CHAIRMAN REED HUNDT FEDERAL COMMUNICATIONS COMMISSION BUSINESS DEVELOPMENT ASSOCIATES, ANTITRUST CONFERENCE FOR CORPORATE GENERAL COUNSELS Washington, D.C. October 22, 1996 (As Prepared for Delivery) Antitrust and Interconnection: Old Wine in New Bottles Introduction Thank you for that kind introduction. I am very pleased to be with my ancestral colleagues today -- the antitrust bar. It was recently discovered that dinosaurs may have been related to birds; perhaps they had feathers and could fly on a windy day. This is good news for the dinosauric, century-old antitrust bar. We will be flying high as the communications revolution gives us the wings to lift off. Already we see the Department of Justice playing a new and not unwelcome role in the review of media mergers -- using traditional antitrust to set policy in an area traditionally reserved for FCC structural rules. We see the FTC providing innovative, bottleneck-breaking remedies in the communications sector -- expanding the scope of antitrust thinking to include diversity of voice and viewpoint, an area traditionally reserved for the FCC. This is also not unwelcome. And we see the FCC at last becoming the Federal Competition Commission as we are embroiled in intense and exciting litigations about opening the local exchange market -- litigations that at their core invoke the same principles underlying the antitrust laws animating our companion agencies. The agencies are shifting their missions, pouring old wine into new bottles. And so they should, as the communications revolution carries us to new frontiers of thinking. But the basic techniques for dealing with the new issues are or ought to be (for all the agencies), orthodox economics and clearly defined conceptions of the public interest. We are all for private competition in communications and public benefits from communications. Indeed, all agencies at the federal or state level should insist on competition in all sectors and should demand true public benefits from all parts of the country's magnificent communications sector. The era of semblance and shibboleth in communications policy is, or ought to be, ended; the era of real insight and real competition and real welfare gains is underway. Congress's Mandate of Competition In February of this year, Congress passed the most important telecommunications law in over sixty years. Indeed, it is one of the most far-reaching de-regulatory initiatives of all time -- it sets the goal of de-monopolization of the local exchange business, a $100 billion a year industry in this country. And that is only its current size -- not the much bigger market we may expect it to be as the result of competitive forces. Let me re-emphasize: the goal of this new law is not limited competition in some markets, but efficient and optimal competition in all demographic and geographic markets. Congress clearly intended that this competition be practical on a national, regional and local scale. Prior to the passage of this historic Act, there was no national competition policy in communications. States were free to adopt pro-competition rules, but most had not. This new law turned the traditional American communications policy upside-down. The new law comports with our advocacy of competition in bilateral negotiations with other countries. It is what we seek on a multilateral basis in the World Trade Organization. It brings communications services policy in line with our policies as to computers, compact disks, and communications equipment. We are for competition instead of monopoly; deregulation instead of regulation; smaller government instead of bigger; market solutions instead of governmentally managed answers. And we are for a national competition policy, not a variable policy where different states tolerate different degrees of competition. The Telecommunications Act of 1996 is certainly historic. But intellectually it is conventional and not revolutionary. It marked a dramatic shift in telecommunications policy in the U.S., but in fact the Act just brought telecom policy in line with our traditional policies for the rest of the American economy. That's not a revolution -- that's just an application of settled principles to a new sector. By contrast, the 1934 Act perpetuated the "natural monopoly" economic theory for telecom regulation. It was a regime -- characteristic of that era -- that required direct state control over decisions telecom firms made over the means of production. In the old regime of regulated natural monopoly, retail and input rates and investments were directly regulated by the government, and jurisdiction was split between states and the federal government in a feudalistic manner. States regulated "intrastate" services and the FCC regulated "interstate" services. This was then and it is now an artificial distinction that has cost the economy probably billions of dollars of welfare gains since the '34 Act was passed. Such a distinction is untenable in an industry of national and international scale that is undergoing rapid technological change. The distinction is also generally irrelevant to consumer welfare. And it led to numerous inefficiencies in pricing, some that stall competition and others that provide incentives for arbitrage and opportunistic entry that would not occur in a competitive market. Finally, to maintain and control this rate structure, many states made it illegal to be a competitive local telephone company. Now, you know, as antitrust lawyers, that we generally do not condone monopolies in America. The history of the Sherman and Clayton Acts is, of course, decidedly anti-monopoly. And