International intrigue

All eyes are on the big foreign providers as they prepare to take the U.S. by storm. But the fate of these uber-mergers has as much to do with politics and foreign policy as it does with telecom

Observers of the international telecom soap opera recently breathed a small sigh of relief after Deutsche Telekom ended almost a year of speculation last month by announcing its plans to buy VoiceStream Wireless to gain a much-needed foothold in the rich U.S. market.

Learning how the German telco giant plans to begin its venture into the U.S. ended months of suspense, but the global telecom plot immediately generated other twists.

The focus of the next episode: Will the U.S. - the self-appointed bastion of free trade and competition - risk years of trade progress and block the $50.7 billion deal, or will it approve the merger amid cries that DT has an unfair competitive advantage? And what will be the fate of Japan-based NTT Communications' $5.5 billion bid to buy Verio, a Colorado-based Web hosting company?

Regardless of the outcome, intrigue undoubtedly will continue to characterize the storyline, which already has featured catcalls, power plays, veiled and unveiled threats, alleged double-crosses and even a touch of espionage.

The stakes are extremely high, especially for the shareholders, employees and executives of the huge service providers involved. Yet despite their immense size, the companies are only a subplot to the big story: the future of the World Trade Organization's telecommunication commitments - and the integrity of the WTO itself.

Be assured the world will tune in, watching intently to see the outcome.

Dawn of the open market

It wasn't always this complicated. For most of its life, the telecom industry has been governed by relatively straightforward policies because almost every country was served by a monopoly.

In the U.S., of course, this changed with the breakup of AT&T in 1983. Meanwhile, the rest of the world continued to be served by monopolies - primarily government-owned. This fact became increasingly frustrating for U.S. telecom concerns trying to conduct business overseas. In addition to regulatory headaches, many met resistance in the form of high interconnection fees, problematic right-of-way policies and a general lack of urgency when seeking cooperation from foreign governments or incumbent telcos.

After passing the Telecommunications Act of 1996, the U.S. pushed for similar reforms in other countries. Negotiations at the WTO were intense - the U.S. contingent even walked out at one point - but they eventually resulted in an agreement that U.S. representatives said mirrored the Telecom Act.

"I am... very proud that, under the able leadership of [U.S. Trade Representative] Charlene Barshefsky, the United States has pioneered a new export industry - what might be called the `competition in telecommunications' industry," then-FCC Chairman Reed Hundt told a House subcommittee after the deal was finalized.

"The deal that Ambassador Barshefsky negotiated on behalf of the American people accomplishes just that - it exports the American idea of open markets and fair rules of competition to 68 of our nation's largest trading partners, which together account for more than 95% of global telecom revenues."

This agreement largely opened worldwide markets to U.S. telecom concerns seeking a global presence. Now, companies from these markets want access to the U.S. But those with the capital to enter the rich U.S. market still have significant vestiges of their government ancestry, which is largely prohibited under U.S. statutes.

Yet the law is not new; it was on the books when the U.S. pushed for the WTO agreement. And critics say that the U.S. had to know that no other country would have signed the deal if it believed their major telecom companies would not be allowed to compete in the U.S.

How the sticky issue will be resolved is unknown. But one thing appears to be decided: The days of two companies making a large telecom deal with only passive oversight by regulators is over. Telecom deals are among the most scrutinized by regulators; more significantly, telecom issues also have become prime leverage points in major trade negotiations worldwide.

"Communications used to be a telecom issue; engineers were the only ones who could talk about it," says Rudy Baca, global analyst for The Precursor Group. "Today, it really is trade driving communications policy."

Casting call

The players involved in these deals are among the largest telecom concerns in the world, as are some of the other foreign carriers that are expected to make a bid for U.S. acquisition (Tables 1 and 2).

These providers are not household names in the U.S. because their operations were limited to their own countries until the last few years. Their ability to succeed in their home markets has largely dictated their ability to make a bid in the rich U.S. market.

As is the case with any vacationer, it is easier to travel abroad when the house is in order.

In fact, disruption on the homefront likely is a reason one of the world's largest carriers - Telefonica of Spain - is not mentioned in speculation regarding potential buyers of U.S. carriers.

Telefonica has plenty of money and an interest in the U.S. - in fact, it recently agreed to purchase Lycos for $12.5 billion - but it is hampered by internal problems.

The company has seen several attempts to buy other European carriers fail, the most notable being its well-chronicled bid this spring to merge with KPN Telecom of the Netherlands. According to news reports, the merger unraveled because of opposition from the Spanish government, which does not own Telefonica stock but retains a "golden share" that allows it to veto major moves.

