3. AT&T must not enter into the electronic publish-
ing business for seven years;51

4, The local Bell operating companies must provide
equal access to all interexchange carriers;

5. The local Bell operating companies may not pro-
vide interstate LATA service;

6. The local Bell operati:

ng companies may not offer
information services;>

7. The local Bell operating companies may not
manufacture telecommunications or terminal
equipment, but may sell such equipment; and

8. The local Bell operating companies may market
the Yellow Pages.

January 1, 1984, was set as the date for divestiture.

THE STRUCTURE OF THE DIVESTED
TELECOMMUNICATIONS INDUSTRY

Five concepts are crucial to understanding the
post-divestiture telecommunications environment: (1)
the Local Access and Transport Areas or LATAs, which
delineate the boundaries between the service (or market)
areas of the local exchange and interexchange carriers; (2)
the structure of the 7 regional holding companies (re-
ferred to as Regional Bell Operating Companies or
RBOCs), which are the parents of the 22 local Bell oper-
ating companies (BOCs); (3) the system of access charges,
which replaced the process of separations and settle-
ments; (4) the threat of bypass or the avoidance of local
facilities by large users of telephone services; and (5) the
struggle to maintain the dual regulatory system. This sec-
tion describes each of the five concepts.

The Local Access and Transport Area or LATA

The fundamental building block of the post-divesti-
ture structure of the telecommunications industry is the
LATA, the geographic area within which the BOCs may
perform exchange and exchange-access functions. With-
out court approval, no LATA may cross state boundaries.
As illustrated in Figure 1, the settlement divided the
nation into more than 160 LATAs, most of which do not
cross state boundaries. According to the decree, a local
BOC may transport telephone calls only between tele-
phones located within the same LATA. A telephone call
that originates in one LATA and terminates in another is an
interexchange call and may not be completed by a BOC.53
All interexchange calls are handled by AT&T and the other
(non-Bell) common carriers (OCC).°4

The decree also ordered the BOCs to provide AT&T
and the OCCs access to subscribers within each LATA.
This directive requires the local BOCs to deliver tele-
phone traffic originating or terminating within a LATA to
or from the point of presence (POP)°> of the interex-
change carrier(s) located within the LATA. AT&T has at
least one POP in each LATA. OCCs choosing to do busi-
ness in a LATA may connect to an AT&T POP. More

12

commonly, however, OCCs establish their own POPs.
The restrictions on the activities of the BOCs arise from
their continuing status as “bottleneck” monopolies. The
decree thus defines three market areas: intrastate intra-
LATA service (handled by the local BOCs*); intrastate
interLATA service (handled by AT&T and the OCCs);
and interstate service (handled by AT&T and the OCCs).

It is important to remember that the boundary of a
LATA is not identical with that of local service areas. The
phrase “local service area” or “exchange” describes the
geographic boundaries of a local (non-toll) telephone call.
For example, single-LATA states may contain several ex-
change areas, and multi-LATA states may have one or
more exchange areas within each LATA.

The Regional Holding Companies

At divestiture, the court ordered AT&T to divide its
assets, liabilities, and employees between the BOCs and
the reorganized AT&T. According to the settlement, own-
ership of the 22 BOCs shifted from AT&T to 7 regional
holding companies, usually referred to as Regional Bell
Operating Companies or RBOCs. Figure 2 depicts the
boundaries of the RBOCs. The MFJ permitted each
RBOC to provide exchange telephone and exchange ac-
cess service through its local BOCs. In addition, each
RBOC could provide directory advertising and sales (Yel-
low Pages), new customer premise equipment, and cellu-
lar mobile telephone service. RBOCSs are prohibited from
supplying information services.57

The initial settlement document limited the RBOCs
to providing regulated monopoly services; it did not allow
the RBOCs to sell new CPE or to market the Yellow
Pages. Judge Greene amended the settlement document
to add the latter two unregulated, competitive services
after he found that to do so would serve the public inter-
est. Greene found the Yellow Pages particularly impor-
tant to the RBOCs because they

. .. provide a significant subsidy to local telephone
rates. . .. The loss of this large subsidy would have
important consequences for local telephone ser-
vice. . . . fit will] reduce the number of households
with telephones and increase the disparity, in terms
of the availability of telephone service, between
low-income and well-off citizens. This result is
clearly contrary to the goal of Providing affordable
telephone service for all Americans.>

Even at the time of the entry of the MFJ, everyone
recognized that the ban on RBOC provision of informa-
tion services was likely to dissipate over time as the border
between telecommunications and computer services be-
came more blurred.59 In 1976, in its Computer II Inquiry,
FCC had attempted to draw a line between basic services
and enhanced services. The commission had defined a ba-
sic transmission service as “the transmission of telephone
messages or the movement of information over the tele-
phone network,” and an enhanced transmission service as
one “which combines basic service with computer process-
ing applications that act on the format, content, code, pro-
tocol . . . of the subscriber’s transmitted information, or


munication services. It is not surprising therefore that the
New York Public Service Commission has taken the lead
in developing a vision of a futuristic modular network.
One of the New York Commissioners, Eli Noam, envi-
sions a “network of networks—domestic and multination-
al, hardware and software, specialized and general, pri-
vate and public.”!85 Admittedly an “untidy affair,” Noam
has named this new network “the pluralistic network.”186
Ultimately, the pluralistic network will require a modular
architectural design. The local exchange carriers will un-
bundle their services into their basic elements and allow
providers of telecommunications services to purchase
only those services that are useful to them. Further, in the
pluralistic network, service providers will be allowed to con-
nect, or collocate, their private lines and their software
packages directly into the local exchange. Three recent deci-
sions of the New York Public Service Commission illustrate
how the commission is moving to implement its vision.

In September 1988, the commission issued its “Order
Instituting Procedures for the Implementation of Open
Network Architecture.”187 The order was a response to
the Open Network Architecture (ONA) plans filed by
New York Telephone with FCC. As noted, FCC, in its
Computer III proceeding, ordered the seven RBOCs to
file ONA plans as a precondition for the removal of the
requirement that the RBOCs conduct their enhanced
service operations in a separate subsidiary. According to
the FCC order, the required ONA plans must describe
the unbundling of services useful to enhanced service
providers, as well as define the procedures for equal treat-
ment of enhanced service providers who wish to intercon-
nect to specific basic network functions. The RBOCs re-
sponded to the FCC order with an ONA model that
allowed enhanced service providers access to basic service
elements (BSEs) through access links called basic service
arrangements (BSAs). BSEs are the smallest service in-
crements offered to enhanced service providers. Exam-
ples of BSEs include custom calling features like call for-
warding. BSAs are the smallest assemblages of network
features and facilities that enhanced service providers can
purchase for access to the network. For example, a plain old
telephone service (POTS) line is a BSA.

Although the model was generally accepted by FCC,
the New York commission found that it did not go far
enough in unbundling services. According to the New
York commission, the ONA concept can work only if the
network is disaggregated into its elemental components,
thereby allowing enough flexibility to accommodate and
encourage future telecommunications advancements.
Thus, the commission ordered New York Telephone to (1)
file tariffs immediately for 19 new BSEs not included in
the FCC filing, and (2) tentative rates for an additional 21
new BSEs by December 1988.

A second commission order, issued in April 1989,
directed New York Telephone to institute an ISDN trial
on the public network. 188 Integrated Services Digital Net-
works or ISDN is a technology first developed abroad that
allows, through digital switching and a high transmission
rate, voice and data to be combined in the same telephone
line and two telephone conversations to be carried on the

33

same line. After noting that Japan, Singapore, France,
and Germany have conducted ISDN trials over the public
network for several years, the commission ordered New
York Telephone, which had delayed such trials citing con-
cern about the absence of demand for ISDN services, to
work with PSC staff to conduct trials of ISDN over the
public network, with New York ratepayers bearing a portion
of the cost of the trials. Prior to this order, New York
‘Telephone had experimented with ISDN only in connection
with the provision of services to specialized users.

The third New York commission decision, entitled
“Opinion and Order Concerning Regulatory Response to
Competition,” was issued in May 1989.189 One of the
questions before the commission in this docket was
whether Teleport, an entity created for business users
through a public/private partnership and equipped with
satellite dishes and links to the long-distance carriers,
could collocate or interconnect its fiber optic facilities
inside New York Telephone central offices in order to
duplicate the local exchange company’s ability to agere-
gate low-volume traffic. The commission ordered New
York Telephone to allow the collocation, stating that
“[a}llowing liberal interconnections with the local ex-
change network generally fosters competition and will
likely provide more effective and efficient carrier access
service.”190 By allowing collocation, the Public Service
Commission has skirted the issue of bypass of the local
exchange because specialized users will share rather than
duplicate the local exchange. The commission has not yet
come to grips with the issues of cost, however. These cost
issues are just as serious with collocation as they are with
bypass. Suggestions for solutions to the cost problem, such
as requiring a collocator to make a contribution in support
of basic services, remain vague and undeveloped.

International Competitiveness

In its ONA and collocation decisions, the New York
Public Service Commission has gone far beyond the pres-
ent stance of FCC, which has to date declined to require
unbundling of services into their most basic elements orto
compel collocation. Instead, FCC has been satisfied to
allow the market to control the development of the public
network. New York Commissioner Noam cites several
dangers of following such a laissez faire policy. First, the
delays created by waiting for the market to demand tech-
nical innovations will cause the United States to lag be-
hind foreign countries whose governments are actively
pursuing the adoption of new technologies. Second, the
countries that are in the vanguard of technological ad-
vances will set the standard for network electronic equip-
ment. To the extent that the United States is not in the
forefront of technological innovations, then, it will have
to purchase its network equipment overseas, increasing
the trade deficit19!

Other commentators have noted similar pitfalls in
the present FCC policy. In their research on the new
telecommunications revolution, Stephen Cohen and
John Zysman found that by relying on the market to drive
the development of the nation’s telecommunications in-
frastructure, the “U.S. is allowing the next generation


the public switched network at Dallas by means of its
private microwave facilities.”1®4 In contrast, the petition-
ers (State of Texas, National Association of Regulatory
Utility Commissioners, and GTE Southwest) defined the
issue as: did FCC exceed its authority when it effectively
issued a federal certificate to provide local exchange tele-
phone service, thereby preempting the Texas certification
law and the Public Utilities Commission’s order regulat-
ing local exchange service?

Although the parties differed in their description of
the legal issues, they agreed on the facts. The location of
the Texas headquarters of ARCO isin Dallas. ARCO also
has a research complex in Plano, which is approximately
19 miles from its Dallas offices. Dallas and Plano lie in
different telephone exchange areas. Dallas is served by
the Southwestern Bell Telephone Company, and Plano is
served by GIE Southwest. Each telephone company
holds a certificate of public convenience and necessity
from the Texas PUC, which authorizes the company to
serve its specifically designated area. The franchises are
exclusive; Texas does not allow competition within a single
exchange area. Telephone service at both the Dallas office
and the Plano plant is handled by ARCO’s private branch
exchange (PBX) switchboards,!6> which are connected by
trunk lines to the public switched network. Until 1982,
access to the public switched network at the Dallas PBX
was provided by Southwestern Bell, while GTE South-
west provided public network access to the PBX at the
Plano plant. Private microwave links connected calls be-
tween the two plants and within the interstate private
ARCONET system.

In 1983, ARCO sought to connect its Dallas PBX to
Southwestern Bell’s central office in Dallas via its existing
private microwave system.16° ARCO planned to have
Southwestern Bell provide access to the public switched
network for the Dallas office and the Plano plant, even
though Plano is outside the franchise area of Southwest-
ern Bell. The Texas PUC ordered Southwestern Bell to
cease and desist from providing service to the Plano plant.
The PUC had found that: (1) ARCO was one of GTE
Southwest’s largest customers, and the loss of the ARCO
business would materially diminish the revenues of GTE
Southwest; (2) GTE Southwest had invested some
$331,000 in serving ARCO’s Plano labs, and much of that
investment would be “stranded” by the loss of ARCO
business; (3) the telephone company’s planning of new facili-
ties would become less efficient and effective because of
arbitrary shifts in customer demand; and (4) Southwestern
Bell was not authorized to serve the Plano area.

ARCO petitioned FCC for emergency relief and a
declaratory ruling ordering Southwestern Bell to provide
service to Plano. In 1985, the FCC Common Carrier Bu-
reau granted ARCO’s request. In 1988, FCC denied the
applications for review of the bureau’s order submitted by
Texas and GTE Southwest,167 finding that ARCO has a
federal right to interconnect its facilities to the public
switched network in a manner that it finds “to be privately
beneficial without being publicly detrimental.”!68 The
commission interpreted the federal right of interconnec-
tion to include a right to choose the particular location

29

and thus the particular carrier for interconnection. Fur-
ther, preemption was necessary because business users
are entitled to uniform national policies regarding the use
and interconnection of their microwave systems. 1

On appeal, the petitioners acknowledged the federal
right of interconnection, but maintained that the federal
right must coexist with state regulatory policies. Accord-
ing to the petitioners, both the federal right of intercon-
nection and state regulatory policies were being served by
requiring ARCO to use GTE Southwest to provide service
to Plano.!79 In contrast, FCC’s interpretation of the federal
right was viewed as allowing large business users to circum-
vent state regulatory boundaries between local service
providers and sanctioning bypass of the authorized local
carrier. The consequent reduction in revenue may adversely
affect basic rates for small business and residential users.

The DC Circuit Court of Appeals upheld the FCC
order, admonishing the Texas PUC for its failure to seeka
middle ground. The court agreed with FCC’s depiction of
the Texas commission’s order as “drastic,” finding that “it
seems to us that, in effect, the Texas PUC threw out the
interstate baby with the intrastate bath water.”!71 The
court noted, however, that it did not accept the broad
proposition that a private microwave operator has an ab-
solute federal right of access to the public switched net-
work at locations of its choice. Despite the court’s protes-
tations to the contrary, the opinion does appear to grant
FCC very broad preemption rights in cases that the com-
mission can characterize as involving the federal right of
access to the public switched network. According to the
court, the test to be applied for affirmation of federal
preemption in such cases—the private benefit must not be
outweighed by a public detriment—is solely a federal
standard, and the alleged public detriment can be proved
only by concrete evidence of economic harm.

The Effect of Federal Preemptive Policies

FCC’s preemptive actions suggest that it has viewed
its mission as one of deregulating telecommunications
services ona national basis in order to encourage competi-
tion and foster a uniform nationwide system of regulation.
Although competition can benefit all users, it may not do
so immediately. Even when competition does bring bene-
fits to all users, it may have a differential effect on differ-
ent customer classes. The early returns on rate reductions
provide evidence of these facts. For example, between
December 1983 and November 1986, local telephone
charges were up 26.1 percent, while interstate long-
distance charges dropped 23.5 percent.!7? In 1987, intra-
state toll rates declined 3 percent, while interstate rates
declined 12.4 percent.173

The primary beneficiaries of the large rate reduction
in interstate service are a few very large business custom-
ers, who are the principal users of interstate long-distance
service. For example, a small number of residential cus-
tomers, 10 percent, make over $25 worth of calls per
month, and only 14 percent of business users make over
$50 worth of long-distance calls per month.!74 The large
business users, with their specialized needs and their
heavy use of the interstate long-distance market, are an


tremely complex and did not consist just of an allowance from
interstate service to basic service. For example, Robert Hor-
witz argues that because users of private line services (primari-
ly large corporations) were always exempt from contributing,
to NTS costs, such users received a subsidy from other inter-
state and intrastate long distance telephone users. Moreover,
the purchase of equipment and services from AT&T at in-
flated prices by the Bell operating companies constituted a
subsidy from the local service to AT&T Long Lines. Robert
Britt Horwitz, The Irony of Regulatory Reform (New York: Ox-
ford University Press, 1989), pp. 135-136.

74 The issue of bypass is covered in the next section.

78 Hearings Examiner Mary Ross McDonald of Texas has char-
acterized this justification in literary terms: “The contention
that the impact of increased monthly flat rates will be ‘offset’
by the predicted lower toll rates is from the Marie Antoinette
School of Rate Design: “Let them make toll calls!” Quoted in
Noll, “State Regulatory Responses to Competition and Dives-
titure in the Telecommunications Industry,” p. 167. McDonald
made the comment after a witness for Southwestern Bell testi-
fied that a customer needed to average more than four toll
calls a month in order to benefit from cost-causative pricing.
Approximately 80 percent of Southwestern Bell’s residential
customers average fewer than four toll calls per month.

7 See “Here Comes the Fiber-Optic Home: Experts Worry that
New Technology Will Encourage Formation of aCommunica-
tions Elite,” New York Times, November 5, 1989. For a slightly
different view, see the discussion in Alfred E. Kahn and Wil-
liam B. Shew, “Current Issues in Telecommunications Regu-
lation: Pricing.” Yale Journal on Regulation 4 (1987): 191. The
authors of this article argue that the decision to install fiber-
optics is driven by its lower capital and maintenance costs,
which make it more economical than the traditional copper
cable even for POTS (plain old telephone service). In contrast,
the authors appear to agree that the replacement of analog
switches with digital switches may inflate inefficiently the in-
cremental costs of subscriber access. Ibid., p. 220.

7 States determine usage based on either the number of calls
placed or the minutes of use for toll calls. Noll, “State Regula-
tory Responses to Competition and Divestiture in the Tele-
communications Industry,” p. 189.

78 Discouraging “uneconomic” bypass was one of the significant
criteria that FCC considered in its design of an access plan. 93
FCC2d 241 (1982), para.78. Defining the distinguishing char-
acteristics between “economic” and “uneconomic” bypass is
not easy. A typical definition of economic bypass will refer to
the scale or nature of the customer’s service requirements and
conclude that an alternative system “offers a real economic
advantage over the local telephone company’s services . . . be-
cause of “fundamental differences in the underlying economic
costs of furnishing the service.” See Coopers & Lybrand, State
Policy and the Telecommutnications Economy in New York (Bos-
ton: Economics and Technology, Inc., 1987), Appendices, p.
17. Similarly, a typical definition of “uneconomic” bypass con-
cludes that uneconomic bypass results from pricing distor-
tions, such as rate averaging and depreciation schedules based
on average service lives, which mislead “customers into per-
ceiving . . . [an] alternative as being less costly.” Ibid. Given the
lack of precision in these definitions and the lack of agreement as
to the cost of providing service, the distinction between economic
and uneconomic bypass appears to lack any real substance.

Examples of large end-users include financial organizations,
such as Citicorp. Chemical Bank, and Manufacturers Han-
over; “Fortune 500” types of distributors or manufacturers
with either national or international distribution networks,
such as Westinghouse and Ford; aerospace industries, such as
Hughes Aircraft; local, state, and federal government agen-
cies, such as GSA, FAA, DOD, and the cities of San Francisco

38

and Los Angeles; large-scale educational complexes, such as
Duke University and UCLA; and the transportation industry,
such as major airlines.

*° The term local exchange carriers (LECs) includes the inde-
pendents as well as the BOCs.

51 For example, FCC’s initial bypass report looked only at private
systems and did not deem private lines available from the tele-
phone company to be part of the bypass issue. Weinhaus and
Oettinger, Behind the Telephone Debates, p. 153. See also the
discussion of the ARCO case, this report, pp. 28.

® U.S. v. Western Electric Company, 673 FSupp. 525, 537 (D.C.
Cir., 1987); aff'd. in part, rev'd on other grounds, No. 87-5388
(D.C. Cir. Apr. 3, 1990).

83 Tbid., p. 538.

4 Huber, The Geodesic Network, 3.9, Table IX.S.

85 U.S. v. Western Electric Company, 673 F Supp. at 640, note 68;
and see People of the State of California et al. v. FCC, June 6,
1990, 1990 U.S. App. Lexis 8930, 500 (9th Cir.) “In short, al-
though the record contains an impressive array of evidence
demonstrating the technical feasibility of bypass, the record
contains no evidence that bypass has become a realistic option
for any appreciable number of ordinary telephone users.”

%© The four primary objectives listed by FCC were: (1) elimina-
tion of unreasonable discrimination and undue preference
among rates for interstate services, (2) efficient use of the local
network, (3) prevention of uneconomic bypass, and (4) preser-
vation of universal service. In the Matter of MTS and WATS
Market Structure, CC Docket No. 78-72, Phase I, Third Re-
port and Order, 93 FCC2d 241 (1982).

87 Thid., para. 78.

*® The California plan was created by the Moore Universal Tele-
phone Service Act (AB 1348). In 1987, AB 1348 was repealed
and reenacted as AB 386. AB 1348 was funded by a tax on the
service suppliers while AB 386 is funded by a surcharge on the
customers.

® The income base is raised each year to reflect increases in in-
flation based on the Federal Consumer Price Index.

°° The amount of the allowance is reduced by the amount of any
credit or allowance authorized by FCC. Currently, FCC pro-
vides a 50 percent reduction in the SLC charge for ULTS sub-
scribers and the ULTS fund provides the other 50 percent.

%! California Public Utilities Commission, Auditing and Com-
pliance Branch, Report on the Results of Workshops Held for
Universal Lifeline Telephone Service, June 1988.

% All figures are from the Federal-State Joint Board, Monitor-
ing Report, CC Docket No. 87-339, March 1989.

°3 The assets of directory publishing were included in the rate
base on which the company was permitted to earn a return,
and the profits of the Yellow Pages were taken into account in
the computation of the allowed rate of return.

°4 The Yellow Pages have always generated “supra competitive”
profits. See US. v. American Tel. & Tel. Co, 552 Supp. 131,
193 (D.D.C. 1982), aff'd sub nom. Maryland v. United States,
460 U.S. 1001 (1983).

