Docket OST-97-2329 (Docket 50176) / Docket OST-95-474 / May 27, 1997

In their Opening Brief, the Airlines repeatedly take issue with the D.C. Circuit's decision in this case, attempting to reargue matters that the Court of Appeals has already decided. They argue that the policies embodied in the governing statutes require the use of historical cost valuation—notwithstanding the fact that the LAX I decision expressly held that nothing in existing law requires the use of historical costs. They also continue to advocate an accounting conception of costs, contrary to the direction of the Court of Appeals. In the process, they ignore basic, unassailable principles of economics.

Even if there were a sound reason to subject airports to historical cost regulation— which there is not—historical costs cannot be required without allowing a commensurate rate of return. The Airlines ignore the fact that utilities receive fair rates of return. In any event, the utility model cannot be applied here, where DOT does not have the power to set the fee.

The Airlines' objective is obvious. They simply seek to obtain a subsidy at the expense of LADOA. They want the use of the airport facilities provided without having to pay reasonable rental charges, which would deprive the airport of the normal, competitive market return to which it is unquestionably entitled.

The D.C. Circuit has already considered—and rejected—the Airlines' argument that applicable cases and statutes require the use of historical cost valuation. It expressly ruled that the "Secretary's view of historic cost as the apodictically indicated measure of 'actual cost' [was] not . . . supported by the applicable law." LAX I, 103 F.3d at 1032. The court also stated that the Supreme Court had never held that "historic cost represents the only true measure of cost" and that nothing in existing law prescribed "an accounting, rather than an economic conception of cost in airport ratemaking." Id. at 1032. Nevertheless, the Airlines attempt to reargue the issue with a slightly different gloss: They argue that while the applicable statutes "may not expressly prohibit the recovery of opportunity costs," the policies underlying those statutes require that airports be permitted to recover only "their actual out-of-pocket expenditures and outlays." Airlines Br. at 5.

The Airlines' effort to persuade DOT effectively to attempt to reverse the D.C. Circuit is misguided, to say the least. First, the cited cases, including Evansville and Kent County, do not define the type of costs airports are permitted to recover under applicable statutes. See Airlines Br. at 4-5; LAX I at 1032-33. Second, the Airlines' assertion that none of the cases cited "contemplates that a compensatory methodology would be based on assessed fair market value" is not helpful: None of those cases states that a compensatory methodology should not be based on FMV. /1 Airlines Br. at 4-5. Third, the Farmer's Union quotation that "an agency may not supercede well established judicial interpretation" does not support the Airlines. Not only is the interpretation they advocate far from a "well established judicial interpretation"—it is directly contrary to the interpretation of the D.C. Circuit in this case. Finally, the applicable statutes and legislative history cited do not suggest that their underlying "policy" is to "minimize" fees or prohibit the use of FMV.

1. The AHTA. The Airlines' discussion of the AHTA is misleading, at best. At the outset, the Airlines fail to quote the applicable language of the AHTA, which specifically authorized airports to collect "reasonable rental charges, landing fees, and other service charges from aircraft operators for the use of airport facilities." 49 U.S.C. App. § 1513(b) (emphasis added) (subsequently recodified at 49 U.S.C. § 40116(e)(2)). Nothing in the AHTA suggested that land rental charges were to be excluded from the express authority granted airports to collect reasonable rental charges.

Next, the Airlines assert that Congress made clear that reasonable charges "should be imposed only where needed for airport development," and that Congress intended by increasing federal subsidies to "minimize the need for additional fees on airlines ...." Airlines Br. at 6 (citing S. Rep. No. 12, 93d Cong., 1st Sess., reprinted in 1973 U.S.C.C.A.N. 1434, 1446, 1455). In fact, the cited portions of the legislative history say nothing of the

1/ It has never been suggested that the application of the compensatory methodology upheld in Kent County precludes the use of other compensatory applications.

kind. Congress sought to prohibit passenger head taxes, not to "minimize" fees charged to airlines for their use of airport facilities. The "two actions" that must be viewed together are the prohibition of local head taxes and federal funding, not "limitations on fees and increased subsidies." Id. at 1455; Airlines Br. at 6. /2

Finally, the Airlines ignore the fact that in Kent County, the Supreme Court expressly refused to infer a "limit on airport surpluses from the AHTA," noting that it "does not mention surplus accumulation." 510 U.S. at 372. The Airlines also ignore DOT's position, which was that as long as charges to air carriers "do not result in revenues that exceed by more than a reasonable margin the costs of servicing those carriers, the Secretary would normally sustain those charges as reasonable under federal law." Id. at 370 (quoting Brief for United States as Amicus Curiae at 25). DOT would not have taken that position if the federal policy was to prevent airports from earning a reasonable return.

