Gattuso/Singleton Letter to Rep. Tauzin on Reciprocal Compensation

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September 11, 2000



The Honorable Willam J. Tauzin

United States House of Representatives

2183 Rayburn House Office Building

Washington, DC 20515


Dear Representative Tauzin:


We write to offer our analysis of the thorny problems with agreements between local phone companies and competing carriers for “reciprocal compensation.”  We also offer an assessment of H.R. 4445, the “Reciprocal Compensation Adjustment Act of 2000.”


Reciprocal Compensation in a Nutshell


Section 251 of the Telecommunications Act of 1996 directed local exchange carriers (LECs) to negotiate agreements with competing exchange carriers (CLECs); these agreements were to set out the terms under which the LECs and CLECs terminated calls from each other’s customers.  Under the reciprocal compensation agreements, LECs agree to pay CLECs when a LEC customer called a customer of the CLEC, and vice versa. 


As written, these arrangements encourage CLECs to look for customers who received many calls, but made few outgoing calls.  Under these circumstances, the CLEC would receive more money from the LEC than it would pay to the LEC.  As the Internet took off, therefore, CLECs sought Internet Service Providers (ISPs) as customers.  LEC customers make many long phone calls to ISPs, but ISPs do not call those customers. 


This has created economic distortions.  In many situations, there is no longer anything “reciprocal” about reciprocal compensation.  CLECs receive enormous payments from LECs, while little money flows in the opposite direction.    The deal has worked out very well for CLECs, but not for LECs.  


There are several public policy questions inherent in the reciprocal compensation problem, so it is of little surprise that Congress takes an interest.


This situation has two likely effects.  One is that LECs face reduced incentives to upgrade and extend their networks when they are deprived of profits from using those networks.  The second is that CLECs themselves benefit so much from reciprocal compensation arrangements that they have little incentive to ever seek any customers who make outgoing calls.  That is, CLECs will compete with LECs, but only in a limited sector of the market.  For example, CLECs are less likely to seek to expand their networks to serve residential customers or even ordinary business customers. 


In addition, the reciprocal compensation arrangements were negotiated in an unusually politicized environment, with most state regulators anxious to show quick results in the form of any kind of “competitive” CLEC activity.  Thus, the resolution of disputes involving reciprocal compensation aired before state arbitrators, most of who continue to favor the CLECs, is somewhat suspect.  Even the FCC, which declared calls to the Internet “interstate,” was quick to boot this political football back to the states.  Some congressional direction for regulators on the issue of reciprocal compensation would be helpful to regulators’ long-term perspective on the importance of incentives to competition.


A Closer Look at H.R. 4445


The substance of H.R. 4445 is contained in subsection 2 (3), parts (A)-(D).  This section reviews each part in turn. 


Relief from Payment Obligation for LECS.  Part (A) relieves local exchange carriers of the obligation to pay CLECs for calls made by LEC customers to connect to the Internet.  The argument in favor of this is that it would make the agreements between CLECs with ISP customers and LECS consistent with agreements between LECs and interexchange carriers (IXCs).  The Public Utilities Commission of Colorado recently issued a ruling recognizing that calls to ISPs are like calls to IXCs, and so the LEC should not pay for Internet-bound calls.


This seems to be a sensible approach.  But there could be others. When a customer of company A makes a call through carrier B’s network to customer C, is it a service to C? To A or A’s customers?  To carrier B?   There seems to be no one “correct” answer to this question.  Under some future circumstances, the requirement that a price for some type of services be set to “zero” may come back to haunt the industry.  The bottom line, however, is that the current system for compensation is not working, and should not be mandated by regulators.


Jurisdiction.  Part (B) would make calls from LEC customers to the Internet subject to the exclusive jurisdiction of the FCC.  This section of the bill would alter the FCC’s determination that the calls are interstate, but that states have jurisdiction under Section 251. 


No Effect on Existing Agreements.  Part (C) means that (A), offering to relieve LECs of the obligation to make payment for Internet-bound calls, would not affect existing agreements.  This is consistent with respect for parties existing rights and obligations. 


Terms of Existing Agreements Need Not be Offered to Newcomers.   Very importantly, Part (D) would deregulate an aspect of contracts negotiated between LECs and CLECs.  Under today’s rules, a CLEC may pick from terms in older contracts negotiated between LECs and CLECs, and demand that the terms be made a part of the new agreements.   This well-intentioned regulation was intended to ensure against discrimination by the larger LECs and offer CLECs a boost.  But the regulation has a serious drawback: LECs are not free to escape from reciprocal compensation when they negotiate new contracts.  Such unintended consequences are quite likely with any regulation that eliminates the freedom of contract on which markets are founded.  Part (D) is fully consistent with the goals of moving telecommunications markets towards a free market.




Resolving the problems of reciprocal compensation is not easy.  But given the distortions caused by present rules, some action is necessary.  While there may be no single “correct” compensation formula, the present system is flawed.  Perhaps a range of alternatives could be defined, with maximum room for negotiation between CLECs and LECs.  As importantly, regulators should not lock in the problems of current agreements by requiring that those terms be made available to others.





Solveig Singleton

Telecommunications Consultant


James Gattuso

Vice President for Policy and Management

Competitive Enterprise Institute


cc: Members, Telecommunications Subcommittee.