Jerome K. Blask*

In 1982, the Federal Communications Commission commenced licensing cellular radio service, the first serious challenge to the plain old telephone's inherent physical limitations. The FCC initially granted cellular licenses by the most antiquated, time-consuming and intellectually incoherent of its license assignment methods--comparative analysis, that is, the attempt to select among mutually-exclusive applicants for the same license the applicant who could best serve the "public interest." The futility of ranking competing applicants on promises concerning service coverage, system expansion, rates, and so on was quickly self-evident. Having established in 1983 rules to assign licenses by lottery (as Congress mandated), the FCC gladly abandoned comparative hearings in 1984, and for the rest of the 1980s and the early 1990s the agency raffled off its cellular licenses.

Only in 1993 did Congress bestow upon the Commission the auction authority long advocated by those seeking to make the market the arbiter of who gets FCC spectrum. Availability of auction authority converged with development of an all-digital cellular-like service dubbed PCS (Personal Communication Service). The FCC began holding auctions for more than 2000 PCS licenses.

The advent of PCS auctions, coupled with auctions for other wireless and satellite services, prompted some observers to declare victory. The recent decision by the Commission's Wireless Telecommunications Bureau (WTB) involving NextWave Personal Communications, high bidder for 63 "C" Block PCS licenses, shows that the FCC auction, while vastly superior to comparative hearings and lotteries, can be substantially improved. Indeed, the NextWave decision reveals that, even with auctions, the government retains substantial discretion over licensing decision, generating controversy even when the auction outcome is affirmed. In the NextWave decision, the government's desire for billions in auction revenue may have caused it to inadequately enforce statutory and regulatory qualification requirements, however anachronistic, with which all FCC applicants are supposed to comply.

Throughout 1996, NextWave submitted high bids totalling roughly $6.3 billion for licenses to construct and operate PCS systems in 63 areas. In devising these "C" Block auctions, the Commission was obligated by statute to mitigate the discrimination Congress perceived small business and others encountered in the market, particularly the capital market. Small businesses, women, and minorities received special benefits under the PCS rules; the preferences for women and minorities, however, were suspended in response to the Supreme Court's decision in Adarand Constructors, Inc. v. Pena.

Under these special rules, an applicant together with its affiliates and certain investors must have gross revenues of less than $125 million in of the last two years and total assets below $500 million to participate in "C" Block auctions. To encourage passive investment in applicants, the Commission insulted from attribution revenues and assets of investors who: (i) held less than 25 per cent of an applicant's total equity and (ii) were excluded from an applicant's "control group." In addition, a small business applicant could avail itself of a 25% bidding credit, and pay out the amount bid over the license terms with interest only (at a preferential rate) for the first six years, if it and its attributable investors and affiliates had less than $40 million in gross revenues, while no individual attributable investor or affiliate had $40 million or more in personal net worth. NextWave claimed eligibility for these small business benefits.

Even assuming that capital markets discriminate against small business, these detailed and arcane qualification rules severely compromised the advantages--ease of participation, speed and certainty of outcome, minimal government intrusion in the overall process--that compelled adoption of auctions in the first place. The financial benefits offered to applicants satisfying the Commission's definition of "small business" entice applicants to scrutinize every nuance, ambiguity, and loophole in the definitions to secure these windfalls with minimal or superficial compliance. One result is the emergence of entities like NextWave, in the FCC's view a "small business" in spite of its real world commitments to finance its obligation to pay the U.S. Treasury $4.7 billion in high bids (75% of $6.3 billion) over a ten year term while simultaneously funding construction and operation of PCS systems in 63 areas.

Considering the contortions that an entity like NextWave must endure to demonstrate that it is a small business despite its multi-billion dollar commitments, it is hardly surprising that "interested parties" (auction losers) exercised their statutory rights to challenge NextWave's qualifications in an effort to invalidate the 63 auctions where NextWave prevailed. Nor is this the first time a "C" Block auction resulted in a challenge to the winner's qualifications. This litigation is a strong sign that the Commission's preferential auctions are conceptually flawed and need to be replaced by traditional auctions procedures that avoid preferring certain bidders over others.

