MPower Communications Corp. v. Illinois Bell Telephone Co. ( 2006 )

In the
United States Court of Appeals
For the Seventh Circuit
____________
Nos. 05-3552 & 05-3677
MPOWER COMMUNICATIONS CORP., et al.,
Plaintiffs-Appellants,
Cross-Appellees,
v.
ILLINOIS BELL TELEPHONE COMPANY, INC.,
Defendant-Appellee,
Cross-Appellant,
and
EDWARD C. HURLEY, et al., Commissioners
of the Illinois Commerce Commission,
Defendants-Appellees.
____________
Appeals from the United States District Court for the
Northern District of Illinois, Eastern Division.
Nos. 04 C 6909 & 04 C 7402—Ruben Castillo, Judge.
____________
ARGUED MAY 1, 2006—DECIDED AUGUST 4, 2006
____________
Before EASTERBROOK, MANION, and SYKES, Circuit
Judges.
EASTERBROOK, Circuit Judge. The Telecommunications
Act of 1996 requires the local phone companies that were
spun off from the old AT&T to supply services that will
2 Nos. 05-3552 & 05-3677
enable new entrants to compete in the business. 47 U.S.C.
§§ 251-54. It is conventional to call the established phone
companies incumbent local exchange carriers (ILECs), their
rivals competitive local exchange carriers (CLECs), and the
services that the CLECs want to buy “unbundled network
elements” or UNEs. The 1996 Act requires ILECs to negotiate
with CLECs for contracts that specify the price that CLECs
pay for UNEs. If they cannot agree (either initially or when
the contracts expire), then state utilities commissions
may arbitrate the dispute. This is an unusual sense of
“arbitration” because it has most elements of standard
ratemaking and is reviewable (in federal court, another
change made by the 1996 Act), but unlike pre-1996
ratemaking this process does not occur unless private
entities are unable to work out their own bargain. State
commissions are required to follow directions issued by
the Federal Communications Commission, which has de-
cided that the price of UNEs should be based on the cost that
an efficient ILEC would incur to provide the service using
modern technology. That forward-looking standard—called
the total element long-run incremental cost approach or
TELRIC, see 47 C.F.R. §51.505—is still another big departure
from old-style ratemaking, which was based on historical
costs. The Supreme Court’s lengthy opinion in Verizon
Communications Inc. v. FCC, 535 U.S. 467 (2002), describes
how the system works and holds that TELRIC is a valid way
to implement the 1996 Act.
Illinois Bell had been AT&T’s operating subsidiary in
Illinois before Ma Bell’s breakup, and it was spun off as a
subsidiary of Ameritech, which comprised all local-exchange
operations in the Midwest. By the time of the 1996 Act, a
decade after the divestiture, the old “local” subsidiaries had
joined many other firms in offering long-distance service in
competition with AT&T. The 1996 Act enabled AT&T to turn
the tables, and it began to offer local service, competing
with its old operating companies using UNEs purchased
under the new statute.
Nos. 05-3552 & 05-3677 3
The first wave of contracts in Illinois was negotiated
amicably, but when they began to expire Illinois Bell took
the position that prices should be substantially increased,
to which the CLECs did not agree. Instead of asking for
CLEC-by-CLEC arbitration, Illinois Bell filed with the Illinois
Commerce Commission (ICC, an acronym no longer ambigu-
ous after the abolition of the Interstate Commerce Commis-
sion) a tariff stating the price at which it would make UNEs
available to all CLECs. Any CLEC could take that price or
negotiate for something better, with arbitration to follow if
need be.
Before the ICC could act, the Illinois legislature stepped in
and directed the agency to use exactly the old contract
formula with two adjustments: lower “fill factors” and
higher depreciation. A “fill factor” is the proportion of an
efficient network that will be used at any given time. It
makes no sense to build new network elements customer-
by-customer; ILECs build on the assumption that demand
will grow, and this enables them to choose efficiently-sized
equipment and avoid disruptions such as digging up the
streets every month to add new cable. If an efficient fill
factor is 50%, then the capital component of the TELRIC
price for a UNE is double what it would be at 100%, for each
UNE effectively must compensate the ILEC for the equipment
necessary to supply two circuits. Similarly, higher deprecia-
tion raises the TELRIC price because it implies that capital
equipment must be replaced faster. The state legislature
required the ICC to use fill factors and depreciation favor-
able to Illinois Bell, and to tamper with nothing else.