2. The AAIA. The Airlines quote the AAIA's provisions that airports accepting federal grants must agree that fees charged airport users be "reasonable" and that revenues generated by such airports be used for the capital or operating costs of the airport. Airlines Br. at 6-7. Nothing in these provisions suggests that airports should not be permitted to charge reasonable FMV-based rental charges. Moreover, LADOA has stated that it intends to use the revenue from the land charge for airport development.

The AAIA also requires that airports be as self-sustaining as possible. 49 U.S.C. § 47101(a)(13). The FMV-based rental charge plainly complies with that mandate, which, together with the reasonableness requirement, means not that fees must be kept to a "minimum" but rather that airports must recover the normal, competitive market value of the services and facilities provided, which, of course, includes opportunity costs. /3

2/ The Airlines go even further, arguing that the policy behind the AHTA is that fees charged airlines "are to be kept to a minimum." Airlines Br. at 7. Keeping rental charges to a minimum would require that they be set at zero. This candid expression of the Airlines' objective makes clear their intent—to maximize their own profits by obtaining a subsidy at the expense of airport proprietors. Obviously Congress had no such intent; when it expressly authorized "reasonable rental charges" it said nothing about "minimizing" such charges.

3/ The Airlines claim that LAX is the only airport ever to have sought to charge a FMV-based rental charge. Airlines Br. at 8 n.2 They are wrong. As the record makes clear, many airports (including LAX) have long charged FMV-based rental charges for the use of land underlying aeronautical facilities, including terminals, cargo facilities and maintenance areas. These charges have allowed airports to recover their opportunity costs and the Airlines have never contended that recovery of these costs is contrary to federal policies.

3. The FAAAA. The statement that airports "should not seek to create revenue surpluses that exceed the amounts to be used for airport system purposes," in no way suggests that the FMV-based rental charge is unreasonable. It does not prohibit surpluses; it states only that surpluses should not exceed the amounts to be used for airport development. Nothing in the record suggests that the land charge will generate revenues that exceed amounts to be used for the development of LAX. With LAX's multi-billion dollar capital program, the Airlines cannot contend that the approximately $14 million in annual revenue from the land charge exceeds the amount necessary to provide needed capacity at LAX into the 21st Century.

Accordingly, contrary to the Airlines' assertions, the applicable statutes do not "evidence a federal policy" that fees be "kept to a minimum" and should not "create 'surpluses."' See Airlines Br. at 7. /4

Throughout their brief, the Airlines argue LADOA is trying to recover "profits" or "lost profits" rather than "actual" costs or expenditures. Contrary to the D.C. Circuit's direction, they continue to approach the issue from an accounting, rather than an economic, perspective. As a result, they misconstrue the opportunity costs LADOA is seeking to recover.

It is important to understand that accountants and economists define "profit" in different ways. /5 LADOA is not seeking to obtain a "profit" in the economic sense through its

4/ Furthermore, the statutes and cases cited do not provide a list of specific types of costs or charges that are to be included or excluded in determining airport rates and charges. Even if they did provide the list the Airlines propose, the land rental charge certainly constitutes a "capital and operating cost" and generates funds that will be used for "airport development." See Airlines Br. at 7-8. Moreover, the Airlines' suggestion that only "out-of-pocket expenditures" may be charged is nonsense. For example, depreciation is not an out-of-pocket cost. See Airlines Br. at 8 n.3.

5 Accounting "profits" represent the difference between an enterprise's revenues and its costs, which include out-of-pocket expenditures and implicit costs of doing business such as depreciation, amortization and reserves for bad debts. In general, accounting profits do not take into account return to the enterprise's owners. For example, the income statement of a listed corporation shows no return to its stockholders, and does not take this required return into account in showing "profits." Obviously, stockholders expect at least the opportunity costs of their funds as compensation for their investment.

