III. Net Benefits Showing Pursuant to
Section 854(b)(2)

Section §854 (b)(2) requires that, in order to warrant approval, merger transactions must produce both "short-term" and "long-term" economic benefits. In addition, § 854(b)(2) requires the Commission to:

Equitably allocate, where the commission has ratemaking authority, the total short-term and long-term forecasted economic benefits, as determined by the commission, of the proposed merger, acquisition, or control, between shareholders and ratepayers. Ratepayers shall receive not less than 50 percent of those benefits.

Section 854(b)(2) thus requires that ratepayers receive at least 50% of the economic benefits of the merger attributable to California measured over the "short term" and "long term," and that the Commission has discretion to allocate the remaining 50% between ratepayers and utility shareholders as specific circumstances warrant. To the extent that specific applicable savings from the merger can be identified, we find that a 50% sharing of those savings between ratepayers and investors is reasonable and consistent with requirements of § 854(b)(2).

A. Qualitative Benefits In Relation to Section 854(b) Requirements

1. Parties' Positions

Applicants' primary claim is that there are no savings from the merger specifically attributable to serving California retail customers, and that there should be no mandatory surcredits or other pass-through of savings to retail customers as a condition of approving the merger. Applicants claim that, to the extent that California retail customers realize any benefits from the merger, such benefits will be in the form of improvements in the range and quality of service, as a result of combining the strengths of SBC and AT&T.

Applicants claim that the merger will facilitate a unified "end-to-end" IP network for ordering, provisioning and maintaining voice, data, and video services. A single, unified IP network will enhance the ability to share bandwidth, and to offer better bandwidth-intensive services. The combined network can also exploit superior speech/text technologies to provide more robust fraud and network security, and to provide superior provisioning and repair.

ORA argues that Applicants' claims of mere qualitative, or "soft," benefits are not the "economic benefits" required by § 854(b). ORA witness Selwyn testified that service quality improvements would not "constitute an `economic benefit' for California ratepayers" unless "existing service quality [from Applicants]. . . in California today is less than satisfactory." (Ex. 126C, p. 18, ORA/Selwyn.) Applicants have not contended that existing service quality is unsatisfactory, nor have they provided specific details about how the merger would improve service quality in California. Applicants make no attempt to associate specific, tangible economic benefits with their claim that the merger will increase innovation.¹⁹ Thus, ORA argues that Applicants' claimed benefits are not designed to improve any current deficiencies in either SBC's or AT&T's services.

2. Discussion

We agree that "soft" benefits, as described by Applicants, do not satisfy the net benefits requirements of § 854(b). Most of Applicants' highlighted advantages of the merger, such as network integration, and the ability to attract a larger number of large global customers, are essentially shareholder benefits. (E.g., Tr. Vol. 10, p. 1379 SBC/Rice. Such "soft" benefits would impact consumers only to the extent they manage to "find [their] way into consumer" segments of the market via a "ripple down" effect. (Tr., vol. 9. p. 1279 AT&T/Polumbo.)

Applicants' witnesses are vague about whether, or when, any consumer benefits at all might be realized. Witness Polumbo stated, "there is no mention of timing." (Tr., vol. 9. p. 1278, AT&T/Polumbo.) With regard to network benefits, SBC witness Rice disagreed with the claim that voice services would be improved by interconnecting the two applicant's networks. (Tr., vol. 10. p. 1401 SBC/Rice.) He stated that the Applicants' "intention" was to develop new products and "apply them to the enterprise market, but we think many of them will apply to the mass market as well." (Tr., vol. 10. p. 1534 SBC/Rice.) Asked about next-generation applications he testified: "We don't know specifically what they are going to be." (Tr., vol. 10. p. 1535 SBC/Rice.) Rice further testified about "interesting projects" but could not specify pricing information because "we don't know the details." (Tr., vol. 10. p. 1536 SBC/Rice.)

ORA witness Selwyn challenges Applicants claims of innovation from the merger, arguing that competition, not the scale of operations, is the driver of innovation. Dr. Selwyn pointed out that firms with few or no rivals have little incentive to bring new products to market. (Ex. 126C, p. 26, ORA/Selwyn.) Academic literature also corroborates that competition drives innovation.²⁰

On the other hand, the proposed merger is risky for ratepayers. ORA witness Selwyn testified that the merger could lead to an overall increase in the rates consumers pay for services subject to the Commission's ratemaking authority, even if in the aggregate, the merger produces positive economic benefits to Joint Applicants.

We next proceed to determine if there are quantitative net benefits to ratepayers due to the merger, and the extent to which consumers receive a share of any such benefits as required under § 854(b).

B. Applicants' Calculations of Section 854(b) Savings From the Merger

Regarding the quantification of net customer benefits expected from the merger, Applicants sponsored the testimony of James Kahan, SBC Senior Executive Vice President of Corporate Development. Mr. Kahan is responsible for the analysis and negotiation of mergers and acquisitions for SBC. The financial projections supporting the analysis of this transaction were created by Mr. Kahan's staff at his direction.

Although Applicants dispute that § 854 (b) applies to the SBC/AT&T acquisition, in compliance with the previously-referenced Assigned Commissioner's Ruling, they produced a calculation of certain merger-related savings that could theoretically be shared with California customers. These savings are generally referred to as "synergies." To calculate a California share of merger savings, Applicants start with the base figure for merger-related savings derived from SBC's "National Synergy Model".

The National Synergy Model was created during the "due diligence" process prior to SBC's signing of the Merger Agreement with AT&T to assist senior management and the board of directors in evaluating the transaction, and to assist in determining the price to pay for AT&T. All expected synergies, or savings, from the merger on a global basis are addressed in the National Synergy Model.