AT&T (in its role as a CLEC) sued its former subsidiary,
and the federal district court held that this statute violated
the 1996 Act because only an agency, and not a legislature,
may act on behalf of a state. We disagreed with that
conclusion but held that the statute is invalid nonetheless,
because it had disabled the ICC from setting a proper TELRIC
rate. AT&T Communications of Illinois, Inc. v. Illinois Bell
4 Nos. 05-3552 & 05-3677
Telephone Co., 349 F.3d 402 (7th Cir. 2003). To follow
TELRIC the agency must look at the current cost of providing
UNEs and cannot freeze any element of the calculation. Our
opinion added that the choice of fill factor and depreciation
rate are just sidelights: the agency should concentrate on
the bottom line (whether the rate per UNE is a sound
estimate of forward-looking costs in competition) rather
than on ingredients, for in competition supply and demand,
not particular items of cost, determine prices. Our opinion
wrapped up by instructing the ICC to reinstate, and resolve,
the tariff proceeding that Illinois Bell had initiated.
Two years later the ICC finished the job, issuing a 299-
page, single-spaced opinion that raised the price per UNE by
more than the CLECs wanted but not as much as Illinois
Bell had proposed. A group of CLECs filed suit—but AT&T
was not among them. In the interim Ameritech had merged
with SBC (formerly Southwestern Bell), and SBC in turn had
acquired what was left of AT&T—and SBC then changed its
own name to AT&T. So AT&T once again is in the business of
both long distance and local telephone service, but there is
much more competition in both segments of the market
than 20 years ago (with cell phone providers, cable TV
proprietors, and voice-over-internet companies offering both
local and long distance service in competition with landline
carriers). The 1996 Act is itself technologically creaky: the
assumptions of a decade ago no longer describe the state of
competition in this business, and with the advent of
competition from so many new sources the whole regulatory
model—which assumes that each ILEC retains a natural
monopoly on local cabling and switches—is open to ques-
tion. The FCC has moved away from the 1996 Act’s model to
the extent the law allows and has permitted proprietors of
new technologies to act as pure competitors, without an
obligation to share their facilities with business rivals. See,
e.g., National Cable & Telecommunications Association v.
Brand X Internet Services, 125 S. Ct. 2688 (2005). Cf.
Nos. 05-3552 & 05-3677 5
Verizon Communications Inc. v. Law Offices of Curtis V.
Trinko, LLP, 540 U.S. 398 (2004) (antitrust laws do not
require ILECs to cooperate with CLECs in sharing or selling
facilities). A mandatory-sharing requirement may delay
innovation. See Marc Bourreau & Pinar Do—an, “Build-or-
Buy” Strategies in the Local Loop, 96 Am. Econ. Rev.
(Papers & Proceedings) 72 (2006). But open competition is
not an option for landline services offered by ILECs, to which
the 1996 Act squarely applies. Thus we, like the ICC, must
apply TELRIC to Illinois Bell’s tariff.
The CLECs contend that the ICC made three errors, each
of which increased the price per UNE: it set the fill factor too
low, it set depreciation too high, and it assumed an ineffi-
cient mix of equipment. Illinois Bell filed its own suit,
contending that the price per UNE had been set too low
because the ICC had not allowed it to earn a fully competi-
tive rate of return on investment. (Other arguments were
made in the district court but have not been renewed on
appeal, so we disregard them.) The district court con-
cluded that the ICC acted properly with respect to fill factors
and depreciation but had erred with respect to the equip-
ment mix and the rate of return on investment, and it
ordered the Commission to revise the tariff accordingly. 381
F. Supp. 2d 738 (N.D. Ill. 2005). The district judge
also considered a further issue: whether the 1996 Act
preempts all tariff proceedings, as the CLECs maintain.
