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UNITED STATES v. WESTERN ELEC. CO.

July 26, 1984

UNITED STATES OF AMERICA, Plaintiff,
v.
WESTERN ELECTRIC COMPANY, INC., AND AMERICAN TELEPHONE AND TELEGRAPH COMPANY, Defendants; UNITED STATES OF AMERICA, Plaintiff, v. AMERICAN TELEPHONE AND TELEGRAPH COMPANY, et al., Defendants



The opinion of the court was delivered by: GREENE

The Regional Holding Companies, *fn1" have requested the Court to waive the "line of business" restrictions in section II(D) of the decree so that they may pursue ventures other than the provision of local telephone service. These motions raise the question whether and the extent to which these companies shall be permitted to engage in new business enterprises -- perhaps the most important issue to have arisen since the AT&T Plan of Reorganization was approved last year. *fn2"

 Section II(D) of the decree mandates that

 
After completion of the reorganization . . ., no [Operating Company] shall, directly or through any affiliated enterprise:
 
1. provide interexchange telecommunications services or information services;
 
2. manufacture or provide telecommunications products or customer premises equipment (except for provision of customer premises equipment for emergency services); or
 
3. provide any other product or service, except exchange telecommunications and exchange access service, that is not a natural monopoly service actually regulated by tariff.

 Section VIII(C) provides for the removal of these restrictions under certain circumstances. Motions filed by the Regional Holding Companies or their affiliated Operating Companies request permission to engage in enterprises ranging from real estate investments to foreign business ventures, and the Court is advised that additional motions, for further diversification, will follow. Some of the proposed enterprises are related and some are unrelated to the telecommunications business. *fn3"

 I

 History of the Restrictions

 In deciding requests for waivers under section VIII(C), the Court must determine whether the petitioning Regional Holding Company has made "a showing" that "there is no substantial possibility that it could use its monopoly power to impede competition in the market it seeks to enter." The parties disagree not only on the factors the Court may consider in making its section VIII(C) determination; they also disagree on the question whether that section establishes the exclusive standard for a removal of the line of business restrictions.

 The Regional Holding Companies argue that such removal is contingent entirely on the anticipated antitrust consequences of their entry into a particular market; that the Court is not free to consider other provisions of the decree; *fn4" and that when the pending waiver requests are considered in light of the proper standard, all of them must be granted without conditions. The Department of Justice and others *fn5" maintain, however, that many, if not all, of the requests should be denied, if only because the Regional Holding Companies have failed to demonstrate that their entry into the markets they seek to penetrate is not likely to impede competition. Beyond that, these parties argue that the Court should refrain from taking a restricted view of its responsibilities but should measure the potential effect of entry on the decree's overall objectives.

 The key remedy adopted in the decree for the elimination of anticompetitive conditions within the telecommunications industry was the divestiture of the Operating Companies from AT&T. As a regulated monopoly, AT&T had both the incentive and ability -- through cross subsidization and various discriminatory actions related to interconnection -- to use its control over the local exchange facilities to foreclose or impede competition in the several competitive or potentially competitive markets. *fn6" The functional separation of the Operating Companies from AT&T was designed to eliminate the potential for such anticompetitive behavior.

 In order to prevent the occurrence or reoccurrence of anticompetitive conduct by the Operating Companies -- each of which retains in its particular area a monopoly over local telecommunications service and thus has the potential for using its monopoly power to discriminate against others -- the decree imposes several restrictions upon their activities. In fact, as originally drafted, the decree flatly prohibited these companies from engaging in any business other than that of supplying local telephone service. *fn7"

 The Court rejected such a blanket restriction, reasoning that the mere theoretical ability to engage in anticompetitive conduct did not constitute a sufficient basis for prohibiting the companies from entering all competitive markets. In the Court's view, the test was to be a pragmatic one. The Operating Companies were different from AT&T -- largely because of their smaller size and relative lack of complexity *fn8" -- and they were therefore to be barred from competitive markets on a less rigid basis.

 After examining the restrictions set forth in section II(D) of the proposed decree in light of that standard, the Court rejected two of these restrictions -- that on marketing of customer premises equipment and that on the publication of the Yellow Pages *fn9" -- and it approved the remainder of the restrictions. In so doing, the Court further noted that

 
It is probable that, over time, the Operating Companies will lose the ability to leverage their monopoly power into the competitive markets from which they must now be barred. This change could occur as a result of technological developments which eliminate the Operating Companies' local exchange monopoly or from changes in the structures of the competitive markets. In either event, the need for the restrictions upheld in Subparts A through C will disappear. . . .

 552 F. Supp. at 194-95.

 Accordingly, the Court required the parties to incorporate into the decree a mechanism by which the line of business restrictions could be removed, and it stated that

 
the removal of the restrictions should be governed by the same standard which the Court has applied in determining whether they are required in the first instance.

 552 F. Supp. at 195.

 The parties accepted the section II(D) *fn10" and section VIII(C) modifications required by the Court. It was also understood that the restrictions would be removed altogether if the rationale therefor became outmoded by technical developments or changes in competitive conditions. *fn11" On that basis, the Department of Justice was required to report to the Court every three years concerning the continuing need for the retention of the restrictions.

