Second Computer Inquiry/Final Decision/7

1. Introduction
190. We now address the manner in which carriers may participate in the provision of enhanced services and CPE.

191. In the First Computer Inquiry we concluded that there should be complete separation of a carrier's regulated communications services from its unregulated data processing ventures. We adopted what has become known as a "maximum separation" policy under which carriers are required to offer unregulated data processing services through a separate corporate entity, with separate officers, operating personnel, computer facilities, and books of account. This

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47 C.F.R, § 64.702(c). A carrier or holding company with revenues under one million dollars is exempt from the "maximum separation" requirements.

policy was established to set forth a structure under which carriers could compete in the provision of data processing services without adversely affecting either monopoly ratepayers or monopoly services. In imposing the conditions of maximum separation we believed that they would "be conducive to removing possible anticompetitive practices and avoid the invocation of corrective measures that might otherwise be called for." Tentative Decision, First Computer Inquiry, 28 FCC 2d at 303. Eschewing regulation of data processing, we sought to limit regulation "to requirements respecting the framework in which a carrier may publicly offer particular non-regulated services, the nature and characteristics of which require separation before predictable abuses are given opportunity to arise." Final Decision, First Computer Inquiry, 28 FCC 2d at 277. The maximum separation policy and the objectives we sought to achieve were substantially affirmed in GTE Service Corp. v. FCC, 474 F.2d 724 (2d Cir. 1973). In so doing the court noted that "the expansive power of the Commission in the electronic communications field includes the jurisdictional authority to regulate carrier activities in an area as intimately related to the communications industry as that of computer services, where such activities may substantially affect the efficient provision of reasonably priced communications service." Id. at 731.

192. In the Tentative Decision we sought to modify this structure for carriers providing enhanced services. We proposed that carriers owning communications transmission facilities be required to offer enhanced services only on a resale basis, which would necessitate the acquisition of the underlying transmission facilities pursuant to tariff if they desired to offer enhanced services. As a result of this modification, underlying carriers would still be limited to the provision of regulated services, but resale carriers could offer both regulated and unregulated services with the latter being offered on a non-tariffed basis.

193. We found significant public interest benefits in this resale structure relative to our regulation of common carrier services and the types of enhanced services that could be offered to the public. As to common carrier regulation, availability of the telecommunications network would be a common denominator for any new entrant or existing provider of enhanced services; the same communications services would be available to all providers of enhanced services on the

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Our objectives were to assure:

"(a) that such [non-regulated] services will not adversely affect the provision of efficient and economic common carrier services; (b) that the costs related to the furnishing of such services will not be passed on, directly or indirectly, to the users of common carrier services; (c) that revenues derived from common carrier services will not be used to subsidize any data processing services; and (d) that the furnishings of such services will not inhibit free and fair competition between communication common carrier and data processing companies or otherwise involve practices contrary to the policies and prohibitions of the antitrust laws. Tentative Decision at para. 34."

same terms and conditions. Moreover, the ability of carriers to engage in predation and other anti-competitive practices without detection through their control over transmission facilities would be reduced. Competition in provision of enhanced services would be fostered between carriers and other service vendors. As we stated in the Tentative Decision:

"[this] structure flows from a recognition that computer processing technology has substantial benefits for communications users and the desire to minimize regulatory obstacles to the full development of its market applications, and not solely from a concerted effort to force competition per se into the telecommunications market; It so happens that the potential for a competitive environment to evolve is very real, and such a possibility should be viewed as a positive contribution. Tentative Decision para. 149."

194. Significant benefits would also accrue to consumers under this structure because a resale carrier would be able to offer any service through its computer facilities. Services would not have to be artificially structured so that only regulated services are offered through one computer and unregulated services offered through a separate computer; any computer processing application could be performed at the resale level through the same computer.

195. Thus, we proposed to eliminate the maximum separation requirements for resale entities providing enhanced services. We also expressed concern that indiscriminate application of the resale structure policy to all owners of transmission facilities might not be warranted. With the relatively recent introduction of competition into selected segments of the telecommunications market, we questioned the need to subject to the resale requirement any carrier that lacks the inherent potential to cross-subsidize or to engage in anti-competitive conduct to the detriment of the communications ratepayer in a significant way. Accordingly, we inquired whether all carriers owning or controlling transmission facilities should be required to offer enhanced services through a resale subsidiary, and whether the resale structure should be extended to the international arena. In essence, we inquired as to the continued necessity for applying the maximum separation policy to all such carriers--the net result being that our maximum separation rules would not be applicable to any carrier not subject to the resale structure. A carrier not so subject could engage in both regulated and nonregulated services without regard to its corporate organization.

196. In addition, we also sought comment on the appropriate degree of separation to be imposed upon a carrier that is subject to the resale requirement for the provision of enhanced services. We noted that there are various cost/benefit factors associated with different levels of separation, and the same degree of separation may not be necessary for all entities operating under a resale structure. On the other hand, we recognized the need to ensure that the competitive subsidiary competes fairly in the marketplace and is not the recipient

of improper cross-subsidization from monopoly services offered by the underlying carrier. Tentative Decision at para. 132.

197. Similar considerations were raised with respect to the carrier provision of customer-premises equipment. We concluded that the public interest would best be served if customer-premises equipment that performed more than a basic media conversion function was offered separate from the basic services of the underlying carriers and marketed through a separate resale or other subsidiary. This structure, we believed, would ensure that basic communications services were not burdened by improper subsidization to sophisticated terminal offerings while at the same time providing flexibility and incentives for new and efficient terminal offerings. Tentative Deicision, at para. 122. At the same time we sought comment on whether the provision of other customer-premises equipment should be separated, especially if uniform regulatory treatment is accorded all CPE.

198. As was to be expected, the commenting parties took divergent positions on each of these areas. For example, carriers such as AT&T and GTE argued for a fairly flexible, non-restrictive approach toward separation. They recommended that the Commission avoid stringent separation requirements and instead rely on measures such as internal organizational separation and accounting systems to provide effective controls on anticompetitive activity. This approach, it was argued, would permit the resale entity and ultimately the consumer to enjoy the benefits of vertical integration. This suggestion was strongly opposed by a number of parties who asserted that there were no particular economies to be gained through vertical integration and urged the Commission to require complete separation between the underlying carrier and its affiliate. They argued that such separation was the minimum measure necessary to limit the incentive and opportunity for underlying carriers to engage in anticompetitive activities. For its part, NTIA took a more moderate approach in that it recommended against total separation. It recommended instead that the resale entity be able to undertake joint ventures with the underlying carrier as well as obtain certain information and receive logistical support from the carrier.

199. Likewise, there was little unanimity among the parties regarding the issue of the applicability of the resale structure. AT&T advocated organizational separation and use of accounting mechanisms as opposed to a separate corporate entity. AT&T further posited that, if the separate resale subsidiary is required, the Communications Act requires that all carriers be treated equally and, accordingly, the resale structure should be equally applicable to all carriers. Otherwise, it argued, those carriers subject to the separation requirement would be placed at a competitive disadvantage with regard to those carriers not so subject. Although their reasoning was different, a number of the data processing and equipment vendors also recommended that all underlying carriers should be subject to the resale structure. These

parties argued that all underlying carriers possess sufficient market power to permit them to engage in anticompetitive practices unless restrained by the resale structure. Other parties, in particular the specialized common carriers, asserted that the resale structure should not apply to non-dominant, or competitive, carriers. Such carriers, they submitted, do not possess sufficient market power to engage in anticompetitive practices. The application of the resale structure to such carriers, they stated, would be unduly burdensome.

200. With respect to carrier provision of CPE, various parties urged the Commission to require that all carriers offer CPE separate from their communications services. Goin one step further, IDCMA suggested that underlying carriers should be required to establish separate subsidiaries to market it. AT&T, on the other hand, argued that a carrier should be given the flexibility to determine how equipment is to be provided.

2. Structural Separation
201. Because of the importance of the issues addressed in this proceeding, we believe it is useful to describe our perception of the advantages, limitations, and mechanics of separate subsidiary requirements in a general way before setting out the specific terms and conditions we believe should govern carrier provision of enhanced services and CPE.

202. Mechanically, the separate subsidiary requirement operates on the vertically integrated structure of the firms subject to it. It attempts to preserve as many of the putative advantages of integration as possible and to limit the disadvantages. In undertaking the task of identifying the possible advantages and disadvantages and fashioning conditions to deal with each, we take as a starting point the hypothesis that vertical integration normally represents a benign, efficiency - producing method of organizing production insofar as it permits avoidance of production and transaction costs. But it is also necessary to take account of the companion hypothesis that, as to a regulated firm's movement into non-regulated areas, vertical integration may be motivated more by a desire to avoid rate-of-return constraints than to achieve efficiencies. See F.R. Warren-Boulton, Vertical Control of Markets: Business and Labor Practices (1978).

203. Thus, the general learning on vertical integration counsels an effort to find some acceptable middle ground between potential economies of integration derived from more efficient production and lowered transaction costs and potential diseconomies stemming from abuses of special positions made possible by integration.