95 Judge Greene rejected an MFI provision that would have pro-
hibited the operating companies from publishing directories
inreturn for an AT&T guarantee of Yellow Pages revenues for
four years after divestiture. U.S. v. American Tel. & Tel. Co.,
552 F Supp. 194.

% U.S. v, Western Electric Company, 592 F. Supp. 846, 856-66
(DDC. 1984).

97 Mountain States Tel. and Tel. v. Public Utilities Commission
et.al, Supreme Court of Colorado, No. 86SA319, October 31,
1988.

% Both New York Telephone and NYNEX Information Re-
sources Company are subsidiaries of RBOC NYNEX. See In


patents to Bell. For its part of the bargain, Bell agreed to stay
out of the telegraph business.>

The period from 1879 to 1894 is generally considered
one of Bell monopolization of the telephone industry.
Moving quickly to consolidate its hold, Bell undertook to
build a vertically integrated system, controlling all aspects
of the industry. In 1881, Bell purchased Western Electric,
which became its exclusive manufacturing arm, from West-
em Union. In 1885, Bell established AT&T to operate
long-distance lines to interconnect the local exchange areas.

Bell concentrated its development efforts in the ma-
jor cities, largely ignoring rural areas and small towns.
This failure to serve less populated areas explains in part
the rapid rise of independent telephone companies when
two of Bell’s basic patents expired in 1893 and 1894. The
increase in the number of new systems between 1895 and
1900 was remarkable— 199 new telephone systems came
into existence in 1895, 207 in 1896, 254 in 1897, 380 in 1899,
and 508 in 1900. The proportion of telephones controlled
by the independents rose from 19 percent in 1897 to 44
percent in 1902 to 51 percent in 1907.6 Looking at these
numbers, Bell recognized that its dominant status was in
danger and turned once again to the tactics that it had
used so successfully against Western Union.

Bell filed five patent infringement suits against the
independents in 1894, and 23 in 1895.7 Yet, the numbers of
independent telephone companies and their subscribers
kept growing. When lawsuits failed to reduce the compe-
tition, Bell turned to other schemes to shore up its waning
status. Under the direction of Theodore Vail, the first
president of AT&T8 (which had been transformed into
the parent company in 1900), and with the financial back-
ing of J.P. Morgan, AT&T began purchasing independent
telephone companies. The independents that refused
AT&T's offers found themselves cut off from intercon-
nection with the other independent companies that had
merged with Bell and from the long-distance lines of AT&T.
The AT&T merger policy reached its peak with the purchase
of the controlling interest in Western Union in 1909.

Some of the disconnected independent telephone
companies began to fight back by filing complaints with
the new state regulatory bodies and by suing Bell under
state and federal laws. Ina move considered by many tobe
proof positive of his extraordinary political savvy, Vail
decided not to risk legal action. Recognizing the anti-big
business social and political temper of the times and the
advantages of regulation, Vail decided to negotiate a
settlement of the federal antitrust suits with the U.S.
Attorney General. The agreement reached by the parties,
known as the Kingsbury Commitment, was in the form of
aletter from AT&T Vice President Kingsbury to Attorney
General J.C. Reynolds. In the letter, AT&T agreed to sell
its Western Union stock, to allow interconnection with
the independent companies, and to refrain from acquiring
any directly competing companies.?

As early as 1907, Vail had spoken of the benefits of
regulation. He expressed his pro-regulatory views in the
company’s annual reports of 1907 and 1910. In a 1915
speech, Vail expressed his support for the concept of a
regulated monopoly as follows:

Tam not only a strong advocate for control and
regulation, but I think Iam one of the first corpo-
ration managers to advocate it. It is as necessary
for the protection of corporations from each oth-
er as for protection to, or from, the public.!0

Sharing Vail’s enthusiasm for a regulated monopoly,
federal legislators amended the Interstate Commerce Com-
mission Act to bring interstate telephone companies under
the jurisdiction of the Interstate Commerce Commission
(ICC), while state lawmakers established and/or strength-
ened their state regulatory bodies.

Depending on the vantage point of the viewer, the
effects of the early period of regulation looked either
beneficial or pernicious. Regulation stabilized the indus-
try, ended the rate wars, curtailed new entries, and pla-
cated the public critics, while allowing AT&T to maintain
its earnings and growth. With public acceptance of regula-
tion, Vail saw on the horizon the fulfillment of his dream
of a telephone system that was “universal, interdepen-
dent and intercommunicating, affording opportunity for
any subscriber of any exchange to communicate with any
other subscriber of any other exchange.” This goal of
universal service could not, Vail believed, be “accom-
plished by separately controlled or distinct systems nor
[by] competition in the accepted sense of competition.”!

THE GROWTH OF REGULATION:
STRUCTURE AND ELEMENTS

There are at least three methods to resolve the con-
flicts that arise from a system of dual state-federal regula-
tion: (1) one government can agree voluntarily to the
policies and goals of the other; (2) one jurisdiction can
command compliance with its regulatory decisions; or (3)
a mechanism can be put in place to require or facilitate
compromise between the two. Because the latter two
methods are under the sole control of the federal govern-
ment, one would expect state regulatory policies to domi-
nate only when conflicts are handled through the first meth-
od. The history of state and federal regulation of the
telephone industry supports this proposition.

The Early Period of State Regulation

Although five states had established some regulatory
control over telephone companies prior to 1907, none of
them attempted to impose authority over telephone
rates.12 After 1907, the number of states that enacted
legislation pertaining to telecommunications grew rapid-
ly.13 This early legislation focused on the conditions un-
der which a telephone company could operate in a state.
Typically, the legislation required that a company apply
for and receive a Certificate of Public Convenience and
Necessity from the appropriate state regulatory body
prior to beginning its operations. Most state commissions
interpreted this legislation to limit the number of tele-
phone companies that could operate in the state. For
example, in their early decisions, the Public Service Com-
missions of New Jersey, Wisconsin, Illinois, Indiana, Mis-
souri, New Hampshire, Arizona, Minnesota, and Pennsyl-
vania adopted policies against duplication of service,


What is ACIR?

The Advisory Commission on [atergoveramental Relations (ACIR) was
Created by the Congress in 1959 ta monitor the operation of the American
federal system and to recommend improvements, ACIR is a permanent na-
tional bipartisan body representing the executive and legislative branches of
federal, state, and local government and the public.

The Commission is composed of 26 members —nine representing the
federal government, 14 representing state and local government, and three
representing the public. The President appoints 20—three private citizens
and three federal executive officia Isdirectly, and four sovernors, three state
legislators, fuur mayors, and three elected county officials from slates numi-
nitted by the National Governors’ Association, the National Conference of
State Legislatures, the National Leaguc of Cities. U.S. Conference of May-
ors, and the National Association of Counties, The three Senators are cho-
sen by the President of the Senate and the three Representatives by the
Speaker of the House of Representatives,

EachsCommission member serves a (wo-year term and may be reap-
poimed.

As a continuing body, the Commission addresses specific issues and
problems, the resolution of which would produce improved couperatinn
among the levels of government and more effective functioning of the fed-
cral system. In addition to dealing with important functional and policy rela-
tionships among the various governments, the Commission extensively stud-
ies critical governmental finance issues, One of the Lon range efforts of the
Commission has been 1a seek ways 10 improve federal, state. and local gov-
ernmental practices and policies to achieve equitable allocation of resources
and increased efficiency and equity,

{ny selecting items for the research program, the Commission considers
the relative importance and urgency af te problem, its minageabilily from
the point of view of finances and stal¥ available to ACUR, and the extent to
which the Commission caa make a fruitful contribetion toward the solutian
of the problem.

Aller selecting specilic intergovernmental issues for investigation,
ACIR fullows a multistep procedure that assures review and comment by
representatives of all points of view, all affected levels of goverament, lech-
Ml experts, and interested groups. The Commission then debates each is-
sue and formulates its policy position. Comm n findings and recommen-
dations are published and dratt billsand executive arders developed Lo assist
in implementing ACIR policy recommendations,



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network to be built to suit the needs of the largest firms,
with the risk that the possibilities of increases from the
smaller batch production firms may be lost.”!92 In con-
trast, many foreign governments are using public policy to
permit small firms, not just large ones, to “capture the
productivity gains implicit in the new technologies.”193
According to these commentators, by continuing the pur-
suit of the present /aissez faire policy, the U.S. “risks devel-
oping a system aimed at large users, but not necessarily
designed to facilitate the adaptation of the economy as a
whole.”!%4 The resulting market-driven telecommunica-
tions infrastructure may be available only to major users
rather than to all Americans.

As illustrated by current experiments, state regula-
tors are in a good position to assure that a strong telecom-
munications infrastructure is available to small businesses
and residential subscribers.

The Search for a New Telecommunications
Regulatory Paradigm

As noted, the 1934 Communications Act established a
dual federal-state regulatory system. According to that
Act, the federal government has authority to regulate
interstate and foreign communications, and the states
have jurisdiction over intrastate communication services.
As interpreted thus far by the courts, the Act allows feder-
al regulators to preempt state regulation of seemingly intra~
state telecommunications services if the services are an inte-
gral part of the interstate network, except when the activities
at issue can be divided into their intrastate and interstate
components and continued state regulation will not negate a
valid federal policy, such as the promotion of a free market.

A jurisdictional test that depends in part on the sever-
ability of intrastate and interstate services may be dysfunc-
tional in the modern telecommunications environment.
For example, some telecommunications providers are
currently developing integrated broadband networks
(IBN). An IBN is a fiber optic transmission network that
permits voice, data, and video transmission over the same
facility. Such a network would consist of a mix of services,
including video entertainment as well as data and voice
transmission. Currently, a variety of federal and state laws
restrict cross ownership among the providers of video,
data, and audio transmissions. The Cable Communications
Policy Act} prohibits a local telephone company from
providing video programming to viewers in its telephone
service area and permits governmental authorities to re-
quire cable service providers to have a local franchise; the
Modification of Final Judgment prohibits the RBOCs
from providing information services; and FCC requires a
local exchange carrier to file an application before it con-
structs and leases facilities to cable systems on a com-
mon-carrier basis.!96 Although the state and federal laws
governing the provision of video, data, and audio services
are confusing, it is still possible to define separate feder-
al-state regulatory systems because cable systems are
physically segregated from telephone service. With IBN,
the bright-line tests for jurisdictional separation will dis-
appear, and that disappearance may require regulators to
find a new paradigm for dual regulation.197

The new model will require more cooperation among

34

the various regulators. The contentious state-federal re-
lations of recent years are no longer viable for either state
or federal regulators. By and large, states are not winners
in the preemption game, and FCC, too, has much to lose
from building its regulatory policy on the foundation of
preemption. For example, as presently constituted, the
Federal Communications Commission has neither the
staff nor the expertise to set local exchange rates. Rate-
making for basic service is an intensely local affair, differ-
ing in states with large rural, mountainous regions (like
Colorado), in thinly populated states (like Wyoming), in
states with multiple urban centers (like California), and in
states with a large financial service industry (like New
York). Subscriber plant costs vary widely across states.
According to a 1984 study, monthly revenue requirements
range from $21 per subscriber in Wisconsin and Texas to
$45 in Wyoming.198

The FCC cannot monitor the numerous regional
problems, such as the cross-subsidization of unregulated
services, and the local consumer protection violations that
are likely to appear as deregulation proceeds. Unlike their
federal counterpart, state commissions frequently hold
public hearings to receive input from a wide varicty of
subscribers. These subscribers cannot afford to testify at
public hearings in Washington DC. Most important, a
policy of preemption would result in an incalculable loss
of the lessons to be learned from state experiments.

The Communications Act contains two provisions for
cooperative state/federal regulation—the Joint Board
process and the Joint Conference procedure.

The Joint Board Process:
Sections 410 (a) and (c)

In 1971, the Congress amended the Communications
Act to provide for the establishment of joint federal-state
boards. The joint boards consist of seven members—four
appointed by FCC from nominations submitted by NA-
RUC, and three FCC commissioners, one of whom is the
chairman of FCC, who chairs all joint boards. The statute
gives joint boards both mandatory and discretionary juris-
diction. For example, FCC must convene a joint board
before it amends its cost separations rules [section 410(c)
mandatory jurisdiction], and may call a joint board before
it revises its other rules [section 410(a) discretionary juris-
diction]. Each member of the joint board has one vote, but
because the board’s power is limited to making recom-
mendations to FCC (which is then free to reject or modify
the recommendations), the joint board process is one of
discussion and compromise, nearly always resulting in a
unanimous recommendation.199

While recognizing the importance of the joint board
process, the states have expressed some dissatisfaction
with its operation. The power to convene a joint board and
to frame the issues rests solely with the FCC chairman,
and the state members do not have an independent source
of funding to hire a staff. State representatives have made
several suggestions for improving the joint board process,
including the following: (1) meetings of the joint board be
convened on motion of a majority of the members of the
board, or of the states; (2) the chairman of the joint board


Preface

In 1987, ACIR decided to examine the intergovernmen-
tal regulatory and tax implications of two of the most rapidly
changing sectors of the American economy—banking and
telecommunications. The banking studies were completed
in 1988—State Regulation of Banks in an Era of Deregula-
tion—and 1989—State Taxation of Banks: Issues and Options.

This study of the regulation of telecommunications is
the first of two reports on the telecommunications indus-
try. The second report, on state and local taxation of
telecommunications, will be published later this year.

Just a few years ago, most Americans took “plain old
telephone service” for granted. It was rather straightfor-
ward: the vertically integrated American Telephone and
Telegraph Company (AT&T) had a virtual monopoly on
local as well as long-distance voice communications. Asan
entity, AT&T was organized much like a corporate pyra-
mid. The base consisted of 22 local operating companies
(the “Bell” companies) and a long-distance division (“long
lines”). The local operating companies held state govern-
ment franchises that were effective in barring competition
from entry into the “local loop.” Long-distance service
was regulated and protected by the Federal Communica-
tions Commission (FCC), which derived its authority from
the Communications Act of 1934.

Beginning in the 1950s, a series of technological ad-
vances, such as microwave transmissions of voice commu-
nications, began to chip away at the pyramid and erode
AT&T’s monopoly status. In 1959, a series of judicial and
regulatory rulings began to erode AT&T’s legal protec-
tions. As technical advancement expanded to include ter-
minal equipment, the regulatory reforms continued to
narrow the scope of the AT&T monopoly. By 1981, FCC
had loosened up on a variety of regulatory matters, rang-
ing from the manufacture of terminal equipment and the
use of most combinations of computers and communica-
tions equipment to the opening of certain types of long-
distance service to new competition, such as MCI.

A particularly important event was the 1982-83 settle-
ment of the U.S. Department of Justice antitrust suit against
AT&T. The decree broke up the vertically integrated mo-
nopoly of AT&T, requiring a whole new regulatory scheme.

This report lays out the key intergovernmental issues
that have arisen as a result of this new regulatory environ-
ment and provides the context and rationale for three
Commission recommendations relating to the intergov-
ernmental regulatory process.

The report begins with a brief history of the telecom-
munications industry and the early development of state
and federal regulation. It recounts the events leading up
to the 1982-83 settlement of the antitrust suit (divestiture)
and examines the elements of the settlement decree. The
report also describes the post-divestiture telecommunica-
tions regulatory environment, including state initiatives
and areas of state-federal regulatory tension.

Robert B. Hawkins, Jr.
Chairman


Circuit, which had upheld the right of FCC to preempt
state regulation of depreciation rates for intrastate tele-
communications property. The lower court had agreed
with FCC that different state depreciation methods must
be preempted because they frustrated the federal goal of
designing an efficient nationwide telecommunications
service. The Supreme Court disagreed. In Louisiana Pub-
lic Service Commission v. FC.C.,"41 the court in a 5-2 vote
held that the system of dual state-federal regulation es-
tablished by the 1934 Communications Act precluded the
attempted preemption.!42 According to the Supreme
Court, “given the breadth of the language of section
152(b), and the fact that it contains not only a substantive
jurisdictional limitation on the FCC’s power, but also a
rule of statutory construction, we [do not] accept the
narrow view urged by [FCC].”!43 The court continued:
“Section 152(b) constitutes . . . a congressional denial of
power to FCC. .... [T]hus we simply cannot accept an
argument that FCC may nevertheless take action which it
thinks will best effectuate a federal policy. An agency may
not confer upon itself power.”144

The Louisiana Public Service case did not halt FCC’s
drive to deregulate and centralize the intrastate and inter-
state telecommunications markets, but it did compel the
commission to rely on alternative theories for federal
preemption. Three recent decisions from the Ninth and
DC Circuit Courts of Appeals illuminate the power of
these alternate theories and the precedential effect of
Louisiana Public Service.

The Statutory Dual Regulatory Scheme

Most of the recent preemption litigation in telecom-
munications has involved conflicts over the proper inter-
pretation of three sections of the 1934 Communications
Act. That Act established a dual federal-state regulatory
system, set forth in 47 U.S. Code, sections 151, 152(a) and
(b). Section 151 grants to FCC the authority to regulate

... interstate and foreign commerce . . . in com-
munication by wire and radio so as to make avail-
able .. . to all the people of the United States a
rapid, efficient, Nation-wide, and world-wide
wire and radio communication service with ade-
quate facilities at reasonable charges... .

Section 152 (a) sets out the reach of the law:

The provisions of this chapter shall apply to all in-
terstate and foreign communication by wire or
radio and all interstate and foreign transmission
of energy by radio, which originates and/or is re-
ceived within the United States, and to all per-
sons engaged within the United States in such
communication ....

Finally, section 152 (b) limits the extent of FCC’s jurisdic-
tion:

{Nothing in this chapter shall be construed to ap-
ply or to give the Commission jurisdiction with
respect to (1) charges, classifications, practices,
services, facilities, or regulations for or in con-

27

nection with intrastate communication service by
wire or radio of any carrier....

The interplay between these three sections forms the
basis for judicial analysis of the Communications Act.

Recent and Pending Preemption Cases

Given the new life breathed into section 152(b) by the
Louisiana Public Service decision, FCC can no longer base
its preemption orders solely on its mandate under section
151 to create an efficient nationwide telecommunications
network. Instead, the commission must refer to specific
statutory authority to support its direct or ancillary juris-
diction to preempt state regulation. The commission also
must demonstrate the inseparability of the interstate and
intrastate components of the service or activity pre-
empted. In two recent appeals of its preemption orders,
FCC relied on an alternate theory of preemption, based
on the classification of the preempted activity as a
non-common carrier service. The force of this theory is a
key issue in two important cases, “Inside Wiring”!45 and
“Computer III”!46 appealed to the DC and Ninth Circuit
Courts of Appeals, respectively. The breadth of the feder-
al right of interconnection to the public switched net-
work!47 as a basis for preemption was reviewed recently
by the DC Circuit Court of Appeals in a third case: Aflan-
tic Richfield (ARCO).148

Inside Wiring (NARUC III)

One of the FCC depreciation orders at issue in the
Louisiana Public Service case involved a mandated change
in the accounting treatment of “inside wiring” (i-e., the
cost of labor and materials to install wire inside the prem-
ises of a business or residence). The FCC rule required
that, henceforth, inside wiring would be treated as a cost
to be expensed in the year incurred rather than asa capital
investment to be depreciated over time. At first, FCC
took the position that its order did not affect state regula-
tion of inside wiring. Indeed, in a 1982 Memorandum
Opinion, the commission specifically noted that its order
did not preclude states “from using their own accounting
and depreciation procedures for intrastate ratemaking
purpose[s] . . .”!49 and that “no policy of this Commission
would be furthered by requiring state commissions to
adhere to the rules that we have adopted for the purposes
of computing the interstate revenue requirement.”150
Later, however, FCC changed its opinion and preempted
state regulation of inside wiring, basing its preemption
order on sections 220 (concerning accounts, records, de-
preciation charges, etc.) and 151 of the 1934 Act. The U.S.
Supreme Court rejected both theories in connection with
the federal attempt to preempt state regulation of depre-
ciation rates in the Louisiana Public Service case.

In February 1986, FCC issued an order deregulating
the installation and maintenance of inside wiring.!51 The
commission had concluded that deregulation would “en-
sure that inside wiring costs were recovered from the cost
causative ratepayer, would stimulate competition and
new entry in the inside wiring market, would produce cost
savings for ratepayers, and would help in developing a




allow the recovery of NTS costs through a flat rate sub-
scriber line charge as does FCC. Instead, states have cho-
sen to charge the carriers either a fixed monthly rate for
each customer they serve or a rate based on use.’?

Bypass

Intimately related to the federal system of access
charge recovery is the phenomenon of bypass. Indeed, the
FCC’s access charge policy was justified largely by the fear
of bypass.78 A large end-user of telecommunications ser-
vices’? can bypass or avoid the local facility by installing a
direct connection from its location to the POP of the
interexchange carrier (loca! facility bypass). Interstate fa-
cility bypass, in the form of avoiding the use of the monop-
oly long-distance provider, began even before divestiture.
For example, MCI began installing microwave towers to
bypass AT&T’s long-distance facilities in 1969. Some
large end-users bypassed the facilities of both local ex-
change carriers®° and interexchange carriers by construct-
ing their own private network (total bypass).

Some analysts allege that bypass poses a threat to the
long-term viability of the public switched network because
a significant loss of customers in the local switched net-
work would require an increase in the rates of the remain-
ing subscribers to cover the costs of the local plant. Such a
rate increase would in turn force more subscribers from
the system, and so on. The threat that bypass actually
poses to the public network is difficult to measure. On the
one hand, consumer advocates assert that the goal of
universal service is thwarted by a policy that (like the
current FCC policy) requires all subscribers to pay in-
creased flat monthly rates for long-distance service they
may never use. These advocates believe that the frequent
users of long-distance service are in a better position to
pay for the increases in long-distance rates that are attrib-
utable to interstate access charges. On the other hand,
champions of FCC’s current policies maintain that de-

19

creasing interstate long-distance rates will help retain
large business subscribers on the public switched network,
thereby advancing the goal of universal service.

