by David Dixon,  – FBR Capital Markets [edited by Alan J Weissberger]

Backgrounder:

The FCC has long sought to impose rules requiring Internet providers to offer “net neutral” treatment to all Web traffic but has faced  litigation over its legal authority at every step. The FCC’s next move  following Verizon’s successful appeal of the FCC’s Open Internet Order has implications for the evolution of the Internet and, potentially, the 2016 presidential race. Stakeholders are fighting hard to  influence Congress, the White House, and the FCC. A Title II-based ruling on fixed broadband appears likely, as are efforts to expand FCC  oversight to wholesale interconnection. Litigation is likely for years  to come.  [Please see Addendum for history and definition of terms]

Regulatory uncertainty comes at a difficult time for the  telecom sector, which is facing multiple challenges:

(1) increased  wireless competition;

(2) improved cable network competitive  positioning due to the extensive fiber-based network reach and  WiFi-based wireless network potential;

(3) continued erosion of value  up the stack to more innovative application service providers; and

(4)  a necessary (but net present value negative) increase in wireline fiber network platform investment to support the ever-increasing bandwidth requirements of the less regulated wireless segment.

Irrespective of  the regulatory outcome, with major wireless networks out of spectrum in many major markets, significant cell site densities and fiber-to-the-home investments are needed to improve competitive  positioning, relative to cable, and to address poor indoor wireless coverage and capacity challenges.

The market is pricing in a  continuance of a light regulatory touch in the wireless and wireline  broadband segments. Importantly, it is not pricing in upside from  higher interconnection revenues, specialized services, or specific  content-distribution agreements. We expect the FCC to maintain a light  regulatory touch (expanded to interconnection and WiFi networks), but  it may decide to maintain this position in the fixed-broadband segment  through the introduction of a heavy-handed legacy framework that  provides flexibility to immediately withdraw regulatory oversight in  areas such as rate regulation. This decision, along with expanded  regulatory scope and uncertainty regarding litigation outcomes, is  likely to negatively affect sentiment toward the sector.

What’s at stake?

The regulatory outcome for broadband services will shape the Internet’s future direction. Proponents of net neutrality argue that paid prioritization will divide the Internet between the “haves” and “have nots”; opponents claim this would   prompt infrastructure upgrades. Furthermore, opponents argue that Title II reclassification will (1) stymie innovation and investment and (2) impede broadband adoption.

Regulatory oversight to incorporate wholesale interconnections (e.g. paid peering):

From a cable and content sector perspective, the FCC would like to establish greater regulatory oversight on interconnection  agreements between last-mile providers and content providers (the major issue for Comcast/TWC and, therefore, a likely merger  condition), but legal authority is unclear.

The FCC is not seeking to end direct-paid peering agreements  or regulate wholesale interconnection pricing. Our FCC checks suggest content providers must be prepared to pay a reasonable amount for carriage. There is more evidence of wholesale arbitrage from content players than monopolistic behavior. Last-mile providers want the flexibility to charge appropriate  interconnection rates (and to seek to increase these rates over time). The FCC will seek legal authority to keep rates just and reasonable. The consent decree for CMCSA/TWC will likely include      such a requirement.

Our position on Net Neutrality Net neutrality has become a high-profile topic, particularly after the White House tossed its hat into the ring. While the issue will likely become even more politicized in the lead-up to the FCC’s decision, we see FCC Chairman Wheeler attempting to thread the needle between the White House’s positions despite his appointment by President Obama.  We think a pragmatic approach by the FCC could with stand challenges in court.

In fixed broadband, Title II, with forbearance, appears likely, and this will be met with litigation.  The hybrid approach is an interesting alternative that could gain industry support over time. In this scenario, Internet traffic would be classified as either “wholesale” or “retail,” but this would not preclude paid prioritization. Data exchange between content originators and ISPs (wholesale) would be governed under Title II, and traffic between ISPs and end users (retail) would be regulated under Section 706. Given market competitiveness, the FCC would likely forebear additional requirements, in our view. Moreover, we believe interconnection fees will garnerfurther scrutiny as the FCC is sensitive to access abuses but still favors a light regulatory touch, providedthe ISP industry maintains a fair and just fee basis for network traffic imbalances with intermediaries.

