985-1995 95 Montana Power Company 1997 Annual Report, page 8

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our company and its owners substantial opportunities, including financial reward.96 Additionally, the CEO Bob Gannon was quoted saying, Our strategy to maintain historic earnings platforms, and to support new initiatives such as telecommunications as we strive to capture new opportunities.97 The same annual report put the transformation this way; Heres what we are becoming: Much more of a telecommunications companymuch less of a traditional electric utility.98 Managements new strategy continued to take shape as Montana Power successfully sold off its utility and energy businesses. On September 27th of 2000, Touch America Holdings, Inc. was incorporated under the state laws of Delaware, although the companys headquarters remained in Butte, Montana. The Growth of Fiber-Optics The operations under Touch America included the operation of a growing fiberoptic broadband network, which the company was expanding to reach nationally, and wireless communications services, which the company offered on a regional basis. Touch America was expanding their broadband network with an aggressive construction program.99 In addition to various construction projects, Touch America engaged in a number of joint ventures in order to share the cost of expanding their fiber-optic network.100 By the end of 1999, Touch America was operating almost 10,700 route miles on its network with construction plans for an additional 12,050 to be completed in 2000 and 2001.101 Another big piece of Touch Americas growth came in

96 97

Montana Power Company 1998 Annual Report, page 4 Montana Power Company 1998 Annual Report, page 4 98 Montana Power Company 1998 Annual Report, page 6 99 Montana Power Company 1999 Annual Report, page i 100 Montana Power Company 1999 Form 10-K, Item 2: Properties 101 Montana Power Company 1999 Form 10-K, Item 2: Properties

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June of 2000 when they acquired wholesale, private line, long-distance, and other telecommunications service customers from Qwest in a fourteen state region. With a growing broadband network, Touch America was able to offer multiple services including data transfer services such as long-distance broadband Internet and leasing network capacity (which consisted of lit, dim, and dark fiber) using their network.102 The company was focused on providing capacity for other large telecommunications carriers, which in 1999 included AT&T, MCI, WorldCom, Sprint, Global Crossing, Qwest and others.103 Touch America claimed 300,000 wholesale and retail customers in 1999 including the aforementioned carriers as well as banks, retail chains, and government agencies.104 Additionally, Touch America sought to join forces with companies with Metropolitan or local fiber networks but who lacked national routes.105 The overall goal or strategy for Touch America, as stated in their filed documents, was to create a low-cost, high-speed, fiber-optic and wireless network.106 Touch America said elsewhere in the same annual report that its focus was on wholesale services as a premier carriers carrier.107 At the same time that Touch America was building a national fiber-optic network, other telecommunications companies were also building networks including the very companies Touch America relied on for business including MCI-WorldCom, Global Crossings, AT&T, and Qwest. In 1997, Touch America as a subsidiary of
102

Touch America developed, owned and operated a high-speed fiber optic network spanning 28 states and approximately 21,000 route miles (2001). The company also provides wireless services mainly through Personal Communication Services (PCS) and Local Multi-Point Distribution Services (LMDS). They provided co-location services and construction management oversight services for installation of fiber networks. Products marketed are, wholesale bandwidth sales and leasing, dark fiber and conduit rights, private line services, optical wave services, packet-based data services, etc. 103 Montana Power Company 1999 Annual Report, page 11 104 Touch America Holdings, Inc., 2001 Form 10-K, Item 1; Business 105 Montana Power Company 1999 Annual Report, page 10 106 Montana Power Company 1999 Annual Report, page 2 107 Montana Power Company 1999 Annual Report, page 11

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Montana Power Company was only the ninth largest network. By 1998, they had the sixth largest network, but fell back to eleventh in 1999.108 In fact, 1997 through 1999 showed large percent increases in both the total number of route miles and the number of owned route miles by national telecommunications carriers.109 The total route miles jumped 28.8% in 1997, 41.5% in 1998 and an additional 47.7% in 1999.110 Like Touch America, many telecommunications companies expanded their broadband networks through joint ventures and joint ownership arrangements, which can lead to inflated statistics of the actual growth in fiber-optic capacity. However, even using owned route miles as a measurement in the growth of capacity, the late nineties showed larger percent increases than previous years. For the industry, owned route miles increased by 14% in 1997 followed by 22% and 24.3% increases the following two years.111 Touch Americas position in the industry is similar using owned route miles as it was with total route miles. The conclusion to be draw from this data is that Touch America was not a leader in the telecommunications industry in the national sense. Certainly the growth of Internet based companies as well as Internet users helped drive the growth in broadband capacity. However, many telecommunications companies forgot the lessons history has taught us about infrastructure building. Infrastructure projects coordinated by a central authority, like the interstate highway system for example, prevent duplication and over capacity which can occur if projects are uncoordinated and left to the market, as was the case for the railroad industry in the 1830s and 40s. Close analysis of the amount of fiber-optic cable being laid in the late nineties should have caused telecommunications companies to question how much
108 109

Hogendorn, Christiaan, Excessive Entry of National Telecom Networks, 1990-2001 See Appendix C 110 Hogendorn, Christiaan, Excessive Entry of National Telecom Networks, 1990-2001 111 Hogendorn, Christiaan, Excessive Entry of National Telecom Networks, 1990-2001

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demand existed for the growing supply of capacity. In retrospect, its easy to point out the fallacies in the assumptions of demand growth for fiber-optic capacity, and its obvious that some very intelligent people who had decades of experience in the industry moved in the same direction as Touch America. Telecom Bubble Bursts The telecommunications industry operates as a classic oligopoly in which the industry leaders have clear advantages and will seek to discourage the entry of new firms unless growth in demand is large enough so that no major firm loses market share. Telecom carriers were likely not concerned with small entrants like Touch America at the beginning of the boom in the industry because they were not perceived as a threat. However, when the industry began to experience a decline in demand, Touch America found itself completely without the ability to compete against much larger firms in the industry. With the Internet bubble bursting and the economy heading into a recession in 2001 and 2002, demand for telecommunications services decreased sharply. companys 2001 10-K stated, The duration and extent of the current U.S. economic downturn directly affects the telecommunications industry in which we operate, decreasing demand for products and services and diminishing the financial stability of some of our customers. The economic downturn has especially impacted the sector of the telecommunications industry in which we operate, the sector reliant upon selling fiber optic capacity.112 As expected in a market downturn with a decrease in demand, inter-firm rivalry intensified and caused prices and profits within the industry to fall. For Touch America whose profitability was dependent upon traffic volume on their network, a drop in data
112

