UV7362

Rev. Nov. 3, 2017

Dominion Gas Holdings, LLC: Anticipatory Interest Rate Hedging

In November 2012, Dominion Resources, Inc. (DRI), one of the largest producers and transporters of
energy in the United States, was planning the creation of a subsidiary that would consolidate the major
components of Dominion’s regulated gas businesses under one intermediate holding company entity. The
timeline called for the formation of a new legal entity, Dominion Gas Holdings, LLC (Dominion Gas), around
September 2013 by transferring several regulated gas subsidiaries from DRI to Dominion Gas. As part of its
new financing plan, Dominion Gas planned to issue at least $1 billion in debt in November 2013. The offering
would consist of senior notes, and the maturities would be a combination of 3-year, 10-year, and 30-year notes.

While the coupon rates for the planned debt were unknown as of November 2012, the company wanted
to lock in its financing costs ahead of time. Interest rates were at historically low levels (see Exhibit 1), and
market commentators were predicting rising interest rates with the end of the U.S. Federal Reserve’s monetary
quantitative easing looming. The company was considering entering into a number of interest rate swaps to
mitigate the interest rate risk associated with the anticipated long-term debt issuance. One particular set of
swaps the company was considering was designed as a pre-issuance hedge for the portion of the 3-year debt
offering that assumed a $250 million principal amount of such notes would be issued in November 2013.

Dominion Gas Holdings, LLC

Before 2006, Dominion’s operations had been a mix of a highly regulated utility and a more speculative
exploration and production (E&P) oil and gas company. Investors who viewed the firm as a regulated utility
wanted Dominion to have stable cash flows, while those who owned it for its oil and gas production assets
wanted the firm to take more risks and increase investment in E&P to realize the value of its energy reserves.
This resulted in Dominion being undervalued against both E&P and utility peers. As such, many investors
believed this problem required some corporate restructuring. Starting in 2007, the company began to sell its
onshore and offshore E&P oil and gas assets. The vision for the remaining company was to create a business
that would derive the majority of its earnings from regulated or “regulated-like” businesses. Dominion
increasingly became more focused on its regulated electric and natural gas transmission and distribution
infrastructure within and around its existing footprint in order to produce a consistent, highly visible earnings
stream. Executives noted that Wall Street analysts and investors rewarded Dominion’s consistent earnings per
share growth with a robust price to earnings multiple and a higher Dominion stock price.

Dominion executives planned to form the holding company Dominion Gas in September 2013 as a wholly
owned subsidiary of DRI (see Exhibit 2). Dominion Gas would serve as the intermediate parent company for
the majority of DRI’s regulated natural gas operating businesses. The holding company would start by being a
wholly owned subsidiary but eventually Dominion Gas would report its standalone financials to the public,

This case was prepared by Pedro Matos, Associate Professor, and Stephen E. Maiden (MBA ’01). Specific numbers and other data have been altered for
pedagogical purposes. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation.
Copyright  2016 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
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perhaps as early as in the fall of 2014. Executives believed that the structure would offer better transparency
into the high recurring revenue business for investors, allowing the company to more attractively finance capital
investments related to the assets and cash flow of DRI’s regulated gas business.

Dominion Gas’s subsidiaries conducted business activities through an interstate natural gas transmission
pipeline system and storage facilities, a local natural gas distribution network, and associated natural gas
gathering, processing, and treatment facilities. Its primary subsidiaries consisted of The East Ohio Gas
Company, Dominion Transmission, and Dominion Iroquois. More details on Dominion Gas’s subsidiaries can
be found in Exhibit 3. Dominion Gas’s standalone financials can be found in Exhibit 4.

Debt-Offering Plans and Pre-issuance Hedging

As part of its new financing plan, the company planned to issue debt directly from the Dominion Gas
subsidiary just as it had consistently done at another wholly owned subsidiary, VEPCO (Virginia Electric and
Power Co.—which did business as Dominion Virginia Power).1 Dominion Gas had plans to commence with a
debt offering in November 2013. Table 1 summarizes the main terms of the notes that the company planned
to offer.

