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The 1996 Telecom Act was an unmitigated disaster. Its lessons must also shape any attempts to regulate the internet.

As a society, we have accepted that an oligopoly of cable and telecom interests will provide consumers with access to the internet. Until recently, telecom companies and cable companies competed for consumer dollars in separate spheres. In exchange for local monopolies or near monopolies, they were required to provide reliable levels of service to all segments of society. Access to telephone service, and to a lesser extent cable, was viewed as modern necessity. Because of the expense and complexity of these networks and the public service requirement imposed upon their owners, they were granted monopolies.

We understand that consumers might get a raw deal from these monopolistic arrangements. You can’t fight city hall or the phone company. Customer service was/is a joke. Innovation was non-existent. Competition was squashed at all costs.

Periodically, the federal government attempted to inject competition in the telecom industry. They broke up AT&T in the 1980’s, bringing competition to the long distance market. Attempting to build upon that success during the 1990’s, a well-intentioned federal government made a gaffe that still haunts us today. A gaffe that must resonate loudly in our net neutrality debate.

The Telecom Act Background

The Telecommunications Act of 1996 and the potential profits associated with the internet led to a gold rush mentality among investors. Under the Telecom Act and the guiding hand of the Federal Communications Commission, Competitive Local Exchange Carriers (CLECs) were given low cost access to the incumbent carrier’s (ILECs, aka the Bell companies) networks. Because new CLECs didn’t have to build the most expensive aspect of a network, the last mile, barriers to entry were lowered and investors threw money at CLECs. The market was flooded with capital, resulting in the telecom bubble.

With access to cheap capital, companies laid fiber under streets in order to build national networks. Companies laid fiber under seas in order to build global networks. Companies bid billions of dollars for wireless spectrum.

All this infrastructure building was expensive. Telecom companies took on over $1 trillion dollars of debt worldwide. Abundant capital resulted in hundreds of companies with nearly-identical and overlapping networks, all of them with excess capacity. Excess capacity meant that there was not nearly enough revenue to be earned to pay down debt and generate a return on investment. Consequently, as capital markets for telecom companies dried up in late 2000 and 2001, CLEC bankruptcies followed.

As hundreds of CLEC and ISP companies availed themselves of the chapter 11 reorganization process, shedding the debt Wall Street had ill-advisedly given them access to, price wars erupted. CLECs that shed their debt put pressure on those that hadn’t, resulting in more bankruptcies. As the price wars intensified, CLECs found that the financial models that they had premised their reorganizations on weren’t viable. With massive overcapacity and unrealistic traffic growth expectations, revenue expectations continued to go unmet. Often a second bankruptcy was necessary.

I worked on a number of telecom bankruptcies in my previous life as a lawyer. I graduated from law school in May of 2000 and, after taking the bar, started work in early October. By Saturday of my first week I began working for a telecom client which in early November would be one of the first of several hundred CLEC bankruptcies in the next half-decade. In my six years of practice, about half of my clients were troubled telecom companies, including two which entered and exited chapter 11 twice during that span. Not that they all had overly competent management, but it just didn’t matter how well a CLEC was run. Its chances of escaping bankruptcy were minimal. Off the top of my head, I can think of Level 3 and Qwest. Qwest’s financials were so bad it nearly took down US West after the merger.

Causes of the Industry’s Problems

The industries problems were two-fold. The first was the overcapacity resulting from over-investment. The second was the CLECs inability to circumvent the Bell companies’ strangle-hold on the last mile of copper. The Telecom Act and the FCC’s implementation of it gave the CLECs only enough rope to hang themselves with.

The weakest CLECs operated using the unbundled Network Element Platform (UNE-P). Essentially this means that the CLECs would sublease, at regulated rates, the last mile of copper from the local Bell company and a node on the local switch. They would then would re-sell it to the consumer for less than the Bell company would provide you service.

The Bell Companies detested this requirement, fought it, and eventually got it overturned. In the mean time, regulatory and legal entanglements wreaked havoc on the industry. CLECs and the Bells fought over everything. Before any court, commission or school board they could find. The Bells knew that they were basically just playing a waiting game. They were losing customers to the CLECs but they were still massively profitable. The CLECs were drawing customers and revenue away from the Bells but they were burning through cash faster than Michael Jackson.

The McLeodUSA Bankruptcy

By way of example, the last case that I worked on was the second bankruptcy of McLeodUSA. This bankruptcy was a “pre-pack.” By design, pre-pack bankruptcies like McLeod’s are designed to last about 60 days. The bankruptcy code is used solely as a means to write off some of the company’s debt (usually bank debt). It will also wipe out the equity shareholders but it usually leaves all other creditors “unimpaired.” Unscathed is probably a better word. If a creditor is unimpaired in a bankruptcy, they will not lose any money.

