just and reasonable rates. While the Communications Act clearly gives the
Commission authority to adopt and the means to apply this form of
regulation, the Act does not expressly mandate it. Nor does the legislative
history of the Act indicate that Congress intended the Commission to use
this form of regulation to assure just and reasonable rates. Review of the
regulatory history of the telecommunications industry shows that when
AT&T“s monopoly power was strongest and least challenged, neither the ICC
nor the FCC perceived the public interest to require such regulation. The
FCC’s decision to turn to this regulatory approach twenty years ago was
triggered by its analysis of the interstate telecommunications market at
that time,32 4 factual determination, and one reasonably subject to

reexamination in the face of a dramatically altered market structure.

32 See p.13 supra; see generally American Tel. & Tel. Co., Docket No.
16258, 2 FCC 2d 871 (1965) (MO&O opening investigation that led to the first
rate of return prescription for AT&T interstate operations), AT&T and
Western Union Private Line Cases, 34 FCC 2d 217 (Mo&0 prescribing an overall
private line services” rate of return for both AT&T and Western Union as
well as adjustments to interstate private line telelphone and private line
telegraph rates. The goal in this Proceeding was to enable the carriers to
achieve these earnings while limiting AT&T’s ability to subsidize rates for
its competitive private telegraph line service with revenues from its
private line telephone service. See id. at 229-30).

- 16 -


Admittedly, the first cases stating the "no single formula" rule were
focusing upon the formulas and methodologies that a regulatory agency might
properly use in the steps required to set “cost-based" rates. For example,
in Federal Power Commission v. Natural Gas Pipeline Gompany,82 the Supreme
Court was confronted with two issues related to the methodology used by the
FPC to define a gas company’s rate base and depletion allowance: (1) whether
either the Constitution or the Natural Gas Act required the FPC to include
“going concern value" in setting the rate base used to compute the gas
company’s interstate revenue requirement; and (2) whether the amortization
period for the business should have started no earlier than the passage of
the Natural Gas Act even though the company had operated for six years
before the legislation was enacted.83 In prescribing interim rates pending
the outcome of a full rate case, the FPC had answered both questions in the
negative. An appellate court disagreed. Holding that the Constitution did
not bind ratemaking bodies to following any combination of formulas in
determining reasonable rates, the Supreme Court stated that if the
Commission’s prescription, "as applied to the facts before it and viewed in
its entirety, produces no arbitrary result," the court would inquire no

further .84

82 315 U.S. 575.
83 Id. at 581,

84 Id. at 586.

-37-


competitive, unregulated markets. Through the Second Computer In iry ,70
the Commission fashioned a regulatory scheme to enable the Bell System to
enter the unregulated data processing services market and still to remain in
compliance with the restrictions imposed by the 1956 Consent Decree./! In
early 1985, the Commission concluded that changed circumstances within both
the unregulated customer premises equipment market and the regulated
interexchange services market warranted replacing with non-structural
safeguards the structural separation requirements that the Second Computer
Inquiry had imposed upon AT&T’s participation in the CPE market./2 Most

recently, the Commission concluded that changed circumstances in the
unregulated enhanced services market and the regulated interexchange

services market warranted its replacing structural separation conditions on

70 Amendment of Section 64.702 of the Commission’s Rules and Regulations
(Second Computer Inquiry), Final Decision, 77 FCC 2d 384, modified on
reconsideration, 84 FCC 2d 50 (1980), modified on further reconsideration,
88 FCC 2d 512 (1981), aff“d sub nom. Computer and Communications Indus.
Ass‘n v. FCC, 693 F. 2d 198 , aff“d on second reconsideration, FCC 84-190
(released May 4, 1984).

71 United States v. Western Electric Co., 1956 Trade Cas. (CCH) para.
68,246 (D. N.J. 1956).

72 See Furnishing of Customer Premises Equipment and Enhanced Services by

American Telephone and Telegraph Co., CC Docket No. 85-26, 102 FCC 2d 655
(1985), modified on reconsideration, 104 FCC 2d 739 (1986).

- 33 -


reasonableness," where rates are neither ‘ess than compensatory,” nor
“excessive.” coos The “zone of reasonableness” is delineated by
striking a fair balance between the financial interests of the
regulated company and the ‘Yelevant Public interests, both existing and
foreseeable.” :

The delineation of the ‘zone of reasonableness” in a Particular
case may ... involve a Complex inquiry into a myriad of factors,
Because the relevant costs, including the cost of capital, often offer
the principal points of reference for whether the resulting rate is
“less than Compensatory” or “excessive,” the most useful and reliable
starting point for rate regulation is an inquiry into costs. ceee At
the same time, non-cost factors may legitimate a departure from a rigid
cost~based approach. [But] ‘each deviation from cost~based pricing
(must be] found not to be unreasonable and to be consistent with the
Commis sion’s [statutory] responsibility.“ 97

The focus of the federal Court of appeals in Farmers Union Central Exchange
was on the upper bound of the zone of reasonableness. In that case, the
court was reviewing FERC ‘s efforts to develop generic ratemaking principles
for oil pipeline Systems subject to regulation under the Interstate Commerce

Act. The ratemaking methodology the commission adopted reflected its view

97 734 F.2d at 1502 (citations omitted).

- 42 -


regulatory powers18 but also the broad regulatory authority of Section

18 Those powers include the power to require a carrier to interconnect
with other carriers and to establish through routes (47 U.S.C, Section
201(a)), to determine whether carriers” rates and conditions of service are
just and reasonable (47 U.S.C. Section 201 (b) ) and without unreasonable
preferences or discriminations (47 U.S.C. Section 202 (a) ). Section 204,
47 U.S.C. Section 204, empowers the Commission to suspend and investigate
Proposed changes in rates on its own initiative, and, should investigation
establish their unlawfulness, Section 205, 47 U.S.C. Section 205,
authorizes the Commission to Prescribe just and reasonable rates. Section
214 enables it to control entry into and exit from the service market. Most
germane to this memo, Title II also gives the Commission all the Powers and
tools it needs to perform cost-of-service regulation. See National
Telecommunications and Information Administration, Comprehensive Review of
B® Regulation of United States Telecommuni
ations Industry, 51 Fed. Reg. at 36,8. e
Commission can: (1) determine the Property to be included in a carrier’s
rate base (47 U.S.C. Section 213); (2) prescribe depreciation rates (47
U.S.C. Section 220); (3) determine rates of return (47 U.S.C. Section 205);
(4) establish criteria for “allowable” Operating expenses (47 U.S.C,
Section 204); (5) develop accounting and information systems (47 U.S.C
Sections 213(£), 218); (6) specify criteria for reviewing tariffs (47 U.S.C.
Section 203); and, (7) establish all rules and procedures required to
exercise such regulatory control (47 U.S.C. Section 201(b)).

- 10 -


Section Iv

Neither the Communications Act, its legislative history, nor legal
Precedent requires the continued use of rate-of-return regulation to control
the earnings of AT&T or to assure its customers just and reasonable rates.
Under current circumstances, the Haring-Kwerel Proposal appears to offer a
less onerous means of assuring just and reasonable rates for all service
users. If an approach that would be less costly to society than
rate-of-return regulation for AT&T can still achieve the Statutory goal of
just and reasonable Fates, it would be more likely than continued
rate-of-return- regulation to maximize consumer welfare. It therefore
appears that it would be in the Public interest to substitute such an
approach for rate-of-return regulation. This Suggests that, at a minimum
the Commission should seriously explore this option, and that it should do

80 a8 soon as possible.

- 52~


AT&T“’s obligation to avoid unreasonable discriminations or Preferences in
its rate levels and Structures. In fact, the Haring-Kwerel Proposal offers
special protection to customers in parts of the country where market forces
may be too weak to Protect them against unreasonably high rates. Because it
prohibits geographic deaveraging for all Services, core or non-core, the
Proposal assures that these customers will Pay no more for their
telecommunications services than will those customers in areas subject to
strong market forces, Thus it carefully protects the Commission’s
commitment to universal service. Moreover, while it would suspend any
obligation to file economic cost support for any proposed rate changes
within the zone of reasonableness defined for core services, or for any
filing for non-core services, the Proposal does not foreclose interested
Parties from filing petitions to suspend or reject AT&T’s tariff revisions,

or from invoking the- Commissions complaint process,112 yy does, however,

showing to justify suspension of a non-dominant Carriers tariff filing:

Policies and Rules Concerning Rates for Competitive Common Carrier Services
and Facilities Authorizations Therefor, CC Docket No. 79-252, First Report,
85 FCC 2d 1, 37 (1980), A similar injunctive relief type standard would
appear to be a reasonable addition to the proposal.