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See, e.g., E. Williamson, "The Vertical Integration of Production: Market Failure Consideration,"- American Econ. Rev. Teece, "Vertical Integration in the U.S. Oil Industry," AEI (1976). Transaction costs generally include information, bargaining and administrative costs.

204. The essence of the separate subsidiary proposal that we are adopting today, and indeed of all such approaches, then, is compromise. It offers advantages, but it also has limitations. A separate subsidiary requirement, from a purely structural perspective, does not guarantee a competitive marketplace because it does not significantly change the incentives of a firm upon which it is imposed. The requirement does not impart an incentive to operate the subsidiary in a manner that would detract from the overall profitability of the parent corporation. Thus, in general, if the parent has an incentive to exercise its market power to the disadvantage of consumers and competitors in the absence of a separate subsidiary, it has the same incentive to do so after one is required.

205. Although the subsidiary requirement does not alter incentives, it reduces the ability of dominant firms to engage in predation or to do so without detection. The principal mechanisms employed are the reduction in the extent of joint and common costs between affiliated firms, the requirement that transactions move from one set of corporate books to another, and, particularly apt where communications common carriers are concerned, the publication of rates, terms, and conditions on which services will be available to all potential purchasers. The result of requiring such arrangements in the commercial affairs of corporate affiliates may be to eliminate some competitive controversies and to narrow others, but it obviously does not foreclose the possibility of predatory conduct altogether. In reality, then, a separate subsidiary requirement is a pragmatic and moderate attempt to enable dominant producers or suppliers whose participation in a given market raises special problems to participate, while reducing the risks that their customers or competitors will be disadvantaged by such participation. It balances communications consumers' interest in open entry and full utilization of the telecommunications network and related facilities with their equally strong interest in not being the source of cross-subsidies and the victims of efficiency-reducing discrimination.

206. Finally, it may be helpful to describe the calculus implicit in the determination of the specific requirements governing the separate subsidiaries. As the remainder of this Order indicates, we have attempted to examine several of the more important functions that must be performed in organizing the production and distribution of enhanced services and CPE to distinguish those whose manipulation would produce the greatest gains to a dominant common carrier inclined toward anticompetitive activity from those of less importance. We have tried to assess the benefits and disadvantages of permitting

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The separate subsidiary mechanism is not unique to this proceeding but is one with which we have developed considerable experience in recent years. See, e.g., GTE Service Corp v. FCC, 474 F.2d 724 (2d Cir. 1973); CML Satellite Corp. 51 FCC 2d 14 (1975), appeal dismissed sub nom. RCA Global Communications, Inc. v. FCC, Nos. 75-1236, 74-1241 (D.C. Cir. 1976).

or prohibiting each to be performed on an integrated basis. With those functions that weighed heavily in the process - the sharing of operating personnel or of facilities for example, - we inclined toward disallowing integrated activities altogether; with those functions that seemed less decisive, the sharing of research and development, for example, we inclined toward assuming the risk that vertical integration poses.

207. Key to this pragmatic effort, as to any other, is its provisional quality. We have attempted to fashion a set of conditions governing the relationship of subsidiaries and affiliates that will maximize the long term welfare of consumers of communications services. The judgments embodied in this Order of necessity are premised upon existing and foreseeable circumstances and upon available evidence. Apart from the possibility that some of these decisions may be mistaken, circumstances will change and new evidence may come to light. These factors may demand changes in the conditions, just as experience may teach that we have incorrectly struck the balance between the asserted danger of carrier participation and the supposed efficiency losses brought about by the conditions. Implicit in this effort, then, is the obligation to change the conditions, or to abandon the effort altogether, as experience and changed circumstances warrant. Stated differently, the cost/benefit analysis embodied in this decision cannot be fixed. It must be recalculated from time to time to assure, in the first instance, that the balance was correctly struck here and, second, that important events have not caused a disequilibrium to develop.

Costs and Benefits of Separation
208. In relying on a structural approach to address our regulatory concerns, the primary benefits of the policy are protection for the regulated market ratepayer against costs transferred from the competitive market by the parent corporation, and protection for the general public against such anticompetitive activities as denial of access and predatory pricing. The magnitude of these benefits is not susceptible to precise quantification, but we do expect it to be substantial. The opportunities for undetected cross-subsidization that prevail in the absence of a separation requirement are so substantial that, at a minimum, protection from such abuses is very important to the telephone ratepayer. The general public would realize benefits equally substantial, if less immediate. We are making an investment today in the vitality of a competitive industry that may be important in serving the needs of the public well into the future. The cost of any avoidable anticompetitive activity permitted in the enhanced services market today may be expected to compound itself throughout the life of the industry. A denial of access, for example, by a parent corporation owning basic transmission facilities, may create a bottleneck in the supply of enhanced services--an artificial shortage that could force prices to a supranormal level. Similarly, this artificial

"bottleneck" could produce a tendency to monopoly by forcing competitors of the carrier's separated affiliate to leave the market or by persuading potential entrants that the extraneous risks of participation are too great. In both cases, the user would be the ultimate victim.

209. In addition, an active and healthy enhanced services market should stimulate demand for underlying facilities owned by the parent corporation. Revenues from the leasing of such facilities will help to defray the cost of providing monopoly services if there are scale economies or over investment in the underlying network. Increased demand and utilization of unused capacity in the underlying facilities should also serve to lower the unit costs of transmitting information. This will only be true, however, to the extent that the market structure prevents such anticompetitive activities as predatory pricing and denial of access from diminishing utilization of the network.

210. The argument is advanced that a requirement that enhanced services or CPE be provided through a separate corporate entity is not necessary and that reliance on accounting tools is sufficient to satisfy regulatory concerns. While accounting has always been a fundamental regulatory tool utilized by this Commission in the exercise of our statutory responsibilities, its use has by no means been recognized as a substitute for structural separation. When used in conjunction with the separate subsidiary concept, accounting serves as a useful regulatory tool for identifying certain abuses. We view separation and accounting as part and parcel of a single regulatory mechanism. At a minimum, a carrier with market power and control over communications facilities essential to the provision of enhanced services could distort the competitive evolution of the enhanced services markets at the expense of the communications ratepayer through cross-subsidization and other anticompetitive behavior. Where a carrier has the incentive and ability to engage in sustained cross-subsidization, or predatory pricing, accounting may be employed to assist in the identification of such practices, but it cannot prevent the misallocation of joint and common costs associated with the provision of basic and enhanced services if provided by the same entity. On the other hand, the separation requirement serves as a structural check on the proper allocation of costs between basic and enhanced services.

211. The major cost of separation, it is argued, is a diminished rate of innovation. The degree to which vertical integration impacts upon rates of innovation, however, is far from settled. Both the economic literature and the comments received in this proceeding leave the issues unresolved. AT&T advances the conclusion that "[t]here surely can be no doubt that the Bell System, with its integrated structure, has been a major source of innovation." We have little reason to quarrel with this conclusion, but we likewise have been given little reason to

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Reply Comments of AT&T, at A-36.

accept the implied statement of causality embedded in it. The extent to which the Bell System's integrated structure contributes to its role in innovative research and development is very problematical. In the absence of competition, there is no objective measure for the performance of the integrated firm. As has been suggested, "[w]hat appears to the outsider to be a sensible, prudent, even a progressive policy of the monopolist, may in fact reflect a lower scale of adventurousness and less intelligent risk taking than would be the case if the enterprise were forced to respond to stronger industrial challenge."

212. AT&T offers a variety of studies to demonstrate its leadership in innovation. This evidence, however, is strongly disputed by other studies conducted by AT&T and by others. Moreover, the economic literature does not confirm AT&T's argument that its vertically integrated structure has yielded greater rates of innovation. One of our country's leading authorities in regulatory economics has noted that while AT&T has mounted a significant defense of vertical integration, it does not take into account the likely contributions which competition can bring, and has brought, to innovation. A. Kahn, The Economics of Regulation (1971). Dr. Kahn also notes that the generalized case for vertical integration by a monopolist is not without serious dangers, particularly where the company is rate-regulated and seeking to engage in unregulated activity. With the effect of vertical integration on innovation rates within the Bell System unestablished, we are unwilling to forego the likely stimulus to innovation that a "competitive" structure will yield.

213. In any event the issue here is not the value of the Bell System's integrated structure in the design and operation of the nationwide switched network. The issue in this proceeding is whether the structural requirements that we are imposing on the provision of enhanced services and CPE by AT&T and GTE will diminish their ability to innovate, and whether the user public will suffer adverse consequences. We believe not. Our maximum separation policy should not result in significant changes in either the incentives or the ability of AT&T and GTE to innovate in these areas. As discussed above the record with respect to the importance of vertical integration on

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U.S. v. United Shoe Machinery Corp., 110 F.Supp. 295, 347. (D. Mass. 1953) (Wyzanski, J.)

See, e.g., Reply Comments of AT&T, at A-35, A-39.

See Bell Labs, License Contract Study, Docket 19129, Trial Staff Exhibit No. 146.