Efforts to find solutions to the problem of bypass have
been hampered by the failure of the interested parties to
agree on what constitutes bypass®! and by a lack of rele-
vant data on the extent of the problem. Some analysts
doubt that bypass is a problem at all. For example, in his
September 10, 1987, order, Judge Greene evaluated the
assertion of the RBOCs that they lacked bottleneck mo-
nopoly power because “there now exists substantial con-
sumer bypass.”82 In denying the request of the RBOCs
for a release from the line-of-business restrictions in the
MFJ, Greene found that:

Exchange telecommunications is characterized
by very substantial economies of scale and scope.
... A Regional Company could easily aggregate
the one percent of total calls that represent po-
tentially competitive special access traffic with all
of its 99 percent monopoly traffic and achieve
lower unit costs than could any bypass system. In
other words, objective economic conditions entirely
preclude the provision of local distribution function
at a lower or equal economic cost than could the es-
tablished local exchange carrier.®3 [emphasis sup-
plied and citations omitted]

In reaching the conclusion that no threat of bypass exists,
Judge Greene relied primarily on the findings in the well
regarded Huber Report, which found that “only one-
tenth of one percent of interLATA traffic volume, gener-
ated by one customer out of one million, is carried
through non-Regional Company facilities to reach an in-
terexchange carrier.”84 According to Judge Greene, the
Huber Report demonstrates that the premise for FCC’s
current policies—the need to halt the menace of growing
bypass and the resulting abandonment by large users of
the regular network—is largely imaginary.85


provide the subscriber additional, different, or restruc-
tured information, or involve subscriber interaction with
stored information.”69 (The term enhanced services is vir-
tually identical to the phrase information service used in
the divestiture order.) The commission found it difficult
to administer these definitional distinctions in the rapidly
changing technological environment.

Nevertheless, Judge Greene found, both in the MFJ
and in a review three years later, that the language re-
stricting the RBOCs from providing information services
was necessary in order to preserve competition in that
segment of the industry. Thus, the local BOCs can pro-
vide only “gateway”6! access to carriers that offer such
services, but cannot supply the actual services themselves.
It is likely that the boundary between basic and enhanced
or information services will continue to be problematic.
Recognizing that, over time, some of the reasons for the
restrictions on the activities of the RBOCs may evaporate
due to technological or market changes, Greene put in
place a method for removing the limitations. On petition
by the RBOCs, the court will remove any restrictions
when it is shown that “there is no substantial possibility
that [the RBOC] could use its monopoly power to impede
competition in the market it seeks to enter.”62

The System of Access Charges

Prior to divestiture, the system of separations and
settlements had allocated a fraction of the costs of the
local exchange plant and operating expenses to the inter-
state toll service (separations) and had mandated that
related interstate toll revenues earned to recover the
imputed local costs be pooled and divided among the
states (settlements) according to the applicable formula.
The separations-and-settlements process did not survive
divestiture. After divestiture, AT&T became just one of
the several, unrelated interexchange carriers that needed
access to the local exchange plant in order to complete
interLATA calls within or between states.

The court had directed the BOCs to “provide access
services to interexchange carriers and information service
providers which are ‘equal in type, quality, and price’ to
the access services provided to AT&'L.”63 To implement
this order, the court instructed the divested BOCs to file
tariffs for their access service. Thus, the BOCs filed rates
for interconnecting long-distance services with the local
network. One of the most significant of the post-divesti-
ture federal-state conflicts concerns these long-distance
access charges and who should pay for them. To under-
stand this important issue requires a review and update of
the process of making a telephone call.

The local exchange facilities used in making a tele-
phone call can be grouped into three categories:

)

Station equipment, which consists of CPE, Pri-
vate Branch Exchanges (PBXs)and inside wiring;

2) Outside plant, which includes drops and blocks,
subscriber line outside plant, exchange outside

plant, and interexchange outside plant; and

3) Central office equipment, which includes the

end office, tandem dial exchange switch, tandem
dial interexchange switch, and circuit equipment
(amplifiers, etc., which maintain or modify the
quality of the signal).6¢

Figure 3 depicts the local exchange plant in schematic
form. Most of the local exchange plant is used for inter-
state toll, intrastate interLATA toll, intraLATA toll calls,
and local exchange service. The only exceptions to this
rule are the tandem dial interexchange switch, which is
used for intraLATA toll as well as for interLATA and in-
terstate toll calls, and the interexchange outside plant,
which is used only for interLATA and interstate toll calls.

Most of the local exchange facility consists of
non-traffic sensitive (NTS) plant.°5 The NTS plant is so
named because the costs associated with that fraction of
the local exchange facility are fixed; they do not vary with
the amount of usage. As illustrated in Figure 4, the NTS
plant (and associated costs) includes CPE and inside wir-
ing, drops and blocks, subscriber line outside plant with its
corresponding circuit equipment and a portion of the end
office. The traffic-sensitive segment of the local exchange
facility includes the bulk of the end office, other switching
offices, exchange and interexchange trunks, and transmis-
sion facilities.66 While commentators agree that much of
the local exchange facility is non-traffic sensitive, they do
not necessarily agree on where to draw the line between
non-traffic sensitive and traffic sensitive (TS) costs. For
example, according to an expert witness at a Wisconsin
Public Utility hearing;

In the long run, some of the so-called [NTS] costs
are actually variable in the economic sense: as a
community expands, more NTS costs must be in-
curred to meet the increasing demand for tele-
phone service. Moreover, usage patterns can af-
fect the level of these costs. . . . Conversely, a
large portion of the so-called [TS] plant and
equipment is actually fixed in the short run. The
switching and trunking facilities in this category
are engineered to meet peak demand; thus their
cost rises as the level of peak demand increases.
However, relatively few costs in this category ac-
tually vary with usage in the very short run. That
is, once the facilities are in place to meet acertain
level of peak demand, the costs are not Signifi-
cantly affected by day-to-day fluctuations.®

The distinction between NTS and TS costs, however
fuzzy, is particularly important in the debate over who
should pay the access charges.

In theory, access charges are similar to the separa-
tions-and-settlements process. Both methods rely on the
concept of joint and common costs; therefore, under both
theories, the interexchange carriers must pay some por-
tion of the NTS costs because an interexchange toll call
cannot be completed without using the local exchange
facility. Like the separations procedure, jurisdiction over
access charges is split between FCC and state regulators;
and like separations, the NTS and TS costs of the local
exchange facility are classified as either interstate or in-
trastate. The costs allocated to the interstate jurisdiction

15


competitive, unregulated telecommunications market-
place.”!52 According to the commission, after deregula-
tion, telephone companies would not act as common car-
tiers in supplying inside wiring services because they would
be likely to tailor their services to the individual need of their
customers and set their prices competitively.153

The commission also preempted state regulation of
inside wiring. In so doing, FCC relied on its authority under
sections 151 and 152(a) and dismissed section 152(b) as irrel-
evant. Citing NARUC II, the commission found that section
152(b) applied only to common-carrier services and activi-
ties. Inside wiring was no longer a common-carrier service;
therefore, section 152(b) did not act as a bar to the preemp-
tion. FCC found an alternative basis for its preemption
order in footnote 4 of the Louisiana Public Service case: “the
inseparability of the interstate and the intrastate compo-
nents of inside wiring.”154

The DC Circuit Court rejected the argument of FCC
that it may preempt state law whenever telephone facili-
ties used for both intrastate and interstate service are
physically inseparable. The court also rejected FCC’s at-
tempt to limit the reach of Section 152(b) to intrastate
common carrier communication services. Nevertheless,
the court did uphold the commission’s preemption of
state regulation of the installation and maintenance of
inside wiring, holding that such state regulation interfered
with the achievement of the federal goal of providing inter-
state users with the benefits of a free market and free choice
in the installation and maintenance of inside wiring.

Computer III

The Computer III appeal arose out of a series of
commission orders involving the provision of enhanced
services, a subject that has a long history with FCC. In its
earlier Computer II decision, 15> the commission had dis-
tinguished between basic telephone services, defined as
“the transmission of telephone messages or the move-
ment of information over the telephone network,” and
enhanced services, described as those which “combine
basic service with computer processing applications that
act on the format, content, code, protocol . . . of the subscrib-
er’s transmitted information, or provide the subscriber addi-
tional, different, or restructured information, or involve sub-
scriber interaction with stored information.”156

The commission concluded in Computer II that the
1934 Act did not apply to enhanced services. Thus, the
Computer II decision drew a line between regulated basic
services and unregulated enhanced services. To guard
against the possibility that regulated carriers would en-
gage in cross-subsidization,157 predatory pricing, and de-
nial of access to the monopoly local network, the commis-
sion instituted a policy of structural separation (i.e.,
AT&T and its wholly owned Bell operating companies
must offer their unregulated enhanced services only
through a separate corporate subsidiary).

In Computer III, FCC reexamined its policies toward
the provision of enhanced services and found that the
costs of structural separation outweighed the benefits.
That is, structural separation requires a duplication of
facilities and personnel, discourages the development of

28

innovative services, and forecloses the opportunity to take
advantage of economies of scale. Moreover, the commis-
sion concluded that nonstructural safeguards could elimi-
nate these costs and still provide protection against Ppossi-
ble cost shifting and discrimination. Consequently, FCC
adopted a plan to permit carriers to offer nonregulated
telecommunications services without having to set up a
separate subsidiary. Carriers choosing to take advantage
of this new freedom must (1) allow competitors equal
access to the network to provide competing services, 158
(2) disclose information to competitors about their regulated
customers and future changes in the regulated network, and
(3) comply with detailed cost-accounting procedures.

The commission’s order in Computer III preempted
state regulation of enhanced services!5? and precluded
states from imposing separate subsidiary requirements or
nonstructural safeguards on the enhanced service opera-
tions of AT&T and the Bell Operating Companies. To
support its preemption order, the commission relied on
theories similar to those discussed in the inside wiring
case; in particular, the inseparability of interstate and
intrastate enhanced services and the inapplicability of
section 152(b) to non-common carrier activities.

On June 6, 1990, the U.S. Circuit Court of Appeals
for the Ninth Circuit vacated both of the FCC orders
under review.160 First, the court overturned the FCC
tuling that the divested BOCs no longer be required to
maintain corporate separation between their regulated
and unregulated activities, finding that the record did not
Support the commission’s conclusion that changed cir-
cumstances reduced the danger that BOCs will “subsidize
their competitive activities with monopoly revenues im-
properly derived from captive ratepayers.”!61 Having
found that the reasons given by FCC for its removal of the
previously required structural separations was not sup-
ported by the record, the court held that the commission’s
decision to remove the required separation was arbitrary
and capricious in violation of the Administrative Proce-
dures Act. With regard to the second FCC ruling on ap-
peal—commission preemption of state regulation of en-
hanced services—the court rejected FCC’s theories, Like
the D.C. Circuit Court in NARUC III, the Ninth Circuit
Court rejected FCC’s attempt to limit the reach of Sec-
tion 152(b) to intrastate common carrier services and lim-
ited the “impossibility” exception carved out of Section
152(b) by the U.S. Supreme Court in Louisiana Public
Service,'62 by requiring the commission to demonstrate
that its order is narrowly tailored to “preempt only such state
regulations as would negate valid FCC regulatory goals.”163
Having found that the commission failed to meet its burden
of showing that its preemption order was necessary to avoid
frustrating its regulatory goals, the court overturned the
FCC preemption order.

ARCO

Not surprisingly, the parties involved in the ARCO
case defined the issues very differently. FCC described
the issue as “whether ARCO’s federal right of intercon-
nection is violated if the Texas Public Utilities Commis-
sion (PUC) prevents it from connecting its Plano lab to


scriber’s right reasonably to use his telephone in ways
which are Privately beneficial without being publicly detri-
mental.”3

The next challenge came in 1968, when an entrepre-
neur named Thomas Carter began marketing the “Car-
terfone,” a device that interconnected mobile radio sys-
tems with the telephone system. Once again, AT&T
refused to allow customers to use the device on the
ground that such use would damage the telephone sys-
tem. This time, however, FCC, mindful of the Hush-
A-Phone decision, ordered AT&T to allow private customers
to use the Carterfone, and it ordered the common carriers
to propose regulations that would protect the telephone
system against harmful devices.38 AT&T filed regulations
that allowed direct electrical connection of foreign equip-
ment to its telephones only through “protective connecting
arrangements” (PCAs) rented by AT&T.

In 1975, FCC eliminated AT&T’s control over the
PCA market by allowing the direct hookup of any device
that met certain performance criteria. Finally, in 1980,
FCC ordered the deregulation of all new customer tele-
phone equipment, or CPE (customer premises equip-
ment) as it was now called.39

Competition in the Long-Distance Market

In the 1950s, technological progress made it possible
for entrepreneurs to challenge the AT&T monopoly in
the long-distance market. Voice transmission by means of
radio waves only a few centimeters long (microwaves) had
been developed during World War II. With the develop-
ment of microwave communication came the potential for
competitive entry into the long-distance market. Building
a microwave communications system was far less expen-
sive and far faster than laying cables. Yet, for some time,
FCC policy hindered that competition. Until 1956, FCC,
believing that there was a shortage of frequencies in the
microwave band, had severely restricted the number of
microwave licenses it granted. Those eligible were com-
mon carriers, certain television broadcasters, and pipe-
lines and railroads.

By 1956, however, microwave technology had pro-
gressed, making it possible to use a greater range of fre-
quencies and causing FCC to review its entry limitations.
The hearings, which began in 1956, culminated in the
“Above 890” decision in 1959. Reversing its earlier policy
of limited access, FCC opened the market to private us-
ers. The “Above 890” decision opened the door for entre-
preneurs to compete in the long-distance market. In 1963,
Microwave Communications, Inc. (MCI) filed a request
with FCC to operate as a limited common carrier provid-
ing microwave voice transmission between St. Louis and
Chicago over private lines. Despite opposition by AT&T
and the independent telephone companies, FCC granted
MCT’s application in 1969.40

Spurred on by MCI’s toehold entry into the intercity
communications market, a large number of other
providers filed similar applications with FCC. The com-
mission opened a broad policy inquiry regarding the ef-
fects of competition in the “specialized communications
field” (i.e., service to or from limited points and pursuant
to private contracts).4! In 1971, FCC issued a general

10

policy statement sanctioning increased competition in the
specialized communications field, which was found to be
served inadequately by existing common carriers. Not sur-
prisingly, the companies providing specialized communi-
cations services soon sought to use their toehold entry
into the field to gain access to the far larger switched
long-distance market.

The challenge came in the form of a new service
offered by MCI—the “Execunet” service. Using Execu-
net, an MCI customer could reach any telephone in dis-
tant cities served by MCI by dialing the local MCI office
and entering a customer number and the number of the
person to be called. AT&T filed a complaint with FCC
Claiming that Execunet competed directly with AT&T's
long-distance switched service, thereby violating FCC
policy restricting the specialized carriers to private line
offerings.42 The commission agreed and ordered MCI to
discontinue the service. MCI chose instead to appeal. Ina
series of cases referred to as Execunet I,,43 II,44 and IIL,45
the DC Circuit Court of Appeals ruled that: (1) FCC
could not forbid MCI from offering its Execunet service
because the commission has no general authority to insist
that carriers receive its approval before filing tariffs pro-
posing new rates or services; (2) FCC must require AT&T.
to provide the local physical interconnection that MCI need-
ed to offer Execunet; and (3) FCC properly allowed MCI to
expand into Lincoln, Nebraska. In 1980, FCC opened the
interstate telephone service market to competition.

Although both FCC (in its Specialized Common Carri-
er decision) and the federal courts (in the Execunet opin-
ions) had ruled that AT&T must provide equal access to
the local exchange facilities to all competitors, technical
difficulties delayed the full implementation of the equal
access requirement. For some time, subscribers to the
services of other common carriers (OCCs) suffered a low-
er quality connection than that of AT&T and were re-
quired to dial extra digits to complete their calls. Because
AT&T owned virtually all of the local exchange compan-
ies (in terms of the number of subscribers per exchange),
and because interconnection with the local exchange was
vital to the ability of the OCCs to reach the homes and
offices of their subscribers, AT&T was arguably in a posi-
tion to frustrate the growth of competition by controlling
the price for access to the local exchange. Not surprising-
ly, then, the tariffs that AT&T filed to provide local ser-
vice for MCI (known as the ENFIA tariffs!) were very
high. After negotiation between AT&T and MCI (under
the auspices of FCC), the parties agreed on reduced rates.

THE SECOND FEDERAL ANTITRUST SUIT

This march toward restricting AT&T’s monopoly sta-
tus and deregulating the communications industry culmi-
nated in an antitrust suit against AT&T and Western
Electric filed by the Department of Justice in 1974. The
usual explanation given for the government’s interven-
tion during a period of regulatory reform was a fear by the
Justice Department that the delaying tactics of AT&T
would impede FCC’s ability to foster competition. When
the suit was finally settled in 1982, AT&T’s vertically
integrated regulated telephone monopoly was given 16
months to dissolve itself. More than a century of rule by
AT&T and its subsidiaries had ended.




ity allowed it under the FCC price-cap plan is long over-
due. Until the adoption of that plan, AT&T was the only
interstate carrier subject to rate-base/rate-of-return regu-
lation. According to AT&T, it has been subjected to regu-
latory discrimination, resulting in increased costs and
harm toconsumers. The FCC price-cap plan is, therefore,
a first step in the direction of a level playing field.

State Experiments
with Alternative Methods of Regulation

States began experimenting with alternative forms of
regulation first in their competitive state markets (i.e., the
intrastate interLATA market). To date, 37 of the 42 mul-
ti-LATA states have authorized more than one facili-
ties-based interexchange carrier to operate in their inter-
LATA markets. In this competitive market, then, 19 states
have removed rate-base/rate-of-return regulation for in-
terexchange services; 15 states allow pricing flexibility for
all or most interexchange services; two states allow partial
pricing flexibility for some services; and one state has
deregulated interexchange services entirely.124

States are exploring new ways to regulate local ex-
change carriers. In this market, 38 states have adopted
some form of regulatory reform. Vermont, California,
New York, North Dakota, and Nebraska represent the
range of current experimentation.

Vermont. In 1985, Vermont began studying the effects
of the new telecommunications environment. Prior to
divestiture and deregulation, Vermont had been in a
unique position. Due to the manner in which the separa-
tions-and-settlement procedure had operated prior to
divestiture and due to the highly rural nature of the state,
the interstate long-distance share of the NTS costs in Ver-
mont was approximately 45 percent. 125 Vis-a-vis the nation-
al average of 26 percent, basic local service in Vermont was
receiving a heavy contribution from toll rates. Thus, when
FCC changed the rules to provide that the interstate portion
of the NTS costs would be a flat 25 percent for all compan-
ies, the state was faced with large rate increases for basic ser-
vice, A move toward a competitive environment appeared to
offer the possibility of stabilizing basic exchange rates while
encouraging technological advancement.

Louise McCarren, chairman of the Vermont Public
Service Board from 1981-1987, proposed a “new social con-
tract” theory of regulation designed to introduce regulatory
flexibility. McCarren proposed to reduce regulation of New
England Telephone in exchange for three concessions:

1) The charges for basic local rates would be nego-
tiated and then be subject to a fixed annual per-
centage change.

2) The company would be prohibited from dropping
the service of any existing markets.

3) The company would commit itself to a modern-
ization program that would ensure the develop-
ment of new technology throughout the state ina
timely manner. 126

In 1987, a modified version of the McCarren proposal
became law. The law allows the Vermont Public Advocate

25

to negotiate a five-year contract with any company that
provides basic exchange telecommunications services,
subject to review by the Vermont Public Service Board.127
Ata minimum, the contract must provide for specified ba-
sic exchange rates during the life of the contract; mini-
mum plant and equipment modernization schedules;
specified service quality levels, including those offered to
competitors; dissemination of technical information
needed by competitors; and rates, terms, and conditions
for access charges.!28 The contract is filed with the Public
Service Board, which must hold a hearing within 45 days
to determine whether it will approve the contract. Before
approval, the board must find that the contract is just and
reasonable, will not create risk of cross-subsidies, and will
promote the general good and support competition. Com-
panies entering into a contract approved by the Public
Service Board under this statute are not subject to tradi-
tional rate-base/rate-of-return regulation. The statute
contains a sunset provision, requiring reconsideration of
the legislation after five years.