In NextWave's case, disappointed participants in certain "C" Block auctions assailed NextWave's compliance with the Commission's affiliation, attribution and foreign ownership requirements. These issues are discussed below.

Affiliation

The petitioners first argued that NextWave could not qualify for small business preferences on the ground that NextWave was affiliated with Qualcomm, Inc., an affiliation that would fail the $40 million gross revenue test. In fact, NextWave's founder and majority owner of Series A stock was a former Qualcomm executive and board member. Three other NextWave senior executives were formerly associated with Qualcomm. In addition, the boards of the two corporations share a common member, and qualcomm is entitled to a seat on NextWave's board. Qualcomm is supplying its patented CDMA technology to NextWave and has financed NextWave with loans and equity investments.

The WTB rejected these allegations, noting that the Commission, in adopting PCS rules, declined to adopt a Small Business Administration rule that presumes affiliation whenever principals from one entity organize a new entity in a similar field and serve as principals in that new entity, with the old entity providing the new entity with subcontracts, financial or technical assistance. The WTB held that the relevant test is control, and there was no "concrete evidence" that the NextWave arrangements amounted to control. Similarly, the WTB held that the contractual relationships between the two entities failed to show that one concern was dependent on the other to such a degree that one had effective control over the other.

These conclusions appear reasonable. But the WTB was sufficiently concerned about the contractual relationships between NextWave and Qualcomm to require submission of their various agreements. When NextWave filed the documents in redacted form, petitioners urged full disclosure, arguing that text omitted from one agreement could show that purchase of CDMA technology was essential if Qualcomm were to achieve sufficient economies of scale to enable CDMA to compete with other technologies. The WTB denied the request in a footnote, ruling that even if true, petitioner's theory failed to establish a control relationship between the two companies. This determination appears excessively narrow (even assuming petitioners failed to use the magic word "control"). If Qualcomm were relying entirely on NextWave's purchase of CDMA to launch this new service, the level of dependency between the two entities would be high and could amount to control. These considerations, however, are nowhere explored in the WTB decision.

Attribution

The petitioners also contended that the assets and revenues of two investors, Qualcomm and Pohang Steel of America Corporation ("POSAM") should be attributed to NextWave, thus subverting its "C" Block eligibility. As mentioned above, a passive investor can avoid attribution if the investor holds less than 25 per cent of an applicant's total equity and is excluded from an applicant's "control group." Since neither Qualcomm nor POSAM met the 25 per cent test with respect to NextWave's parent, NextWave Telecom Inc. (NTI), the WTB's analysis of the attribution claims rested on whether either investor exerted de facto control over NextWave or deprived NextWave's control group of de facto authority over the company.

The WTB quickly determined that these investors lacked sufficient rights to exercise control. The investors were Series B shareholders in NTI with the right to vote for a minority of the board of directors and, for some investors, to a seat on the board. These shareholders enjoy other rights identified by the WTB only as rights "of the kind the Commission has said generally do not amount to de facto control. . ." Finally, the WTB noted that NTI and POSAM had agreed to that POSAM could veto any equity investment in NTI by any other Korean investor prior to any qualified public offering by NTI. The WTB held that this limitation on NTI's discretion was insignificant because it involved only Korean investment and, as a result of the determination that NTI had exceeded the foreign ownership benchmark in Section 310 of the Telecommunications Act, discussed in the next section, it was unlikely that there would be any foreign investment for the foreseeable future.