- 50 -


{which} are by themselves not “just and reasonableTM and thus should avoid

the “fundamental flaw" that led the court to strike down the ratesetting

methodology proposed by FERC in Farmers Union Central Exchange 109

Under the Haring-Kwerel Proposal, rates for non-core services would not
be subject to direct regulation by the Commissjon; they would, however,
clearly be subject to indirect regulation that would compel them to fall
within the zone of reasonableness defining lawful rates. AT&T would be free
to set its rates for these non-core services at non~confiscatory levels. 110
The incentive to set them lower would be absent since the cap on core
services substantially limits AT&T’s ability either to recapture unrecovered
costs from core service customers, or to recover monopoly profits in the
future. Setting the charges for other non-core seryices at offsetting, but
extortionate levels would cause customers to migrate either to the services
of competitors or to core services, for which rates would be capped at just
and reasonable levels. Thus the selection of core services, coupled with
the setting of caps for their rate levels that are based upon carefully
selected factors tied closely to costs, has the effect of achieving the
statutory goal of just and reasonable rates for Mon-core services. For this

reason the Haring-Kwerel proposal appears to be the sort of indirect

109° 734 FP, 2d at 1509.

410 But see p. 49 infra.

~ 48 -


in the Federal Communications Commission.38 The courts have consistently
characterized the Primary purpose of the FPC to be protecting consumers
from being exploited by natural gas companies.39 Ip contrast, the FCC’s
mandate, to make rapid, efficient nationwide communications services
available to all at reasonable rates, makes rate levels only one of several
factors the Commission must balance in fulfilling its statutory purpose.
Moreover, while it must assure that rates are just and reasonable, the
Commission is explicitly given the discretion to "prescribe such rules and
regulations as may be necessary in the public interest to" achieve this
result.40 and yet, during the 1960’s and 1970°s, the Supreme Court
consistently upheld FPC decisions to replace the individual cost of service
method of fixing rates for Segments of the natural gas industry with less

onerous, albeit less precise methods for setting just and reasonable rates.

In Wisconsin v. FPC,41 the Supreme Court upheld the FPC’s decision to

abandon the individual cost~-of-service method of fixing rates for natural

38 = See Note, Storming the AT&T Fortress: Can the FCC Deregulate
itive Carrier Services?, 32 Fed. Com. L.J. 205, 212-14 (1982),

39 See FPC v. Hope Natural Gas Co., 320 U.S. at 610; Chic v. FRC,

458 F. 2d 731, 750 (D.C. Cir. 1971), cert, denied, 405 U.S. 1074 (1972); see
generally FPC v. Texaco, 417 U.S. at 397-400.

40 47 U.S.C. Section 201 (b).

41 373 U.S. 294 (1963).

- 20 -


Subsequently, in Federal Power Commission v. Hope Natural Gas
Go.,85 the Supreme Court reviewed an FPC order reducing that gas company’s
rates for natural gas sold in interstate commerce. The rate reduction arose
in part because the Commission used "actual legitimate cost" rather than
reproduction cost or trended original cost to define Hope’s rate base and
refused to include in that rate base certain costs previously charged to
operating expenses. Finding that the Commission had used the “wrong”
formula for computing the gas company’s rate base, and, in particular, that
it should have included the disallowed Operating expenses in that base, the
court of appeals held that the prescribed rates were not just and reasonable
from the company’s perspective, The Supreme Court, however, explained that
it was unnecessary to determine the different ways in which the Commission
might permissibly define the rate base on which the company’s return would
be computed because the end result reached by the FPC in this case was
neither unjust nor unreasonable from the investor’s viewpoint, and "it is

the result reached, not the method employed which is controlling. "86

It was in Wisconsin v. Fpc8? that the Supreme Court first applied the

85 320 U.s. 591,
86 =-Id. at 602.

87 373 U.s8. 294,

- 38 -


Section I

In a recent paper, Haring and Kwerel have proposed that the Federal
Communications Commission ("Commission") replace rate of return regulation
of AT&T with a system of price caps on a limited set of “core” services.1
Under this proposal, the Commission would not only abandon rate of return
regulation as the touchstone for determining whether AT&T’s interstate
earnings overall were reasonable, but also no longer require
service-by-service analysis of costs for determining whether individual
rates were lawful. It would replace traditional cost-of-service tariff
reviews with the "core" concept, directly regulating rate levels for some
services, and indirectly regulating these levels for others. It would

prescribe no explicit cap on overall earnings, however.

This proposal raises several legal issues, which this paper addresses.

The two principal questions that must be answered in the affirmative
for this or a similar proposal to withstand legal scrutiny are:

l. whether, consistent with its obligations under the

Communications Act of 1934, as amended, the Commission may

"abandon" rate-of-return regulation for AT&T; and

1 J. Haring and E. Kwerel, Competition Policy in the Post-Equal Access
Market, OPP Working Paper # 22 (1987)(hereinafter "Competition Policy").


that they assert will protect consumers fully, but at lower costs to society
than the current regulatory scheme. The following subsection presents a

legal analysis of their proposal.

B. The Haring-Kwere! Proposal.

The Haring-Kwerel proposal is simply described.68 It calls for
setting a price ceiling for each of a small set of “core services." Each
ceiling price would be uniform nationwide. Among the core services would be
at least one close substitute for each service over which AT&T has
non-trivial market power. The rate for each core service would be capped
initially at the tariffed rate in effect immediately prior to the
introduction of their plan. The cap would be adjusted to reflect changes
in access charges. The cap might also be adjusted to reflect changes in the
purchasing power of money as well as the rate of long-term productivity
growth in the telecommunications industry. AT&T would be allowed to set
the price of non~core services as it chose, subject to continuation of the
current nationwide averaging requirements. It would also be permitted to

offer any new service without prior FCC tariff review.

68 See Competition Policy at 27-28.

-31-


B. Judicial Standards Governing Regulatory Reform.

A decision to replace rate-of-return regulation of AT&T with some other
form of regulatory control would almost certainly trigger judicial review.
Thus in order to avoid creating unnecessary uncertainty in the
telecommunications industry, it is important to determine whether
there is legal precedent to support such a decision. Thus examination of
judicial opinions reviewing efforts of other federal regulatory agencies to
relax their regulation of industries within their jurisdiction becomes
essential in making this assessment because these opinions articulate the
standards that appellate courts would apply in judging the legality of an

FCC decision to replace rate-of-return regulation for AT&T.

In reviewing an agency’s decision to change its policies and
procedures, the courts appear to apply a two-pronged test. First a court
will look to see whether the Commission’s decisionmaking is reasoned in

light of the record.33 The courts recognize, however, that “the

33 Elaborating on this standard, the Supreme Court explained, “Normally,
an agency rule would be arbitrary and capricious if the agency has relied
on factors which Congress has not intended it to consider, entirely failed
to consider an important aspect of the problem, offered an explanation for
its decision that runs counter to the evidence before the agency, or is 80
implausible that it could not be ascribed to a difference in view or the
product of agency expertise." Motor Vehicles Mfrs. Ass‘n v. State Farm Mut.
Auto. Ins. Cos, 463 U.S. 29, 43 (1983).

-l7-


As noted earlier, the Commission’s mandate is exceptionally broad, 50
and the standards by which its actions are judged are equally expansive.)
Relevant case law strongly suggests that, while not unbounded, the FCC’s
statutory authority would certainly permit it to replace rate-of-return
regulation for AT&T with some less onerous form of regulatory oversight in

the face of an. increasingly competitive interstate services market.°2

Section III focusea upon one specific form of less onerous regulation,
the Haring-Kwerel proposal, and discusses why under current circumstances
this proposal would be a legally acceptable substitute for rate-of-return

regulation.

50 See n. 17 and accompanying text supra.

51 See Advanced Micro Devices v. CAB, 742 F. 2d at 1541; American
Tel. & Tel. Co. v. FCC, 572 F. 2d at 25.

52 See cases discussed at 18-20 supra , American Tel. & Tel. Co, v.
FCC, 572 F. 2d at 25.

- 23 -


statutes.36 Because the statutory boundaries on an agency’s discretion
determine in large measure the extent to which that agency can modify its
form of regulation, whether an agency operates under a "public interest"
standard or some more narrow, less flexible standard becomes especially
significant .37 The degree of freedom or flexibility accorded an agency
seeking to change its regulatory direction appears to be closely tied to
the breadth of its legislative mandate and the standards governing its
execution of that mandate. For this reason, if an agency with a statutory
mandate more narrow than that of the FCC had received judicial approval of
its efforts to lighten regulation for at least some segments of the
industries it regulated, this would seem to augur well for similar FCC

efforts. The Federal Power Commission appears to have been such an agency.