Soon after passage of the law, a contract covering 90
percent of the state’s ratepayers was negotiated between
New England Telephone and Vermont’s Public Advocate.
The contract was filed for review with the Public Service
Board in October 1987. Initially rejected by the board, the
contract was renegotiated and approved as modified in
December 1988. Among the modifications required were
the following: basic residential services must not be di-
rectly bundled with new services; blocking of unwanted
“976” services must be available at no charge; basic ex-
change rates must not be raised throughout the term of the
contract; the $284 million in revenue expected to be spent
for network enhancements must be spent or returned to
ratepayers. The board required the last modification in or-
der to prevent the cross-subsidies that could occur if a pool
of unused funds became available for that purpose.12

California. In 1985, the California Public Utilities
Commission began an investigation of the new telecom-
munications industry to determine whether it should
grant regulatory flexibility to AT&T Communications of
California (AT&T-C),13° the dominant firm in the state’s
interLATA market. In the first decision rendered under
the investigation, the commission determined that some
regulatory relaxation was appropriate and considered two
approaches: a prediction approach!3! and an observation
approach.132 The prediction approach requires the com-
mission to make a finding that AT&T-C’s market power is
too weak to allow it to engage in anti-competitive practic-
es. After such a finding, the commission may relax its reg-
ulation of AT&T-C. According to the observation approach,
the commission initially grants regulatory flexibility and
thereafter monitors the results to assess the response of the
marketplace and the costs to ratepayers.133

In October 1987, AT&T-C submitted a price flexibility
proposal under the observation approach that would al-
lowit to respond more quickly to changes in market condi-
tions. The plan called for rates for existing services to be
set initially at their current level and thereafter to vary
asymmetrically within a range specific to each service. For
example, increases in rates for WATS services were lim-


kinds of assistance to qualifying low-income subscribers.
First, the plan reduces the flat-rate monthly subscriber
line charge by (1) 100 percent if the subscriber’s state of
residence has a narrowly targeted lifeline plan filed with
and approved by FCC and offers an equivalent reduction
in the local exchange rate; or (2) 50 percent if the subscrib-
er’s state of residence has a plan for an equivalent reduc-
tion in the local exchange rate and a verifiable means test
designed by the state. Second, the “Link Up America”
portion of the federal lifeline assistance plan offsets half
of the telephone connection and installation charges upto
a maximum of $30. Currently, 38 states and the District of
Columbia take part in the Link Up America program.
‘Twenty-six states and the District of Columbia have taken
advantage of FCC’s waiver program. These states have
adopted policies that meet FCC requirements for a full
waiver of the subscriber line charge by “piggy-backing”
their lifeline service plans on state-run social service pro-
grams. California has found, however, that FCC man-
dated verification requirements are costly to administer
and create inequities among those in need of assistance.

California adopted its lifeline program in 1983,88 welt
before the FCC plan wasin place. California residents are
eligible for Universal Lifeline Telephone Service (ULTS)
if they meet three criteria: the residence at which the
service is requested is the principal place of residence in
California for the applicant, there is only one telephone
line serving that residence, and the total income of the
applicant’s household does not exceed 150 percent of the
federal poverty level for the fiscal year in which the ser-
vice is furnished.8° Eligibility for state assistance is han-
dled through a self-certification procedure. Residents
qualifying for the California plan receive a 50 percent
subsidy toward the basic telephone rate and an allowance
equal to the current federal subscriber line charge.9° The
California plan is funded by a surcharge, currently set at 4
percent, which is levied on intrastate interLATA and in-
traLATA toll services.

After FCC introduced its waiver program, the Cali-
fornia Public Utilities Commission held a series of work-
shops to investigate the effectiveness of its lifeline lawand
to determine whether the state could develop a verifica-
tion plan that would meet FCC requirements.9! At the
close of the workshops, the California regulators recom-
mended no change in its verification of eligibility require-
ments. Participants in the workshop found that FCC veri-
fication requirements would be too costly to implement
unless California adopted a system of piggy-backing on
social service program verification procedures. Yet, the
state regulators criticized the use of social service pro-
gram eligibility lists as discriminatory because new immi-
grants and aliens granted amnesty do not qualify for many
social service programs. The use of social service verifica-
tion procedures prevents these needy persons from receiv-
ing the subsidy, a result that the California Commission was
unwilling to endorse. Therefore, the California plan is not
eligible for the 100 percent federal subsidy.

Using FCC’s definition of the preservation of univer-
sal service (i.e., avoiding actions that would cause a signifi-
cant number of local exchange subscribers to cancel ser-

22

vice) the commission appears to have achieved its
objective with its access charge plan. According to Census
Bureau figures for November 1988, the percentage of
households subscribing to some kind of telephone service
is 92.5, while in November 1983 that percentage was 91.4.
It is too early to proclaim that the goal of universal service
has been achieved, however, because there are significant
variations in penetration levels among white, black, and
Hispanic households and across income levels. For exam-
ple, in November 1988, the percentage of black house-
holds having telephones ranged from 63 to 91, depending
on the age of the subscriber; the percentage of Hispanics
with telephones ranged from 59 to 93, again depending on
the age of the subscriber. The percentage of whites having
telephones ranged from 81 to 96. Similar patterns exist
when fenetration is measured according to family in-
come.% No statistics exist that measure the differences
among rural and urban areas, or whether the subscriber
has single or multi-line service, an issue (discussed in the
next section) of increasing importance to states that seek to
promote the competitiveness of their economic climate.

Lifeline legislation, such as that enacted by the states
participating in the federal plan, is one mechanism for
furthering the goal of universal service by specifically
targeting state and federal subsidies to low-income tele-
phone subscribers. State regulators also seek to further
the goal of universal service by adopting measures to keep
local telephone rates low for all subscribers. For example,
prior to divestiture, many state regulators used the profits
from directory advertising to reduce local rates.23 After
divestiture, however, six of the seven RBOCs caused their
subsidiary BOCs to transfer the responsibility for produc-
ing the Yellow Pages to an affiliate of the holding compa-
ny. In return for the right to publish and receive the
revenues from the highly profitable Yellow Pages, the
BOCs typically received a publishing fee from their affili
ate.54 Judge Greene had considered and rejected a simi-
lar proposal in the settlement.% In a subsequent opinion,
Greene found that the transfers of the directory advertis-
ing to affiliates of the RBOCs were contrary to his deci-
sion that the revenues from the Yellow Pages be used to
protect the universal service goal.

Several state commissions sought to void these trans-
fers as contrary to the public interest. For example, the
Colorado Public Utilities Commission (PUC) ordered
Mountain Bell to reacquire the publishing assets that it
had transferred to U.S. West Direct, an affiliate of RBOC
U.S. West. According to the findings of the Colorado
PUC, Mountain Bell would suffer a net loss of $45.7
million over the three-year term of its contract with U.S.
West Direct, and Mountain Bell’s customers would lose
an annual rate offset that the PUC valued at over $29
million. Mountain Bell appealed the decision, contending
that the commission did not have jurisdiction over the
directory publishing assets because the transfer was made
as part of Mountain Bell’s private business. Alternatively,
Mountain Bell argued that the remedy of voiding the
transfer was an abuse of discretion and/or unconstitution-
al. In October 1988, the Colorado Supreme Court af-
firmed the decision of the Colorado PUC ordering Moun-



Contents

Findings and Recommendations ..........---- 22s cece tree eee e ener eee eee ener a aE
Introduction... 0.00 cece cece ee EEE EE EEE EEE DETERS EEE TEETER EEE ES
Chapter 1—Historical Background of the Telecommunications Industry ..........606sseeeeeee ee eeeee eer nees

Beginnings: From Competition to Monopoly and Back Again
The Growth of Regulation: Structure and Elements .
The First Federal Antitrust Suit ..

Moving toward Divestiture .
The Second Federal Antitrust Suit .

Chapter 2—Divestiture «0... 60.00 cece cece reenter reentrant eee n ern ee teen een e een n eee e es

Overview of the Settlement
The Structure of the Divested Telecommunications Industry ..

Chapter 3—The Post-Divestiture Environment: Phase One ..

Overview of Phase-One Issues ..
Universal Service

Cross-Subsidies ..
Regulating the New Telecommunications Industry .
Overview of Federal Preemption of State Law

Chapter 4—The Post-Divestiture Environment: Phase Two .......-... +20 +e0eeese sneer nee eee e eee reese e es

Overview of Phase-Two Issues
Local Economic Development Issues
Conclusion

Figures

Figure 1—National Local Access and Transport Areas (LATA) Map, March 1988 ...
Figure 2—Territories of the Regional Holding Companies .
Figure 3—Schematic of Local Exchange Plant ...........
Figure 4—Schematic of Non-Traffic Sensitive (NTS) Plant .....-.++++++esseeees



Acknowledgments

iv

Sandra B. McCray is the principal author of this
study.

The Commission wishes to thank the following per-
sons who read and commented on various drafts: Tom
Aust, Michael Behrens, Clarence Brasfield, Michael
Dworkin, Cary Hinton, Andre La Chance, Ray Lawton,
Ron Lehr, John Mayo, Eli Noam, Kathleen Oleinyk,
Cindy Schonhaut, and Peggy Tumey.

Full responsibility for the content of this report, how-
ever, lies with the Commission and its staff.

John Kincaid
Executive Director

Robert D. Ebel
Director, Public Finance Research


Divestiture

Hi

OVERVIEW OF THE SETTLEMENT

A key concept in the government’s lawsuit was its
theory of “bottleneck monopoly’—a monopoly over a
necessary part of a larger economic process. According to
this theory, market power in the bottleneck is easily ex-
panded to other markets by (1) charging high prices for
access to the bottleneck, (2) setting unreasonably strict
conditions for access, and/or (3) refusing access entirely.
In the antitrust suit against AT&T, the bottleneck was, of
course, the monopolistic local Bell operating companies.
According to the government’s theory, AT&T had en-
gaged in all three practices at one time or another to
foreclose competition in the long-distance market. The
government’s case was thus aimed directly at the heart of
AT&T’s integrated structure. Structural reform—severing
one or more of AT&Ts vertical or horizontal limbs—was the
only relief acceptable to the Department of Justice.

As the suit dragged on, AT&T began to realize that it
could not contro} the outcome of the suit. First, the com-

pany had attempted, and failed, to persuade the Adminis-
tration and the Congress of the imprudence of the suit.
Second, Judge Harold Greene had denied the motion to
dismiss filed by AT&T after the presentation of the gov-
ernment’s case. Although such motions are typically de-
nied, in this case Greene also filed a lengthy opinion in
which he expressed his preliminary opinion as follows:
“The testimony and the documentary evidence adduced
by the government demonstrate that the Bell System has
violated the antitrust laws in a number of ways over a lengthy
period of time.”47 Soon after Greene denied AT&T's mo-
tion to dismiss, settlement talks began in earnest.

The negotiated settlement was framed as a modifica-
tion of the 1956 final judgment, which had ended the
government's first antitrust suit against AT&T. The modi-
fication of the final judgment (MFJ): (1) required AT&T
to file a plan of reorganization that transferred ownership
of the Bell operating companies to AT&T stockholders;
(2) directed the operating companies to provide equal
access to all competing firms; and (3) prohibited the di-
vested operating companies from furnishing interex-
change long-distance service. The government filed the
settlement with the court and moved for a dismissal of its
lawsuit. In a move that surprised some, Judge Greene
invoked the Tunney Act,4® and retained jurisdiction over
the case to assure that the settlement was in the public
interest. Publication of the proposed settlement in the
Federal Register and the call for comments resulted in the
filing of more than 600 responses from the public, legisla-
tors, regulators, and representatives of the industry.
Based on these responses, Greene amended several pro-
visions of the settlement and signed an order dismissing
the suit on August 24, 1982.

As modified by Judge Greene, the settlement allowed
AT&T to offer hybrid communications-computer services
and to enter the computer and electronic fields without
restriction. It also contained eight major mandates:

J. AT&T must divest itself of all of the Bell operat-
ing companies;>°

2. AT&T may retain Long Lines, Western Electric,
and the Bell Labs;


Findings
and
Recommendations

Recommendation 1:
Continuing Regulatory Experimentation

The Commission finds that the differences in the
nature of the intrastate intraLATA and interLATA mar-
kets create a diversity of requirements and that a number
of states have been innovative in developing forms of
regulation that are well tailored to differences in the
competitive nature of their geographic market areas.

The Commission recommends, therefore, that states
continue to explore alternative forms of regulation for
their intrastate intraLATA and intrastate interLATA
markets in order to fulfill their roles as laboratories for
experimentation and creativity.

Recommendation 2:
Promoting Universal Service
and Access to the Benefits
of the Information Age

The Commission finds that states are actively engaged
in studying, planning, and initiating experiments to promote
the economic competitiveness of their states by implement-
ing policies that will encourage the development and spread
of new technologies to all state residents.

The Commission recommends, therefore, that state
legislators and regulators (and ACIR) continue to study
the changing nature of the telecommunications infra-
structure with respect to (1) adopting plans for the future
needs of businesses and residents in rural as well as ur-
ban areas, and (2) the interests that all citizens of a state
have in access to the benefits of the information age.

Recommendation 3:
Strengthening Joint Board
and Conference Procedures

‘The Commission finds that the institutional pro-
cesses associated with the joint boards and conferences
could be improved by permitting the states, rather than
solely the Federal Communications Commission (FCC),
to convene meetings and select board and conference
chairpersons.

The Commission recommends, therefore, that the
Congress amend 47 USS.C. sections 410 (a), (b), and (o) to
allow meetings of the joint board and the joint conference
to be (1) initiated and convened upon motion of FCC or on
vote of a certain percentage of the 50 states as determined
by the National Association of Regulatory Utility Com-
missioners, and (2) that issues to be considered by the
boards and conferences be drafted in partnership be-
tween FCC and the states.! Finally, the Commission rec-
ommends that state and federal regulators continue to
use the joint board and joint conference procedures as re-
vised in order to build an integrated, competitive, nation-
al public telecommunications network.

The recommendations were adopted by the Commission
on September 29, 1989.


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7


Intergovernmental Regulation

of Telecommunications



commission approved all of the proposed rate bands that fell
within this limit.

235 California Public Utilities Commission, Decision 88-12-091,
December 19. 1988.

336Tn late 1989, New York Telephone expressed dissatisfaction
with the rate moratorium and sought modification to the plan,
including a return to rate of return regulation, at least until a
new and broader incentive program is negotiated.

37North Dakota Century Code, Chapter 49-21.

138 For telecommunication companies with more than 50,000 sub-
scribers, the election is a one-time, irrevocable decision. Other
telecommunications companies face no such constraint.

See, for example, National Association of Regulatory Utility
Commissioners v. FCC (NARUC I) 525 F.2d 630 (1976), cert.
denied, 425 U.S. 992 (1976); North Carolina Utilities Commis-
sion v. FCC (NCUC D), 537 F2d 787 (1976), cert. denied, 429
U.S. 1027 (1976). But see National Association of Regulatory
Utility Commissioners v. FCC (NARUC II), 533 F2d 601
(1976).

“See, for example, NARUC v. FCC (Inside Wire), Case No.
86-1678, D.C. Circuit Court of Appeals, decided July 7, 1989.

141106 S. Ct. 1890 (1986). See also John Kincaid, “The State of
American Fecleralism —1986,” Publius: The Journal of Federal-
ism 17 (Summer 1987): 15-16.

1 Chief Justice Warren E. Burger and Justice Harry A. Black-
mun dissented. Justices Lewis F Powell, Jr., and Sandra Day
O'Connor did not take part in the decision.

13 Tbid., p. 1901.

“4 Tbid.

TMSNARUC et al. v. FCC, No. 86-1678, (D.C.Cir.)

446 People of the State of California et al. v. FCC, Nos. 87-7230,
7233, 7265, 7361, 7362, 7441, 7451, (9th Cir.), 1990 U.S. App.
Lexis 8930.

‘7The public switched network refers to the “partnership”
among AT&T and other common carriers (e.g., MCI and
Sprint) as well as the local operating companies (Bell Operat-
ing Companies and independent companies), which allows
them to interconnect through switches the parts of the nation-
wide network owned by different entities.

148 Public Utility Commission of Texas v. FCC, Nos. 88-1274,
88-1287, 88-1294, (D.C. Cir.)

+ Uniform System of Accounts, 89 FCC 2d 1094, 1095.

180 Tbid., p. 1097.

151 Detariffing Order, 51 Federal Register 8498 (J.A. 473). FCC had
considered the possibility of detariffing inside wiring earlier,
in a 1985 Further Notice of Proposed Rulemaking, 50 Federal
Register 13991 (J.A. 323).

*S? Brief for Federal Communications Commission in the United
States Court of Appeals for the District of Columbia Circuit,
No. 86-1678, p. 15 (November 1988)

153 Tbid., p. 24.

*54Concurring statement of Commissioner Dennis Patrick, 1
FCC Red. at 1200. In footnote 4 in the Louisiana Public Ser-
vice case, the Supreme Court appeared to affirm the continu-
ing validity of the NCUC I and II opinions, at least insofar as
the facts in those cases demonstrated that it was “not possible
to separate the interstate and intrastate components of the as-
serted FCC regulation.”

15577 FCC 2d 384 (1980), aff’d CCIA v. FCC, 693 F2d 198 (1982),
cert. denied, 461 U.S. 938 (1983).

55 Computer II Final Decision, 77 FCC 2d p. 58.

157 Cross-subsidization occurs when a carrier misattributes costs
incurred in the provision of unregulated services to the provi-
sion of regulated services. The misattribution of costs results

40

in the carriers's monopoly ratepayers bearing a part of the cost
of unregulated services.

*58 In telecommunications jargon, the equal access plan is labeled
“comparably efficient interconnection” (CET). To gain maxi-
mum regulatory freedom from the requirement of structural
separation, a telephone company must file an approved “open
network architecture” (ONA) plan. ONA compels the use of
CEI concepts in the overall design of the basic network.

‘8 The FCC argued on appeal that its preemption of state regula-
tion of enhanced services was merely a reaffirmation of its pre-
vious order in Computer II (Computer II Final Decision, 77
FCC2d at 431-35), which had been upheld by the D.C. Circuit
Court of Appeals (CCIA v. FCC, 693 F.2d 198, 1982; cert. de-
nied, 434 U.S. 903, 1977).

1 U.S. Circuit Court of Appeals for the Ninth Circuit, Nos.
87-7230, 87-7233, 87-7361, 87-7362, 87-7441, 87-7451; June 6,
1990, 1990 US. App. Lexis 8930.

impossibility” exception arises out of footnote
4 of the Louisiana Public Service case in which the Supreme
Court indicated that it might uphold federal preemption of
state regulation of admittedly intrastate activities if the con-
tested state regulation cannot feasibly coexist with the federal
scheme; e.g., if “it were not possible to separate the interstate
and intrastate components of the asserted FCC regulation.”
476 US. 375, n. 4.

181J.§. Circuit Court of Appeals for the Ninth Circuit, Nos.
87-7230, 87-7233, 87-7361, 87-7362, 87-7441, 87-7451; June 6,
1990, 1990 U.S. App. Lexis 8930, p. 77.

464 FCC, Memorandum Opinion and Order, 3 FCC Red. No.11, p.
3091, January 1988.

165 4 PBX consists of common equipment—a switchboard or
switching equipment, remotely located station equipment
(ie., telephones), and wiring connecting the two.

166 Accordingly, ARCO directed Southwestern Bell to connect 81
trunks to the microwave site in Dallas and to assign 2,000 tele-
phone numbers having a Dallas prefix. At the same time,
ARCO instructed GTE Southwest to remove most of the 73
trunks between the GTE central office and the ARCO PBX and
to discontinue assignment of all 1,600 numbers having a Plano
prefix. See Joint Brief of Petitioners, In the United States Court
of Appeals for the District of Columbia, PUC of Texas v. FCC,
Nos. 88-1274, 88-1287 and 88-1294, pp. 4.5 (December 1988).

167 FCC, Memorandum Opinion and Order, 3 FCC Red. No.11
(January, 1988).

‘68 Thid., p. 3090. The test is from Hush-A-Phone v. U.S., 238 F2d
266 (1956).

13 FCC Red., p. 3092.

17 ARCO had raised a question about the quality of service it was
receiving from GTE Southwest. Yet, the company did not use
the state's statutorily defined method to deal with service
problems. Under Section 61 (1) of Article VII of the Texas Act,
the Commission can order a public utility to provide specified
improvements in its service in a defined area, ifservice in such
area is inadequate or is substantially inferior to service in a
comparable area and it is reasonable to require the company
to provide such improved service. Article VII also allows a car-
tier to apply for a certificate outside its designated area. Such
an application will be granted if the Texas PUC determines
that the requested certificate is necessary for the service, ac-
commodation. convenience. or safety of the public.

'%! Public Utility Commission of Texas v. FCC et al, No. 88-1274,
D.C.Cir., September 22, 1989.

12U,S, Department of Labor, Bureau of Labor Statistics, CPI
Detailed Report, cited in Kahn and Shew, “Current Issues in
Telecommunications Regulation: Pricing,” pp. 191, 196.

1 ECC Monitoring Report, CC Docket 87-339, July 1989.


parts of the intrastate market and in virtually all of the
interstate market. Currently, state regulators are experi-
menting with new methods of regulating and/or deregu-
lating the restructured telecommunications industry.
Thus, telecommunications providers may be subject to
different regulatory schemes, depending on the state in
which they are located, the type of service they offer, the
market in which they operate, and whether they are
deemed to be a dominant or nondominant provider.

In addition to the structural changes wrought by the
divestiture decree, technological advances have changed
the face of the industry. Advances in fiber optics, which
allow a higher transmission rate, and the increasing use of
digital switches, which allow additional information ser-
vices, have paved the way for the integrated transmission
of voice, data, and video over the same loop. Cognizant of
technological advances in the industry, states are redefin-
ing universal service, studying and experimenting with ways
to develop a telecommunications structure that will enhance
their economic competitiveness, and prodding the industry
to begin test runs of integrated digital transmission services
within the public switched network. In these experiments,
some state regulators have moved out in front of FCC,
introducing diversity and flexibility into the system.

As this report concludes, however, in recent years
states have frequently been thwarted in their efforts to
develop a telecommunications policy tailored to the

needs of their citizens and businesses by the actions of
FCC in preempting state law. Continued pursuit of a
federal policy of preemption may result in an incalculable
loss to the nation of the lessons tobe learned from and the
models developed by the current state experiments. Uni-
formity of technical engineering standards is essential to
assure the development of an integrated national net-
work; uniformity of regulation in other areas is not. Anew
federal-state regulatory paradigm, built on the coopera-
tive base of joint boards and conferences provided for in
the Communications Act, would assure uniformity of tech-
nical standards where needed to produce an integrated
national telecommunications system. Restraint in using
federal preemptive powers will protect the vitality and
diversity of the system.

