The Hartman Memorandum: FCC Rules Created Massive Cross Subsidies for Business Data Services.

NOTE: The Hartman Memorandum and History are written by telecommunications experts for regulators and specifically submitted to the FCC to start to stop the cross subsidies.

When you pay your wireless bill, or when your company uses a business broadband service (sometimes called Special Access), or maybe you just have local phone service from Verizon or AT&T - should you be gouged?

These services are all related. For example, your wireless service is really a wired service with an invisible extension cord because when you call or download or send something, you connect through a cell site to - a wire, a special access wire. And business services, like ATM machines or broadband services, are now mostly delivered over a special access wire, now renamed "business data services" by the FCC. Even competitors, like Sprint, that offer wireless service usually have to rent these special access services from the incumbent phone companies.

The FCC is about to make a decision about these special access networks, claiming that the Agency can create prices that are 'just and reasonable' for end users and the competitors.

The Hartman Memorandum proves that the FCC can never create just and reasonable pricing for special access services because the FCC's own cost allocation rules created massive financial cross subsidies between and among the state-based wired utilities, and the companies' other lines of business, such as special access, or the wireless service.

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I'll come back to this chart in a moment, but if you want crazy, two items stand out:

  • 75%-25% Rule -- 75% of most network expenses are paid by the Local Service phone networks (intraLATA) vs any 'interstate' services, such as Special Access, which pays only 25%. This rule was created in 1984 and has not been adjusted or replaced for 32 years.
  • "Cost Allocation Rules" Were Set Based on the Year 2000 -- In 2001, the FCC created a series of rules pertaining to the allocation of expenses to match the year 2000--16 years ago. In 2001, Local Service was about 65% of revenues and it paid about 65% of costs. In 2015, Verizon New York's Local Service revenues were 25% but it still paid 61.2% of all 'corporate operations' expense. Access services, which represented 47% of revenues, only paid 28.6% of the corporate operations expenses.

And these rules are still in use today, regardless of the knee jerk reaction many have. They claim that the companies are under price caps and that these rules were 'forebeared', meaning not enforced by the FCC but are still on the books.

Maybe you weren't aware that, say, Verizon New York or Verizon Pennsylvania are state utilities and that most of Verizon's wireless networks--the wires to the cell sites, were installed as part of the state utility. Or maybe you don't know that the special access wires or the FIOS wires or, well all of the fiber optic wires were cross subsidized, where the capital expenditures were paid for by the local phone customers as Verizon claimed these were just upgrades, are classified as "Title II", and are part of the utility.

And all of the affiliate companies have been 'vertically integrated', meaning that they all get benefits and perks from the ties to the state utility that no other competitor gets, or that allows them to control the pricing of not just wireline but wireless and other services, like special access.

And what we're about to expose is that the FCC's rules have run amok. Combined with a failure of the FCC and state commissions to actually provide oversight, the FCC's rules created a massive financial shell game--costing us all extra fees. The price of a 'gig' of wireless service has been inflated based on the special access profits and the cross subsidies with the wireless company. There have been rate increases on local service to pay for these cross subsidies, and the pricing of special access can't be set at 'just and reasonable' rates without examining actual costs and removing the subsidies.

In short, The Hartman Memorandum details why immediate investigations are necessary, and not some jiggled, made up pricing by the FCC that doesn't address the issues or fix the problems.

The Hartman Memorandum is part of the Fixing Telecom series and is accompanied by:

  • The History & Rules of Setting Phone Rates in America --The FCC's 'Big Freeze' & Cross Subsidies -- which supplies a history of the FCC and state rules and ratemaking process for the last 50+ years.
  • Fixing Telecom, Fixing Broadband Data Services -- which supplies a road map on how to use the Memorandum to get cities upgraded and bring in robust competition to lower prices. (Release Date: TBA)

Backdrop

In 2002, the second version of AT&T (1984-2005), filed against the incumbent, wireline phone companies, which are now AT&T, Verizon and Centurylink.

A quote from the opening of the original AT&T Petition, October 2002:

"As detailed below, there is now indisputable proof that: (i) large LECs, and particularly the Bell Operating Companies ("Bells"), retain pervasive market power in the provision of these services, (ii) the large ILECs are abusing that market power with patently unjust and unreasonable rates that impose a multi-billion dollar annual overcharge or tax on American businesses and consumers and also severely harm both local and long distance competition, (iii) the Commission's existing rules are incapable of addressing this worsening crisis, and, indeed, only exacerbate the problem, and (iv) the Commission therefore has a clear legal obligation promptly to reform its regulation to protect the public interest and to put an end to these monopoly abuses."

NOTE: "LECs" or "ILECs" are the local exchange companies, the state-based utilities. In 2002, the "Bell Operating Companies" controlled the access wires. Today, this represents AT&T, Verizon and CenturyLink.

And today, in 2016, any incumbent provider that controls these networks controls all of telecom, wired, wireless broadband, IP, and any future wireless services that will arrive called "5G".

