Input:
	Background

In June 2018, DOD’s Chief Management Officer established the  Community Services Reform Task Force to perform a business case  analysis to determine whether consolidating the defense resale  organizations would result in efficiencies. The task force conducted its  work from July 2018 through November 2018, during which it collected  financial and other data from the four resale organizations and conducted  workshops with subject matter experts from the resale organizations. In  November 2018, the military departments were given an opportunity to  review the business case analysis, provide comments, and indicate  whether they concurred with the analysis.
In its business case analysis, the task force recommended consolidating  the four defense resale organizations into a single organization. The  task force stated that consolidation would eliminate duplication that  currently exists across the resale organizations and increase the  competitiveness, or financial viability, of defense resale, which has seen  sales declines in recent years. Specifically, the task force recommended  that a single chief executive officer or director be responsible for leading  the organization and report to a single board of directors. The task force  also recommended that separate leadership positions for commissary  operations and exchange operations be established, and that a chief  administrative officer manage the business functions that are common to  the current resale organizations, such as information technology (IT),  human resources, marketing, and finances. Figure 1 shows the task  force’s recommended organizational chart for the consolidated resale  organizations.
The task force estimated that the time frame for consolidating the four  defense resale organizations would be 5 years for implementation, and  that consolidation would result in “net savings” (i.e., estimated savings  minus estimated costs) ranging from about $690 million to $1.3 billion  during the first 5 years, followed by annual net savings of approximately  $390 million to $670 million every year thereafter. Specifically:
Estimated savings: The task force estimated that consolidating the  four defense resale organizations would result in savings in three  areas: (1) reduction of the cost of goods sold in the commissaries and  the exchanges; (2) reduction of the cost of goods and services that  are not sold but are necessary for operating stores (e.g., plastic  shopping bags and custodial services); and (3) reduction of payroll  costs by eliminating redundant personnel. According to the task  force, consolidation would result in estimated savings of $1.4 billion to  $2.1 billion over the first 5 years, followed by annual savings of $470  million to $750 million.
Estimated costs: The task force estimated that consolidating the  defense resale organizations would result in costs from four areas: (1)  development of new, common IT systems; (2) severance pay for  separating employees and retention bonuses to incentivize  employees to remain; (3) operation of a transformation management  office, supported by private contractors, to implement the  consolidation; and (4) costs to convert DeCA to a non-appropriated  fund organization. According to the task force, consolidation would  result in estimated costs of $700 million to $810 million over the first 5  years, followed by annual costs of $80 million.
DOD’s Chief Management Officer in March 2019 and the Deputy  Secretary of Defense in August 2019 both approved the results of the  business case analysis and directed that plans be made for consolidation,  pending congressional action to remove the statutory prohibition on  consolidating the commissary and exchange systems.

	DOD’s Business Case Analysis Supporting Defense Resale Consolidation May Not Provide Reliable Savings and Cost Estimates

The task force may have overestimated the expected savings from  reducing the “cost of goods sold” (i.e., the cost of purchasing products  that are resold in commissaries or exchanges) and underestimated the  expected costs from IT consolidation and headquarters relocation.

		DOD’s Task Force May Have Overestimated the Expected Savings to Be Achieved from Reducing the Cost of Goods Sold

