the parent has an incentive to exercise its market What FCC sees as a "limitation" inherent in the separate subsidiary approach, others perceive as a fatal flaw. For example, one economist, who is also a specialist in telecommunications regulatory matters, has characterized the separate subsidiary approach as a * * half-solution [which] fails to address, much less resolve, the economic incentives associated with horizontal and vertical market structure. Beset by built-in conflicts of interest, the separate subsidiary approach is a policy snare and delusion." In connection with proposed legislation providing for the use of the separate subsidiary device as a safeguard against the anticompetitive effect of allowing the dominant carrier to engage in competitive offerings an antitrust expert testifying in September 1980 before the Subcommittee on Monopolies and Commercial Law, House Committee on the Judiciary 1/ commented that the separate subsidiary: ** is an ineffective safeguard, * * * a fiction, 11 Finally, the Department of Justice has observed in connection with FCC's proposed reliance on separate subsidiaries to prevent anticompetitive behavior that: "It is clear *** that the separate subsidiaries 1/Hearings Before the Subcommittee on Monopolies and Commercial Law of the House Committee on the Judiciary, 96th Cong., 2d Sess. on H.R. 6121, Sept. 9 and 16, 1980, serial no. 69, p. 378. Separate subsidiaries are essentially an accounting device The fact that separate subsidiaries constitute essentially an accounting safeguard rather than a definitive structural solution to the problem of monopoly power is acknowledged by the Commission in its final decision in Computer II. The Commission, in recognizing that the separate subsidiary requirement does not alter incentives, maintains, nevertheless, that it reduces the ability of the firm on which it is imposed to engage in predation or to do so without detection. This is accomplished, the Commission states, through reduction of joint and common costs between affiliated entities, the requirement that transactions move from one set of corporate books to another, and the publication of rates, terms, and conditions on which services will be available to all potential purchasers. The separate subsidiary requirement is thus intended to separate and segregate costs associated with producing particular products and services while at the same time providing visibility, accountability, and auditability for intracorporate transactions. In this sense, as the Chief of the Commission's Office of Plans and Policy has observed, accounting and separate subsidiaries are complements and not substitutes for one another. In fact, in a very real sense, separate subsidiaries are really nothing more than an extension of accounting, a means of illuminating and subjecting to public scrutiny a vast array of corporate decisions and actions relating to such items as transfer and valuation of assets, cost allocations, pricing of intracorporate transfers and transactions, pricing of product and service offerings, and distribution of revenues. Structural separation requirements, as well as requirements of arm's length dealings and fully compensatory transfer pricing between corporate affiliates are clearly regulatory requirements. Just as clearly, imposition of such requirements presupposes the imposition of still other requirements--notably costing principles and methodologies and accounting procedures--which make it possible to detect and prevent cross-subsidy and to ensure, where appropriate, that intracorporate transactions take place on a fully compensatory, arm's length basis. Because costing methodologies and accounting tools are so crucial to the workability of an approach which, by general agreement, does not significantly alter incentives to engage in anticompetitive conduct, these tools must be fully developed and implemented before a separate subsidiary approach is made operational. Otherwise, there will simply be no way to adequately assure that separation is accomplishing the pro-competitive, public interest purposes for which it is intended. Chapter 4 discussed in detail the Commission's efforts to date to develop a satisfactory and feasible methodology for allocating joint and common costs. Because separate subsidiaries do not totally eliminate joint and common costs, resolution of the costing problems outlined in that chapter will have to precede full implementation of separate subsidiary operations. Moreover, since traditionally regulated basic services will presumably continue to experience ever increasing competitive incursions, it will be equally essential to have costing methodologies which can protect against interservice cross-subsidy and predatory pricing in the basic interexchange services sector. Just as it will be necessary to resolve longstanding costing problems before moving ahead with separate subsidiaries, it will be essential to have in place fully developed cost accounting for all affiliated corporate entities to ensure that intracorporate transfer prices are fully cost compensatory in nature. Without such cost accounting, the need for which is discussed in detail in chapter 5, the Commission will not be able to make valid comparisons of prices and costs. It will also not be able to maintain proper surveillance between corporate entities, particularly between the traditionally regulated monopoly sector and the deregulated, competitive (enhanced services, customer premises equipment) sector. 