Discussion of Operating Expense Limits and the Further Notice of Proposed Rulemaking Prepared by Doug Kitch, CPA, Principal Alexicon Telecommunications Consulting May 2016

Agenda Operating Expense (OpEX) Caps Further Notice of Proposed Rulemaking

Operating Expense Caps Background Carriers should be prudent and efficient with their expenditures Corporate expense cap has been in place since about 1996 for HCLS This cap was extended to ICLS in the Transformation Order Corporate expenses alone account for about 15% of all loop costs (2013 data) Leading up to the current Order, the Associations proposed that the Commission adopt limits on OpEX

Operating Expense Caps Associations also proposed comparing all companies’ expense per location to a regression model, plus two standard deviations The Commission adopted “double log regression” methodology The Commission ultimately adopted 1.5 standard deviations As an example: one Alexicon client was disallowed $430,000 of OpEX using two standard deviations, and disallowed $1.489M using 1.5 standard deviations Reasoning: two standard deviations impacted 17 study areas, while 1.5 standard deviations impacted 50 study areas Also leading up to the Order, “locations” was used as one of the coefficients instead of “housing units”, which was ultimately adopted

Operating Expense Caps Regression methodology determined/calculated annually Caps are going to be instituted for all operating expenses, except for depreciation expense, taxes, and [what appears to be] access expense/FUSC Disallowed OpEX will be phased in over a two-year period: 50% in year one and 50% in year two It is still unknown when the OpEX caps will be implemented, however it could still possibly be this year By June 13th, NECA is to submit to USAC 1) a schedule of companies that are impacted by OpEX limits; and 2) the dollar amount of the reductions in HCLS and CAF BLS

Operating Expense Caps Expenses eligible for capping: Cable and Wire Facilities Expense Central Office Equipment Expense Network Support and General Support Expense Network Operations Expense Limited Corporate Operations Expense Information Origination/Termination Expense Other Property Plant and Equipment Expenses Customer Operations Expense: Marketing, and Customer Operations Expense: Services

FNPRM Review of Permitted Expenses: Para 349: Adopt guidelines that define what constitutes prudent expenditures (used and useful)? Starting para 339: Expenses currently not recoverable from high cost funding, and of which the Commission is proposing (not just seeking comment) to also exclude from interstate revenue requirement Recaps Oct. 19th, 2015 public notice. See handout High-cost support provided to an ETC must be used “only for the provision, maintenance, and upgrading of facilities and services for which the support is intended” “We note that the Commission continues to look at methods of limiting expenses to reasonable levels, with a primary focus on corporate operations expenses that are excessive.  We intend to take further action to ensure that high-cost funding is used for its intended purposes, and that ratepayers of rate-of-return carriers are not made to subsidize excessive expenditures”

FNPRM Review of Permitted Expenses: (continued) Starting para 339: (continued) FCC encourages state commissions to look carefully at information and report areas of concern to the Commission for further investigation and potential enforcement action “ETCs face significant consequences for rule violations that result in carriers obtaining funds to which they are not entitled, or misuse of funding received, or other abuses of the high-cost or Connect America Fund support mechanisms” Be prepared to substantiate if any of this is necessary

FNPRM Commission has provided insufficient evidence “Bad apples” Permitted Expenses – Alexicon Comments Commission has provided insufficient evidence “Bad apples” USAC report to FCC More targeted audit procedures in independent financial audits?? Mechanisms are already in place: 1) corporate expense limitation; 2) opex capping mechanism from new USF Order; 3) Part 32 rules; 4) attestation/certification

FNPRM Permitted Expenses – Alexicon Comments Scholarships, donations, memberships in clubs/organizations create goodwill and good standing within the community Childcare attracts quality personnel AND is a fringe benefit in accordance with IRS rules Sometimes difficult quality personnel to rural areas. Housing allowances and other benefits help with this hurdle Fall back on IRS guidelines…no reason to reinvent the wheel Final note: LET THE CURRENT REFORMS WORK!!

FNPRM Disallowed expenses: Impact General note - expenses under consideration for disallowance fall into corporate expense caption Corporate expenses: a) capped once for HCLS USF purposes; b) capped again for ICLS purposes resulting from Transformation Order; c) now capped yet again for opex regression capping limitations; and d) has been/will continue to be capped a fourth time for overall USF budget constraint

FNPRM Disallowed expenses: Impact Perspective 1) FCC says corporate expenses comprise ~ 15% of total costs assigned to the loop 2) Corporate expenses generally get combined ICLS & HCLS cost recovery of about $.55 on the dollar (looking at Alexicon clients overall). Ranges as high as 80+% 3) Isolating donations; membership fees; community events: assume average company spends $50,000/yr x avg cost recovery of 55% = $27,500 (allowed today; disallowed tomorrow) x 1,307 carriers (from Order) = approximately $36,000,000 of disallowed costs that, up til now, have been cost-recoverable

FNPRM Further Expense Scrutiny Para 345,346: Limitations on compensation for CEO’s and board members? Para 347: seeking comment on whether to limit or exclude buildings purchased or rented Affiliate Transactions: Para 353>: Interested in adopting new rules that provide greater clarity on allocating costs between regulated and non-regulated affiliates Para 357: seek comment on misallocation of costs; more proper allocation method of reg/nonreg costs Should SLC cap be raised to permit recovery of amounts not supported by high cost?

FNPRM Compliance: Seek comment whether carriers should certify they have not included prohibited expenses in cost submissions Readdresses the “deemed lawful” provision for prohibited costs Seeks comments on NECA’s role for enforcing rules for prohibited expenses

FNPRM Reducing Support in Competitive Areas From the Order: Disaggregation of Support in Competitive Census Blocks Multiple Options: Option 1: allocate CAF BLS revenue requirement based on density of competitive and non-competitive areas Option 2: disaggregate using a ratio of competitive to non-competitive square miles in study area Option 3: disaggregate CAF BLS based on ACAM results for competitive and non-competitive areas From the FNPRM: What other methods to disaggregate support? Based on actual costs How should non-supported amounts be recovered? Increase SLCs?

FNPRM Tribal Support Record is clear The Commission itself recognizes disparities Includes a Tribal Broadband Factor, similar to the Tribal Coefficient from QRA Is requesting/expecting funding, if approved, to be paid out of CAF reserves Should OpEX be capped at all? Other options/alternatives?

FNPRM From the Order: Streamlining ETC Reporting Requirements For newly served locations, carrier must supply to USAC within 30 days of service the geocoded location and speed information USAC to establish online tool to permit access to all information (for state regulators, Tribal governments) From the FNPRM: Seeks to eliminate five sets of current requirements: 1) outages; 2) unfulfilled service requests; 3) number of complaints; 4) pricing; 5) compliance with service quality standards What are regulatory costs incurred in producing this information?