October 2015 Archives

October 26, 2015 3:08 PM

Why Is the FCC Hiding the Ball on Special Access Price Regulation?

On October 16th, the FCC issued an Order Initiating Investigation and Designating Issues for Investigation ("Investigations Order") concerning the provision of point-to-point data transmission services ("special access") by the country's largest incumbent LECs (AT&T, CenturyLink, Frontier, and Verizon).  These services, when provided by ILECs, are still subject to FCC price regulation.  Although the FCC has "de-tariffed" many of these services, much like the recently re-classified "Broadband Internet Access" service, ILEC special access services remain subject to Section 201's requirement that they be "just and reasonable."  

The Commission's Non-Price "Concern"

Superficially, the FCC's investigation is about the ancillary effects of the volume and term commitments that some CLECs have agreed to in order to receive the ILECs' lowest prices on special access services.  However, the Commission's overview and explanation of its concerns suggest that its inquiry is much broader than the competitive concerns with discount contracts that have been identified in the case law, and associated economics literature, the Commission briefly discusses.  See, Investigations Order at n. 54.

The Commission's only potentially-legitimate non-price concern is succinctly stated only once in the entire first 12 pages of the Investigations Order.  The FCC quotes a CLEC ex parte letter arguing that the term and volume commitments in the ILEC tariffs "shrink[ ] the addressable market for competitive wholesale special access providers (thereby preventing them from achieving minimum viable scale), and cause[ ] special access prices to remain higher than would otherwise be the case."  Investigations Order, Paragraph 12 [internal citation omitted].  

Everything else the Commission identifies as a question, or unresolved contention between the ILECs and CLECs, is more properly classified as "something that the CLECs don't like having to do in order to get the lowest possible prices."  The CLECs' gripes are certainly reasonable (from their perspective), but they are not competition-affecting issues; they are bargaining issues.

When Good Discounts Go Bad

One issue (out of many the FCC identifies) is that conduct that is otherwise competitively benign "may be impermissibly exclusionary when practiced by a monopolist." See, U.S. v. Dentsply, 399 F.3d 181, 187 (3d Cir. 2005).  Sometimes monopolies (firms with market shares approaching, or greater than, 80%) will use "discount contracts" as a way to limit the ability of new entrants to enter the market for the product/service being offered through the discount contracts.  The FCC references some of these cases in n. 54.  Let's take a closer look at a representative case in order to better understand situations in which these agreements can injure competition.

In ZF Meritor, LLC v. Eaton Corp., 696 F.3d 254 (3d Cir. 2012), the product market was heavy duty transmissions for big trucks, such as 18 wheelers, cement mixers, and garbage trucks.  The defendant, Eaton, was a monopolist in the U.S. heavy duty transmissions market from the 1950s until Meritor entered in 1989.  By 1999, Meritor had garnered a 17% share of the heavy duty transmissions market.  In mid-1999, Meritor and a leading European heavy-duty transmissions manufacturer, ZF AG, formed a joint venture to adapt a popular ZF AG model to the U.S. market.

In the U.S. market for heavy duty transmissions, there are 4 direct purchaser customers; these firms are the original equipment manufacturers ("OEMs").  Truck buyers, the ultimate consumers of heavy duty transmissions, purchase trucks from the OEMs by "assembling" components from the OEMs' catalogs.  It is, therefore, vitally important for a component part manufacturer to be listed in the OEM catalog--and on reasonable terms.  

From late 1999-2000, the U.S. trucking industry experienced a 40-50% decline in demand for new vehicles.  Shortly thereafter, Eaton entered into new long term agreements ("LTAs") with the 4 OEMs.  Long term agreements were not uncommon in this industry, but Eaton's new agreements were "unprecedented" in their length (the shortest were for a minimum of 5 years).

The new LTAs provided the OEMs with substantial up-front cash "rebates" of $1-2.5 million.  In exchange, the OEMs agreed to use Eaton transmissions in a very high percentage (usually, >90%) of their vehicles sold.  If an OEM missed its sales targets in any year, it was required to return in full all "advance" rebates it had received from Eaton.  Finally, the agreements required OEMs to artificially increase the price of ZF Meritor transmissions by $150-200, and to impose additional "penalties" on customers that still chose ZF Meritor transmissions.