although states have their own antitrust statutes to attain similar goals, we have had federal antitrust law for more than a century. Where the statutes conflict, Federal law is supreme. In antitrust, that is not only good constitutional law but is also good economics: competition law should not be Balkanized from state to state because economics is not different from state to state. For many years, we rejected competition policy in industries where the "natural monopoly" theory took hold -- the railroads, airlines, power, and telecommunications. Those industries are the historical exceptions to the century-old rule of competition. But now in all these industries we have at last repudiated the natural monopoly theory as overbroad and unwise. I am convinced that, in the end, in the communications sector (one of the last and biggest bastions of monopoly) the policy of full competition will prevail and is best for the country. I know I'm certain. I hope I am also correct. In any event, without question, for an antitrust lawyer, it's a great time to have my job and I'm loving every bit of it. The FCC's Interconnection Order and the 8th Circuit Stay In implementing the 1996 Telecommunications Act, the FCC faced a clear choice between favoring competition or favoring certain competitors. This is an inevitable choice presented by any reversal of pro-monopoly policy. As counselled by numerous Supreme Court cases, we chose competition. And we rejected importunings from industry and states to favor certain competitors at the expense of others. Every antitrust lawyer learns this basic point of antitrust law early on: the law safeguards competition not competitors. As Congress directed, and as the FCC Order reflects, there are four key elements of a pro-competitive (instead of pro-competitor) approach: (1) Do not favor any particular mode of competitive entry (such as facilities construction, leasing unbundled elements, or resale), but allow entrants to select the methods of entry that best fit their business plans; (2) Entrants must not be charged more than economic cost, and incumbents must be allowed to charge economic cost, for leasing parts of the incumbent network or for terminating calls on the network for leasing those elements and termination; (3) Wholesale prices for resold local service must be priced at retail less avoided costs that can or should be avoided; and (4) The job of creating and sustaining subsidies must be separated from the prices for leasing parts of the incumbent monopolist's network, or for terminating calls on the incumbent's local network. Congress embodied each of these key elements in the 1996 Act, and the FCC's interconnection order reflected each of these key points. Four states and certain LECs sought and obtained a stay of the FCC's interconnection order. The key issue has been whether the FCC has jurisdiction to establish national pricing methodologies reflecting the four key elements of a pro-competitive policy. They would have the states be the sole arbiter of what constitutes appropriate pricing policies. Some states claim they want to adopt their own competition policies and their own pricing methods for the four elements. But if there are no binding national principles, if one state seeks and obtains the power to determine prices to new entrants in its own idiosyncratic (albeit allegedly pro-competitive) manner, that necessarily means that any state has the power to reject any or all of the four key principles of a pro-competition policy. What states are saying, in reality although not in their rhetoric, is that they seek the unfettered authority to set anti-competitive prices with respect to any or all of the basic rights extended to the new entrant: the right to buy at wholesale prices, to lease parts of the incumbent's network, and to interconnect. I am not saying that I know of any particular state that will exercise such authority, or that states generally intend to act in bad faith or succumb to industry capture. I am saying that nevertheless states are opposed to a grant of authority to the FCC or to any federal court that would preclude a state from selecting an anti-competitive policy in the communications sector. In fact, you can see the potential for anti-competitive policies in some state laws and in the arguments the states presented to the court. Florida, for example, has a law that outlaws one form of competitive entry (resale) in the name of promoting another (facilities-based entry). Of course, as many economists have pointed out, in markets such as long distance, resale was a necessary competitive stepping stone to facilities-based competition. Resale gave entrants the opportunity to build the customer base necessary to justify and sustain facilities-based investment. Florida's request for stay in the 8th Circuit in effect protects its right to choose to be pro-competitor instead of pro-competition. This is ill-advised and contrary to Congressional intent. Indeed, Florida, in seeking a stay, actually seeks the authority to be pro-incumbent, if they choose to follow that policy. It is irrelevant that they've not done so. The question presented is why should Florida have the power to deviate from the national competition policy? How can Congress be thought to have intended that result? Iowa argued in the 8th Circuit that it must be permitted to set prices for unbundled elements and interconnection based on historic cost, rather than economic cost, because on the facts in Iowa this generated a lower price for new entrants. This approach to pricing is also pro-competitor rather than pro-competition. The