The judge gave a negative answer, and we start with that
subject because it has the potential to make everything else
irrelevant.
Wisconsin Bell, Inc. v. Bie, 340 F.3d 441 (7th Cir. 2003),
on which the CLECs rely, holds that states may not insist
that ILECs file tariffs for UNEs. The 1996 Act starts with
contracts rather than tariffs, see 47 U.S.C. §252(a), and
state regulators serve as arbitrators rather than rate-
setters, §252(b)(1). Forcing ILECs to file tariffs is equivalent
6 Nos. 05-3552 & 05-3677
to compelling them to make public their reservation price
(that is, the lowest price they will accept in bargaining).
That would unhinge the 1996 Act’s system, we concluded,
for it would give the CLECs an extra opportunity: they
could take the offer if it turned out to be attractive, or
bargain for still lower prices in the knowledge that the price
never could exceed the tariff. In ordinary contracting, by
contrast, someone who rejects an initial offer takes the
chance that the final deal will be at a higher price. We held
that states must respect the statute’s framework: bargain-
ing precedes the involvement of regulatory officials, and in
bargaining the parties may keep their reservation prices to
themselves and may raise their demands as part of the
bargaining process. See also Indiana Bell Telephone Co. v.
Indiana Utility Regulatory Commission, 359 F.3d 493 (7th
Cir. 2004) (holding that another state’s system compelling
ILECs to offer prices or services in ways other than the 1996
Act provides is preempted by federal law).
Illinois has not required any ILEC to file a tariff. Our
holding in Wisconsin Bell that states cannot compel ILECs to
use tariffs does not imply that states must forbid ILECs to
employ that device. The problems with a mandatory-
tariffing approach are that it compels ILECs to tip their
hands when they may prefer confidentiality, deprives them
of a bargaining strategy, and it moves regulatory price-
setting ahead of negotiation. None of these has occurred
in Illinois. Indeed, Illinois Bell and the CLECs did negotiate
contracts before any tariff was filed. Illinois Bell turned
to the ICC only after the contracts had expired and a dispute
had erupted about the price for renewal. The 1996 Act
empowers state utilities commissions to resolve such
disputes, §252(b)(1), and the contracts themselves pro-
vide that the parties may repair to the ICC if negotiations at
renewal time fail. Although the statute calls the state
agency’s role “arbitration,” we remarked three years ago
that as a functional matter this tariff proceeding is the
Nos. 05-3552 & 05-3677 7
arbitration of which the federal law speaks. 349 F.3d at 405.
The FCC agrees, stating that, when common questions affect
multiple contracts, state regulators may address these
questions in a consolidated proceeding while reserving other
subjects for arbitration. See Implementation of the Local
Competition Provisions in the Telecommunications Act of
1996, 11 F.C.C.R. 15499 at ¶693 (Aug. 8, 1996). As it
happens, Illinois Bell initiated a consolidated proceeding so
comprehensive that nothing will be left for individual
arbitrations, but that can’t diminish the state agency’s
power to resolve at one go all of the questions that the
parties voluntarily submit for decision.
When we turn to the merits, one fact eclipses everything
else: neither Illinois Bell nor the CLECs contends that the
ICC’s estimate of TELRIC is unreasonable or unsupported by
substantial evidence. Instead the parties cherry-pick issues:
Illinois Bell disagrees with the ICC about the competitive
rate of return, and the CLECs with the Commission’s
handling of fill rates, depreciation, and equipment mix. Yet
such an issue-by-issue approach is a characteristic of old-
style rate regulation, where a state commission determines
how much capital a utility has reasonably invested in its
plant and then sets the reasonable rate of return on that
investment. TELRIC is supposed to be different. The parties
(when they negotiate) and the regulators (when they
arbitrate) are supposed to approximate how much it would
cost to supply a given service with new equipment in a
competitive market.
