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Press Release

    Regulators to the Rescue?


    With Congress concerned with little more than how the WorldCom bankruptcy will play during November midterm elections, regulators more insulated from short-term political pressures could play a constructive role in the next few months. While the spotlight is on accounting and the ways WorldCom concealed its poor economic performance, regulators at the Justice Department and Federal Communications Commission (FCC) can rethink the way public policy contributed to the poor business performance WorldCom executives sought to conceal.

    In October of 1999, WorldCom CEO Bernard Ebbers announced a plan to acquire Sprint, the long-distance and wireless phone provider. Regulators at the Justice Department and FCC opposed the merger because they believed that the combined company would have too much pricing power in the consumer long-distance market. Yet less than two years after regulators deemed the companies too powerful to merge, WorldCom is bankrupt and facing liquidation, while Sprint is under pressure to sell assets and reduce costs just to survive.

    The most obvious reason why regulators would stop these companies from merging is that WorldCom lied about its expenditures and inflated its traffic, deceiving investors and duping regulators into thinking the company was stronger than it was. This would be a convenient explanation were it not for the fact that WorldCom has only restated earnings for the period after the merger had already been rejected. And even if it is discovered that accounting improprieties began before 2001, as many suspect, this would not do anything to change the fact that the long-distance voice business – both companies’ top revenue source – was in a state of disrepair as “free” wireless long distance, e-mail, and instant messaging transformed the market.

    At the time the merger was announced, earnings from consumer long-distance had stagnated and were expected to contract. The merger was designed to reduce overhead costs and maintain profit margins in the face of falling prices caused by technological change. Even if WorldCom cooked its books well before 2000, regulators could not have missed obvious trends in the long distance industry.

    Of course, the markets knew that long-distance was dying and still loved WorldCom and Sprint’s growth potential, so maybe a better explanation is that regulators were simply acting on the same expectations as investors. WorldCom’s UUNET Internet division was the envy of the industry for its technological sophistication, as well as its impressive traffic growth. Sprint’s PCS wireless unit showed similar promise as its subscriber growth vitiated the huge capital outlays necessary to construct its nationwide digital network.

    But how could regulators justify intervention into an infant industry swimming in hundreds of billions in speculative investment? Debt markets showered start-up telecommunications providers with funds used to construct high-capacity data networks and provide commercial services. So much growth in Internet traffic was forecast that some businesses thought they could make a fortune without any customers of their own by trading supplementary capacity to overstretched networks.

    Not only did the projected traffic increases not materialize, many believe Internet traffic has actually contracted. With the excess fiber optic capacity, prices fell dramatically. To retain customers, WorldCom had to close its profit margins, leaving much less revenue to finance the debt required to build its world class network. Ultimately, this debt load proved unbearable, even for a network that carries 50 percent of worldwide Internet traffic.

    A third explanation is that the merger was blocked by the Justice Department to take the heat off of the European Competition Commission, which was hostile to WorldCom-Sprint’s aggressive deployment of data networks to service business customers on the continent. By rejecting the merger before the EU filed its formal objection, so the logic goes, the United States could use the resulting goodwill as currency the next time cross-Atlantic trustbusters didn’t see eye-to-eye. If such diplomacy did enter into Justice’s decision, it was futile, as the EU’s rejection of the GE-Honeywell merger the following year made clear.

    Whatever the reasons for objecting to the merger, it is imperative that regulators learn from their mistakes, or, more pointedly, learn from the mistakes of their predecessors. This not only means greater latitude from antitrust regulators, but also greater liberalization in the telecom market in general.

    Clinton Federal Communications Commission (FCC) Chairman William Kennard opposed Sprint-WorldCom because he thought it was tantamount to “surrender” in the long-distance price war. But attributing the price war to industry rivalry between AT&T, Sprint, and MCI WorldCom completely ignored the aforementioned technological developments that caused the price war in the first place.

    Perhaps the FCC could not see the competitive effects of innovations in wireless and data services on the long distance business due to loyalties to its own anachronistic industry sub-groupings. The FCC has segmented different companies that provide nearly identical services into categories determined by their platform (cable, telephone line, satellite, etc.) or historical market position (Bell companies and new local phone competitors). Acronyms like ILEC, ISP, CLEC, IXC, and DBS are used to identify these subgroups and segment them for proper regulatory treatment, which differs across all acronyms.

    This suffocatingly complex system of economic regulation drove speculators to invest in acronyms where pricing was largely unregulated, like mobile wireless, Internet backbone, and cable. While overcapacity is a problem in many unregulated segments, the local telephone infrastructure, where economic regulations are most consuming, has remained virtually the same. Broadband is provided over existing copper lines using an old compression technology. With regulations that make profits virtually unattainable, no one has been willing to invest on the local level, which has artificially constrained Internet traffic growth and contributed to overcapacity in other segments.

    With the WorldCom bankruptcy following countless others in this industry, it is time for regulators to put finally their alphabet soup regulatory distinctions to rest. Discretionary risk capital should be directed towards projects that provide the greatest opportunities for return, not towards services or subgroups that have engineered the regulatory system to receive the most favorable treatment.

    Congress would be more interested in instituting public hangings for wayward corporate executives than reforming regulations to guard against the “next WorldCom.” But if regulators do their job and show some independence from the political class that appointed them, good things could come out of the bankruptcy yet.