After WorldCom: How Much Consolidation Can U.S. Telecom Regulators Permit?

By Gregory Staple and Neil Imus*
WorldCom's recent bankruptcy has likely set the stage for a new round of telecom industry mergers that will test the long-standing competition policies of U.S. regulators. As Federal Communications Commission (FCC) Chairman Michael K. Powell told Congress in July: "It is difficult to imagine the industry stabilizing without some modest and prudent restructuring."

With new financing in hand and relief from old debts, WorldCom could emerge from bankruptcy as the low cost provider in two key markets: long distance (through the MCI business), and Internet backbone services (through WorldCom’s subsidiary UUNet which already has about one-third of the market). If that happens, some WorldCom competitors may consider initiating a copy-cat bankruptcy, merging with another industry player, or taking some other action. Any resulting combination, however, would force the FCC and antitrust officials at the Department of Justice (DOJ) to revisit two competition policies dating from the 1980s.

The first holds that so long as a local exchange carrier has a de facto monopoly in its home area, it should not be permitted to leverage that power into the long distance market. This rationale underlies the 1984 antitrust decree requiring AT&T to divest its Regional Bell Operating Companies (RBOCs), the predecessors of Verizon, SBC and Bell South. The same view is reflected in the 1996 Telecommunications Act, which requires the RBOCs to open their local markets before offering in-region long distance services.

Second, the FCC has consistently maintained that the Internet should remain unregulated so that new communication services, including Internet telephony, can flourish. The FCC and the DOJ agree though that regulation may be needed at the wholesale level to prevent undue control of the underlying transmission networks or backbones, such as those owned by UUNet.

So what will regulators do if a major inter-exchange carrier (IXC) wishes to combine with a former RBOC? And how much concentration in Internet backbone ownership is too much? The answers may well turn, in part, on how any deals are presented to regulators - whether as part of a bankruptcy proceeding or de novo - and how broadly regulators construe the relevant markets.

Let us start with some potential bankruptcy issues.

Under the antitrust laws, the courts have ruled that a merger which might otherwise substantially lessen competition or tend to create a monopoly is permissible if the likely alternative would be the financial failure of one of the merging parties. This "failing firm defense" allows otherwise questionable mergers and acquisitions to proceed. But the merger parties will likely be required to show that the target has no realistic prospects for a successful reorganization; that the assets may actually leave the market; and no alternative buyer can be found that poses a lesser risk to competition.

To date, the failing firm defense has not been tested by the current wave of telecom bankruptcies. But, until recently, there have been very few buyers. With some exceptions, the RBOCs have yet to step forward in acquiring arguably distressed companies. What if they did?

Since the AT&T divestiture, an RBOC-IXC merger has essentially been unthinkable for telecom regulators primarily because the RBOCs are presumed to have a monopoly over the "last mile" of network facilities required by any IXC to reach its customers. However, there is growing evidence at odds with this assumption and, consequently, the unthinkable might soon become the acceptable.

First, the FCC and the DOJ have already conceded that, per Section 271 of the 1996 Act, the RBOCs’ networks are now open to competitors in almost half the states, including the core of Verizon’s territory (New York, New Jersey, Pennsylvania), portions of SBC’s territory (Texas, Kansas, Oklahoma, Missouri), and key states served by Bell South (Georgia, Louisiana). By early 2003, regulators are expected to add another 10-15 states to this list, including Illinois, Michigan, Ohio, Virginia, Maryland, North Carolina and California. Once that happens, it will be difficult to argue that Verizon and the other RBOCs still have a monopoly over the local loop.

Second, the rapid build out of competing cellular telephone networks (there are now five or six in most large cities) has given consumers an alternative to both local and long distance wireline services. Indeed, the absolute number of wireline subscribers is now declining for the first time ever and cellular customers (now totaling over 140 million) may soon surpass wireline subscribers. As well, cellular providers typically offer flat rate monthly service for local and long distance calls. These developments have undercut the market definitions that regulators have previously used to assess the economic power of local and long distance carriers alike.

Third, the rise of unaffiliated internet service providers (ISPs) has offered customers additional distance-insensitive communication services, including Internet-based telephony. Further, in many key markets, cable TV and other facilities-based competitive local exchange carriers now offer last mile services.

Taken together, these facts make the competitive impact of any prospective RBOC-IXC combination much less problematic than before. In fact, future competition issues concerning the RBOCs may stem not so much from the their dwindling power in the local market, but from their rising position in the long distance market - assuming that a separate long distance market still exists, which is increasingly unclear.

Let us now turn to the Internet backbone market.

In 2000, regulators decided to block WorldCom’s bid to acquire Sprint in part because of their concern regarding each party’s sizeable share of the Internet backbone market. The DOJ contended that any increase in WorldCom’s market share — then estimated at approximately 37% based upon traffic — would permit the company to restrict access, raise prices or degrade service to downstream ISPs and their customers. In 2001, these concerns also led the DOJ to block WorldCom from buying a second tier backbone facility from Intermedia (later divested for $12million) as part of WorldCom’s $5billion acquisition of the Digex web hosting business.

In the months ahead, with UUNet and at least five of the other top ten backbone operators in bankruptcy or in dire financial condition, antitrust officials will face these issues again. How much backbone concentration is permissible? And how do you measure it?

Both questions have long been debated by industry observers and, as recently as last October, the government’s General Accounting Office (GAO) told Congress that no publicly available data existed to accurately evaluate the market’s structure. However, a new July 2002 report from TeleGeography, a Washington-based research group, helps to close the informational gap.

According to TeleGeography, prices for backbone capacity have fallen by 40-50% annually since 2000. And, although WordCom controls approximately 30% of the bandwidth used on the top 20 U.S. Internet routes, other backbones have comparable capacity on specific routes and have a similar number of connections as WorldCom to the top 100 websites. AT&T also reports that it carries as much of the Internet’s total backbone traffic (approximately 15%) as WorldCom. Most importantly, perhaps, TeleGeography found that only 2-3%, at most, of the available (i.e., "lit") bandwidth on top U.S. routes is used by Internet backbones, and "lit" capacity may be 10% or less of the total transmission capacity that has been built.

These facts strongly suggest that no backbone provider will have the ability to exercise market power (i.e., to raise prices, restrict output or degrade service downstream) for very long. There is simply too much network capacity in place and the barriers to entry are apparently far too low.

So how much industry consolidation can telecom regulators permit without significantly impairing competition? We recognize that regulators will judge any merger based upon the relevant facts but, in general, we suspect the answer may prove to be "more than you might think," — especially if the "failing firm" doctrine reasonably can be invoked.

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