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method but the project may be of greater benefit to the unregulated portion of the organization. The degree of benefit is not always a tangible percentage that can be captured in a cost allocation formula... Given different scenarios, the allocation methods may never be accurate."

#12

The holding company structure of the RBOCs also allows the phone companies to assign some personnel from the regulated operations to develop and help manage unregulated businesses. The NARUC audit of Pacific Telesis, for example, noted that Pacific Telesis subsidiaries were "borrowing" Pacific Bell personnel to do work for subsidiaries, including not only advisors, but "often the project leaders or...key members of the affiliates' projects or operations." Since these personnel are paid by the regulated company, i.e., by the telephone customer, their uncompensated use by the subsidiary amounts to a cross-subsidy.

13

The same point is made in NARUC's summary of RBOC audits, which notes "[t]he new money-losing ventures certainly must absorb much more of management's attention than the telephone companies, which have a long history of successful operation. Under these circumstances, it is likely that the use of allocation factors such as gross revenue, equity, and number of employees send a greater amount of the expenses to the regulated companies than is warranted. This is quite obviously a detriment to ratepayers."

M14

As these examples make clear, cross subsidies are not simply the result of one company's management approach. Rather, in the persistent allocation of costs from unregulated businesses to the regulated phone services, telephone companies reflect a strong, simple economic incentive: a telephone company will, at every occasion, allocate costs to the regulated phone service customer base because it is virtually guaranteed to receive full payment, including a rate of return, for those costs. This incentive, which is at the heart of the RBOC's practice of acting anticompetitively, makes phone ratepayers likely "involuntary investors" in any nonregulated RBOC business activity."

12 State of Ohio Public Utilities Commission, The Ameritech Bell Operating Company Relationship: A Regulatory Perspective, August 8, 1986, (Hereafter to be referred to as "NARUC Audit of Ameritech") P. 49.

13 California Public Utilities Commission, A Report on Pacific Bell's Affiliated/Subsidiary Companies, June 3, 1986, (Hereafter referred to as "NARUC Audit of Pacific Telesis") p. 1-4.

14 NARUC Summary, p. 9-10.

15 This incentive to allocate costs to regulated phone service still exists under the "price cap" form of regulation as currently proposed by the F.C.C. In theory, price cap regulation would set limits on telephone service prices, as opposed to current rate of return regulation, which limits the return on investment that phone companies may earn. As proposed, however, price cap regulation would entail an examination every three years of the phone companies' return on investment, with resulting adjustments in the event the rates of return are too high. Therefore, the incentive to allocate costs to regulated phone service remains virtually unchanged under proposed price cap regulation. See F.C.C. Docket No. 87-313.

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Apart from abuses of the cost allocation process, one of the most common attempts to force telephone customers to finance competitive services is through the transfer of regulated company assets to an unregulated affiliate. For example, a NARUC audit of NYNEX criticized the company for creating a subsidiary (NYNEX Materiel Enterprises Company, or MECO) to provide equipment repair, testing and other services for the regulated telephone subsidiary. The MECO subsidiary, due to its affiliation with regulated phone subsidiaries, gains several tax advantages that give MECO access to essentially "cost free capital," which in turn "creates an artificial advantage for MECO which enables them to underprice outside suppliers."16 The N.Y. Department of Public Service concluded that this arrangement "amounts to a subsidy of non-regulated operations by the captive regulated entities [i.e., the regulated telephone subsidiary]."17 In a similar vein, the N.Y. Department of Public Service concluded that the establishment of a NYNEX equipment marketing subsidiary "may have led to subsidization by these ratepayers of the unregulated operations of NYNEX BISC [the subsidiary]."

18

And in the case of another RBOC, the NARUC audit of Pacific Telesis complained that "guidelines governing intercompany transactions are inadequate." These transactions included transfer of real estate from Pacific Bell (the regulated telephone subsidiary) to PacTel Properties (the real estate subsidiary) at "below fair market rates," thereby "shortchanging" the ratepayers whose monthly bills originally paid for the real estate.

