The Telecommunications Act of 1996 says that local exchange carriers must pay incumbents for transporting and terminating local calls.  This is called reciprocal compensation.

In other words, when a customer of an incumbent local exchange carrier (ILEC) makes a local call to a customer of a competitive carrier (CLEC), the CLEC incurs a cost to terminate that call -- and vice versa.  The reciprocal compensation provisions of the Act requires ILECs and CLECs to pay each other for local calls that are terminated on their respective networks.

Not surprisingly, CLECs and ILECs initially had two very different perspectives for reciprocal compensation.  CLECs viewed reciprocal compensation as a cost to be minimized.  Initially, CLECs argued that each party would terminate roughly the same amount of local traffic between the two networks and therefore recommended a compensation mechanism known as Bill and Keep.  Bill and Keep is where parties do not bill each other for use of the network because these bills would simply cancel each other out. 

ILECs, however, initially claimed that CLECs would originate more local traffic to the ILEC then would be terminated.  As a result, ILECs opposed Bill and Keep, arguing that this would result in a subsidy to CLECs.  ILECs recommended that each carrier bill the other carrier for the cost of using their respective networks.

It did not take long for CLECs to discover that terminating local traffic could actually generate profits if more local traffic was terminated by a CLEC then by the ILEC.  As a result, CLECs abandoned their Bill and Keep approach and accepted ILEC recommendations for reciprocal compensation, including ILEC rate levels that appeared to be exorbitant.  If they are receiving compensation for terminating local traffic, CLECs reasoned, the higher the rate, the better.

CLECs began to look for customers with significant amounts of in-bound local traffic and soon discovered Internet Service Providers (ISPs), who typically have a lot of local dial-up traffic.  ISPs would obtain local service from a CLEC, establish local telephone numbers and begin selling local dial-up internet access services to the public.  When customers use an ISP, their calls are routed to the CLEC network via the ILEC. 

With ISP traffic terminating on their networks, CLECs began to bill ILECs millions of dollars for reciprocal compensation.  Needless to say, ILECs discovered this activity and quickly sought help from both regulatory commissions and the courts.  A legal morass had begun.

Legal issues aside, there are important financial implications associated with reciprocal compensation for ISP traffic.  For some CLECs, ISP compensation accounts for up to 70 percent of all revenues.  And while most CLECs are experiencing negative EBITDA, the EBITDA for ISP reciprocal compensation is positive.  In terms of reciprocal compensation as a percentage of EBITDA growth, at least one CLEC reports a 124% growth rate.  In short, reciprocal compensation can represent a significant revenue stream that generates growth for the CLEC.

However, CLECs who continue to rely solely on ISP reciprocal compensation do so at a great risk.  Since ILECs have appealed every regulatory and court decision, CLECs will roll up large legal fees to obtain this revenue. This could cause accounting concerns for those CLECs which report this revenue on their books but have yet to actually receive it from the ILEC.  

In addition, some state commissions are tiring of CLEC business plans based on an “exploitation” of the reciprocal compensation.  According to state regulators, these CLECs are not interested in promoting local exchange competition and, as a result, some commissions are eliminating or limiting payment for ISP traffic. 

Finally, as second generation contracts are negotiated, ILECs have learned from their past mistakes and are making it harder for CLECs to obtain this revenue stream.  The ILECs have been forcing CLECs into arbitration on this issue and have recommended a number of solutions including excluding ISP traffic from traffic that is subject to reciprocal compensation and recommending a reduced compensation rate if traffic is significantly out of balance.

Another issue that has yet to be resolved is whether reciprocal compensation payments apply to data traffic such as IP, frame relay and ATM.  At present, this traffic is removed from the public switched network when it is delivered to the ILEC switch and is placed on a separate data network.  The reciprocal compensation section of the Act does not distinguish between voice and data, it could be argued that reciprocal compensation should apply if ILEC and CLEC data networks become interconnected.

There is no dispute that ILECs and CLECs have a statutory right to recover the costs associated with terminating each other’s traffic.  Whether ISP traffic is included in that compensation will continue to be a hot topic of debate during 2000.  However, clever CLECs eventually will think of ways to incent in-bound traffic.  In other words, while targeting in-bound calls for your revenue stream may not be fancy, it does generate revenue and positive cash flow quickly, which all CLECs need.

John P. Kern has consulted for CLECs for the past six years focusing on local exchange issues.  Prior to consulting, Mr. Kern worked for the Missouri Public Service Commission for four years and as a Director for Ameritech for seven years.