1/ Along with detailed cost accounting, there will be a need for audits. Without audits, FCC will be compelled to rely, as it has so often in the past, on the word of the carrier for the accuracy and reasonableness of the accounts, data, and reports. The problems posed by FCC's reliance on unaudited carrier data are discussed in chapter 3 in connection with an evaluation of the agency's traditional price/earnings regulatory activities. As can be readily seen, separate subsidiaries do not represent a quantum leap in FCC's ability to prevent and detect cross-subsidy or to mitigate the risk of anticompetitive actions. Regulatory authorities will still be obliged to deal with highly subjective, complex, and troublesome problems of cost allocation. They will still need to ensure that a vast array of intracorporate transactions as well as external product and service offerings are priced in a fully cost compensatory manner. They will still be relying, in short, on those techniques which have proven difficult to apply effectively in the past and imperfect as safeguards against anticompetitive behavior. In this regard, the former chief of FCC's Common Carrier Bureau during congressional testimony in late 1979 stated: * "✶ ✶ ✶ I don't wish to appear too negative about 1/We recognize that private and governmental enforcement of antitrust laws will also aid in deterring anticompetitive practices. that there wouldn't be cross subsidies employing We can't guarantee that there won't be cross subsidies In addition, where goods and services are trans- So, while separate subsidiaries are helpful and [Absent divestiture or its functional equivalent] Separate subsidiaries presuppose intensive regulatory involvement Given the present lack of truly workable competition in most sectors of the telecommunications industry and the salient features of the separate subsidiary approach, that is, it does not alter the firm's incentives and relies heavily on accounting techniques to highlight opportunities for abuse of market power-one can only conclude that reliance on the separate subsidiary approach presupposes continuing intensive involvement of the regulatory authorities. This is a conclusion of utmost importance for those who might be tempted to conclude that the present state of competitive development in various sectors of the industry constitutes a justification for withdrawing regulatory safeguards and entrusting these markets to the self-regulating, invisible hand" of competition. Clearly, deregulation, in the sense of using separate subsidiaries and associated structural conditions and competitive safeguards as an alternative to traditional price/earnings type regulation, does not mean the absence of regulation. 1/Transcript of unpublished testimony by Phillip Verveer, Chief, Common Carrier Bureau, FCC, before the Subcommittee on Communications, House Committee on Interstate and Foreign Commerce, Nov. 8, 1979. To have any confidence at all in separate subsidiaries as means of promoting and protecting emerging competition, we believe that FCC will have to have a direct involvement in specifying the form and number of separate subsidiaries as well as the products and services that will be offered by these subsidiaires. The agency, we believe, will need to prescibe a variety of conditions and competitive safeguards to be imposed on the operation of the separate subsidiaries as well as on their dealings with other corporate affiliates and with competing entities. FCC will need to prescribe and oversee the development of the accounting and reporting systems that will be relied on to provide the "visibility" and "auditability" which are the hallmarks of this approach and its primary deterrents to abuse of market power. It will need to oversee and approve the valuation of assets transferred to the separate subsidiary(ies) as well as the initial capitalization and subsequent financing of the subsidiaries. Once the separate subsidiaries are operational, FCC will have to monitor, on a continuing basis, the competitive state and performance of the markets. It will need to (1) police compliance with the various conditions, prescriptions, and prohibitions which it has imposed on separate subsidiary arrangements, (2) respond to and investigate complaints of anticompetitive conduct, and (3) on its own initiative, scrutinize transactions between and among affiliated entities to ensure where required that they are fully cost compensatory and made on an arm's length basis. MAXIMAL SEPARATION IS NEEDED If separate subsidiaries are to be relied on for protecting and promoting competition and if the regulatory tasks implicit in this approach are to be kept within realistic and feasible bounds, it will be necessary, we believe, to fashion structural separation conditions and competitive safeguards in such a way as to make it as difficult as possible to abuse market power and at the same time as easy as possible for FCC to fulfill its regulatory responsibilities. What is needed is a set of structural requirements, conditions, and prohibitions which will severely constrain the firm's ability to act on anticompetitive incentives and at the same time minimize the need for repeated ad hoc regulatory determinations and detailed, day-to-day regulatory oversight and intervention. What we have in mind here is an approach more closely approximating true "maximal separation." Such an approach involves identifying the sources of market power as well as the principal opportunities for its abuse and fashioning appropriate structural arrangements and safeguards to limit the potential for anticompetitive actions. Through such an approach, FCC can segment and partition the dominant carrier's operations to (1) minimize joint and common costs, (2) contribute a high degree of visibility and auditability to transactions which take place between and among |