The

Touch America Holdings, Inc., 2001 Form 10-K, Item 1: Business

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transfer needs caused profits at newly formed Touch America to plummet. In 2001, the company reported a loss of $3.9 million dollars, compared with a $36.3 million dollar reported profit the year before.113 Despite the fact that revenues had increased modestly, Touch Americas expenses increased greater proportionately, mostly due to the added costs of operating and maintaining a larger network. By the time the network reached its greatest breadth at 26,000 route miles, approximately 5-10% of the network was being used.114 Without a diversified set of businesses and with revenues from discontinued operations shrinking rapidly, Touch America was forced to make cutbacks in an attempt to prevent bankruptcy. Legal Problems Touch America was rather fortunate that they had no significant outstanding short or long term debt at the time of the economic recession which became an advantage over other telecom firms straddled by large debts acquired through the process of building out their networks. At the same time, Touch America was engaged in two important lawsuits. The first was brought on August 10th of 2001 by Qwest, and contested the agreement made on June of 2000 to acquire certain Qwest assets and customers. Trouble with Qwest started shortly after the agreement was struck. Qwest had agreed to sell Touch America 250,000 long-distance customers to meet the competitive requirement for Baby Bells to enter the national long-distance market as set forth by the 1996 Telecommunications Act. Touch America claimed that Qwest was guilty of understating revenue due to Touch America and additionally was over-charging Touch

113 114

Touch America Holdings, Inc., 2001 Form 10-K, Item 6: Selected Financial Data 1997-2001 Richards, Bill, Utilitys Telecom Gamble Becomes a Big Loss

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America for its billing services.115 Touch America also lodged a complaint against Qwest for continuing to sell long-distance services to large customers in the 14-state area they were forced to divest. Qwest counter-sued claiming Touch America owed an additional $100 million dollars for Qwest services. The suits went to arbitration in October of 2002 and ended in an unfavorable decision against Touch America in March of 2003. Another lawsuit was filed on August 16th of 2001 by shareholders claiming Montana Power directors violated their fiduciary duty when they sold generating assets without shareholder approval. The lawsuit charged the utility including its board of directors, senior management, and outside consultants with a breach of fiduciary duty, and sought to reverse the divestiture of Montana Powers energy assets. The filing also claimed that the transition was not legally founded because state law requires a vote of the shareholders before actions such as the sale of the companys generating capacities. The action brought by the shareholders sought to nullify the sale of many of the generating assets sold to Pennsylvania Power and Light and have those assets and their revenues placed in a trust for shareholders. The suit also made claims to recover $3 billion in stock value lost as a result of the companys actions.116 Six of the states largest law firms, led by Frank Morrison, a former Montana Supreme Court Justice, reported that the team was collaborating as they expected a long and costly legal battle. Touch Americas legal troubles continued when a class action was filed on August 5, 2002 on behalf of shareholders. The action applied to all shareholders between the class period of January 30th, 2001 and November 14, 2001 and charges

115 116

Hudson, Kris, Montanas Power Failure High-Tech Meltdown Meant Doom for Touch America Montana Power Company, Brief in Support of Defendants Motion for Change of Venue

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Montana Power Company and CEO Robert Gannon with violating sections of the Securities and Exchange Act of 1934117 by issuing statements found to be materially false.118 The case filing specifically points to problems with the Qwest acquisition, which the plaintiffs sight as not being disclosed in a timely manner. The suit charges that following the Qwest customer acquisition in June 2000, Qwest failed to transfer certain customers and improperly assessed costs to Montana Power that resulted in a loss of revenue for the company. The company allegedly failed to disclose such issues in part to secure the passage of the shareholder approval of the sale of energy assets in September of 2001. Second quarter earnings announcements in June of 2001 reported that the $.11 per share net loss was mainly due to the decision to buyout a remaining energy contract at a cost of $.55 a share. After shareholder approval was achieved, the company announced on October 21, 2001 that its quarterly financial results would be delayed. On November 14, 2001 the company reported a net loss of $.26 per share. The press release also reported noncompliance with some covenants of its Senior Secured Credit Facility as a result of poor earnings and the company further disclosed litigation entered into by the company against Qwest in August of 2001 that was not disclosed at that time. The share price declined from slightly over $20 per share at the beginning of the class period to $4.70 upon the release of third quarter earnings. The plaintiffs sought to recover damages resulting from the loss of share price. The case is currently still in litigation.

117 118

specifically sections 10(b) and 20(a) and Rule 10b-5 Erika Goldstein on behalf of all others similarly situated vs. Montana Power Company f/k/a Touch America Class Action Suit,

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Another lawsuit was filed on September 12th of 2002 on behalf of the employees of Montana Power Company in the U S district Court in Missoula, Montana.119 The suit charged that top executives and others failed in their fiduciary duty to protect the companys pension fund. Plaintiffs charge that change-of-control payments made to executives created a conflict of interest that resulted in their failure to safeguard the pension fund, which represented significant savings and retirement plans for employees. The suit also charged the company with of withholding information concerning the difficulties with Qwest and caused employee investments to decrease further. The company continued to match employee contributions until as late as November 2001 but refused to assess whether or not the stock remained a prudent investment choice for employees in their retirement funds. Plaintiffs are still in litigation seeking reclamation of losses in their retirement funds. Touch America Files for Bankruptcy Touch America vigorously defended against legal actions, but finally lost the lawsuit with Qwest at the cost of $60 million. The amount owed Qwest totaled more than the cash available to the company and helped push Touch America into bankruptcy as the company was on the brink of bankruptcy. In November of 2001 the company publicly stated that they needed an additional $40 million to continue operations until it could close the sale of its distribution assets to NorthWestern Energy in the early part of 2002.120 In February of 2002 in attempt to dissolve the relationship with Qwest, Touch America took over its own billing operations, but the operation failed to bill $10.3 million in revenue due to problems identifying customers. Lost

119 120

Press Release, Montana Power Company Employees Sue Former Officers for Pension Plan Losses Hudson, Kris, Montanas Power Failure High-Tech Meltdown Meant Doom for Touch America

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revenues helped Touch America miss earnings targets in the second quarter and contributed to the precipitous fall of the stock price. Shareholders watched as their once steady energy stock rose to a share price high of $64 in March of 2000 after the announcement that MPC was selling their energy business. By late 2001 the share price dropped to below $10, and in August of 2002, the stock was trading at $.55 a share, and was de-listed from the New York Stock Exchange in 2003 after trading below $1 for an extended period. The remainders of the companys long-distance operation that consisted of 70,000 customers it acquired from Qwest was sold to Buyers United, a telecom service provider based in Salt Lak5 former employees e City. The employee base was trimmed back to 450 in January of 2003, leaving 225 people unemployed and prompting the board and top managers to take a 20% reduction in salary. The company filed for chapter 11 bankruptcy protection in June of 2003, due to being legally insolvent. Touch Americas debts totaled $554.2 million while assets amounted to $631.4 million, although some believe that asset total is inflated. Touch America sold much of its remaining telecommunications assets to 360networks, a Canadian telecom company, for $28 million at the time of filing.121 The sale of assets to 360networks caused its own small controversy as shareholders and creditors claimed the proceedings discouraged the competitive bidding process. A round of competitive bidding was opened, which attracted other companies including Qwest, although the assets eventually went to 360 networks regardless. In an ironic twist, Qwest loaned $10 million to Touch America to keep it operational while the company proceeds through bankruptcy, largely due to the fact that