The National Synergy Model identifies approximately $16 billion (net present value) in synergies from the proposed merger on a global basis. The Applicants attribute almost 50 percent of these synergies to network operations and IT functions, with substantial synergies from procurement cost savings and increased revenue opportunities.²¹ Applicants also expect synergies from the reduction in third party network expenses due to moving network traffic onto AT&T's network, elimination of overlap between SBC and AT&T's staff relating to national networks, enterprise sales and support, and headquarter operations (e.g., finance, accounting, human resources, and legal).

Although Applicants expect $16 billion in benefits, they deny any meaningful synergies will be achieved in local network operations or personnel, claiming that AT&T has few, if any, local network facilities. In evaluating the merger, the Applicants did not analyze California-specific quantifiable benefits, but only considered benefits at a national level. AT&T predominantly provides mass market service via the Unbundled Network Element Platform (UNE-P) relying on the network of SBC and others to provide local retail service. These UNE-P customers are already being served over the existing SBC local network and this arrangement is not expected to change after the merger. Applicants' witness Rice testified that there will be no changes in SBC California's local network as a result of the network integration that is contemplated post-merger.

Notwithstanding its claim that there are no significant synergies related to California retail services, Applicants performed a calculation of net customer benefits in response to the Assigned Commissioner's Ruling. Applicants calculated operating synergies in California relating to: (1) total revenues and operating expenses in 2004 for both SBC and AT&T; (2) California intrastate total revenue and operating expenses for AT&T's California certificated subsidiaries in 2004; and (3) the combined company operating expense synergy forecasts presented by senior management to the board of SBC.

By taking AT&T's estimated operating expense for California as a percentage of the combined firm operating expense, the Applicants estimated a California operating expense factor. This factor was multiplied by the forecasted net expense synergies for the combined company for each of the first five years post-closing, yielding estimated California-specific expense synergies for each year.

The Applicants then discounted the forecasted synergies to present value to compute economic benefits to be $27 million attributable to AT&T California local and intrastate operations. Applicants then reduce the $27 million savings by 50% (based on the § 854(b) directive) to assign approximately $14 million as the savings available to California consumers.²² This amount represents only 2/10 of 1% of the total corporate synergies.

C. ORA and TURN Calculations of Section 854(b) Savings Attributable to California

ORA and TURN each performed their own analysis of synergy savings attributable to California consumers, and presented testimony concluding that Applicants' calculation of the total merger synergies allocated to California consumers was significantly understated. As a basis for their calculations, ORA and TURN relied on the Applicants' synergy model as a starting point, and made adjustments to the Applicants' figures. On a net present value basis, taking into account adjustments for the alleged deficiencies, ORA estimates of the correct amount of synergies attributable to California is $1.84 billion, while TURN calculates the amount as $1.983 billion.²³ ORA and TURN propose applying 50% of these synergy savings to ratepayers pursuant to § 854(b). ORA thus calculates savings of $919 million and TURN calculates savings of $991 million. CTFC Witness Braunstein also presented testimony commenting on merger-related synergies. Although Braunstein did not prepare a separate calculation of synergy benefits, Braunstein believes that over $1.2 billion in short term and long term synergies are attributable to California from this merger. In reaching this figure, Braunstein agrees with the major adjustments made by ORA and TURN. Braunstein notes that the $1.2 billion figure is only a small fraction of the total overall synergies from the merger.

The ORA and TURN figures differ with Applicants figure by a considerable amount principally due to two adjustments: (1) the inclusion of SBC California operations in the synergies allocation and (2) extending the period over which ratepayer savings are measured to equal the period used by Applicants for evaluating shareholder synergies. ORA and TURN also propose various other adjustments that have a smaller impact on the calculation, as summarized below. We reach a determination on each of the proposed adjustments in the discussion below, and arrive at an adopted figure for the total synergy benefits to be allocated to consumers in accordance with § 854(b)(2).

Applicants also take issue with parties' disagreements over their calculation of synergies, characterizing it as "second guessing" the professional judgement of managers. We disagree with this characterization of opposing parties' critical inquiry into the synergies calculations. Opposing parties are entitled to examine all relevant documentation in an effort to validate any part of Applicants' modeling methodology. To the extent that the development of national synergies estimates were developed through due diligence and the "best business judgment" of SBC senior management, parties should be able to validate that due diligence and the methodology employed in developing specific estimates. Neither parties nor the Commission should have to take such estimates on face value in evaluating whether, and to what extent, this merger produces net benefits that are in the public interest.

D. Disposition of Issues Relating to Net Synergies Allocated To California Consumers

1. Definition of Short-Term and Long-Term for Measuring Ratepayer Benefits

a) Parties' Positions

As noted above, one of the largest factors accounting for the difference between the Applicants and ORA/TURN in measuring benefits subject to § 854(b) ratepayer sharing relates to the time period over which synergies forecasts are recognized. For purposes of their calculation of $27 million in California-specific synergies subject to ratepayer sharing, Applicants limited the time horizon to a five-year period. The $27 million represents the lump sum discounted present value of the stream of annual economic effects calculated by Applicants over the first five years of the post-merger period. Applicants recognized no distinction in their calculation between the "short term" and the "long term" (pursuant to § 854(b)) for purposes of allocating benefits to ratepayers.

Section 854(b), however, requires that there be both "short-term" and "long-term" consumer benefits from the merger. The statute does not provide a specific definition of what constitutes the short term versus the long term. Accordingly, we must establish such a definition for purposes of our § 854(b) analysis here. Based on the time period we establish as the short-term and long-term, we must then ascertain what, if any, merger benefits are expected to be realized over this period. Based on this factual determination, we must then make findings on whether the conditions of § 854(b) are adequately satisfied.