Table 1. Planned terms for Dominion Gas’s long-term debt offering.

Issuer Dominion Gas Holdings, LLC
Issue Date November 2013 (planned)
Notes $1 billion aggregate principal amount, consisting of:
Offered
 3-year senior notes with $250 million principal maturing on November 2016
 10-year senior notes with $500 million principal maturing on November 2023
 30-year senior notes with $250 million principal maturing on November 2043
Interest Fixed coupon rates (to be determined at offer date). Interest payable quarterly in arrears on
February 1, May 1, August 1, and November 1, commencing on February 1, 2014.
Optional Issuer may redeem all or any of the notes at any time at the make-whole redemption price to
Redemption be described in the offering memorandum.
Ranking The notes will constitute Dominion Gas’s senior unsecured indebtedness. The notes are not
guaranteed by DRI or any of its subsidiaries.
Source: Author estimates.

Dominion valued the ability to manage costs, such as floating interest rate costs, in a predictable way during
each projection period. DRI was thus a regular user of forward-starting interest rate swaps as anticipatory
hedging tools to mitigate a substantial portion of the interest rate risk associated with its forecasted long-term
debt issuance. For accounting purposes, these interest rate–sensitive derivatives were designated as cash flow
hedges. For example, as of December 31, 2011, DRI and VEPCO had $2.3 billion and $1.3 billion, respectively,
in aggregate notional amounts of these interest rate derivatives outstanding.2

1 Dominion Gas would then use the proceeds from these initial debt offerings to purchase existing intercompany long-term notes between DRI and

its subsidiaries, thereby allowing DRI to reduce its external debt obligations previously incurred for these subsidiaries’ capital needs. Dominion wanted
to free up debt capacity at the parent company as it had budgeted more than $2 billion of capital expenditures for infrastructure growth during the 2013
to 2018 planning period. It intended to maintain a capital structure that balanced debt and equity (with all equity continuing to be held by DRI) to support
a strong investment-grade credit rating.
2 Dominion Resources, Inc. Form 10-K, 2012.

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The use of forward-starting interest rate swaps as a pre-issuance hedging tool could cause some accounting
and regulatory risks, as had occurred in 2009 with VEPCO (see Exhibit 5). This could be an issue again if the
timeline for the Dominion Gas plans was delayed or if its internal cash flow generation turned out stronger
than expected. In such a case, the company might be subject to a regulatory or accounting review if it did not
end up issuing the forecasted long-term debt securities as planned in 2013 and instead settled early again on the
swaps (at a gain or a loss) as it had done in 2009. The accounting treatment of these gains or losses as hedging
might place the firm in the “penalty box” with its regulators and auditors and complicate future swap
transactions.

While many utilities such as Dominion valued the fixed financing costs obtained through interest rate swaps
along with benefits of hedge accounting, not every competitor chose to make anticipatory interest rate hedges.
Duke Energy, the largest electric power holding company in the United States, chose not to hedge at all. Duke’s
policy assumed that frequent financings would tend to keep its all-in average financing costs lower as the
transaction costs associated with hedging were avoided. Alternatively, Exelon Corporation hedged a portion of
its financings through anticipatory rate swaps but did not seek the benefit of hedge accounting. Exelon reported
the costs of its hedge program on its income statement, but also showed investors a pro forma operating
earnings that stripped out these expenses.

The Way Forward

In order to manage financing costs and bring clarity to its operational budget and external earnings
guidance, Dominion wanted to hedge the interest rate risk involved with Dominion Gas’s 2013 debt issuance.
The interest rates for the planned debt would only be known at issuance in November 2013, but the company
was interested in locking in these rates ahead of time since interest rates were, in its view, historically low.

For the $250 million of 3-year debt it would be offering, the company was trying to determine what fixed
rate it could set as of November 2012 for a forward-starting interest rate swap that would start in November
2013 and end in November 2016. In the transaction, Dominion would swap floating rate for fixed on a notional
principal of $250 million. The proposal would involve Dominion receiving the three-month LIBOR rate and
making fixed payments on the same dates as the scheduled payments for the 3-year senior notes described in
Table 1. In order to analyze competitive forward-starting swap rates, Dominion had gathered market data on
Eurodollar futures prices (Exhibit 6).