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Hudson, Kris, Montanas Power Failure High-Tech Meltdown Meant Doom for Touch America

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a significant portion of Qwests long-distance traffic utilizes Touch Americas network.122 Corporate Strategy As an energy company, Montana Power focused on providing reliable, low-cost energy, partially enabled by their vertically integrated model and their incumbent status. Montana Power was able to compete successful to a certain extent due to their ability to secure inputs such as coal, but a component of the companys strategy was to minimize risk by having more than one type of generating asset (hydroelectric and coalfiring). Montana Power was also well diversified between their generation, transmission, and retail businesses. The oil and natural gas utility, independent power group, and the coal and lignite divisions further diversified Montana Powers risk by generating revenues in a variety of different but related industries. In an industry like the energy business where changes in regulations can have a dramatic impact on the company, it is important for companies to diversify their products and services, which Montana Power did with success. The only non-energy business that remained a part of Montana Power was the telecommunications subsidiary. While it doesnt seem suitable for an energy company to acquire a small telecommunication company, Montana Power already had to maintain call centers to serve their retail customers as well as between divisions. Additionally, Montana Power already had experience with retail customers and with operating and maintaining an infrastructure based business. While Touch America was a small carrier of long distance in a relatively stable industry, it was not a problem for management and the board to operate.
122

Hudson, Kris, Montanas Power Failure High-Tech Meltdown Meant Doom for Touch America

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Changes in regulations in both the energy industry and the telecommunications industry123 marked the beginning of the creation of new business models. Montana Powers strategy had always been designed to compete in a stable energy environment, and there was no reason to conclude that those strategies would be successful in a new, rapidly changing marketplace. Montana Power sensed the changes in their industry and took some actions designed to help them compete under new circumstances. First, Montana Power changed their structure segmenting their business into utility and nonutility. Second, the company endorsed retail deregulation in conjunction with large industrial energy users, which they felt was necessary to retain those important customers. However, the first dramatic change in strategy came with the companys decision to sell its generating assets. The impact of the decision by Montana Power Company to leave the power generation industry cannot be overstated. Power generation was the core competency upon which the company was founded and sustained for more than eighty years. In fact, Montana Powers departure from the vertically integrated structure of the company was a departure from the traditional utility model of the twentieth century.124 By abandoning the proven, industry-accepted model, Montana Power was exposing itself to serious market uncertainties in addition to the uncertainties created by the newly deregulated retail market. It also bears noting that some strategic decisions are somewhat reversible while others are not, and it is therefore appropriate to assign greater risk to strategies that cannot be undone. In the case of Montana Power, their

123 124

The FERC open access ruling in 1996 and Congress Telecommunications Ant of 1996 for example. Peltzman and Winston eds., Deregulation of Network Industries Whats Next?, pp.117

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exit from the power production industry would have been difficult to reverse, and they certainly wouldnt have been able to recover assets sold. Managing Risk in Strategic Decisions A further discussion of some of the risks involved with various corporate strategies is appropriate at this point. Montana Power faced very little downside risk had they decided to continue to generate, transmit, and distribute energy. Research conducted by the Edison Electric Institute in 1997 showed that 30 utilities produced power cheaper than the company while 164 utilities had higher costs.125 The possible downside risks within the energy industry included the forced divestiture of generation assets, the flight of customers to other energy producers, and the possibility that larger producers would undercut Montana Powers rates. The likelihood of these events was low because Montana Power was capable of selling power outside the state at very competitive market prices. In the event the company was acquired, shareholders would have received a return on assets greater than book value, assuming the buyer was willing to pay equal or greater than the amount paid by PP&L. The upside in the utility market was likewise limited, although under the deregulated system, Montana Power had the potential to sell its power at higher rates out of state as PP&L did. The up and downside risks of the telecommunications industry were greater in magnitude. On one hand, the telecommunications company had the potential to greatly increase the share price of the company and produce much higher rates of growth than were likely in the energy industry. The downside risks were considerable as buyer demand tended to be much more elastic in telecom than in energy. Additionally, the

125

Montana Power Company, Comparing Electric Rates, Montana Energy; Helpful Information for our Customers

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fiber-optic network industry required significant sunk costs that would have to be recovered before the company would produce a profit, which created the significant risk that the operation would not produce a positive return on investment. Without generating assets, a piece of Montana Powers proven strategy was gone. Montana Power had a competitive advantage before the sale of their generating assets because they could deliver a bundle of energy services cheaper than most power companies. However, because the federal government fixed the rates at which the company was allowed to charge for transmitting power, MPC would be reliant on their competitive advantages in their retail operations such as customer loyalty or the lack of an alternative provider if they did not have generating assets. Additionally, the odds of Montana Power achieving the economies of scale necessary to provide retail service at a competitive rate was unlikely. The conclusion is that the Montana Powers most important competitive advantage was their generating assets, which could produce electricity at below average costs, and the sale of those assets all but predetermined the companys exit from other energy businesses. The Growth Mentality Montana Power had until that time focused on value rather than growth. This is not to say that Montana Power did not grow or that growth is not important to all companies, rather, it is an observation that Montana Power had conservative growth rates that reflected the growth of the industry in which it operated. Annual growth rates of 3-4% were common in the utility industry while companies in the telecom market were experiencing growth rates anywhere from 15 to 30% annually. The prospects for high rates of growth in the Montana energy market were not likely. As a utility,

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Montana Power paid a regular dividend, a practice it discontinued in an October 2000 meeting of the board of directors as part of its transformation into a growth company.126 This is an example of the companys desire to reflect a growth-oriented image to the public, especially the investing public. The markets responded positively to the companys announcements of selling its generating assets and to leaving the energy industry, partly due to the perception that a telecommunications company had more growth potential and also because Touch America could fund its growth using proceeds from the sale of its assets. It is important to note that the course of action chosen by the board was not the only way to proceed in the market or to unlock the value of Touch America. While the changes in the utility industry were not likely to change in Montana Powers favor, it did not justify entering an industry that was even less suitable, such as telecommunications. In fact, most companies dont attempt to transform themselves from a steady income earner to a business with much greater potential and even greater risk. Normally when a company is presented with a subsidiary that is growing quickly and has excellent potential, that company would consider a spin-off, much the same way AT&T spun-off Lucent in the late nineties to let the business develop independently without risking the assets of the rest of the corporation. Such a structure would have worked for Montana Power and Touch America, but according to board member Tucker Hart Adams, two things prevented the spin-off of Touch America. First, the spin-off of Touch America came with significant tax implications that would make that course of action very expensive. More importantly, according to Mr. Adams,

126

Montana Power Company 2000 Form 10-K, Item 1: Business

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the market for initial public offerings (IPOs) became significantly less attractive.127 Again, bounded rationality can be employed to explain the course of action taken by the company. Selling the remaining energy assets was a satisfactory way to separate the telecommunications from the energy business, but it wasnt the optimal decision by any means. Strategy Analysis Regarding the strategy pursued by Touch America in the telecommunications industry, some strategic analysis would indicate that Touch America was without a competitive advantage in the marketplace. Touch America did not have experience and expertise and other advantages equivalent to their rivals such as AT&T, Sprint, and Qwest. According to Montana Powers 1999 10-K, some telecom competitors had equal or greater resources, capacities, and competitive advantages including: greater name recognition; financial, technical, and marketing resources, larger customer and revenue bases, well-established relationships with current and potential customers, and more sophisticated industry knowledge, which is disproportionately distributed across the telecommunications industry. While telecommunications remained an inconsequential business unit for Montana Power for over a decade, it represented the core competencies of competitors businesses. Despite that fact that MPC/Touch America had been involved with the telecommunications industry for 16 years, it was nave to believe that the companys prior experience would adequately prepare it to compete in a highly competitive and rapidly changing oligopoly with much larger and more experienced companies.

