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Straightening out the story on telecom's routing game

Posted on: Wednesday, 27 August 2003, 06:00 CDT

In ancient Rome, sending letters by messenger was extremely expensive. So wealthy Romans would send a slave, who would also take along letters from friends and neighbors -- for a small fee.

People have been gaming communications systems ever since. The tactics have just gotten more complicated and, on occasion, possibly illegal.

The latest: an alleged ''deception'' -- this one by MCI -- that has placed telecom gaming in the national spotlight with perhaps the greatest chance of resulting in industry reform.

AT&T accuses MCI of improperly routing domestic calls to Canada and back into the USA on AT&T's network so AT&T gets stuck with the fee of delivering the call. Verizon and SBC also accuse MCI of disguising long-distance calls as local to avoid paying fees on them. The Justice Department is investigating. Congress wants to conduct hearings. MCI, formerly WorldCom, says it is innocent. The news has overshadowed -- and endangered -- MCI's attempt to emerge with a clean bill of health this fall from Chapter 11.

Sounds dire.

But deep inside the telecommunications industry, the darker truth is that this kind of thing has gone on for years. Rampantly. And now, the Internet -- in conjunction with murky federal rules -- has made gaming more prevalent than ever, threatening the economics of the telecom industry.

''Over the past seven years, every major segment of the industry, new and old, has spent an immense amount of time scheming to game the complex process,'' the Texas Office of Public Utility Council and Consumers Union told the Federal Communications Commission in January. The FCC should ''simplify and unify'' the tangle to ''take the fun and profit out of gaming the system.''

In some ways, gaming helps consumers. If a long-distance company shaves a few cents off the cost of sending calls, it can cut prices, says Jack Holt, CEO of DueTel, which helps companies monitor phone bills. But it has also weakened other telecom empires.

That's because the fees add up. For No. 1 long-distance carrier AT&T, access and other connection fees equal $10 billion a year -- about 30% of operating expenses. On the other end, for SBC Communications, they made up $2.1 billion, or 5% of 2002 revenue. Local carriers warn they may have to raise prices to consumers to offset the lost revenue, or cut services. ''That could be a reasonable result, absolutely,'' says John Stephens, controller of SBC.

The gaming happens because of access fees. When you make a long-distance call, it likely leaves your house via a local phone company, which takes the call to your long-distance company, which carries the call to the town you're calling. There, it's dumped on that area's local phone company network to be delivered. At that last connection, the long-distance company pays the local phone company to finish the call.

Complicating matters is the fact that the FCC sets the fee for interstate calls. But states set fees for in-state calls. The in-state fees are much higher in some parts of the USA than others. Thus, the games go on much more in some regions as carriers try especially hard to avoid high-fee areas.

In Texas, for one, the access fee for a long-distance call that starts in Texas but ends in another state is well under 1 cent a minute. The phone company that delivers the call collects the fee from the long-distance carrier. But the in-state fee, for long-distance calls within Texas, can be 6.5 cents a minute. Again, the company that delivers the call collects from the long-distance carrier. The higher the fee, the higher the cost to consumers.

Although it might seem simple to calculate how much phone companies owe each other, it's not. Because millions of calls fly around, tracking the amount owed is almost impossible, phone executives say. So local phone companies often rely on the long-distance companies to tell them what percentage of their calls are interstate vs. in-state.

The situation ''begs the participants to try to game . . . the system to reduce costs,'' says Mark Graves, a former BellSouth executive now with investment firm Headwaters MB.

And so they do.

Sometimes, they cross the line into illegality.

It starts with a code

For years, executives at the Texas-based long-distance reseller NTS Communications told SBC that their customers only called other states. Prosecutors found a different story. NTS customers were making in-Texas calls, too, which carried a higher fee. But NTS paid SBC only the lower fee for state-to-state calls.

The indictment alleged that the Texans operated similar schemes in other cities, including Tampa and Charlotte.

SBC, prosecutors alleged, was defrauded of more than $76 million over five years. NTS pleaded guilty to five counts of mail fraud in February 2002.

How the NTS scam worked: All calls originate with a code attached. That identifies where the call comes from. It's what tells your Caller ID box what number to display. According to Assistant U.S. Attorney Karen Norris, NTS intentionally routed calls through older network segments that couldn't handle the data. When the calls came to SBC, the data were gone, making it impossible for SBC to verify the calls' origins.

''Sending calls through older equipment has become a classic method of fraud,'' says SBC General Counsel Paul Mancini.

A year earlier, a grand jury indicted several Texas executives on charges of fraud. They had told SBC and AT&T that they needed local lines for their telemarketing company. Instead, they contracted with long-distance carrier Thrifty Call to use the lines for long-distance calls. That defrauded SBC and AT&T of $5 million in fees.

