Discussion of Operating Expense Caps and Other Expense Considerations Resulting From the FCC’s Universal Service Fund Reform Order Prepared by Doug Kitch, Principal, CPA Alexicon Telecommunications Consulting May 2016

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

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 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: Anything personal in nature Political contributions/lobbying Donations, scholarships, penalties, sponsorships of community events Other/additional expenses the Commission is now seeking to exclude from cost recoveries: artwork; unnecessary vehicles (aircraft, watercraft, ATVs, etc); childcare; cafeterias; housing allowances for employees Be prepared to substantiate if any of this is necessary

FNPRM 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? 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 Streamlining ETC Reporting Requirements From the FNPRM: From the Order: 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?