A bank had approached Dominion with an indicative quote of 0.70% base for the 3-year forward-starting
swap beginning in November 2013 and ending in November 2016. Dominion wanted to get a sense if this was
a fair rate. There were a few other issues to work out in terms of the swap. First, Dominion knew that, in
addition, there would be a credit charge of something—perhaps in the 0.01% range—for a short maturity swap,
which was a reasonable spread given the credit risk it posed as a counterparty.3 Another issue was that the bank
had asked whether Dominion was willing to engage in a swap against the overnight index swap (OIS) rate
instead of LIBOR. This was a collateralized-based solution (see Exhibit 7 for more details).

3 Of course, Dominion itself avoided not concentrating credit risk and instead had multiple banks as swap counterparties.

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Exhibit 1
Dominion Gas Holdings, LLC: Anticipatory Interest Rate Hedging
Historical Evolution of the Term Structure of U.S. Treasury Interest Rates, November 1992–November 2012

Data source: Federal Reserve Bank of St. Louis, Federal Reserve Economic Data (FRED), http://research.stlouisfed.org/fred2/ (accessed April
14, 2016).

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Exhibit 2
Dominion Gas Holdings, LLC: Anticipatory Interest Rate Hedging
Dominion’s Organizational Structure

Source: Company document, used with permission.

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Exhibit 3
Dominion Gas Holdings, LLC: Anticipatory Interest Rate Hedging
Dominion Gas Holdings, LLC—Business Overview

Dominion’s regulated gas businesses encompassed an interstate natural gas transmission pipeline system and storage
facilities, a local natural gas distribution network, and associated natural gas gathering, processing, and treatment facilities.
These businesses would be carried out through the following subsidiaries:
 Dominion East Ohio Gas Company (East Ohio): A regulated natural gas distribution operation serving more
than 1.2 million residential, commercial, and industrial gas sales and transportation customers in eastern and
western Ohio communities. It operated more than 21,700 miles of natural gas distribution, transmission, and
gathering pipeline along with underground natural gas storage capability. Revenues provided by these operations
were based primarily on rates approved by the Public Utilities Commission of Ohio.
 Dominion Transmission (DTI): An interstate natural gas transmission pipeline company serving a broad mix of
customers such as local gas distribution companies, marketers, interstate and intrastate pipelines, electric power
generators, and natural gas producers. It maintained approximately 7,100 miles of transmission and gathering
pipeline across six states. DTI also operated one of the largest underground natural gas storage systems in the
United States with 345 million dekatherms of storage capacity. At its Hastings extraction/fractionation plant in
West Virginia, DTI was a producer and supplier of natural gas liquids (NGLs). DTI’s revenue from providing
services was primarily based on rates established by the Federal Energy Regulatory Commission (FERC),
including negotiated, firm, and interruptible fee-based contractual arrangements. Additionally, DTI sold extracted
products at market rates.
 Dominion Iroquois: A 24.72% general partnership interest in a 416-mile FERC regulated interstate natural gas
pipeline extending from the U.S.–Canadian border at Waddington, New York, through the state of Connecticut
to South Commack, New York, and Hunts Point, Bronx, New York. The Iroquois pipeline had more than
doubled its design day capacity since 1991.

Dominion Gas believed it had several competitive strengths:

 Advantageous location in Mid-Atlantic, Northeast, and Midwest regions of the United States running north from
Virginia to New York and east from Ohio to Maryland.
 Stable cash flows derived primarily under term contracts with a base of diverse customers that demonstrated a
historical track record of recontracting with Dominion.
 Strong investment-grade profile since it was committed to maintaining a capital structure consistent with
producing strong credit metrics and ratings.
 Reliable and safe operations across the natural gas transmission, storage, and local distribution businesses.

