A $500 Million Mistake

by Asher Brynes | September 26, 1964

On the first of July American Telephone and Telegraph, the largest business on earth, announced new records in net income ($x.6 billion) earned over the year ending May 31. In issuing this cheerful news the head officer of the company took time out to mention a small cloud across the rainbow. Three weeks before, on June 11, the California Public Utilities Commission had ordered a sharp reduction in the future profits of the company’s subsidiary in that state. What is more, it ordered the same reduction to be made in its past profits over the two years preceding and this was to be refunded forthwith in a lump.

The future reduction of profits amounted to a cut of about 14 percent in the current dividend on the company’s stock. The commission’s order for the refunding of the claimed excess of profits for the two preceding years would weaken dividend coverage considerably more. The day after the California announcement, AT&T’s stock, which is held by the largest shareholder family on earth, took a dive to the lowest point in the year. Subsequently an uneasy recovery set in, buoyed up by the record earnings of the rest of the Bell System companies and the California Commission’s conditional offer to suspend its order pending an appeal by the company to the state’s Supreme Court. The condition is the impounding of the money to be refunded, plus six percent interest, until the Court rules.This is not merely a quarrel over money. It would be simpler if it were. The point in dispute is whether the AT&T, a licensed monopoly operating in 50 jurisdictions in the United States, should be regulated as an enterprise selling a service, or as a concessionaire providing all there is to be had of it for cost plus a fixed fee.

There is no doubt that in providing its essential service - the connection of the uncomplicated telephones and telephone circuits you and I use most of the time—the company is a monopoly pure and simple. It does not have to sell anything. It can sit and take its toll from the wired-word traffic generated by all of us in our daily living. But it has developed enterprising characteristics in recent years; it purveys special services for which many customers are willing to pay extra, and so there is a fringe of its activities that is subject to the risks of the market. And since the company is not wholly free from risk, it says that it needs a cushion of extra profit to reimburse its stockholders for the shrinkage of income that may occur in bad times.

How much risk? How much profit? The average of recent ups and downs in its earnings should determine how much of a cushion of extra money it needs to soften the shocks it may suffer. Every investor calculates this for himself, presumably, when he buys AT&T’s stock, and when new issues are sold out briskly, as occurred recently, it is obvious that the investing public is satisfied. But AT&T’s idea of a properly risk-adjusted rate of profit is eight percent on its investment, which is more than it is allowed to earn - except in Texas (where hundreds of local authorities regulate telephone rates) and in Ohio.

 

The Need for Capital

A peculiarity of AT&T which is little understood by outsiders is the degree to which it is involved both with electronics, one of the most rapidly-growing technologies today, and with the over-all growth of our economy itself. The cost of handling telephone calls shrinks as a result of the interaction of these two factors, and if rates are not cut back from time to time profits rise rapidly. The chief witness for the company at a 1962 hearing before the full Board of Commissioners of the Federal Communications Commission, after insisting that it needed more profit, did not ask the commissioners to allow AT&T to charge more. On the contrary, he and the other company witnesses implored them in the most explicit terms to do nothing. “Notwithstanding our present inadequate earnings levels, we are not seeking higher rates at this time. But we earnestly urge you, gentlemen, that you give us the opportunity to attain [more profits] through our own management effort.” The FCC acted with restraint on this occasion, and AT&T earned almost eight percent (7.9 to be exact) the following year.

The indisputable fact about such licensed monopolies is that they do need considerable capital, far more than most other businesses. AT&T’s current investment in telephone plant is over $30 billion. “In the determination of rate levels, capital-attracting adequacy is properly considered a basic test of a fair return,” says James C. Bonbright {Principles of Public Utility Rates, Columbia University Press, 1961). This view is generally accepted among regulatory commissions, state and federal: licensed monopolies should be allowed to charge enough for the services they supply to generate sufficient earnings to attract investors. Their capital requirements are so large that they not only have to keep old stockholders, they have to attract new ones as they grow.

There are other considerations to be kept in mind, but they are commonsensical; they call for fair and reasonable objectives in the management of businesses vested with a public interest. Indeed, fair and reasonable are the key terms of art in the literature of regulation. Public utilities experts use them to indicate the limits of arithmetic in the analysis of this business. However, such language implies the presence of a public watching over the rate proceedings as spectators do in a conventional trial in a courtroom, anxious to see justice done. But in reality rate hearings are not like that at all. The commissioners themselves sit for the public, which is usually absent.

What the experts mean by fair is a regard for the interests of all the groups affected, the weak and the strong alike, the utilities as well as the public as represented by the regulatory commission itself. For the latter in theory, if not always in practice, is in fact in the more powerful position. The commission’s decisions cannot be appealed without carrying the dispute into the courts of law. There, the record shows, the utility companies virtually have to plead confiscation to get relief. Utility lawyers and engineers and accountants testifying before the commission feel, obliged repeatedly to ask for fairness.