The purpose of this report is to examine and evaluate
the key intergovernmental regulatory issues that arise as a
result of the changing institutional and economic structure
of the telecommunications industry. The report begins with
a review of the history of the telecommunications industry
and the early development of state and federal regulation. It
then recounts the events leading up to divestiture and ex-
amines the elements of the decree. Next, the report de-
scribes the post-divestiture telecommunications regulatory
environment, including state initiatives and the areas of
state-federal tension. The report concludes with a descrip-
tion of a new state-federal regulatory paradigm.


Introduction

States began regulating telephone companies in the
beginning of the 20th century. Early regulatory legislation
focused on the conditions under which a telephone com-
pany could operate in the state. Typically, legislation re-
quired a company to apply for and receive a Certificate of
Public Convenience and Necessity from the appropriate
state regulatory body prior to beginning its operations.
Because telephone service required a heavy investment in
rights of way, equipment, and wire, it was frequently
thought of as a natural monopoly. Most states therefore
prohibited competitive entry, emphasizing the impor-
tance of protecting the investment of the incumbent
phone companies and the goal of universal service.

To control the intrastate rates of the monopoly tele-
phone companies, state regulators turned to rate-base/
rate-of-raturn regulation. According to this system, com-
panies set their rates to recover their reasonable expenses
and earn a fair return on their investment in the property
used in the telephone business. The state commissions
determined the allowable rate of return. Although seem-
ingly straightforward, this method of rate regulation
proved difficult to administer. An administratively
troublesome aspect of rate-base/rate-of-return regula-
tion involved the separation of the costs of the local tele-
phone plant between intrastate and interstate service.
Because the local plant was used to complete both local
and interstate toll calls, its costs and operating expenses
had to be divided between intrastate service (regulated by
the states) and long-distance toll service (regulated by the
Interstate Commerce Commission). Eventually, state and
federal regulators and the industry instituted a process of
separations, whereby the costs of the local plant were
apportioned between intrastate and interstate business,
and settlements, whereby a fraction of the interstate toll
revenues was pooled and divided among the states.

As long as intrastate and interstate telephone service
remained primarily in the hands of one monopoly
provider, the vertically integrated American Telephone &
Telegraph Company (AT&T), rate-base/rate-of-return
regulation and the separations-and-settlements process
basically constituted a system of internal transfers of costs
and revenues. In 1982, however, the structure of the in-
dustry and the regulatory system that had been developed
over a half-century came to an end. The federal judicial
divestiture decree, which settled the federal govern-
ment’s antitrust suit against AT&T, required AT&T to
divest itself of all Bell operating companies by January 1,
1984. The decree also directed the Bell operating com-
panies, which retained monopoly control of the local ex-
changes, to provide equal access to the local exchange for
all competitors in the long-distance market. The settle-
ment prohibited the Bell operating companies from pro-
viding long-distance service and from manufacturing tele-
communications and terminal equipment.

The breakup of the vertically integrated monopoly
telecommunications network created a disaggregated
telecommunications system, requiring a new regulatory
scheme. Although the Bell operating companies have
largely retained monopoly control of the local exchange,
several telecommunications providers compete in some


define the issues, and chair a joint board or conference,
the joint board and conference process could form the
basis fora new regulatory paradigm. Uniformity of techni-
cal standards is essential to assure the development of an
integrated national network; uniformity of regulation in
other areas is not. State and federal regulators could use
the boards and conference mechanism to assure uniformi-
ty of technical standards where needed to produce an
integrated national telecommunications network. Re-
straint in using federal preemptive powers will protect the
vitality and diversity of the dual regulatory system.

NOTES

1 The Commission considers the role of the states in the joint
board and joint conference procedures to be of paramount im-
portance. Although the Commission has stopped short of rec-
ommending that the decisions of the joint boards and confer-
ences be final and binding on all parties, subject only to
judicial review, the Commission believes that the states’ role
on these entities should not be limited to cheerleading. In or-
der for the states to have an effective voice under the dual reg-
ulatory scheme set up by the Congress, the joint boards and
joint conferences should be decisionmaking bodies, and the
State representatives should have full voting power.

Gerald W. Brock, The Telecommunications Industry (Cam-
bridge: Harvard University Press, 1981), p. 85.

3 Bell patent, reprinted in The Bell Telephone (New York: Arno
Press, 1974), p. 463-469, cited in Brock, The Telecommunica-
tions Industry, p. 91.

* Brock, The Teleconmunications Industry, p. 91.

STbid, p. 95.

6 J.R. Bornholz and D.S. Evans, “The Early History of Compe-
tition in the Telephone Industry,” in David S. Evans, ed.,
Breaking Up Bell: Essays on Industrial Organization and Regula-
tion (New York: North-Holland, Elsevier Publishing Co.,
1983), pp. 12-13.

7 Brock, The Telecommunications Industry, p. 115.

® Theodore Vail was president of AT&T from 1885-1887 and
from 1907-1917,

° Brock, The Telecommunications Industry, p. 155.

' Theodore N. Vail, “Some Truths and Some Conclusions,”
speech to Vermont State Grange, December 14, 1915, quoted
in Brock, The Telecommunications Industry, p. 159.

uw AT&T Annual Report, 1910, quoted in Harry M.
Shooshan III, ed., Disconnecting Bell: The Impact of the AT&T
Divestiture (New York: Pergamon Press, 1984), p. 10.

? Brock, The Telecommunications Industry, p. 158.

'3 William K. Jones, “Origins of the Certificate of Public Conve-
nience and Necessity: Developments in the States, 1870-
1920,” Columbia Law Review 79 (1979): 426.

'* Tbid., p. 501. Cream skimming is the practice of soliciting only
the most profitable business, leaving the established phone
company with the less profitable business, thereby threaten-
ing the provision of service to marginal customers.

5 Thid., p. 481.

% Richard Gabel, Development of Separations Principles in the
Telephone Industry East Lansing: Michigan State University,
1967), p. 22. Ina 1910 hearing in which the New York Public
Service Commission attempted to determine the reasonable-
ness of metropolitan area exchange rates in the state, the
Commission vacated the inquiry, stating: “It is impossible to
determine the cost of the toll service separately from that of
the local service for the reason that the greater part of the cost

ofboth is joint cost and there is no way of allocating the proper
portion of the joint cost to each branch of service.” FCC Dock-
et 6053 reported in 1941 NARUC Proceedings, p. 142, and
quoted in Gabel, p. 22.

Gabel, Development of Separations Principles in the Telephone
Industry, p. 14.

"8 Thid., p. 15.

19 In practice, the two theories shift costs among users in very dif-
ferent ways. For example, small business and lower income us-
ers tend to make short-distance calls, while larger businesses
and wealthier users make far more long-distance calls. Thus,
shifting cost recoveries between long-distance and short-
distance rates has real distributional effects.

9 Smith v. Illinois, 282 U.S. 133 (1930).

21 Tbid,, p. 151.

? According to the Court, “The separation of the intrastate and
interstate property, revenues and expenses of the Company is
important not simply as a theoretical allocation to two
branches of the business. It is essential to the appropriate rec-
ognition of the competent governmental authority in each
field of regulation.” Smith v. Illinois, at 148.

?3 Lindheimer v. Hlinois Bell, 299 U.S. 151 (1934).

4 Gabel, Development of Separations Principles in the Telephone
Industry, pp. 30, 37.

?5 48 Stat. 652 (1934).

6 Brock, The Telecommunications Industry, p. 159.

27Tbid., p. 179.

8 Gabel, Development of Separations Principles in the Telephone
Industry, p. 36.

® Ibid., p. 43.

> A tariff is a statement filed by a carrier with a state or federal
regulatory agency describing a publicly available service, a
schedule of conditions, and the charges for the service.

>! Originally, the non-traffic sensitive (NTS) costs of the local ex-
change plant were apportioned between interstate and intra-
state jurisdictions according to a formula that took into ac-
count only the subscriber line use (SLU); i.e., the relative
minutes of use of the plant for local exchange service, intra-
state toll service, and interstate toll service for a given compa-
ny. In 1971, the Ozark Plan added a distance-sensitive multi-
plier to the formula: the so-called subscriber plant factor or
SPE On average, interstate calls cover longer distances than
state toll calls; therefore, the use of a distance-sensitive multiplier
increased the portion of the NTS costs assigned to the interstate
jurisdiction, causing an aggregate increase in interstate toll and
decrease in intrastate rates (the more costs that are assigned to
interstate service and recovered from interstate rates, the less
they need to be recovered from local rates). See Carol L. Wein-
haus and Anthony G. Oettinger, Behind the Telephone Debates
(Norwood, New Jersey: Ablex Publishing, 1988), pp. 80-103.

The multiplier effect of the SPF was not uniform. The
greater the relative distance of long-distance calls within a
company/state combination, the greater its SPF and, there-
fore, its share of NTS costs. Mark L. Lemler, “The FCC Ac-
cess Charge Plan: The Debates Continue” (Cambridge: Har-
vard University, Center for Information Policy Research,
1987), pp. 34-35. Before divestiture, the states with the five
highest SPF factors were Nevada, Wyoming, Arizona, Ver-
mont, and the District of Columbia, and the states with the five
highest SLUs were Nevada, Wyoming, Vermont, New Hamp-
shire, and Delaware. In 1980, the interstate SPF was frozen, and
in 1983, it was replaced with a gross allocator of 25 percent for all
companies. Weinhaus and Oettinger, pp. 99, 102-103.

32 The 26 percent figure is an average. In fact, the actual local
plant cost assigned to interstate service varied from state to
state. See footnote 31.

3 Weinhaus and Oettinger, Behind the Telephone Debates, pp.
64-66.


tive market [of] more timely telecommunications ser-
vices, preferential access, or both.”

After reviewing the issue again in his June 1989 opin-
ion, Judge Greene concluded that the “potential for Re-
gional Company cross-subsidization with respect to infor-
mation services, and thus for use of the companies’
monopoly power to impede competition, is enormous.” . . .
“[G]iven the Regional Company structure and the exist-
ing economic incentives, [anticompetitive activities] are
well-nigh inevitable.”111

In its 1987 report on cross-subsidy between regulated
and unregulated services, the U.S. General Accounting
Office! !2 mirrored those concerns. GAO found “substan-
tial reason for regulators to be concerned about the
cross-subsidy potential between regulated and nonregu-
lated activities of the local telephone companies.”!13 Asa
result of its investigation, GAO concluded:

[T]he level of oversight we see FCC prepared to
provide will not, in our opinion, ultimately pro-
vide telephone ratepayers or carrier competitors
positive assurance that FCC’s joint cost rules will
guard against cross-subsidy . . . such assurance is
important in the future with the growth in carri-
ers’ competitive ventures, the loosening of re-
strictions on their entry into more of these ven-
tures, and the increased potential for undetected
cross-subsidy in the absence of structural separa-
tion requirements. 114

As discussed below, FCC attempted to preclude the
states from imposing either separate subsidiary or variant
nonstructural safeguards on enhanced service operations.

REGULATING THE NEW
TELECOMMUNICATIONS INDUSTRY

Both state and federal regulators are questioning the
continued validity of rate-base/rate-of-return regulation
in the post-divestiture, pro-competitive telecommunica-
tions environment. Rate-base/rate-of-return regulation,
formerly thought to emulate the operation of a competi-
tive market and once touted as promoting universal ser-
vice, efficiency, low telephone rates and high quality ser-
vice, is in the post-divestiture era frequently charged with
creating inefficient incentives,!45 restraining innova-
tion, 16 fostering cross-subsidization,!7 and increasing ad-
ministrative costs. The alternative methods of regulation
proposed by state and federal regulators are now the recipi-
ents of the praise previously reserved for rate-of-return
regulation. This section describes some of those alternatives.

The FCC Price Cap Plan

In March 1989, FCC issued its Report and Order,18 in
which it adopted a new plan of incentive or price-cap
regulation for dominant carriers. The new FCC plan,
which took effect on July 1, 1989, applies to all “domi-
nant”!19 interexchange carriers (AT&T). The price-cap
method limits the prices that dominant carriers charge for
their services rather than their rate of return. Under the
plan, AT&T is regulated as follows:

24

1. Allofits existing regulated services are subject to
the aggregate price cap and service category price
bands.120

2. The affected services are grouped into one of
three baskets: residential and small business, 800
service, and all other AT&T business services.

3. Each basket is subject to an aggregate price cap;
that is, the weighted average of the group of ser-
vices within each basket must remain below the
price cap applicable to the basket.

4. Initially, the aggregate price cap for each basket
is to be set by reference to AT&T’s existing rates
for the services included in each basket.

5. The rates are adjusted each year pursuant to a
formula that reflects economy-wide cost changes
as measured by the Gross National Product Price
Index. Rates are also adjusted for cost factors be-
yond AT&Ts control, such as changes in tax laws
and jurisdictional separations.

6. AT&T must adjust its rates downward each year
by 2.5 percent to reflect the productivity gains
that AT&T has historically experienced, and by
another 0.5 percent in order to ensure that con-
sumers receive a guaranteed share of “the addi-
tional efficiencies flowing from the improved in-
centives created by price cap regulation” (the
so-called Consumer Productivity Dividend).121

7. To moderate the cost shifting that can occur un-
der an aggregate cap, AT&T must comply with a
system of price “bands” on categories of services
within each basket. A “band” is the range within
which the carrier may raise or lower any individu-
al rate element in any year.

FCC will treat AT&T tariffs that comply with the aggre-
gate price caps and individual price bands as presumptive-
ly valid, thereby allowing AT&T to use those rates 14 days
after filing without the need for an administrative hearing
on their reasonableness. In the future, the commission
plans to implement price-cap regulation for local ex-
change carriers as well.

The National Association of Regulatory Utility Com-
missioners has identified what it believes to be three ma-
jor flaws in the FCC price-cap plan.122 First, FCC pro-
poses to cap rates at current levels, which were set
according to rate-of-return regulatory principles and may
therefore be unreasonably high. According to NARUC,
FCC has chosen to cap prices at rates that it admits are
inflated. Second, although FCC maintains that the 5 per-
cent limit on price increases within each price band will
protect consumers against excessive price changes, during
the first four years, a carrier will be able to raise or lower
the initial rate by 22 percent without any FCC review.!23
Third, the FCC proposal may lead to a decline in the quality
of service because price caps create an incentive to reduce
operating costs to improve earnings, and FCC has not en-
acted service standards to counteract the potential decline.

In contrast, AT&T maintains that the pricing flexibil-


374 Horwitz, The Irony of Regulatory Reform, p. 274, citing 1984
AT&T statistics.

175 According to a recent article in the Wall Street Joumal, con-
sumers will find little benefit in the long-distance rate reduc-
tions, which were skewed heavily toward reducing the cost of
long-distance calls during business hours. Robert Daniels and
Sanford Jacobs, “AT&T Makes Cuts in Rates Deeper than
Proposed,” Wall Street Jounal, April 3, 1989.

176 Providers of alternative operator services resell long-distance
service for operator-assisted calls. These providers package
the resale of toll with the operator assistance function, which
they provide themselves. These firms contract with institu-
tions, such as hotels and hospitals, where large volumes of de-
mand for operator assisted calls are concentrated. When a ho-
tel or a hospital has a contract with an AOS provider to carry
all of its operator-assisted traffic, the customers or patients
may have no alternative means of carrier selection. These cap-
tive users are thus vulnerable to high rates and poor service.

"77Donald A. Dillman and Donald M. Beck, “Information Tech-
nologies and Rural Development in the 1990s,” The Journal of
State Government 61 (1988): 33.

178 Estimates of multiparty line usage from data provided by the
United States Telephone Association and the Rural Electrifi-
cation Administration indicate that from 1984 to 1987, the
number of multiparty lines has declined from 4.2 million to3.1
million. According to these estimates, multiparty lines repre-
sent approximately 2.5 percent of all lines nationwide. Edwin
B. Parker, Heather E. Hudson, Don A. Dillman, Andrew D.
Roscoe, Rural America in the Information Age: Telecommuni-
cations Policy for Rural Development (Colorado, Aspen Insti-
tute and University Press, 1989), pp. 69-70.

19 Don A. Dillman, Lesli P. Scott, and John Allen, “Telecommu-
nications in Washington: A Statewide Survey” (1988).

180 Washington Utilities and Transportation Commission, “1989
Report on the Status of the Washington Telecommunications
Industry,” Vol. II, p. 41.

181 Enhanced 911 features include automatic identification of the
phone number and location of the calling party.

182 Washington Utilities and Transportation Commission, “1989
Report on the Status of the Washington Telecommunications
Industry,” Vol. Hl, p. 11.

183 Rural areas, too, are beginning to address the problem of how
to assure that their residents have access to high quality tele-
communications systems. For example, in a recent report en-
titled “Telecommunications Opportunities for Bloomsburg,”
the town of Bloomsburg, Pennsylvania, made several recom-

41

mendations for upgraded services intended to attract back of-
fice services of large companies and information intensive opera-
tions in education, management, consulting, and similar fields.
‘The authors of the report also noted that a high quality telecom-
munications system would increase the educational opportunities
of Bloomsburg residents, including the development of relation-
ships with Asian and European educational institutions.

164«The Intelligent Network Task Force Report,” October 1987,
p. 31.

485 Eli M. Noam, “The Past Five Years and the Next Five Years: A
Look at the Post-Divestiture Network and the Next Regulato-
ty Agenda,” paper presented at the Annual Regulatory Con-
ference at Williamsburg, Virginia, p. 19.

186 Tid.

187 Case 88-C-004.

188NY PSC, Order Directing ISDN Trial, Case No. 88-C-196.

189 Opinion No. 89-12, Case 29469.

1 Thid., p. 25.

191 Eli M. Noam, “Beyond ONA: Designing a Modular Network
as a Strategy for National Competitiveness,” Discussion Pa-
per, May 1989.

12 Stephen S. Cohen and John Zysman, Manufacturing Matters:
The Myth of the Post-Industrial Economy (New York: Basic
Books, 1987), p. 180.

193 Ibid.

14 Tbid., p. 190.

195.47 U.S.C. sec. 521 et. seq.

19647 CFR 63.01.

197 For a detailed discussion of the technical, legal, and regulatory
issues involved in IBN, see Robert M. Pepper. Through the
Looking Glass: Integrated Broadband Networks, Regulatory
Policies, and Institutional Change (Washington, DC: Federal
Communications Commission, Office of Plans and Policy,
1988). Working Paper No. 24.

198 Congressional Budget Office, The Changing Telephone Indus-
try: Access Charges, Universal Service, and Local Rates (Wash-
ington, DC: CBO, June 1984), pp. 12-13.

19 Telephone conversation with Cindy Schonhaut, FCC Special
Council for Joint Board Matters, July 5, 1989.

2° Telephone conversation with Ron Choura, Special Assistant
to the Michigan Public Service Commission and Chief of Staff
for Joint Board staff, July 5, 1989.

201 FCC Memorandum Opinion and Order, In the Matter of Fil-
ing and Review of Open Network Architecture Plans, CC
Docket No. 88-2, p. 112, Released December 22, 1988.


tain Bell to reacquire the publishing assets and resume its
publishing operations in Colorado.”? In case with similar
facts, the New York Court of Appeals upheld a decision of
the state’s Public Service Commission disapproving a di-
rectory publication agreement between New York Tele-
phone and NYNEX Information Resources Company.°8

CROSS-SUBSIDIES

In the post-divestiture era, all of the interexchange
carriers can offer nonregulated services as well as regu-
lated ones. Nonregulated “enhanced”? telecommunica-
tions services are described as those “which combine basic
service with computer processing applications that act on
the format, content, code, [and] protocol . . . of the sub-
scriber’s transmitted information, or provide the subscrib-
er additional, different, or restructured information, or
involve subscriber interaction with stored informa-
tion”;100 along with regulated “basic” services, defined as
“the transmission of telephone messages or the move-
ment of information over the telephone network.”101
Although the BOCs are still prevented from offering
information (i.e., enhanced) services,!02 they can provide
other nonregulated services, and many urge the lifting of the
restraints to allow the BOCs to offer nonregulated informa-
tion services. Thus, the issue of how to guard against
cross-subsidies!93 flowing between the regulated and non-
regulated activities of both interexchange and local ex-
change carriers has gained in importance since divestiture.

State Investigations of Cross-Subsidization

In September 1986, the NARUC staff subcommittee
on accounts issued its “Summary Report on the Regional
Holding Company Investigation.” The report summarizes
the results of state examinations of the financial relation-
ships between the regulated and unregulated subsidiaries
of six of the seven regional holding companies. The state
auditors found many instances of cross-subsidization that
were detrimental to the ratepayers of the regulated enti-
ties and to the competitors of the unregulated companies.
Specific problems included inadequate accounting prac-
tices, improper allocation of costs between regulated and
unregulated affiliates, use of highly qualified personnel
from the telephone company to direct projects of unregu-
lated companies without compensation, and transfer of as-
sets among affiliates at prices below fair market value.104

The Evolving FCC Policy
on Cross-Subsidization

Although the Federal Communications Commission
has never defined the term “cross-subsidization” specifi-
cally, it has described the kinds of intercompany and intra-
company transactions it deems troublesome. For exam-
ple, in First Computer Inquiry, FCC sought to control cost
shifting among the regulated and nonregulated services
provided by telephone companies (other than AT&T) by
requiring them to provide data processing services
through separate subsidiaries. In Second Computer Inqui-
ry, FCC described two harms that could result from the
mixing of nonregulated and regulated services in the same

entity. The carriers could use their control over regulated
telephone services to discriminate against competitors
and could misallocate costs from nonregulated to regu-
lated activities, imposing an unfair burden on ratepayers.
To guard against the possibility that regulated carriers
would engage in cross-subsidization, predatory pricing,
and denial of access to the monopoly local network, the
commission instituted a policy of structural separation—
AT&T and its wholly owned Bell operating companies
must offer their unregulated enhanced services only
through a separate corporate subsidiary.