Although Applicants have provided no distinction between short-term and long-term with respect to benefits allocation, TURN argues that the projected costs of implementing the merger are likely to result in no net benefits for customers in the short-term, representing the initial years of the merger.

Although Applicants have calculated the California-specific synergy benefits by truncating the forecast time horizon after five years, the National Synergy Model forecasts additional merger synergies through the year 2013, and also includes an additional terminal value for synergies anticipated into perpetuity. The national merger synergies estimates were used as a basis to make representations to the financial community.²⁴

The estimated costs to achieve the merger occur in the first initial years after the transaction, while offsetting savings are realized over a longer period. Using a five-year period for measuring California ratepayer synergies thus ensures that all of the initial merger costs are incorporated, while only a much smaller percentage of the offsetting savings forecasted by the National Synergy Model is included in the synergies allocated to California ratepayers.²⁵ As a result, ORA and TURN claim that Applicants' approach is unfair in truncating the calculation after 5 years because ratepayers are allocated none of the synergy benefits that Applicants have estimated will be realized on a national basis.²⁶

ORA and TURN argue that Applicants provide no valid reason to limit the California-specific forecast of benefits to a shorter period than the one used by Applicants to calculate merger benefits to justify the Federal Communications Commission (FCC) approval of the transaction.²⁷ ORA and TURN thus argue that the "long term" for purposes of allocating ratepayer benefits should coincide with the period used to assess synergies to be realized by shareholders. ORA argues that an economic definition of "long-term" should refer to the period of time after merger implementation costs were incurred, allowing all permanent synergy and other efficiency gains to be included in the calculation of merger benefits.²⁸ This definition of long-term coincides with the forecast period presented by Applicants to the financial community, even though Applicants use a five-year definition of long-term for ratepayer sharing.²⁹ Applicants claim that if the Commission uses the same definition of long-term used for Applicants' forecasts presented to the financial community, there will be an "inordinate risk upon the companies' financial operations and shareholders."³⁰

ORA witness Selwyn testified, however, that the merger poses virtually no investor risk, while ratepayers will "confront[] an enormous risk because ... the effect of this merger will ... create a far less competitive market overall... [and] ratepayers and California consumers generally will see price increases."³¹ ORA thus argues that the Commission should not reduce ratepayer benefits to account for alleged shareholder risk by cutting off the calculation at five years and ignoring subsequent years projected benefits. Accordingly, ORA calculated the synergies attributable to California over the same time frame used by SBC for its shareholder and investor synergy disclosures.³²

Alternatively, if the Commission were to adopt Applicants' five-year term for the purpose of attributing merger synergies to California, ORA proposes adjustments to avoid allocating a disproportionate share of merger-related costs to ratepayers. Because Applicants fail to capture a significant portion of the long-run cost savings used as a major justification of the proposed merger, ORA and TURN recommend that upfront merger costs be reallocated over a longer period to avoid a disproportionate allocation to consumers.³³ ORA witness Thompson performed a recalculation of the ratepayer share of benefits on this premise. ORA notes that once the five-year long-term limit is reached, the subsequent years account for 74% of the gross full national synergy benefits. ORA witness Thompson thus excluded 74% of the costs-to-achieve upfront as an alternative approach in the event that only a five-year period were adopted for measuring ratepayer benefits. This calculation would increase the California synergy benefits by $44 million.

b) Discussion

Section 854(b) requires that ratepayers receive benefits over both the short-term and long-term, but does not specifically define a duration for either period. In prior decisions analyzing § 854(b), we have held that the definition of long-term may vary with the circumstances of each individual case. (See, for example, D.91-05-028, 40 CPUC2d 159, 174; D.98-03-073, mimeo., p. 14.) In this case, because ORA and TURN have utilized a longer duration in defining the "long term," they have captured a much larger magnitude of synergy-related savings that would be subject to § 854(b) ratepayer benefits. Although Applicants have prepared forecasts of potential synergies over a period longer, the Applicants' forecast horizon for making presentations to shareholders does not automatically dictate the period that we adopt for applying § 854(b) ratepayer benefits.

As previously noted in the SBC/Telesis decision, the level of competition is among the principal factors we consider in defining the long-term. (D.97-03-067, 71 CPUC2d 351, 375.) We consider the level of competition not only in a static sense (e.g., current market share, current number of competitors), but also in a dynamic sense (e.g., changes in market share; changes in numbers of competitors; the pace of change in technology, the industry, and the market, including regulatory changes).

The state of regulation and ratemaking is another factor in determining the long-term, and is as important a factor as competition. (D.97-03-067, 71 CPUC2d 351, 375.) We concluded in the SBC/Telesis merger decision that this factor supported 5.6 years. As we noted in the SBC/Telesis decision, the planning horizon is a secondary factor that may be considered in determining the long-term. (D.97-03-067, 71 CPUC2d 351, 374-375).

In reaching our decision here as to the time frame for quantifying benefits, we also consider how the long-term has been defined in other merger proceedings. One of the principles we have previously adopted is that the long-term must be determined for each individual merger based on the specifics of each case. Nonetheless, even though each was determined separately based on individual circumstances, we have tended to find about five years as the period for the long-term.³⁴ Perhaps the most similar recent merger was that of SBC/Telesis. We found the long-term there to be 5.6 years.