favored competitors are new entrants. No wonder U.S. West is complaining about Iowa's policies. If Iowa actually used this approach to pricing, Iowa would be favoring purchasers of unbundled elements over facilities-based providers, and would be artificially discouraging investment in competing facilities. Incidentally, Iowa announced its first arbitration results last Friday, forcing important agreements between new entrants and the incumbent. Early reports state that Iowa may have effected in arbitration prices that were calculated with a forward looking economic cost model rather than historic costs. If true, it is good policy, although contrary to what Iowa told the 8th Circuit. And if it is true, I am left really to wonder why Iowa is fighting for the right of other states to set anti- competitive, historic cost prices. New York appears to be another example of an unnecessary, inappropriate departure from a pro-competition policy. New York has a rule called "play or pay". As a new entrant, if you agree to serve all customers in your service territory, you pay a relatively low cost-based price for terminating calls on the incumbent monopolist's network, but if you serve only some customers, you pay a much higher price for terminating the same calls. This generates huge subsidies for incumbents. In their litigation, the states are defending New York's right to use interconnection prices to generate subsidies for basic telephone service, regardless of the effect on competition. How can it be good for the country -- or for Americans in any state -- for the cry of "states rights" to be used to defend the power of any state to be against competition in any material respect, to pick winners and losers in the telecom marketplace of the twenty-first century, to burden some but not all competitors with universal service obligations? Why do some states who say they are committed to pro-competition outcomes go to court to argue for the right of states not to adopt such policies? In 48 pages of its interconnection rules, the FCC detailed Congress' pro-competition policy framework. These rules did not mandate or dictate specific prices to the states. Rather, they lay out the pro-competition principles, including the forward-looking cost pricing methodology, on which states are to make their determinations of the price of the leased elements and interconnection obtained by new entrants. States were directed to use forward-looking economic cost because it is the only correct pro-competition pricing methodology. But states also are to select key variables on their own, including cost of capital, depreciation rates, assumptions of fill factors, and other components of determining forward looking economic costs. Our approach to federalism was routinely praised. Merrill Lynch said that by the August Order, "the FCC has smoothed the way for ... local market competition." Morgan Stanley called it "evenhanded," CS First Boston said that "the FCC Order hits the mark," and that "the FCC is set on the right course." The Order was the talk of the world communications circuit. In fact, it is a reasoned explanation of our negotiation posture in dozens of bi-lateral international discussions. If the principles of the Order are implemented, we will see major new investment and job growth in our own country, billions of dollars of welfare gains, and a major boost to our glorious communications revolution. In a word, it is the blueprint to the building of the information highway. But last week, Congress, the FCC, communications companies (both existing and unborn) and, above all, American consumers ran face first into a wall of frustration when the 8th Circuit issued a stay regarding the national pricing methodology in our rules. The FCC's 48 pages of rules were backed up by 650 pages of our reasoning, which in turn reflected a 17,000 page record. But the 8th Circuit stayed the forward-looking pricing methodology in a 9-page decision affirming the allegedly traditional state role in intrastate pricing. Yet virtually no state has any tradition of pricing the inputs to rivals that are the subject of the FCC Order. And Congress clearly made a federal question of the national competition policy, vesting the FCC as its principal interpreter for applying the national competition policy. The 8th Circuit decision was, in my opinion and with respect for the court, breathtaking judicial activism. Judicial disregard of the intent of Congress and the expert work of agencies causes reasonable and widespread criticism of our cumbersome, delay-prone, status quo-protecting, expensive, and intractable legal culture. Judge Bork, in his new book, Slouching towards Gomorrah, which inveighs broadly against judicial activism, has a telling instruction for someone in public life: It has been the judiciary, and not its critics, that has misled the public as to the role of judges in a constitutional democracy. Harsh criticism by political leaders of outrageous judicial decisions is a legitimate and necessary response. I don't mean to be harsh or overly critical of the 8th Circuit ruling. But I am eager to see the Supreme Court affirm the deference to Congress and to its expert and independent agency that is appropriate for courts. The Supreme Court should lift the stay -- as Justice Stevens did last year after the 6th Circuit enjoined one of our auctions. And our country should have one national competition policy, as set forth in our rules, and implemented by all states, for the communications sector. The Economic Basis for the Order As I suggested earlier, the economic basis of our interconnection order is