It was subject to a number of risks related to its business which included, among many others:
 The rates of gas transmission and distribution operations were subject to regulatory review.
 It was subject to complex governmental regulation.
 It depended on third parties to produce the natural gas it gathered and processed and the NGLs it fractionated
at its facilities.
 Its operations were subject to a number of environmental laws and regulations that imposed significant
compliance costs.

Source: Created by the author based on information from Dominion SEC filings,
http://www.sec.gov/Archives/edgar/data/1603291/000119312514249162/d700274d424b3.htm (accessed April 14, 2016).

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Exhibit 4
Dominion Gas Holdings, LLC: Anticipatory Interest Rate Hedging
Dominion Gas Holdings, LLC—Summary Financial Data (2011)

Statement of Income Data

Operating revenue $1,878
Operating expenses 1,303
Gain on sale of assets –
Income from operations 575
Other income 37
Interest and related charges 44
Income from continuing operations before income taxes 568
Income tax expense 214
Net income $354

Balance Sheet Data

Current assets $778
Investments 105
Net PP&E 4,762
Deferred charges and other assets 1,502
Total assets $7,147
Current liabilities $2,079
Affiliated long-term debt 817
Deferred credits and other liabilities 1,908
Membership interests 2,471

Other Financial Data

EBITDA $775
Funds from operations (FFO) $665
Ratio of earnings to fixed charges 9.91

Data source: Dominion SEC filings,

http://www.sec.gov/Archives/edgar/data/1603291/000119312514249162/d700274d424b3.htm
(accessed April 14, 2016).

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Exhibit 5
Dominion Gas Holdings, LLC: Anticipatory Interest Rate Hedging
Accounting and Regulatory Issues with Anticipatory Debt Issuance Hedging

Cash Flow Hedge Accounting Treatment

During its regular course of business, Dominion would identify debt financing needs for future periods as
part of its financial planning process. As the future financing needs were identified, the company began to
monitor the projected interest rate expected to be established for the planned debt issuance and the resultant
interest payments to be made over the term of the debt. The yield established for an actual debt issuance was
based on a yield on the equivalent U.S. Treasury bond plus a spread for the company’s credit and any other
structural or new issue concessions. In order to protect against changing yields on U.S. Treasury bonds until
the debt was issued, Dominion might enter into a forward-starting swap (FSS) or Treasury lock (T-Lock) to
hedge the expected effective yield of its debt issuances. The derivative (FSS or T-Lock) would be terminated at
the same time that the debt security was priced (coupon interest rate established). The FSS did not actually
continue past its forward-starting date but was evaluated over that future period based on the current forward
yield curve. Either a FSS or a T-Lock derivative would serve as an economic hedge—as actual interest rates
rose (ultimately resulting in a higher interest rate on the debt instrument), the value of the derivative also rose
in a similar fashion, offsetting the higher interest amount. Although the cash gain on the derivative was received
at the issuance of the debt, it was normally recognized from an accounting perspective through earnings over
the term of the debt. The reverse was also true in that if Treasury yields were to fall (reducing the coupon or
yield to be established on the debt instrument), then the value of the derivative would fall to offset the lower
interest amount.

By definitively establishing a future financing need to its accounting team and its auditors, Dominion was
able to establish a cash flow hedge accounting relationship under Generally Accepted Accounting Principles
(GAAP). An established cash flow hedge relationship allowed Dominion to exclude the valuation changes of
treasury derivatives due to price movements (colloquially referred to as “mark-to-market changes”) from
reported current period earnings. Under cash flow hedge accounting there was no immediate income statement
impact. Changes in fair value of derivatives were reclassified into the income statement (from other
comprehensive income in the balance sheet) when the expected (hedged) transaction affected the net income.
This made financial statements and the resulting earnings per share less volatile. More details on electing and
maintaining cash flow hedge accounting treatment can be found in FASB’s Statement 133.1

1 Financial Accounting Standards Board, “Accounting for Derivative Instruments and Hedging Activities,” June 1998,
http://www.fasb.org/summary/stsum133.shtml (accessed Apr. 13, 2016).

