Companies, People, Ideas
Shortchanged
Scott Woolley, 05.12.03

The Baby Bells may have bilked consumers out of billions by inflating the cost of their networks. Regulators seem content to overlook the matter.

Front-page headlines in June 2000 hailed a historic deal that dramatically cut phone rates for the nation's consumers. The Federal Communications Commission, in persuading the Baby Bells to slash the access fees they charge long-distance carriers for routing calls to their local lines, said it would save customers $3.2 billion a year. The FCC's claim to have enacted "the largest rate cut in the history of federal telephone regulation" was the New York Times' lead story.

By the Numbers
Vaporware?
The vast majority of local phone prices in the country are still set by regulators at levels justified in large part by the cost of equipment purchased long ago. FCC auditors set out to match company records with that equipment.
$47 billion
Value of audited equipment.
$10 billion
Estimated amount of missing or unauditable equipment.
$153 billion
Value of equipment never audited.

The true saving, it turns out, fell far short of that. While the Bells agreed to chop their access fees, they also won the right to offset that reduction by boosting flat monthly fees charged to local customers. These offsetting fee increases now approach $5 billion a year and, even in a world of telecom deflation, have sent local phone bills climbing. Today customers of Verizon (nyse: VZ - news - people ), the biggest of the four surviving Bell companies, see the $72 annual fee--up $30 a year per line so far--listed as the "FCC line charge" on their phone bills, though the Bell gets the cash.

The little-noticed shift in fees was part of an extraordinary agreement the FCC negotiated with the Bells and a few long-distance titans in a series of secret meetings ending in early 2000. One FCC person present likens the talks to "Al Capone and Bugs Moran in there, cutting up Chicago. Consumers were not at the table." The resulting deal was officially named Calls, for the Coalition for Affordable Local and Long Distance Service, no irony intended. But it also was a way for the Bells to bury what could have become a multibillion-dollar accounting scandal.

Funny numbers have always defined the phone business--arbitrary rate caps imposed by regulators; 40-year depreciation for gear that nowadays loses its value in only a few years; access fees that charge more for carrying calls across town than it costs to carry them across the country. And in the Calls agreement, the Bells managed to paper over some funny numbers indeed: some $10 billion in equipment that FCC auditors found to be missing, nonexistent or untraceable. The total could end up being several times that. The massive discrepancy--which Bell officials vehemently deny--turned up in an FCC audit in the months leading up to the Calls settlement three years ago. Most regulators attribute the overstatement to sloppy recordkeeping rather than to a Bell conspiracy to intentionally mislead.

Either way, though, the result would be the same: Bells reaping billions of dollars more in revenue over the years than they otherwise would have been allowed to collect. That is because local rates and access fees were all originally justified by carriers' cost bases. Assets carried at erroneously (or intentionally) inflated costs on the books naturally lead to higher regulated prices.

Now some factions are pushing regulators to take a harder look inside this can of worms. In February a small watchdog group, TeleTruth, petitioned the Securities & Exchange Commission to launch an investigation. A coalition of 42 consumer groups, irked by a California state audit that accuses SBC (nyse: SBC - news - people ) of overcharging customers by $350 million, has filed a plea with the FCC. It demands: "When will the Commission systematically determine if violations of accounting requirements … have resulted in interstate overcharges, not only in California, but in all states in which SBC conducts its operations?" It calls the missing $5 billion in gear "the tip of the iceberg."

But the FCC seems unlikely to deal with this would-be accounting mess. The reason: As part of the Calls settlement, FCC staffers and long-distance executives say, the FCC killed the equipment audit entirely. The Bells counter that the audit was flawed from the start, based on bad statistics and hasty conclusions. "It's a farce," says a Verizon spokesman. "A sham," says SBC. "There's no ‘there' there," adds BellSouth (nyse: BLS - news - people ).

Will the FCC reopen the mystery of the missing equipment? An FCC spokesman says "the order to terminate the audit proceedings remains the Commission's last word on the subject." He adds that the Calls deal had "significant benefits" for consumers, and that moving toward flat monthly fees has spurred the creation of "all-you-can-eat" calling plans.

The secret meetings played out in Washington in early 2000. At the FCC, Lawrence Strickling, the chief phone regulator at the time, hosted the clandestine discussions with people from AT&T (nyse: T - news - people ) and WorldCom on the long-distance side, and Verizon, SBC and BellSouth on the local side.

Long-distance carriers were paying the locals upwards of $15 billion in access fees each year, a remnant of the 1984 breakup of the old AT&T empire. The summit's purpose was to renegotiate how those billions flowed, but AT&T and WorldCom had an advantage at the table: They could use the devastating findings of the FCC audit as a cudgel.

Click here for a joint response from BellSouth, SBC and Verizon.

For the first time, the FCC auditors had traveled the country and spot-checked telephone buildings to verify the existence of equipment carried on the books. They discovered $5 billion in assets was missing outright. At least another $5 billion was impossible to audit, although federal law explicitly requires otherwise. Moreover, they looked at only 25% of the Bells' gear, the stuff at central switching offices; billions more in questionable accounting might lie in the rest of the network.

The implications were staggering. FCC auditors were intent on levying large fines and seeking billions in refunds. "When the audit team started getting huge numbers, the Commission started getting very, very nervous," says one senior person at the FCC. "The dollars were so huge that there was no way the FCC would pursue them," says a long-distance executive.

And so, even as the auditors continued digging, the Calls parties struck a backroom bargain that reshaped the regulation of the $120 billion industry to their mutual benefit--and simultaneously killed the audit and buried the existing evidence. In November 2000 the FCC voted to halt the audit work; 16 months later it dismantled the audit department altogether.

Copies of audit documents show records in chaos, some of them bafflingly sloppy. Beyond missing equipment, the books are littered with such entries as "unallocated other cost" and "undetailed investment." Unverifiable items amount to a huge black hole, totaling some $5 billion in untraceable gear. The Bells say such equipment--whatever it is--was in fact purchased, still exists and was rightly built into the regulatory rate base.

When the auditors could find equipment, it often was carried at wildly varying--or simply puzzling--prices. One type of unit used to link phone lines to a switch is carried at $4; exactly the same piece of equipment, bought in the same year, is elsewhere recorded at $133,543. Dozens of other records list items with a quantity of zero and a collective value of millions, including zero batteries worth $47,290 and zero printers worth $23,570. Even when the quantity was listed as one, there are head-scratchers: GTE (now part of Verizon) carried gloves on the books at a value of $458.

At the time, the Bells succeeded in keeping these details private. AT&T and WorldCom executives, who signed nondisclosure agreements, got a look at the specifics; after the Calls deal came out, the audits faded away. Months later a wave of accounting scandals swept American business, hitting telecom companies particularly hard.

For now the Calls deal continues to determine prices paid for the roughly 85% of phone lines that remain subject to price-cap regulation. (Much of the rest is resold to the long-distance companies under a contorted regulatory policy that has sparked still more fighting between long-distance and local-service rivals.)

Calls has been a lifesaver for the Bells. Access fees, following years of steady declines dating back to the breakup of AT&T, are now frozen. Average local phone bills are up, after years of being flat or declining. In the 1990s the big three Bells' interstate revenue earned them an average return of 14%, according to FCC data. Then came Calls and the purported sacrifices it required of the Bells. Yet in the two years since, their average rate of return has risen to 18%. Says one FCC staff member: "These guys are earning like monopolists, and that's an indictment of the Calls plan."

Click here for a joint response from BellSouth, SBC and Verizon.