The Natural Gas Act, which created the FPC, seems to have vested far

less regulatory discretion in that agency than the Communications Act places

36 Farmers Union Cent. Exchange, Inc. v. FERC, 734F. 2¢ at 1510. The
Supreme Court, and following in its footsteps, the federal courts of appeal
have upheld regulatory ratesetting approaches that would substitute reliance
on market forces for some degree of (but not total) regulatory control.
See, e.g. FPC v. Texaco, 417 U.S. 380 (1974); Permian Basin Area Rate Cases,
390 U.S. 747 (1968); Advanced Micro Devices v. CAB, 742 F.2d 1520 (D.C.
Cir. 1984). Compare these cases with Farmers Union Cent. Exchange, Inc. v.
FERC, 734 F.2d at 1510.

37 See Advanced Micro Devices v. CAB, 742 F.2d at 1541.

-19-


The proposal might at first blush apppear to be a radical departure
from current Commission Practice. It can, however, reasonably be viewed as
the next logical step in a regulatory process that since divestiture, and
arguably even before that event, 69 has reflected the Commission’s
recognition that the changing face of the interstate telecommunications
industry requires a creative and flexible approach if it is to fulfill its

statutory mandate.

In a series of decisions predating divestiture, the Commission has

relaxed the conditions under which AT&T may enter and participate in

69 In decisions antedating divestiture by several years, the Commission
consistently revealed an intent to impose only the minimun regulation
required to assure the public just and reasonable rates. See Policy and
Rules Concerning Rates for Competitive Common Carrier Services and
Facilities Authorization Therefor, Notice of Inquiry and Proposed
Rulemaking, CC Docket No. 79-252, 77 FCC 2d 308 (1979); First Report and
Order (First Report), 85 FCC 2d 1 (1980); Further Notice of Proposed
Rulemaking, 84 FCC 2d 445 (1981); Second Report and Order, 91 FCC 2d 59
(1982), recon, denied, 93 FCC 24 54 (1983); Second Further Notice of
Proposed Rulemaking, 47 Fed. Reg. 17308 (1982); Third Report and Order, 48
Fed. Reg. 46791 (1983); Third Further Notice of Proposed Rulemaking, 47 Fed.
Reg. 28292 (1983); Fourth Report and Order, 95 FCC 2d 554 (1983); Fourth
Further Notice of Proposed Rulemaking, 49 Fed. Reg. 11856 (1984); Fifth
Report and Order, 98 FCC 2d 1191 (1985); Sixth Report and Order, 99 FCC 2d
1929 (1985), evd and remanded sub nom. MCI Teleconmunications Corp. v.
FCC, 765 F. 2d 1186 (1985

-32-


allowed rate of return for AT&T’s interstate service offerings. 27 Noting

that the Communications Act had set no specific standard for computing a

27 American Tel. & Tel. Co., Docket No. 16258, 9 FCC 2d 30 (1967). Since
that time the Commission has acted on four occasions to represcribe the rate
of return for AT&T“s interstate operations. See American Tel. & Tel. Co.,
Docket No. 19129, 38 FCC 2d 213 (1972), aff“d sub nom. Nader v. FCC, 520
F2d 183; American Tel. & Tel. Co., Docket No. 20376, 57 FCC 2d 960 (1976);
American Tel. & Tel. Co., 86 FCC 2d 221, recon. denied, 87 FCC 2d 34 (1981),
aff“d sub nom. United States v. FCC, 707 F.2d 610 (D.C. Cir. 1983);
Authorized Rates of Return for the Interstate Services of AT&T
Communications and Exchange Telephone Carriers, CC Docket No. 84-800, Phase
IIL, FCC 86-354, released August 25, 1986. In other phases of Docket No.
84-800, the Commission codified the procedures and methodologies to be used
in its future proceedings to represcribe rates of return for both AT&T’s
interstate services and the interstate access services of local exchange
carriers (Phase II) and enforcement mechanisms for handling overearnings
(Phase I). Authorized Rates of Return for the Interstate Services of AT&T
Communications and Exchange Telephone Carriers, CC Docket No. 84-800, Phase
1,50 Fed. Reg. 41350 (October 10, 1985), recon., 51 Fed. Reg. 1103 (April 1,
1986); Authorized Rates of Return for the Interstate Services of AT&T
Communications and Exchange Carriers, CC Docket No. 84-800, Phase II, FCC
85-645, released December 20, 1985, modified on recon., 104 FCC 2d 1404
(1986). With its codified procedures, the Commission intends to hold
biennial proceedings to represcribe these rates of return.

-14-


regulating AT&T, the ICC never investigated the reasonableness of AT&T’s

long distance rates and earnings nor did it ever order any changes to them.10

In 1934, at the suggestion of President Roosevelt,11 Congress passed
the Communications Act of 1934.12 As the President had recommended, the
Act consolidated in a single independent agency, the Federal Communications
Commission, responsibility and authority to regulate all facets of
interstate telecommunications Previously scattered among the ICC, the
Federal Radio Commission, and the Postmaster General.13 Section 1 of the
Act created the Commission " [flor the Purpose of regulating interstate
and foreign commerce in communication by wire and radio so as to make
available so far as possible, to all the people of the United States a

rapid, efficient, Nation-wide ... wire and radio communication service with

10 G. Brock, n.9 supra, at 159.

11 Message to Congress, Feb. 26, 1934, Feprinted in H.R. Rep. No.1850,
73d Cong., 2d Sess. 1-2 (1934).

12 47 U.S.C. Section 151 et Seq.

13° The legislative history of the Act would suggest that this
consolidation, rather than any great desire to increase agency power to
regulate, was the primary motive of Congress in enacting this legislation.
See H.R. Rep. 1850, 73d Cong., 2d Sess. 3 (1934); Loeb, n.5 supra, at n.128
and accompanying text. The Act, however, not only achieved the desired
consolidation, but also substantially increased the powers of the agency
regulating the telecommunications industry. See n. 15, infra.


In their paper Haring and Kwerel identify the significant costs that
rate-of-return regulation imposes. While describing in some detail the
direct and opportunity costs associated with administering this form of

regulation,63 they focus their remarks upon the economic losses that rate-of

1985); SouthernTel of Virginia, 62 P.U.R. 4th 245 (Va. State Corp. Comm’n
1984). Through legislation enacted last spring, effective January 1, 1987,
Nebraska deregulated interLATA toll service, while banning interLATA rate

deaveraging until September, 1991. See NTIA Report at 33.

63 See Competition Policy at 5-7.

- 29 -


their second full revision, as called for under FCC rules.55 AT&T’s market
share has also declined significantly in this Period, and its share of

“productive Capacity" is declining even more rapidly 56

Significant facilities-based competition, Particularly in intrastate
markets, ig definitely a post-divestiture phenomenon. Thirty-six of the

thirty~eight multi~LATA states have now authorized such competition;57

55 See 47 C.F.R. Section 69.3. The MFJ required that the division of
revenues mechanism through which AT&T compensated the BOCs for their
Provision of origination and termination of interstate traffic be replaced
with a system of non~discriminatory access tariffs through which the BOCs
would receive compensation from all the interexchange carriers using their
facilities to originate or terminate interLATA traffic. 552 F. Supp. at
233-34, Subsequently in December, 1982, and as a consequence of its
investigation into the appropriate market structure for the MTS and WATS
market the FCC imposed access charges as the industry-wide mechanism for
compensating exchange carriers Providing facilities to originate and
terminate interstate traffic. See MTS and WATS Market Structure, CC Docket
No. 78-72, Phase I, 93 FCC 2d 241, modified on reconsideration, 97 FCC 2d
682 (1983), modified on further Eeconsideration, 97 FCC 24 834, aff'd in
Rertinent part sub nom, Net‘l Ass‘n of Util. Comm’rs v. FCC, 737
R- 2d 1095 (D.C. Cir.), cert. denied, 469 U.S. 1227 (1984), modified on
further Eeconsideration, 99 FCC 24 708 (1984), modified on further
Feconsideration, 101 FCC 24 1222 (1985), appeal Bending sub nom, U.S.
Teli v. FCC, Nos. 84-1115, 85-1386 (D. « Cir., filed March 23, 1984 and

June 24, 1985), afta on further Teconsideration, 102 FCC 2d 849 (1985).
56 See Competition Policy at 14-20,

57 See National Telecommunications and Information Administration,
Telephone Competition and Deregulation: A Survey of the States at 6 (1986)
(hereinafter cited as "NTIA Report"]. Idaho and North Dakota are the two
multi-LATA states yet to authorize facilities-based competition. While
Idaho is currently examining this issue, AT&T’s competitors have not sought
to enter North Dakota‘’s interLATA market. id.

~ 2% -


describes the criteria that Title II of the Communications Act would require
any scheme for regulating common carriers to satisfy and explains how the
Haring-Kwerel proposal meets these requirements. Section IV contains a
brief summary of the conclusions reached in the preceding two sections,
conclusions that support, if not compel, reexamination of how the Commission

regulates AT&T.