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Montana Power/Touch America also assumed that part of their competitive advantage was their ownership of rights of way along its system of natural gas network. While it was easy for Montana Power to expand their fiber optic network within the confines of Montana given those rights of way, beyond the state borders, that edge evaporated. Additionally, other pipeline companies like Williams and Enron were pursuing similar strategies but with much larger resource capacities. Touch America couldnt build a network at lower costs without some type of advantage over their competitors, which Touch America did not have as a result of this analysis. Low-Cost Strategy Despite the lack of a clear cost advantage or other competitive advantage, statements regarding Touch America indicated the companys assumption that they were building a low-cost network The companys 1998 annual report declared the companys approach very clearly; Touch Americas simply stated strategy: Extend the regional network into a continental network, develop businesses that add traffic to the network, and do that in a low-cost way. A similar statement was in CEOs letter to the shareholder in Montana Powers 1999 annual report: The most important development of 1999 was continuing to grow Touch Americas low-cost, high-speed, fiber-optic and wireless networks.128 At the end of the same letter, the CEO again describes the network as high-speed, high-tech, with low-cost bandwidth.129 Furthermore, MPC believed their network provided them a competitive advantage as the companys 1999 10-K states, Our low-cost fiber network helps us to compete in national and regional telecommunications markets.130 A later statement in the annual report indicates that
128 129

Montana Power Company 1999 Annual Report, page 2 Montana Power Company 1999 Annual Report, page 4 130 Montana Power Company 1999 Form 10-K, Item 1: Business

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MPC was also relying on their lack of debt as an advantage in competing in the telecommunications industry; Touch America is well positioned financially and strategically to add to its low-cost fiber-optic, wireless, and direct-connect businesses.131 While excessive debt can be a limiting factor to businesses, almost all companies finance some of their expansion through debt. Debt has a few advantages, not the least of which is that interest on debt is tax deductible. The fact that Touch America had very little debt when the economy collapsed in 2001 prolonged the period before bankruptcy, but it was by no means a sound strategic advantage. Statements made by Touch America indicate they were pursuing both a low cost and a differentiation strategy. A low cost leadership strategy was incongruent with Touch Americas commitment to high quality service, costly expansion, and technology upgrades. Through observation it appears that Touch America was stuck in the middle; in other words, Touch America did not have a strategy coherent to lowcost or differentiation. In general, telecommunications services are a commodity, much like energy. It was very difficult to differentiate Touch Americas product given the very nature of the offering without major expenditures to promote name recognition and relationships with customers as well as other aforementioned valuable intangible advantages. The end result was an undifferentiated service that did not survive in a significant drop in industry demand. Interestingly, 10-Ks for 1999 and 2000 boast of a low-cost network while the release of Touch Americas 2001 10-K no longer referred to its network as low-cost, indicating that management realized they did not have a competitive cost advantage in the industry. Instead its corporate strategy was, To

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Montana Power Company 1999 Annual Report, page 13

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complete our fiber-optic network and become a profitable, nationally recognized provider of telecommunications transport services. Through analysis of other companies who survived the market downturn, conclusions can be drawn about other major flaws in the strategy at Touch America. The demographics in the state of Montana make it an unappealing market for many service providers mainly due to the low population density and the unpopulated regions between cities. Despite these characteristics, Touch America laid thousands of miles of fiber-optic cable in the state and in neighboring states. While they were able to connect a few metropolitan areas, particularly after 1997, the cost per person connected was much higher than it might have been in higher population density areas. The same concept applies to Touch Americas acquisition of customers in the mid-west region. The companys ability to increase market share in those regions was limited due to the limited size of the customer base. Furthermore, the cost of any improvements, upgrades, or investments in service would be higher per person than in high-density areas like California or the Eastern Seaboard. It is not Touch Americas fault for basing themselves in Montana, but given that circumstance, they should have known more about the likelihood of profitability when operating in that environment. Finally, Touch America made one other major strategic error; they failed to diversify against market risk. In the transition from Montana Power Company to Touch America, the company was transformed from a diversified operation with multiple business units into a single business unit. Part of Montana Powers ability to remain in business and create profits every year stemmed from its broad array of

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products and services132. By cutting away many of its products and services, Touch America left itself vulnerable to greater risk. Just like modern portfolio theory, businesses with diversified operations and investments can moderate volatility because other segments can offset losses or gains in one segment. Had management and Touch America made different choices including keeping a diverse operating platform, the company might have survived the market downturn and avoided bankruptcy. The general conclusions from the analysis of the strategy pursued in the transformation of Montana Power to Touch America are that management with the approval of the board of directors made inappropriate strategic decisions the greatest of which was exiting the energy business. Additionally, this analysis finds that the strategy formulated for Touch America in the telecommunications industry was ineffective, leading to the conclusion that the strategy was either poorly designed or poorly executed or perhaps both. Assuming strategy had a significant role in the fall of Touch America, the next section explores in greater detail the forces driving the strategy creation process for top management and the board of directors with particular attention paid to the corporate governance failures that allowed agency problems to impact the strategic decisions. Corporate Governance and Strategy Formation Bounded Rationality Decision-making, including the strategy formulation that is the subject of this section, is a human process. As such, the process is subject to the limitations of the people involved. In other words, decision makers are capable of limited or bounded

132

The fact that Montana Power operated a regulated monopoly also greatly increased the likelihood of sustainability and profitability.