We also consider the period over which we may make a reasonable forecast, to ensure that we secure the total benefits for ratepayers that are required by § 854 while not exceeding our ability to reasonably predict the future. The pace of change and the inherent uncertainty in regulation, markets and technology led us to reject proposals for 10 and 20 years in the SBC/Telesis proceeding. (D.97-03-067, 71 CPUC2d 351, 375.). Consistent with our approach in the SBC/Telesis proceeding, we likewise decline to utilize such an extended time frame for defining the "long term" in determining § 854(b) net benefits. In consideration of these factors, we conclude that a six-year period is appropriate in defining the "long term" for purposes of applying net benefits to consumers applicable under § 854(b). A six-year period is reasonable in view of the approach we took in the SBC/Telesis merger in applying § 854(b) in which we used a 5.6-year period to define the "long term."³⁵

While we define the long term time as six years, we agree with ORA and TURN that Applicants' calculation produces a skewed result by deducting 100% of merger-related costs during the initial implementation in computing § 854(b) ratepayer benefits. Since the majority of the synergies associated with these merger costs are forecast to occur beyond the initial six-year period, the costs should be adjusted to assign a proportionate share to the period beyond the initial six years. We shall adopt ORA's proposal in this regard to allocate a pro rata share of the merger costs to the period after the initial six-years. Thus, because only a limited percent of Applicants projected synergy benefits are forecast to occur through the sixth year, we shall limit the same percentage of merger costs to the period through the sixth year.

2. Should Synergies Be Based Only on AT&T's Operations?

a) Parties' Positions

Another major difference in the ORA/TURN calculations of synergies has to do with whether SBC California operations are taken into account in allocating benefits. Assuming that the Commission applies § 854(b), Applicants believe that the Commission should only assess customer savings based only on AT&T's operation as the acquired company while ignoring any effects on SBC operations. ORA and TURN disagree, however, claiming that no provision of law supports limiting merger synergies to only AT&T operations. ORA argues that doing so would render the statute meaningless, since a transaction could always be designed so that the firm, affiliate or subsidiary subject to Commission review realized few of the benefits.

ORA and TURN argue that all AT&T and SBC California activities "where the Commission has ratemaking authority" should form the basis for the § 845(b)(2) allocation of benefits to California ratepayers.³⁶ Applicants' exclusion of SBC's California intrastate operations from the allocation of synergies to California ratepayers results in a substantial reduction in California-specific synergies. This effect occurs because of the far larger intrastate operations of SBC California and other SBC affiliates, which form the bulk of the merger synergies related to the combined post-merger California operations.

b) Discussion

We conclude that the proper approach to calculating ratepayers' share of synergies is to incorporate the effects of both utilities involved in the merger. Applicants argue that calculating merger synergies relating only to the firm being acquired is consistent with the approach followed in the SBC/Telesis merger. Yet, in the SBC/Telesis proceeding, the acquiring firm, SBC, had no significant California operations at that time. It made sense in that case to measure California specific synergies based solely on the company being acquired because it was the only entity with significant California-regulated operations. That merger proceeding however, did not address how to identify California-specific merger benefits when both the acquired and the acquiring company have substantial assets and operations in California. A similar principle applied in the Bell Atlantic/GTE merger. Thus, neither of those proceedings serves as precedent³⁷ for excluding SBC California operations from the merger synergies in this proceeding.

Furthermore, in the Bell Atlantic/GTE decision, the Commission found that a "greater portion of the savings associated with common cost functions will be achieved by the company that utilizes or consumes more of that function."³⁸ Consistent with this logic, the merger savings related to SBC's California operations are a valid component of the California-specific synergies subject to § 854 (b)(2).³⁹

Public Utilities Code 854 (b)(2) expressly requires the Commission to "[e]quitably allocate[] . . .the total short-term and long-term forecasted economic benefits. . .of the proposed merger, acquisition, or control, between shareholders and ratepayers."⁴⁰ Thus, the totality of merger-related benefits must be considered, not merely the fraction attributable to one of the firms involved.⁴¹ There are no exceptions in § 854 (b) allowing for exclusion of synergies relating to the acquiring company. The Commission has a duty to include all forecasted economic benefits.

The Commission's past practice has been to assess benefits based on all the firms involved in a transaction. For example, in the Southern California Gas Company (SoCal) and San Diego Gas and Electric Company (SDG&E) merger, (D.98-03-073) and in the GTE and Contel merger (D.94-04-083) proceedings, the Commission determined ratepayer benefits by examining synergies realized by both the acquiring and the acquired companies.

Benefits from "synergies" necessarily involve the combination of the two companies in producing the benefits. Additionally, Applicants' publicly stated rationale for the merger, as presented to the financial community, places as much emphasis on benefits flowing to SBC from acquiring AT&T as they do on benefits moving in the other direction.⁴²

We shall therefore determine the net benefits allotment to ratepayers based upon the total long-term benefits from the merger, as required by § 854 (b) considering savings realized by the combined California operations of both AT&T and SBC over a six-year period. ORA adjusted the California synergy calculation, adding the SBC California intrastate operations expenses to the AT&T California operations expenses, by using data from the SBC California intrastate operations report.⁴³ We shall adopt this approach, applied over a six-year period.

3. Inclusion of Expenses for UNE Services

Applicants did not include the cash operating expenses attributable to UNE services in their expense calculation applicable to AT&T-CA Services, claiming that UNE services were not part of the analysis⁴⁴ because the expense to provide these services is actually borne by SBC, not AT&T.

ORA notes, however, that the National Synergy Model analyzes synergies associated with UNE services in areas such as wholesale headcount reductions,⁴⁵ thereby providing a basis for including the cash operating expenses attributable to UNE services in the expense calculation. ORA added UNE-related expenses back into the California synergy calculation. We find this adjustment reasonable, and hereby adopt it.

