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Upon Further Review

Progress Snapshot
Release 3.18 December 2007

by W. Kenneth Ferree*

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It is time to throw the red flag. Several years ago, the FCC was asked to approve the acquisition of DIRECTV, a program distributor, by News Corporation, which has interests in a number of high-value programming channels, including regional sports networks ("RSNs"). In its Order approving the transaction, the FCC imposed a government-mandated arbitration process for disputes involving those high-value programming channels and distributors that compete with DIRECTV. That mechanism, which was crafted to address a specific and well-articulated set of competitive concerns, was a departure for the FCC. Unfortunately, it is fast becoming a refuge for importunate, but unsatisfied programmers, opportunistic politicians, and captious consumers.

Most recently, the NFL has suggested that the FCC should impose mandatory arbitration on cable operators who will not otherwise agree to the terms of carriage upon which it insists for the NFL Network. The FCC's original narrowly-tailored arbitration remedy, it appears, was only the nose of the camel under the tent - the "camel" in this case being regular government intervention into the programming market. It's time to call for a replay review.

Although the Commission has long enforced a set of statutorily-defined program access rules, which forbid exclusive agreements and certain other discriminatory practices involving satellite-delivered, vertically-integrated programming, the government generally has not otherwise injected itself into contract negotiations between programming suppliers and cable or DBS service providers.

The discretion the government has shown has been a proven success. In the past ten years, the number of cable programming networks has grown from 145 to 565, while vertical integration has decreased (in 1996, nearly 50% of networks were vertically integrated, today less than 15% are). Simultaneously, competition in programming distribution has become a reality (DIRECTV and EchoStar are now the second and third largest distributors of video programming), and large communications companies like AT&T and Verizon have recently entered the video market in earnest.

Having said that, the programming market, like any other, can fail under certain circumstances. In the News-DIRECTV decision, the Commission found, following an exhaustive examination of the effects of foreclosure, that although permanent foreclosure was not likely to be a profitable strategy for a vertically integrated News Corp., temporary foreclosure of access to its RSNs could be profitable, allowing it to drive subscribers from rival distributors to DIRECTV. That is, losses that News Corp. might suffer during the withholding period could be more than offset by gains in DIRECTV subscriber fees.

There were important analytical bases for that conclusion. First, the FCC found that the temporary foreclosure strategy would work only for programming services with the most high-value content. Based on data from prior cases, the Commission concluded that, for the vast majority of program services, subscribers simply will not suffer the transactions costs associated with changing distribution platforms when faced with the loss of a single programming service. Thus, losses incurred by a programmer that withholds its content from a distributor are normally unlikely to be recouped in any economic time frame (and of course, if the content is withheld permanently, losses will never be recouped).

RSNs, on the other hand, are (in the words of the FCC) "comprised of assets of fixed or finite supply - exclusive rights to local...sports teams and events - for which there are no acceptable readily available substitutes." Sports programming also may be differentiated from general entertainment programming in that it is extremely time-sensitive. There is no substitute for a playoff game on the day it is contested. As a result, owners of that content wield a significant amount of market power. When regional sports programming is withheld from a particular distributor, substantial subscriber defections to competing platforms may be expected.

Second, and importantly, for a temporary foreclosure strategy to be effective, the programmer must be able to reap the benefit of any subscriber defections that it can motivate. That is, the programmer must be vertically integrated with the competing distribution platform to which disaffected subscribers will flee.

It is fair to argue whether these conditions were met satisfactory to warrant imposition of a mandatory arbitration provision in the News-DIRECTV case. Whatever the merits of that initial decision, however, it at least cannot be gainsaid that the merged entity would have ultimate control of extremely high-value sports programming and a program distributor in the markets in which the programming was most highly prized. Recent efforts to extend the remedy adopted in that order cannot be sustained on that ground.

For example, last year, in an order approving asset transfers to Comcast and Time Warner as a result of the Adelphia bankruptcy, the FCC imposed mandatory arbitration to resolve an impasse between the cable operators and the Mid-Atlantic Sports Network ("MASN"), a non-vertically integrated RSN that owned the rights to, among other things, the Washington Nationals and Baltimore Orioles baseball games. Oddly, although the News-DIRECTV merger order was cited by the Commission as precedent for its decision, there was almost no similarity between the potential harms sought to be averted in the first case and the actual breakdown of market negotiations in the second.