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rationality, which creates strong pressure on actors to choose the first satisfactory option they come across rather the best possible one, according to March and Simon.133 The board of directors and management at Montana Power/Touch America was subject to the same principle of bounded rationality described above when they engaged in the decisions that affected the company. However, it was their fiduciary duty to minimize the limitations of the human element by fitting the board of directors with the most suitable, competent, and qualified people possible. It follows logically that if people are limited in their ability to understand and deal effectively with complex problems such as those facing a company, then those decision makers should be experts at dealing with the specific challenges of the company they are employed to monitor. Indeed, boards of directors and also top managers are hired and appointed based on their specific expertise, their backgrounds, and their connections to help meet the particular needs and challenges of the company. It is the duty of the board to conduct continual self-evaluations to confirm that the board is both a suitable and effective group of individuals in place to protect the interests of the shareholders. Likewise, when a company experiences radical changes, it is paramount that the board assess its ability to provide effective corporate governance. It is unclear to what extent this process took place at Montana

Power/Touch America, but it is obvious that the board remained virtually identical throughout the transition from a regulated utility to an unregulated telecom company. The strategic decisions at Montana Power/Touch America were a collaborative effort between management and the board of directors to provide a direction for the

133

March, James G. and Herbert A. Simon, Organizations. See also Handel, Michael J. ed., The Sociology of Organizations: Classic, Contemporary, and Critical Readings, pp. 181

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company that would serve the interests of the shareholders. While management may or may not have had the primary responsibility of formulating and executing strategy, the board of directors was charged with the responsibility of assuring suitability and feasibility not to mention profitability. To understand the board as a whole, further background is needed on the individuals who comprised the board throughout the transition period, for no board is better than the sum of its members. The Board of Directors The board of Montana Power in 1996 was designed to achieve the corporate governance function in a low risk environment in which in-state connections and political pull as well as basic business knowledge were important characteristics of effectiveness for directors. In 1997, the board consisted of fifteen directors, four of whom were part of the management team134. In that year, there were three retirements including the CEO and chairman Daniel Berube, who was succeeded by an internal candidate, Robert Gannon. Two of the fifteen members were not Montanans, and the majority of directors were executives or owners of various small businesses throughout the state including a law firm, a steel and recycling facility, a bank, a gardening company, an insurance company, and a food distributor. The two out-of-state directors were executives at an economic research group and a retail operation. Over the course of the next four years, Montana Power had three additional retirements and appointed three directors from outside Montana with expertise in technology industries. One of those newly appointed directors, the CIO for a computer software company, chose to exit his position in 2001, before the end of his term. A

134

For more information on the board of directors, see exhibit

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core of nine directors remained intact throughout the period of 1996-2001 and the transition to Touch America. Certainly the demands imposed upon the board when Montana Power was a regulated utility were different than those demanded when deregulation was adopted, and vastly different than the capacities required from the board of a company competing in a high-technology, high risk telecommunications company. As a regulated utility, Montana Powers business was not subject to intense business cycles because of the inelastic nature of energy goods (although demand was greater in the winter months). In fact, given its regulated monopoly status, it would have been difficult for Montana Power as a utility to make a serious strategic error. Some of the only ways the company could have failed were to over building generation or transmission capacity, to under bill, to buy significant power on the open market135, or to have one or more of their plants shut down. The nature of the utility in the context of regulation meant that the company was guaranteed an ability to price their goods and services above cost, enough profit to allow for a return to shareholders. Montana Power did not have a history of making such poor decisions, partly because managing a utility company was the core of their business. The fact that the regulated utility industry was fairly stable, relatively insulated from market pressures and devoid of competition lead to very low monitoring costs for the board because the job of managing the utility was not overly complex or laden with abundant risks. The structure and behavior of the board inevitably lead to a passive board, one that did not have the need to make decisions that would be vital to the survival of the company.
135

As a regulated utility, Montana Power Company did buy some of its power on the open market, but those purchases represented about one quarter of all energy distributed to MPC customers (24.5% in 1996) according to Montana Power Companys 1996 Annual Report

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Additionally, the board not only didnt have a history of questioning managements strategic decisions, they also didnt have a history of evaluating the advise of outside advisors such as the ones they hired to consult on how Touch America could be separated and developed independent of the energy business. In the context of agency theory, the board of directors was supposed to act as the agent for the shareholders and protect their interests. However, the board was not prepared and had no previous experience of being required to do so especially not to the extent that drawing back the management team from excessive risk would be necessary. An alternative hypothesis is that the board helped management develop the strategy, in which case their objectivity was compromised. Either way, the board that made the decision to sell generating assets in 1997 and the board that decided to divest all energy assets was virtually the same board that presided over Montana Power as a regulated utility. The fact that the majority of individuals were not board members of companies that operated in competitive industries, nor were many of them involved with the telecommunications industry supports the finding that the boards characteristics and capacities did not match the needs of the company the moment it was subject to deregulation. The board also had the responsibility to the shareholders to hire, evaluate, and potentially fire not only themselves, but also the management team. Bob Gannon, the CEO as of the end of 1997 was trained inside the company and had been on the board of Montana Power Company since 1989 and served the company as an employee since 1974. His background as an attorney, assistant state and US attorney, and long-term employee of Montana Power meant he had no prior experience running unregulated

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companies, nor did he have a background in telecommunications. There were a number of momentous changes that took place at Montana Power, including one that required approval by the shareholders, which should have prompted the board to evaluate the capacities of the management team more closely. CEOs of rival telecommunications firms had decades of experience in the industry. Other telecommunications executives like those at Sprint, MCI, and Qwest also had more experience competing against industry giant AT&T, the dominant player in the industry. Executive and Director Compensation The Personnel Committee, which handled all compensation issues, was composed solely of outside directors in 1997 and afterward. Their approach was to provide comparable compensation to similar business, a strong linkage between compensation and performance, to align shareholder and executive incentives, and create equity amongst officers.136 In 1997, Montana Power transitioned away from the non-qualified retirement plan for non-employee directors in favor annual grants of 480 shares of common stock to each of the ten outside directors in an effort to align the boards interest with those of the shareholders. The 1998 proxy statement in which the compensation was outlined justified the 480 shares as being cost equivalent to previous retirement benefit contributions. Then in 2001, the board approved a pay increase for directors raising the annual compensation from $19,500 to $35,000 only to later take a pay cut when the company ran into serious financial trouble. In 1994, the board created Dividend Equivalent Awards, described as incentive compensation tools that were based on performance criteria, the awards were primarily based on comparing the companys total shareholder return against its peer group of
136

Montana Power Company, 1998 Proxy Statement, Executive Compensation

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utilities137. The incentives if awarded were designed to be reflective of high relative performance, the maximum incentive being awarded at or above the 90th percentile mark. Compensation was awarded by the board for performance despite lower earnings and return on equity in 1995 from 1994.138 The personnel committee justified the awards due to the rebound in earnings in 1996, the successful restructuring of the company down to two operations, and the passage of the deregulation legislation.139 A table provided in the March 1998 proxy statement shows that CEO Robert Gannon and his immediate family owned 59,711 shares as of February 4th 1998, and 51,900 of those shares were exercisable in the 60 days of the same proxy filing. Mr. Gannon exercised his option to sell 23,000 shares on April 30th of 1998 for a reported profit of over $350,000.140 The sale took advantage of the fact that the stock price rose from around the $22 dollar level with the December 1997 announcement the company planned to sell its generating facilities to a share price of approximately $37 dollars on April 30th. From the period of February 6th to March 6th in 1998, Montana Power insiders sold stock for proceeds totaling $1.522 million, which almost tripled the previous one-month high for insiders of $523,000 back in 1992.141 Some of the profits from stock option sales were used to purchase company shares, enough to have the Wall Street Journal list it as the company with the forth-highest 10 percent owner purchases in the first quarter of 1998.142 When the company filed for bankruptcy, the