4. Double Counting of Wholesale Costs

ORA noted an error in the calculation of the allocation factor to identify the AT&T California share of the certain economic benefits of the merger derived from SBC's National Synergy Model. In calculating this allocation factor, Applicants double-count expenses related to wholesale services provided for each company by the other. The effect of double-counting results in a smaller allocation of annual synergies to California. We find this adjustment reasonable, and hereby adopt it.

5. Savings attributable to AT&T's reduced cost of capital

Applicants' calculation of synergies to be shared with California ratepayers excludes any savings attributable to reductions in AT&T's cost of capital. TURN witness Murray recommends that synergy savings be increased to recognize anticipated savings in AT&T's cost of capital, calculated by taking the current "spread" between AT&T's pre-merger cost of capital and SBC's post-merger cost of capital and applying it to AT&T's annual stand-alone capital expenditures. In response to SBC's criticisms of the calculation, Murray subsequently refined her methodology using updated information and accounting for depreciation.

TURN witness Murray thus adjusted her calculation and reduced the synergies estimate. Applicants argue, however, that Murray's revised calculation still ignores Kahan's contention that any synergies from a reduction in AT&T's cost of capital would be offset and outweighed by significant up-front transaction costs of financing AT&T's debt at a lower rate.⁴⁶ While making this criticism, however, Applicants failed to quantify any of the claimed up-front refinancing costs. Moreover, Applicants' claim that such costs outweigh the savings contradicts their own claims that AT&T's reduced costs of capital is a benefit of the merger. Accordingly, Applicants' criticisms are not sufficiently explained or documented. We adopt TURN's cost of capital adjustment.

6. Overhead Transactions costs

TURN witness Murray identified certain categories of transactions costs included in the National Synergy model that remained unexplained with no apparent justification as to why they should be netted against merger savings in computing net benefits to be shared with ratepayers. TURN claims that to the extent that it can be inferred as to what the costs represent, they appear to be costs that should not be passed on to California ratepayers. TURN provides justification concerning its recommendation to exclude these costs in the confidential portion of the testimony of Terry Murray (see Exh. 135C, pp. 35-37).

We agree that the Applicants have failed to provide documentation or justification for applying these costs as offsets to derive the net savings sharable with California ratepayers pursuant to § 854(b). Accordingly, we shall adopt the adjustments for these transactions costs described and summarized on pages 54 through 57 of the confidential version of TURN's opening brief.

7. Severance Costs

ORA witness Hieta testified that corporate salaries used to determine costs associated with the proposed merger were incorrectly fully loaded⁴⁷ when calculating severance payments and should be adjusted. Applicants also included in the national synergy model an offsetting cost to fund severance bonuses. As is the case with retention bonuses, ORA recommends that severance bonuses should be excluded in computing synergies. A main reason for the severance bonus is as reward for service and coercion to leave the company.

The Commission has previously determined that excessive payments for executives should not be funded by ratepayers. In D.04-09-061 the Commission did not have to declare what would reasonably be funded because it accepted SBC's proposal to voluntarily limit its executive compensation. The Commission also stated that "for its excess executive compensation costs, the Commission's affiliate transaction rules require that there be some benefit associated with an allocated cost."⁴⁸ The Commission has declared that there is precedent to at least cap payments to executives. Because Applicants have failed to produce justification for the claimed level of severance costs, we shall not require ratepayers to absorb them. ORA's adjustments here are adopted.

8. Exclusion of WilTel Contract Termination Costs

ORA argues that the Commission should exclude the WilTel contract termination cost from the National Synergy Model because the contract was terminated prior to the merger's close, rather than after, and that the cost would occur whether or not the merger occurs.⁴⁹ SBC responds, however, that it would not have terminated the WilTel contract absent the merger with AT&T. Otherwise, it would have had no network to use to complete the long distance calls for the millions of customers served by SBC LD nationwide - or even between San Francisco and Los Angeles.⁵⁰ We agree with Applicants' here, and ORA's adjustment is not adopted.

9. Investment Banking Fees

ORA contends that investment banking fees should not be included as an cost offset in the calculation of ratepayer savings.⁵¹ SBC argues, however, that investment banking fees are a necessary transaction cost that would not have been incurred without the merger and without which the merger could not happen. ORA witness Johnston acknowledged on cross-examination that investment bankers fees were allowed as costs in the SBC-Telesis merger and the Bell Atlantic-GTE merger.⁵² Consistent with prior precedent, ORA's adjustment here is not adopted.

10. Revenues from CallVantage

With respect to this AT&T Voice over Internet Protocol (VoIP) application, TURN argues that "the Commission should include potential California revenues from this product in any benefits analysis."⁵³ TURN does not explain, however, how continuing to offer VoIP will provide intrastate California revenue synergies. Although Kahan admitted that consumer market revenue synergies would result from the combined entity's sales of VoIP.⁵⁴ Applicants claim that Kahan only conceded that it would represent a potential for a consumer market revenue synergy outside of California.⁵⁵

Second, Applicants argue that the FCC has specifically held that VoIP is an interstate service and preempted states from regulating VoIP.⁵⁶ Thus, Applicants argue that revenue synergies that are both jurisdictionally interstate and that occur outside of California provide no basis for increasing the Applicants' calculation of California synergies.

We agree with Applicants that these savings are not properly included in the California synergies.

11. Inclusion of Capital and Revenue Synergies in Ratepayer Allocation

Applicants include only operating expense synergies in calculating the share of savings to be passed through to consumers under § 854(b), but have excluded capital expenditure and revenue synergies which, however, are part of the total economic benefits forecasted in SBC's own National Synergy Model. ORA and TURN incorporated these additional synergies in producing its alternative synergies calculation.