See, e.g., M. R. Irwin, Implementing Competition in Intercity Communications Services, A.C.C.T., Sept. 1977.

M. Kamien and N. Schwartz, "Potential Rivalry, Monopoly Profits and the Pace of Innovative Activity," Review of Economic Studies (Oct. 1978); K. Arrow, "Economic Welfare and the Allocation of Resources for Invention," Rate and Direction of Inventive Ability (1962). There is, however, some authority to the contrary. See J. Schumpeter, Capitalism, Socialism and Democracy (1962), criticized by F. Fisher and P. Temeri, "Return to Scale in Research and Development: What does the Schumpeter Hypothesis Imply?" Journal of Political Economy (Jan. 1973).

innovation is ambiguous. But it is clear that the benefits of vertical integration are less in the specialized discrete areas of enhanced services and CPE than in the design and operation of a unified, integrated facility offering basic services. Further, any advantages that the operating companies now enjoy from their access to the innovative research of AT&T or GTE will also be enjoyed by a separated subsidiary providing enhanced service and CPE. As explained, infra, except as to software development the only restriction being applied at this time is that the subsidiary, if it shares the research and development product of its parent corporation, must do so on a fully compensatory basis. By the same token, AT&T and GTE will not be prevented from realizing any mass production economies that may presently exist. AT&T and GTE will presumably be active participants in a competitive technology market with a growing demand for telecommunications products, and any separated subsidiary would have the option of creating its own research and development facilities.

214. The comments raise issues of other costs which a separation requirement may effect. We have considered these costs in our evaluation of the degree of separation to be imposed, and have addressed those issues infra, where we discuss the appropriate degree of separation that should exist between the subsidiary and its parent.

Applicability
215. In ascertaining which carriers should be subject to the resale structure the decision must be based not only on a carrier's ability to engage in anti-competitive activity but also on its resources. The latter is relevant because we have no desire to foreclose entry into the enhanced services and CPE markets by any carrier. Hence, we must give due recognition to the ability of carriers to cover the costs of separation. Such costs include not only the capital expenditures involved, but also some increased risks associated with separation which would presumably be greater for the small carrier. For these smaller carriers, separation may also result in more limited access to capital markets. Another important factor is that if separation does cause some economic inefficiency, the measure of this inefficiency will decrease as the size of the firm increases. This is so because greater size corresponds to greater flexibility in effectuating the separation, thus permitting closer approximation to an economically efficient outcome.

216. As stated above, structural separation will aid to diminish the likelihood of abuses of monopoly power through either (1) denial of

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A rigorous statement of the measure of inefficiency and of this result may be found in K.J. Arrow and F.H. Hahn, General Competitive Analysis, at 385ff., especially Theorem 10 at p. 399, citing R. Starr, "Quasi-Equilibria in Markets with Nonconvex Preferences," Econometrica (1969), and references therein. Simple numerical examples may also be constructed to illustrate this point.

access to the "bottleneck," i.e., local exchange and toll transmission facilities or (2) cross-subsidization from the monopoly service to competitive enhanced and CPE markets. Both of these activities can generally occur where the monopolist perceives a substantial opportunity to extend its power into the adjacent markets. As explained in detail below, the abilities and incentives to attempt such conduct vary significantly among carriers.

217. In its reply, NTIA contends that the best measure of a carrier's potential for anti-competitive activity is its "total revenue generated from monopoly services--the sources of funds for the cross-subsidization of competitive services." While this might be a good measure of a carrier's ability (though not necessarily its incentive) to cross-subsidize, the measure of a carrier's ability to gain advantage by denying access is not accounted for by this test. A carrier's ability and incentive to engage in anticompetitive conduct in adjacent markets must be measured with some recognition of the parameters of those markets. Thus, what must be recognized is that while market power in the provision of telephone service may be appropriately measured within both local and national geographic markets, the provision of enhanced services and CPE has been largely undertaken, and increasingly so, on a national basis. These services, in essence, are and will continue to be directed at residential and business users spread over broad geographical markets. A carrier such as AT&T, with a nationwide network of transmission systems and local distribution plant in major metropolitan areas, could obviously harm a competitor through its control over these facilities in an anti-competitive manner. GTE, serving over 8% of the nation's telephones (see Table 1) and several major population and business centers, would also have significant ability to engage in predatory or discriminatory practices On the other hand, a carrier like Continental, with most of its resources concentrated in rural distribution plant, would not be able to deny competitive access to any significant portion of the potential customers for enhanced services. The diminished likelihood of success in such attempts also serves to diminish the incentive to try.

218. To the extent that all firms offering enhanced services and CPE are not yet marketing their services on a nationwide basis, we believe this is largely a function of the infant yet promising nature of these markets. Regional markets, centering around large urban industrial cities where the large business users are located may currently be another appropriate area in which competition for these services can be measured. But here, too, we note that only AT&T and GTE appear to have significant abilities and incentives to engage in

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Reply comments of NTIA, at 16.

Major cities served by GTE telephone companies include Long Beach and West Los Angeles, California; Tampa and St. Petersburg, Florida; Honolulu, Hawaii; Lexington, Kentucky; Fort Wayne, Indiana; and Erie, Pennsylvania.

anticompetitive conduct, since it is in these areas where they control the local facilities. In contrast, the rural telephone companies would be hard pressed to attempt to bankrupt competitors in their local areas where such competitors may flourish in the major metropolitan areas, or throughout the nation generally. Again, we believe that the unlikely prospects of their success will in turn diminish their incentives to attempt predation, leaving the local ratepayer at much less risk than those captive to AT&T and GTE local services.

219. The importance of the control of local facilities, as well as their location and number, cannot be overstates. As we evolve into more of an information society, the access/bottleneck nature of the telephone local loop will take on greater significance. Although technological trends suggest that hard-wire access provided by a telephone company will not be the only alternative, its existing ubiquity and the amount of underlying investment suggest that whatever changes do occur will be implemented gradually. Moreover the monopoly rent that a company can extract from such bottleneck facilities is likely to bear some relation to the number of subscribers served. It is probable that many of the new information services that will be offered over telephone lines will incur developmental expenses that will require large customer bases. As we observed, many of them are likely to be national in scope. A telephone company serving a relatively small proportion of the nation's homes and businesses is perhaps less likely to pursue such activities independently. For the most part, long-term profitable entry into the enhanced services field will probably require penetration of the market on a national scale, and it is unlikely that such a national operation could be effectively subsidized from a small pool of monopoly revenues, or that it could gain any significant competitive advantage by restricting the access of its competitors to a very limited network of underlying facilities. The effectiveness of other regulatory tools available to this Commission and other authorities is also considerably improved when they are applied to smaller telephone carriers.

220. The need, then, does not exist to subject carriers to the resale structure if such entities lack the potential to cross-subsidize or to engage in anticompetitive conduct to any significant degree. We believe that with the changes taking place in the competitive makeup of the communications industry our regulatory concerns which give rise to the need for structural separation should be directed at monopoly telephone companies exercising significant market power on a broad geographic basis.

221. Non-telephone carriers do not have the kind of market power we are concerned with here. Specialized carriers, such as MCI and SPCC, lack local distribution facilities entirely, and have no reservoir of monopoly ratepayers from which to extract the excess profits necessary to cross-subsidize other services. Such carriers would be in a position to deny access on only a limited number of interexchange

transmission systems. Any private advantages from such conduct would be short-lived, as customers could readily avail themselves of alternative suppliers. Domestic satellite carriers also have no local distribution plant, and no ability to monopolize interexchange transmission systems. They are in competition not only with terrestrial systems, but also with each other, and thus, with the possible exception of their video service offerings, their market power is limited. Similarly Western Union does not possess local monopoly facilities which could be employed to deny or reduce access to enhanced services competitors nor does it generate profits or cash flow comparable to that of the larger telephone holding companies which could be employed as a source of cross-subsidies. Moreover, we would expect our recent PMS decision to result in a further diminution of any capacity Western Union might possess to engage in anticompetitive conduct on a substantial basis.

222. Weighing the competitive changes which have occurred in the communications sector since the First Computer Inquiry, we do not believe that broad application of the resale structure is necessary to satisfy the regulatory objectives set forth there. Moreover, we have been able to monitor the development of new and innovative services, and conclude that the potential for these services to reach a greater segment of society would be substantially increased if we exercised restraint in the exercise of our discretion in applying the resale structure. Weighing these factors, and recognizing the risks involved, we find that the separation requirement should be applied only to those telephone companies having sufficient market power to engage in effective anti-competitive activity on a national scale and which possess sufficient resources to enter the competitive market through a separate subsidiary.