137

the proxy statement lists the Standard & Poors 26 Electric Power Company Index as the benchmark used to compare peer performance. 138 Montana Power Company 1996 Annual Report, Financial Highlights 139 Montana Power Company, 1998 Proxy Statement, Executive Compensation 140 Johnson, Charles, Gannon Sells MPC Stock, Buys More 141 Johnson, Charles, MPC Execs Cash in on Stock 142 Johnson, Charles, MPC Execs Cash in on Stock

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CEO still owned 32,000 of common shares in addition to 271,489 worthless stock options.143 In 1997, the board of directors at Montana Power created a new compensation package for senior employees that initiated the use of stock options as incentive compensation. The policy was formally adopted until January of 1998 although a similar interim bonus plan to operate in 1997 until the finalized legal documents could be finished. The board cited the necessity to retain key managers through total compensation levels closer to industry standards144. Additionally, the new compensation sought to more directly align the interests of the management with those of the shareholders. The maximum bonus opportunity in the interim plan ranged from a maximum of 20-25% of base salary,145 and base salary was partly determined by comparing information gathered by the Edison Electric Institute regarding compensation levels for officers within the industry. It is more than coincidental that the beginning of the new executive compensation policy in 1997 coincided with Montana Powers decision to approach the telecommunications industry with more focus. Undoubtedly management and the board saw the growth in telecom revenues within the company and wanted to foster that growth, but the potential for lucrative financial gains must have played some psychological role, in the decision making process due to the self-interested nature of individuals including Montana Power executives and board members. A number of board members in addition to Bob Gannon owned significant shares in Montana Power/Touch America. They had every incentive to pursue the
143 144

Falstead, Jan, Shareholders Take Stock of MPC Moves Montana Power Company, 1998 Proxy Statement, Executive Compensation 145 Salaries in 2000 were reported to be $619,500 for the CEO, $290, 500 for the CFO and $529,500 for the COO according to forbes.com

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strategy they believed would increase the value to shareholders. The opportunity to increase his personal wealth was a motivating factor for Mr. Gannon and others to pursue the telecommunications industry. Touch America offered the possibility to accumulate far more wealth than would have been possible operating a utility company with low growth rates, which is a powerful incentive for any executive. With 32,000 shares and additional 250,000+ stock options, Bob Gannon stood to gain tremendously if the value of the stock increased significantly. In fact, the total return potential in his stock and stock options exceeded the expected returns as a CEO of a slow-moving utility. Management and the board of directors chose a course of action through careful deliberation and consultation; however, the corporate governance practices at Montana Power failed to change as the demands and environment of the company changed. This led to the inability of the board to adequately control for managements incentives to pursue growth opportunities. The board also failed to properly evaluate the risk profile of the telecommunications industry and match the capacities and abilities of management to operate in the market, and finally, to determine the boards own effectiveness. Change of Control Payments The same 1998 proxy statement that outlined the executive compensation package also detailed severance agreements with corporate executives. In the event the company changed control (was acquired), top executives would have the right to certain benefits if they were released from the company without cause as a result of the change in control.146 Sometimes referred to as golden parachutes, such employment clauses were not unusual in Fortune 500 companies. However, the way in which those
146

Montana Power Company, 1998 Proxy Statement, Executive Compensation

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employment clauses were exercised was quite unique. Days after Touch America announced third quarter 2002 losses of $30 million, the CEO released news that himself and three other executives would receive a total of $5.4 million in change of control payments from the transition from Montana Power to Touch America, regardless of the fact that the share price had slipped below $10 and the company had limited cash flows. Shareholders were highly agitated at the development primarily because the executives had not changed through the transition from one company to the other. Capital Markets and Corporate Advisors Montana Powers decision to enter the telecommunications market coincided with not only a stock market bubble but also a technology bubble fueled by the growth of the Internet. The stock market in the late nineties was by all accounts inflated. In particular, technology stocks saw increases in stock prices that were unfounded by such market fundamentals as earnings per share, price to earnings ratio, or annual revenue growth. Companies associated with the Internet and Internet technology experienced a disproportionate level of price appreciation, partly driven by the enthusiasm and the perceived profit opportunities associated with the technology. The opportunity to greatly enhance the price of Montana Powers stock was undoubtedly a driving force in the companys decision to invest in telecommunications. In 1997 alone, the first year Montana Power invested significantly in building their fiber-optic network, the stock price moved from $22.625 at the close of business in 1996 to $32.25147, close to a 43% increase. While Montana Power continued its network expansions in 1998, the stock price shot up to a high of $57.13, almost a doubling in price. The stock hit a high of
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Montana Power Company 1997 Annual Report, page 2

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$64 dollars in early 2000 when the company announced they would be selling off the remaining energy components. Some fortunate investors sold their shares at its peak price, but the vast majority of investors didnt realize the extent to which Montana power had become affected by the stock market bubble. Additionally, it was months if not years before the public realized the true extent of over capacity in fiber optics. The gains in valuation were short-lived and quickly vanished at an accelerated pace when the market started to decline in the latter half of 2001. In August of that year the stock dipped below $8 dollars per share, and ended the year below the $5 per share mark. In addition to regulation, other external forces played a part in the development of strategy at Montana Power/Touch America. Some have conjectured that advisors like Goldman Sachs and other advisors were largely responsible for encouraging the decisions that eventually caused the downfall of Touch America. Its true that the investment banking team certainly shaped the structure of the transition from a utility to a telecom company and recommended the strategy the company eventually adopted, but the firm did consider other options for Montana Power; in fact an insider reported that a spin-off would have produced greater total fees for the investment bank. The board and management at Montana Power considered other options including a spin-off and IPO, but ultimately took the recommendations of their strategic advisors.148 Its irresponsible to blame advisors for the errors in strategic advice when the ultimate authority to accept or reject that advice was with the board. Regardless of Goldman Sachs influence, it was not the most powerful external force operating on the company. According to rational market theory, a rise in the stock price can signal the markets approval of a strategic decision. In the case of Montana Power, the stock
148

Richards, Bill, Utilitys Telecom Gamble Becomes a Big Loss

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price rose when the company announced their decision to sell energy assets and pursue the telecom industry. Unfortunately, the rise in the stock price was more reflective of inflated expectations for growth in technology-related companies like Touch America in addition to a general speculative bubble in the stock market. Observers today might conclude than in retrospect, Montana Power was a casualty of market forces beyond its control. However, this viewpoint negates management and the boards duty to assess and manage risk on behalf of the shareholders whose capital is represented in the assets and equity of the company. Findings In the aftermath of the bankruptcy at Montana Power Company/Touch America, many individuals are searching for a simple and clear explanation. Employees, shareholders, power users and other stakeholders are looking for someone or something to blame for the loss in utility. This case is not the story of a company that made a mistake; it is the story of a corporate governance mechanism that failed. The governance system allowed an individual or a group of individuals to profit or have the potential to profit greatly from operating a risky business venture. CEO Bob Gannon attempted to make himself wealthy through stock options, and in the process create wealth for his fellow shareholders, but risks involved with the venture were not suitable for the company he directed. The board of directors is designed to perform a continual monitoring of management, which involves reviewing, approving, and evaluating the actions of management. The directors are involved in all the high level corporate activities including strategic planning, capital allocation, long-range goals, performance appraisal, risk management and manpower planning.