While less favorable, other approaches under FCC consideration include:

(1) full Title II reclassification,

(2) full Section 706 implementation, and

(3) Title II reclassification but with Section 706 application.

The FCC willcontinue to push for clarity on three fronts, and its rules will vary by service. These thrusts include:

(1) Capital Hill legislation, which would likely be a four- to six-year cycle.  The FCC has always been responsive to Congress, but long cycles are problematic. A contentious FCC position could accelerate Republican efforts on the Hill and slow FCC progress at the same time.

(2) The courts: the FCC understands it must provide rules that are legallydefensible and, as such, is biased to Title II–based rules.

(3) Merger conditions will expand on the Comcast/NBC Universal consent decree to include oversight of wholesale interconnection and WiFi networking.

Rules will likely vary by service: (1) fixed broadband, (2) mobile broadband, (3) interconnection, (4) special services, and (5) WiFi.

We expect a decision on fixed broadband rules in 1Q-2015 followed by rules on mobile broadband and interconnection in mid 2015, coincident with regulatory approval and merger conditions imposed on Comcast/Time Warner Cable.

From a fundamental perspective, while there was a substantial valuation shift in the 2000s from the cable sector to the content sector due to higher payments for broadcast content distribution rights, and the table stakes are high for ISPs in the Internet interconnection domain, it is too early to determine the extent of any potential valuation shift in favor of ISP carriage over content.

Addendum:  A Brief History of Net Neutrality and FCC Efforts to Regulate Broadband Services

In 2002, the FCC issued the Cable Modem Order, which established broadband service as a lightly regulated(Title I–based) information service, versus a heavily regulated (Title II–based) telecommunications service.This Order was unsuccessfully appealed by Brand X to the Supreme Court, which was seeking wholesaleaccess to high-speed Internet access services.

The Supreme Court ruled in 2008 that administrative agencies(such as the FCC) have the authority to interpret ambiguous statutes. Specifically, the Court found that,if a statute (e.g., Telecom Act of 1996) is ambiguous, and if the implementing agency’s constructionis reasonable, precedent requires the Court to accept the agency’s construction of the statute, evenif the agency’s reading differs from what the Court believes is the best statutory interpretation. This interpretation trumped precedent established by the Court of Appeals unless the Court found the statuteto be unambiguous.

In 2004, FCC Chairman Powell introduced an unenforceable Internet policy statement, known as the“four Internet freedoms,” to encourage broadband deployment and preserve and promote the open andinterconnected nature of the public Internet:

(1) Freedom to Access Content: consumers should haveaccess to their choice of legal content;

(2) Freedom to Use Applications: consumers should be able to runapplications of their choice;

(3) Freedom to Attach Personal Devices: consumers should be permitted toattach any devices they choose to the connection in their homes; and

(4) Freedom to Obtain Service Plan Information: consumers should receive meaningful information regarding their service plans.

Although the FCC did not adopt rules in this regard, it planned to incorporate these principles into its ongoing policy making activities.In 2005, FCC Chairman Martin adopted a wireline broadband report and order and notice of proposed rulemaking that classified wireline broadband Internet access services as information services.

This brought these services, including DSL service, out from under the Title II regulatory regime and in line with theTitle I–based regulatory treatment of cable modem services.  The determination was sought by the major telecom service providers that were investing capital to deploy DSL service in an effort to catch the market leadership position established by the cable sector.

In 2007, the U.S. Court of Appeals denied a petition forreview of the FCC’s Wireline Broadband Order. FCC Chairman Martin responded, saying, “I am pleased that the Court affirmed the FCC’s decision to remove outdated, decades-old regulations from today’s broadband services. By removing such regulations, the Commission encouraged broadband investment and fostered competition. As a result of the Commission’s deregulation policies, broadband adoption has increased and consumers have benefited in the form of lower prices and improved broadband service.”

The FCC also released an Internet Policy Statement in 2005 that endeavored to ensure that broadband consumers would have access to all lawful internet content and that all lawful applications could be used on the networks. Similarly to Chairman Powell’s four Internet freedoms, the Statement outlined four principlesto encourage broadband deployment and preserve and promote the open and interconnected natureof the public Internet:

(1) Consumers are entitled to access the lawful Internet content of their choice;

(2) consumers are entitled to run applications and services of their choice (subject to the needs of lawenforcement);

(3) consumers are entitled to connect their choice of legal devices that do not harm thenetwork; and

(4) consumers are entitled to competition among network providers, application and serviceproviders, and content providers.