Ironically, as the danger of cross-subsidies has in-
creased, FCC has decreased the stringency of its rules
against cross-subsidization. In Third Computer Inquiry,
FCC found that the costs of structural separation out-
weighed the benefits. That is, structural separation re-
quires a duplication of facilities and personnel, discour-
ages the development of innovative services, and
forecloses the opportunity to take advantage of econo-
mies of scope. Moreover, the commission concluded that
nonstructural safeguards could eliminate these costs and
still provide protection against possible cost shifting and
discrimination. Consequently, FCC adopted a plan to
permit carriers to offer nonregulated telecommunica-
tions services without having to set up a separate subsid-
iary. Carriers choosing to take advantage of this new free-
dom must (1) allow competitors equal access to the
network to provide competing services,195 (2) disclose
information to competitors about their regulated custom-
ers and future changes in the regulated network, and (3)
comply with detailed cost-accounting procedures. 106

There is some reason to believe that these safeguards
may not be sufficient to prevent cross-subsidies. For ex-
ample, Judge Greene, in his opinion of September 10,
1987, found that “the cross-subsidization problem is as
acute now as it ever was.”!07 He went on, “{I]t is intrinsi-
cally difficult for a relatively small group of regulators to
prevent cross-subsidization within several multi-billion
dollar entities, particularly if the entities are as complex
internally and as fluctuating organizationally as the Re-
gional Companies.”108

Inarecent opinion, Judge Greene denied the request
of Bell South, Bell Atlantic, and Southwestern Bell that
the court permit them to provide electronic publishing
and electronic directory services, finding that to allow the
BOCs to provide such information services would likely
lead to improper cross-subsidization.109 In the opinion,
Greene reviewed the incentives and potential for
cross-subsidization by the regional companies described
in previous opinions.!10 According to those earlier opin-
ions, a regional company would “have the incentive as
well as the ability to ‘milk’ the rate-of-return regulated
monopoly affiliate to subsidize its competitive ventures
and thereby to undersell its rivals in the markets where
there is competition.” Other cross-subsidies noted in-
clude the “transferring of assets from . . . regulated affili-
ates to... unregulated affiliates at less than their cost or
below their market value”; “the bundling of... regulated
monopoly services with . . . competitive products or ser-
vices”; and the provision to its “customers in the competi-




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14


The Post-Divestiture
Environment:
Phase Two

31

OVERVIEW OF PHASE-TWO ISSUES

The Phase-One docket contains issues requiring
prompt attention and, often, the search for short-term
solutions to transitional problems. Phase-One tasks have
required states to implement new methods of regulating
telecommunications providers, monitor the relationship
between the competitive and noncompetitive activities,
maintain universal service in the face of lost interstate
subsidies and the threat of bypass, and resist federal en-
croachment on state control of the intrastate telecommu-
nications market. Other Phase-One tasks not covered in
this report include some First Amendment issues (e.g.,
the banning of dial-a-porn), and alternative operator ser-
vices.176

Although state legislators and regulators will contin-
ue to be occupied primarily with Phase-One tasks, some
states have already moved into a new regulatory era,
called here Phase Two. If Phase One wasa reactive phase
marked by deregulatory experiments and contentious fed-
eral-state relations, Phase Two promises to be a proactive
period in which states encourage telecommunications
providers to bring forth the developmental and competi-
tive promise of the information age. Phase Two also offers
the hope of a harmonious state-federal partnership.

The Phase-Two agenda is replete with prickly policy
issues. For example, some state regulators are now actively
involved in the design of their state’s telecommunications
infrastructure, prodding the industry where it is found to be
moving too slowly. Also, federal and state regulators have
embarked on a joint project to chart a national, modular
network with uniform standards of interconnection. The
agenda is being driven by the desire to stimulate local eco-
nomic development and to capture the market in an increas-
ingly competitive international telecommunications arena.
Optimists will see in the agenda an opportunity to spur
economic growth by fostering a flexible, pluralistic network
and to create an innovative paradigm for dual state-federal
regulation. Pessimists will raise the specters of network
balkanization, intrusive government regulation and interfer-
ence with free market principles.

LOCAL ECONOMIC DEVELOPMENT ISSUES

Many commentators have noted that we live in an
information age, and that the new business that virtually
every state seeks to woo from other localities and/or nur-
ture from seed are likely to be information intensive.
Thus, “fiber optic cables, digital switching, laser disks,
satellite communication, word processors, facsimile
transmissions and computer-integrated manufacturing
are now as essential to economic development as inter-
state highways, industrial parks, water and sewage sys-
tems, and assembly lines were to the mass society era.”177
One of the much-heralded benefits of the information age
and the service economy involves the uncoupling of employ-
ment opportunities from urban centers. In theory, at least,
some service industries can locate wherever an advanced
telecommunications infrastructure exists, and an employee
can sit at a computer workstation hundreds or even thou-
sands of miles from a home office. Such services are de-
scribed as “footloose” because they have little or no produc-


tion constraints restricting their locations. Research and
mail-order retailing are two examples of footloose services.

Rethinking Universal Service

In an information age, the economic health of states
will depend in large measure on a strong telecommunica-
tions infrastructure. Yet, the evidence to date, though
scanty, suggests that without government intervention,
many communities and citizens will be deprived of the
benefits of the information age. Rural communities, for
example, frequently lack the kind of telephone service
necessary to join the information age. For individual
work-at-home projects, the minimum requirements in-
clude one-party telephone service, touch-tone calling,
and digital switching. These essential core elements facili-
tate the connection of a computer to a modem for data
transmission, allow access to custom calling features, and
assist in effective machine communication. Yet, in rural
communities, where the cost of providing such services is
high, the percentage of households with one-party lines
and touch-tone service may be far below that in urban and
suburban households.

No nationwide surveys have measured the extent and
geographic spread of one-party service and touch-tone
calling,‘78 but at least one state, Washington, has con-
ducted its own statewide survey. According to the survey
conducted for the state’s Joint Select Committee on Tele-
communications,!79 only 4.8 percent of the state’s resi-
dence customers had party-line service, but 24 percent of
the rural countryside residents were on multi-line service.
Such disparities in rural and urban telecommunication
services recently led the Utilities and Transportation
Commission of Washington to conclude that the defini-
tion of universal service should be revised. The commis-
sion’s study represents the range of issues involved in
redefining universal service.

In the past, the Washington commission had required
all local exchange companies to offer multiparty service as
a lower price alternative in order to promote universal
service. While reaffirming its commitment to universal
service, the commission noted that the definition of what
constitutes universal service is evolving. According to the
commission, so-called Plain Old Telephone Service
(POTS), consisting of a local access line and basic central
office switching for a single, flat monthly fee, is no longer
an adequate universal service goal. In the commission’s
words, “simply maximizing the number of residents of the
state who have working telephones in their homes is no
longer sufficient to meet the policy goal of universal tele-
communications service in a meaningful way. A
rotary-dial telephone hooked to a multiparty local access
line that is served by a mechanical central office switch isa
link with the past rather than a connection with today’s
information age.”180 A universal service goal consistent
with the information age requires at a minimum afford-
able single-party service with touch-tone calling.

The Washington commission cited several reasons for
the need to upgrade the definition of universal service.
Some of the reasons cited belong in the public safety
category (i.e., access to enhanced 911 emergency fea-

32

tures!8! and automated burglar and fire alarm systems,
each of which require single-party lines). Others belong in
the economic development category. While careful to
point out that a sophisticated telecommunications infra-
structure is not a panacea for the ailments of economically
disadvantaged areas of the state, the commission found
that “the availability of a modern, high-quality telecom-
munications infrastructure is a threshold resource that
the State of Washington must achieve and maintain to
remain competitive in a national and global information
economy.”182 Accordingly, the commission ordered all
local exchange carriers participating in the state’s new
incentive regulation program to submit specific plans for
conversion to universal one-party, touch-tone service.
The conversion to universal one-party, touch-tone
service has profound implications for the state’s tele-
phone rate structure. The primary reason for the relative
prevalence of party lines in rural areas is affordability. For
example, 16 of the 24 local exchange carriers assess an
incremental charge on basic service rates for customers
whose premises are outside of the base rate area (i.e., the
area closest to the location of the central office in a given
exchange). In general, the farther the customer is from
the base rate area boundary, the higher the monthly basic
service charge. In Washington, many suburban and most
rural single-party line subscribers are subject to the incre-
mental charge through a so-called suburban mileage
charge, which can add $40 or more to the monthly bill for
basic telephone service. In most cases, however, the sub-
urban mileage charges are not assessed on the lowest
available grade of service, the four-party line.
Moreover, the commission found that existing plant
capacity in many service areas was not sufficient to allow
total conversion to one-party service without significant new
investment. The cost of the required investment must in
turn be recovered from subscribers, again impacting local
ratepayers and raising questions of whether one-party ser-
vice should be subsidized and if so, how. In order to study
these complex rate issues, the commission has ordered the
state’s local exchange carriers to provide it with estimates of
the cost for conversion to one-party service and to design
alternative rate plans to recover those costs. 183
California, too, has begun to reexamine the concept
of universal service. In a 1987 report issued by a consumer
advisory council commissioned and funded by Pacific Bell,
the council noted that “we now face the real possibility of
a society divided between the information rich and the
information poor, with the information poor precluded
from most of the nation’s jobs.”184 Accordingly, the coun-
cil recommended that regulators and the industry rede-
fine universal service to include affordable access to
touch-tone service, publicly supported information ser-
vices (i.e., data bases and public library services), special
provisions for disabled persons and for those not fluent in
English, including automatic language translation.

Urban Centers

New York is a state with a highly developed financial
services industry, which competes directly in the interna-
tional market and relies heavily on sophisticated telecom-


20




the Matter of New York Telephone Co. v. Public Service Com-
mission, October 25, 1988. The Wyoming Supreme Court and
the Minnesota Court of Appeals reached a different result.
Based on the statutes of those states, the two courts held that
the state regulators could not void the transfers. Both courts
found, however, that the regulators could investigate the rea-
sonableness of the publication fees and impute income to the
BOC if the fees were found to be inadequate.

°° The term used in the divestiture decree is information ser-
vices. Apparently, no real distinction exists between the terms
enhanced services and information services.

20° Computer II Final Decision, 77 FCC2d, p. 55.

1 Ibid.

1°-The MFI contained provisions preventing the BOCs from en-
tering certain lines of business, such as providing information
or long-distance services and manufacturing telecommunica-
tions equipment. In 1987, the Justice Department recom-
mended to the court that the restrictions on the BOCs’ provi-
sion of information services and manufacturing of equipment
be relaxed. After reviewing the Justice recommendations and
receiving comments and testimony from interested parties,
Judge Greene relaxed the restrictions only to the extent of al-
lowing the BOCs to provide “gateway” transmission services
and to engage in non-telecommunications services. The order
also retained the restraints on manufacturing and providing
long-distance service. U.S. v. Western Electric Co., et. al,
#82-0192 (D.C.Cir., 1988).

13 Cross-subsidization occurs when a carrier misattributes costs
incurred in the provision of unregulated services to the provi-
sion of regulated services. The misattribution of costs results
in the carrier’s monopoly ratepayers bearing a part of the cost
of unregulated service and in unfair competition.

'°4The report noted differences found among the six regional
holding companies. For example, the auditors gave Bell Atlan-
tic the highest marks for its attention to separating the two
sides of its business and for developing a reasonable and effi-
cient method of consolidating functions among its regulated
and unregulated subsidiaries. In contrast, the operations and
methods of Pacific Telesis were found to “bring to life the
worst nightmares of regulators.”

195 Th telecommunications jargon, the equal access plan is labeled
“comparably efficient interconnection” (CED. To gain maxi-
mum regulatory freedom from the requirement of structural
separation, a telephone company must file an approved “open
network architecture” (ONA) plan. ONA compels the use of
CEI concepts in the overall design of the basic network.

16 On June 6, 1990, the Ninth Circuit Court of Appeals over-
turned the FCC’s decision in Computer III. See the discussion
of the Computer III case in the section entitled “Overview of
Federal Preemption of State Law,” page 26.

107673 ESupp. 571.

108 Tid.

1S. v. Western Electric Co., Civil Action No. 82-0192
(D.C.Cir.), June 13, 1989.

00592 F Supp. at 853-54.

US, v. Western Electric Co., Civil Action No. 82-0192 at 21.

12U,S. General Accounting Office, Telephone Communications:
Controlling Cross Subsidy between Regulated and Competitive
Services (Washington, DC: GAO, October 1987).

1B Tbid., p. 10.

14 Tbid., pp. 54-55.

45 According to FCC, rate-of-return regulation creates distorted
incentives. In a competitive market, prices are dictated by the
market, and a company’s costs and profits are inversely re-
lated. Under rate-of-return regulation, a carrier seeking to in-
crease its earnings often can do so merely by increasing its ag-

39

gregate investment on which it earns a return. Thus, profits
can go up as investment goes up. This relationship is said to
create a powerful incentive to “pad” costs. See FCC, Price Cap
Proposal, June 6, 1988 (Chicago: Commerce Clearing House),
p. li.

16 Examples given by FCC include the following: If a carrier at-
tempts to produce the same service at a lower cost, rate-of-
return regulation denies the carrier any future benefit by forc-
ing a rate reduction. Rate-of-return regulation offers carriers
little incentive to bring new services to market because they
are denied the benefits of successful innovations to the extent
the benefits exceed the authorized rate of return. Ibid., p. 62.

47 FCC maintains that carriers subject to rate-of-return regula-
tion have an incentive to manipulate their reported cost allo-
cations, assigning the greatest amount of costs to their least
competitive services, thereby cross-subsidizing their most
competitive services. Ibid., p. 63. This proposition is somewhat
difficult to reconcile with the FCC position that rate-of-return
regulation and the separations-and-settlements procedure as-
signed too many costs to the long-distance services, which was
and is the most competitive market.

48 Tn the Matter of Policy and Rules Concerning Rates for Domi-
nant Carriers, CC Docket No. 87-313, Report and Order, FCC
89-91 (1989).

19The FCC has classified as dominant certain carriers that are
considered to have market power sufficient to exploit consumers
by charging excess rates or discriminating unreasonably in the
provision of service. Under that definition, AT&T and all local
exchange carriers are deemed dominant carriers. Ibid., pp. 8-9.

120 New services, defined as those that offer users an additional
measure of choice, are outside the price cap structure.

"1 Price Caps v. Rate of Return Regulation, Text of Statement by
Chairman Dennis R. Patrick before the House Subcommittee
on Telecommunications and Finance, July 13, 1988 (Chicago:
Commerce Clearing House), para. 23,399.

12NARUC, Comment on FCC Price Cap Proposal, in 1988 Re-
port of the Administrative Director on Litigation, pp. 154-156.
NARUC has noted the same flaws in the FCC price cap pro-
posal for interstate access services. See FCC, “Reply Com-
ments of the National Association of Regulatory Utility Com-
missioners,” In the Matter of Policy and Rules Concerning
Rates for Dominant Carriers, CC Docket No. 87-313.

53 Tbid., p. 159, note 32.

124 Correspondence from Kathleen Oleinyk, District Manager,
Eastern Region, AT&T, May 24, 1989.

25 Vermont Office of Policy Research and Coordination, New
Opportunities, New Challenges. First Report and Recommenda-
tions of the Vermont Telecommmuications Commission (Mont-
pelier: January 1986), p. 35. For an explanation of the Vermont
situation, see note 29 of that report.

26 Tbid., pp. 31-32.

27 “Basic exchange telecommunications service” is defined as
the provision of publicly switched, voice grade interactive tele-
communications services between or among two or more end-
users, where a single central office provides that service. 30
Vermont Statutes Annotated, Sec. 226 (a).

"8 Tbid.

Phone conversation with Michael H. Dworkin, General
Counsel, Public Service Board, January 12, 1989.

3° California Public Utilities Commission, (1) 85-11-013 (1985).

131 See ibid.

132 California Public Utilities Commission, (D.) 87-07-017 (1987).

See California Public Utilities Commission, Decision
88-12-091, December 19, 1988, pp. 3-4.

TM4One of the commission-ordered modifications sets a maxi-
mum/minimum limit of +/- 15 percent on all rate bands. The


34 John Brooks. Telephone, the First Hundred Years (New York:
Harper & Row, 1975), p. 266.

35 Brock, The Telecommunications Industry, pp. 191-193.

36 Hush-A-Phone v. United States, 238 F2d 266, 268 (1956).
57 thid., p. 269.

38 13 FCC 2d 420, recon. denied, 14 FCC 2d 571 (1968).

» The FCC order was effective January 1, 1983.

4 Brock, The Telecommunications Industry, p. 210.

41 Specialized Common Carrier Services, Notice of Inquiry to
Formulate Policy, Notice of Proposed Rulemaking, and Or-
der, 24 FOC 2d 318 (1970), 29 FCC 2d 870 (1971), Washington
Utilities & Trans. Comm'n. v. FCC, 513 F2d 1142 (9th Cir.
1975), cert. denied, 423 U.S. 836 (1975).

*# Private line service is “a service whereby facilities for commu-
nication between two or more designated points are set aside
for use of a particular customer and authorized users during
stated periods of time.” 47 CFR sec. 21.2. In contrast, public
message service is “a service whereby facilities are offered to
the public for communication between all points served by a
carrier or by interconnected carriers on a nonexclusive messa-
ge-by-message basis, contemplating a separate connection for
each occasion of use.” Ibid.

43 MCI Telecommunications Corp. v. FCC, 561 F2d 365 (D.C.
Cir., 1975), cert. denied, 434 U.S. 1040 (1978).

44 MCI Telecommunications Corp, v. FCC, 580 F2d 590 (D.C.
Cir. 1978), cert. denied, 439 U.S. 980 (1978).

45 Lincoln Tel. and Tel. Co. v. FCC, 659 F2d 1092 (D.C. Cir,
1981).

4° ENFIA is the acronym for Exchange Network Facilities for In-
terstate Access.

47 US. v. American Tel. & Tel., 524 ESupp. 1336, 1381(D.C.Cir.,
1981).

#815 U.S.C. sec. 16. The Antitrust Procedures and Penalties Act,
popularly known as the Tivmey Act, requires that any proposal
fora consent lecree submitted by the United States in an anti-
trust proceeding be filed by the court and published in the Fed-
eral Register at least 60 days prior to the effective date of the
judgment. The purpose of the Tinney Act was to assure the pub-
lic and governmental representatives that antitrust settlements
are in the public interest. Peter Temin, The Fall of the Bell System
(New York: Cambridge University Press, 1987), p. 252.

* Temin, The Fall of the Bell System, p. 287.

% Except that AT&T was allowed to retain its minority ownes-
ship in Cincinnati Bell and Southern New England Tele-
phone.

51 Proponents of this restriction justified it on First Amendment
(free speech) grounds. Opponents saw it as protection for the
politically potent newspaper interests.

5? “Information services” are defined in the divestiture decree as
“the offering of a capability for generating, acquiring, storing,
transforming, processing, retrieving, utilizing or making avail-
able information which may be conveyed via telecommunica-
tions. ...” U.S. v. American Tel. and Tel. Co., 552 F Supp. 131,
179 (1982).

53 The MFJ contained two exceptions to the rule barring the
BOCs from providing interLATA interexchange services: a
corridor between the New York Metro LATA and the North
New Jersey LATA and another corridor between the Philadel-
phia LATA and the Delaware Valley, New Jersey LATA. In
these two corridors, the BOCs and AT&T compete directly.
Weinhaus and Oettinger, Behind the Telephone Debates, p. 131.

54 OCCs are the large independent companies, the seven largest
of which are MCI, Western Union, SPRINT, Tymshare, US
Transmission Systems, RCA Communications, and US Tele-

37

phone. Weinhaus and Oettinger, Behind the Telephone De-
bates, p. 48.

55 A POP is “a physical location where there is a point of inter-
face between the BOC facilities providing a LATA access
function and an interLATA carrier's facilities providing an in-
terLATA function.” A POP must be located within the bound-
ary of the LATA being served, and it may contain an interLA-
TA carrier’s switching system or some other designated
facility. AT&T Plan of Reorganization, p.12, n.11.

% Some states allow competitive entry in the intraLATA toll
market.

5? See note 52 for a definition of information services.

58 U.S. v. American Tel. & Tel. Co., 552 F. Supp. 131, 194 (D.C.
Cir. 1981).

* Thid., p. 179.

© Computer II Final Decision, p. 55.

A gateway is an electronic device that modifies electronic in-
formation for more efficient transmission, management, and
access (but does not modify the user content). See U.S. v.
Western Electric Co. Inc. et al, 673 ESupp. 525 (1987) and
US. v. Western Electric Co. Inc. et al., No. 82-0192, March 7,
1988.

© US. v. American Tel. & Tel.Co., 552 E Supp. at 231.

8 Tbid., p. 196.

© Mark L. Lemler, “Ihe FCC Access Plan: The Debates Con-
tinue” (Cambridge: Harvard University, Center for Policy In-
formation Research, 1987), pp. 22-23.

6 Lemler, pp. 25-28.

® Ibid., p. 26.

7 Wisconsin Public Service Commission, Hearings, In Re Investi-
gation of Intrastate Interexchange Access Charges and Related
IntraLATA and InterLATA Compensation Matters, Docket No.
05-TR-5, Testimony of Ben Johnson, p. 11, quoted in Lemler,
p. 27.