Section II
A. Federal Regulation of the Telecommunications Industry (1910-1986).

The Federal Communications Commission has a statutory responsibility to
ensure that AT&T’s rates are just, reasonable and nondiscriminatory .3>
Currently the Commission attempts to meet this responsibility by assuring
that AT&T’s interstate services” rates are set overall at levels that will
cover AT&T’s cost of service, including the cost of raising capital. Before

. the Commission considers turning to any alternative form of regulation, a
preliminary question that must first be answered is whether the Commission
is under any legal compulsion to use rate of return regulation. To answer

this question, one must look to the Communications Act of 1934, as amended,

3 MCI Telecommunications Corp. v. FCC, ree F. 2d 1186 (D.C. Cir. 1985)
(quoting American Tel. and Tel, Co. v. » 572 F. 2d 17, 25 (2d Cir.),
cert. denied, 439 U.S. 875 TGo7a)s N Nader oe: om 520 F. 2d at 201.



2. whether the alternative form of regulation proposed by Haring

and Kwerel complies with the requirements of Title II of the

Communications Act and relevant case law.
A review of relevant administrative and case law reveals legal precedent
to support a Commission decision to replace its current Tate-of-return
regulation of AT&T with the "core" Proposal developed by Haring and
Kwerel.2 The remaining pages of this Paper set forth that precedent and
show how it would Support such action. Section II reviews the case law
and other factors that Support a conclusion that the Commission is under no
statutory obligation to impose rate-of-return regulation upon AT&T, and may,
with the Proper attention paid to procedural requirements, replace this form
of regulation with one less onerous. Section III of the paper contains a
discussion of whether relevant Commission and court decisions would permit

a regulatory scheme such as Haring and Kwerel Propose. That Section also

2 The term “rate-of-return regulation", as used in this paper, describes
4 pervasive form of regulation designed to control not only the level of
the regulated firm’s Profits, but also the contribution each of its services
may make to those profits. Under rate-of-return regulation (also called
cost-of service regulation) the Commission not only to determines AT&T’s
allowable rate of return, but also determines whether: 1) the utility’s

properly reflected in the rate calculations; and 4) the rates Proposed or in
effect actually cover these costs and produce a fair rate of return. Nader
v. FOC, 520 F. 2d 182, 204 (D.C. Cir. 1975). Through the tariff review
Process, the Commission controls the extent to which rates for a specific
AT&T service may contribute to meeting AT&T“s total interstate costs.


rate of return,28 the Commission found its standard for judging the
reasonableness of a rate of return to lie in the statutory standard of
Section 201(b) calling for "just and reasonable" charges and in the stated
purpose of the Communications Act, found in Section l, that there be
“adequate facilities at reasonable rates."29 That first rate of return
prescription was followed in 1970 by rules requiring AT&T to submit
substantially more economic data as cost support for its tariff filings ,30
and finally in 1981 by the Interim Cost Allocation Manual, which still
governs how AT&T must allocate costs among its interstate MTS, WATS, and

private line services categories.31

Thus examination of the Communications Act and its legislative history

reveals no statutory obligation to use rate-of-return regulation to achieve

28 American Tel. & Tel. Co., 9 FCC 2d at 52.

29° Id.
30 Tariffs - Evidence, 25 FCC 2d 957, recon. denied, 40 FCC 2d 149
(1970). Among the rules adopted in this proceeding were Section 61.38, 47
C.F.R. Section 61.38, which imposed the cost support requirements with which
any AT&T tariff filing must now comply, and Section 61.69, 47 C.F.R.
Section 61.69, which made failure to comply with the provisions of Part 61
grounds for rejection of a tariff filing.

31 American Tel. & Tel..Co., CC Docket No. 79-245, 84 FCC 2d 384, recon.,

86 FCC 2d 677 (1981), aff“d sub nom. MCI Telecommynications Corp. v. FCC,
675 F. 2d 408 (D.C. Cir. 1982), modified, 94 FCC 2d 1118 (1983).

-15-


Whether its other responsibilities diverted its attention from the
telecommunications industry’ or its powers were inadequate to make it an
effective regulator,® the record shows that the ICC was less than a
vigorous regulator of interstate telephone service .? In particular,

during the entire twenty-five year period that it had responsibility for

7 See Interdepartmental Committee Study of Communications (Roper Report),
73d Cong., 2d Sess. 6 (Sen. Comm. Print 1934); Loeb, n.5 supra, at 17.

8 See Loeb, n.5 supra, at 17. Loeb asserts that the ICC could neither
initiate actions against telephone and telegraph companies on its own nor
prescribe rates to replace rates it found unjust or unreasonable. Id.

9 The consensus , in fact, seems to be that ICC regulation of the
industry was at best nominal. See S. Rep. No.781, 73d Cong., 2d Sess. 2
(1934); Loeb, n.5 supra, at nn. 82 & 83 and accompanying text; G. Brock,
The Telecommunications Industry: The Dynamics of Market Structure 159-60
(1981). The ICC’s most lasting contribution to telecommunications
regulation seems to have been its prescription of a uniform system of
accounts for telephone and telegraph companies, which the FCC subsequently
adopted and the Supreme Court upheld in American Tel. and Tel. Co. v.
United States , 299 U.S. 232 (1936). Only recently did the Commission vote
to replace this system with a new system of accounts which it expects will
better suit today’s regulatory environment. See Revision of the Uniform
System of Accounts and Financial Reporting Requirements, CC Docket No.
78-196, FCC 86-221, released May 15, 1986. Ironically, even the ICC’s
uniform system of accounts may not have been its own work product but rather
an adaptation of an 1894 Bell System accounting circular. See Nelson,
Development of the Domestic Communications Industry: Evolution of Its
Structure in Consideration of Technological, Political and Economic
Influence, 28 Fed. Com. B.J. 118, 121 (1975).



gas producers and to substitute in its stead area ratemaking. Then in the
Permian Basin Area Rate Cases,42 the Supreme Court approved the FPC’s
implementation of that decision through a two-tiered rate structure for
setting maximum just and reasonable rates for gas produced in the Basin.
To derive a maximum charge for “new gas-well gas" produced in the Permian
Basin the FPC had relied upon composite cost data intended to reflect the
national average costs in 1960 of finding and producing gas-well gas. The
maximum just and reasonable rate for all other gas produced in the Basin was
derived from cost data intended to show the average historical cost of
gas-well gas produced in the Basin. Noting that this two-tier approach
would both provide an incentive for exploration, thus protecting the
interests of future consumers, and a shield against excessive profits, thus
protecting the interests of current consumers, the Court held that this
departure from rate-of-return regulation still led to just and reasonable
rates because it would "effectively serve the regulatory purpose

contemplated by Congress. "43

Subsequently, in FPC v. Tex. »44 the Supreme Court held that the

Federal Power Commission could, consistent with the Natural Gas Act, “engage

42 390 U.S. 747 (1968).
43 Id. at 797-98, 800.

44 417 U.S. 380.

-21-




considered to be the minimal non~confiscatory rates, the Supreme Court
indicated. that to avoid being found confiscatory, rates had to be set high
enough to enable a regulated Company to meet its operating expenses and its
capital costs, ice., at levels developed by traditional cost~of~service

ratemaking principles, 101

The cases discussed above establish that the zone of reasonbleness is
“bounded at (the lover) end by investor interest against confiscation and
at {the upper] end by the consumer interest against exorbitant rates,"102
An agency may Prescribe any Fratemaking methodology it pleases as long as
“the methodology result(s] in « reasonable balance between consumer and
investor interests,” that is, the resulting rates fall within that zone of

reasonableness, 103

The issue discussed in this section is whether the Haring~Kwerel
Proposal would result in lawful rates, that is, rates falling within that
zone of reasonableness. To anever that question it is necessary to examine

the proposal to see whether it contains mechanisms either capable of driving

101-320 U.S. at 603.

102 Jersey Centya) Power & Light v. FERC, 768 F, 2d 1500, 1503 (1985)
(citing Mashington Gas Light Co. v. Baker, 188 F, 24 1l, 15 @.c. Cir,
1950), cert. denied, 320 ¥.8. 952 (1951).)