On the other hand reference to the standard of reasonableness is favored by experts who argue for the public at these proceedings. It implies the need for plausible grounds for any rates the utilities are allowed to charge, and for the profits they are allowed to keep. In this view a public utility is created primarily for public purposes and has the status of a trustee; it carries out a function of the state. That’s why it is privileged to be a monopoly. The interests of stockholders are to be considered only so far as the public interest requires. That is the price stockholders pay for shelter from the hazards of the marketplace conferred on them by the state. And the regulatory commissions must see that they pay it. They are free to go elsewhere if they are dissatisfied. They can sell their AT&T stock and buy into a successfully uninhibited enterprise like General Motors. In fact, there have been no cases of the larger telephone companies actually driven to the wall by overregulation, though they were in trouble in the postwar inflation that ended in the late forties. Today, in good times, there is reason to think they are underregulated.

 

Importance of Bookkeeping

There is one sharp distinction between the telephone industry and all other kinds of licensed monopolies. Eighty-five percent of it is operated by the AT&T with headquarters in New York, although it is regulated by separate commissions in each of the 50 states and federal jurisdictions. The overseeing of the largest single part of its business, the interstate and overseas portion of it (25 percent of the whole), is in the hands of the Federal Communications Commission in Washington. And the accounting methods upon which regulation is based, not only in Washington but throughout the country, originate in continuous conferences between company headquarters in New York and the FCC office.

All the operating subsidiaries of AT&T use an identical accounting procedure, the so-called Uniform System of Accounts which is issued by the federal agency. Clarification of these complex procedures, in an industry subject to such continuous technological developments, is covered by “standard practice” instructions furnished by the head office of the AT&T to all its operating companies after conferences with FCC’s accounting compliance staff. Afterwards, on a three-year rotation basis, the FCC staff discusses them with the various regulatory commissions of the separate states.

Three things embedded in this ponderous bookkeeping system are of interest to telephone users:

1. The distinction between costs that are chargeable to operating expenses and are to be paid by a direct levy on subscribers, and the costs that should be charged to the shareholders, i.e. withdrawn from the profit account. The FCC, for instance, permits the AT&T to charge all the cost of its research subsidiary, the Bell Telephone Laboratories, to operating expenses. Critics may object that this mighty combine originated as a patent pool in the bad old days of the trusts, and such usage enables it to preserve its technical dominance at the expense of its customers. But few can deny that whatever the effect of the Bell Laboratories’ labors on AT&T’s position of leadership in the industry, it is an excellently managed research facility.

2. The determination of depreciation rates for the various types of equipment used to furnish and maintain telephone service. At the end of last year the value of AT&T’s affiliates’ investment in telephone plant, etc. was over $30 billion, and this year it is spending $3.35 billion on replacement of old plant and for new facilities. Where does all that money come from? Most of it comes from a so-called depreciation reserve, a complex of accounts in which each item of plant is charged, in every year of its useful life, with the fraction of the total amount that will have to be spent ultimately to replace it. How long are the useful lives of all this gadgetry? There is so much technical obsolescence in the industry that sometimes engineers do not know exactly; accountants know even less. And in order to produce what the depreciation accounts don’t provide for, the company must raise new money, even sell a new issue of securities, to secure the additional capital.

3. The computation of the rate base, or the total of other than operating expenses, on which the rate of return will be fixed for the AT&T by its regulators. In the federal jurisdiction these are the FCC Commissioners appointed by the President, a mixture of Democrats and Republicans, to make up a bipartisan group. At the present time, the commissioners feel the AT&T’s rate of profit or return on its interstate business should be about 7.25 percent, and have so given notice in their formal report (1963) to Congress. However, the FCC persists in shooting at this target in an indirect way. In recent years, for instance, the commission has ordered the schedule of night fees for coast-to-coast calls to be drastically reduced. And it has repeatedly initiated changes in the “separations” procedures by which the AT&T is ordered to distinguish between the portion of its expenses which is devoted to interstate business, and that devoted to intrastate services, regulated by local commissions. Whenever more of these expenses are shifted from the intrastate account to the interstate, the state commissions can order the reduction of local telephone fees accordingly. At the same time of course, the rate of profit on the federally-regulated service should go down.