 It is in light of this history that the issues now before the Court must be analyzed.

 II

 Cross Subsidization

 In one respect, the risk that a Regional Holding Company will use its monopoly power for anticompetitive purposes becomes more remote as the market it seeks to enter becomes increasingly unrelated to and independent of local exchange service. That is so because products or services in unrelated fields are not dependent upon interconnection to the companies' monopoly bottleneck facilities, and discriminatory access therefore cannot injure the manufacturers or sellers which compete with them. However, competition can be impeded as readily in another way -- by cross subsidization, that is, by a subsidy to a new, competitive line of business with profits earned from or assets held by the existing, regulated monopoly line of business.

 As long as a Regional Holding Company is engaged in both monopoly and competitive activities, it will have the incentive as well as the ability to "milk" the rate-of-return regulated monopoly affiliate to subsidize its competitive ventures and thereby to undersell its rivals in the markets where there is competition. For that reason, caution with respect to "outside" activities is always warranted, particularly in the case of wholesale diversification because the larger the scale and the greater the diversity of a company's activities, the more difficult it is to detect and to remedy cross subsidization between the various affiliates. Compare also note 8 supra. Indeed, widely diversified Regional Holding Companies could enjoy greater opportunities to cross subsidize than did the Bell System which, under the 1956 consent decree, was limited to a relatively narrow range of products and services.

 Cross subsidization may take a variety of forms. One such practice would be the misallocation of common costs. To the extent that a Regional Holding Company used the same facilities, equipment, and personnel to serve both its regulated and its unregulated activities, it would have the ability to overallocate the costs assigned to the former in order to maximize the amount that would be passed on to the ratepayers (who have no choice but to pay). *fn12" Not only would this improper assignment of costs burden the ratepayers; it would also enable the company profitably to charge less for its competitive products and services than do its rivals who enjoy no such subsidy.

  A Regional Holding Company could also subsidize its competitive ventures by transferring assets *fn13" from its regulated affiliates to its unregulated affiliates at less than their cost or below their market value. *fn14" Such a practice would not only adversely affect the ratepayers who ultimately fund the research and development costs of the transferred assets, *fn15" but it would, once again, impede fair and effective competition in the competitive market: this cross subsidization would give the company's unregulated enterprise an obvious and improper advantage over its competitors. Conversely, a regulated affiliate could "purchase" assets from the unregulated affiliate at a price above their market value and pass on the extra costs to the ratepayers. *fn16"

 In addition to cross subsidization, a Regional Holding Company could impede competition in markets unrelated to telecommunications by exploiting the marketing advantages stemming from its local exchange monopoly. The company would have a unique advantage over its competitors if, for example, it "bundled" its regulated monopoly services with its competitive products or services, or if it advertised, and in fact provided to its customers in the competitive market, more timely telecommunications service, preferential access, or both. *fn17"

 In response to these concerns, the Regional Holding Companies argue primarily that cross subsidization is not a competitive issue but a regulatory cost allocation matter for which regulatory sanctions and penalties already exist. In addition, they contend that, even if they did engage in such anticompetitive conduct, the appropriate remedy would be a new antitrust action, not a refusal to grant a waiver. *fn18" These arguments are entirely without merit.

 The cross subsidization of competitive activities with profits earned from a regulated enterprise constitutes precisely the kind of conduct the decree was intended to curb, and for which the decree contains -- in a denial of a section VIII(C) waiver request -- a very precise remedy. There is therefore no reason or basis for turning elsewhere when such practices are threatened by organizations subject to the provisions of the decree.

 That remedy, moreover, is preferable to a regulatory one. Cost misallocation and improper transfer pricing in interaffiliate sales have proved difficult, if not impossible, to detect. *fn19" It is for that reason that regulatory oversight has not been in the past, *fn20" nor is it likely to be in the future, an adequate check against them; it is for that reason that section VIII(C) was incorporated in the decree; and it is for that reason, too, that the burden was placed on the Operating Companies to demonstrate the absence of an anticompetitive effect. By contrast, in a new antitrust action or in a regulatory proceeding the proponent of a restriction would have the burden of proof. In short, the prevention of cross subsidization and other anticompetitive practices is an appropriate and significant ingredient in any decision under section VIII(C).

 It does not follow from what has been said that all waiver requests must or will be denied. As noted below (Part VII infra) some of the problems discussed above can be alleviated by the imposition of conditions or safeguards upon the grant of waivers. It is also apparent, however, that such safeguards or conditions alone are not likely to be adequate to resolve legitimate concerns in this sensitive field, where claims of cross subsidization have contributed to a massive restructuring of the entire telecommunications industry, and where considerable caution is warranted to avoid yet another upheaval.

 Thus, what plainly needs to be done is to avoid a headlong rush by the Regional Holding Companies into diversification programs which, for the reasons stated, would offer them too many opportunities for anticompetitive conduct. *fn21" The Court will therefore require that the entry of these companies into competitive markets proceed at a measured pace (see pp. slip op. 57-58 infra). Additionally, as will now be seen, immediate, ...


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