These principles were limited by the needs of broadband providers toreasonably manage their networks. The FCC applied one of the agreed-upon conditions to the October 2005 approval of both the Verizon/MCIand the SBC/AT&T mergers. The companies agreed to commit, for two years to conduct business in a way thatcomported with the Internet policy statement. In a further action, AT&T included in its concessions to gain FCC approval of its merger to BellSouth to adhering, for two years, to significant net neutrality requirements.

Under terms of the merger agreement, which was approved on December 29, 2006, AT&T agreed to notonly uphold, for 30 months, the Internet Policy Statement principles, but also committed, for two years (expired in December 2008), to stringent requirements to maintain a neutral network and neutral routing in its wireline broadband Internet access service.

In 2005, Vonage, a voice-over-IP (VoIP) service provider, complained to the FCC that MadisonRiver Communications, a small North Carolina–based rural telephone company also operating as anInternet service provider (ISP), had inserted filters into its ISP network to block VoIP traffic. Madison River Communications was the former Mebane Home Telephone Company that fought Carterfone, the 1968 decision that first allowed subscribers to attach their own equipment to telephone lines.

Although it was the”poster child” for anti-competitive behavior, blocking VoIP traffic meant that it was impossible for Vonageto offer competitive VoIP service to customers of Madison River’s Internet service. Madison River and the FCC agreed to a consent decree that said that Madison River Communications would not block VoIP trafficfor at least 30 months. The consent decree was backed up by an FCC order. The consent decree said that theinvestigation into Madison River regarded its compliance with section 201(b) of the Communications Actof 1934, but it did not provide any legal finding that Madison River had actually violated the Act.

The FCC stepped in to stop an ISP from blocking the ability of its customers to purchase Internet-based services from whomever they wanted.  

(1) There was no legal finding that blocking VoIP is wrong meant that a betterfunded provider not compromised by an IPO could test the precedent;

(2) the resolution was VoIP specific:Madison River could block anything else;

(3) the decree was limited to 30 months, after which Madison Rivercould start blocking again; and

(4) the Act that the FCC referred to may not cover Internet service providersthat are not part of a telephone company.

In 2006, the two major trade associations representing both the cable sector (National Cable and Telecommunications Association) and telecom sector (United States Telecom Association) publicly committed to the Internet Policy Statement at a Senate Commerce Committee Hearing on net neutrality in February 2006.

In 2008, the FCC ordered Comcast to stop interfering with BitTorrent traffic. ISPs had been throttling BitTorrent traffic for years. Specifically, Comcast was actively disconnecting BitTorrent seeds. FCC Chairman Martin noted that BitTorrent throttling was “arbitrary” and that the company had violated the FCC’s Internet Policy Statement. Chairman Martin said that Comcast slowed down BitTorrent users independently of theamount of traffic they use, and that the company failed to communicate its network management practices to consumers.

Comcast appealed the FCC decision, saying that the agency’s order was outside the scopeof its authority. In 2010, a unanimous decision by the Federal Appeals Court ruled that the FCC lacked the authority to force Internet service providers to keep their networks open to all forms of content.

The U.S. Court of Appeals for the D.C. Circuit found that the FCC lacked the power to stop Comcast from slowing traffic to BitTorrent,a popular file-sharing site. The decision focused on the narrow principle of whether the FCC had the right to regulate Comcast’s network principles. The opinion was written so narrowly as to prompt the former legal counsel for the FCC, Sam Feder, to classify it as the worst of all worlds for the F.C.C. In his estimation,the Court case made it all but impossible for the FCC to expect an appeal victory, but it also opened upenough alternatives for the FCC to accomplish its same goals.

Thus, the Court’s decision prompted the FCC to review ways to more concretely establish the agency as a regulator of Internet services. The Court ruled that the FCC relied on laws that give it some jurisdiction over broadband services but not enough to make theaction against Comcast permissible: “For a variety of substantive and procedural reasons, those provisions cannot support its exercise of ancillary (Title 1) authority over Comcast’s network management practices.”

