The FCC looks to plug loopholes in advance of the Incentive Auction.

One never fails to marvel at the ingenuity of man. No matter what program, policy or rule the FCC adopts to further some worthy public interest goal, a clever gamesman inevitably figures out a way to manipulate the system to garner a benefit that was never intended. So there is a ceaseless cycle of plugging loopholes in the system, which then opens new loopholes, and the cycle begins again.

Such is the FCC’s Designated Entity program.

The FCC has released its order (full name, if you can believe it: “Report and Order; Order on Reconsideration of the First Report and Order; Third Order on Reconsideration of the Second Report and Order; Third Report and Order”) addressing the terms under which Designated Entities (DEs) may qualify for discounts in upcoming auctions, including the 600 MHz “Incentive Auction” scheduled for next spring. The FCC’s order is a commendable effort both to expand opportunities for small businesses to win licenses in auctions and at the same time to curb abuses of the DE system. The FCC also takes the opportunity to lift some of the burdens on “former defaulters” – people who had previously failed to pay non-tax debts to the federal government — and to revise other auction procedures which had permitted collusive behavior among related auction participants. Let’s take a quick look at what the FCC did and didn’t do.

DE Eligibility. The main impetus for the initiation of this proceeding was resentment by small entities of the “AMR” or Attributable Material Relationship rule. This rule provides that entities that acquire licenses through DE credits in an auction will be attributed with the revenues of any entity to whom they lease more than 25% of their spectrum capacity in any market. Since the lessee would often be a larger carrier, the attribution of the larger carrier’s revenues to the DE would result in the loss of DE status, thereby triggering the obligation to pay unjust enrichment penalties to the FCC. Small entities objected that this rule unfairly barred them from one of the normal benefits of owning a license – the right to lease it in compliance with the FCC’s secondary market rules under the clear guidelines for retention of control by the licensee.

The FCC had adopted the AMR rule with the understandable intent to prevent DEs from getting licenses at discounted rates and then simply leasing them to non-DE big carriers, with the public paying the price of the arbitrage. The minority community in particular had argued that the rule disadvantaged them, so the FCC took another look at Section 309(j) of the Communications Act and decided that Congress only wanted to foster small business ownership of licenses – not necessarily small business construction or operation of licensed facilities. The FCC accordingly decided to abolish the AMR rule. In its place, it has established a rule that if any 10%- or- greater Disclosable Interest Holder (DIH) in a bidder uses, or has a right to use, more than 25% of a license’s spectrum capacity, that DIH’s revenues will be attributed to the bidder itself. The idea here is to prevent otherwise non-attributable, non-controlling, non-eligible DIHs from getting discounted access to spectrum.

Of course, gamesters are already licking their lips since the new rules permit small business DEs to acquire licenses with the plan to lease them to big carriers. As long as those DEs maintain the minimum incidents of control mandated by the normal spectrum leasing rules, that will be fine: the big carriers get the spectrum at a discount from what they would have had to pay themselves and the small carriers get a license for less than they would have paid. And as indicated above, the taxpayer eats the difference. Why do we feel that this situation will eventually be perceived as an abuse of the system that will call for a remedial measure like – you guessed it – an AMR rule?

In addition to abolishing the AMR rule, the FCC clarified how DE eligibility is established more generally. The test has two prongs. The FCC will look first at a bidder’s overall business operations to assess who really controls the company. Aspects reviewed will include a spectrum lessee’s role in the day-to-day business of the lessor and any agreements that limit the DE’s use, deployment, operation or transfer of its licenses. Such provisions may be deemed to extend the role of investors “beyond the standard and typical role of a passive investor.”

If the DE passes muster under the first prong, the FCC will evaluate on a license-by-license basis whether individual spectrum leases, network sharing arrangements, or other involvements by an investor in the DE give that investor effective control over the DE. Here the FCC will apply well-known criteria for determining control which, while longstanding, have often been difficult in practice for both the FCC and the industry to apply and interpret. The bright line test that many commenters had sought was not adopted. Instead we are left with a very blurry line which will spawn confusion and litigation down the road, leading to – you guessed it again – a bright line test that tells everybody what they can and can’t do.

Interestingly, the FCC made it very clear that ordinary non-equity debt financing is not a factor to be considered. It also rejected proposals to limit the amount of debt a bidder could incur relative to equity.

Changes in small business definition and caps on benefit. As expected, the FCC did increase the revenue thresholds for small business qualification. As a result, “very, very small businesses” are now those having under $4 million in three year average revenue, those under $20 million are “very small”, and those under $55 million are “small”. As before, these revenue categories qualify the bidder for 35%, 25% and 15% discounts, respectively. The application of the three categories to individual auctions will be specified for each one. For example, the FCC declared that the “very, very small” category will not apply to the Incentive Auction.