These actions have always been announced by the FCC itself as samples of its regulatory initiative. Yet AT&T’s profits on interstate business seem to be unaffected by them. The largest reduction of interstate rates in the 30-year history of the FCC was ordered in 1959. In i960 the interstate operations of AT&T showed profits of 7.81 percent. In i960 they were reduced again. The interstate profits for the next year, 1961, turned out to be 7.75 percent. In 1962 the FCC resorted to a change in the “separations” procedure calculated to reduce various costs formerly chargeable to the states in the amount of $107 million. This action was “estimated,” so the FCC said in its report to Congress in 1963, “to have the effect of reducing the annual rate of [AT&T’s] interstate earnings by approximately one-half of one percent” in the following year, that is, down to the level, so often aimed at by the FCC, and always missed—7.25 percent. On January 29, 1963, the FCC again said that this rate was reasonable for the interstate private-line telephone and telegraph rates of AT&T, Nevertheless, the profit rate in 1962 remained 7.74 percent. And in 1963, it was 7.9 percent.

What’s half a percentage point of the net profit on this fraction of AT&T’s business?—$50 million. The uncertain aim of the FCC has similar effects of slippage on the other 49 state regulatory commissions. Since the states have the oversight of the major portion of AT&T’s business in the United States—indeed three times as much of it in dollar volume - the effect on users of local telephone service is that much greater. The company keeps all its books in accordance with the Uniform System of Accounts prescribed by the FCC under a law (the Federal Public Utility Code) applicable only to the FCC itself. From time to time a state commission may formally dispute the rulings that are frozen into this federally-licensed accounting system. But it is rare.

California Order

This is one of the notable things that occurred in California on June 11 of this year. Californians have a traditional dislike of monopolies, whether regulated or unregulated. Memories persist of the days when The Octopus (the Southern Pacific Railroad in the Gilded Age) dominated the state. This memory is kept alive by the need for irrigation water and cheap electric power in the agricultural districts.

The California Utility Commission took two years (from July, 1962, to June, 1964) to consider the matter of AT&T’s local telephone service rates. There were 52 days of hearings in which the company’s records were subjected to joint discussion and review. Then the staff of the commission labored on the analysis of the account books and the testimony. At an early point, the commission had to consider a matter of law which turned out to be decisive. The company kept insisting that as a result of the federal requirement that its books be kept in a prescribed form, the so-called Uniform System of Accounts, the authorities in Washington had “preempted the field” in the determination of depreciation rates on all telephone equipment whether used in local or long-distance service.

Curiously, at the time of these hearings in California the company was arguing for the allowance of still higher depreciation rates in Washington. Testifying before the FCC, R. R. Hough, vice president and chief engineer of the entire System, admitted that the current rate was adequate to take care of the expense of replacing present telephone equipment if utilized for its full physical life. (Currently the company charges its customers $1.3 billion yearly for the cost of replacing worn-out plant and equipment.) But the company’s engineers have forward-looking ideas. Where is the money for improved types of equipment to come from? As another vice president of the company explained on this occasion, “If it does not come out of depreciation, it will have to come out of earnings.” AT&T prefers to serve its customers by using the latest equipment, which they are to pay for by accelerated depreciation charges.

The California Commission was concerned with the fact that the company, under the Federal Uniform System of Accounts procedure, assigns 88 percent of its total depreciation expenses to intrastate operations although only 75 percent of AT&T’s earnings were derived from customers making local calls. So the California Commission said, “We specifically reject respondent’s [AT&T’s] contention that the Federal Communications Act of 1934 has prescribed depreciation rates for intrastate rate-making in California, or that Congress has the power to do s o … That determination lies with this Commission.” Thereupon it proceeded to revise these schedules and adjust other accounts and in conclusion found that although the company was on notice to hold its profits to a level of 6.75 percent over the past seven years, it had earned in the “test year” (the 12 months ending September 30,1962) 7.23 percent. The new analysis showed, to the satisfaction of four out of five of the commissioners, that a return of 6.3 percent on the company’s expense of doing business in California would be fair and reasonable.

Such is the magnitude of AT&T’s operations that this apparently insignificant fraction worked out to a savings of $41 million a year to customers for local service in that state.

To this the Californians added another action that is unique. On the grounds that the company overcharged local customers throughout the two years in which this matter was under litigation it not only ordered California telephone rates to be reduced in the future; it directed the AT&T to refund past overcharges in the amount of over $81 million. This order was duly entered although the company was not on notice that its rates might be reduced retroactively, that is, from the date the investigation began. Actually, it made a formal complaint that its earnings were too low and asked for annual rate increases of $44 million in the second year of the hearings.

On a nationwide scale the total earnings ($1.6 billion) of AT&T, which owns most of the stock in most of its subsidiaries, are between $.4 and $.5 billion more than the rate of return on its investment recommended by the FCC’s public utility consultants, by FCC’s staff, by the General Services Administration, and by commissions such as the one in California.

This article originally appeared in the September 26, 1964 issue of the magazine.

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