103 Id. at 1504.

~ 64 =


transportation common carriers.15 Ip contrast, Section 1 of the Act is “not
derived from, or even foreshadowed by the [earlier] communications
amendments to the Commerce Act or the overall railroad regulation scheme

to which the amendments were appended."16 Lacking virtually any

15 The result is an agency with substantially more power to achieve its
statutory mandate than the ICC ever held over the providers of
telecommunications services. For example, Section 203 of the
Communications Act, an adaptation of Section 15(7) of the Interstate
Commerce Act, required telecommunications common carriers to file tariffs
with the Commission for all their interstate services. Section 15(7) of
the Interstate Commerce Act had applied only to transportation common
carriers. Section 204 of the Communications Act authorized the Commission
to use the tariff filings to investigate proposed rates, either at the
request of a user or on its own motion, and to suspend proposed rates
pending such investigation. This section was also adapted from Section
15(7) of the Interstate Commerce Act, which had given the ICC such
investigative and suspension Powers over the railroads, but not the
telephone companies. For a more detailed comparison of the provisions of
the Interstate Commerce Act and the Communications Act, see Hearings on 8,
2190 Before the Senate Comm. on Interstate Commerce, 73d Cong., 2d Sess.
200-13 (1934). This incorporation becomes significant when it is necessary
to construe such statutorily undefined terms as “just and reasonable." See
Hearings on H.R. 8301 Before the House Comm. on Interstate and Foreign
Commerce, 73d Cong., 2d Sess. 15 (1934).

16 Loeb, n.5 supra, at 21.


adequate facilities at reasonable charges..." and charged it with
“execut{ing] and enforcling] the provisions of the Act." 47 U.S.C. Section

151. Title Il of the Act sets forth the specific provisions relating to

regulation of communications common carriers.14

Title Il of the Act borrows heavily from the regulatory provisions of
the Interstate Commerce Act in effect in 1934, Title LI incorporates not
only the portions of the latter that had explicitly governed telephone and

telegraph companies, but also parts that had applied only to regulation of

14 Title II requires interstate common carriers to "furnish [their]
services upon reasonable request" (47 U.S.C. Section 201(a)) and to make
“all charges, practices, classifications and regulations for [those]
services ... just and reasonable." (47 U.S.C. Section 201(b)). They must
also establish physical interconnection with other carriers whenever the
Commission finds, after opportunity for hearing, that such interconnect ion
is in the public interest. (47 U.S.C. Section 201(a)). Title II makes
unlawful any unjust or unreasonable discrimination or unjust preference in
charges, practices, classifications, regulations, facilities or services
related to like communications. (47 U.S.C. Section 202(a)), Each carrier
must file with the Commission a tariff showing the rates, terms and
conditions for each of its interstate services before offering that service
(47 U.S.C. Section 203), see MCI Telecommynications Corp. v. FCC, 765 F.2d
1186, as well as copies of all contracts with other carriers relating to
traffic covered by the Act. (47 U.S.C. Section 211). Section 214, 47 U.S.C.
Section 214, prohibits a carrier from offering new or additional service
until the Commission has found that service to be in the public convenience
and necessity; it also prohibits a carrier from discontinuing a service
before the Commission determines that "neither present nor future public
convenience or necessity will be adversely affected by its discontinuance."


reasonableness.“"92 thus the touchstone for determining whether rates are
“just and reasonable" is whether they fall within a “zone of
reasonableness," not whether they were computed by using a specific

methodology or may produce a certain average rate of return .

Tn the Hugoton~Anadarko Ares Rate Case,93 4 federal appellate court

discussed the significance of rate of return as a factor in determining
whether rates calculsted using non-cost based vatemaking principles are just
and reasonable. In that Post Permian Basin decision, the ninth circuit
examined an FPC order setting rates for natural as produced in the
Rugoton-Anadarko Seographic area based upon an industry settlement Proposal
to which consumer interests had not agreed. Consumer interests then
appealed the decision because the FPC had failed to make a finding as to
the overall rate of return that would result from rates prescribed under the
terms of the settlement. They asserted that without knowing the appropriate
rate of return, it would be virtually impossible to decide whether the rates
fell above the zone of reasonableness. The court observed, however, that
once the FPC departed from individual cost-of-service ratemaking Principles,

the precision and objectivity which a rate-of-return determination appears

92 Id. at 519.
93 466 F. 2d 974 (9th Gir. 1972).


no longer the capital intensive operation it was prior to divestiture. This
means that allowed earnings on investment comprise a significantly smaller
component of its revenue requirement and consequently have much less effect
on service rate levels than they did before divestiture. Small shifts in
revenues, however, can translate into dramatic shifts in earnings. Under
these circumstances, making efforts to control AT&T’s level of Profits the
principal focus of regulatory energy compels a commitment of substantial
administrative resources to a regulatory exercise with relatively
insignificant impact on the charges ratepayers pay. Sharing this opinion,
the California Public Service Commission intends to consider in its next
general rate proceeding involving AT&T new Proposals for determining whether
AT&T’s intrastate earnings are reasonable.61 Based upon their assessment
of current circumstances in their intrastate markets, ten other states have
already abandoned rate-of-return regulation for AT&T operations within their

state boundaries.62

61 See Pacific Telephone and Telegraph Co., 66 P.U.R. 4th 104, 109 (Cal.
Pub. Util. Comm‘n 1985),

62 See Interexchange Telephone Carrier Regulation and Proposed Rulemaking,
Docket No. 3522-0 (Ga. Pub. Serv. Comm'n Jan. 8, 1986); AT&T gos icat i

of Illinois, Inc., 86-0003 (111. Commerce Comm’n April 23, 1986); and
Sharges of AT&T ‘Communications of Maryland, Inc., Case No. 7941 (fd. Pub.
Serv. Comm'n Sept. 17, 1986); Adoption of Administrative Rules relating to
the Provision of Telecommunications Seryices, AR 131 (Or. Pub. “Util.
Comm’r Nov. 14, 1986); MCI ZTelecommupications Corp., 75 P.U.R. 4th 487 (W.

Va. Pub. Serv. Comm‘n 1986); AT&T Communications of Nevada, Inc., Docket
No. 84-758 (Nev. Pub. Serv. Comm’n April 15, 1985); Regulation of
intrastate InterLATA Garriers, Cause No. 29217 (Okla. Corp. Comm’n July 24,
1985); Intrastate Access Charges, 69 P.U.R. 4th 69 (Pa. Pub. Util. Commn

- 28 -


rates into that zone or of detecting and correcting for the failure of

market forces to achieve this result.104

Under the Haring-Kwerel proposal the Commission would designate certain
services as “core services," and would set the maximum charges, or "caps,"
for each service so designated. Initially the cap for each would be set at
the current tariffed rate. The Commission would probably have to make
a specific finding that these rates were just and reasonable.105 since they
are presumably based on costs, and few, if any, rates become effective
under the current regulatory scheme without close scrutiny by competitors
and the Commission to assure their being cost-based, and therefore just and
reasonable, it should be possible to make this finding without much
difficulty. Once the initial rates were certified as just and reasonable,
the Commission would attach a presumption of lawfulness to rates for core
services as long as they did not exceed these caps. The caps could
periodically be adjusted to reflect : (1) changes in access costs; (2)
inflation; and (3) projected trende in industry productivity. While clearly
a departure from traditonal rate-of-return regulation, this methodology

still ties the lawfulness of rates to costs, at least on an industry-wide

104 See Farmers Union Central Exchange v. FERC, 734 F.2d at 1509, and
discussion supra at p. 19.
105 See Advanced Micro Devices v- CAB, 742 F.2d at 1540.

~ 45 -


almost half of these states had never granted certificates of public
convenience and necessity to AT&T’s facilities-based competitors before
mid-1984. Since that time, however, AT&T’s control of intrastate

interLATA9§ service markets has undergone a marked decline. 59

All the factors discussed above have acted to erode AT&T’s market
power ,©0 and swith it, the concerns that led the Commission to select rate of
return regulation as its tool for achieving just and reasonable rates.
Divestiture-related changes in AT&T’s corporate structure have also made

this form of regulation increasingly ineffective. The restructured AT&T is

58 LATAs, or Local Access and Transport Areas, are a creation of the MFJ.
To effectuate the MFJ requirement that BOCs provide only exchange and
exchange access services, the territories they serve were subdivided into
164 LATAs. See generally United States v- Western Electric Co.,
569 F. Supp. 990 (D. D.C. 1982). The BOCs may provide exchange and
exchange access services within these LATAs; with only two exceptions, in
the absence of a waiver of the MFJ, they may not carry telephone calls
beyond LATA boundaries.

59 See, e.g+, MCI Telecommunications Corporation, 75 P.U.R. 4th 487, 494
(W. Va. Pub. Serv. Comm’n 1986); Interexchange Telephone Carrier Regulation
and Proposed Rulemaking, Docket No. 3522-U, slip op. at 7-8 “Bae Pub. Serv.
Comm’n Jan. 8, 1986); AT&T Communications of Nevada, Inc,, Docket No.
84-758, slip op. at 13-15 (Nev. Pub Serv. Comm’n April 15, 1985);
‘el of Virginia, 62 P.U.R. 4th 245, 255-56 (Va. State Corp. Commn

1984).