223. An objective standard upon which a determination can be made as to which telephone companies possess these characteristics is not easily established. However, when we examine Table 1, we see that only four companies have more than 1% of industry revenues, and a fifth is above the 1% level in terms of number of telephones. As the Table exhibits, there is a sharp distinction with respect to these shares between AT&T and the rest of the industry and between GTE and the rest of the independents. The companies ranked 3, 4 and 5 in terms of revenues form an approximate group of their own. The remaining companies possess a combination of size, geographic service area(s), and monopoly revenue base (which is typically a small fraction of the total operating revenues shown in Table 1) such that we are not convinced that the benefits of separation outweigh the costs. Even when we consider the market penetration of the top five carriers listed in Table 1, a fairly clear distinction can be drawn between AT&T and

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Domestic Public Message Services, 71 FCC 2d 471 (1979). Review pending sub nom. Western Union Telegraph Co. v. FCC, D.C. Cir. No. 79-1352 (1979).

GTE on the one hand, and the other telephone companies on the other hand. Because of the relative size of AT&T and GTE and the diverse national markets they serve, we conclude that, at present, the resale structure should be applied to AT&T and GTE. We realize that an argument could be made for subjecting other telephone companies to this structure, but we conclude that it would better serve the public interest to take a restrictive approach at this juncture in applying the resale structure and wait to see if competitive abuses develop which warrant further application of this structure for either enhanced services or CPE.

224. Some of the concerns in this regard may be mitigated by the fact that some of the larger telephone companies have already made independent judgments that there are benefits that derive from some organizational separation of regulated and unregulated activities. Although the rules established in the First Computer Inquiry have undoubtedly been a factor as well, as discussed below the observed organizational changes go beyond what is required by the "maximum separation" policy. We believe that such decisions regarding organizational structure comport with technological and marketplace realities, and they suggest that our limited imposition of an analogous structure may yield even greater benefits than those we have explicitly addressed. Moreover, that such steps have been taken by companies appreciably smaller than AT&T and GTE increases our confidence in our analysis that the separation requirement will not be unduly burdensome to the nation's two largest telephone companies. As noted, we are reluctant to impose regulation where it may not be necessary, and our reluctance is compounded by our desire to provide flexibility to companies that are beginning to participate in a meaningful manner in the enhanced services and CPE markets. If the factual predicate changes, we may revisit this determination. Nor, of course, does this determination preclude us from imposing conditions under our Title II, Title III or ancillary jurisdictional authority in response to specific applications as circumstances may warrant.

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U.S. Transmission Systems, 48 FCC 2d 859 (1974); ITT Domestic Transmission 62 FCC 2d 236 (1976); Communications Satellite Corp., 45 FCC 2d 444 (1974); CML Satellite Corp., 51 FCC 2d 14 (1975); RCA Global Communications, 56 FCC 2d 660 (1975); Satellite Business Systems, 62 FCC 2d 997 (1977); and Domestic Satellite, 35 FCC 2d 844 (1972). GTE-Telenet Merger Authorization, 72 FCC 2d 111 (1979), modified 72 FCC 2d 516 (1979), recon. denied, 74 FCC 2d 561 (1979).

AT&amp;T and the Ten Largest U.S. Telephone Companies

225. Illustrative of the ability to maintain enhanced services and CPE subsidiaries are GTE, United, and Continental, which have already entered the data processing market through separate subsidiaries. These three companies, in fact, presently own more than a dozen subsidiaries operating in unregulated markets, and have been providing enhanced services through subsidiaries for more than a decade. GTE Data Services, Inc., formed in 1967, has primarily served GTE operating telephone companies; but United Computing Systems, also dating from 1967, with data centers in London and Zurich, as well as Kansas City, is clearly hoping to reach a wide market.

226. As indicated in its 1978 Annual Report, GTE divides its principal operations into a telephone operating group and a products group (which includes communications products). More recently, GTE formed a new group, GTE Communications Network Systems, to consolidate its operations in the data communications market. Units of the group are GTE Telenet, GTE Telecommunications Systems, and GTE Information Systems. Similarly, United Telecommunications "has reorganized itself into three operating groups as part of its program to diversify its operations beyond traditional telephone industry operations." The groups' division of responsibilities will be (1) regulated telephone operations, (2) competitive telecommunications services and distribution activities, and (3) interactive graphics, remote computing services, and international computer services activities. The current thrust of Continental Telephone is carrying it into activities different from traditional telephone operations. A newspaper article reports on Continental's recent acquisitions and credits the company with recognizing "early that deregulation presented an opportunity, rather than a stumbling block." The 1978 Annual Report of Central Telephone & Utilities continues the theme of expansion into non-traditional areas and reorganization. With regard to the first, the letter to shareholders states, "... we are actively seeking new investment opportunities. In view of our marketing and technical experience in the communications equipment and operations fields, we believe the most attractive and promising growth area for us is expansion into related communications businesses where such expertise can be utilized to our best advantage. Ideally, these are businesses which operate under little or no regulation." Concerning the latter, "Effective January 1, 1979, Centel realigned its three major business activities under the newly created positions of Group Vice Presidents to distinctly separate the Company's traditional utility operations from its new endeavors."

227. The rationale for imposing a separation requirement only on

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"New GTE Unit Merges Data Network Offerings," Telephony, December 24, 1979, at 9.

"United Telecom Reorganizes, Prepares for Diversification", Telephony, March 3, 1980, at 11.

"Continental's New Connections," New York Times, February 29, 1980.

AT&T and GTE has even greater force when considering CPE. Only these two U.S. telephone companies have basic manufacturing operations producing large quantities of a wide range of telecommunications equipment. Both AT&T and GTE hold substantial market positions, if not market power, in the provision of certain kinds of CPE. Their significant participation in these markets indicates that these companies have substantial incentives to sustain their market positions by thwarting the provision of such equipment on a competitive basis. Their local monopoly positions, in turn, provide the opportunity (without maximum separation) to engage in such anticompetitive conduct--with the monopoly ratepayer being forced to subsidize below cost pricing of CPE. United and Continental, on the other hand, have shown little inclination to participate in the equipment manufacturing market, apparently due to the cyclical nature of profits in that market. Continental Supply and Service Corporation does provide centralized purchase and distribution of equipment and parts for Continental's operating telephone companies, and Continental Telephone Laboratories tests and recommends practical applications for equipment; but the carrier sold its primary manufacturing subsidiary (Vidar Corporation) in 1975, explaining to stockholders that "[T]he cyclical nature of manufacturing operations and other considerations have led to the conclusion that the Company and its stockholders would benefit by withdrawal from the field of manufacturing and by concentration of investment and manpower in telephone operations." The following year Continental completed its divestiture of manufacturing operations with the sale of the Cable Division of Superior Continental Corporation, and again cited the "volatility of earnings inherent in the cyclical nature of these operations." Similarly, United's subsidiary, North Supply Company, an international distributor of telecommunications products with more than a quarter of a billion dollars in annual sales, was formerly a division of North Electric Company. United sold the manufacturing division of North Electric in 1977, incurring a $2.3-million loss on the transaction, and notified stockholders that the sale, together with the 1978 sale of Central Kansas Power Company, left "United Telecom's resources concentrated in three activities--telephone service, computer services and distribution services. All are strong markets and United is well positioned in each of them."

228. Thus we believe that continued application of our maximum separation policy to all carriers is inappropriate in the face of the present and foreseeable market applications of computer processing technology and increased competition in the provision of regulated communications services. Contrary to the approach in the Tentative Decision, we conclude that not all carriers owning transmission

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Continental Telephone Corporation, Annual Report to Stockholders, 1975, at 5.

Id., 1976, at 3.

United Telecommunications, Inc., Annual Report to Stockholders, 1978, at 2.

facilities should be required to provide enhanced services through a separate corporate entity. Separation is appropriate in those cases in which there is a substantial threat of injury to the communications ratepayer and where other regulatory tools would not suffice. Both AT&T and GTE provide franchised monopoly telephone service and competitive services. Moreover, both are vertically and horizontally integrated with affiliated equipment manufacturers which supply the preponderant share of the equipment needs of the affiliated telephone companies. Thus, both AT&T and GTE have significant market positions in various equipment product lines as well as certain service categories in certain large geographic markets. We are thus concerned that both companies could exploit their dominance in these product lines to support below cost prices in more competitive markets. Weighing the public interest benefits of our objectives and the economic tradeoffs of the separate subsidiary requirement, we have determined that restricting the requirement to AT&T and GTE will best serve the monopoly and other communications ratepayers and the public interest more generally. Accordingly, we are removing the maximum separation requirements for all carriers except those under direct or indirect common control of AT&T or GTE.

229. The thrust of applying the resale structure to AT&T and GTE is to establish a structure under which common carrier transmission facilities are offered by them to all providers of enhanced services (including their own enhanced subsidiary) on an equal basis. Inherent in the resale structure is the fact that the separate corporate entity may not construct, own, or operate its own transmission facilities. In essence, the resale subsidiary must acquire all its transmission capacity from an underlying carrier pursuant to tariff. This means that the same transmission facilities or capacity provided the subsidiary by the parent, must be made available to all enhanced service providers under the same terms and conditions. Requiring the subsidiary to acquire its transmission capacity from other sources pursuant to tariff provides a structural constraint on the potential for abuse of the parent's market power through controlling access to and use of the underlying transmission facilities in a discriminatory and anticompetitive manner.