Because the endeavor is hypothetical and prospective,
it is impossible to find “right” answers; there are only better
and worse estimates. And because, in competition, firms
can’t “recover costs”—that’s the natural-monopoly
ratemaking approach, while competition sets price where
supply and demand schedules meet—detailed estimates
of these costs are not controlling. That’s why our initial
8 Nos. 05-3552 & 05-3677
opinion observed that the Illinois legislature made a
substantive error in directing the ICC to adjust only the
fill rates and depreciation factors. Fill rates and other items
are not right or wrong in the abstract, but only useful (or
not) as reality checks when trying to estimate the price that
would prevail under competition with efficient production.
That is the objective of the exercise, and an unduly high fill
rate may balance unduly low depreciation—or both could be
beside the point if there is some other way (such as looking
at the behavior of new entrants, or ILECs building new
networks) to get at the subject directly. It is also why, as we
stressed in 2003, the FCC has allowed parties and state
agencies to use many different approaches, for they are just
mileposts rather than free-standing ingredients of some
formula. See 349 F.3d at 405.
So we are not at all inclined to pore over the ICC’s decision
one issue at a time. All a court need do is determine
whether the ICC’s bottom line is supported by the record.
That is what the Supreme Court in Verizon assumed would
happen. See 535 U.S. at 522-28. It is what we said three
years ago should happen, 349 F.3d at 409, and the parties
have not supplied any reason to depart from that under-
standing. Yet neither have the parties addressed the
subject. None of the litigants has given us any reason to
doubt that the agency’s bottom line is supported by substan-
tial evidence.
To see why it would be foolish to take issues out of the
context of the whole calculation, one has only to consider
the parties’ dispute about what return a competitive market
would allow to an ILEC on capital investments. Instead of
asking that in a straightforward way, the ICC (apparently at
the parties’ urging) first decided how much capital an ILEC
would raise from stock and how much from debt, and then
it set a rate of return on each. Debt investments are safer,
because in bankruptcy debt investors recover in full before
equity investors are entitled to anything, so the stated rate
Nos. 05-3552 & 05-3677 9
of return on debt is lower than the (implicit) return on
equity, which represents the residual claim after all other
participants (debt investors, workers, vendors, and so on)
have been paid off. In the district court the parties accepted
the ICC’s assumption about the overall rate of return on
debt plus equity, but Illinois Bell argued that the ICC had
prescribed the wrong capital structure for a competitive
firm. That, however, attempts to disentangle matters that
are inseparable: one can’t assume a rate of return on debt
(or equity) and then play with the ratio between them, or
the reverse. Instead the ratio determines the risk, and this
the rate of return, for each component.
The parties’ submissions imply that they (and perhaps
the ICC) have overlooked the point—fundamental to corpo-
rate finance—that the debt/equity ratio does not affect
aggregate returns but just apportions returns according to
the risk each set of investors has assumed. See Stewart C.
Myers, Capital Structure, 15 J. Econ. Perspectives 81
(Spring 2001) (surveying the state of the field, and in
particular the foundational work of Franco Modigliani and
Merton H. Miller, starting with The Cost of Capital,
Corporate Finance, and the Theory of Investment, 48 Am.
Econ. Rev. 261 (1958)). See also, e.g., Michael J. Barclay &
Clifford W. Smith, Jr., The Capital Structure Puzzle: The
Evidence Revisited, 17 J. Applied Corporate Finance 8
(Winter 2005); Merton H. Miller, Leverage, 46 J. Finance
479 (1991). One wonders why, so long after Modigliani and
Miller won Nobel Prizes, the ICC bothers to think about
capital structure, as opposed to an overall risk-adjusted rate
of return, but none of the litigants has raised that issue.
Instead they want us to concentrate on just one aspect of an
indivisible whole, which would make no sense.
Now we do have to grapple with one issue as a stand-
alone matter. The district judge concluded that the ICC
made a legal error that is independent of any practical
effort to estimate the cost of furnishing efficient service.
10 Nos. 05-3552 & 05-3677
One piece of equipment required for modern phone service
is a digital loop carrier. The ICC concluded that an efficient
provider would use about 88% universal digital loop carriers
(UDLCs) and 12% integrated digital loop carriers (IDLCs).
