Fair Return on Fair Value

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FAIR RETURN ON FAIR VALUE

The doctrine of a fair return on a fair value, which the Supreme Court propounded in smyth v. ames (1898), provided that any government regulation of rate schedules charged by railroads or utilities must allow a reasonable profit or fair rate of return based on a fair valuation of the property. The principal considerations were the original cost of the property, and the cost of reproducing it at the time of the rate regulation. Having entered the business of supervising the details of ratemaking, the Court remained in that business until 1944.

The Court first provided the basis for the doctrine by equating rate regulation with eminent domain : just compensation must accompany a taking of property, and to the Court a rate regulation was comparable to a taking. In chicago, milwaukee, and st. paul railway company v. minnesota (1890) the Court declared that the failure to allow a company to charge reasonable rates for the use of its property constituted an unconstitutional taking of property or a violation of substantive due process of law comparable to a taking. In reagan v. farmers ' loan and trust company (1894) the Court voided rates because they were fixed so low that they virtually took property without compensation. (See granger cases.) In Smyth v. Ames the Court, in a unanimous opinion by Justice john m. harlan, proclaimed that a company was entitled to receive a reasonable profit based on the rates it could charge and that a reasonable rate must be determined by the fair value of the property. To ascertain that value, Harlan declared that among the matters to be considered "and given such weight as may be just and right in each case" are the following: "the original cost of construction, the amount expended in permanent improvements, the amount and market value of its bonds and stock, the present as compared with the original cost of construction, the probable earning capacity of the property under particular rates prescribed by statute, and the sum required to meet operating expenses.…"

Prior to world war i, the Court usually relied on original costs in determining whether a particular rate schedule yielded a fair return. The Court switched to reproduction costs after the war, when prices and costs rose, thereby challenging more rates. Smyth' s vague and flexible standards allowed the Court to act as it wished, without restraints. In united railways & electric company v. west (1930), for example, the Court voided rates allowing a profit of 6.26 percent on the ground that anything less than 7.5 percent was "confiscatory."

Fair value governed fair return standards against the opposition of Justices louis d. brandeis and oliver wendell holmes, who attacked the doctrine as legally and economically unsound. In 1939, Justices felix frank-furter and hugo l. black called for the rejection of the doctrine, and in 1942 the Court indicated that the determination of property value, although useful, was not indispensable. Finally, in federal power commission v. hope natural gas (1944), the Court rejected the fair value doctrine. Thereafter the Court permitted government rate-making bodies to fix rates without judicial interference, on condition that the ratemaking process respected procedural due process.

Leonard W. Levy
(1986)