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Exhibit 5 (continued)

Regulatory Issues

In 2009, DRI’s subsidiary VEPCO (doing business as Dominion Virginia Power) had entered into forward-
starting interest rate swaps as a pre-issuance hedging for its planned 10-year and 30-year notes to be issued in
2010.2 Due to proceeds from the 2010 sale of gas properties though, the company ended up not having to issue
the forecasted long-term debt securities and instead settled early on the swaps for a gain.

When DRI realized the swap gains, it received push back from the regulators and auditors over the
accounting of the windfall profits for regulatory and hedge accounting purposes. The Virginia Committee for
Fair Utility Rates (VCFUR) and the State Corporation Commission Staff (Staff) recommended against
VEPCO’s regulatory accounting treatment of amortizing the gains over the originally forecasted terms of
10 years and 30 years, respectively. The Staff argued that “these gains should be treated like other gains and
losses incurred as part of the Company’s service obligation and shared equally between the ratepayers and
shareholders. Virginia Power experienced the gain in 2010. Accordingly, the gain should be reflected in the cost
of service for that period. Amortizing the gain over an extended period of years would result in ratepayers
receiving an insignificant benefit from the gain.”

In its regulatory testimony, VEPCO’s controller countered that “VCFUR and the Staff, either intentionally
or unintentionally, have engaged in a form of “Heads We Win/Tails You Lose” regulation.”3 The company
argued that the amortization of the gain was consistent with regulatory accounting for early debt
extinguishments described in the Federal Energy Regulatory Commission (FERC) Uniform System of
Accounts and it was also consistent with GAAP (ASC 980, previously SFAS No. 71). The amortization of the
gain over the life of the planned period passed the benefit of the hedge to customers over time to offset interest
expense as originally planned, which was consistent with prior regulatory accounting guidance and practices.

Though VEPCO successfully argued its case once, Dominion’s senior management knew they should
manage the Dominion Gas interest rate hedges conservatively to avoid any further conflict with regulators or
other stakeholders.

2 State Corporation Commission of Virginia, Case No. PUE-2011-00027, Rebuttal Testimony of Maxwell R. Schools, JR, Controller, Regulatory

Accounting for Virginia Electric and Power Company, 2011.

3 State Corporation Commission of Virginia.

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Exhibit 6
Dominion Gas Holdings, LLC: Anticipatory Interest Rate Hedging
Eurodollar Futures Prices, November 2012

Maturity Date Settle Price Yield

Nov. ’12 99.56 0.44%

Feb. ’13 99.63 0.37%
May ’13 99.62 0.38%
Aug. ’13 99.60 0.40%
Nov. ’13 99.59 0.41%
Feb. ’14 99.55 0.45%
May ’14 99.53 0.47%
Aug. ’14 99.49 0.51%
Nov. ’14 99.44 0.56%
Feb. ’15 99.38 0.62%
May ’15 99.32 0.68%
Aug. ’15 99.23 0.77%
Nov. ’15 99.19 0.81%
Feb. ’16 99.15 0.85%
May ’16 99.13 0.87%
Aug. ’16 99.09 0.91%
Nov. ’16 99.05 0.95%
Feb. ’17 99.04 0.96%
May ’17 99.02 0.98%
Aug. ’17 99.00 1.00%
Nov. ’17 98.99 1.01%
Data sources: Bloomberg and author estimates.

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Exhibit 7
Dominion Gas Holdings, LLC: Anticipatory Interest Rate Hedging
LIBOR versus OIS

The LIBOR Scandal1

The Bank for International Settlements estimated that, by 2010, close to $500 trillion loan contracts
were linked to London interbank offered rate (LIBOR).2 LIBOR consisted of the average interest rate at which
banks could borrow from one another in London. The British Bankers’ Association (BBA) began publishing
LIBOR in 1986 so that banks could use it as a uniform benchmark to charge for different types of loans. The
BBA promoted the rate-setting process as transparent. For each currency, more than a dozen top global banks
(including Citigroup, Barclays, UBS, and others) estimated how much interest they would pay to borrow money
on a short-term basis from other institutions. The calculations, performed by Thomson Reuters, discarded the
four highest and four lowest submissions as outliers, and averaged the remaining ones. It was published at
11:30 a.m. London time, along with each bank’s submissions. There were 150 different LIBOR rates, covering
10 currencies and 15 maturities. Banks often charged borrowers LIBOR plus a spread to reflect the credit risk
(typically 2 to 3 percentage points for mortgages and 1 percentage point for corporations). Many banks used
LIBOR to set the prices on derivatives based on interest rates, currencies, and other assets.