In 2007, the FCC stopped collecting basic business and financial data on the incumbent phone companies, called "The Statistics of Common Carriers", which had started publication in 1939.

In 2015, the FCC collected data on special access, renaming it 'Business Data Services". This collection was very limited, as it collected information from companies who spent over $5 million in billings annually.

Based on this data, the FCC found that special access was a $45 billion dollar market in 2013, and that 60%, the majority, was still copper-based services, $27 billion. (We believe this is the low case scenario.) The data is supposed to be used for finally dealing with AT&T's original special access petition and setting a new direction.

And there's a problem with the FCC's finding - Common wisdom says that there was a decline in copper-based access lines. Yet, from 2007-2015, Verizon New York's special access services increased 80%--and thus these lines have also increased. However, all of the fiber optic wires are also part of the state utility and Title II as well.

In 2015, special access revenue in just New York was $2 billion, and this means that the 'mostly copper' wire-based services were almost $30 billion nationwide. And the profit margins for these services appear to be obscene. In NY, the EBITDA, Earnings Before Interest, Taxes, Depreciation and Amortization was 66%. I.e., these are the profits of a mostly monopoly service.

In fact, in April, 2016, Consumer Federation of America (CFA) found massive overcharging of special access networks.


"Taking on one of the most pressing issues facing the current Federal Communications Commission (FCC), the Consumer Federation of America (CFA) today released a study that estimates that large incumbent telephone companies have engaged in abusive pricing practices for high-speed broadband "special access" services, with overcharges totaling about $75 billion over just the past five years. As a result, CFA estimates that the indirect macroeconomic loss to American consumers doubles that damage to a total in excess of $150 billion since 2010."

And in 2016, the CFA and New Networks Institute (NNI) filed joint comments in the special access proceeding.

Also, in April 2016, INCOMPAS, the non-incumbent competitor association, known as 'CLECs', cut a deal with Verizon, proposing a decrease in rates, and some other points.

As of November 4th, 2016, the FCC has just floated a new proposed deal that cuts these competitors off at the knees. And, this will not fix the overcharging, and it is not based on actual financial reports but mathematical models, which hides the cross subsidies.

The Hartman Memorandum makes the case against the carriers and the FCC, detailing that the FCC's failure to fix the cost allocations rules to match reality created a regime of massive cross subsidies - in all states, as there is no indication that any state has undertaken any examination of the cross subsidies between and among affiliates and the state utilities.

Many Harms Need Immediate Investigation

This Distortion of the Accounting has had Multiple, Direct and Harmful Impacts on All Services -- Special access had a 66% (EBITDA) -- because it paid only a fraction of expenses while Local Service paid the majority. In fact, all of the 'interstate' broadband networks, including the wires to the cell sites for Verizon Wireless or even FiOS TV, all paid fractions of the expenses and thus have very high profit margins.

Direct Harms to All Wired Services -- Unfortunately, special access cannot be examined without looking at all of the other lines of business, from Local Service to the implications of massive cross subsidies that were designed and helped to create harmful public policies.

At the same time, these expenses made the local phone networks artificially unprofitable, which has been used as an excuse to 'shut off the copper' or force customers onto 'more profitable' wireless services. This has also been an excuse for not building out FiOS broadband to many areas throughout the East Coast.

The FCC's Proposed Rules Do Not Address Cross Subsidies -- The proposal does not fix the excessive profit margins nor examine that the FCC's rule making doesn't include the fact that local phone customers have been overcharged, having paid the excess profits. Moreover, the agency has never addressed the fact that these wires are part of the state utility as they are classified as Title II, and that the expenses paid are mostly within the state and thus 'intrastate' where the FCC does not have jurisdiction, since its jurisdiction is 'interstate'.

The FCC's Plan Also Includes a Host of Proposed Actions that Will Cause Multiple Harms -- For example, the FCC's plans do not require the incumbents to share any new build-out of fiber optic special access services with high speeds with competitors, even though the majority of the expenses were paid for by local service under the FCC's own rules, or rate increases agreed to by the state commissions.

Harm to Broadband and Internet Competition -- Much of the incumbent's retail business is in Internet access now, including DSL and FiOS and they are classified as interstate. In fact, anything that carries Internet services is interstate. Thus, all of the growth areas, including competitive ones, are in the interstate basket, which is not paying its fair share. This also makes it easier for the ILECs to undercut "broadband" competition.

Harms to Users and Municipalities -- As we discuss, the Consumer Federation of America found over $75 billion in special access customer overcharging in just the last five years. Moreover, these financial distortions diverted monies to the affiliate companies, such as Verizon Wireless, that should have gone to upgrade and maintain communities' network infrastructure for broadband and internet services.

The Cost Allocation Regulations have been Erased but Are Still In Use -- Worth mentioning again, there are those who will say that the rules have been 'forebeared' - i.e., while the rules are still on the books but are no longer required. Unfortunately, the Verizon New York annual reports and matching reports from Massachusetts prove that the rules are still in use. But it also exposes that the price caps, where the price is set but the profits aren't examined, did not work.