The opposition revolved around the Dutch government's 44% stake in KPN, which would have meant that the Dutch government would have a greater financial interest in the potential combined company than the Spanish government. The circumstances reportedly generated considerable friction between the Spanish Prime Minister Jose Maria Aznar and Telefonica Chairman Juan Villalonga.

Since the deal fell apart, the European Commission has taken the Spanish government to court over its golden stake. Meanwhile, Villalonga resigned two weeks ago amid accusations of illegal insider trading prior to Telefonica signing an alliance with MCI WorldCom in 1998. Villalonga's successor is Carlos Alierta.

Although not surrounded by resignation rumors, DT's Ron Sommer is another high-profile CEO who reportedly is under pressure because of failed deals.

DT has an acquisition war chest of more than $100 billion, but this blessing carries expectations that major deals will be completed - something Sommer has failed to accomplish during his tenure at DT. While late offers for Sprint last year and Qwest Communications this year were not realized, he was most criticized for DT's botched attempt to buy Telecom Italia last year.

France Telecom has finished several significant purchases recently, the most notable being its $38 billion buy of Orange, the U.K.-based mobile operator. Combined with the fact that it is not as cash-rich as DT, many analysts point to France Telecom's expensive spending as its greatest obstacle to making a bid for a U.S. carrier - the company already has too much debt to make another large buy, according to critics.

Too much debt is not a problem for NTT. As the world's largest telecom company, NTT has the money and the desire to enter the rich U.S. market, but it must resolve a number of internal issues before it can consider making an outright purchase of a U.S. carrier.

Most issues involve the structure of the service provider. A former state-owned monopoly, NTT remains majority owned by the Japanese government, which has dictated several restrictions that limit the telco's ability to compete globally. In fact, NTT was prohibited from pursuing deals outside Japan until last year. Even with that restriction lifted, NTT is limited because it is not allowed to sell stock as part of the financial package used in an acquisition. As a result, NTT must make all-cash offers such as the $5.5 billion bid made by its international arm for Verio.

With only cash at its disposal - albeit a great deal of it - NTT cannot make an outright purchase of a large operator. Of course, the company's strategy has been to gain access into global markets via purchases of smaller stakes in carriers, such as its deal with KPN, which followed the collapse of the Telefonica deal.

U.S.: Gateway or roadblock?

Each of these foreign carriers has the resources to bid for a carrier in the U.S., which prides itself on being the world's most open market. Whether the rest of the world agrees with this perception likely will depend on actions in the next year, as telecom companies seeking global presence find themselves being used as pawns in a high-stakes chess game of world trade negotiations.

The first volley fired in this arena was NTT's bid for Verio. Although not subject to FCC review, the bid has been scrutinized heavily in the U.S.

First, a group of seven Republican congressmen asked the Clinton administration to intervene, saying that NTT should not be allowed to buy a U.S. telecom company until Japan opened its telecom market. U.S. officials had long asserted Japan was not a competitive market because NTT charged other carriers exorbitant fees to use NTT lines - two to five times more than the interconnection rates in other G-8 countries.

Rep. Chip Pickering, R-Miss., reportedly said that the request to the Clinton administration was not designed to stop the NTT/Verio deal, but to give U.S. trade representatives a bargaining chip in trade negotiations with Japan.

Officially, the Clinton administration never responded, but soon it became public that the FBI was investigating the NTT/Verio deal on the basis of national security concerns (Telephony, July 24, pages 8 and 9). Reportedly, the FBI was worried that it would not be able to conduct surveillance of U.S. Internet traffic through an NTT-owned Verio.

News that the NTT/Verio merger might be in jeopardy seemed to spark Japanese officials' interest in negotiating a reduction in NTT's interconnection fees. After weeks of intense negotiations, Japan agreed to lower NTT's interconnection fees by 20% for local lines and by 50% for regional lines.

"[In Japan] we're going to see U.S. deregulation, Part II," says Ron Westfall, senior analyst for Current Analysis. "What it is is a foundation.... But you've got to start somewhere, and it's finally coming to fruition in terms of NTT.

Bill Hahn, a research analyst for Dataquest, also sees an important parallel between telecom deregulation in the U.S. and Japan: Do not expect an incumbent - in this case, NTT - to be particularly helpful to competitors.

"[NTT] can treat the other carriers as customers or as competitors; they've chosen to treat them as competitors," Hahn says. "They're still going to resist it; that's what they've done in the past - and that's not unusual for an incumbent."

