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Many observers argue that the telecommunications industry’s major ills (oversupply and underpricing) will not be solved without significant consolidation. We agree because there is new evidence to suggest that yesterday’s telecom merger rules are outdated. To see why, let’s look at the future of WorldCom’s core businesses. At the moment, WorldCom struggles under the twin burdens of accounting scandal and Chapter 11. But with new financing and relief from old debts, the telecom giant could emerge from bankruptcy as the low-cost provider in two markets: long-distance (through its MCI division) and Internet backbone service (via its UUNet subsidiary). That should make WorldCom an attractive buyout candidate, including for such regional Bell operating companies as Verizon, SBC, and BellSouth. (Some hard-pressed WorldCom competitors might also seek to join forces with one of those companies.) Any combination involving one of the Bells, however, would probably force antitrust officials at the Department of Justice and the Federal Communications Commission to revisit two competition policies dating from the 1980s. The first holds that so long as a local exchange carrier has a de facto monopoly in its home area, it should not be permitted to leverage that power into the long-distance market. This rationale underlies the 1984 AT&T antitrust decree, which required AT&T to divest the Bell operating companies. The same view is reflected in the 1996 Telecommunications Act, under which the Bells must show that their local markets are open to competition before they can offer long-distance services. Second, while the FCC has consistently maintained that the Internet should remain unregulated so that new communication services (including Internet telephony) can flourish, the FCC and the DOJ have agreed that regulation may be needed at the wholesale level to prevent undue control of the underlying transmission networks or backbones, such as those owned by UUNet. So what will regulators do if a major long-distance carrier wishes to combine with Verizon, SBC or BellSouth? And how much concentration in Internet backbone ownership is too much? The answers may well turn, in part, on how any deals are presented to regulators — whether as part of a bankruptcy proceeding or de novo — and how broadly regulators construe the relevant markets. FAILING FIRMS Let’s start with some potential bankruptcy issues: Under the antitrust laws, the courts have ruled that a merger that might otherwise substantially lessen competition or tend to create a monopoly is permissible if the likely alternative would be the financial failure of one of the merging parties. This “failing firm” defense allows otherwise questionable mergers and acquisitions to proceed. Companies asserting this defense are generally required to show that the target has no realistic prospects for a successful reorganization, that the asset may actually leave the market, and that no alternative buyer can be found posing a lesser risk to competition. To date, the failing-firm defense has not been tested by the current wave of telecom bankruptcies. But, until recently, there have been very few telecom buyers. With some exceptions, the Bells have yet to step forward to acquire arguably distressed companies. What if they did? Since the AT&T divestiture, any merger between a Bell operating company and a long distance carrier has essentially been unthinkable for telecom regulators, primarily because the Bells are presumed to have a monopoly over the “last mile” of network facilities required by any long distance carrier to reach its customers — and merging carriers might leverage that monopoly to gain customers in the long distance market. But there is growing evidence at odds with this assumption. Soon the unthinkable might become the acceptable. PHONE RIVALS First, the FCC and the DOJ have already conceded that the Bell operating companies’ local networks are now open to competitors in almost half the states, including the core of Verizon’s territory (New Jersey, New York, Pennsylvania), portions of SBC’s territory (Kansas, Missouri, Oklahoma, Texas), and key states served by BellSouth (Georgia, Louisiana). By early 2003, regulators are expected to add another 10 to 15 states to this list, including California, Illinois, Maryland, Michigan, North Carolina, Ohio and Virginia. Once that happens, it will be difficult to argue that most Bells still have a monopoly over the local loop. Second, the rapid build-out of competing cellular telephone networks (there are now five or six in large cities) has given consumers an alternative to both local and long distance wireline services. Indeed, the absolute number of wireline subscribers is declining for the first time ever, and cellular customers (now totaling more than 140 million) may soon surpass them. As well, cellular providers typically offer flat-rate monthly fees for local and long distance calls. These developments have undercut the market definitions that regulators have previously used to assess the economic power of both local and long distance carriers. Third, the rise of unaffiliated Internet service providers has offered customers additional distance-insensitive communication services, including Internet-based telephony. And fourth, in many key markets, cable TV and other facilities-based local carriers now offer last-mile services. All together, these facts make the competitive impact of any prospective local-long-distance combination much less problematic. INTERNET BACKBONES Let’s move on to WorldCom’s Internet backbone service. In 2000, regulators decided to block the company’s bid to acquire Sprint in part because of their concern regarding each party’s sizable share of the Internet backbone market. The DOJ contended that any increase in WorldCom’s market share — then estimated at approximately 37 percent based upon traffic — would permit the company to restrict access, raise prices, or degrade service to downstream service providers and their customers. In 2001, these concerns also led the DOJ to block WorldCom from buying a second-tier backbone facility from Intermedia (later divested for $12 million) as part of WorldCom’s $5 billion acquisition of the Digex Web hosting business. With UUNet and at least five of the other top 10 backbone operators in bankruptcy or close to it (including Global Crossing, Teleglobe, Genuity and XO), antitrust officials are again facing these issues: How much backbone concentration is permissible? And how do you measure it? In October 2001, the General Accounting Office told Congress that no publicly available data existed to accurately evaluate the market’s structure. However, a July 2002 report from TeleGeography, a D.C.-based research group, helps to close this information gap. According to TeleGeography, prices for backbone capacity have fallen by 40 percent to 50 percent annually since 2000. And although WorldCom controls approximately 30 percent of the bandwidth used on the top 20 U.S. Internet routes, other backbone providers have comparable capacity on specific routes and a similar number of overall connections to the top 100 Web sites. AT&T today claims to carry as much of the Internet’s total backbone traffic (approximately 15 percent) as WorldCom. Most importantly, perhaps, TeleGeography found that only 2 percent to 3 percent, at most, of the available bandwidth on top U.S. routes is used by Internet backbones, and available bandwidth may be 10 percent or less of the total transmission capacity that has been built. These facts imply that no backbone provider will have the ability to exercise market power (i.e., to raise prices, restrict output, or degrade service downstream) for very long. There is simply too much network capacity in place, and the barriers to entry are apparently far too low. So how much industry consolidation can telecom regulators permit without significantly impairing competition? We recognize that regulators will judge any future merger based upon the specific facts. But, in general, the answer may prove to be “more than you might think” — especially if the failing-firm doctrine reasonably can be invoked. Gregory Staple and Neil Imus are partners in the D.C. office of Vinson & Elkins (www.velaw.com). Staple, a member of the telecom practice group, founded TeleGeography. Imus, a member of the antitrust practice group, is editor of the American Bar Association’s Premerger Notification Practice Manual. Their firm does not represent WorldCom. They write in their private capacity.

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