In his deposition, Kahan argued that any capital expenditures synergies associated with this transaction are interstate in nature since SBC and AT&T are combining national networks.⁵⁷ Accordingly, Kahan claims that such synergies should not be allocated to California ratepayers.⁵⁸

Kahan also acknowledged, however, that there is an interrelationship between capital and operating synergies, and revenue and operating synergies. Nonetheless, Kahan did not study the extent to which those interrelationships exist in the model.⁵⁹ For example, there can be operating costs to achieve capital expenditure synergies, as well as general interrelationships between operating and capital synergies in integrating the networks of the two companies.⁶⁰ Rather than perform analyses to test the impact of these acknowledged interrelationships between synergies on the total California benefits, Kahan simply excludes capital and revenue synergies based on SBC's legal interpretation of § 854(b).⁶¹

These benefit categories have been included in prior Commission forecasts of the total short-term and long-term economic benefits of telecommunications mergers.⁶² The history of prior SBC mergers also suggests that the operating expenses category is not necessarily the primary driver of synergies from such mergers.⁶³ Thus, we shall adopt the ORA adjustment here.

E. Adopted Synergy Benefits to be Allocated to California Consumers

Based on our findings discussed above regarding adjustments to Applicants' synergy calculation, we find Applicants' calculation of net benefits of $27 million significantly understates the level of synergies reasonably attributable to California utility operations. We agree with certain of the adjustments to the synergy calculation made by ORA and TURN, to the extent adopted in our discussion above. By applying the adjustments that we find reasonable, we calculate the amount of net synergy benefits applicable to California for purposes of calculating § 854(b) shared savings amounts to be $659.2 million on a discounted net preset value basis.

We note that Applicants have entered into a settlement with Greenlining and LIF in which certain stipulated amounts of philanthropic contributions would be designated as the sole § 854(b) benefits to be adopted in this proceeding. Yet, the settlement does not purport to represent any quantitative analysis of actual synergies that would actually be realized through the merger. For reasons discussed below in Section V, we decline to limit § 854(b) benefits solely to those identified in the settlement.

In order to find that this merger is in compliance with § 854(b), we hereby require that 50% of the $659.2 million net synergies be shared with California consumers, resulting in an allocation of $329.6 million on a discounted net present value basis. This allocation to consumers complies with the directives of § 854(b) that at least 50% of the net benefits of the merger over the long-term be shared with California ratepayers. We address the implementation of the allocation of these consumer benefits in Section III.G below.

F. Ratemaking Authority to Implement Net Benefits Allocation

Applicants argue that irrespective of whatever level of merger savings may be attributable to California utility operations, the Commission should not impose a mandatory sharing of such benefits because the Commission does not have "ratemaking authority." Since AT&T and its affiliates are classified as CLECs and NDIECs, they are not subject to cost-of-service rate regulation. Accordingly, Applicants argue that because the utilities being acquired are not subject to rate regulation, the merger transaction, itself, is not subject to the purview of § 854(b)(2).

Applicants assert that the legislative history of Assembly Bill 119 of the 1995-1996 legislative session (AB 119) demonstrates that NDIECs and CLECs are exempt from § 854(b)(2)'s requirements.

ORA and TURN disagree. They point out that the language of the statute specifically refers to NDIECs and CLECs. California courts rightfully express "skepticism about looking beyond the statutory language when trying to discern the legislature's meaning." (Pacific Bell v. Public Utilities Com. (2000) 79 Cal. App. 4^th 269, 280.) The Commission has looked to the extent of its regulatory authority as one factor justifying an exemption, under unique circumstances. For example, AT&T and Media One, supra, case does not establish that sharing doesn't apply to NDIECs or CLECs. Rather, it grants a § 853(b) exemption to a transaction involving an Internet Service Provider (ISP) because "internet services...are offered in an area generally unregulated by this Commission or any other State or Federal regulatory body." (Id., 2000 Cal. PUC LEXIS 355 at p. *23.) Other cases discussed in the Application Supplement, e.g., MCI and BT, supra, and AT&T and Teleport, supra, also involve the granting of a Section 853(b) exemption.

The fact that the regulatory status of a company is relevant to whether or not an exemption should be granted does not show that the statute automatically excludes NDIECs and CLECs from §§ 854(b) and (c) review. In any event, this transaction involves the acquisition-and removal from the market-of a very significant NDIEC and CLEC. It also involves an acquisition by California's largest ILEC. Thus, this transaction is not analogous to past proceedings where NDIECs and CLECs continued to participate in the market after the merger closed, and where no dominant ILEC was involved in the acquisition.

Applicants also cite AT&T and McCaw Cellular (1994) 54 CPUC 2d 43 (D.94-04-042) to support a claim that only "qualitative standards" should be used to assess any benefits of this transaction under § 853(b)(2). Applicants claim that American Tel. & Tel. and McCaw Cellular, supra, provides the Commission with authority to review only, "qualitative short-term and long-term benefits to consumers" because this transaction involves "entities over which the Commission does not exercise traditional ratemaking authority." (Supplement, at p. 4.)

a) Discussion

We conclude that we have ratemaking authority to implement the net benefits requirements of § 854 (b) (2). We conclude that approach we took in the AT&T/McCaw decision is not applicable here. That decision was rendered after several parties reached settlement, and before the record was developed. (AT&T and McCaw Cellular, supra, 54 Cal. P.U.C.2d at pp. 48-49.) The Commission's decision does not even use the word, "qualitative." The decision in that case was based on factors not present here. The AT&T/McCaw transaction, "even more than other recent mergers, is a paper transaction." The Commission also pointed out: "the merger involves two companies in essentially different lines of business, no consolidation of operations affecting the 15 McCaw California utilities is proposed at this time."

