affiliated entities, and (3) erect fairly impervious barriers to anticompetitive cross-subsidy and other forms of abuse of market power. Maximal separation stands in marked contrast to the limited, and, in our view, inadequate separation provided for in FCC's Computer II proceeding. Key FCC officials we consulted during our review acknowledged that the structural separation conditions and competitive safeguards provided for in Computer II are minimal by any standard and were formulated as much or more with an eye to what would be acceptable to a Commission divided on the question of need for any structural separation at all, than to what is essential to ensure full, fair, and effective competition. Repeatedly, we were told that the chief obstacle to stronger separation requirements and competitive safeguards was the lack of support on the Commission for more stringent separation and, in some cases, a lack of conviction that any separation is necessary. We believe that maximal separation constitutes an appropriate quid pro quo for relaxation of regulatory entry barriers and traditional rate of return/rate base regulation insofar as the dominant carrier's participation in competitive product and enhanced service offerings is concerned. 1/ In addition to successfully implement its chosen approach to the regulation of competitive offerings, the Commission and its 1/It might be argued that in imposing separation conditions and other procompetitive safeguards there is a cost imposed at the same time, chiefly through sacrificing certain scale economies attributable to the vertical integration of a firm. Much has been said about such economies in a general sense but relatively little work has been done to document and quantify them in specific terms. Almost every firm is characterized both by scale economies and scale diseconomies in its operations. Any net economies must be weighed against the alternatives of specialization economies and economies of technological change as assessed in light of the present and future characteristics of consumer demands. FCC in its discussion of the benefits and costs of the structural approach mandated in Computer II cited an expectation of substantial public benefits from its chosen approach for encouraging the growth and vitality of a competitive telecommunications industry. At the same time it concluded that the costs to the firm subjected to separation requirements as well as to the public in terms of any negative impact on innovation would not be significant. A requirement of separation or prohibition of sharing discussed in this chapter could be reconsidered if specific evidence is developed which demonstrates that the costs imposed are likely to outweigh the procompetitive benefits which may be procured by such a requirement. staff will need to devote far more attention than has been the case to date to the resource and organizational requirements implicit in using the separate subsidiary regulatory scheme. This includes needs in regard to the size and organization of staff; the specific analytical, monitoring, enforcement, and other functions that will need to be performed; the mix of skills, experience, and training that will be required; and the types of support systems and facilities (e.g., record and report filings and electronic data processing equipment) which will be needed to carry out the Commission's regulatory tasks. Implementing the Computer II approach is a matter that has received little attention by the Commission. At the time of completion of our review only three individuals were assigned fulltime to the Computer II Implementation Task Force. Many senior Commission staff who had key roles in developing the Computer II approach have since left the Commission, including the chief of the Common Carrier Bureau. Without more attention devoted to matters basic to implementation it is extremely doubtful that Computer II can--or, for that matter, should be allowed to--go into effect on March 1, 1982, as presently scheduled. The need to attend to these important matters is underscored by FCC's apparent intention, as illustrated by its April 1981 Cellular Land Mobile Decision (Docket 79-318) to make broad use of the separate subsidiary device in the future. FCC's COMPUTER II DECISION FALLS The FCC's Computer II Decision, although it refers repeatedly to the concept of "maximum separation" first enunciated by the Commission in the Computer I Inquiry, falls short of maximal structural separation in our view, in several important respects. inadequacies of the separation required by FCC relate primarily to the allowable grouping of activities within the deregulated separate subsidiary prescribed for competitive offerings and the degree of separation required for such important and basic functions as research and development and manufacturing. A single conglomerate subsidiary versus multiple, stand alone subsidiaries FCC's Computer II Decision allows, but does not require, more than one separate subsidiary for a carrier's deregulated competitive offerings, that is, it would allow the dominant carrier to provide both enhanced services and customer premises equipment through a single, conglomerate subsidiary. Such a subsidiary would be endowed from the moment of its creation with massive size, pervasive dominance, and a significant potential for abuse of market power. In recent testimony before the U.S. District Court for the District of New Jersey, where it is attempting to secure a definitive construction of the 1956 Consent Decree to be able to fully implement the deregulatory scheme envisioned in the Computer II rulemaking, AT&T testified that it has already initiated a massive corporate restructuring in line with the Computer II decision. This will entail transferring between $10 and $15 billion of its assets and about 100,000 employees to a new separate subsidiary. Because of the fledging character of much of the competition in this industry and the ability of a single conglomerate subsidiary to practice internal cross-subsidy and to selectively target particular markets for anticompetitive actions, we believe that the Commission should have focused more attention on the potential for cross-subsidy, predatory pricing and other abuse inherent in a single conglomerate subsidiary and should have explicitly provided for structural separation of deregulated competitive offerings in