I. INTRODUCTION

The telephone industry, particularly the seven Regional Bell Operating Companies (RBOCs), has been actively advocating the removal of federal restrictions that prevent phone companies from entering the television business. The phone companies argue, among other things, that they should be allowed into the television programming business in order to finance the conversion of the local telephone network from copper wire to fiber optics technology.

The telephone industry maintains that if the current restrictions on telephone entry into the television business were lifted, the local telephone network conversion to fiber optic technology would occur more quickly because, by generating television service revenues, local phone companies could cover the high costs of converting their networks to fiber optics. The conversion to fiber, the phone companies argue, will enable local telephone companies to offer the public new video and advanced information services that cannot be delivered over the current copper wire networks, and will promote competition in the video marketplace.

However, careful analysis of the economic rationale for this contention makes it clear that removing the current prohibition would not lead to more rapid installation of fiber to the home by the phone companies.2 In addition, the phone companies obscure several key elements regarding the current restrictions.

First, absent from the phone companies' arguments is a clear statement about precisely what the federal restrictions prohibit. Specifically, none of these federal restrictions, found in the AT&T Consent Decree, FCC regulations, and the Cable Communications Policy Act, prevent local telephone companies from constructing fiber optic networks, or serving as the transmission providers of television programs. These

3

1 The RBOCs are actually holding companies composed of individual Bell Operating Companies, or BOCs. 2 See for example Kenneth Baseman, "The Economics of Local Telephone Company Integration into the Retailing of Video Programming", in Comments of the National Cable Television Association, F.C.C. Docket No. 87-266, December 16, 1988; also see Comments of MCI Telecommmunications Corp, F.C.C. Docket No. 87-266, December 16, 1988, p. 41-44.

3 Federal restrictions on telephone company entry include the Cable Communications Policy Act of 1984, which states "it shall be unlawful for any common carrier (telephone company]... to provide video programming directly to subscribers in its telephone service area." (47 U.S.C. Sec 533 (b)(1)). The Act allows telephone companies to provide programming in areas where such programming "demonstrably could not exist except through a cable system owned by or affiliated with a telephone company. These Footnote continued on next page

-2

restrictions only prevent the phone companies from actually owning television programs or from deciding what television programs get delivered via wire into the home.

Second, absent from the phone companies' arguments is any discussion of why these restrictions were imposed on the telephone industry in the first place. The phone companies, and in particular the RBOCs, have been barred from the television business, as well as other businesses, due to their well-established history of, and proclivity toward, anticompetitive and anticonsumer behavior. Indeed, the Bell System was broken up precisely because of the anticompetitive and anticonsumer behavior of the phone companies.

In order to discover whether the telephone companies have continued to act anticompetitively since divestiture, NCTA reviewed proceedings at the state Public Utility Commissions, at the Federal Communications Commission, and at various state and federal courts. NCTA also reviewed documents and studies of the phone companies produced outside of formal regulatory proceedings, including Congressional testimony, a General Accounting Office report, and an especially revealing series of audits of the RBOCS conducted under the auspices of the National Association of Regulatory Utility Commissioners (NARUC).

As the following analysis of this material demonstrates, the RBOCs are no less capable now, and may even be more capable, of engaging in anticompetitive behavior than when they were part of the Bell System. Indeed, as District Court Judge Harold Greene, who presided over the breakup of AT&T, said in his 1987 opinion upholding restrictions on telco diversification, "when still part of the Bell System, [the RBOCs] participated widely in anticompetitive activities, [and] were they to be freed of the restrictions they could be expected to resume anticompetitive practices in short order, to the detriment of both competitors and consumers."* Judge Greene commented further that "[i]n view of the fact that when compared with the Bell System, the

Footnote Continued.

4

areas are usually underpopulated areas not served by cable companies. These Cable Act provisions generally codified an FCC rule implemented in 1970 which prohibited telephone company ownership of cable video programming. (47 C.F.R. Sec. 63.54-63.56) There are also restrictions on telephone company ownership of video programming embodied in the line-of-business restrictions imposed by the Consent Decree (or Modification of Final Judgment) governing the breakup of AT&T. The MFJ prohibits local telephone companies from offering "information services," and this prohibition includes the offering of video programming. United States v. Am.Tel. & Tel. Co., 552 F. Supp. 131, 195 (D.D.C. 1982), aff'd sub nom. Maryland v. United States, 460 U.S. 1001 (1983).

United States of America v. Western Electric Co., 673 F.Supp.525 (D.D.C.1987) (Hereafter referred to as Triennial Review Order") p. 601.