wholly consistent with conventional notions of economics and antitrust policy. Any attempt to introduce competition in local markets must deal with the network externalities and the economies of scope and density that make up the incumbent's advantage in this market. In the Act, parties are encouraged to negotiate interconnection agreements. So why does any government -- whether the FCC or the states -- have to get involved? Because the bargaining power in these negotiations is unequal. Moreover, in the Act, Congress insisted that the incumbent share the advantages of the existing network and the economies of density and scale -- again, advantages due to incumbency. It did so by giving new entrants the right to interconnect, to lease portions of the network, and to buy retail services at a wholesale price. All these rights, of course, are real if and only if they can be exercised at a price that is pro-competition, not pro- any single competitor. By giving entrants these rights, Congress, in effect, repealed federal and state rules that give an incumbent such power over entrants that the industry might indeed be a natural monopoly. It mandated instead rules that equalize bargaining power and lower the entrant's cost curve, without raising the incumbent's. The rules create a level playing field by, I suppose you could say, raising the entrant's end of the playing field, without lowering the incumbent's. For instance, Congress gave entrants the right to purchase unbundled elements of the incumbent's network at cost-based prices. To be pro-competition, these "cost-based" prices must be based on forward-looking cost. When the incumbent in a competitive market contemplates expanding or rebuilding or selling or generating a retail price for a customer using its network, it is forward-looking cost that it considers; thus only forward-looking cost gives the new entrant the same opportunities from the existing network that the incumbent gets. Indeed, sound business decisions, by competitive and monopolistic firms alike, are based on forward-looking costs, so it is in terms of forward-looking costs that the playing field must be leveled. Moreover, only prices based on forward-looking costs can prevent incentives for arbitrage as retail prices become more competitive. It's true that Congress gave entrants the right to choose which unbundled elements to take from the incumbent. And it's also true that the value of network elements can fluctuate. But that is a policy problem only if the price set for the network elements is based on historic cost. If the price the entrant must pay is economic user cost with economic depreciation, based on forward-looking, or replacement cost -- i.e., reflective of current market value -- then the incumbent doesn't get left holding the bag. It gets paid enough to continue to invest in, to maintain, to operate, and to profit reasonably from its network. Lease prices for elements based on historic cost pricing do not provide such guarantees because entrants have a right to choose which unbundled elements to take. And meanwhile under forward-looking cost pricing, the entrant gets into business more quickly and more broadly, with a cost function that shares the incumbent's efficiencies of scale. That is just what Congress wanted and just what consumers should want. Of course, any incumbent wants to get more money from its rivals rather than less money. This impulse is inevitable. But to load recovery of historic costs, or universal service subsidies, or any other extra charge, onto the prices of inputs sold by incumbents to competitors is tantamount to raising rivals' costs and is therefore anti-competitive. Traditional universal service goals can be and should be funded with competitively neutral mechanisms, and the same is true of any other funds that need to be raised for socially desirable purposes. A National Policy is Necessary and Appropriate Despite the obvious and clear correctness of the forward-looking methodology, some continue to say that there should be no national policy requiring forward-looking pricing of the network inputs acquired by the new entrants. Without such a policy, the door would be open to the continuation of the anti-competitive policies that, in whole or in part, are manifest in the rules of most states. Let me say that a state like Illinois has done much to prove it's an exception to this assertion. But there are few complete, holistic exceptions of states with pro-competition policies. The continuing theme we hear is that the states can manage the local monopoly in some way that is better than the congressionally-mandated national competition policy. Rarely, if ever, does anyone even aspire to explain in convincing detail what that sort of state-by-state management would do for competition or the public interest. One suspects that there still lurks in this discussion -- if only between the lines -- some sense of approval for the natural monopoly notion. Recall what the natural monopoly theory meant -- because of the greater efficiency of larger size, greater density, and greater connectivity, competition could not thrive, and would not be helpful if it could. But what is a natural monopoly and what isn't depends not only on technology and consumer preferences, but also on the rights and duties of firms -- on the rules that govern competition. Antitrust lawyers know this very well -- every oligopoly that has high barriers to entry would "naturally" be a monopoly if firms had an absolute right to merge or to collude through binding agreements on pricing. And every industry with a fixed set of customers would