The Commission also noted that cost of service ratemaking did not apply to McCaw's California subsidiaries since they operated in fields that are largely competitive, and "our regulation of these fields is correspondingly relaxed." (AT&T and McCaw Cellular, supra, 54 Cal. P.U.C.2d at pp. 50-51.) By contrast, SBC is a dominant carrier subject to price regulation through the New Regulatory Framework (NRF) procedure. Particularly for customers without clear competitive options, the only way that they can be assured of net benefits from the merger is through a mandatory pass-through of savings. There is no assurance that market forces will flow through savings to such customers.

The SBC/AT&T merger therefore is not analogous to the AT&T/McCaw merger. SBC/AT&T merger is expected to produce quantitative benefits, and there is no need to retreat to a qualitative standard.

Moreover, in the prior cases where we did not apply § 854(b)(2), both the acquired and the acquiring company were not subject to rate regulation. In this case, however, SBC California is an ILEC subject to the Commission's ratemaking authority through the NRF mechanism. Thus, the exemptions from § 854 (b) noted in the previous transactions that exclusively involved NDIECs/CLECs do not apply here where we exercise price regulation over the surviving company.

We previously addressed the question of whether market forces can be relied upon to pass through merger savings to customers in reviewing the SBC/Telesis merger. In D.97-03-067, we observed that the markets in which SBC/Telesis planned to operate were, at that time, at varying degrees of competition. We found that, at least for Category I and Category II services, they were not sufficiently competitive to conclude that any merger savings would be passed through as a result of market forces. As a result, we included these services in the calculation of savings to be shared between ratepayers and shareholders. On the other hand, we excluded all savings associated with Category III services from our calculations of savings to be shared between ratepayers and shareholders.

G. Measures to Implement Pass-Through of Synergy Benefits to Consumers

Having found that § 854(b) applies to this merger, we address the specific means by which the identified net benefits shall be passed through to consumers.

ORA and TURN did not formulate specific proposals concerning how the net benefits should be allocated among different groups of consumers. ORA and TURN do agree, however, that merger savings to be shared with ratepayers need not all necessarily flow through as rate surcredits. ORA witness Selwyn characterized ratepayer benefits as "currency" to "spend" on various mitigation measures. ORA believes that proposals for the uses of shared benefits be subject to examination and further comments. ORA and TURN propose that the specific allocation of the net benefits among different consumer groups and interests be addressed in a separate phase of this proceeding.

Also various other parties and individuals at the PPHs have advocated that any net benefits be earmarked for designated purposes, such as in funding programs to help bridge the "digital divide" experienced by the various underserved elements of the communities in which SBC provides service. In this regard, we are also separately adopting certain conditions pursuant to § 854(c) relating to philanthropy commitments by SBC, as discussed in a subsequent portion of this decision.

Thus, in order to provide a proper basis upon which to determine how net consumer benefits from the merger should be distributed, we will adopt the ORA/TURN proposal to take further comments on this issue. Before determining the specific allocation of net benefits adopted herein, we solicit comments to be filed 20 calendar days following the effective date of this decision concerning proposals for the specific allocation of the net benefits among consumer groups and/or other programs for the benefit of consumers. Following receipt and review of comments, we shall proceed with further steps to implement the distribution of net benefits to consumers as adopted in this decision.

ORA and TURN have also proposed that additional measures be implemented concurrent with approval of this merger, to mitigate the risk that any net ratepayer benefits that might otherwise be realized might be taken away through rate increases.

Given the potential for short-term benefits to be eroded by rate hikes for captive customers, TURN and ORA recommend that Applicants be required to:

4. Maintain a five-year rate freeze for residential and small business basic local exchange services, include 1FR, 1MR, 1MB customers. ORA adds residential inside wire maintenance plans to the list of services.

5. Make the above services available to consumers on a stand-alone basis without any requirement to purchase other bundled services.

6. List the separate availability of these services prominently (noting that there is no requirement to purchase other bundled services) in their phone books and in any advertising on Web sites or through bill inserts.

7. Retain a pricing option for California-jurisdictional long-distance calling that does not have any minimum monthly charge or fee.

Underserved consumers, including low-income, minorities, and those with disabilities are particularly concerned about the trend of companies offering telecommunications services in bundles to residential consumers, and the resulting impact on the affordability of basic phone service. Because consumers with disabilities are disproportionately represented among low-income consumers, they have a particular interest in ensuring that basic and affordable telephone service will be provided by the new entity. To effectively serve the disability community, the new merged entity must ensure that the increased marketing of bundled services does not inflate the price of basic service, which low income individuals, including people with disabilities, may prefer.

We shall adopt the recommendation of ORA and TURN for a five-year cap on the residential and small business basic exchange services, including inside wire maintenance plans, as identified above. By adopting this recommendation, we will mitigate the risk that residential and small business ratepayers would have their rates increased to pay for the short-term implementation costs of the merger. This adopted measure is thus necessary to provide assurance that ratepayers realize merger benefits over the short term, rather than being at risk for rate increases to pay for the merger. We shall also adopt the recommendations to make these basic services available on a stand-alone basis, to separately list the service in their web sites and through bill inserts, and to retain a pricing option for long-distance calling with no minimum monthly fee. These conditions shall remain in effect during the five-year rate cap period.

¹⁹ ORA witness Selwyn pointed out that the existence of risks diminishes the potential value of a particular outcome. Any attempt to quantify the effects of soft benefits, must take into account both the likelihood of the benefit not occurring and the likelihood of a risk offsetting the benefit. (Ex. 126C, pp. 42-43, ORA/Selwyn.)

