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

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

3. 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

4. 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

5. 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

6. 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

7. 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”

8. 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

9. 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

10. 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!!

11. 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

12. 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

13. 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?

14. 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

15. 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?

16. 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?

17. 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?