The big bad wolf in this pre-pack was AT&T. Much of McLeod’s network was located in AT&T service area. Every telecom company is a competitor of every other telecom company. They are also each others largest suppliers. If a customer of one telecom company wants to make a phone call to the customer of another telecom company they must use both telecom’s network. As a result, telecom companies generate significant revenue and expense from each other every month.

The regulatory regime for the telecom industry is notoriously complex. The FCC regulates some aspects. Each state maintains their own regulatory bodies. Rules regarding what one company must pay another are conflicting and the subject of constant litigation. As a result, billing disputes were common. Withholding revenue from a competitor, in the form of disputed billings, allowed a company to gain leverage.

AT&T had known for months that McLeod would be filing a prepack. Everyone in the industry knew it. AT&T also knew that they would be unimpaired through the bankruptcy and that they would lose no money owed to them by McLeod as a result of the bankruptcy. Even knowing this, AT&T did anything that they could in order to make life more difficult for McLeod. Pretty much every other creditor of McLeod, including the other Bells, made a decision to wait out the bankruptcy. Having experienced numerous similar bankruptcies over the previous decade, they knew that their legal rights and the revenue owed to them would be preserved. Once McLeod emerged, they would simply go back to litigating their issues before the appropriate regulatory bodies.

AT&T decided to take an aggressive litigation posture however. They attempted fight in the bankruptcy court matters that were properly left to regulatory bodies. Without going into the boring details, the bankruptcy code afforded AT&T a few options that were not available to them under the regulatory regime. The risks to AT&T of pursuing this course were minimal. Their worst case involved spending a few hundred thousand dollars in legal fees. Even if they lost in court, they would succeed in diverting the attention of McLeod’s management for a few months. In their best case however, they would have eliminated a major competitor. The risk to McLeod was real, if remote. If the bankruptcy court were to side with AT&T it could very well have resulted in McLeod going out of business.

Ultimately, AT&T ‘s litigation was dismissed. McLeod limped on, like the other remaining CLECs. I got out of lawyering. Since then, my only connection to the telecom industry has been an intellectual curiosity regarding how it will look in the future. I know that in many ways the industry has strongly recovered. At least the big boys have. The hangover from the 1996 Telecom Act is fading. Even as the landline business continues to decline, broadband and wireless revenues have been soaring. Capital spending is on the rise. A new era is underway as they expand their high speed networks closer to the home.

Lessons of the 1996 Telecom Act

Looking back at the telecom boom and bust, I think there are a couple of lessons that are relevant to our discussion of net neutrality. The first, obviously, is the effect that an improperly implemented regulatory regime can have on any industry. As I mentioned, its my opinion that the Telecom Act and the FCC only gave the CLECs enough rope to hang themselves. The regulators completely misunderstood how much of a barrier to competition owning the last mile of copper is. They encouraged the building of hundreds of independent regional and national networks, creating loads of capacity in a part of the industry that could not create a competitive environment for consumer dollars.

Calling the 1996 Telecom Act imperfect regulation is too simplistic however. The Act’s problems went beyond the means it used to facilitate competition. The Act was also ill-timed. Think about it for a moment. Wasn’t 1996 the exact wrong time to fiddle with the rules regulating land-line telephones? Right at their last moment of relevance? Right before an entire generation of people was going wireless only? Right before the telecom and cable industries began deploying broadband internet access throughout the country? Sure, its only in hindsight that we understand that the entire communications industry was about to change. But isn’t that the point?

The damage from the 1996 Telecom Act has been far-reaching and long lasting. One group that was negatively impacted were the CLECs and their investors. Beyond that however, the Act did enormous damage to the Bells themselves. Right at the moment in history when they should have been going on the most massive capital spending campaign in their history, the Telecom Act forced them to fight a defensive rear-guard action against the CLECs. The landline customers that the CLECs were taking from the Bells were responsible for a large percentage of their profits. As they lost revenue and were forced into a price war, they were forced to reduce capital spending.

Even if the Bell’s financials hadn’t been negatively impacted by competition from the CLECs, they would have been reluctant to aggressively roll out broadband. The uncertainty of the regulatory environment under the Act was a second, independent cause for the Bell’s slow implementation of broadband. Throughout the early years of the decade, the Bells, the CLECs and the FCC were litigating what the rules would be for sharing broadband lines. Until that was settled (in favor of the Bells) they had very little reason to spend money building out their networks. They had no interest in spending money to upgrade the last mile of wire only to be forced to lease it to the CLECs.

As consumers, we have a vested interest in inducing telecom and cable companies to spend money in order to upgrade the service that they are able to provide us. If we decide that the net needs to be regulated, that regulatory regime must create an environment in which the telecom and cable companies can be fairly certain to recoup the massive sums that we expect them to invest.

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