²⁰ . See, e.g., Wendy Carlin, et al., A Minimum of Rivalry: Evidence from Transition Economies on the Importance of Competition for Innovation and Growth, Contributions to Economic Analysis & Policy, Vol. 3, Number 1, 2004, Article 17, cited in Ex. 126C, ORA/Selwyn.

²¹ SBC Press Release, January 31, 2005.

²² Applicants claim the underlying data supporting the synergy calculation is confidential, as contained in Applicants' Supplemental filing, Exhibit 1.

²³ These amounts are expressed in beginning-of-year 2005 dollars. TURN recommends that they be adjusted to beginning-of-year 2006 dollars to compute the correct basis for any payments to California ratepayers, which would not begin until calendar year 2006. Ex. 135C, Kientzle Reply Testimony, pp. 9-10, Revised Exhibit ERYK-2, Revised Exhibit ERYK-4, and Exhibit ERYK-5. ORA concurs, and SBC apparently does as well. Ex. 46C, Kahan Deposition Transcript, pp. 164-166.

²⁴ Ex. 126C, Reply Testimony of Lee Selwyn, p 62.

²⁵ Ex. 136C, Reply Testimony of Terry L. Murray, p 41.

²⁶ Ex. 127C, Reply Testimony of Hillary Thompson, p 11; Ex. 135C, Reply Testimony of Elizabeth R. Y. Kientzle, pp 5 and 9.

²⁷ Ex. 136C, Reply Testimony of Terry L. Murray, p 46.

²⁸ Ex. 126C, Reply Testimony of Lee Selwyn, p 13; versus the definition of "short-term" which is the transition period during which the combined company is being reorganized and restructured so as to implement the merger activities.

²⁹ Ex. 136C, Reply Testimony of Terry L. Murray, p 40, citing Kahan Exhibit 2; SBC Response to ORA 12-2.

³⁰ Opening Brief of Joint Applicants, p 46, citing Tr., vol. 13, at pp. 2068-2070, SBC/Aron.

³¹ Tr, vol. 14, at pp. 2202-04, ORA/Selwyn.

³² Ex. 127C, Reply Testimony of Hillary Thompson, p 11.

³³ Ex. 127C, Reply Testimony of Hillary Thompson, p 11; Ex. 135C, Reply Testimony of Elizabeth R. Y. Kientzle, p 9.

³⁴ We adopted a settlement, and found five years reasonable for the GTE/Contel merger. (D.94-04-083, 54 CPUC2d 258 (1994).) We found 5.6 years reasonable for the SBC/Telesis merger. (D.97-03-067, 71 CPUC2d 351.) We found five years reasonable for the Pacific Enterprises/Enova merger. (D.98-03-073.)

³⁵ A six-year period is in keeping with the SBC/Telesis time frame, rounded to the nearest whole year.

³⁶ Ex. 127C, Reply Testimony of Hillary Thompson, p 12.

³⁷ Ex. 136C, Reply Testimony of Terry L. Murray, pp 48-49.

³⁸ Ex. 136C, Reply Testimony of Terry L. Murray, p 49, citing D.00-03-021, 2000 Cal. PUC LEXIS 211, *36.

³⁹ Ex. 136C, Reply Testimony of Terry L. Murray, p 49.

⁴⁰ Ex. 136C, Reply Testimony of Terry L. Murray, p 50, citing P.U. Code Section 854 (b)(2), emphasis added.

⁴¹ Id.

⁴² Ex. 136C, Reply Testimony of Terry L. Murray, pp 50-51.

⁴³ Ex. 127C, Reply Testimony of Hillary Thompson, p 12.

⁴⁴ Ex. 127C, Reply Testimony of Hillary Thompson, p 8.

⁴⁵ Ex. 127C, Reply Testimony of Hillary Thompson, p 8.

⁴⁶ Kahan, Ex. 44, pp. 20-21.

⁴⁷ "Fully loaded" means that such costs as mileage reimbursement and lodging costs were incorrectly included in the base salary.

⁴⁸ D.04-09-061, mimeo., pp. 84-85.

⁴⁹ ORA Opening Brief, p. 23.

⁵⁰ Rice (JAs) 10 Tr. 1395.

⁵¹ ORA Opening Brief, p. 22.

⁵² Johnston (ORA) 14 Tr. 2249-2250.

⁵³ TURN Opening Brief, p. 43.

⁵⁴ TURN Opening Brief, p. 43.

⁵⁵ Kahan (JAs) Ex. 46C, p. 288.

⁵⁶ In re Vonage Holdings Corp. Petition for Declaratory Ruling Concerning an Order of the Minnesota Public Utilities Commission, Memorandum Opinion and Order, FCC 04-267, WC Docket 03-211, ¶ 14 (rel. Nov. 12, 2004) ("Vonage Preemption Order") (ruling that the characteristics of some IP-enabled services "preclude any practical identification of, and separation into, interstate and intrastate communications for purposes of effectuating a dual federal/state regulatory scheme" and that such services are exclusively jurisdictionally interstate).

⁵⁷ Kahan deposition at 69.

⁵⁸ Id. at 69, 82.

⁵⁹ Id. at 79-82.

⁶⁰ Id at 79-82.

⁶¹ Id. at 68-76.

⁶² Ex. 136C, Reply Testimony of Terry L. Murray, pg 28, referencing D.00-03-021, pg. 35, which found that "[t]here can be no reasonable doubt that revenue synergies are an economic benefit" when considering the proposed Bell Atlantic/GTE merger; D.97-03-067, pg. 49, which, disagreeing with SBC, found that "capital savings will accrue as a result of the merger" when considering the proposed SBC/Pacific Telesis merger.

⁶³ Ex. 136C, Reply Testimony of Terry L. Murray, p 28.