By 2003, ZF Meritor determined that it was limited to no more than 8% of the market due to the Eaton's agreements with the OEMs.  ZF Meritor needed to get at least 10% of the market in order to remain viable, so it adopted a strategy of trying to sell directly to the end-user customers.  Nonetheless, at the end of 2005, its market share had dropped to 4%, and, in January of 2007, ZF Meritor exited the market.  Shortly thereafter, ZF Meritor sued Eaton on antitrust grounds. A jury returned a verdict in favor of ZF Meritor, which was upheld on appeal by the 3d Circuit Court of Appeals.

The Commission's Investigation of Dissimilar Discounts

Every antitrust case involving discount contracts, as well as the economic literature cited by the Commission, has several facts in common with the ZF Meritor case. First, the product or service has to be an input to the product or service the customer sells to its customers.  Second, it must be the case that only 1 firm can supply the majority of any customer's demand for the input, and, that firm almost always has a market share of 80% or greater.  Third, the primary "victim" of the contracts is not the purchaser, but rather the direct competitor, of the seller.

Finally, and this last condition is implicit, but the most important for our purposes.  In every instance where discount contracts have been found to harm competition, these contracts affect the entire relevant market for the product or service (or a very high majority of that market)If a new entrant can enter the market (for the same service the dominant firm is supplying through its "discount contracts") without selling to the same customers, then the discount contracts can have only a speculative and de minimus effect on competition--regardless of  how "unfair" they may seem to an outside observer.

Do CLECs Represent the Majority of Demand for Wholesale Data Transmission Services?

This, of course, is the first question the FCC should have addressed if it was genuinely concerned about competitive conditions in the wholesale transmission market.  To understand the importance of CLEC demand to the capital deployment decisions of competitive wholesale network service providers, let's look at a competitor that successfully entered the market after the FCC started its special access inquiry.  Zayo, according to the company history on its website,

was founded in 2007 in order to take advantage of the favorable Internet, data, and wireless growth trends driving the demand for bandwidth infrastructure, colocation and connectivity services.

So, if the ILECs have tied up the demand of some CLECs--which could otherwise go to competitors like Zayo, then who is buying from Zayo instead of the ILEC?  Fortunately, Zayo solves this mystery in a presentation to investors in May of this year.  
zayo_sales channels from pdf.jpg

What?  Zayo is selling to some of these same CLECs and those wascally ILECs?   In fact, as we can see, while wireline providers--including those same special access sellers that are under investigation--do constitute the largest group of potential customers for a new entrant, they are still only a minority of total market demand.  Moreover, it is hard to say how much the incremental CLEC demand would be--if not "locked down"--but it's doubtful that it would make the pie a whole lot wider. 

Why Does the FCC Insist on Its Ruse of an Investigation?

We've previously pointed out that "ILEC special access" is not a relevant product market.    Because "ILEC special access" is not a relevant market, it's not at all surprising that the FCC cannot point to a single, specific, direct competitor victim.  Instead, the Commission seems quite willing--perhaps too willing--to simply accept the purchasers' assurances that a victim exists; just a more "theoretical" victim than the antitrust laws protect.   

So, if the Commission's ostensible question for "investigation" is nothing more than the thinnest veneer to disguise price regulation, why is the FCC even bothering with the pretense of an investigation?  While it doesn't make much sense to price-regulate a fraction of a "market," if that's what the FCC wants to do, then it should at least regulate prices in a transparent manner.  Good government isn't always smart, but it should always be transparent to its citizens.
 

October 5, 2015 11:46 AM

Special Access Regulation: Always Best for Retail Customers?

The notion that extending regulation of ILEC special access could be bad for anyone (who's not an ILEC), much less retail business customers, may seem incongruous.  After all, if the competitors--who are serving real business customers--are in favor of imposing regulations on ILEC special access, then how could it possibly hurt their customers? 

Competition, Contracts, and Consumer Inertia

Last September, Chairman Wheeler described the mass market for broadband Internet access as so non-competitive that it made little difference if a customer faced a monopoly, or had a choice of service provider.  The Chairman stated,  

[c]ounting the number of choices the consumer has on the day before their Internet service is installed does not measure their competitive alternatives the day after.

Speech at 4.  The reason, he explained, is that "[o]nce consumers choose a broadband provider, they face high switching costs [like] . . . early-termination fees. . . .  Id.  Interesting observation, but is it accurate?   