19

B. General Anticonsumer Behavior

The telephone customer, or "involuntary investor," in addition to financing risky diversification efforts, is also harmed by the ongoing attempts by regulated telephone subsidiaries to evade state utility commission regulation of their conventional telephone service. As noted earlier, since telephone companies are, under rate of return regulation, virtually guaranteed the ability to earn a certain percentage return on their investments, telephone companies have powerful economic incentives to inflate

16 New York State Department of Public Service, Report on NYNEX Corporation and Affiliates, March 1987 (Hereafter referred to as "NARUC Audit of NYNEX”) p. 62. Recently, the Boston Globe quoted several current and former NYNEX employees as saying that NYNEX ordered the regulated telephone subsidiaries to purchase services only from MECO, and that MECO inflated prices to the telephone subsidiaries as much as 250%, thus driving up phone bills. Boston Globe, December 22, 1988, p. 1.

17 Initial Brief of N. Y. Department of Public Service on Department of Justice Report and Recommendations, Triennial Review Proceeding, Civil Action No. 82-0192, p. 18.

18 Ibid, p. 21.

19 NARUC Audit of Pacific Telesis, p. 3.

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20

This type

the cost of doing business or add unjustified investments to their expenses. of behavior has been uncovered by state regulators' reviews of expenses submitted by the RBOCS.

As one example, the California Public Utilities Commission (CPUC) Division of Ratepayer Advocates investigated Pacific Bell's investments in plant modernization. The PUC staff recommended in 1988 that customers' rates be reduced by $700 million to compensate for Pacific Bell's "deficient and unacceptable decision making," "inadequate levels of performance in its investment justifications," and "inability or failure to provide data required to justify such decisions."21 Thus, Pacific Bell invested in technology at the expense of the ratepayer without sufficient justification that the investment benefited the ratepayer. Such investments are often used to offer new, diversified services, the benefits from which do not accrue to the ratepayers who made them possible. Moreover, the CPUC staff had "no conclusive evidence that Pacific's unsatisfactory performance is not continuing." Therefore, the staff recommended an additional $130 million annual refund to compensate for the continuing harm to consumers caused by the still deficient investment planning process.

22

In a separate proceeding, the CPUC, in its annual rate review, ordered Pacific Bell to reduce rates by over $500 million in 1989, and also ordered a $200 million refund to compensate consumers for "excessive revenue" collected in 1988.2 Even though Pacific Bell's operating costs had declined over the previous two years, the company did not pass those savings on to consumers until forced to do so by regulators.

In another case, the staff of the Missouri Public Service Commission has filed a complaint charging that Southwestern Bell's rates produced "excessive earnings" in 1987. The PUC recommended cutting telephone service rates by $200 million annually because Southwestern Bell was not passing through savings to customers resulting from lower interest rates and other improvements in the economy.“

23

In addition to these specific cases, a number of other regulators and analysts have concluded that the residential telephone customer is generally bearing the brunt of a variety of anticonsumer behavior by the phone companies. The Consumer Federation of America has reviewed the financial and regulatory performance of the RBOCs, and

20 See footnote 16.

21 California Public Utilities Commission, Division of Ratepayer Advocates, Staff Report on Pacific Bell's Capital Decision-Making Process, August 5, 1988, p. xiii-xv.

22 California P.U.C. Resolution T-13037, reported in Communications Week, December 26, 1988, p. 9 and Wall Street Journal, December 20, 1988, p. B2.

23 Missouri Public Service Commission, Docket No. TC 89-14; reported in Wall Street Journal, 8/16/88, p. 13.

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The CFA

has demonstrated that the RBOCs have been granted special regulatory treatment resulting in $6 billion in "excessive" charges to consumers since divestiture." 24 also notes that, "It is no surprise that just as regulators start realizing that consumers are paying $2 billion a year too much in phone rates, the phone companies propose less regulation. Although they are virtual monopolies, the Regional Bell Companies have outearned the nation's largest competitive firms for the last three years by almost three 25 percentage points."

Judge Greene, in his triennial review of the MFJ, compared telco income from telephone operations with income or losses from competitive subsidiaries. He concluded that the increase in basic telephone revenues, "may be due in some significant part to cross subsidization, that is the diversion of ratepayers' monies to finance the Regional Companies' ambitions to become full-fledged players in conglomerate America."26

C. Diversification Won't Lower Phone Rates

Judge Greene's ruling in 1984 on phone company requests for permission to enter unregulated lines of business also concluded that diversification appears to push local telephone rates higher. "Even if the Regional Holding Companies could somehow reap significant profits from their outside ventures they would not use them to benefit their regulated telephone affiliates. In fact, the opposite appears to be true."