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Each of these functions occurs in a cycle so that the outcomes from each of the aforementioned processes of corporate management impact following actions. For example, in the case of Montana Power, when the board approved the telecommunications build-out, it became part of the companys strategic plan. They set in motion a chain of events including devoting funds to lay fiber-optic cable and otherwise expand their telecommunications operations and set goals for that expansion. Although the board evaluated the companys progress, they failed to complete the other components of a thorough performance evaluation including evaluations of the management team and the board itself. In the case of Montana Power, the needs of the board changed with the passage of the deregulation bill in July of 1997. Such a reevaluation of the board composition might have prevented decisions that eventually brought the company to bankruptcy. The only reasons for Montana Power not to adopt corporate governance best practices were either the directors were averse to change, although they later proved that not to be the case, or they felt it was unnecessary in their industry. Montana Power with the approval of the board, failed to create a strategy that was consistent with their core competencies, and without a formal process for evaluating the boards own abilities to provide oversight or a history of questioning managerial decisions, the board was unequipped to handle the fiduciary duties involved in a company operating in competitive markets. Structural and behavioral weaknesses in the corporate system played a role in the downfall at Montana Power Company. Directors at Montana Power Company also felt the pressure of market valuations when their utility became

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deregulated. Corporate executives pursued a risky growth strategy on the assumption it would increase the value of Touch America stock, but the result was a loss of value for not only shareholders of Touch America, but also stakeholders like the energy consumers of Montana. Stock options and other incentives played a role in encouraging the pursuit f the telecommunications industry and therefore the suitability of such compensation schemes is called into question in this case. It is the finding of this thesis that the board that made the decisions to exit the power generation industry and to invest the majority of the proceeds of those sales in the telecom industry was not composed of individuals with adequate skills to meet the board, however, it is worth exploring a set of skills that would have been helpful on the board of Montana Power. If the board were serious about matching their capacities and backgrounds with the needs of a telecom company, directors with experience in industries with retail products with a high rate of product change would have been appropriate additions. Also, individuals with a background in producing hardware, software, and services for TV, cellular phones, or products that directly serve consumers would have been key contributors on a board like Touch America. Additionally, individuals with experience in volatile industries would have added valuable expertise about dealing with risk and changes in demand in the telecom industry, in particular, those with experience building communications networks and infrastructure. Finally, in dealing with changes in the utility industry, it would have been helpful to have a director with experience in declining or devolving industries.

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The boom in the telecom industry had dramatic influence on the Montana Power Company. As MPC executives searched for a market strategy to lead the company into the next millennium, they found great potential in their rapidly developing and profitable telecom subsidiary, Touch America. Just as Montana Power executives fell victim to the internet investment euphoria, so were they victims of the industry and stock market bust. In retrospect, had Montana Power Company remained the stable energy company it was for ninety years, it would still be in existence today. Montana Power in a Changing Industry Montana Power was not alone in facing changes in the utility industry. Other companies went into new industries like Montana Power, and some companies decided to continue operating in the energy industry but in different ways. For example, when utilities in California were forced to un-bundle their generating assets from transmission and retail operations, some bought generating facilities in other regions of the United States as well as internationally. The logic behind such business decisions relied upon the corporations decisions that they should continue to operate generation facilities because it was a core competency. The proceeds from the sale of Montana Powers generating could have been used to invest in other energy industry opportunities instead of telecommunications. The company would have had to adapt to a competitive market environment, which still might have included changes in board membership and senior management due to the increased risk involved, but in such a scenario, the company would not have lost more than eighty valuable years of experience in energy operations.

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Implications It is unlikely that we have seen the end of corporate governance failures in the United States, the question is how to minimize the likelihood of such events. Stock options may not be suitable for companies in high technology or even high-risk industries. It seems more reasonable that risk management should be a key component of evaluating executives in aforementioned industries, which should also be reflected in their compensation schemes. Additionally, boards of directors are cautioned to learn the effects of stock option incentives and operate in a way that more closely monitors and evaluates senior managements incentives. Montana Power would have benefited from the addition of a board member with significant experience as a director of a company using stock options. Unfortunately, structural reforms alone are unlikely to effectively prevent corporate malfeasance, board behavior is equally as important as structure and it will take a shift in the understanding of directors responsibilities and duties in boardrooms across America for optimal functioning of the corporate governance mechanism. In the case of Montana Power, the adoption of innovations in the energy and telecommunications were clearly being embraced while the capacities, structures, and processes to handle such innovations were clearly not being adopted at the same rate. The case of Montana Power is a lesson in what happens to companies who do not build the capacity to mitigate serious change, and more importantly, risk in the industry and in the marketplace. When part of the governance system breaks down, the system is predisposed to failure. Unforeseen circumstances occur in all businesses, and at those times the corporate governance function becomes absolutely critical.

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Corporate strategy does not change on a day-to-day basis, but that strategy has to be coherent with the capacities and resources of the company as well as the prevailing market environment. Energy Deregulation Its easy with hindsight to blame the fall of Montana Power/Touch America on the legislative body that originally allowed the company to exit the utility business. Its true that without Senate Bill 390, Montana Power would have likely remained relatively unchanged from its traditional utility structure. Unfortunately, continued regulation only serves to stifle competitive forces, which in the long run stifles innovation and cost-containment. Particularly in the energy market where higher prices would encourage conservation efforts, there are some serious social consequences to masking price signals.149 It is more appropriate to view deregulation as a disruptive but important force that will ultimately lead to increased efficiency and productivity in the energy market, regardless of the fact that individuals outside the state of Montana may reap the majority of those benefits. Research Limitations Due to a number of lawsuits filed against Montana Power/Touch America, the board of directors has been unwilling to share information about the proceedings of meetings or actions of senior management. Only the directors know exactly what transpired in the boardroom, how strategic choices were formulated and adopted, and what the true motivations were for those strategies. Consequently, research gathered

149

Gray, Robert, Energy Pulse, The Long Term Consequences of Californias Electricity Deregulation Experiment

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for this thesis is limited to public statements and filings of the company as well as other publications and interviews. Further Research The effects of stock options, especially in technology and technology-related companies, needs to be explored to a greater extent. Stock options have theoretical potential to remedy many agency problems, but they can also lead to risk assessment behaviors as in the case on Montana Power. More work is needed to find a better structure for stock options, if one is possible. Given an infinite amount of time and access to information, further researchers could examine the influence of outside advisors like Goldman Sachs and others who have not been forthcoming with the information they provided to the board. Additionally, it is possible to gather much more information from board members and senior executives who had a closer relationship with the company. Further research might also include long-term studies on the performance outcomes for other utilities that stayed in the power industry after deregulation to make conjectures about whether Montana Power could have continued in their industry successfully. Finally, additional long-term research is needed to measure the value and efficacy of corporate governance best practices as well as the role of board behavior as a factor in preventing corporate governance failures.