The Commission addressed concerns voiced by many commentators regarding the overall size of the benefit which can be enjoyed by small businesses. The concern was that so-called small businesses were reaping hundreds of millions of dollars in discounts, which seemed inconsistent with their supposed status as “small” businesses. The solution here was to impose a cap of not less than $25 million on the small business benefit and $10 million on the rural service provider benefit for the auction as a whole. The actual amount will vary from auction to auction depending on the value of the licenses being auctioned. So for the Incentive Auction, the small business cap has been set at $150 million for small businesses in markets above 118 in size and $10 million in markets below that size. This means that a very small Mom ‘n’ Pop business could still bid up to $600 million in the largest markets to maximize its discount benefit.

A newcomer to the cast of DE characters is the “rural service provider.” Small telcos had requested such a credit to allow them to compete against the big carriers even though their revenues exceed the normal DE thresholds. The FCC obliged by establishing a 15% credit for any rural service provider – not just a telco – that is in the business of providing commercial communications service to fewer than 250,000 subscribers and serves a predominantly rural area. “Rural areas” are defined as those counties with less than 100 persons per square mile. Oddly, the FCC did not restrict the applicability of this credit to the areas where rural service providers actually provide service, which seems to open the door to abuses. A well-funded big rural carrier could bid on San Francisco with a 15% discount. However, this potential loophole was plugged by limiting the overall benefit that can be garnered by a rural service provider to $10 million. This severely limits the attraction of bidding on large markets based on the rural credit. Note too that the rural credit cannot be cumulated with regular small business credits.

Former Defaulter Rule. The FCC has historically imposed an upfront surcharge on bidders who had formerly been in default on non-tax debts to the federal government. Such bidders had to make a 50% higher upfront payment to be able to bid on markets. The concept here was that such bidders are less trustworthy and therefore need to have more “skin in the game” to ensure that they do not default again. While some commenters sought abolition of the rule altogether as ineffective and counterproductive, the FCC limited its reform by excepting several categories of default from the application of the rule. These circumstances are where:

  1. the notice of the final payment deadline or delinquency was received more than seven years before the relevant short-form application deadline;
  2. the default or delinquency amounted to less than $100,000;
  3. the default or delinquency was paid within two quarters (i.e., six months) after receiving the notice of the final payment deadline or delinquency; or
  4. the default or delinquency was the subject of a legal or arbitration proceeding and was cured upon resolution of the proceeding.

These measures ensure that old and petty defaults do not forever brand the delinquent debtor. The FCC also clarified that the scarlet FD is only branded on the foreheads of those applicants whose controlling interests are former defaulters. The FCC did not exempt from the FD category defaulters whose default remains in dispute by appeal or other means.

The FCC also added an interesting footnote to the former defaulter status. It observed that it has not treated as a former defaulter a reorganized debtor under Chapter 11 of the Bankruptcy Code that has defaulted or been delinquent on any non-tax debt owed to any Federal agency prior to being in, or during, bankruptcy. This seems odd since the purpose of the former defaulter rule is to ensure payment from previous deadbeats, and the fact that a previous deadbeat escaped its debt by bankruptcy does not make it more trustworthy than any other deadbeat. The rationale for this treatment is found in the bankruptcy code, which prevents anyone from discriminating against a bankrupt person or entity based on the debt which has been the subject of a bankruptcy.

Interests in Multiple Applications. Finally, the FCC dealt with the issues raised by DISH Network’s much discussed program of holding interests in multiple applicants in Auction 97 (the AWS-3 Auction) who sometimes bid against each other but also appeared to act in a coordinated way. Applying the time-tested administrative tactic of closing the barn door after the horses have escaped, the FCC adopted rules that prohibit:

  1. joint bidding arrangements among any two or more applicants; and
  2. regardless of whether all the participants are actual bidders, bidding arrangements between any applicant and a nationwide service provider, bidding arrangements between nationwide service providers, and bidding arrangements between a nationwide service provider and a non-nationwide service provider. Non-nationwide service providers may, however, form joint ventures or consortia to bid in a single applicant.

These measures preclude collusive behavior among applicants and among the big four nationwide carriers, but interestingly do not prohibit a non-nationwide carrier such as DISH from having non-controlling interests in multiple applicants, as long as there is no joint bidding arrangement.

The FCC also used this opportunity to clarify a matter that has troubled communication lawyers for some time. Because there are serious penalties for violating the anti-collusion rules, applicants have been reluctant to talk to any other applicant about anything during the auction black-out period. This has restricted the ability of parties to engage in normal business interactions that really had nothing to do with the auction. Now we are advised that applicants may have agreements that are solely operational in nature. Such agreements would include those that address operational aspects of providing a mobile service, such as: agreements for roaming; spectrum leasing and other spectrum use arrangements or device acquisition. They would also include agreements for assignment or transfer of licenses. The principal caveat is that that any such agreement may not both relate to the licenses at auction and address or communicate, directly or indirectly, bidding at auction or post-auction market structure.

In its 156-page order the FCC streamlined or clarified the application of the DE rules and other auction participation rules, but those listed above are the key ones. The new rules apply prospectively only, but at least they have come in time to guide the planning process of potential bidders in next year’s Incentive Auction.