230. The separate subsidiary for enhanced services and CPE also provides a structural mechanism for the separation of these carriers' regulated and nonregulated activities, thereby lessening the potential that the communications ratepayer will be subsidizing their unregulated ventures. While we discuss below the relationship between the subsidiary and affiliated entities, the subsidiary itself is not regulated. Thus the subsidiary may not provide basic transmission services for to do so would subject it to regulation and negate the structural separation of regulated and non regulated activities.

231. By removing other carriers from the separate subsidiary requirements of the First Computer Inquiry, they are now able to offer basic and enhanced services through common computer and

transmission facilities. However, an essential thrust of this proceeding has been to provide a mechanism whereby non-discriminatory access can be had to basic transmission services by all enhanced service providers. Because enhanced services are dependent upon the common carrier offering of basic services, a basic service is the building block upon which enhanced services are offered. Thus those carriers that own common carrier transmission facilities and provide enhanced services, but are not subject to the separate subsidiary requirement, must acquire transmission capacity pursuant to the same prices, terms, and conditions reflected in their tariffs when their own facilities are utilized. Other offerors of enhanced services would likewise be able to use such a carrier's facilities under the same terms and conditions.

232. We have already noted our belief that, while the establishment of separate subsidiaries cannot be relied on to absolutely prevent subsidization, it can make it more readily detectable by competitors and regulators. On the other hand, the provision of certain complementary goods or services by the same company may not pose unacceptable dangers of this kind while generating efficiencies in the form of reduced operating expenses or other legitimate cost savings. Consumers of telecommunications products and services should not be required to forego such economies unless they are clearly outweighed by other costs which joint operation would impose. It is in this context that we specify the particular form in which AT&T and GTE may sell or lease CPE and enhanced services.

Degree of Separation
233. Having concluded that the resale structure and the maximum separation policy are applicable to carriers affiliated with AT&T and GTE, we now address the degree of separation that should exist between separated entities. In the First Computer Inquiry we established certain minimum separation requirements which were necessary in order to meet the regulatory objectives necessitating a separate subsidiary. In this regard we required that the separate entity maintain its own books of account, have separate officers and separate operating personnel, and utilize computer equipment and facilities separate from those of the carrier in providing unregulated services. Moreover, a carrier subject to the separation requirement was prohibited from engaging in the sale or promotion of the separate entity's services and from making available any computer capacity or computer system component, used in the provision of its communications service, to others for the provision of unregulated services. See 47 C.F.R. §§ 64.702(c) and (d). We now undertake to examine, in light of experience gained since these separations requirements were adopted, whether this degree of separation should be maintained and whether other separation requirements are warranted.

234. We requested that the parties comment on the relative costs and benefits of various degrees of separation that might be relied upon

to reduce the likelihood of anticompetitive activity. While many parties discussed the probable cost-benefit tradeoffs of a separation policy, few have addressed, with the specificity we would have wished, the costs and benefits associated with various degrees of separation. The comments of NTIA and the reply comments of AT&T are notable exceptions. In addressing the implications of a separate subsidiary requirement, the comments generally intermingle the separation concept with the degree of separation in discussing the various costs and benefits. The most thorough discussion of possible costs is found in the reply comments of AT&T which argued against the separate subsidiary requirement for enhanced services and CPE while emphasizing alleged efficiencies of vertical integration. We will endeavor to address the arguments it has raised. We note, however, that the costs of separation are difficult to quantify. The parties to this proceeding have addressed them in qualitative terms, just as we will here.

235. Various parties to this proceeding have urged stringent separation where a separate subsidiary is imposed. It is even argued that interactions between the subsidiary and affiliated entities should be the same as those between the parent and other third parties or non-affiliated entities. In certain situations this type of relationship may be warranted, but we are not prepared to adopt this standard for all inter-corporate transactions between the subsidiary and affiliates. AT&T and GTE are vertically integrated corporations. To the extent there may be efficiencies within their structures they should not be precluded from capitalizing on them where countervailing regulatory considerations do not demand stringent separation. Accordingly, in addressing the appropriate degree of separation we take care to impose only the minimum necessary to address those regulatory concerns where sole reliance on accounting is an inappropriate safeguard against potential anticompetitive behavior.

236. Our structural approach is predicated on the use of accounting mechanisms to complement the separate subsidiary requirement. Accounting is an important regulatory tool to aid in the effective regulatory oversight not only of those carriers subject to the separate subsidiary requirement, but also of those carriers that engage in unregulated activities without structural separation. Accordingly, the separate subsidiary must maintain its own books of account, and non-separated carriers must maintain separate books of account for their unregulated activities.

237. An essential thrust of the structural approach is to separate joint and common costs associated with the provision of regulated and unregulated activities. Ideally, the parent and subsidiary should have

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For an extensive discussion of the safeguards we have applied in GTE Telenet with respect to its relationship to other GTE companies see General Telephone and Electronics, 70 FCC 2d 2249 (1979), recon. denied, 72 FCC 2d 91 (1979); GTE-Telenet Merger Authorization, 72 FCC 2d 111 (1979), modified 72 FCC 2d 516 (1979); recon. denied, 74 FCC 2d 561 (1979).

no joint or common costs to allocate, since the simplest mechanism for transferring competitive market costs to the regulated market is the misallocation of joint and common costs. Yet, there may be circumstances where joint undertakings should not be foreclosed based on efficiency or practical considerations. To this extent a balancing process is involved.

238. The manner in which enhanced services are provided and marketed are two areas where the potential for anticompetitive behavior and misallocation of cost is great. Because of the inherent difficulties in allocating joint and common costs, we conclude that effective regulation requires eliminating the allocations by prohibiting joint activities in these areas.

239. More specifically, the separation of regulated and unregulated activities and associated costs requires that the subsidiary have its own operating, marketing, installation and maintenance personnel for the services and equipment it offers. This means that the unregulated subsidiary must do its own marketing, including all advertising related to the offering of any service or equipment it offers. Affiliated entities may not advertise on behalf of the subsidiary. We are cognizant of AT&T's assertions that maintenance and training costs will be increased by a separation requirement. However, to the extent that the separated entity uses specialized facilities, the cost savings from sharing maintenance and training functions with AT&T affiliates would be minimal. Moreover we are not foreclosing the subsidiary from obtaining support services for sophisticated equipment purchased from any affiliated manufacturing entity on a compensatory basis. For example, the subsidiary could contract with the manufacturer for the installation, maintenance or repair of equipment, or the manufacturer could train personnel of the subsidiary to perform these functions. Aside from this, however, we are precluding entities or organizations affiliated with the parent from performing any function related to the training, operation, installation, marketing, and maintenance services associated with the subsidiary's offerings.

240. The separation of these functions, combined with the above-stated requirement that all enhanced service providers have equal access to basic transmission facilities, compels that we address the relationship between the enhanced service subsidiary and the underlying carrier. A key issue here is the joint use of physical space. In this regard we conclude that the enhanced service subsidiary should be precluded from using in common any leased or owned physical space or property with an affiliated carrier on which is located transmission equipment or facilities used in the provision of basic transmission services. The reasons for this are two-fold. First, it is imperative that there be nondiscriminatory access to AT&T's and GTE's basic transmission services. To allow the subsidiary to share physical space with an affiliated carrier is to significantly increase the potential for the carrier to discriminate in favor of its affiliated subsidiary. For example

it also offers the potential for a carrier to establish a means by which it may discriminate against other enhanced service vendors through such mechanisms as the manner in which the subsidiary is able to interconnect or through its charges for the facilities necessary to interconnect enhanced services with the underlying network where the need for such facilities by its own subsidiary might be eliminated. Separation in this area creates an environment conducive to ensuring that all vendors of enhanced services are afforded the opportunity to access a carrier's network on a nondiscriminatory basis. Second, the sharing of physical space again raises the inherently difficult problems associated with the allocation of joint and common costs.

241. In addition, our existing separation rules require that unregulated services be provided through computer facilities separate from those of the carrier. Various parties have argued that sharing of computer capacity should be allowed. In its Response to the Tentative Decision, NTIA contends that, "most carriers ... will need computer facilities capable of performing data processing functions to assist them in providing the basic communication services, and a separate entity with separate computer facilities will be pure duplication. Moreover, basic communications usage generally is characterized by extreme peaking, and the inability to use computer facilities to provide enhanced services during off-peak hours could result in a great deal of wasted processing capacity." Bell goes a step further--arguing that the resale entity should not only be permitted to share the underlying carrier's computer capacity, but also the information in the computers.

242. Although there may be some operational inefficiencies associated with a policy prohibiting the sharing of excess computer capacity, there are also some likely inefficiencies associated with a policy permitting sharing, even if other vendors were afforded comparable access. First, it is unrealistic to believe that non-Bell or non-GTE entrants in the competitive market will avail themselves of the opportunity to use AT&T's or GTE's excess computer capacity. If they did not there would be no way to establish whether the rates AT&T and GTE charged their subsidiaries for the use of the computer capacity were compensatory, thereby potentially burdening the communications ratepayer. Second, the existence of a regulatory policy permitting the sharing of excess capacity would tend to generate that capacity. Third, such a policy would create large non-market incentives

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Response of NTIA, at 9.

