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.
 

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