60 Even AT&T’s competitors in the interexchange services market would
concede that AT&T’s market power had declined markedly in the past three
years. See, e.g., MCI’s Petition for Reconsideration at 6, Authorized Rate
of Return for the Interstate Services of AT&T Communications and Exchange
Telephone Companies, CC Docket No. 84-800, Phase III (filed Oct. 17, 1986).

-27-


47 U.S.C. Section 151 £t seq., and its legislative history. Because that
legislative history is so scant, it is also necessary to examine whether the
agencies charged with responsibility for regulating interstate
telecommunications services have in the past interpreted their statutory

mandate as requiring cost of service regulation.4

Federal regulation of interstate communications began in 1910,5 when
the Mann-Elkins Act6 placed interstate telephone and telegraph services
under the supervision of the Interstate Commerce Commission. The Act
empowered the ICC to investigate rate complaints and, upon reaching a
conclusion that rates were "unjust" or “unreasonable," to declare

those rates unlawful.

4 See FOC v. Midvest Video Corp., 440 U.S. 689, 696, 708 (1979);

Philadelphia Television Broadcasting Co. v. FCC, 359 F. 2d 282, 284 (D.C.
Cir. 1966).

5 But see Loeb, The Communications Act Policy Toward Competition: A
Eailure to Communicate, 1978 Duke L.J. 1 (1978) . Loeb asserts that
through its judiciary, the federal government was, in fact, already "engaged
in a roundabout form of regulation” through aggressive application of the
fourteenth amendment’s "due Process" clause to state rate-setting bodies.
id. at n.17; see, e.g., Smyth v. Ames, 169 U.S. 466, modified, 171 U.S. 361
(1898) (setting the standard for reasonableness against which state
ratemaking decisions were measured until it was altered by FPC v. Hope
Natural Gas Co., 320 U.S. 591 (1944) ),

6 Commerce Court (Mann~Elkins) Act, Pub. L. No. 218, ch. 309, Section 7,
36 Stat. 544 (1910) (amending the Interstate Commerce Act of 1887, ch. 104,
Section 1, 24 Stat. 379 (1887)) (provisions relating to telegraph,
telephone, and cable companies repealed 1934),


reevaluation of extant Policy is not, standing alone, an indicator of
arbitrariness or Caprice; to the contrary, it can be evidence of reasoned
decisionmaking .... The key is whether the agency [is] changling] its
policy only after reasoned consideration of relevant factors."34 Section
ILI, infra, discusses the sort of relevant factors that a court might expect
the Commission to weigh in deciding whether to replace its current method of

rate regulation with another approach.

The second question the courts ask when reviewing a change in
regulatory policies is whether the revised policies are consistent with the
congressional mandate from which the agency derives its authority.35 1f an
agency can show that under current circumstances the goals and purposes of
its governing statutes can be accomplished through substantially less
regulatory oversight, then the courts will find justified its decision to

move from heavy to lighthanded regulation within the boundaries of those

34 Western Union Intern‘] v. FCC, No. 84-1202, slip op. at 24 (D.C. Cir.
October 31, 1986) (citations omitted); accord, Drummond Coal Co. v. Hodel,

610 F. Supp. 1489, 1502, 1504 (D. D.c. 1985),

35 | Farmers Union Gent. Exchange, Inc. v. FERC, 734 F. 2d 1486, 1500 (D.C.
Cir.), cert. denied sub nom, Williams Pipeline Co. v. Farmers Union Cent.

Exchange, Inc., 469 U.S. 1034 (1984).

- 18 -


to forsake, at least in this limited case, the traditional regulatory
response to such doubts, an investigation of the tariff before it can become
effective. Instead the Bureau chose to rely on accounting and reporting
requirements to monitor directly the actual demand, costs and revenues
associated with the services, and, indirectly, the justness and
reasonableness of the rates for these services.// In a rulemaking
proceeding begun subsequent to this decision, the Commission has proposed to
apply this regulatory approach more generally to services for which ql)
AT&T’s market share is not significant and (2) ease of entry into that

service market is an established fact 78

Segmenting AT&T’s services into two categories, those subject to
traditional rate of return regulation and those subject to some form of
streamlined regulation in which post hoc reporting and accounting
requirements replace Part 61 and Part 65 requirements, may be a reasonable
reaction to the uneven development of competition in the interstate markets

AT&T serves, but it compounds the difficulties and costs the Commission will

77 See AT&T Communications, Inc. Tariff F.C.C. No. 7, Transmittal No.
518, Mimeo No. 4620 (released May 20, 1986) at 4-5.

78 Decreased Regulation of Certain Basic Telecommunications Services, CC

Docket No. 86-421(Notice of Proposed Rulemaking), FCC 86-548 (released Jan.
9, 1987).

~35-


have to confront if it continues to apply these rules to AT&T on either a
market or submarket basis. The bifurcated approach only enhances the need
for regulatory reform of the sort proposed by Haring and Kwerel. The
question is whether, consistent with the Communications Act and relevant
case law, the Commission can respond to that need by replacing its current
form of regulation with either the Har ing-Kwerel Proposal or some variation

on it.

GS. Statutory Goals and the Haring-Kverel Proposal.

In its ratemaking responsibilities, the Commission’s immediate goals
and purposes are simply stated. It must assure that rates for interstate
telecommunications services are just and reasonable, 79 and the rules it
adopts to achieve this result must be in the public interest .80 Examination
of federal case law governing rate regulation reveals that there is no
single method or formula that must be used to achieve just and

reasonable rates,81

79 Nader v. FCC, 520 F. 2d at 201.
80 Section 201(b), 47 U.s.c. Section 201(b); see n. 19 supra.
81 See FERC v. Penzoil Producing Lo., 439 U.S. 508, 517 (1979); Wisconsin v.

EPC, 373 U.S. at 309; FPPC v. Natural Gas Pipeline Co., 315 U.S. 315 U.S.
575, 585-86 (1942); EPG v. Hope Natural Gas Go., 320 U.S. at 600-02 .

- 36 -


create a presumption of lawfulness for any filings associated with non-core
services and any filings within the zone of reasonableness for core
services.

In summary, Haring and Kwerel offer a proposal to reduce, but not
eliminate, the regulatory role assumed by the Commission vis-a-vis AT&T.
Grounded in sound economic principles, it appears to be consistent with
legal precedent and current Commission initiatives. Adoption of
reporting requirements enabling the Commission to monitor the results of the
proposal’s introduction might satisfy any lingering doubts about the
Commission’s ability to fulfill its statutory obligations through this
proposal. Such additional safeguards could reassure a reviewing court that
the Commission was not abdieating its statutory responsibilities. They
could also enable the Commission to ascertain that the anticipated benefits
of this less onerous form of regulation were, in fact, realized. And,
should those anticipated benefits fail to appear, reporting requirements

would enable the Commission to take prompt remedial action.

-51-


Section II}

As Gurrent Circumstances

Three years have elapsed since the divestiture of AT&T’s local
operating companies, the Bell Operating Companies, or BOCs, mandated by the
terms of the consent decree terminating the government’s antitrust suit
against AT&T.53 During that time the BOCs have met the schedule set forth
in the MFJ for providing all interexchange carriers with equal access to the

local network facilities needed to originate or terminate their

53 See United States v. American Tel.& Tel.Co.(MFJ), 552 F.Supp. 131 (D.
D.C. 1982), aff’d sub nom. Maryland v. United States, 460 U.S. 1001 (1983).

- 24-


nee





that rate regulation for oil pipelines should-serve only as*a cap’ on
egregious price exploitation. 98 By FERC’s own admission the methodology was
designed to protect against only "egregious exploitation and gross abuse,”
held that rates resulting from this methodology would fall above the.zone
of reasonableness because "[rJates that ‘permit exploitation,. abuse,

overreaching or gouging are by themselves not “just and reasonable. 99

The lower bound for the zone of reasonableness had actually been set
much earlier in cases like National Gas Pipeline , in which regulated
entities complained that government prescribed rates, because they were
unconstitutionally low, were neither. just nor reasonable. In National Gds
Pipeline, the Supreme Court observed that "[bly longstanding ‘usage in the
field of rate regulation, the “lowest reasonable rate“ is one:which is not

confiscatory in the constitutional sense."100 Elaborating in Hope on what it

98 Under the FERC plen oil pipeline companies could choose from among
eight alternative measures for setting their. cost of equity .the measure most:
advantageous to them. Among the alternatives available to them were: (i)
the realized nominal rates of return on shareholders” book equity in
American industry generally over either the past year or the past five
years; (ii) the particular parent or parents” realized nominal rate of
return on total non-pipeline book equity over either the most recent fiscal
year or the past five years; and (iii) total returns (dividends plus capital
gains) on a diversified common stock portfolio over either the past five
years or "the long run -- 25 years, 50 years, or more...." Id. at 1522.