The NTT/Verio deal did not influence negotiations with Japan in the agreement, Barshefsky said. But most industry observers believe that the U.S. must drop opposition to the Verio buyout for the new accord to retain any legitimacy.

"This may close down the [U.S.] government initiative outside the FCC [regarding the NTT/Verio deal]; after all, Japan can say they did what was asked," says Dataquest analyst Ron Cowles. "The next time this will come up again is if NTT tries to buy a U.S. carrier - not a Web hosting company but an actual carrier. Then, all bets are off."

It's not over yet

Indeed, higher-level politics are expected to influence the outcome of DT's bid for Voice-Stream. For more than a month, U.S. and European officials exchanged threatening messages regarding the possibility of DT or another major European carrier buying a U.S. operator.

In fact, many observers believe this political environment caused DT to pursue VoiceStream in the first place. The consensus among analysts is that the best business deal for DT would be to buy Sprint, whose recent merger attempt with WorldCom collapsed. After all, DT already owns 10% of Sprint, and the Kansas-based telco boasts desirable data, wireless and long-distance assets that would fit well into the German telco's global strategy.

"Sprint represents the last coherent operation for a foreign operator to buy to enter the U.S. market," says Stephen Kamman, telecom analyst for CIBC World Markets.

But it soon became apparent that a play for Sprint would not be easy. As soon as speculation surfaced about the possibility of DT buying Sprint, a bill that effectively would block such a deal was introduced by Sen. Ernest Hollings, D-S.C.

The bill, and a subsequent letter to FCC Chairman William Kennard that was signed by 30 senators, opposes the transfer of U.S. licenses to companies that are more than 25% owned by a foreign government. A federal statute prohibiting such action exists, but the FCC can waive this prohibition if it is considered to be in the public interest. The FCC has waived the statute in cases in which the provider is based in a country that signed the WTO's telecom agreement in 1997.

Noting that DT's entrance into the U.S. market would be unfair to domestic carriers - "You can't compete with someone who can print money" - Hollings seeks to close this waiver power with his legislation. "They're not going to get a license here," Hollings says. "That's why I've been writing all these letters, so I can save them the money."

In a carefully worded response, Kennard said he agreed with Hollings that the FCC must seek to "promote competition and maintain a secure telecommunications system for our national security." Kennard promised to consider the senators' concerns that such takeovers would thwart competition in the U.S. market, threaten national security and conflict with existing law.

"While it would be inappropriate for me to prejudge the outcome of a hypothetical transaction, I assure you that I would give close scrutiny to any merger involving foreign government-controlled providers," he wrote in a letter to Hollings.

After watching previous deals unravel, such political interference was not what DT needed. Cowles does not believe Hollings' bill will become law, but he acknowledges that the firestorm may have "spooked" officials for the German telco.

Combined with the fact that Sprint was not eager to be involved in yet another deal wrought with government scrutiny, DT's decision to look elsewhere is understandable.

The irony of free trade

Instead of bidding on a high-profile U.S. carrier, DT set its sights on VoiceStream, the largest GSM wireless operator in the U.S., but only the eighth-largest in the country.

"There's no doubt in my mind that the regulatory and political scrutiny associated with Deutsche Telekom buying someone like VoiceStream - while it wouldn't be insignificant - would not be as difficult as it would if they tried to buy someone like Sprint," says Mitchell Brecher, a shareholder in the law firm of Greenberg Traurig and a former FCC attorney.

Attempting to merge with a smaller telecom player should help the German telco navigate the political and regulatory hurdles established by those who did not want a premier U.S. company such as Sprint to be owned by a foreign government-controlled company.

A smaller deal does not change the impact of U.S. law in its scrutiny, however. Although the German government's stake in DT would be reduced to 45% if the VoiceStream acquisition closes, it remains well above the 25% limit.

Thus, the U.S. government has legal grounds to justify blocking the deal. But such an action likely would have severe consequences in the world trade arena.

"There are some ironies here," Brecher says. "The U.S. has been at the forefront of encouraging other countries to sign the WTO agreement.

"But free trade has to be a two-way street, doesn't it? [If a foreign government-controlled group has a U.S. buy blocked by regulators,] I suspect the U.S. would be defending itself before the World Trade Organization in a trade dispute."

Indeed, the threat already has been made. Amid complaints from European and German officials, European Commissioner for Trade Pascal Lamy wrote a July 24 letter to Barshefsky warning that the European Union would "obviously face strong pressures to react" to any attempt by the U.S. to block mergers such as the DT/VoiceStream deal.