The History of the Cost Allocation Rules for Telecommunications

SEE: The History & Rules of Setting Phone Rates in America --The FCC's 'Big Freeze' & Cross Subsidies

The Communications Act of 1934 mandated that everyone in America was entitled to phone service, and this would be delivered to homes and offices, schools and libraries throughout America. Moreover, phone service would be delivered by a state-based utility that had a state-based (or city-based) franchise to offer phone service and the wires were based on copper wires.

These wires, just like gas or electricity or even water, got benefits such as the use of the public 'rights-of-way', or guaranteed profits via rate increases. More importantly, the service rates were based on actual costs.

With telecommunications, there are different services using the exact same wires; these include 'Local Service' or companies using the 'special access' networks.

And the different services have 'classifications' and are controlled by different regulators. "Local Service" was 'intrastate', (calls and service within the state), and it is regulated by the state utility commissions. Other services, like long distance or later broadband and Internet, were declared 'interstate' and under the jurisdiction of the FCC.

Returning to the Opening Chart:

In order to make sure that the different lines of business paid their fair share to use the networks, a system was created so that both state and federal regulators were on the same page:

  • Uniform System of Accounts (USOA) (also called "Part 32") was created. It itemized the tens of thousands of expenses, revenues, taxes, and put them into a database/catalog with hundreds of separate categories.
  • Separations Manual (Part 36) was created to be able to allocate these expenses to the different lines of business.

So, local 'POTS' or plain old telephone service would be listed in specific revenue categories using the USOA and the expenses would be charged based on the Separations Manual. Originally, the expenses were based mostly on revenues (with caveats).

Also, around 1984 the FCC decided that the long distance 'interstate' portion would only pay 25% of expenses for various network costs--Local Service would pay 75% of these expenses for specific items, like cables and wires.

Then, in 2001, the FCC froze the 'Separations Manual' to allocate expenses based on the year 2000--that's right, the year 2000--and there it sits until 2017.

In 2007, the FCC stopped collecting and publishing data on the state utilities. Known as the "Statistics of Common Carriers", (which had been continually published since 1939), contained details about the revenues and expenses, while the FCC's ARMIS database supplied much of the info about expenses and revenues.

By 2008, the FCC 'forebeared' many of these rules, meaning they would stop requiring some, if not most of the regulations on cost allocations. This also meant that the price of service was no longer tied to the expense of offering the service.

Unfortunately, the states did not stop applying the rules and it is clear that what's been going on is a massive cross-subsidy system to use local service as a cash cow to fund all of the other lines of business, while at the same time, pleading poverty.

Gaming the System: A Mockery of the Principles of a Utility and Public Obligations.

This diagram sums up what happened in virtually every state. Specific parts of the state networks would be deemed interstate and profitable as they aren't paying their fair share of the expenses, while the local networks would start to deteriorate.

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The Hartman Memorandum shows the impacts of the FCC's rules and negligence using Verizon New York's 2015 financial report, as well as comparing it to the years 2000 and 2007. And it shows the impacts from the 'Big Freeze'.

According to Verizon NY's 2015 annual report, Local Service brought in $1.3 billion and had an EBITDA of -132%. This is in contrast to Special Access fees, which were $2.5 billion in revenue and had an EBITDA of 66%. (Special Access was $2 billion and represents 80%+ of the total.)

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One would say that 'Local Service' was losing money until one examines the network costs ("Plant Specific and Non-Plant Specific") and notices that Local Service paid $1.47 billion, which is in contrast to Special Access services only paying $716 million, literally half of what Local Service paid. i.e., Local Service paid 117% of revenue while Special Access paid 29% of revenue.

Local Service revenues are mostly from the copper-based "POTS", "Plain Old Telephone Service", lines. Verizon has stated it is no longer upgrading and maintaining these lines, the retail copper lines.
How can Local Service be paying the majority of network expenses? And how can Special Access services have a 66% EBITDA for mostly copper-based services while the same exact wires have massive losses?

Manipulating the Accounting of Lines

What happened to the state utility in general is - Local Service ended up having the majority of expenses being dumped in the accounting of the 'intrastate' side instead of the 'interstate' side paying its fair share of common costs due to the Big Freeze. In fact, some areas that the company wanted to be profitable, such as wireless or special access - were even removed from the basic accounting.

This can be seen best in the accounting of lines. 'Common wisdom' says that Verizon's is losing lines, but these are only the intrastate POTS copper based phone lines. They do not include the majority of lines in service.

  • DSL
  • Competitive copper based lines
  • Special access lines
  • FiOS Lines
  • Wireless and hot-spot back haul lines

See: How Many 'Special Access' Lines Are There in America? 'Zero' or 600 Million?

In our previous chart, all of these access lines would be part of the apple slices and separate from the 'core'.

Coda: The Hartman Memorandum and the History are written by telecommunications experts for regulators and specifically submitted to the FCC to start to stop the cross subsidies. However, the implications are enormous and we will come back to this story as things progress... or regress.