99 Id. (emphasis in text).

100 315 U.S. at 585 (citations omitted).


to give that agency’s ratemaking decision becomes somewhat illusory.94 The
court stated that while the average rate of return that may result from
rates based at least in part on non-cost factors may be a consideration
in determining their reasonableness, it is neither an indispensable nor a
controlling factor in this determination.?5 In upholding the FPC’s approval
of the proposed settlement, the court concluded that the prescribed rates”
exceeding rates based on individual cost-of-service ratemaking principles
would not necessarily make the former unjust or unreasonable, as long as
reliance on non-cost based factors, like the current economic climate,
trends in the industry and supply and demand problems, still led to

prescribed rates falling within the zone of reasonableness. 96

Without standards that enable courts and regulators to identify the
boundaries of the zone of reasonableness this touchstone would be of little
practical use. Again it is case law that provides the necessary
guidelines. In Farmers Union Gentral Exchange v- FERG, the court
summarized those guidelines:

{Aln agency may issue, and courts are without authority to

invalidate, rate orders that fall within a "zone of

94 Id. at 982.
95 Id. at 983.

96 See generally, id. at 987-89.

~41-


4(i), 47 U.S.C. Section 154(i).19 the courts have consistently interpreted
this statutory scheme as showing congressional intent to give broad
discretion to the Commission in choosing how it will regulate the
telecommunications industry .20 This sweeping mandate, broad regulatory
authority and broad discretion are essential to justifying any

substantial change to the way in which the Commission regulates AT&T.

While the Communications Act of 1934 gave the Commission expansive
powers and discretion, it also gave the Commission responsibility to ensure
that AT&T’s rates are just and reasonable.21 To meet this responsibility
the Commission now seeks to assure that AT&T’s charges for its interstate
services are set overall at levels that will cover the costs of AT&T’s

regulated interstate operations, including its cost of raising capital.

19 See Nader v. FCC, 520 F.2d at 203. Under Section 4(i), the Commission
“may perform any and all acts, make such rules and regulations, and issue
such orders, not inconsistent with [the] Act, as may be necessary in the
execution of its functions." 47 U.S.C. Section 154(i). There is also a
“mini Section 4(i) within Title II itself. The last sentence of Section
201(b) states that the Commission "may prescribe such rules and regulations
as may be necessary in the public interest to carry out the provisions of
this Act." 47 U.S.C. Section 201(b).

20 See, e.g-, Western Union Intern“] v. FCC, No. 84-1202, slip op. at
25-26 (D.C. Cir. Oct. 31, 1986); Computer & Communications Indus. Assn
v. FCC, 693 F.2d at 212 ; Ame

26; Note, Recent Federal Actions Affecting Long Distance Telecommunications:
ssues Co ig the Microwave Specialized Common Carrier
Geo. Wash L.Rev. 878, n.89 and cases cited therein (1975).

21 nited States v. FCC, 707 F.2d 610 (D.C. Cir. 1982).

-li-




Ironically it was competition that caused the Commission to turn to
the rigorous rate-of-return approach upon which it currently relies for
controlling AT&T’s rate levels and earnings .25 By the mid-sixties the
Commission had become concerned about the likelihood of AT&T’s using revenue
from its MTS and WATS monopoly services to subsidize its private line
services, for which there was at least incipient competition. 26 As an
outgrowth of this concern, in 1967, over thirty years after it was created

to regulate AT&T’s rates, the Commission for the first time prescribed an

25 D. Kelley, Deregulation after Divestiture: The Effect of AT&T Settlement
on Competition, OPP Working Paper # 8, 16-17 (1982).

26 See n. 32, infra.

-13-


Loosening the Ties That Bind:
Regulating the Interexchange Services
Market for the 1990‘s

Kathleen B. Levitz!

Office of Plans and Policy
Federal Communications Commission
Washington, D.C. 20554
February 1987

1 The opinions and conclusions expressed in this paper are those of the
author. They do not necessarily reflect the views of the Federal
Communications Commission or any of its staff other than the author. The
author appreciates the comments and suggestions of Peter Pitsch, Tom
Spavins, Ken Gordon and Evan Kwerel of the Commission’s Office of Plans and
Policy. Any errors in this paper are, however, the responsibility of the
author alone.


AT&T’s participation in the former market with less onerous non-structural

safeguards./3

The Commission has also relaxed the procedural rules governing its
review of AT&T’s tariff filings. 74 Without conceding any reduction in
the degree of power AT&T exerts in interstate service markets, the
Commission has modified its Standards for reviewing the lawfulness of both
Private line service discounts and optional MTS calling plans.75 More
recently, the Commission upheld a decision of the Common Carrier Bureau that
permitted the AT&T SKYNET Ku-band services tariff to become effective
despite the fact that the cost support data demonstrated that the services
would not become compensatory in the near future and despite doubt about

their long-term Profitability.76 the Bureau’s order reflected a decision

73 See Amendment of Section 64.702 of the Commission’s Rules and
Regulations (Third Computer Inquiry), CC Docket No. 85-229, 104 FCC 2d 958
(1986), reconsideration pending.

74 Amendments of Parts 1 and 61 of the Commission’s Rules, CC Docket No.
83-992, 98 FCC 2d 855 (1984).

75 See Private Line Rate Structure and Volume Discount Practices, 97 FCC
2d 293 (1984); Guidelines for Dominant Carriers" MTS Rates and Rate
Structure Plans, CC Docket No. 84-1235, FCC 85-540 , 50 Fed. Reg. 42, 945
(October 23, 1985), reconsideration pending.

76 See AT&T Communications: Revisions to Tariff F.C.C. No. 7 to Establish
Rates and Regulations for SKYNET Ku-Band Service, FCC 87-3, released
January 22, 1987 (Memorandum Opinion and Order denying applications for
review of Bureau Order allowing tariff revisions to become effective).

~ 34 -


in indirect regulation of small [natural gas] producers."45 The Court
concluded that, while the FPC lacked the authority to rely exclusively upon
market place forces to determine just and reasonable rates for such
Producers, or to exempt them from complying with the just and reasonable
rate standard, 46 nothing in the Act required the Commission to fix the rates

of these producers through orders directly addressed to them.47

Earmers Union Central Exchange v. FERC illustrates, however, that even

agencies with broad vatemaking authority can exceed their mandate. 48 In
that case FERC adopted a methodology for setting ceilings on profits of oil
pipeline operators that permitted a range of allowable prices that would
have been excessively high "unless competition in the oil pipeline market
drlove] the actual prices back down [to reasonable levels]. But nothing in
the regulatory scheme itself actled] as a monitor to see if this [would]
occurl] or to check rates if it [did] not."49 For this reason, the court
held the methodology to be fatally flawed and inconsistent with FERC’s

statutory mandate to assure just and reasonable rates.

45 Id. at 387.
46 Id. at 394, 400.
47 Id. at 387.

48

~

34 F, 2d 1486.
49 Id. at 1509,

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EA



basis, because the factors relied upon in adjusting the initially
cost~based caps would themselves all clearly be tied either directly to
changes in AT&T’s costs of Operation (e.g., access charges) or to
industry-wide costs (e.g. inflation and Productivity). For this reason,
this approach can fairly be compared to that approved by the courts in the

Permian Basin Area Rate Cases106 and the Hugoton-Anadarko Area Rate Case,107

The failure to set a lower bound on rates for core services may at
first appear troublesome. There are safeguards built into this ratemaking
methodology, however, that should assure that AT&T would be neither
compelled nor able to set rates below the zone of reasonableness. The
manner in which the initial core service rate caps are set assures that
these rates fall within the zone of reasonableness. The factors on which
adjustments would be based assure that the caps remain within the zone of
reasonableness. Thus the new ratemaking methodology would not compel AT&T
to set rates for core services at confiscatory levels. The cap on core
service rates should, moreover, eliminate AT&T’s incentive to price such
services below cost because it Prevents AT&T from being able to extract

long-run monopoly profits from users of an initially underpriced service.

106 = 390 U.S. 347. See discussion at pp.20-21 supra.

107 466 F. 24 974. See discussion at pp-40~41 supra.


return regulation imposes on consumers ,64 They identify three important

ways that this form of regulation reduces consumer welfare:

(1) it “significantly weakens the economic incentives for a regulated
company to minimize costs and to maximize benefits it provides the
public ;"65

(2) it “divert[s] resources away from marketplace competition to
competition within the regulatory and political arenas;"66 and,

(3) it “prevents the Commission from acquiring the information it
needs to make a reasoned determination about the long-term viability of

competition in the long-distance business. "67

Haring and Kwerel conclude that the changes to the structure of the

interexchange services market described above have made these costs

unacceptably high. They Propose an alternative method of regulating AT&T

64
65
66
67

See id. at 7-11.
Id. at 8.
id. at 10.
id. at ll.