such a way to reduce the potential for anticompetitive abuse. One of the more obvious possibilities for structural separation would involve creating at least two fully separated subsidiaries, one for enhanced service offerings and another for competitive terminal equipment offerings. Each subsidiary, in addition to having its own directors, officers, employees, facilities, books of account and recordkeeping would perform the majority of its own operating and administrative functions. Such minimal administrative and other services as the separate subsidiaries might be permitted to secure from the parent firm or from other corporate affiliates would be provided on a fully cost compensatory, fully auditable, arm's length basis. Structural separation along these or similar lines would go far, we believe, in reducing the potential for predatory pricing and a number of other potential abuses of market power. It would also greatly facilitate FCC's tasks of fostering workably competitive telecommunications product and service markets as well as monitoring competitive performance in deregulated markets. Separation of research and development and manufacturing In its final decision in Computer II and again upon completion of Reconsideration, the Commission determined to permit the sharing of research and development as well as manufacturing by the parent corporation and its competitive separate subsidiary(ies). In the final decision the Commission also announced its intention to examine the dominant carrier's license contract arrangement through which monopoly derived revenues are used to fund research and development as well as "other issues generic to the use of monopoly revenues to support competitive research and development." It indicated that at the conclusion of its inquiry it would feel free to modify its treatment of research and development as the facts might warrant. 1/ The dominant carrier argued against imposing unnecessary regulatory constraints on the separate subsidiary which would prevent it from competing fairly and effectively. Separation of its research and development and manufacturing, the dominant carrier argued, would have the effect of handicapping any separate subsidiary as a provider of enhanced services and customer premises equipment competing with large domestic and foreign firms. Moreover, it argued that preventing the separate subsidiary from using the dominant carrier's research and development and manufacturing capabilities would deny customers of enhanced services and customer premises equipment the benefits of integrated research and development and manufacturing, resulting in inefficient fragmentation and duplication. Numerous other parties offering comments in the Computer II proceeding commented on the, as they saw it, inadequate separation and competitive safeguards provided by the Commission regarding research and development and manufacturing. They pointed out that these areas are of enormous importance to provision of enhanced telecommunications services and innovative terminal equipment offerings and also that they have an inherent potential for significant anticompetitive abuse of market power. Chief among the potential abuses cited were cross-subsidy and anticompetitive transfers of information. Many commenters stated that the Commission's failure to require complete separation of research and development as well as manufacturing was inconsistent with the principle of maximum separation which it had espoused, as well as with the goal of promoting competition in the provision of telecommunications products and services. A number of parties observed that the alleged benefits of a vertically integrated structure were not at issue in the proceeding, since the separate subsidiary would be free, in any event, to develop its own vertically integrated structure with its own research and development and manufacturing capabilities. We agree with those who maintain that adoption of a procompetitive policy coupled with reliance on the separate subsidiary device to assure full and fair competition requires maximal 1/A Notice of Inquiry in this matter was adopted by the Commission on November 25, 1980, and a document released February 6, 1981. Comments were due by June 22, 1981, and reply comments by August 10, 1981. Bureau staff have begun the task of summarizing and analyzing the comments received. separation of applied research and development 1/ and manufacturing activities. Otherwise, in our opinion, the risks of cross-subsidy and other forms of anticompetitive behavior are unacceptably great. We note that the Commission itself has stated, regarding the policy of maximum separation, that "*** separation is appropriate in those cases in Such is clearly the case, we believe, regarding research and development and manufacturing. In dealing with the arguments surrounding the issue of vertical integration, the Commission has observed that "*** the record with respect to the importance of Whatever the benefits of vertical integration, they would continue to be available to a fully separated, stand-alone subsidiary which satisfied the bulk of its own research and development and manufacturing needs as the Commission itself has acknowledged. Thus, using the example above, a separate CPE subsidiary could be required to perform its own research and development as well as manufacturing. Similarly, an enhanced services separate subsidiary could be required to satisfy its own research and development requirements, as well as requirements for computer software and hardware. Integrating these capabilities into the separate subsidiaries would significantly reduce the potential for anticompetitive allocation of joint and common costs and would result in the separate subsidiaries functioning as virtually autonomous, fully integrated providers of competitive service and equipment offerings. The final consideration which leads us to conclude that full separation of research and development and manufacturing is appropriate has to do with regulatory efficiency and effectiveness. As we have noted elsewhere, the existence of activities shared between regulated and unregulated sectors implies the potential for misallocation of joint and common costs and a consequent need for continuing regulatory oversight to ensure that 1/Applied research and development being that which is product and enhanced service specific. |