During the financial crisis of 2008, banks almost stopped lending to one another unless they earned a high
interest rate in return. Despite the market volatility, LIBOR remained the benchmark rate used in financial
markets. Allegations of rate manipulation surfaced in the press that, between 2005 and 2007, employees in
Barclays’ trading units convinced employees responsible for submitting LIBOR rates to alter the bank’s rates
based on the bank’s derivatives trading positions in order to bolster its own profits. Later, during the height of
the financial crisis, it was alleged that Barclays submitted artificially low rates to give the impression that the
bank could borrow money more cheaply and was healthier than it was. The integrity of LIBOR was called into
question. In June 2012, Barclays agreed to pay $450 million to settle accusations by regulators that it had
submitted false LIBOR rates. These were followed by additional fines to other banks (UBS, Royal Bank of
Scotland, Rabobank, etc.). In December 2013, the European Union fined eight global financial institutions to
settle charges they colluded to fix two benchmark interest rates. Barclays and UBS, which alerted European
Union officials to the improper practices, avoided fines as part of the settlement.3

LIBOR versus OIS

The financial crisis of 2008 raised questions about the creditworthiness of banks, and allegations of
manipulation lead market participants to question whether LIBOR could maintain its role as the benchmark
for over-the-counter (OTC) derivatives. Until 2007, there was no spread in overnight loans between banks
whether using U.S.-dollar LIBOR rates (unsecured lending) or overnight index-swap OIS rates (collateralized
by U.S. Treasuries), indicating that LIBOR and OIS rates tracked one another. The LIBOR-OIS spread jumped
to close to 1% and then widened further to more than 3% during the peak of the crisis in the fall of 2008. By
2012, the LIBOR-OIS spread had gradually dropped but not yet reverted to 0%.

1 This section draws on “Behind the LIBOR Scandal,” New York Times, July 10, 2012.
2 Bloomberg, “OIS Discounting Overview.”
3 The banks that reached settlements related to Euribor were Barclays, Deutsche Bank ($633 million), R.B.S. ($178 million), and Société Générale

($606 million). The banks that reached settlements related to yen LIBOR were UBS, R.B.S. ($353 million), Deutsche Bank ($351 million), JPMorgan
($108 million), and Citigroup ($95 million). The British broker RP Martin Holdings also agreed to a fine over yen LIBOR.

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Exhibit 7 (continued)

With the onset of the crisis, however, the LIBOR-OIS spread widened, and the relationship became
choppy. In interdealer trading, more stringent bilateral credit support annexes (CSAs) between counterparties
in OTC derivatives deals became required. This practice became prevalent throughout 2009 among top dealers
and was further cemented for market participants by the Dodd-Frank Act in July of 2010 (which mandated
central clearing for most swaps and the collateralization of uncleared swaps on dealer balance sheets). The use
of such legal agreements requiring daily margin maintenance of liquid collateral such as cash or Treasuries led
market participants to use the OIS curve as the benchmark risk-free curve for discounting cash flows of swaps
(and for other OTC transactions). Central clearing parties (CCPs), such as LCH and CME, also required daily
margin maintenance of liquid collateral (they also required clearing participants to provide a capital reserve
margin, or “cushion,” in the event of a clearing member credit event, such as a default).

Naturally, a shift from using LIBOR to OIS would have ramifications for valuing interest rate
derivatives. Before the credit crisis, the standard was to use LIBOR swap curves for discounting most swap
and derivative transactions. Post-crisis, however, market participants believed that it made sense to modify
stripping/bootstrapping methods applicable to such market quotes and to use the OIS curves for discounting.4

4 Bloomberg.

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