''All I had to prove is that they lied about getting these lines,'' says Assistant U.S. Attorney Donna Eide, who prosecuted the case. ''Any fraud is false representations to obtain a thing of value.''

A Mack truck-sized loophole

The industry has seen many similar games that don't wind up in prosecutors' hands.

That's partly because disputes regarding access fees are common. And phone companies have long worked them out among themselves or before regulators.

Civil lawsuits are also used.

In 2002, long-distance provider Sprint accused MCI, then known as WorldCom, of improperly shifting access fees to Sprint. Sprint says MCI improperly routed calls to avoid higher in-state access fees. It says it wound up paying part of MCI's tab and is seeking $113 million in restitution. MCI disputed the lawsuit, which is pending. Even though Sprint's allegations are similar to AT&T's fraud allegations against MCI, Sprint accused MCI merely of unjust enrichment and breach of contract.

Of all the gimmicks, the Internet loophole has the most potential to rock the economics of the industry.

Congress inadvertently made that possible when it wrote the landmark 1996 Telecommunications Act. Wanting to ensure the growth of the Internet, it ruled that data traffic would not be subject to the same access fees as voice long-distance calls. But by 1998, AT&T had figured out how to convert long-distance voice calls into ''data packets'' and deliver them as such -- making them exempt from access fees.

Since then, the maneuver has become central to industrywide gaming to avoid or minimize access fees. AT&T does it. MCI does it. DataVon -- now part of Transcom Communications -- and dozens of little long-distance companies do it. And it burns up the big local phone companies, such as Verizon Communications, which lose those lucrative access fees.

The loophole is so big, ''You can drive a Mack truck through it,'' says Hugh Simpson, founder and former CEO of DataVon.

Indeed, federal policy on it is murky, leaving states to sometimes craft their own contradictory rules.

Most often, long-distance carriers such as AT&T, which sends some voice calls over data networks, don't pay traditional access fees on those calls. Instead, they pay much lower fees. Local phone companies say they should pay full freight. But AT&T last year asked the FCC to validate its contention that phone-to-phone Internet calls are exempt from access fees the way computer-to-computer Internet calls are.

While the FCC has been mute, the state of New York, home to No. 1 local phone company Verizon, last year set a precedent regarding one company in deciding that voice calls over the Internet are roughly equivalent to traditional phone service and should be subjected to the same fees.

Minnesota regulators, too, have taken at least one step toward eroding the protection given data carriers. They recently ruled that Internet telephony company Vonage is subject to state oversight regardless of its argument that it is an exempt data service rather than a traditional telephone company.

That could make Vonage -- which offers phone-to-phone Internet telephony -- and other upstarts liable for local access fees in that state. That could result in higher prices. Currently, Vonage offers unlimited local and long-distance calling for $40 a month in 85 markets nationwide.

''What we're doing is really disruptive technology,'' says Vonage CFO John Rego, which ''could displace the telephony world that we know today.''

Sprint, a traditional phone company, has the same view -- but from a different angle. In December, it told the FCC: The ''cost imbalance'' arising from a policy that imposes fees on traditional phone companies while exempting data carriers ''will quickly force all'' long-distance carriers ''to convert all their voice traffic'' to data traffic to match their competitors' costs.

Lawsuits, investigations

The allegations against MCI involve both the routing of calls to avoid fees and the use of data carriers such as DataVon.

AT&T has alleged that it was duped into believing MCI's Canadian calls were ''truly international traffic'' because the calls were routed through as many as three intermediaries. In a brief filed last month in MCI's bankruptcy proceedings, AT&T said the deception was so elaborate that it took weeks to figure out even after AT&T was notified by law enforcement.

Verizon executive Joseph Mulieri then picked up the gauntlet, complaining to the FCC this month that ''the extreme measures'' MCI has taken ''to disguise the nature of the traffic'' show that it knew the traffic was subject to access charges.

Earlier this year, Verizon filed court documents accusing Dallas-based DataVon of stripping or altering MCI call codes so MCI could avoid access fees. DataVon's Simpson, its CEO until mid-2002, denies knowledge of altered calls and says DataVon operated within the rules when it converted voice calls to data. He says the problem is the FCC's loophole.

The FBI, meanwhile, has subpoenaed documents related to DataVon. And it has asked for witnesses with knowledge of alleged fraud involving MCI to come forward.

MCI counters that its rivals are trumping up the charges to kill its exit from Chapter 11. It says it legally transferred calls through DataVon. Neither prosecutors nor MCI rivals have yet to produce evidence to the contrary. MCI creditors last week asked to see what they've got.

Criminal charges could send the nation's No. 2 long-distance carrier into a tailspin, affecting phone pricing and services.

The key is whether the calls' origins were altered, which could constitute fraud, legal experts say.

''It turns into a crime when you . . . change or fabricate the information,'' says Alexander Bono, corporate litigation partner at Blank Rome.

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