Most obviously, the MASN case involved no foreclosure by a programmer - the potential harm sought to be remedied in the News-DIRECTV case. Instead, it was alleged, the distributors in the MASN case were engaging in what effectively became a lock-out. Indeed, because MASN owns no distribution facilities in the relevant region, there is no chance that it could have used temporary foreclosure to affect the downstream distribution market in its favor. Yet, we know from the FCC's findings in the News-DIRECTV case that RSN programming is highly valued by subscribers and that the failure to carry the programming will lead to subscriber defections. The only conclusion that can be drawn is not that there was a market failure or that there were anticompetitive forces at work, but that one party to the negotiations (the programmer in this case) simply was overreaching and demanding more than the programming was worth in the market.

The FCC, to its credit, recognized that the rationale for imposing the arbitration condition in News-DIRECTV was inapposite in the MASN case and stretched to articulate a new rationale by turning the old one on its head. The theory posited in the MASN Order was that, although the distributors would suffer considerable harm in the short term by locking out an unaffiliated RSN, they might do so in the hope that they someday could force the RSN out of the market, acquire the rights to carry the teams involved for their own vertically-integrated services, and then recoup earlier losses with rents from the new vertically-integrated services.

Without belaboring the point, there are reasons to question the plausibility of this potential scenario, not the least of which is that it is completely lacking in any analytical foundation. Yet even this dubious rationale seems now to have been cast aside, as the NFL Network and others seek arbitration whenever a cable operator will not agree to a programmer's demands. As the crescendo of the NFL season nears its climactic final weeks, there is growing concern among policy-makers and fans alike that a subset of the games will not be readily accessible for some because the NFL Network has exclusive rights to those games and it has not been able to reach agreement with several large cable operators for widespread distribution. The precise nature of the disagreement is largely irrelevant to this essay. What is clear is that this dispute does not involve facts that are analogous to those either in the seminal News-DIRECTV case, or the mutated step-child MASN case.

The NFL Network is not vertically integrated with any multichannel distribution platform and its programming is not of such regional interest as to render it vulnerable to a lock-out scenario such as that posited in the MASN Order. The NFL Network, to be sure, owns the rights to extremely valuable content. Indeed, the final game of the season for the New England Patriots, in which they may be vying for an historic undefeated season, will be available only on the NFL Network. The cost, then, to distributors who do not carry the network must be thought to be substantial. Indeed, because the network is carried on at least one national distribution platform (i.e., DIRECTV), disgruntled consumers have the option of changing service providers rather than miss their favorite teams or important games. But because the NFL Network lacks vertical integration, the circumstances are not like those in News-DIRECTV where one might fear that the NFL Network was engaged in temporary foreclosure in order to benefit its down stream properties.

Moreover, unlike the MASN case, it cannot plausibly be argued that the cable operators that have not reached terms with the NFL Network are trying to lock them out in an effort to drive them from the market and obtain access to the carriage rights for their own networks. There is no evidence to suggest that the network's lack of carriage on the cable systems in question poses any threat to its existence or, if it did, that the cable operators would have any realistic chance of obtaining the rights to the underlying content.

That is, once again, the natural and logical conclusion from the facts presented is not that there is a market failure requiring government intervention, but rather that the NFL Network simply has insisted upon rates and terms that the market will not accommodate. It is fair to be sympathetic to the consumers who subscribe to cable systems that have not acceded to the NFL Network's demands, but that sympathy is not a basis for regulatory intrusion into negotiations between large, commercially sophisticated enterprises.

To the contrary, the cable operators' refusal to accept the demands of the NFL Network suggests that the market is working efficiently, not that it has failed. The cable industry has been struggling to control consumer prices in the face of increasing costs for programming and expanded services. By holding the line on new programming costs - particularly programming such as that on the NFL Network which appeals to a defined subset of consumers - the cable operators may be able to help control against cable rate increases for all subscribers.

Thus, there are powerful forces acting on both sides of the bargaining equation. On the one hand, the NFL Network owns the rights to extremely valuable content, which every distributor would dearly like to carry. On the other hand, cable operators are under tremendous pressure to control consumer rates, and limiting programming costs is perhaps the most direct means of achieving that end. The market, not regulatory authorities or appointed arbitrators, is best positioned to balance those interests.

*W. Kenneth Ferree is President of The Progress & Freedom Foundation. The views expressed here are his own, and are not necessarily the views of the PFF board, fellows or staff.



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