Although IDLCs are less expensive per customer, they are
also more difficult to use in providing UNEs to CLECs. The
ICC concluded that IDLCs “cannot be effectively unbundled”
and thus are less flexible. Without taking issue with the
ICC’s finding either about limits on the ways IDLCs can be
used or the mix that a fully competitive phone provider
would select, the district court held that the agency must
base its decision on an assumption that TELRIC requires
100% IDLC equipment. 381 F. Supp. 2d at 756-57. That’s so,
the court stated, because, when calculating TELRIC in a
proceeding arising from Virginia, the FCC used 100% IDLC
as the basis of its rate. See In re WorldCom, Inc., 18
F.C.C.R. 17722 at ¶312 (Aug. 29, 2003). Once the FCC takes
a stand on any issue, the district court concluded, all
state agencies must fall into line.
One problem with this conclusion is that “the FCC” has not
taken a stand. The Virginia dispute was arbitrated by the
FCC’s Wireline Competition Bureau; that Bureau’s decision
was not appealed to, or passed on, by the Commission. No
one appointed by the President took any part in the pro-
ceedings. Under the Administrative Procedures Act, federal
agencies make binding decisions through rulemaking or
adjudication; the Virginia arbitration was neither. State-
ments by agencies’ bureaucracies (or their lawyers) may
offer illumination helpful in understanding published rules
or decisions. See Japan Whaling Association v. American
Cetacean Society, 478 U.S. 221, 233, 241 (1986); Indiana
Bell Telephone Co. v. McCarthy, 362 F.3d 378, 386 (7th Cir.
2004). Here, however, there is no decision by the Commis-
sion in need of explication. All we have is action by subordi-
nate employees. See also Chicago Board of Trade v. SEC,
883 F.2d 525, 529-30 (7th Cir. 1989) (ruling by SEC’s
Nos. 05-3552 & 05-3677 11
Division of Market Regulation has no legal consequence
unless reviewed and approved by the Commissioners).
A second problem is that, even if the Wireline Competi-
tion Bureau were speaking for the Commission, it did not
establish a legal rule that 100% IDLC is the only setup that
satisfies TELRIC. Both the Commission and the D.C. Circuit
have stressed that there can be multiple ways to approxi-
mate that benchmark—which, since it is hypothetical and
prospective, has no tried-and-true or mandatory ele-
ments. See AT&T Corp. v. FCC, 220 F.3d 607, 615-16 (D.C.
Cir. 2000); Sprint Communications Co. v. FCC, 274 F.3d
549, 556 (D.C. Cir. 2001); Report and Order, FCC 03-36, 68
Fed. Reg. 52,276, 52,284 (Aug. 21, 2003) (Triennial Review).
That’s what we said three years ago. 349 F.3d at 405. The
Bureau used 100% IDLC in the Virginia proceeding, but to
say (or demonstrate) that “X is a lawful way to proceed” is
not to establish that “X is the only way to proceed.” Confus-
ing sufficient with necessary conditions is a logical blunder.
See United States v. Knights, 534 U.S. 112, 117-18 (2001).
Nothing in the Virginia Arbitration Order implies that
100% IDLC is indispensable in all efforts to approximate a
TELRIC price.
It remains only to say that we have considered the
parties’ arguments about fill factors, depreciation, and rate
of return, and concluded that these contentions do not show
that the ICC made any error so large that it threw the
bottom line out of whack. Attempts to estimate a hypotheti-
cal rate are bound to be contentious, and it will always
be possible to say that the agency should have used a little
more of one thing or less of another. Unless these argu-
ments show that the bottom line is an arbitrary or capri-
cious estimate of TELRIC, however, they do not supply a
good reason to upset the agency’s decision.
The judgment of the district court is vacated, and the case
is remanded with instructions to enter a new judgment
sustaining the ICC’s decision in full.
12 Nos. 05-3552 & 05-3677
A true Copy:
Teste:
________________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—8-4-06