Economic "profits" are the residual of revenues less payments to all factors. All factor owners contribute to an ongoing enterprise to earn a return. Workers expect wages, landowners expect rent, etc. In economics terms, all factors must be paid. Thus, economic profits are revenues less the opportunity costs of all factors employed, because the opportunity costs represent the minimum required return to the factors' owners. See, e.g., P. Samuelson & W. Nordhaus, Economics 119-120, 255 n.6 (15th ed. 1995).

land rental charge. All LADOA is seeking to recover is what economists call a normal or competitive return—so that all factors are paid their economic worth. That is what economics requires in a competitive market to ensure an optimal allocation of resources. Accordingly, LADOA is not seeking to earn profits above a normal return.

Furthermore, opportunity cost is an actual cost. It is income forgone, just like an expenditure. If an individual earning $50,000 per year decides to quit work to go back to school, the total cost of going to school is not merely the cost of tuition. It includes the $50,000 of income forgone (i.e., the opportunity cost of the forgone salary). At the end of the year in school, the student has $50,000 less in his or her pocket—the same result as if the student had incurred an expenditure of $50,000.

The opportunity cost of the land at issue—whether or not it is optimally employed in its highest and best use—is still its return in its next best alternative use. LAX land is optimally employed as an airport if and only if it is at least earning the return it could receive in its best alternative employment (i. e., its opportunity cost). From an economic perspective, calling this return "profits" only serves to obfuscate the issue.

The Pennsylvania Electric decisions and the Baumol & Sidak treatise were cited by the D.C. Circuit simply as examples of the fact that regulatory agencies and economists take opportunity costs into account. Distinguishing the specific issue of opportunity costs in electric transmission pricing in no way controverts the proposition for which they were cited— and cannot possibly establish that LADOA's land charge is unreasonable. The Airlines' selective discussion of Kahn is equally unavailing. Finally, their attempt to controvert the basic economic principles in Kenneth Arrow's declaration is plainly without merit.

1. Pennsylvania Electric. The opportunity cost at issue in these cases related to the fact that, in serving other customers, the utility gave up cost savings that it would have realized had it served only its native customers. The fact that FERC decided that a utility cannot both sell and retain the same capacity has nothing to do with the issues in this case. In any event, LADOA is not seeking to "have it both ways" by charging fees for using the land as an airport and recovering "profits" it would have earned if the land was used as other than an airport. See Airlines Br. at 11. LADOA is seeking to obtain only one reasonable return in the form of a land rental charge for the airlines' use of the land. Moreover, the Airlines ignore the fact that, apart from the opportunity costs at issue in Pennsylvania Electric, the utility was receiving a reasonable rate of return. If LAX were to be regulated like an electric utility—although there is no basis to do so—LAX certainly would be entitled to a fair return on its regulated assets.

2. Baumol & Sidak. The Airlines' discussion of Baumol & Sidak adds nothing. It depends on the Airlines' arguments regarding the underlying policies and possible monopoly profits. See Section I above and II.C. below. In fact, Baumol & Sidak's discussion of opportunity cost supports the FMV-based charge. /6 They state that "where the firm uses assets purchased in the past, the cost of using them must be evaluated as the opportunity cost of that use that is tile price that those assets could fetch if transferred to an alternative use." W. Baumol & J. Sidak, Transmission Pricing and Stranded Costs in the Electric Power Industry at 53-54 (emphasis added); see also id. at 116-17.

6 The authors note that cost calculations

W. Baumol & J. Sidak, Transmission Pricing and Stranded Costs in the Electric Power Industry at 53.

3. Kahn. First, the portions of Kahn's treatise cited by the Airlines are inapplicable. Kahn is referring to a monopolist subject to COS regulation. DOT has found that airports generally do not exercise monopoly power. 61 Fed. Reg. 32007 (1996). Further, while the Airlines have not established that LAX has asserted, much less abused, any monopoly power, the issue of monopoly is immaterial—all LADOA is asking for is a competitive (non-monopolistic) rate of return. Second, the Airlines neglect to point out that Kahn necessarily includes allowance of a fair rate of return. See, e.g. A. Kahn, The Economics of Regulation 42 (1970) (entitled "Selection of the Permitted Rate of Return"); see also id. at 109 ("prices should reflect marginal cost at the time of sale, not at some time in the past."). /7 Finally, as to Kahn's observation regarding the "stability and predictability" of historic costs, the Airlines ignore Kahn's next sentence, where he states that the question of what constitutes a "fair" rate of return "would seem to be just as potentially productive of controversy as the question of what constitutes 'fair value."' Id. at 41. In sum, Kahn does not advocate use of historic costs without a fair rate of return. /8