© Third Report and Order. 93 FCC2d 241.

© In 1983, 84 percent of all call minutes on the Bell System’s
switched network were local, and 16 percent were toll. Peter
Huber, The Geodesic Network, Report on Competition in the
Telephone Industry (Washington, DC: U.S. Department of Jus-
tice, Antitrust Division, 1987), 2.3.

7 U.S. v. American Tel. & Tel. 569 FSupp. 990, 998-1000, (D.C.
Cir. 1983).

74 For a detailed description of the congressional action, includ-
ing letters between FCC and members of the U.S. Senate, see
Lemler, The FCC Access Charge Plan: The Debates Continue,
pp. 60-65.

” The $3.50 cap is the maximum flat rate subscriber line charge.
In low-cost states, the subscriber line charge is less than $3.50.

® One of the promised benefits of FCC’s current policy is the
elimination of the prior “cross-subsidization” of the local ser-
vice by the interstate long-distance service. The existence and
extent of this subsidy has been and continues to be a contro-
versial subject. Some do not accept the theory of joint and
common costs, believing that imputing any portion of the NTS
costs of the local exchange facility to interstate service creates
an unwarranted subsidy. See discussion in Peter Temin and
Geoffrey Peters, “Cross-Subsidization in the Telephone Net-
work,” Willamette Law Review 21 (1985). 199. Others accept
the theory of joint and common costs, but believe that the
amount of NTS costs assigned to interstate service (25 per-
cent) is too high. See, for example, Roger G. Noll, “State Reg-
ulatory Responses to Competition and Divestiture in the Tele-
communications Industry,” in Ronald E. Grieson, ed.,
Antitrust and Regulation (Lexington, Massachusetts: Lexing-
ton Books, D.C. Heath Co., 1986), p. 167 et.seq. Still others
maintain that the pre-divestiture system of subsidies was ex-


thereby prohibiting competitive entry. In their refusals to
grant the required certificate to competitors, the state
regulators affirmatively emphasized the importance of
protecting the investment of the incumbent phone com-
panies and the goal of universal service, stating that addi-
tional facilities would create “wasteful duplication,” “ru-
inous competition,” and “cream skimming.”14

On rare occasions, such as when a state commission
found that an existing telephone company provided inad-
equate service, the commission would grant a certificate
to a competitor company. More often, however, state
commissions found that even in the case of inadequate
service “the remedy is not to attempt to install another
plant, thereby so depleting the revenue of both that nei-
ther can afford to furnish adequate service but to apply to
[the] Commission [for relief].”15 The commissions
claimed to have sufficient power to correct the usual com-
plaints of service deficiencies, the failure to allow inter-
connection of systems, and high rates.

By 1930, all but three states had enacted legislation
giving state regulatory commissions power over intrastate
telephone rates. In regulating the rates, the commissions
focused on the reasonableness and efficiency of the earn-
ings of the companies within their jurisdiction. According
to the rate-base/rate-of-return regulation, a telephone
company should set its rates so as to recover its “reason-
able” expenses as well as to earn a “fair” return on its
investment in property (rate base) used in the regulated
business. In order to calculate its rate of return (ROR),
the company related its net earnings (the difference be-
tween intrastate revenues and intrastate expenses) to its
net property investment in the state according to the
following formula:

revenues-expenses
state (net) property investment

ROR =

Rates (r), then, would be deemed proper if they were set
to produce revenues according to the following formula:

r= (RORx state net property investment)
+ expenses

The commissions determined the allowable rate of re-
tum. If, for example, a state commission found that 10
percent was a fair rate of return, the telephone company
would set its rates so as to generate sufficient revenue to
cover its approved expenses and earn 10 percent on its
investment.

Hidden in the above formula isa cost-of-service prob-
lem that has plagued the telephone industry continuously
since it was first identified in 1910.16 An explanation of
the problem must begin with a brief description of the
operation of the telephone system of the 1920s and 1930s.
Assume that Person X living in City A wants to make a call
within the same city. One commentator has described the
path of such a call as follows: X would take the receiver off
the hook, and then

. ..@ light would flash in front of the switchboard
operator indicating the specific customer desiring
service. The operator would plug in her answering
cord into the jack and obtain the called number.
She then would plug in the calling end of her cord
circuit into the jack associated with the called
party’s line and ring. Upon completion of the con-
versation, the line lamps would re-flash and the op-
erator would disconnect by removal of the cords.!7

If X made a long-distance toll call to another city or state,
the same procedure would occur, with the additional need
to access a toll office.

[T]he operator at the local originating switch-
board would plug into an idle outgoing toll con-
necting trunk, which terminated at the toll
switchboard. The toll operator recorded the de-
tails of the call and completed the call by jacking
into the trunk before her to summon the inward
toll operator at the called exchange. When the
subscriber hung up at the end of conversation,
the toll operator would enter the time on the toll
ticket and disconnect.!8

Thus, while the toll connecting trunks, circuits, and
switching trunks, and the toll offices were used only for
the toll service, the local telephone plant—the loop and
local office—was used for both local service and long-
distance toll service. This shared use of the local plant
created a problem for regulators in determining what por-
tions of the joint and common costs for the property
should be recovered by toll rates and by local service rates.
‘Two theories competed to provide the answer.

The board-to-board principle of telephone costing,
which predominated prior to 1930, held that toll rates
should be set so as to cover only the cost of the toll
connecting equipment and switches (i.e., the facilities be-
ginning at the trunk side of the originating local switch-
board and ending at the terminal side of the terminating
toll switchboard). In modern economic jargon, the
board-to-board principle is very similar to the concept of
incremental costing. Advocates of the competing sta-
tion-to-station theory of telephone costing maintained
that because the local loops and switchboards were used
to complete a long-distance toll call, some portion of the
local plant costs should be recovered through the toll rates.
Otherwise, the local exchange ratepayer would be subsidiz-
ing the toll user. Station-to-station principles required fully
distributed costs, that is, the costs of interstate services
should include the fraction of the joint and common costs of
the local telephone plant assigned to interstate service.

Because telephone rates were set so as to produce
revenue sufficient to allow the company to recover its
expenses and a fair return on the property used in its
regulated business, the choice between the theories hada
significant impact on telephone rates. If, for example, a
state regulatory body were to adopt the station-to-station
theory, then some portion of the costs (expenses plus
investment in plant) of the local exchange service would
be imputed to interstate long-distance service. The reduc-
tion in the costs (smaller rate base and fewer expenses)


setting forth what fraction of the component costs (ex-
penses and physical plant) would be imputed to the inter-
state services. At issue was the formula to apportion or
separate each unit of the physical plant and its related
costs between the intrastate and interstate telephone ser-
vices. The NARUC-FCC committee had suggested that
the separations be based on the relative actual use made
of the plant for each of the services.

Over the following three decades, state and federal
regulators experimented jointly with varying formulas, all
of which were criticized by one or more of the players as
arbitrary and/or inequitable. The fact that the formulas
tried were found wanting in one or more particulars did
not, however, undermine the basic agreement among the
regulators as to the propriety and importance of the sta-
tion-to-station method in promoting the shared goal of
universal telephone service. Indeed, over the years, FCC
acquiesced in a gradual increase in the fraction of the local
exchange plant assigned to the interstate jurisdiction.>1
By 1980, the formula assigned approximately 26 percent of
the costs of the local plant and its related expenses to the
interstate toll service.3?

State regulators used two other methods to keep ba-
sic rates relatively low. First, they engaged in “residual
ratemaking.” That is, the regulators spread general rate
increases among the various intrastate telephone services
according to a hierarchy that placed intrastate toll rate
increases at the top, increases in the cost of directory
advertising and sales in the middle, and basic exchange
rate increases at the bottom. According to residual rate-
making policies, basic rates were raised only as a last
resort.2? Second, state regulators allowed telephone
companies to depreciate their plant and equipment over
long lifetimes. This depreciation policy allowed recovery
of these costs (with their associated revenue require-
ments) to be spread over many decades.

By keeping the local service rates low, the separations
process, residual pricing, and depreciation policies all played
a key role in the growth of the telephone system across the
nation. By 1965, 85 percent of all households located in areas
served by AT&T were able to afford a telephone.34

THE FIRST FEDERAL ANTITRUST SUIT

The Communications Act of 1934 established the Fed-
eral Communications Commission to regulate interstate
communications and authorized the new agency to inves-
tigate the industry and make recommendations for fur-
ther legislation if needed. The FCC investigation lasted
several years and culminated in two reports. The first
“Proposed Report” (also known as the Walker Report),
issued in 1938, criticized the close ties between the Bell
operating companies and Western Electric, especially the
agreements covering the purchase of telephone equip-
ment from Western Electric. The report urged that the
operating companies be required to buy their telephone
equipment through competitive bidding.

The Walker report drew widespread and sharp criti-
cism from the press. The criticism had its desired effect,
and the final report, issued in 1939, backed away from the
previous pro-competition recommendations. Instead, the

report advocated minor changes in the law and more
money for enforcement. The issue of the ties between
Western Electric and AT&T did not die, however. Based
on information garnered from the FCC investigation, the
Justice Department filed a Sherman Act antitrust suit
against AT&T and Western Electric in 1949. The relief
requested by the government included divestiture of
Western Electric by AT&T and a ban against restrictive
agreements among AT&T, the Bell operating companies,
and Western Electric.

Because of numerous delays caused by legal maneu-
vering and the outbreak of the Korean war, the suit lay
dormant for many years. The passage of time anda change
in political administrations led to settlement negotiations
beginning in 1953. In 1956, the parties agreed to the entry
of a consent decree that limited the activities of AT&T
and the entire Bell system as follows: (1) AT&T could not
engage directly or indirectly in any business other than
that of providing common-carrier communication ser-
vices (e.g., AT&T could not enter the computer informa-
tion market) and (2) all patents owned by the Bell system.
must be licensed to others on request. The decree allowed
the existing agreements amon, ng the companies of the Bell
system to continue in force.>

MOVING TOWARD DIVESTITURE

Although AT&T’s vertically integrated corporate
structure emerged untouched from the antitrust lawsuit,
other developments were brewing that would lead ulti-
mately to the company’s breakup. Competition, in the
form of attachments to Western Electric telephones, new
service offerings in specialized markets and finally in the
public service network itself, gradually eroded the AT&T
monopoly. Technological advances, entrepreneurial chal-
lengers, a shift in federal regulatory policy, and judicial
activism all played a role in the process.

Challenges to the Telephone Equipment Monopoly

Challenges to Western Electric’s control over tele-
phone equipment began modestly enough. In the 1920s, a
company began selling a telephone accessory called
Hush-A-Phone. The cup-like device was snapped on to
the telephone handset to focus the speaker's voice direct-
ly into the telephone instrument, thereby providing priva-
cy. AT&T policy prohibited the attachment of any device
to the telephone that was not furnished by the company.
Violation of this “foreign attachment” rule could result in
suspension or termination of service. The rationale for
the policy was that the use of such devices might be “dele-
terious to the telephone system and injure the service
rendered by it.”36 Asa result of this AT&T policy, some of
the Hush-A-Phone distributors stopped selling the de-
vice. In 1948, the Hush-A-Phone company filed a petition
with FCC requesting that the commission order the Bell
system to allow the connection. When FCC ruled against
the company, Hush-A-Phone appealed the decision to the
DC Circuit Court of Appeals. The court set aside the FCC
order, finding that the device did not harm the telephone
system. The court set out a much-quoted standard prohib-
iting “unwarranted interference with the telephone sub-


A Commission Report

Intergovernmental Regulation
of Telecommunications

Advisory Commission on A-115
Intergovernmental Relations July 1990


important constituency of the FCC. Some analysts argue
that residential and small business users will find little
benefit in the long-distance interstate rate reductions
prompted by FCC policies. Further, recent price cuts in
AT&T's interstate long-distance rates (during business
hours) were accompanied by a monthly increase in the
charge that customers pay for their local service.!75

It is, of course, the task of government regulators to
balance these differential effects. If the natural constitu-
ency of FCC is large businesses, residential and

small-business telephone subscribers must rely on state
regulators (who are usually more sensitive to local con-
cerns) to protect their interests. The dual regulatory sys-
tem serves, therefore, to mediate between two goals: a
telephone service that is flexible enough to serve large
specialized users and yet is available to and affordable by
all. Continued federal preemption of state law by the
Federal Communications Commission may destroy this
balance created by the Congress.


are recovered through charges for interstate service and
the costs assigned to the intrastate service are recovered
through charges for intrastate service. Because this pro-
cess uses station-to-station principles, an increase in the
Costs assigned to the interstate jurisdiction should result
in an increase in the interstate telephone rates in order to
recover those costs, as was the case prior to divestiture. In
fact, however, the post-divestiture interstate telephone
rates closely follow board-to-board principles. The rea-
sons for this anomaly are found in FCC policies.

The MFJ required state and federal regulators to
replace separations charges with a set of tariffs for the
provision of access to the local network. To implement this
order, FCC adopted an access charge plan in December
1982.68 According to the plan, each telephone subscriber
would pay a minimum flat rate monthly to recover the
NTS portion of the interstate access charges. Initially,
FCC ordered that only a portion of the charge would be
recovered through the flat rate (set at $2 per residential
subscriber line and $4 per business subscriber line), with
the remainder to be recovered as a common-carrier line
charge passed on as a part of the charge for the use of
interstate toll service. Over time, however, FCC planned
to increase the subscriber line charge to cover the total
interstate NTS allocation. Thus, the effect of the FCC
access charge plan is to increase the rates of telephone
subscribers even if they do not use interstate telephone
service. To a telephone subscriber, the new flat rate sub-
scriber line or end user charge looks and acts like an
increase in local rates and a return to board-to-board
principles of telephone costing. To AT&T, recovery of
NTS costs through the subscriber line charge is merely a
reduction in the prior payments running from the
long-distance market to the users of the local exchange.

The FCC access charge plan drew heavy criticism
from state regulators, consumer groups, the Congress,
and Judge Greene. These critics charged that the imposi-
tion of a flat rate subscriber line charge without regard to
interstate telephone service use or the extent of such
use® was a disguised attempt to set local rates, a violation
of the principle of universal service, and “directly count-
er” to the intent of the consent decree.” In 1983, two
bills, which were designed to reverse the FCC ac-
cess-charge recovery plan, were introduced in the Con-
gress. S.1660 prohibited the imposition of flat fees to
recover NTS costs from residential and business custom-
ers. The bill provided that the NTS costs would be recov-
ered by a surcharge on long-distance carriers. H.R.3621
also reversed the flat rate end-user charge and required
privately owned and operated telephone systems that by-
pass the local telephone company to contribute to the
local telephone company’s costs. Reacting to the political
pressure, FCC announced on January 25, 1984, its deci-
sion to defer implementation of the subscriber line
charges until June 1985. The next day, S.1660 was de-
feated by a 44-40 vote.7! In June 1985, the first residential
subscriber line charge took effect. Currently, the flat rate
subscriber line charge is permanently capped at $3.50 per
residential and single-line business line.’ The multi-line
business charge is currently set at up to $6.00 per line and
is not permanently capped.

The FCC plan for recovery of the traffic sensitive

18

piece of the interstate access charge has not caused any
controversy. The TS costs appear as common-carrier line
charges and are passed along by the interexchange carri-
ers to the telephone subscriber according to actual use of
the interstate telephone service. Thus, at present, all tele-
phone subscribers pay a portion of the NTS access charge
costs as a flat rate subscriber line charge regardless of
their use of interstate telephone service, and subscribers
that use interstate service also pay a portion of the NTS
access charge costs as well as the TS costs based on their
use of interstate phone service.

The FCC policy is designed to compel a gradual shift
of NTS access charge costs away from common carrier
line charges to flat rate subscriber line charges. The re-
sults will be a decrease in interstate telephone rates for
heavy users of that service anda corresponding increase in
the rate for basic telephone services. According to FCC,
there are several justifications for this policy. First, the
commission argues that true competition requires that
prices be matched with costs. Accordingly, NTS costs
should not be recovered through traffic sensitive services
like interstate telephone service.73 Second, a mismatch of
prices and costs will result in the overpricing of interstate
telephone service relative to the marginal or incremental
cost of providing the service, causing common carriers to
bypass”* the regulated service. Third, if prices correspond
to costs, the price of interstate service will decrease, and
consumers will come out the same. This last justification
appears to ignore the fact that only a small number of
subscribers use interstate service at a level that will allow
them to benefit from the rate decrease.75

Critics of the FCC’s subscriber line charge policy
assert that it is based on the erroneous assumption that
local facility costs are truly non-traffic sensitive and are
incurred for the provision of local service, when in fact
many of these costs are directly related to interstate toll
calling. For example, the cost of improving the quality of
the signal would not be incurred for local calling alone, and
the higher levels of usage tied to toll service require more
and longer subscriber loops. According to the critics, FCC
should properly treat the former costs as part of the margin-
al costs of providing interstate toll service. Other local facil-
ity costs, such as the replacement of copper wires (tradition-
ally used to connect residential subscribers to local
exchanges) with fiber optic cables and analog switches with
digital switches are related to the provision of enhanced
services offered through the network, such as burglar alarm,
voice mail, and video text services. For that reason, some
commentators maintain that the latter costs should be
treated as part of the marginal costs of enhanced services
rather than recovered in the flat charge for basic service.76

In addition to supplying access for interstate calls, the
BOCs provide access to the local network for interex-
change carriers who transport intrastate interLATA toll
telephone calls. All states require that the traffic sensitive
portion of the intrastate access charge be based on use and
recovered from the carriers, who then pass such charges
along to the end users of the toll service. No such unifor-
mity exists, however, with state rules governing the recov-
ery of intrastate NTS costs. To date, most states do not


Members
of the
Advisory Commission on Intergovernmental Relations

uly 1990)

Private Citizens
Daniel J. Elazar, Philadelphia, Pennsylvania
Robert B. Hawkins, Jr., Chairman, San Francisco, California
Mary Ellen Joyce, Arlington, Virginia

Members of the U.S. Senate

Dave Durenberger, Minnesota
Carl Levin, Michigan
Charles S, Robb, Virginia

Members of the U.S. House of Representatives
Richard K. Armey, Texas
Sander M. Levin, Michigan
Ted Weiss, New York

Officers of the Executive Branch, U.S. Government

Debra Rae Anderson, Deputy Assistant to the President, Director of Intergovernmental Affairs
Samuel K. Skinner, Secretary of Transportation
Richard L. Thornburgh, Attorncy Gencral

Governors

John Ashcroft, Missouri
Booth Gardner, Washington
George A. Sinner, North Dakota
Stan Stephens, Montana

Mayors
Victor H. Ashe, Knoxville, Tennessee
Donald M. Fraser, Minneapolis, Minnesota
Robert M. Isaac, Colorado Springs, Colorado
Joseph A. Leafe, Norfolk, Virginia

Members of State Legislatures
John T. Bragg, Tennessee House of Representatives
David E. Nething, North Dakota Senate
Ted L. Strickland, Colorado Scnate

Elected County Officials
Harvey Ruvin, Dade County, Florida, County Commission
Sandra R. Smoley, Sacramento County, California, Board of Supervisors
James J. Snyder, Cattaraugus County, New York, County Legislature



42


ited to 5 percent, while decreases of 15 percent were
allowed. In general, the proposal provided for rate fluc-
tuations within bands that contained greater downward
than upward flexibility. AT&T-C could implement rate
changes that fell within the bands on five days notice.
With a few modifications, the California commission
adopted the AT&T-C plan in December 1988,134

In return for this pricing flexibility, the commission
ordered AT&T-C to maintain statewide average rates,
introduce all new services on a statewide basis, make a
maximum of four revisions within approved rate bands per
service per year, not impose restrictions on the resale and
sharing of its services, not abandon any service except by
formal application to the commission, not seek to with-
draw any service from a community on a geographically
discriminatory basis, and use the formal application pro-
cess for any new service submission or for the revision of
existing services.135

New York. New York recently adopted “incentive reg-
ulation” for both local exchange and interLATA service
providers. In 1986, the New York Telephone Company
and the state Public Service Commission entered into an
agreement for deferring any general rate increase for 18
months; later, the agreement was extended through 1990.
The plan allows New York Telephone two limited rate in-
creases for the purpose of recovering increases in wages
and fringe benefits, separations charges ordered by FCC,
New York City property taxes, and depreciation cost. Dur-
ing the rate moratorium, New York Telephone receives
two benefits: it is exempted from rate-of-return regula-
tion and it is permitted to retain some of the increased
earnings that may result from operational efficiencies.
Any increase in earnings that leads to a return on equity
greater than 14 percent is shared equally with the ratepay-
ersat the end of the moratorium. Thus, under incentive reg-
ulation, the telephone company bears the risk of increased
costs but retains the benefits of increased productivity and
sales at least until a portion of the profits is returned to rate-
payers in the next general rate increase.136 The commission
has entered into a similar plan with AT&T.

North Dakota. In 1989, North Dakota enacted a law
exempting all telecommunications companies and ser-
vices from rate-of-return regulation.!37 According to the
law, any telecommunications company can notify the state
public service commission that it wants to be subject to
rate-of-return regulation.138 Except for a class of services
deemed essential, the new law does not regulate the price
that can be charged for telecommunications services. Es-
sential services include, in part, access, billing and collec-
tion of the billing company’s own essential services, direc-
tory listing and local exchange directory assistance,
connection to the local exchange, and emergency 911 ser-
vices. Increases in charges for essential services may be as-
sessed no more than once a year, and the aggregate annu-
al price change for a service may not exceed an amount
calculated according to a telecommunications price fac-
tor. Company productivity gains must be shared 50-50
with subscribers. Essential service price increases so cal-
culated go into effect automatically, but the public service

26

commission retains the right to investigate (on its own mo-
tion or on complaint of any person) and set aside any un-
reasonable or inadequate price. The charges for all toll
services, including intraLATA toll, are deregulated be-
cause the latter services are deemed nonessential.