-3

organizational state of the Regional Companies is much less rigid and far more complex -- with their subsidiaries, partnerships, joint ventures, and other enterprises, some regulated, some unregulated, some regulated in part -- discrimination against competitors and cross- subsidization are far more difficult to detect, prevent and rectify through regulation now than they were in 1982."5

As the following analysis also demonstrates, regulations designed to protect against telephone company anticompetitive and anticonsumer behavior often fail because local phone companies "are so complex, so technologically dynamic, and characterized by such joint and common costs that no set of regulations could realistically prevent competitive abuses." This byzantine complexity in how local phone companies operate, keep their accounts, and report on their activities means that efforts to control the phone companies' unregulated activities will, in the words of NARUC, "bring to life the worst nightmares of regulators."7

In such an uncertain regulatory environment, it is imperative to continue to rely on line of business restrictions rather than untested or ineffectual accounting procedures. Given the RBOCs' incentive and ability to act anticompetitively, sound judgment dictates that current restrictions on RBOC entry into the television business must remain in place.

5 Ibid, p. 569. 6 Ibid, p. 541.

7 NARUC, Summary Report on the Regional Holding Company Investigations, September 18, 1986, (Hereafter referred to as "NARUC Summary") p. 17. This is a summary prepared by NARUC of a series of audit reports on the Regional Bell Operating Companies prepared by task forces of regulators in the service area of each RBOC under the auspices of NARUC.

-4

II. THE POTENTIAL COSTS TO PHONE SERVICE CUSTOMERS

The costs of telephone company entry into the television business would likely be borne by phone service customers. Historically, both before and after divestiture, the phone companies have shifted costs onto their monopoly customers through cross subsidization (the shifting of costs from one business activity to another) and through general phone company attempts to evade regulation. The following sections demonstrate that the phone companies are capable of, and have been found repeatedly to engage in, cross subsidization and anticonsumer behavior, despite regulatory safeguards designed to prevent this behavior. Moreover, despite the claims of the telephone industry, telephone company diversification into the television business will not contribute to lower phone bills.

A. Cross Subsidization

Telephone companies receive guaranteed, or monopoly, revenues from customers who must purchase telephone service from the local monopoly telephone company. Under regulations which have evolved over many years, the prices sged these "captive" ratepayers are a function of the underlying costs of providing service to them. Therefore, to the extent that they can do so without detection, telephone companies have the incentive to misallocate the costs of other services they might offer, such as television service, for which consumers do have a choice, to their regulated telephone service, which ratepayers have no choice but to purchase from their local phone company.

The RBOCs are able to improperly assign, or allocate, the costs of competitive unregulated services to their regulated telephone services in a variety of ways owing to their organizational complexity. The RBOCs are holding companies composed of the regulated local telephone service provider (sometimes called the Bell Operating Company, or BOC) as well as a number of diversified businesses, some regulated and some not. Each of the diversified businesses (which could include proposed television services) are also subsidiaries of the holding company (these subsidiaries are sometimes known as affiliates). In such an organization, costs incurred by the holding company (for example, executives' salaries) can be allocated to either a regulated or unregulated subsidiary. Alternatively, the costs of one of the unregulated businesses

-5

(such as major capital expenditures for fiber-based television service) may be allocated to the regulated local telephone business. Further, this allocation becomes even more arbitrary if both regulated and unregulated services are provided over shared facilities. The evidence shows that this allocation process has not been a precise exercise and, indeed, has provided significant opportunities for anticompetitive behavior.

For example, a National Association of Regulatory Utility Commissioners (NARUC) report found that "[t]he operations and methods of [the RBOC] Pacific Telesis bring to life the worst nightmares of regulators. There appears to be no advantage to the holding company structure except to the unregulated businesses of Pacific Telesis, which are cross-subsidized at every turn by Pacific Bell (the regulated telephone subsidiary of Pacific Telesis]."8

The NARUC report also concluded that Pacific Telesis "appears to have purposely muddied the waters surrounding such allocations" of costs between regulated and unregulated operations, and that "the company has no internal standards governing intracompany transactions, nor any acceptable means of tracking the various movements of funds and personnel. It appears that Pacific Telesis is testing the waters to determine just how far it can go in sidestepping all regulatory rules and concerns."10

In another case involving improper cost allocation, an audit of BellSouth conducted by a NARUC task force of state regulators found that "there is no way to avoid the flow of the largest portion of shared service costs from the holding company to the regulated subsidiary" because of the way allocation formulas are "heavily weighted" to the regulated part of the company. Further, "even though costs associated with establishing new ventures and competitive subsidiaries are directly billed as project costs, there is no assurance that all of these costs are identified and billed to the new ventures or 11 subsidiaries."

And in still another NARUC audit, investigating Ameritech, the auditors made the point that "the costs of the project may be accurately assigned per the allocation

8 NARUC Summary, p.17

9 NARUC Summary, p. 9.

10 NARUC Summary, p. 17.

11 Special Accounting Task Force of Southern Public Service Commissions, Report on BellSouth Corporation, May 16, 1985, p. 11. This is one of a series of audit reports on the seven Regional Bell Operating Companies (RBOCs) prepared by task forces of regulators in the service areas of each RBOC under the auspices of the National Association of Regulatory Utility Commissioners (NARUC). This report will hereafter be referred to as the "NARUC audit" of BellSouth.