"I therefore urge you to resist such legislation and indicate clearly to Congress the opposition of the U.S. administration to its adoption and, if necessary, the firm intention of the president to veto any such legislation," Lamy wrote to Barshefsky. "We have to avoid a very damaging trade fight in this highly important sector."

With this in mind, Baca believes the DT/VoiceStream merger will be approved. "This is going to get done, eventually," Baca says. "The timing is problematic, and the scope could change, but I think it will be approved."

Indeed, global political realities mean the negotiated WTO agreement carries more weight than any domestic U.S. law, says Scott Cleland, an analyst for The Precursor Group.

"We're talking about a free-trade, Republican Congress and free-trade Clinton administration," Cleland says. "Blocking a deal like that would reverse 20 years of progress."

As telecom firms try to establish their global presence, proposed deals have to survive the increasingly tangled web of worldwide political scrutiny. The political spotlight on Deutsche Telekom's $50.7 billion bid for VoiceStream Wireless seems to get brighter every day. And ultimately, the glare may threaten completion of the deal.

Leading the effort to block the deal is Sen. Ernest Hollings, D-S.C. He has introduced a bill to remove the FCC's ability to waive a statute that prohibits U.S. licenses - such as VoiceStream's wireless licenses - from being owned by companies controlled by a foreign government.

Hollings and many other U.S. officials believe telecom companies with significant ownership by foreign government should not be allowed to buy U.S. carriers. These foreign telcos have an unfair competitive advantage because the revenue streams in their home markets are protected through the regulatory efforts of the same governments that own them, Hollings says.

"My objection is not to competition or foreign competition but to foreign government," he says. "[DT] picked up $14 billion in a bond issue. They never would have raised that much if they were a private company. But since they are backed by the government..., [the bonds] are like T-bills."

With the German government owning 59% of DT, the German telco essentially can "print money," allowing it to spend more than $22,000 per VoiceStream subscriber - a price that is effectively unattainable for a U.S. company, Hollings says."We're really trying to continue the competition, but you can't c ompete with the government coming in," he said during a recent verbal exchange on the Senate floor.

"If they're going to allow that, I'd vote that... we go over there and take over China's communications. If we can take over China's communications, we can cut the defense budget in half. They wouldn't know what to do or how to do it. We'd be in charge over there in Beijing."

In addition to his Senate bill - mirrored in the House by a bill sponsored by Reps. John Dingell, D-Mich., and Edward Markey, D-Mass. - Hollings has written several letters to FCC Chairman William Kennard on the matter, including one letter signed by 30 other senators. Kennard promised to consider the senators' concerns.

These events were not well received in Europe. Officials for the European Union and the German government have threatened to initiate World Trade Organization sanctions against the U.S. if the DT/VoiceStream deal is blocked.

But Hollings says European critics have no grounds for such action, noting that Italy blocked DT's effort to buy Telecom Italia last year.

For its part, DT is maintaining a relatively low profile on the matter. However, the German telco notes that the German government has just one member on the company's executive board, plays no role in day-to-day operations and does not have a "golden share" that would give it veto power on major strategy decisions. It also claims that the German market is open.

Perhaps the most intriguing wrinkle in the argument is just hypothetical now.

DT Chairman Ron Sommer reportedly suggested he would consider bidding soon for another telecom company - not necessarily in the U.S. - if the right deal was available.

As strange as it might seem, this strategy could benefit DT's standing with U.S. regulators. Because large acquisitions are made by selling stock, buying a large telecom firm would provide the German government with an avenue to sell more of its stake in DT - the sticking point in the VoiceStream deal.

While the U.S. threshold for designating a company as government controlled is a 25% stake, there seems to be some uncertainty about when this measurement is considered.

For example, DT is 59% owned by the German government, but that stake would be reduced to 45% upon completion of the VoiceStream deal - still well above the 25% threshold. But what if DT makes acquisitions to fill its data and Internet needs that, when combined, would drop the government's share below 25% when all the deals are closed?

An FCC spokeswoman said she does not know of any policy dictating when the 25% threshold is con sidered - at the time of the FCC filing, during application updates or at the time of closure for the proposed deal, or deals.

If FCC commissioners interpret the law to allow the last scenario, a large DT purchase such as Qwest Communications or Sprint - or a combination involving possible targets such as Global Crossing, Level 3 Communications and Cable & Wireless of Britain - could reduce the German government's share in DT below the 25% mark, making the government-ownership issue moot.

Hollings' interpretation of the law is that such a tactic should not allow DT to skirt the foreign government-ownership regulations in the U.S., but he acknowledged the notion is being discussed.

"Oh yeah, these lawyers on K Street are trying everything under the sun."