The Federal Communications Commission has approved the transfer of control of ComSouth Corporation (“ComSouth”) to Hargray Communications Group, Inc. (“Hargray”).[1] The transaction involves high-cost universal service fund (“USF”) support provided under two different mechanisms – one fixed and one cost-based. Because those details raise cost shifting concerns that could produce an unjust increase to Hargray’s USF support, the FCC approved the transaction subject to a condition that will prevent such a result. The decision to approve the transaction was made at the Commission level at the request of FCC Commissioner Michael O’Rielly.

So what’s really going on here? Hargray has two cost-based incumbent local exchange carriers (“ILECs”), and the transaction includes the purchase of an ILEC that receives fixed, Alternative Connect America Cost Model (“A-CAM”) support. The FCC was worried that Hargray could transfer the A-CAM company’s costs on to the books of the two cost-based ILECs, which would boost the cost-based companies’ overall costs and overall USF support. To prevent this, the FCC’s condition caps the combined operating expenses of Hargray’s two cost-based ILECs at certain levels for a period of seven years. More on this below...

The Target Company Has An ILEC That Receives A-CAM Support

ComSouth is a Georgia corporation. Through subsidiaries and affiliates, ComSouth provides local and long distance telephone, broadband, and video services in Peach and Macon counties in Georgia. One of its subsidiaries, ComSouth Telecommunications, Inc., is a model-based rate-of-return ILEC, meaning it receives USF support derived from the A-CAM.

The Buyer Has Two Rate-of-Return ILECs Subject To Revised Cost-Based Rules

Hargray is a privately held corporation. Through subsidiaries and affiliates, Hargray provides telecommunications services in South Carolina and Georgia. It has two rate-of-return ILECs: (1) Hargray Telephone Company, Inc., serving over 23,000 residential and business customers in Hilton Head, Hardeeville, and Jasper, South Carolina; and (2) Bluffton Telephone Company, Inc., serving over 15,000 residential and business customers in Bluffton, South Carolina. Hargray’s two rate-of-return ILECs receive high-cost USF pursuant to the FCC’s revised cost-based rules.

Description Of The Transaction

The W. Mansfield Jennings Limited Partnership, a Georgia limited partnership, is ComSouth’s direct parent. Pursuant to a stock purchase agreement, Hargray purchased 100 % of ComSouth’s common stock from the limited partnership, making ComSouth and its subsidiary entities wholly owned subsidiaries of Hargray.[2] ComSouth and Hargray did not have any overlapping or adjacent service areas.

Model-Based USF Support vs. Cost-Based USF Support Or A-CAM vs. Legacy

In the 2016 Rate-of-Return Reform Order, the FCC established a process to allow some rate-of-return ILECs to voluntarily elect to receive USF support amounts derived from a cost model (the A-CAM).[3] Those carriers that opted in to the model will receive support for 10 years in exchange for meeting broadband network build-out obligations and service performance standards. Rate-of-return carriers were required to elect to move to the A-CAM on a state-level basis, which according to the FCC, prevented them “from cherry-picking the study areas in a state where model support is greater than legacy support, and retaining legacy support in those study areas where legacy support is greater.”[4]

The Rate-of-Return Reform Order was also a game changer for rate-of-return ILECs that didn’t move to the A-CAM because the order provides USF support to help defray costs associated with the provision of stand-alone broadband service. Specifically, the order created a new mechanism – Connect America Fund Broadband Loop Support (“CAF BLS”) – to provide federal high-cost universal service support to rate-of-return carriers for their network investments regardless of what services are ultimately purchased by customers. To create the new support mechanism, the FCC expanded and reformed its existing interstate common line support (“ICLS”) rules to provide support for stand-alone broadband service. 

The FCC’s Review Of The Transaction

An ILEC provides interstate telecommunications services pursuant to a Section 214 authorization.[5] When an ILEC is purchased, control of this authorization is transferred to the purchaser, but only upon approval by the FCC. In general, when an entity applies for approval of a transfer of control, the FCC assesses (1) whether the proposed transaction complies with the Communications Act, other applicable federal statutes, and the FCC’s rules; and (2) if the transaction does not violate a statute or rule, the FCC considers whether the transaction could result in public interest harms by substantially frustrating or impairing the objectives or the implementation of the Communications Act or related statutes.[6] The FCC’s review of transactions is informed by traditional antitrust principles, but the FCC’s analysis under the public interest standard looks at more than just competitive impact. When approving a transaction, the FCC may impose and enforce conditions that address potential harms – conditions that remedy harms that arise from the transaction and are related to the FCC’s responsibilities under the Communications Act.

So What’s Really Going On With This Transaction: A Cost-Based Company (Hargray) Acquires An A-CAM Company (ComSouth)

To understand what happened, it’s important to start with how the FCC characterized the transaction – “the combination of two companies that receive high-cost universal service support under different mechanisms, one fixed and one cost-based.” The fixed support company was moved under the umbrella of the cost-based company (so to speak since we are really dealing with a holding company). That’s the focus of the FCC’s review – ComSouth’s model-based ILEC subsidiary ComSouth Telecom becoming a subsidiary of Hargray.