Well, in April of 2010, the FCC surveyed a representative sample of broadband subscribers about their broadband purchasing/switching behavior over the prior 3 years.  The Commission found that 36% of customers had switched broadband providers in the past 3 years (compared with 19% of mobile customers switching providers over the same period). Survey at 6, 10.  Of the consumers that had switched ISPs, the overwhelming majority (86%) said the process of switching providers was either "very easy" (56%) or "somewhat easy" (30%).  Survey at 10.

Instead of describing any unique market failure in the consumer broadband Internet market, what Chairman Wheeler intuitively sensed was the phenomenon of "consumer inertia."   Consumer inertia is a behavioral tendency in markets where products are purchased through contracts--like cable TV, or insurance.  In these markets, consumers may aggressively shop for their initial service, but then neglect to continue to monitor market prices and, thereby, over time receive less competitive terms.

Consumer Inertia Is Good for Competitors, But Not Customers

The effect of customer inertia--on their service providers--is best illustrated by the fact that there are a lot of locations where competitors are serving retail customers with ILEC special access, even though competitive fiber is available.  See, e.g., T-Mobile example in last blog.  One reason that a CLEC will not automatically use competitive fiber when it becomes available is that each time a retail customer location switches to a different physical transmission line, the CLEC must physically "groom" the retail customer's premise equipment (modems/servers/PBXs) onto the new network.
groom5.jpgCarriers Hate Physical Grooms.  A physical groom is a hassle for both the CLEC and the customer.  To better understand why, let's consider a hypothetical example. 

Let's say you're a CLEC, and you're serving a customer with 5 locations in a metro area.  Your own fiber is serving 3 of the customer's locations, and the other 2 are served via ILEC special access.  To get those 2 special access locations on anyone's fiber, you (and your customer) have to physically be present to: 1) allow physical access/wiring by the new access vendor, and 2) configure/test the customer's new service.  Also, to mitigate the consequences of any service disruption, this usually happens at 3:00 in the morning, preferably on a weekend.

falling down2.jpgIf the worst happens, the business customer could temporarily lose service, lose business, or even end up causing their IT guy to turn into the Michael Douglas character from Falling Down.  The risk varies, but it's always there, and that's without the nastier risk of . . . competition. 

Customers Love New Fiber Facilities.  Physical grooms are hard on carriers, but customers love how a groom just "wakes them up!"  You see, the retail business market works kind of like Chairman Wheeler imagined the mass market for broadband Internet service to work--at least in the sense that business telecom contracts really do have high termination penalties.  See, e.g., these small business customer complaints to the BBB about tw Telecom.  Early termination penalties--after the original contract term--may even promote consumer inertia.  But, things change when the service provider wants to change the customer's physical service configuration.

In fact, nothing disrupts consumer inertia like the customer spending a lot of time on the phone with their current supplier (as a customer might do to prepare for a coordinated service cutover).  In fact, since the CLEC is only coordinating with the customer because it has alternatives, it's only a matter of time before the customer starts thinking the same thing.

So, referring back to our previous example, let's say you're the CLEC and have been serving this customer for 7 years.  And, let's say that the customer has had no disruptions/complaints in that 7 years.  You've been sending out bills and they've been sending out checks; it's every carrier's "fairy tale" customer relationship! 

Then, you try to do something nice by putting the customer's special access locations onto competitive fiber, and what happens?  The customer's eye starts wandering, suddenly nothing in your contract is good enough for them anymore, you become clingy, and, before you know it . . . the "fairy tale" unravels in tears and bitter rancor?!
    
groom4.jpgWell, it's not always that bad.  But, at best, if you want to keep the customer, you're probably going to have to lower their price, and stop coming home drunk (or the telecom equivalent).  So it's kind of easy to see--from the CLEC's point of view--why, if a customer's service was initiated using ILEC special access, they would need a really good reason to take the customer off that service.
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Some carriers are lobbying for the blanket extension/expansion of special access regulation, because this service fits comfortably with the network architecture they decided on 15-20 years ago.  But, Chairman Wheeler recognizes the limiting effects of inertia on retail consumers, and he knows better than to simply assume that the outcome favored by service providers is also the best outcome for their customers.  If the effect of extending special access regulation is to keep retail customers believing that their choices are no different than "the day before they had their service installed" many years ago, do these carriers really believe the FCC will think this is the best choice outcome for consumers?