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"no single formula" rule to uphold a regulatory commission’s decision to
set rates on industry average costs rather than‘an individual company’s
costs of service, and in the Permian Basin decision, 88 the Court upheld
the FPC’s execution of that ratemaking methodology. In the latter case,
in a further clarification of the "no single formula" rule, the Court found
that the Commission ... hald] quite appropriately incorporated in its
calculations factors other than producers” costs ....89  Pinally in Federd]
Energy Regulatory Commission v. Pennmil Producing Co.,90 the Supreme Court
rejected a lower court’s conclusion that FERC was obligated to grant
Pennzoil special relief from prescribed area’ rates because the oil company“s
royalty payments caused its profit margins to decline. Here the Court
applied the "no single formula" rule to conclude that FERC was not obligated
to adhere "rigidly to a cost-based determination of rates, much less to one
that base[s] each producer’s rates on its own costs. 91 The Court held
that, under either the Constitution or the Natural Gas Act, FERC‘s
obligation to provide rate relief would be triggered only when prescribed

rates fell to confiscatory levéls or “outside the “zone of

88 390 U.S. 747. See discussion supra at pp.20-21.
89 Id. at 814.
90 439 U.S. 508.

91 Id. at 517.

-39-


interexchange services.°4 The access tariffs that replaced the
pre-divestiture crazy quilt of compensation mechanisms, including

settlements, division of revenues, ENFIA, and FX tariffs, have undergone

54 The MFJ required that upon "bona fide request, every [BoC] end office
offer [equal] access by September 1, 1986." 552 F. Supp. at 233. It did
recognize an exception to this requirement for end offices "employing
switches technologically antecedent to electronic, stored program control
switches or those offices served by switches that characteristically serve
fewer than 10,000 access lines,"upon a showing that "the costs of conversion
for such offices outweighed the potential benefits to users." Id. While
the conversions of specific end offices required to bring them into
compliance with the terms of the MFJ is yet to be completed, as of October
1, 198, the BOCs had converted over 67 million access lines (as
distinguished from end offices) to equal access. See FCC Public News Notice
# 1290, released December 31, 1986. The court will shortly determine a
framework for defining reasonable conversion schedules for the remaining
offices. The Department of Justice has urged that most of these conversions
occur by March, 1988. See Memorandum of the United States Regarding BOC
Schedules for Equal Access (filed November 21,1986) in United States v-
Western Electric Co., Civil Action No. 82-0192 (D. D.C.) . Under the terms
of another consent decree, the General Telephone Operating Companies are
also required to offer equal access facilities under a schedule calling for
complete conversion to equal access no later than 1990. See United States
v. GTE Gorp,, 603 F. Supp. 730 (D. D.C. 1984). Materials filed with its
October 3, 1986 interstate access tariff filing indicate that by December
31, 1986, GTE will have converted 51.2% of its access lines to equal
access. See FCC Public News Notice # 1291, released December 31, 1986. In
the third phase of its access charge docket, the Commission had imposed an
equal access requirement upon the remaining local exchange carriers. MIS
and WATS Market Structure, CC Docket No. 78-72, Phase III, 100 FCC 2d 860
(1985). For a summary of the percentage of total access lines each of the
major independent telephone companies has converted in the past three years
and anticipates converting during 1987, see FCC Public News Notice # 1291.

-~25-


legislative history, this section has consistently been interpreted as
granting the Commission a “sweeping mandate." 17 To enable the Commission

to fulfill this mandate, the Communications Act provided not only specific

17 Washington Uti). and Transp. Comm‘n v. FOC, 513 F.2d 1142, 1157 (9th
Cir.), cert. denied sub nom. National Ass'n of Regulatory and Util, Comm’rs
v. FCC, 423 U.S. 836 (1975); see Loeb, n.5 supra, at 29. A corollary to the
granting of its broad mandate is the Commission’s assumption of the role of
“expert agency." The courts have consistently acknowledged that “C(t The
FCC’s judgment about the best regulatory tools to employ in a particular
situation is ... entitled to considerable deference from the generalist
judiciary." Western Union Intern“] v. FCC, No. 84-1202 , slip op. at 25
(D.C. Cir. Oct. 31, 1986) (citing Computer and Communications Indus. Assn
vy. FOC, 693 F.2d 198, 212 (D.C, Cir. 1982), cert. denied, 461 U.S. 938
(1983)); accord, Philadelphia Television Broadcasting Co. v- FCC, 359 F. 2d
at 284.


In the short run, the cap on earnings for all the core services should
effectively preclude AT&T from being able to offset revenue shortfalls from
one service with excess earnings from another core service. Efforts to
recoup earnings shortfalls from non-core services would be similarly
unsuccessful since for each non-core service there would be a close
substitute among the core services. High prices for the non-core service
would merely drive customers to the price-capped core service, if not into

the arms of AT&T’s competitors.

Admittedly, the Haring-Kwerel proposal may permit AT&T to realize
profits in excess of its cost of capital. As noted above, however, this
does not lead to a result that is necessarily unreasonable per ge.108 The
use of a factor reflecting projected trends in industry productivity to
adjust core service rate caps assures that even if market forces prove
inadequate to protect customers against “unreasonable high profits," AT&T
would still share with ratepayers the fruits of any marked increase in
efficiencies. The productivity factor could provide the necessary safeguard

against "[rlates that permit exploitation, abuse, overreaching, or gouging,

108 See discussion at pp.37-44 supra; FPC v. Natural Gas Pipeline Co., 315
U.S. at 585-86; Banton v. Belt Line Ry., 268 U.S. 413, 423-24 (1925);

Leventhal, Vitality of the Comparable Earnings Standard for Regulation of
Utilities in a Growth Economy, 74 Yale L.J. 989, 1004, 1016-17 (1965).

- 47 -


regulation found by the courts to be a legally acceptable alternative to

strict rate-of-return regulation.111

Special mention should be made of the proposal’s treatment of new
services as non-core services. Based on past experience, the Commission can
reasonably conclude that a new service, while perhaps based on a more
efficient use of existing technology or the application of a new technology,
will be evolutionary rather than revolutionary. It would therefore be
almost certain to have a close substitute already included among the core
services. Thus, like all other non-core services, the presence of its core
substitute with capped service rates would control the rate level of the new
service, albeit indirectly. If a new service should fall into the
“revolutionary” category, however, the proposal would certainly not preclude
the Commission from deciding to determine a specific just and reasonable
rate for that service or from requiring AT&T to provide cost data to aid the

Commission in this effort.

It is important to emphasize that the Haring~Kwerel proposal does not
alter or suspend AT&T’s obligation to file tariffs pursuant to Section 203

of the Communications Act, 47 U.S.C. Section 203(a). Nor does it eliminate

111 See FPC v. Texaco, 417 U.S. at 388-89; Pan American Airlines v. CAB,
392 F.2d 483, 396 (D.C. Cir. 1968).

- 49 -


With respect to specific service offerings, the Commission requires that
AT&T set the rates to recover the costs properly allocated to that service.
AT&T must supply comprehensive cost support data to establish that its
proposed rates will meet this requirement. The Commission’s reliance on
this approach to meeting its Statutory obligations is, however, a relatively
recent innovation to federal regulation of AT&T. It was not until the
mid 1960°s that the Commission determined that the rate-of-return model
would be its regulatory touchstone. 22 During the period in which AT&T’s
monopoly power was undisputed and for all practical purposes unchallenged,
the Commission did not rely upon rate of return regulation, 23 Instead
it used "continuing surveillance" to Prevent earnings of the Bell System

from reaching unreasonably high levels. 24

22 See American Tel.& Tel Co., Docket No. 11645, 34 FCC 217, 231 (1963),

aff'd sub nom. Wilson & Co, v. United States, 335 F.2d 788 (7th Cir. 1964),
sert. denied, 380 U.S. 951 (1965),

23°, See Rollo, Title II of the Communications Act, 18 Fed. Com. B.J. 37

(1963); Blachly, The Role of Smyth v. Ames jin Federal Rate Regulation, 33
Va. L.Rev. 141, 159-69 (1947),

24 In the proceeding that led to its first rate of return prescription,
the Commission described continuing surveillance as "a process by which many
previous interstate rate adjustments have been brought without formal
proceedings ... [, in which] either the Commission or [AT&T] would initiate
discussions looking toward appropriate rate changes whenever the level of
ses total interstate earnings hae appeared to warrant such action."
American Tel. & Tel. Co., Docket No. 16258, 2 PCC 2d 173, 177 (1965).
The Commission characterized continuing surveillance as an often
“effective and highly efficient method of regulation," which, under
appropriate circumstances, it intended to use again. Id. at 178.

-1l2-