See Reply Comments of AT&T at A-23, A-26.

We note that telephone companies do have pricing options that could reduce the peaking that is responsible for much of the excess computer capacity. Moreover, unless the usage pattern of enhanced services over time were highly negatively correlated with basic communications usage, the peaking phenomenon and the underutilization of facilities would continue even if sharing were permitted.

to rely exclusively on the parent's computer capacity, because it would enlarge the monopoly rate base. Together, these three effects of a permissive sharing policy introduce a greater than tolerable risk of the inefficiencies of a Bell or GTE subsidiary operating below real cost in a competitive market. The regulated services would be carrying the burden of an unnecessarily high unit cost to their subscribers' disadvantage, while the risks of failure facing the non-Bell and non-GTE entrants in the competitive market would be increased, along with all the costs associated with higher risk. Moreover, if sharing of computer capacity by the subsidiary were allowed, any structural mechanism for ensuring nondiscriminatory access to the network would be negated. It should also be remembered that computers are not as large or expensive as they once were, and they almost certainly will be even smaller and less expensive in the future. Therefore, the size of any inefficiencies resulting from the maximum separation policy is not likely to be large. Further, the cost of obtaining the computer capacity necessary for operation in the data communications market is not likely to be prohibitive of entry. Accordingly, we affirm our present proscription against the sharing of excess network computer capacity. Moreover, whatever degree of "wastefulness" might legitimately be argued to exist will be attenuated by the preponderant cost and specialized nature of software in the totality of enhanced services.

243. Intimately related to issues concerning computer facilities are those dealing with software development. Because of the significance of software in the provision of enhanced services and sophisticated CPE, there is a need to address the allocation of its costs. Electronic equipment such as that used for computers and communications is becoming more and more software driven. At the same time, relative costs are shifting from hardware to software. This reflects the rapidly declining cost of hardware as well as the human capital intensive nature of programming. Because software development, operations, and maintenance constitute such a substantial cost factor, involving the association of joint and common costs, in the provision of these services, we will require that the underlying carrier (including its affiliates) and the resale subsidiary not perform software work for each other. Moreover, we find this requirement reasonable, i.e., not onerous because software needs may be separable, based on (1) the specialized nature of the software that would be applicable to the activities of the separate subsidiary, (2) the general diseconomies of scale experienced in writing software, and (3) the continuing ability of the underlying carrier to spread the fixed cost of software development for underlying operations to its telephone companies (see, Reply

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Professor Scherer suggests that such deliberately maintained excess capacity may be useful to monopoly, in "scaring off new entrants or fighting them more effectively if they do enter." F. Scherer, supra n. 55, at 876.

Comments of AT&T, A-18 through A-24). The subsidiary is, of course, free to contract with non-affiliated sources for software development, but not on a joint basis with an affiliated entity.

244. We appreciate that software will be embedded in some of the CPE distributed by the subsidiary. The condition that the subsidiary and its affiliates not perform software design and development for one another is not intended to preclude the subsidiary from marketing software integral to CPE obtained from affiliated entities. Moreover, other enhanced services hardware may be provided with the generic software (such as operating systems), but not applications programs.

245. Another area of significant concern involves the exchange of information between the separate subsidiary and other affiliated entities. There is little doubt that AT&T and GTE would be able to confer a significant competitive advantage on their separate subsidiaries and further extend their market power, if the subsidiaries are provided access to certain information that is not equally available to other vendors of enhanced services or CPE.

246. In this regard there are three areas of information flow which deserve attention. The first type of information is that which AT&T and GTE possess by virtue of their control over communication facilities essential to the nation-wide transmission of information. Within this category falls information relating to network design and technical standards, including interface specifications, information affecting changes which are being contemplated to the telecommunications network that would affect either intercarrier interconnection or the manner in which CPE is connected to the interstate network, and information concerning construction plans. This type of information must be disclosed to the public by AT&T and GTE. Moreover, when it is disclosed to an enhanced services or CPE separate subsidiary, such information must be disclosed to competitors of the subsidiary at the same time and under the same terms and conditions. It is essential to the competitive provision of CPE and enhanced services that this type of information be disclosed, just as it is essential to assuring that monopoly ratepayers are afforded their statutory right to efficient service by reducing the possibility that use of the network will be restricted for anticompetitive purpose, with resulting negative effects on unit costs.

247.The second area of information flow that offers the potential for distorting the competitive evolution of enhanced service markets is that dealing with research and development. We recognize that technological innovation will be very important to the enhanced services market, and that the established carriers are capable of making significant contributions to the emerging technology. We have no desire to restrict their participation in research and development for the competitive market beyond the extent necessary for the protection of the communications ratepayer. While we have indicated that software design or development work for a separate subsidiary must

be undertaken by the subsidiary, or an outside contractor on behalf of the subsidiary, we do not intend at this time to prohibit the exchange of work products in other areas of research and development between the parent and its subsidiary, provided such exchanges taken place on a completely cost compensatory basis. This assumes appropriate records of account are established for research and development performed for the subsidiary. Such exchanges must be monitored, and if it is determined that research and development is being performed for the subsidiary on a less than a compensatory basis, further exchanges will be prohibited.

248. The primary concern in allowing joint research and development rests in the fact that, through such mechanisms as the Bell System license contract arrangements with the operating companies, monopoly derived revenues are used to fund research and development. To the extent misallocations of these costs occur, it is the monopoly ratepayer that is burdened. We are allowing sharing of research and development by affiliated entities at this time, but we intend to examine into the license contract arrangements and other issues generic to the use of monopoly revenues to support competitive research and development. At the conclusion of this process we are free to modify the approach we have set forth here, if the facts so warrant.

249. While research and development purchased from an affiliated entity by the separate subsidiary need not be shared with other competitive service or equipment vendors, information which finds a principal use in marketing, such as customer proprietary information, must be disclosed to other competitive vendors at the same time the subsidiary receives the information and under the same terms and conditions if it is shared with the subsidiary. By "customer proprietary information" we mean any information which an affiliate acquires by virtue of the corporation's common carrier activities. Such information constitutes the third area of information flow. Because of the anticompetitive advantage that can accrue to the separate subsidiary from advance information in these areas, we are maintaining our requirement that the subsidiary have separate officers.

250. The principle upon which we have relied in our consideration of the most appropriate corporate structure for GTE and AT&T in the provision of CPE and enhanced services is that a firm with a dominant market position--either in terms of a market position insulated from effective competition or as a result of effective control of facilities essential to the operation of its competitors, or both--must be prevented from exploiting that position by extracting supra-competitive profit from the customers of one service to price another service at below cost levels. Simply relegating certain activities to a separate subsidiary may not, however, prevent abuses of market power and anticompetitive conduct. Since both AT&T and GTE have significant market positions in various equipment product lines as well as certain service categories, there are other conditions which we will require

that offer substantial benefits in return for costs that are likely to be small.

251. As to the provision of CPE, we have determined that AT&T's and GTE's dominant position in the terminal equipment market requires some special treatment. There has been some concern that requiring a separate entity for the provision, installation, and maintenance of CPE will be unduly costly, especially for residential users with "plain old telephone service." For the companies to which our separate subsidiary requirement applies, we reject this argument. In the first place these functions are performed by hundreds of equipment vendors and are part and parcel of participation in the equipment business. Implicit in the argument is the assumption that the telephone company employee responsible for maintaining the transmission line actually functions or is qualified to function as the installation, maintenance, and repair person for CPE, including sophisticated computer terminals. While we do not believe this is borne out by experience, even if it were true, costs associated with the provision of CPE should be divorced from the costs associated with a carrier's provision of basic services. In point of fact, the Bell System now dispenses more than half its new phones through almost 2,000 Phone Center Stores. We recognize, however, that it is precisely in the case of smaller telephone companies serving smaller numbers of subscribers that there may be validity to the claim that separate maintenance and installation staffs may be inefficient. In such instances, indivisibilities may cause economies of scale in the provision of such service. In such cases, a separation requirement might be unduly costly, but we do not contemplate applying the requirement to the small carriers. Moreover, consideration will be given to possible waivers for the truly rural operations of carriers under direct or common control of AT&T or GTE.

252. We believe that any AT&T or GTE resale subsidiary which provides enhanced services should also be able to lease or sell terminal equipment. It may also engage directly in the manufacturing of CPE. However, this CPE/enhanced service provider will be required to deal at arm's length with any other affiliated equipment manufacturer. The transfer of any products between this CPE/enhanced service provider and any affiliated equipment manufacturer must be done at a price that is compensatory. To police this requirement we will require

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See C. Frank, Jr., Production Theory and Indivisible Commodities, 48-49 (1969), and T. Koopmans "The Construction of Economic Knowledge" in Three Essays on the State of Economic Science, 152 (1957).