What’s the issue here? Hargray’s two existing ILECs receive USF support based on their costs and ComSouth Telecom does not. The FCC was worried that Hargray could transfer ComSouth Telecom’s costs on to the books of Hargray’s two cost-based ILECs (Hargray Tel and Bluffton Tel). Why would that be an issue? Because ComSouth Telecom is an A-CAM company, its USF support is locked-in regardless of whether its costs increase or decrease. On the other hand, Hargray Tel and Bluffton Tel still receive USF support based on their embedded costs. So if their costs increase, their support should increase (yes, there is a budget control mechanism and other cost/support control mechanisms in place that limit this, but you get the point). It should be noted that companies often merge to “generate efficiencies that reduce the combined company’s costs.” If a merger results in increased costs, and thus increased USF support, then something is not right, or at least that’s the FCC’s opinion.

A transaction involving A-CAM and cost-based companies presents an opportunity to get creative with cost accounting and game the system to receive increased USF support. In other words, since the A-CAM company’s support is locked in, its costs could be shifted to a non-A-CAM company, boosting that company’s overall costs and overall USF support. Here’s how the FCC explains how the transaction could open the door to nefarious cost shifting:

If such cost shifting were to happen in this case, Hargray, as the cost-based support company, could seek to recover high-cost support above its pre-merger level despite making no change in either service offerings or deployment, while ComSouth would continue to receive the same fixed level of support under A-CAM as it did prior to the transaction. As a result, the combined company, post-transaction, could obtain more universal service support than the two companies did as separate entities, not because of any new investment, expense, or buildout, but rather solely because of the application of accounting procedures.[7]

Cost shifting of this sort does not comply with the goals of the universal service fund. Cost shifting of this sort, the FCC concluded, “could result in potential harm to the...goal of ensuring that limited universal service resources are distributed efficiently and effectively.” Could that really happen or would someone really do that? Regardless of your answer, the FCC has to assume it would happen. And, it has previously addressed cost shifting in at least one other area of rate-of-return regulation – the “all-or-nothing” rule. That rule prevents creative cost shifting by imposing price cap regulation on all parties following a merger or acquisition involving price cap carriers and non-price cap carriers.

So what did the FCC do here? It placed a condition on its approval of the transfer of control to prevent Hargray from shifting costs (shared or common costs) of the newly-acquired A-CAM company to Hargray’s two cost-based ILECs and receiving high-cost universal service support based on those increased costs. Here is the specific condition:

The combined operating expense as defined below for Hargray’s two existing rate-of-return subsidiaries, Hargray Telephone Company and Bluffton Telephone Company, shall be capped at the averaged combined operating expense of the three calendar years preceding the transaction closing date for which the operating expense data are available.[8]

The operating expense cap will apply to cost recovery under both High-Cost Loop Support and CAF-BLS and will be applied proportionately to each company’s accounts used to determine eligible operating expense for HCLS and CAF-BLS. An inflation factor, though, will be applied annually. The cap will remain in effect for seven years from the consummation of the transaction. However, the cap will sunset if Hargray’s rate-of-return ILECs become model-based support companies at any point during the seven-year period. The FCC has directed NECA to implement the cap and determine support amounts, with USAC validating all calculations.

Public Interest Harms & Benefits

At the end of the decision, the FCC covers public interest harms and benefits. The FCC concludes the operating expense cap condition addresses any potential public interest harms of the transaction. As for the transaction’s public interest benefits, the FCC states that granting approval fits with the goal of “fostering the free transferability of licenses and authorizations.” The FCC notes that Hargray and ComSouth claim numerous other public interest benefits, but the FCC only finds one other benefit: “that it is likely that the transaction will result in continued, and perhaps improved, financing for ComSouth, which may result in a greater incentive or ability to enhance and extend its service offerings.”[9]

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[1] Joint Application of W. Mansfield Jennings Limited Partnership and Hargray Communications Group, Inc., for Consent to the Transfer of Control of ComSouth Corporation Pursuant to Section 214 of the Communications Act of 1934, WC Docket No. 18-52, Memorandum Opinion and Order, FCC 18-62 (May 11, 2018) (Hargray Order).

[2] The FCC’s Wireline Competition Bureau released a public notice requesting comment on the transfer of control application, but no comments were filed in response. Domestic Section 214 Application Filed for the Transfer of Control of ComSouth Corporation to Hargray Communications Group, Inc., WC Docket No. 18-52, Public Notice, DA 18-195 (Feb. 27, 2018).

[3] 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 (rel. Mar. 30, 2016) (Rate-of-Return Reform Order).

[4] Rate-of-Return Reform Order at ¶65.

[5] See 47 U.S.C. § 214(a).

[6] See, e.g., Applications of Level 3 Communications, Inc. and CenturyLink, Inc. for Consent to Transfer Control of Licenses and Authorizations, Memorandum Opinion and Order, 32 FCC Rcd 9581, 9585, para. 8 (2017); Joint Application of Securus Investment Holdings, LLC, Securus Technologies, Inc., T-NETIX, Inc., T-NETIX Telecommunications Services, Inc. and SCRS Acquisition Corporation for Grant of Authority Pursuant to Section 214 of the Communications Act of 1934, as Amended, and Sections 63.04 and 63.24 of the Commission’s Rules to Transfer Indirect Ownership and Control of Licensees, Memorandum Opinion and Order, 32 FCC Rcd 9564, 9569 n.33 (2017); Applications filed by Qwest Communications International Inc. and CenturyTel, Inc. d/b/a CenturyLink for Consent to Transfer Control, WC Docket No. 10-110, Memorandum Opinion and Order, 26 FCC Rcd 4194, 4198-99, para. 7 (2011).

[7] Hargray Order at ¶20.

[8] Hargray Order at ¶27.

[9] Hargray Order at ¶33.