perhaps "naturally" be a monopoly if the first entrant had a right to sign customers to binding contracts and not to deal with entrants. Yesterday, our brilliant chief economist Joe Farrell brought up to you at this conference an interesting analogy between patent law and the Telecom Act. He correctly pointed out that patent law in effect creates "natural" monopolies because the patent holder is given the right by the government to exclude others from using his invention. In the context of patent law, however, society states that at some point it becomes more important to have competition in that market, and we require that the benefit be shared with competitors. The Telecom Act does the same thing with the incumbent LEC's "natural" monopolies. In effect, the interconnection rules are a mandatory licensing policy on the incumbent monopolies' networks. Similarly, the program access rules for cable television programming networks require that cable system operators with interests in cable programming networks must sell access to that programming to their competitors on a nondiscriminatory basis -- for, essentially, the same price that they charge in free, competitive markets. This was a significant policy decision because most of the popular cable programming networks were owned in whole or in part by cable system operators. There was a network effect present that harmed competition to cable from other multichannel rivals because the programming that people wanted to see was available on cable only. In essence, the 1992 Cable Act adopted program access rules that mandated that cable system operators share those effects with cable's competitors such as DBS and MMDS by selling those networks on a nondiscriminatory basis and on just and reasonable terms. Those rules have been credited, in part, for the launch of several rivals to cable systems, such as DBS. In Aspen Ski, the Court essentially required that the "network effect" that resulted from offering "All-Aspen" ski resort passes be offered to all ski resorts in Aspen and not just some. In United Shoe, the Court basically ordered that United Shoe "unbundle" -- or perhaps I should say "untie" or "unlace" -- the leasing of shoe equipment from maintenance or sale of those machines. This result was necessary because United Shoe would otherwise hamper competition by offering "free" maintenance by bundling this service with the lease. The forward-looking cost issue was debated in the 1982 MCI/AT&T case, when MCI made a predatory pricing claim. And the 7th Circuit ruled against this claim by referring with approval to AT&T's "costs on a forward-looking basis." The 7th Circuit explicitly stated -- [I]t is current and anticipated cost, rather than historical cost, that is relevant to business decisions to enter markets and price products. The business manager makes a decision to enter a new market by comparing anticipated revenues (at a particular price) with anticipated additional costs. . . . The historical costs associated with the plant already in place are essentially irrelevant to this decision since those costs are 'sunk' and unavoidable and are unaffected by the new production decision. (708 F.2d at 1116-17, as modified). That statement unquestionably supports the FCC's interconnection pricing methodology. Congress clearly created in the new law a federal question of the most traditional sort: are the incumbent monopolies in the various states setting prices for the inputs of wholesale pricing to new entrants and leased portions of the incumbents' networks at anti-competitive or pro- competitive levels? The answer can be found by using the optimal pricing methodology for efficient competition as to all demographic and geographical markets in the existing telephone company monopolies described in the MCI case. Namely, it is forward-looking cost. In the wake of the 8th Circuit stay, I call on all states voluntarily to adopt this pricing methodology and to say so expressly. In that way the FCC and judicial review of their various rules and decisions, as appropriate, can be expedited and facilitated. Conclusion It is vital that we all push towards ending the current regulatory monopoly model for local telecommunications. Every day I read or hear about some possible new service that would be "on our doorstep" if the current bottleneck were removed. But continuing the era of monopoly will only lead to high prices, low quality, and a lack of innovation. We cannot allow ourselves to be hung up in the old regulatory paradigm. It is competition -- not monopoly -- that will replace narrowband bottlenecks with low-cost, high quality, and innovative broadband pipelines. The Sherman Act was an appropriate and sound tool for breaking up the monopolies that had developed during the Industrial Revolution. It was so successful that many other nations copied our approach. What is odd is not the application of solid antitrust thinking to local telecommunications services markets, but how long these markets have remained protected from competition by active, anti-competitive government regulation. When cases like Standard Oil and Alcoa were decided, our economy ran on oil and metal. Our economy now runs on impulses of digital bits transmitted via fiber, wire or the ether. It is high time that the communications industry (so vital to our country) operate under the same pro- competitive policy as every other industry in the U.S. And -- despite the intricacies of our legal culture, which has at least given an interesting and rewarding life to the lawyers in this room -- I am confident that this will happen and happen quickly. -FCC-