The North Dakota law prohibits cross-subsidization
by forbidding companies from using revenues from Tegu-
lated services to subsidize unregulated or nonessential
services. As an enforcement tool for this provision, the
law gives the public service commission authority to re-
quire companies to keep separate books of account, or to
allocate costs in accordance with procedures established
byrule or order of the commission. Profits from nonessen-
tial services can be used to subsidize essential services.
Finally, the statute creates a six-member regulatory re-
view commission composed of two members of the public
service commission, two members of the Senate and two
members of the House of Representatives. The review
commission is charged with the duty of monitoring and
reporting annually to the legislature on the effects of the
new law from 1989 through 1995.

Nebraska. Nebraska has gone further than any other
state in deregulating its basic local exchange service. In
1986, the Nebraska legislature enacted LB 835, which de-
regulated the rates of all local exchange and toll (interLA-
TA and intraLATA) service providers in the state. Due to
a constitutional challenge to the law, the state’s Public
Service Commission did not implement the law until
March 1987. The deregulation provisions of the Nebraska
Jaw are drastic; although there is no competition in basic
local service, the law removes virtually all state regulatory
oversight of that monopoly market. According to LB 835,
local exchange service rates can be changed, without the
need for a prior hearing (or indeed without even notifying
the commission) on the reasonableness of the rate
changes, on 60 days notice to all affected subscribers. The
commission can hold a hearing only if the rate increase is
above 10 percent or if a certain percentage of subscribers
petition for a hearing. Changes in rates for toll service are
effective on 10 days notice. Regardless of the percentage
increase and the number of complaints, the commission
has no regulatory jurisdiction over toll service.

Although it is too early to evaluate the effectiveness of
these state experiments, their existence is a sign of the vital-
ity of the state telecommunications regulatory environment.

OVERVIEW OF FEDERAL PREEMPTION
OF STATE LAW

The Federal Communications Commission in recent
years has aggressively preempted state regulation of the
intrastate telecommunications market. Prior to divesti-
ture, FCC had argued that preemption of state law would
foster competition through deregulation. In nearly every
case, the federal Circuit Courts of Appeals upheld the
FCC preemptive orders.139 After divestiture, FCC added
another argument—state regulation is inconsistent with
the need for uniform national policies. Once again, the
Circuit Courts of Appeal upheld FCC. 140

In 1986, however, the U.S. Supreme Court reversed a
decision of the U.S. Court of Appeals for the Fourth


be chosen by vote of the board; and (3) the decisions of the
board be final, subject only to review by the courts.200
These changes will require a statutory amendment.

The Joint Conference Process:
Section 410 (b)

Recently, FCC established a joint federal-state con-
ference under Section 410(b) of the Communications Act
to facilitate federal-state cooperation on ONA issues.
FCC established the joint conference in response to a
NARUC resolution calling for the conference. The mem-
bers of the joint conference include 13 state commission-
ers chosen from each of the BOC regions and three FCC
commissioners, one of whom is the chairman of FCC and
who will serve as chairman of the joint conference. Ac-
cording to the FCC plan, the conference will focus on “(1)
ONA technologies, the delivery of new services to the
public, nondiscrimination and efficiency in ONA services,
and the relationship of ONA implementation to state and
national economic development and competitiveness; (2)
the propriety of, and possibly the development of, model
ONA tariffs, with uniform nomenclature, format, and
terms and conditions; and (3) coordination of state and
federal efforts in such areas as BOC technical and mar-
keting trials for enhanced services and the effects of one
jurisdiction’s rules and policies on those of the other.”201

State and federal regulators have great hope for the
new joint conference process. The regulators tout the
greater flexibility of the joint conference which, unlike the
joint board, has no specific statutory requirements regard-
ing its output. In a ringing affirmation of dual regulation,
FCC noted that the conference should serve as a vehicle
to foster cooperative efforts to encourage compatibility
between state and federal regulations and to facilitate the
full measure of economic development that is crucial to
the country’s economic vitality in the emerging informa-
tion age. Because this ONA joint conference is the first
use of section 410(b), and because only two meetings of
the conferees have been held to date, it is too early to
evaluate the effectiveness of the approach. It isimportant
to note, however, that the joint conference procedure is,
like the joint board process, under the control of FCC,
which has the sole power to convene the conference,
appoint state members nominated by NARUC, and de-
fine the issues heard. Also, like the joint board, the joint
conference procedural guidelines do not provide for for-
mal votes on the issues addressed by the conferees but
rely instead on a process of consensus.

CONCLUSION

Prior to divestiture, telephone service in the United
States was provided by means of a highly integrated, monop-
olistic, centralized public switched network. AT&T and its
Bell subsidiaries provided most of the long-distance and
local telephone service for the national network. In the
early 1900s, states began regulating the telephone rates
charged by the monopoly providers by means of a
rate-base/rate-of-return formula, which was designed to
emulate the operation of competitive markets. This meth-

35

od was used by fedcral regulators, too, after the passage of
the 1934 Communications Act. The Act established a dual
federal-state regulatory system, giving states authority over
intrastate communication services and the FCC authority.
over interstate and foreign communication.
Rate-base/rate-of-return regulation was designed for
an integrated, monopolistic industry. With the introduc-
tion of competition into the interstate market, that meth-
od became less credible. With divestiture, the demise of
rate-base/rate-of-return regulation became inevitable.
The 1982 judicial divestiture decree, which settled the
federal government’s antitrust suit against AT&T, re-
quired that company to divest itself of all of the Bell operat-
ing companies (BOCs), restricted the BOCs to providing
intrastate intraLATA service, and required the BOCs to
provide equal access to the local plant for all toll carriers.
In addition to the structural changes effected by the
divestiture decree, technological advances have changed
the face of the telecommunications industry. Advances in
fiber optics and the increasing use of digital switches,
which allow a higher transmission rate, have paved the
way for the integrated transmission of voice, data, and
video over the same loop. These technological changes
have led states to redefine universal service, to study how
telecommunications can enhance their economic compet-
itiveness, and to prod the industry into upgrading the
public network. In these activities, some states have moved
out in front of FCC, introducing innovations into and creat-
ing diversity and flexibility within the public network.
These structural changes and technological advances
require a response from regulators that goes beyond the
adoption of new methods of regulation and the redefini-
tion of universal service. The changes require an entirely
new state-federal regulatory paradigm. Under the old
model, the federal government has sought, in recent
years, to create a uniform national telecommunications
network by preempting state laws. The new model will
require more cooperation among the regulators. The con-
tentious state-federal relations of recent years are no
longer viable for either state or federal regulators. By and
large, states have not been winners in the preemption
game, and FCC, too, has much to lose from building its
regulatory policy on the foundation of preemption. For
example, FCC has neither the staff nor the expertise to
set local exchange rates. Ratemaking for basic service is
an intensely local affair, differing in states with large ru-
ral, mountainous regions (like Colorado), in thinly popu-
lated states (like Wyoming), in states with multiple urban
centers (like California), and in states with a large finan-
cial service industry (like New York). Nor can FCC moni-
tor the numerous regional problems, such as cross-subsidi-
zation of unregulated services, that are likely to appear as
deregulation proceeds. Most important, a policy of preemp-
tion would result in an incalculable loss to the nation of the
lessons to be learned from the current state experiments.
The 1934 Communications Act, which created the dual
regulatory system, may contain the answer. Sections
410(b) and (c) of the Act provide for joint federal-state
boards and conferences. Restructured to meet some of
the concerns of the states, including who may convene,


The Post-Divestiture
Environment:
Phase One

21

OVERVIEW OF PHASE-ONE ISSUES

Divestiture introduced a new telecommunications
environment and created new regulatory problems, many
of which remain unresolved. First, prior to divestiture, the
regulatory goals were clear. Basic agreement existed
among regulators that universal service was the funda-
mental goal and that the separations-and-settlements
procedure, regardless of its complexities and controver-
sies, furthered that goal. Moreover, the structure of the
industry was consistent with that goal. AT&T, as the mo-
nopoly provider of local and long-distance telephone ser-
vice and related telephone equipment, was in an ideal
position to deliver low-cost basic telephone service. From
the point of view of vertically integrated AT&T, it mat-
tered little whether the system’s total revenue requirements
were recovered through local service rates or long-distance
rates. In the post-divestiture environment, the rules are
changed. The breakup of the vertically integrated monopoly
telecommunications network created a disaggregated sys-
tem, the components of which are furnished by competitors
with divergent interests and with a large stake in who pays
the charge for access to the local network. State and federal
regulators are searching, therefore, for alternative methods
of assuring universal telephone service.

Second, prior to divestiture, general agreement ex-
isted among regulators as to the wisdom of rate-base/
rate-of-return regulation of the monopoly provider.
Today, state and federal regulators are experimenting
with a wide variety of regulatory options from price cap to
social contract to incentive regulation for the so-called
dominant providers of telecommunications services.
Third, divestiture has brought with it a new kind of
cross-subsidization problem—that between regulated
monopoly services and unregulated competitive services
offered by the same carrier. Finally, prior to divestiture,
the need fora single regulator and single set of regulatory
policies was not essential for a nationally integrated tele-
communications system. One company provided virtually
all of the nation’s telephone service and related equip-
ment. Today, numerous companies compete in the
long-distance and telephone equipment markets, and fed-
eral regulators advocate preemption of state law to avoid
“balkanization” of the national network. This section ex-
amines these issues and states’ responses to them.

UNIVERSAL SERVICE

In a 1983 order, the Federal Communications Com-
mission listed a set of policy objectives for its access charge
plan. Included in those objectives was the preservation of
universal service.86 The commission described this objec-
tive as “avoiding actions that would cause a significant
number of local exchange service subscribers to cancel
that service.”87 Critics of the FCC policies have suggested
another way to describe the goal of preservation of univer-
sal service —avoiding actions that would cause a reduction
in further penetration.

Responding to complaints that the recovery of the
interstate access charge through a flat-rate subscriber line
charge might affect universal service adversely, FCC
adopted a lifeline program. The program provides two


Historical
Background

of the
Telecommunications
Industry

BEGINNINGS:
FROM COMPETITION TO MONOPOLY
AND BACK AGAIN

On the eve of the invention of the telephone, West-
ern Union dominated the telegraph industry in the
United States. With its lines strung alongside railroad
rights of way, Western Union’s telegraph services
spanned the nation. As the holder of the Morse patents,
Western Union also enjoyed a virtual monopoly in the
business. The company identified two potential threats to
its continued primacy, however: (1) attempts by financiers
to organize the existing small companies into a single
system, and/or (2) the development of major technologi-
cal innovations-not controlled by Western Union.?

Western Union had strategies in place to counter
such challenges. With small companies that were viewed
as potentially serious competitors, the company first en-
gaged in price wars and then offered favorable merger
terms. The company also purchased the patents to those
technological inventions that it identified as posing a risk
to its dominance. For example, in 1868, the company pur-
chased for $250,000 a patent from one J.B. Stearns for a
device that would permit the transmission of more than
one message at a time on a telephone wire. In 1877,
however, Western Union turned down an offer from
Alexander Graham Bell to purchase for $100,000 his pat-
ent on a method of “electrical transmission of articulate
speech and sound of every kind... .”3 In part, Western
Union’s refusal resulted from its belief that an engineer
employed by its subsidiary, Western Electric, had superior
patent rights on a similar invention.4

Rebuffed by Western Union, Bell formed his own
company. The Bell company began by leasing telephones
to customers who strung their own wires to connect with
those telephone lessees of their choice. In this way, each
telephone lessee created a private line between two
points. Despite the awkwardness of this arrangement,
Bell’s telephone leasing business proved successful. In
fact, many of Bell’s first business customers had been
customers of Western Union. Hoping to stem the loss of
its business base, Western Union hired Thomas Edison to
improve on Bell’s invention. Edison was up to the task. He
invented a transmitter that greatly improved the quality of
the voice transmission.

The two companies engaged in a heated battle, each
seeking to gain an advantage over the other. One of the
products of this competition signaled the birth of the mod-
em telephone industry: the creation of the Bell exchange
company, a switching center through which each subscriber
line passed in order to connect all subscribers. Bell’s other
competitive strategies included emphasis on technological
excellence and the filing in 1878 of a patent infringement
lawsuit against Western Union. Both tactics were successful.
With the invention of its own new transmitter, the quality of
the Bell voice transmission equaled that of Western Union,
and a negotiated settlement to Bell’s patent infringement
lawsuit in 1879 left Bell in control of the telephone industry.
According to the terms of the settlement, Western Union
withdrew from telephone service, sold its network of phones
to the Bell company, and transferred its telephone-related


Recent Publications of the
Advisory Commission on Intergovernmental Relations

The Volume Cap for Tax-Exempt Private-Activity Bonds: State and Local Experience in 1989,
M-171, 7/90, 40 pp.

1988 State Fiscal Capacity and Effort, M-170, 8/90, 128 pp.

Significant Features of Fiscal Federalism, 1990 Edition, Volume 1, M-169, 1/90, 152 pp.
Volume IT, M-169-II, 7/90, 220 pp.

State and Local Initiatives on Productivity, Technology, and Innovation, A-114, 6/90, 180 pp.
Local Revenue Diversification: Rural Economies, SR-13, 4/90, 60 pp.
State Taxation of Banks: Issues and Options, M-168, 12/89, 48 pp.

A Catalog of Federal Grant-in-Aid Programs to State and Local Governments:
Grants Funded FY 1989, M-167, 10/89, 40 pp.

Local Revenue Diversification: Local Sales Taxes, SR-12, 9/89, 56 pp.
Changing Public Attitudes on Governments and Taxes: 1989, S-18, 9/89, 36 pp.

State Constitutions in the Federal System: Selected Issues and Opportunities
for State Initiatives, A-113, 7/89, 128 pp.

Residential Community Associations: Questions and Answers for Public Officials, M-166, 7/89, 40 pp.

Residential Community Associations: Private Governments in the Intergovernmental System?
A-112, 5/89S pp.
Readings in Federalism—Perspectives on a Decade of Change, SR-11, 5/89, 128 pp.

Disability Rights Mandates: Federal and State Compliance with Employment Protections
and Architectural Barrier Removal, A-111, 4/89, 136 pp.

1986 State Fiscal Capacity and Effort, M-165, 3/89, 128 pp.

Hearings on Constitutional Reform of Federalism: Statements by State and Local
Government Association Representatives, M-164, 1/89, 60 pp.

State and Federal Regulation of Banking: A Roundtable Discussion, M-162, 11/88, 36 pp.

Assisting the Homeless: State and Local Responses in an Era of Limited Resources,
M-161, 11/88. 160 pp.

Devolution of Federal Aid Highway Programs: Cases in State-Local Relations and Issues
in State Law, M-160, 10/88, 60 pp.

State Regulations of Banks in an Era of Deregulation, A-110, 9/88, 36 pp.
State Constitutional Law: Cases and Materials, M-159, 9/88, 480 pp.
Local Revenue Diversification: Local Income Taxes, SR-10, 8/88, 52 pp.
Metropolitan Organization: The St. Louis Case, M-158, 9/88, 176 pp.
Interjurisdictional Competition in the Federal System: A Roundtable Discussion, M-157, 8/88, 32 pp.
State-Local Highway Consultation and Cooperation: The Perspective of State Legislators,
SR-9, 5/88, 54 pp.
Governments at Risk: Liability Insurance and Tort Reform, SR-7, 12/87, 42 pp.
The Organization of Local Public , A-109, 12/87, 64 pp.

Js Constitutional Reform Necessary to Reinvigorate Federa ism? A Roundtable Discussion,
M-154, 11/87, 39 pp.

Local Revenue Diversification: User Charges, SR-6, 10/87, 64 pp.

ions for Federalism, B-9R, 10/87, 88 pp.

Devolving Selected Federal-Aid Highway Programs and Revenue Bases: A Critical
Appraisal, A-108, 9/87, 56 pp.

Estimates of Revenue Potential from State Taxation of Out-of-State Mail Order Sales,
SR~5. 9/87, 10 pp-

Fiscal Discipline in the Federal System: National Reform and the Experience of the States,
A-107, 8/87. 58 pp -

Federalism and the Constitution: A Symposium on Garcia, M-152, 7/87, 88 pp.

onomii

The Transformation in American Politics: Implic:

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assigned to the local service market meant that less reve-
nue was needed to earn the allowed rate of return in that
market. The station-to-station theory, then, had the ef-
fect of reducing (or maintaining without increase) local
rates, and increasing long-distance toll rates, which now
had to earn revenue sufficient to reimburse the local
exchange companies for the local exchan ge costs imputed
to the long-distance service.

Conversely, if a state public service commission re-
quired board-to-board principles for telephone rates, the
local rate base would be deemed to include 100 percent of
the expenses and plant (subset, loop, and local office)
incurred to provide both local and toll service, leading to
the need for increased revenues and higher local tele-
phone rates. By allowing long-distance toll rates to be set
at their incremental cost, the board-to-board theory mini-
mized long-distance rates but raised local rates.19

Jurisdictional Separations

Ina 1930 decision, the U.S. Supreme Court addressed
the federal-state jurisdictional aspect of the problem. The
issue before the Court in Smith v. Illinois29 was whether an
order of the Illinois Commerce Commission, which re-
duced the rates for certain classes of local telephone ser-
vice, was confiscatory in violation of the due process
clause. Without deciding the ultimate question, the Court
held that because the Illinois regulatory body had not
“separated” (i.e., apportioned) the intrastate and inter-
state property, revenues, and expenses of the Illinois Bell
Telephone Company, it could not rule on the validity of
the rate reduction ordered by the Ilinois commission.
According to the Court, the failure to impute some of the
costs of the local exchange to the interstate toll service
resulted in the subsidization of interstate toll service by
the local service: “unless an apportionment [of the local
exchange costs] is made, the intrastate service to which
the exchange property is allocated will bear an undue
burden. . . .”2! Thus, in Smith v. Illinois, the Supreme
Court adopted the station-to-station theory.

The decision had no practical effect, however, be-
cause the Court failed to clarify how the process of sepa-
rating the costs of the local exchange between intrastate
and interstate markets should be accomplished. Indeed,
the Court’s decision left the impression that the separa-
tion of the costs was primarily a matter of drawing bound-
aries between state and federal authority in regulating
telephone rates.?2 In fact, ina later case, the Court found
it acceptable for the telephone company to impute a frac-
tion of the local costs to the interstate service along witha
corresponding amount of revenue.?3

The Smith decision also had an unintended effect on
State regulation. Because the Supreme Court emphasized
the federal-state jurisdictional nature of the separations
Process, its decision extended federal jurisdiction over
what had been solely state costs under the board-to-board
theory. Consequently, many state regulators refused to
adopt station-to-station principles, recognizing that to do
so would threaten their exclusive regulatory authority
over local exchange rates.24

The Early Period of Federal Regulation

By the 1940s, changes in federal regulatory policies
led to a recognition of the full significance of the sta-
tion-to-station theory and to its adoption. In 1934, the
Congress created a new regulatory structure for the tele-
phone industry. The 1934 Communications Act?5 estab-
lished the Federal Communications Commission (FCC),
and conferred on that agency control over interstate and
foreign communications companies, including the tele-
phone industry. The Act also retained the dual feder-
al-state regulatory system. Prior to this time, jurisdiction
over interstate telephone service rested with the Interstate
Commerce Commission (ICC). Because ICC viewed its pri-
mary function as the regulator of the railroads, it had neither
time for nor interest in the telephone industry.26

The Federal Communications Commission proved to
be a more shrewd regulator than ICC, if not a more active
one. Between 1936 and 1940, interstate rates were reduced
on four separate occasions. Commentators do not agree on
the role of FCC in these rate reductions; some maintain that
the reductions were a result of voluntary action by AT&T;27
while others contend that the reductions were a result of
negotiations spearheaded by FCC.?8 All agree, however,
that FCC took credit for the rate reductions.

One of the side effects of the decrease in interstate
toll rates was a disparity between the rates for interstate
toll service and intrastate toll service. While the rates for
interstate toll service (regulated by FCC) had dropped,
the intrastate toll rates (regulated by state commissions)
remained relatively high. The growing divergence in the
rates finally jolted state regulators out of their lethargy. In
1941, a group of state regulators and representatives of
the National Association of Regulatory Utilities Commis-
sioners (NARUC—a quasi-governmental nonprofit orga-
nization of regulators in the SO states, the District of
Columbia, Puerto Rico, and the Virgin Islands), met with
FCC to discuss the disparity in the toll rates. The outcome
of the meeting was an agreement to begin a comprehen-
sive cooperative investigation of separations problems.

Moreover, after 1940, FCC began to take a more
active role in supervising continued reductions in the in-
terstate rates. As a result of the increased federal regula-
tory surveillance over its rates and rate of return, AT&T
began to see the wisdom of the station-to-station theory.
AT&T reasoned that by using station-to-station principles
its interstate business would be less vulnerable to forced
rate reductions because its property base and expenses
would be swelled by absorbing some of the costs of the
local exchange.?9 In 1943, AT&T filed its interstate tar-
iffs>? using station-to-station principles, resulting in a $22
million transfer of revenue to the local Bell companies.
Seven years later, the local Bell companies also adopted
station-to-station principles in filing their intrastate tar-
ifs. Thus, in 1950, 30 years after the Supreme Court had
advocated station-to-station costing in Smith v. Ilinois,
that method became the norm.

An Era of Cooperative Regulation

AT&T pressed state and federal regulators to for-
malize station-to-station principles by adopting policies