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Appendix A: Qualitative Data from Montana Power Company

Table 3: Timeline of Events at Montana Power Company 1912 1931 1951 1959 1968 1984 1985 1988 1990 1996 1997 Montana Power Company is formed by the merger of four regional electric companies Montana Power adds natural gas service Montana Power is the first major utility to import Canadian natural gas Montana Power acquires coal reserves in Eastern Montana The company begins surface mining of coal reserves Entech, a subsidiary of Montana Power is formed to manage non-utility mining, oil, and natural gas operations and telecommunications Montana Power opens a lignite mine in Texas The Independent Power Group (IPG) is created to manage long-term electricity contracts and invest in non-utility generation facilities Montana Power acquires Touch America, a small long-distance company based in Missoula, Montana California becomes the first state to deregulate retail energy prices Touch America begins offering internet service Robert Gannon is promoted to CEO The company implements Economic Value Added (EVA) to evaluate investment decisions The company reorganizes from three to two divisions: utility and non-utility Montana Power begins a strategy to expand their fiber-optic network Montana Legislature passes retail energy deregulation o Montana Power and large industrial users back the bill o Industrial users are allowed to choose their power provider upon passage of the bill Montana Power Company board of directors approves new compensation plan for directors and executives o Compensation plan includes the use of stock options Montana Power announces it will sell its energy generation assets 101

1998 1999 2000 2001 2002

The company places a higher priority on telecommunications while maintaining a presence in the energy industry Montana Power begins limited wireless operations along their network Montana Power exits the business of trading and marketing electricity Montana Power serves 285,386 electric and 147,994 natural gas customers The fiber-optic network expands to 10,000 route miles CEO Bob Gannon exercises 23,000 share for proceeds of approximately $350,000 Montana Power completes the sale of its generation facilities to PPL resources Inc. for slightly less than $1 billion Montana Power repurchases 4% (4.7 million shares) of common stock with sale proceeds at a cost of $145 million The fiber-optic networks expands to 12,000 route miles Montana Power makes the decision to exit the energy industry completely NorthWestern is announced as the acquirer of many of Montana Powers energy assets Montana Power acquires long-distance customers in a 14 state area Touch America incorporates in Delaware The fiber-optic networks expands to 18,000 route miles Touch America hits its record share price of $64 Board of Directors approve a compensation increase for directors from $19,500 to $35,000 plus additional compensation Shareholders file suit claiming the sale of assets was illegal Qwest files suit over disagreements regarding the acquisition in 2000 Shareholders file suit over shareholder approval of sale of assets Company delays third quarter earnings report Montana Power completes the sale of its transmission and distribution assets to NorthWestern The Montana Power Company ceases to exist Touch America takes over customer billing operations formerly performed by Qwest and fails to accurately bill customers A shareholder class action suit is filed charging the company with failure to disclose meaningful information Former employees file suit claiming failure of fiduciary duty with regard to the employee pension plan

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Bob Gannon and three other top executives arranged $5.4 million dollars in change of control payments

2003

Touch America is delisted from the New York Stock Exchange for trading below $1 for eight months Court decision regarding Qwest requires a $60 million payment Touch America files for bankruptcy Touch America sells majority of its telecom assets to 360Networks Qwest grants Touch America a $10 million loan to continue operating

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Table 4: The Montana Power Company / Touch America Board of Directors Bob Gannon was president and Chief Executive Officer of the Montana Power Company, where he worked for more than 20 years. Before joining Montana Power in 1974 as an attorney, he served two years as an assistant attorney general for the State of Montana, and another two and a half years as assistant U.S. attorney for Montana. Gannon is a native of Butte, Montana. He graduated from the University of Notre Dame with a bachelor's degree in government. He earned his law degree in 1969 from the University of Montana and completed the Harvard University Advanced Management Program in 1989. Dr. Adams is a resident of Colorado Springs, Colorado, and has been President and Chief
Executive Officer of The Adams Group Inc., a consulting firm specializing in economic research, analysis, and forecasting, since January 1989; and publishes the newsletter "Today's Economy." Other Directorships: Trustee: Tax Free Fund of Colorado; Trustee, Aquila Rocky Mountain Equity Fund; and Director, Avista Labs.

Mr. Cain is a resident of Bigfork, Montana. Recent Positions: Director of The Montana Power
Company from March 1989 to February 2002; and was President and Chief Executive Officer of BlueCross BlueShield of Montana, a health service corporation, in Helena, Montana, from March 1986 until his retirement in September 1999.

Mr. Corette is a resident of Butte, Montana, and has been an owner and attorney at Corette,
Pohlman & Kebe, a law firm in Butte, Montana, since 1966.

Ms. Foster is a resident of Billings, Montana, and has been President of Planteriors Unlimited,
Inc., an interior foliage plant sales and maintenance business in Billings and Missoula, Montana since April 1999; and has owned this business since December 1980.

Mr. Jester is a resident of Gig Harbor, Washington, and has been President of Bargain Street
LLC, a retail firm, since September 1997. Recent Positions: President of Muzak Limited Partnership, a telecommunications-based business, from January 1988 to May 1997.

Mr. Lehrkind is a resident of Bozeman, Montana; has been President of Lehrkind's, Inc., a
beverage bottler and distributor in Bozeman, Montana, since February 1970; and has been President, Owner and Operator of Yellowstone Country Food and Beverage restaurants in Livingston, Montana and Miles City, Montana since February 1993.

Ms. McWhinney is a resident of San Francisco, California, and has been President of
Schwab Institutional for Charles Schwab, Inc., a provider of financial services, since February 2001. Recent Positions: President of Internet Profiles Corporation (I/PRO), a provider of Web traffic measurement, auditing, and research from July 1999 to January 2001; Executive Vice President from May 1997 to July 1999 and Senior Vice President from 1995 to 1997 for VISA International. Other Directorships: Director, Novadigm, Inc.

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Mr. Meldahl was President and Chief Operating Officer. Mr. Meldahl has held his present
position since April 2001. He served as the Executive Vice President and Chief Operating Officer, Technology Division from 1998 to 2002; Vice President, Communication Services, Energy and Communications Division, from 1996 to 1998 for The Montana Power Company; and Vice President, Technology Operations for Entech, from 1997 to 1999.

Mr. Pederson is a resident of Butte, Montana, and has been Vice Chairman of the Board of
Directors since July 1993 and Chief Financial Officer since May 1991. Recent Positions: Mr. Pederson was Touch America Holdings, Inc. Vice President from May 1991 to February 2002, and Treasurer from September 2000 to April 2001, and Chief Information Officer from May 1996 to May 1999 for The Montana Power Company.

Mr. Vosburg is a resident of Great Falls, Montana, and has been President and Chief
Executive Officer of Pacific Steel & Recycling, a steel service center and recycling business in Great Falls, Montana, since May 1982.

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