A recent news release announced that Federal Communications Commission (“FCC”) Chairman Ajit Pai has circulated an Order related to the high-cost universal service support mechanism. According to the news release, the FCC will allocate over $500 million to promote rural broadband deployment presumably by allocating broadband reserve funds to address a shortfall in high-cost universal service fund (“USF”) support. This part of the Order was covered in Part I of this blog series.

The news release also states that the Order will “put in place strong new rules to prevent abuse of the high-cost program.” While the FCC’s announcement is short on details, it sounds like the Order could contain new rules prohibiting rate-of-return carriers from recovering certain expenses that are not related to the provision of interstate telecommunications services. The FCC teed up this issue in 2016. In the Further Notice of Proposed Rulemaking (“FNPRM”) accompanying the Rate-of-Return Reform Order, the FCC sought comment on which investments and expenses may be included in a local exchange carrier’s rate base and revenue requirement for ratemaking and USF purposes. [1]

What does this mean? It may mean Rate-of-return carriers should get ready for increased scrutiny of their accounting and cost studies – how they record their investments, expenses, and other financial activity. In the future, audit results may be unpleasant.

To understand what the FCC is proposing and why the FCC believes stricter oversight of cost recovery is needed, its helpful to start with an overview of rate-of-return regulation, which the FCC provided in the FNPRM. The interstate rate base is the amount upon which a carrier is entitled to earn a return. It consists of investments in “plant” and equipment that are used in the provision of interstate telecommunications services, net of depreciation and amortization, and minus certain allowed deductions (such as the interstate portion of deferred taxes and customer deposits). Well-known examples of investment included in a carrier’s rate base are central office equipment, switches, copper wire, and fiber-optic cable. If something is also used for non-regulated services (an activity that is not subject to rate regulation), a carrier must allocate the cost between the two categories. Costs that are assigned to the regulated side are then further separated between intrastate and interstate categories.

Whatever ends up in the regulated interstate cost category generally makes up the interstate rate base. A carrier then adds its interstate operating expenses and taxes to its rate base to determine its interstate revenue requirement. The interstate revenue requirement is used to determine the interstate rates a carrier is permitted to charge.

There is one very important over-arching principle that applies to regulated interstate costs – they must meet the FCC’s “used and useful” standard. The investment or equipment that is represented by the cost must be “used and useful in the efficient provision of interstate telecommunications services.” [2] The cost of purchasing a new softswitch would meet the used and useful standard, while a rate-of-return carrier’s cost of purchasing new artwork for its office would not.

All of the aforementioned expense accounting is also used to calculate the amount of high-cost USF support that a rate-of-return carrier is eligible to receive. This is an important piece to understanding what’s driving the FCC’s review of permitted expenses.

The Communications Act requires that USF support must be used “only for the provision, maintenance, and upgrading of facilities and services.” [3] In other words, including the cost of artwork when calculating a carrier’s USF support violates the Act. Using support for any purpose other than building networks and providing service is prohibited, and may subject a carrier to enforcement action.

FCC Review Of Investment And Expenses

The FCC’s review of investment and expenses initiated in the Rate-of-Return Reform Order FNPRM builds off of an October 2015 Public Notice warning carriers that they are obligated to use high-cost USF support only for its intended purposes of maintaining and extending communications service to rural, high-cost areas. [4] The Public Notice outlined certain expenses that should be expressly excluded, including personal travel, entertainment, and alcohol. There was a joint statement by FCC Commissioners O’Rielly and Clyburn, and a statement from then-Commissioner Pai supporting the action.

In the FNPRM, the FCC proposed to prohibit the following additional expenses: artwork and other objects which possess aesthetic value; corporate aircraft, watercraft, and other motor vehicles designed for off-road use, except insofar as necessary to access inhabited portions of the study area not reachable by motor vehicles travelling on roads; any vehicles for personal use; tangible property not logically related or necessary to the offering of voice or broadband services; childcare; cafeterias and dining facilities; and, housing allowances or other forms of mortgage or rent assistance for employees.

If adopted, the proposed rules prohibiting non-necessary expenses would supersede any existing rules or precedent that might otherwise suggest such expenses are appropriate.

We’ll have to wait for the release of the Order to see the full extent of any “strong new rules to prevent abuse of the high-cost program.”

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[1] Connect America Fund, WC Docket No. 10-90, ETC Annual Reports and Certifications, WC Docket No. 14-58, Developing a Unified Intercarrier Compensation Regime, CC Docket No. 01-92, Report and Order, Order and Order On Reconsideration, and Further Notice Of Proposed Rulemaking, FCC 16-33, ¶ 327 (rel. Mar. 30, 2016) (Rate-of-Return Reform Order).

[2] 47 C.F.R. § 65.800. “Property is considered used and useful for regulatory ratemaking if it is ‘necessary to the efficient conduct of a utility’s business, presently or within a reasonable future period.’” Rate-of-Return Reform Order at ¶ 334 (quoting American Tel. and Tel. Co., Phase II Final Decision and Order, 64 FCC 2d 1, 38, ¶ 111 (1977)).

[3] U.S.C. § 254(e).

[4] All Universal Service High-Cost Support Recipients Are Reminded That Support Must Be Used For Its Intended Purpose, WC Docket Nos. 10-90 and 14-58, Public Notice, FCC 15-133 (Oct. 19, 2015).