4. Arrow. The Airlines' attempt to remove Professor Arrow's declaration from the record in this case only demonstrates that the points he makes are unassailable. /9 First, once an entity commits itself an opportunity cost is incurred, regardless of whether or not the decision is reversible. See Airlines Br. at 16. If one is conscripted into the army, one incurs an opportunity cost. The Airlines are also wrong when they contend that no other use of the land

7/ Kahn also states that "inflation can be taken into account just as effectively by varying the permissible rate of return as by continuing to fight the old valuation controversies." Id. at 42 n.53; see also id at 116 (if government wants to adjust returns in the interest of fairness it can do so by varying "the permissible rate of return, or by applying some sort of price index number to the total dollars of permitted net income.").

8/ Kahn also notes the many shortcomings of the use of historical cost that necessitate adjustments to the fair rate of return. See, e.g. Kahn, at 110-11 ("Original rate-base costing tends to produce a perverse cyclical behavior of prices," holding down charges and encouraging consumption of services in periods of general inflation.)

9/ LADOA submitted Prof. Arrow's declaration with its Answer to the Airlines' Complaint. In their reply declarations, the Airlines were unable to controvert the fundamental economic principles Professor Arrow summarized. While the declaration was withdrawn from the proceeding before the ALJ, it has always been part of the record before the Secretary. It also was part of the record on appeal to the D.C. Circuit. The declaration's unmistakable relevance is underscored by the Court of Appeals' discussion of it in the LAX I decision. While it may be regarded as duplicative of points made by Professor Levy, see, e. A, Ex. LAX-F para 15, 17, it is certainly not "duplicitous." See Airlines Br. at 15.

is possible. See LADOA's Opening Br. at 7-9. Second, the assertion that no other use of the land would produce a better allocation of resources assumes that the current use is properly compensated. See Airlines Br. at 16. Third, Professor Arrow's opinion that the land in an alternative use would increase the product of goods and services is obviously correct because it would earn a higher return than DOT's Final Decision would provide. The return the land should earn as an airport is equal to what the land would earn in its next best use—and LADOA is seeking to recover only one return (i.e. the return on the land in its next best use). /10 Fourth, as discussed above, no federal policy rejects basic economic principles, and LADOA is not seeking "profits" in economic terms. Fifth, the Airlines' speculation that opportunity costs "may" include monopoly profits is irrelevant. Finally, Jersey Central in no way suggests that regulated entities are not entitled to a reasonable return. LAX is not seeking an above-market rate; LADOA's capital costs include a reasonable return. /11

Despite the fact that the Airlines never bothered to challenge LADOA's airfield valuation, they nevertheless argue that "the appraiser's report in this very case demonstrates the difficulties inherent in such valuations." Airlines Br. at 19. The Airlines' arguments must be disregarded under the Rules of Practice because they were not timely made. Further, far from demonstrating the difficulties inherent in land valuation, the Airlines' contentions

10/ The regulated utility cases cited by the Airlines, in which profits from the sale of land were deemed to belong to the ratepayers, not the utility's investors, are inapposite. See Airlines Br. at 19 (citing Southwestern Bell Corp. v. FCC, 896 F.2d 1378, 1381 (D.C. Cir. 1990)); Democratic Central Comm. v. Washington Metropolitan Area Transit Comm'n, 485 F.2d 786, 821-22 (D.C. Cir. 1973), cert. denied, 415 U.S. 435 (1974)). The Airlines once again neglect to point out that in those utility regimes, the utility and its investors receive a determined allowed reasonable return. See, e.g., Democratic Central Comm., 485 F.2d at 815-18. Thus, it is not surprising that if the utility receives additional revenue (above its allowed rate of return) from the sale of land, the customers charges should be reduced. Moreover, under a compensatory regime, LADOA, not the airlines, bears the risks and burdens of the enterprise.