„27

NARUC, in its summary of RBOC audits, also expressed a pessimistic view of the effects of phone company diversification. "The RHCs [RBOCs] have no intention of using unregulated profits (if there ever will be profits from these ventures) to support #28 basic residential service." A NARUC audit of NYNEX found direct evidence that

24 Consumer Federation of America, Divestiture Plus Four: Take the Money and Run, December 1987, p. 7. Monthly residential phone bills have risen over 50% between divestiture in 1984 and the end of 1988. Divestiture Plus Five: Residential Telephone Service Five Years After the Breakup of AT&T, December, 1988, p. 1.

25 Press Release accompanying Divestiture Plus Four. Incidentally, the International Communications Association, a non-profit association of large telecommunications users such as Sears and General Electric, has endorsed the CFA study, saying "excessive returns have unfairly impacted all ratepayers of local [telephone service]." (State Telephone Regulation Report, 9/11/86, p. 11. CFA's followup report, Divestiture Plus Five (page 19), reiterated that consumers have paid billions in excessive rates.

26 Triennial Review Order, 673 F. Supp. at 582.

27 U.S. vs. Western Electric Co., Inc. 592 F. Supp. 846 (D.D.C., 1984), p. 864. In fact, this ruling quoted RBOC statements that the earnings of the companies belong to the shareholders and are not used to lower phone bills. (p. 864-865.) This is particularly interesting in light of recent RBOC claims that telco entry into the television business might lower the cost of phone service.

28 NARUC Summary, p. 4-5.

n29

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"the regulated affiliates [local telephone companies] realize only a portion of the actual economies attributable to the monopoly operations, while the non-regulated affiliates achieve significant benefits from monopoly scale through higher profits and/or reduced costs. The New York State Department of Public Service has confirmed that the NYNEX goal of enhancing the corporate parent's well-being "encourages the use of the operating companies [local telephone companies] simply as vehicles to support the parent's diversification. In this manner, the NYNEX corporate structure and philosophy enhances NYNEX's competitive advantage at the expense of ratepayers.' "30

The National Association of State Utility Consumer Advocates (NASUCA) testified before Congress that "diversification is a one-sided proposition-consumers bear many of the costs but receive few, if any, of the benefits."31 A review conducted by NASUCA of 1985 data, indicates that the diversified businesses (excluding the Yellow Pages) of the seven RBOCs lost a total of $939 million.32

D. Failure of Regulations to Prevent Cross Subsidization

The above evidence indicates that RBOCs have been using telephone customer revenue to finance risky competitive ventures, and have also been harming consumers through unjustified rate increases. The evidence indicates that existing regulatory safeguards have been ineffectual at preventing such anticonsumer behavior.

The telephone companies have argued that new accounting rules proposed by the FCC will prevent cross subsidy and other abuses.33 But a wide array of organizations and individuals clearly disagree. Some of these critics have studied the particular

29 NARUC Audit of NYNEX, p. 3.

30 Initial Brief of New York Department of Public Service on Department of Justice Report and Recommendations, Civil Action No. 82-0192, p. 14.

31 Testimony of Joel Blau, on Behalf of the National Association of State Utility Consumer Advocates, before Subcommittee on Telecommunications, Consumer Protection, and Finance, Committee on Energy and Commerce, U.S. House of Representatives, Competitive Status of the Bell Operating Companies, 99th Congress, 2nd Session, March 13, 1986, p. 604.

32 Comments of NASUCA on the Department of Justice Recommendations, Triennial Review Proceeding, Civil Action No. 82-0192, p. 21. Securities analysts specializing in the telephone industry have also pointed out that RBOC diversification has had negative effects on profits. Dean Witter Vice President Joel Gross commented, "their [RBOC] earnings this quarter [2Q,1987] to some degree reflect losses contributed by the unregulated side." Analyst Harry Carrel of Northern Business Information, Inc. agreed, saying the unregulated operations that "the RBOCs have no experience running" helped depress their quarterly profits. NYNEX itself admitted its earnings were "slowed by investments" in unregulated businesses. (Network World, August 10, 1987, p. 9.)

33 CC Docket No. 86-111, Separation of costs of regulated telephone service from costs of non-regulated activities, Report and Order, adopted December 23, 1986.