The decision came as Comcast pursued FCC approval of its proposed $30 billion merger with NBC Universal, which put a library of content under the control of the nation’s largest cable provider. In a consent decreeas part of the merger approval for Comcast/NBC Universal, Comcast promised to support the FCC’s Open Internet Order and to keep the Internet “neutral” until 2020. Comcast agreed not to block its customers’ability to access lawful Internet content, applications, or services. Throttling would still be an option as longas it was part of standard network management procedure, or targeted at unauthorized transfers.

In December 2010, the FCC adopted its Open Internet Order, which was law from 2010–2014. Prior to 2010,the principles of an open Internet encapsulated net neutrality from 2005 until the establishment of the Open Internet Order; but these standards were unenforceable. The Open Internet Order created two classes of Internet access: one for fixed-line providers, and the other for wireless providers.

The net neutrality stance towards fixed-line broadband providers was more stringent than the approach towards wireless providers. Wireless carriers were less regulated because these companies were much more constrained than fixed-lineconnections. The Open Internet Oder followed three specific rules:

■ Transparency. Fixed and mobile broadband providers must disclose the network management practices, performance characteristics, and terms and conditions of their broadband services

■ No blocking. Fixed broadband providers may not block lawful content, applications, services, or nonharmfuldevices; mobile broadband providers may not block lawful Web sites or block applications thatcompete with their voice or video telephony services.

■ No unreasonable discrimination. Fixed-broadband providers may not unreasonably discriminate intransmitting lawful network traffic.

In mid 2014, in Verizon v. FCC, the United States Court of Appeals for the District of Columbia Circuit vacated the “no blocking” and “no unreasonable discrimination” rules of the Open Internet Order. The Court upheld the “Transparency” rule in the same ruling. The FCC has continued to encounter difficulties in its efforts to establish an open Internet policy. The court’s decision emphasized the FCC’s distinction between information services (broadband providers) and telecommunications services, which are treated as common carriers.

Because the FCC had previously chosen not to classify broadband providers as a telecommunications service, the court ruled them exempt from treatment as common carriers. More specifically, the non-blocking andnon-discrimination violated the Telecommunications Act of 1996’s ban imposing common carrier obligationson ISPs, which the FCC refused to classify as common carriers. The FCC did not appeal the ruling but planned to reissue rules under Section 706 of the Telecommunications Act.

Section 706 focuses on the FCC’s role to oversee the virtuous circle of innovation, with innovation from edge providers driving increased demand for broadband, driving network improvement, and driving further innovation from edge providers.  In Verizon v.FCC, the Court found in favor of the FCC in the following areas:

• Section 706 is an independent grant of authority to the FCC.

• The FCC reasonably interpreted section 706 as empowering it to regulate broadband access providers.

• There is substantial evidence supporting “virtuous circle” justification for rules.

Title II versus Section 706 of the Telecommunications Act of 1996 Under Title II, consumer broadband would be reclassified as “common carriers” and entail all of the rights and responsibilities that it implies. Title II offers both anti-blocking and anti-discrimination protection forconsumers, while ISPs are provided greater protection regarding copyright content being transmitted acrosstheir networks, compared to the Digital Millennium Copyright Act (DMCA).  However, it also burdens ISPs with additional obligations. Furthermore, many believe potential Title II reclassification would also lead to additional government requirements that neither proponents nor opponents would like to see, such as universal broadband access at the same price, or FCC-set pricing and rules around access and peering.

While burdensome, the FCC does have the authority to forebear these additional responsibilities. Given the FCC’s track record, it is likely the FCC would choose to forebear if consumer broadband is reclassified under Title II. The FCC appears to have the most solid legal case to implement Title II–based regulation, but this is the most politically difficult solution, which will be subject to intense Congressional pressure on the FCC.

In contrast, Section 706 requires the FCC to promote (not regulate) broadband use in the U.S., and it does not mandate onerous requirements on ISPs (i.e., tariffs and set prices on peering). While many ISPs would favor this approach, it also comes with fewer protections. For example, under the Section 706 scenario, an ISP would be permitted to negotiate rates directly with individual content providers/originators (i.e., Netflix) for faster, prioritized access while limiting other providers to the standard (and slower) service. However, ISPs would not be protected from anti-discrimination rules.

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