11/ The Airlines' suggestion that LADOA has no equity costs is ridiculous. Equity costs equal opportunity costs. Moreover, once debt service on land has been paid, a landlord certainly is entitled to charge for the land's use. Even tenants whose rental payments were applied to retire a landlord's mortgage cannot claim a right to use the land without charge forever. In fact, the Airlines' own witness conceded that the Airlines did not pay the debt service on the land. Recommended Decision, at 20. Moreover, nothing in the residual agreements provided that, upon expiration of the agreements, the airlines would have free use of LAX's assets. In any event, regardless of who paid for the land, it belongs to LADOA and there is still an opportunity cost associated with the land's use.

simply demonstrate the futility in trying to challenge an extremely conservative appraisal without competent evidentiary support. /12

First, the Airlines incorrectly suggest that the D.C. Circuit was wrong in assuming "a ready market" in comparable sales. Id. at 19. LADOA's appraisers divided the airfield and apron lands into smaller parcels for the purpose of evaluating comparable sales. As the D.C. Circuit anticipated, there was no difficulty finding "a ready market" in comparables. Indeed, the appraisers evaluated over 50 comparables. There is plainly no basis for the assertion that LADOA's appraisal is "not based on comparable sales of land at all." Id. at 20.

The Airlines next contend that LADOA's appraisal assumes huge returns to the City of $25 per square foot, less development costs. This is, to say the least, an incomplete statement of the facts. LADOA's appraisers did use $25 per square foot as the initial basis for arriving at current appraised value, based on the evaluation of comparables. However, after providing for development costs and absorption over a very conservative 25-year period, the appraisal arrived at a current fair market value of just $3.44 per square foot, or $150,000 per gross acre. Ex. LAX-14 at 34-35. There is no evidence to suggest that this absorption period is not entirely reasonable.

The Airlines also contend that the use of FMV will lead to too many fee disputes. Airlines Br. at 21. The Airlines should not be allowed to dictate DOT policy by the threat of future legal controversy. Moreover, there is no evidence that it will unduly strain DOT resources to pass on claims of unreasonableness of fair market valuation of land. Indeed, there are many other contexts in which airports, airlines, DOT and FAA are perfectly able to arrive at FMV of airport land. In practice, the threat of possible challenge is incentive enough for airports to use conservative valuations, as LAX has done here.

12/ The Airlines had abundant opportunity to challenge LADOA's appraisal, and chose not to introduce the testimony of a valuation expert. The criticism of FMV contained in the declaration of Daniel Kaspar, who has no real estate or appraisal expertise, hardly qualifies as expert opinion on the reasonableness of the appraisal. The Airlines' request to reopen the proceeding to allow them to introduce such evidence must be denied under the Rules of Practice. Moreover, the Airlines' excuse for failing to challenge LADOA's appraisal-that they assumed the Policy would apply-is unconvincing. The Airlines had no reason or legal basis to assume that the Policy would be given retroactive effect. Moreover, in the Airlines' original complaint in this proceeding-filed before the Interim Policy was issued-the Airlines made no allegation that LADOA's appraisal was inflated.

Finally, the Airlines have attempted to make the appraisal process appear more complicated than it actually is by introducing the concept of "net opportunity costs," otherwise known as "cross-crediting." Airlines Br. at 22. The Airlines seek to obtain a credit against fair rental value for (1) revenues earned generally by the City as a result of the airport and (2) concession revenues earned directly by LADOA. Of course, they are entitled to neither. Under a compensatory methodology, LADOA is entitled to charge for the cost of providing service to the Airlines, without providing a credit for the benefits the City might otherwise receive. See, e.g. Kent County, 510 U.S. at 369.

As a fall-back position, the Airlines argue that the opportunity costs LADOA seeks to recover "may" include "monopoly profits." Airlines Br. at 17. Significantly, they do not assert the land charge does in fact include monopoly profits. Their assertion is speculative, at best, and cannot possibly establish the charge is unreasonable. By definition, FMV based on valuing the land in its next best use (not as an airport) cannot result in "monopoly profits."