The Commission has discussed the issue of "arm's length" dealings in a number of its past decisions. See ITT Domestic Transmissions, Inc. 62 FCC 2d 236 (1976); Communications Satellite Corporation, 45 FCC 2d 444 (1974); CML Satellite Corporation, 51 FCC 2d 14 (1975); RCA Global Communications, 56 FCC 2d 660 (1975); Satellite Business Systems, et al. 62 FCC 2d 997 (1977); Docket 19129 (Phase II), 64 FCC 2d 1 (1977); National Aeronautics and Space Administration, 61 FCC 2d 56 (1976); and GTE-Telenet Merger Authorization, 72 FCC 2d 111 (1979), modified, 72 FCC 2d 516 (1979), recon. denied, 74 FCC 2d 561 (1979).

that any transaction between the enhanced services subsidiary and any other affiliate which involves the transfer (either directly or by accounting or other record entries) of money, personnel, resources or other assets be recorded in auditable form. Moreover, any contract entered into between such entities must be filed with the Commission, where it will be made available for public inspection. (This requirement will not apply to any transaction governed by the provisions of an effective state or federal tariff.) We will monitor these contracts and, should abuses be discovered, we will re-examine our determination with regard to the appropriate degree of separation.

253. Moreover, a subsidiary which provides both CPE and enhanced services may not market any other equipment, e.g., transmission or other network equipment, because of the potential for the communications ratepayer to bear the cost of non-compensatory intra-corporate transfer pricing that may inure to the benefit of the enhanced subsidiaries. By this proscription we are not altering the present arrangement whereby manufacturing affiliates sell directly to affiliated carriers, nor does this requirement preclude either firm from providing any of its terminal equipment product lines through another arm's length subsidiary. Thus, if either AT&T or GTE, or both, would prefer to offer certain types of terminal equipment (e.g. telephones) through the enhanced service subsidiary (perhaps for sales primarily to customers of its enhanced services) as well as through another subsidiary (perhaps for sales to residence and business customers not served by the enhanced services subsidiary), that form of corporate organization is acceptable under our decision today.

254. AT&T, in its Reply Comments, has cited a number of administrative and operational costs that it would expect to result from the creation of a separate subsidiary. However, it is not altogether clear whether many of these costs would be incurred in the process of entering the enhanced market even without a separate subsidiary requirement. In its analysis of operational cost effects, AT&T has clearly failed to consider the full cost of entering a competitive market without a separation requirement. In assessing the advisability of a separation requirement, only the marginal costs of the policy are important, not the full cost of entering the competitive market; these marginal costs are generally negligible. In discussing the marginal operating costs it is important to keep three additional points in mind. First, the regulated market will continue to interact with the competitive market; commerce will remain between the two, permitting regulated carriers to continue providing transmission and distribution facilities to carriers in the competitive market, and protecting any scale economies that presently exist in underlying facility production. Second, the separated entities will be providing services unique to the competitive market, relying, for the most part, on highly specialized facilities. Third, we are not applying the separation requirement to small carriers.

255. In addition, we are allowing the sharing of administrative services, such as legal services, by the parent and the subsidiary on a cost reimbursement basis. This assumes, of course, the existence of an accounting system which accurately reflects the costs of administrative services provided by an affiliated entity. With an appropriate accounting system, whatever administrative efficiencies may exist are preserved. As to the scope of efficiencies alleged to exist in this area, however, we think it useful to point out the distinction between scale economies and the spreading of fixed costs over a larger base. The examples provided by AT&T generally fall into the latter category. If there truly are economies of scale, nothing in our separation requirements would preclude a non-related entity from providing services to both the underlying carrier and its separate subsidiary. If the unaffiliated entity can attract additional customers for the same service (e.g., payroll accounting and check preparation), it may be able to offer greater economies than those available to the telephone company alone. At the same time it should be noted that we are not foreclosing bulk purchase savings among affiliated entities as long as the costs are shared on a pro rata basis.

256. Addressing a different matter, we have previously noted that the separate subsidiary requirement, per se, does not change the incentives for a firm to engage in predation. One effective means of deflecting such incentives and providing protection to the communications ratepayer is to require the infusion of some independent equity financing for the subsidiary with the concomitant securities law obligations owed to minority shareholders.

257. No one, however, argues for an immediate infusion of outside capital. NTIA suggests that outside capital be "phased in over a period of years." We are not at this time mandating that there be outside financing for several reasons. First, outside financing would subject the subsidiary to the costs of securities regulation and disclosure regulation. Second, it may affect the cost of obtaining outside equity and debt. Third, the corporate and regulatory implications of outside financing have not been addressed in any significant detail in the course of this proceeding. Prior to imposing such a requirement we believe these areas deserve further exploration. Fourth, under the structure we have set forth, AT&T and GTE are provided flexibility as to the manner in which enhanced services and CPE can be provided within parameters of their existing corporate structures. To impose an outside financing requirement at this time may serve to constrain their flexibility and foreclose certain structural options. Therefore, we

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Response of NTIA at 24.

In the Tentative Decision we inquired as to whether separate directors should be required. Were we to require some degree of outside financing, the argument for separate directors would be compelling. Since we are not requiring independent financing here, we defer consideration of this issue.

believe that it would be appropriate to wait until the carriers actually submit their capitalization plans to the Commission and ascertain at that time if further action is warranted.

258. We are interested, however, in the manner in which the subsidiary is capitalized. In the Second Report and Order in Docket No. 16495, the Domestic Satellite policy proceeding, 35 FCC 2d 844 (1972), we determined that the public interest required that Comsat engage in competitive ventures through a separate subsidiary. There, as here, our concerns were, first, that transfers of assets during capitalization not serve as vehicles for inappropriate subsidies, to the detriment of basic service ratepayers, See, e.g., Comsat, 45 FCC 2d 444, 451 (1974), and, second, that the subsidiary, at the end of some determinate period, "be in a position to establish its financial independence and assume for itself the risks associated with" its competitive ventures. Comsat, 42 FCC 2d 677, 681 (1973). We do not intend to prescribe here the manner in which the carriers subject to the resale structure may formulate the financial structure of the separate subsidiary. As in the case of Comsat, we believe this to be an appropriate area for the exercise of management judgment subject to ultimate Commission approval of the proposed capital structure. See Second Report and Order, 35 FCC 2d at 853. To the extent costs are incurred in the development of enhanced services prior to the establishment of the separate subsidiary, such costs must be accounted for in the capitalization plan.

259. Our authority to examine into the relationships between carriers and "persons directly or indirectly ... controlled by" them is explicitly set forth in the Act. See Section 218; 219(a). These sections are further enhanced by our authority to examine relationships between carriers and any other persons, Section 211(b), and our general plenary powers under Section 4(i). Specifically, Section 219(a) authorizes us to require reports from all carriers subject to the Act, and from persons controlled by them, with regard to the manner in which such "persons" are capitalized, including shareholder interests, and the general financial operations of such "persons." Further, 218 authorizes the Commission to obtain from such persons "full and complete information necessary to enable the Commission to perform the duties and carry out the objects for which it was created."

260. Our decision here to require carriers subject to the resale structure to obtain prior approval of plans for capitalization of separate subsidiaries is necessary in furtherance of our statutory obligation to insure that rates for communications services be "reasonable". 47 U.S.C. § 151. Subsidies flowing from the parent to separate subsidiary, in the form of transfer of assets on capitalization, or by

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Section 215(a), in addition to the other sections cited, covers reports by the Commission to Congress regarding, inter alia, transactions between carriers and their subsidiaries. It has been previously ruled that this section is not a limitation on the "expansive grant of power" given by Congress to this agency. GTE Service Corp. v. FCC, supra n. 9.

means of the parent underwriting, for an indeterminate period, the risks of the subsidiary's competitive ventures, would inevitably be passed through to the communications ratepayer. Our broad powers "to employ a full range of remedies, including restrictions, conditions, nonrenewal of licenses, or divestitures ..." have been previously established. See United States v. FCC, F.2d (D.C. Cir. No. 77-1249, March 7, 1980), slip op. at 72. See also 47 U.S.C. § 154(i).

Conclusion
261. We have essentially retained the degree of separation required in the current rules but have also specified other areas where interaction between the separate subsidiary and other affiliated entities would undermine the "separateness" of the resale subsidiary requirement. We have attempted to avoid as much as possible the problems associated with allocating joint and common costs, related to facilities, personnel, services, and software development. We have singled out software and joint research and development as deserving special attention over and above what is addressed by the existing rules. We have concluded that the separate subsidiary must maintain its own books of account, have separate officers, utilize separate operating, marketing, installation and maintenance personnel, and utilize separate computer facilities in the provision of enhanced services. We have proscribed the joint sharing of computer capacity and software development. At the same time we have delineated the condition under which certain transfers of information must be disclosed to prevent anticompetitive behavior. We have also weighed the costs and benefits associated with sharing various administrative expenses and have concluded that the separate subsidiary may obtain administrative services from the parent on a compensatory basis and share in whatever savings may be derived from bulk purchases. However, we reserve judgment as to whether outside financing should be required.