Foreign Ownership

The WTB was most preoccupied by the allegation that NextWave had failed to abide by limits on foreign ownership. Section 310(b)(4) of the Telecommunications Act allows the Commission to decline a radio license to corporations directly or indirectly controlled by corporations in which more than 25% of the stock is owned or voted by aliens or foreign corporations. In its long form applications, filed after the auctions, NextWave asserted that total foreign ownership of NTI's capital stock was less than 23 per cent. The WTB noted, however, that foreign investors paid a higher percentage of capital into NTI for a lesser proportion of NTI's issues and outstanding stock; as a result, the WTB examined foreign capital contributions as well as actual stock ownership.

The WTB analysis centered on two NTI debt instruments--Convertible Promissory Notes and Convertible Senior Subordinated Notes--to determine whether they were bona fide debt or really equity. Relying on standards developed for federal tax law, the WTB unequivocally concluded that both instruments were equity for a number of reasons, including: NTI's ability to avoid paying interest on the entire principal amount of the debt; the debt's junior level; NTI's high debt-equity ratio (minimizing the likelihood of repayment in the event of a business loss); and the improbability that a prudent commercial lender would extend a loan with such a low interest rate (6%). Characterizing the two debt instruments as equity results in about 30% of NTI's total shares outstanding being foreign-owned; at the same time, the percentage of foreign capital paid into NTI increases to almost 40%. Because both benchmarks substantially exceed the statutory threshold, WTB concluded that NextWave violated Section 310(b)(4).

The certainty of its conclusion notwithstanding, the WTB held that the 310(b)(4) violation did not warrant dismissal of NextWave's PCS applications and reauction of the underlying licenses. Rather, the WTB issued the licenses to NextWave on condition that the NTI conform its capital structure to section 310(b)(4) within six months.

Three aspects of the WTB's justification for this decision deserve comment. First, the WTB contends that, in contrast to cellular lottery applications, the Commission expressly declined to adopt a "letter perfect standard" for PCS applicants because the "up-front" payment required of auction applicants and the 10% downpayment required of auction winners "act as a built-in mechanism to screen applicants and deter speculative or unqualified bidders." But the petitioners never alleged that NextWave engaged in speculation or was otherwise insincere. Rather, they established that NextWave violated well-established legal requirements--e.g. Section 310(b)(4)--and reaped an unfair advantage in the selection process.

Second, the WTB stresses that NextWave met its up-front payments without funds from either of the debt instruments that were ultimately classified as equity. This same analysis was conspicuously absent with respect to NextWave's downpayment of $420 million (10% of $4.2 billion). Thus, the WTB never considers whether NextWave would have defaulted on some or all of its winning bids but for foreign capital contributions in excess of the 310(b)(4) benchmark.

Finally, the WTB ruled that there was no "reliable evidence" that in devising its capital structure NextWave "deliberately attempted to deceive the Commission or evade its rules." At the same time, however, the WTB acknowledged that NextWave never provided information concerning the percentage of foreign dollar contributions in NTI's capital structure in its long form PCS applications, because NextWave unilaterally concluded that data quantifying NTI's foreign capital was irrelevant to the section 310(b)(4) determination. This data was supplied only in response to claims by the petitioners and a specific letter of inquiry that the WTB served on NextWave.

In a highly publicized decision in 1995 (Fox Televisions Stations, Inc.) the Commission ruled that applicants were obligated to inform the Commission whenever an ownership structure under consideration could exceed the 310(b)(4) benchmark. Failure to make that disclosure could raise issues regarding the applicant's candor. NextWave appears to have violated the rule in Fox without consequence, casting doubt on the uniformity with which Commission policies are enforced.

The WTB deserves credit for analyzing and resolving the difficult issues raised in the NextWave case. Nevertheless, the decision illuminates the pitfalls of fashioning an auction that extends substantial benefits to certain preferred bidders and begs the question whether the FCC relaxes its enforcement scrutiny for "small businesses" that promise to pay the U.S. Treasury $4.7 billion.

* Jerome Blask is a partner at Gurman, Blask, and Freedman, Chtd.