In any event, the Airlines' monopoly argument is flawed. First, Los Angeles, like many other cities, is served by more than one airport. /13 LAX competes with John Wayne International Airport and with Burbank-Glendale-Pasadena Airport, which is closer to downtown Los Angeles than is LAX. Second, there is extensive competition between airports for domestic hub, international gateway and cargo business, as DOT recognizes. /14 Third, even

13/ See, e.g., Airport Substitution in a Short Haul Model of Air Transportation, Int'l J. Trans. Econ. 157 (June 1993) (research shows that airport substitution plays a significant role in the determination of the number of origin-destination enplaned passengers); Western Pacific's Low-Fare Alternative for Denver, New York Times, Aug. 8, 1995, at D2 (Colorado Springs Airport, slightly further from downtown Denver, competing with DIA).

14/ In the Final Policy, DOT rejected the Airlines' monopoly argument as a general proposition:

61 Fed. Reg. 31994, 32007 (1996).

if airports had some degree of locational market power, because they also compete for hub, gateway and cargo traffic, they would risk losing their through traffic to other airports if they were to assert that power. Fourth, the Airlines certainly have not demonstrated that LAX has exerted, much less abused, any market power. As DOT recognizes, public proprietors do not have an incentive to charge exorbitant rates. 61 Fed. Reg. at 32007; see also Warren-Boulton, Ex. LAX-I2 at 11 5 (municipal ownership "is generally regarded as a substitute for COS regulation in inhibiting the exercise of any monopoly power").

Finally, even if the Airlines had demonstrated both the existence and abuse of market power at LAX, there is no reason to conclude that it should be required to use historical cost valuation without a fair rate of return. At most, it would be an argument to limit fees at LAX to FMV, which is exactly what is being done at LAX.

The Airlines' approach has failed to provide LADOA's choice of methodology and the resulting rates with the deference and the presumption of lawfulness to which they are entitled, on at least the following grounds:

1. LADOA's choice of methodology and the resulting 1993 and 1995 Fees were adopted after the public input, consideration, and administrative process required under California law and were duly approved by the appropriate public deliberative bodies, the Airport Commission of the City of Los Angeles and the Los Angeles City Council.

2. LADOA's choice of methodology and the resulting rates are entitled to deference and a presumption of lawfulness. See Hansen v. City of San Buenaventura, 729 P.2d 186, 190 (1986); City of Anchorage v. Richardson Vista Corp., 242 F.2d 276, 285 (9th Cir. 1957).

3. Nothing in the AHTA, § 47129, or other applicable federal law expressly authorizes DOT to deny LADOA the deference and presumption of validity to which it is entitled under California law or under general administrative law principles.

4. Nothing in the AHTA, § 47129 or other applicable federal law authorizes DOT by implication to deny deference, especially in light of the expedited procedure of § 47129 in which an ALJ must reach a decision in 60 days and the entire proceeding must be concluded in 120 days, as well as the prohibition on setting fees and establishing specific methodologies.

5. Finally, in Kent County and Evansville the Supreme Court held that airport rates are entitled to deference so long as they fall within a broad range of reasonableness. Evansville, 405 U.S. at 717; Kent County, 510 U.S. at 369.

The Airlines are thus wrong to contend, and DOT would be wrong to conclude, that this proceeding can simply determine de novo the appropriate methodology that can be used by LADOA to calculate its rates and the resulting fees.

For all of the foregoing reasons, the FMV-based land rental charge in the 1993 and 1995 Fees should be upheld as reasonable. At the very least, DOT should find that the Airlines failed to establish that the charge was unreasonable. Accordingly, the Airlines' complaints should be dismissed.

Dated: May 27, 1997

Respectfully submitted

Steven Rosenthal

Jonathan Band

Anthony L. Press

Gregory B. Koltun

MORRISON & FOERSTER CUP

2000 Pennsylvania Ave., N.W., Suite 5500

Washington, D.C. 20006

(202) 887-1500

Ronald N. Wilson

Stanley A. Zamel

Leilani F. Battiste

WILSON & BECKS

5900 Wilshire Boulevard, Suite 2000

Los Angeles, CA 90036-5020