262. In restricting the resale structure and our maximum separation requirements to AT&T and GTE, the structural remedy is limited to those carriers having significant market power and the ability to exercise it to the detriment of the communications ratepayer and the competitive evolution of enhanced services on a national scale. We believe the approach we have taken here is, on balance, a moderate one. Our broad discretion to choose between structural remedies or solely conduct regulation is already established. GTE Service Corp. 474 F.2d at 731. Moreover, our ability to impose and administer different regulatory schemes among a wide variety of carriers under our jurisdiction is similarly without question.

263. Numerous regulatory agencies have imposed differing regulations

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Our Computer Inquiry I separation requirements did not apply to all carriers. Carriers whose operating revenues did not exceed $1,000,000 were exempted from those rules. See GTE Service Corp., 474 F.2d at 730, n. 7.

on their regulatees, and have been sustained on these grounds. See Permian Basin Area Rate Cases, 390 U.S. 747 (1968); American Airlines v. CAB, 359 F.2d 624 (D.C. Cir. 1966). Also, see FPC v. Texaco, 417 U.S. 380 (1974) (affirming as to agency authority to order different treatment of "small" and "large" producers, reversing on other grounds). There is no question, then, that our "broad discretion in choosing how to regulate ..." AT&T v. FCC, 572 F.2d 17, 26 (2d Cir. 1978), includes discretion to select different schemes for different regulatees. See U.S. v. FCC, F.2d, slip op. at 73 (D.C. Cir. No. 77-1249, Mar. 7, 1980).

264. In selecting only certain carriers to whom the structural requirements apply we are not unaware of the risks associated with exempting other carriers. However, potential abuses not safeguarded by structural requirements can currently be safeguarded by our broad authority to regulate the conduct of these carriers. All of the entities offering basic services, of course, remain subject to the dictates of the full range of Title II regulation. Moreover, we remain free to re-examine our current approach should such potentials for abuse actualize, or as circumstances change generally. See e.g., FCC v. WOKO, Inc., 329 U.S. 223 (1946); Pocket Phone Broadcast Service v. FCC, 538 F.2d 447 (D.C. Cir. 1976). See generally, K. Davis, Administrative Law Text ch. 17 (3d ed. 1972). Indeed, the D.C. Circuit Court of Appeals has indicated that we are obligated to re-examine our rules if circumstances change substantially. Geller v. FCC, 610 F.2d 973 (1979).

Transition Period
265. Various comments urge that there be a transition period to the extent structural changes are adopted. GTE is currently subject to the maximum separation rules, and although Section 64.702(c) specifically excepts companies of the Bell System, the exception was predicated on the belief that the Bell System would not be offering unregulated services over the telecommunications network. See Tentative Decision, First Computer Inquiry, 28 FCC 2d at 305. However, our adoption of a regulatory scheme which distinguishes between basic and enhanced services dictates that current enhanced services offered by either GTE or the Bell System through facilities used in interstate communications be provided pursuant to the resale structure. Moreover, because we are requiring the separation of CPE from the provision of basic services, the Bell System and GTE will be required to restructure their current method of marketing terminal equipment. Accordingly, we believe that a transition period should be established

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The range of available responses to abuse of the letter or spirit of the requirements specified in this Order is, of course, quite broad. Should experience show it is necessary, we are prepared, for example, to prohibit all information flows, to require some measure of third party equity financing for the separate subsidiary, or, in the extreme case, to ban dominant common carriers from the provision of some enhanced services or CPE altogether.

to accommodate the potential restructuring of certain existing services, future services, and the offering of CPE.

266. Insofar as a transition period for enhanced services is concerned, we distinguish between services that are currently being offered and new services that are offered subsequent to the adoption of this order. Any new enhanced service which is offered after the effective date of this order must be provided pursuant to the resale structure. With respect to existing services, however, carriers subject to the resale structure will have until March 1, 1982 to restructure the manner in which they are provided. As of March 1, 1982 carriers under direct or indirect common control of AT&T and GTE shall not offer enhanced services or CPE except as set forth in this decision. We appreciate that a great deal of effort, particularly on the part of carriers, will be required to effect the transition. We are confident that the attainment of the new approach to the provision of CPE and enhanced services we have specified today will more than justify the effort from the viewpoint of the consuming public. At the same time, it is important that the transition be accomplished in a manner which will not disadvantage the affected carriers, their shareholders, or their employees. As we have indicated, see, e.g. paras. 165-166 supra, we are prepared to assist in smoothing the transition. But it is abundantly clear to us that the burdens of working out the transition must be borne in the largest measure by the affected carriers. They much more than any other entities involved have the ability to implement the transition in a timely and efficient manner or to retard its achievement and raise the costs of attaining it for all concerned. We hope that they share our view that society's interest in efficient communications will be well served by proceeding as rapidly as possible to the arrangements described here. But, even if they do not, we hope that they do not fail to see that a cooperative approach to achieving the new arrangements is essential if significant institutional and personal dislocations are to be avoided.

International
267. In the Tentative Decision we sought comment on whether we should extend the resale structure to the IRCs. We were concerned that our failure to extend the resale structure into the international area would, over the long term, create problems with respect to the possible expansion of enhanced services internationally, particularly on a competitive basis. Tentative Decision at para. 15. Since the resale principle is implicit in the separation requirement that we adopt today, the basic issue still remains whether resale should be extended into the

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We note that GTE Telenet is currently subject to various separations requirements which are undergoing re-examination by the staff. Where those requirements are less restrictive than what we are setting forth here, GTE Telenet may act in accordance with the already established separation requirements until the staff review is completed and any modifications are made.

international area. We conclude that it is inappropriate for us to address this issue in the current proceeding.

268. First, any decision we make in this proceeding with regard to international resale would be premature. In our recently released CCI Order, we stated that "the Commission has not adopted a general policy one way or the other as to the resale of international facilities and ... has made no findings as to the lawfulness of international tariff provisions which restrict the third party use of international facilities." We indicated that an appropriate notice initiating a proceeding to assess the applicability of resale principles to international communications would be forthcoming. Consequently, any determination that we make in this Inquiry would have the effect of prejudging some of the basic issues to be considered in that proceeding. We believe that issues generic to the international arena should be addressed prior to imposing a resale requirement for enhanced services. We will defer consideration of this issue until completion of the international resale inquiry.

269. Second, the need for an immediate determination as to whether the IRCs should be subject to the resale structure is, to a certain extent, mitigated by our recent actions directed at the market power of the IRCs. On December 12, 1979 we decided several important matters both reflecting and affecting the market structure of the IRC industry. We stated our belief "that the combined effect of these decisions will be an improved international communications system with more choices for consumers, more diverse service offerings, and lower rates". During the pendency of our broad inquiry on international resale, we will have an opportunity to observe whether these actions have, in fact, resulted in an improved market environment for the provision of communications and enhanced services. Depending on the outcome of the international resale inquiry and the characteristics of the market at that time, we are free to examine whether the IRCs should be subject to the resale structure.

270. We are also aware that Comsat is a major facilities provider for international services. Many of the concerns that we address in this proceeding, however, are not relevant to Comsat since it does not

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ITT Worldcom et al. v. Consortium Communications International, Inc. at para. 18 (released February 12, 1980).

See Preliminary Audit and Study of Operations of International Carriers and Their Communications Services, Docket No. 20778, FCC 79-840; International Record Carriers Scope of Operations, Docket No. 19660, FCC 79-841; Dataphone, Docket No. 19558, FCC 79-842; Datel, Docket No. 19558, FCC 79-843; Western Union, New Telex Service Arrangements via Mexico and Canada, File No. C-L-2 FCC 79-845; ITT World Comm. et al. v. CCI, File Nos. TS-9-78, TS-10-78, TS-78-1945, FCC 79-846; PMS, CC Docket No. 78-96, FCC 79-847; Interface of the International Telex Service with the Domestic Telex and TWX Services, Docket No. 21005, FCC 79-844 (adopted December 12, 1979).

International Telex, at para. 6.

provide communications services or enhanced services directly to consumers. To the extent this premise should change, we are not foreclosed from subjecting Comsat to the resale structure if the facts so warrant. Moreover, any action in this proceeding with regard to Comsat's corporate structure could be duplicative as Comsat is already subject to a separation requirement in that we have required Comsat to form a separate corporate entity to engage in any domestic satellite ventures and in any other non-INTELSAT related activities. Additionally, we are currently studying, pursuant to congressional mandate, whether Comsat is optimally structured to engage in a variety of activities involving different markets as well as whether the validity of the separation requirement imposed on Comsat remains valid. We expect that this report, which must be transmitted to Congress no later than May 1, 1980, will provide additional insight as to whether Comsat should be subjected to further separation requirements. If, after the Comsat report is compiled and various international proceedings are concluded it appears that Comsat should be subjected to further separation requirements, we will take appropriate action at that time.

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Communications Satellite Corporation, 45 FCC 2d 444 (1974).

See Interim Report and Notice of Inquiry, Implementation of Section 505 of the International Maritime Satellite Telecommunications Act, CC Docket No. 79-266 (released October 19, 1979).