The task force estimated that most of the savings (i.e., about 70 percent  annually) to be achieved from consolidating the four defense resale  organizations would result from reducing the cost of goods sold.  According to the task force’s business case analysis, retailers often pay  different costs for identical products, and mergers are an opportunity for  retailers to compare costs across a larger combined organization and  make decisions that maximize savings. In the case of a consolidated  defense resale organization, the task force stated in its business case  analysis that savings could be achieved by implementing what the task  force called category management reforms and by obtaining the lowest  cost for identical products sold by both commissaries and exchanges.  Task force officials added that one board of directors and one chief  executive officer overseeing the consolidated resale organization would  be more likely to achieve savings than the current, individual boards of  directors and chief executive officers of the resale organizations.
GAO-18-151SP.
DeCA and one or more exchange organization, or
Two or more of the exchange organizations (and not DeCA).
In addition to overlap in identical products sold, task force officials told us  that savings from category management reforms are dependent, in part,  on the amount of overlap in vendors that sell products to the resale  organizations. Specifically, task force officials stated that there are  opportunities to reduce cost of goods sold through negotiations with  vendors that sell items to both DeCA and the exchange organizations.  For example, task force officials stated that the consolidated organization  could negotiate better prices with a vendor that sells family-size items to  DeCA and single-size items to the exchange organizations, even though  those items are not identical.
Industry Benchmarks  The industry benchmarks used by the task  force are based on proprietary data gathered  and owned by Boston Consulting Group  based on its experience working with mergers  and category management reforms in the  private sector retail industry. These  benchmarks were presented as a percentage  of cost of goods sold; specifically, the task  force estimated that savings from obtaining  the lowest cost for identical items were from 1  to 1.5 percent of the cost of goods sold, and  savings from category management efforts  were from 2.5 to 4 percent of the cost of  goods sold. We did not review and evaluate  the underlying data that were used to develop  the proprietary benchmarks.
Based on this information, the task force calculated the estimated savings  that would result from reducing the cost of goods sold by multiplying the  total cost of goods sold for all four resale organizations in fiscal year 2017  ($9.5 billion) by industry benchmarks developed by Boston Consulting  Group (see sidebar for more information on these benchmarks). This  calculation showed an estimated annual savings of $329 million to $517  million from reducing the cost of goods sold.
However, additional information from the task force suggests this savings  estimate may be overstated because there is limited overlap in the  products DeCA sells (i.e., groceries and household goods) and the  products the exchange organizations sell (i.e., goods and services similar  to retail stores). According to the task force, about $2.2 billion of DeCA’s  cost of goods sold in fiscal year 2017 were for products also sold by at  least one of the exchange organizations, which is equivalent to about 23  percent of the total cost of goods sold for the four resale  organizations. This differs from the data provided in the business case  analysis, which stated that 62 percent of the total cost of goods sold was  for identical products sold by two or more resale organizations; however,  that figure also includes products sold by two or more exchange  organizations and not DeCA (we further discuss product overlap among  the exchange organizations below). Given the more limited product  overlap between DeCA and the exchange organizations, it is unclear  whether using the total cost of goods sold for all four resale organizations  as the basis for estimating savings was appropriate.
Additionally, the business case analysis did not fully identify the amount  of vendor overlap that exists between DeCA and the three exchange  organizations, but the data that were provided in the business case  analysis suggest that limited vendor overlap exists. Specifically, the  business case analysis provided data for 10 vendors that sell to the  defense resale organizations, but those vendors represent less than 20  percent of the cost of goods sold to DeCA and the exchange  organizations in fiscal year 2017. Further, only 5 of the 10 vendors  identified in the business case analysis sold goods to both DeCA and the  exchange organizations, and their cost of goods sold accounted for about  10 percent ($972 million) of the total cost of goods sold for the four resale  organizations ($9.5 billion). Based on these data, the extent of vendor  overlap between DeCA and the exchange organizations—and, as a  result, how much can be saved through category management reforms by  consolidating DeCA and the exchange organizations—is unclear.
Although the task force stressed the importance of a conservative  estimate in both its business case analysis and in meetings with us, our  assessment of the assumptions and methodology for estimating savings  from the cost of goods sold found that a more conservative approach  could have been used to better ensure estimated savings were not  overstated. For example, one method could have been to multiply the  benchmarks by the cost of goods sold for just the three exchange  organizations (about $5.5 billion in fiscal year 2017, per the task force), as  data provided by the task force indicate that about 67 percent of the cost  of goods sold for the exchange organizations in fiscal year 2017 were for  identical products sold by at least two exchange organizations. Another  method, which task force officials suggested after we shared our  concerns about their methodology, could have been to multiply the benchmarks by the cost of goods sold for the exchange organizations,  plus the portion of DeCA’s cost of goods sold that overlaps with at least  one exchange organization (about $2.2 billion in fiscal year 2017, per the  task force). Either method would be more conservative than the one  adopted in the business case analysis and would yield a savings estimate  that is about 20 to 40 percent lower, but would be more consistent with  the task force’s assertion that consolidation savings are dependent on the  amount of overlap among the merging organizations.
DOD policy states that an economic analysis should base its analysis of  benefits on facts and data whenever possible. Additionally, our  Assessment Methodology for Economic Analysis states that an economic  analysis should examine the effects of an action by considering relevant  alternatives and justifying what the world would be like under each  alternative; describe and justify the analytical choices, assumptions, and  data used; and assess how plausible adjustments to each important  analytical choice and assumption affect the estimates of savings.
Ensuring that the estimates for cost of goods savings are accurate is  particularly important, as they account for approximately 70 percent of the  task force’s overall savings estimate from consolidation. However, the  task force did not fully identify and analyze in its business case analysis  how many identical products are sold by both DeCA and the exchange  organizations or how many vendors sell products to both DeCA and the  exchange organizations. According to task force officials, they did not  provide data on product overlap between DeCA and the exchange  organizations because it would not change their savings methodology or  estimate, and they did not provide more information on vendor overlap  because of the proprietary nature of that data. However, the amount of  product and vendor overlap that exists across the four resale  organizations will have a direct effect on the amount of savings to be  achieved from consolidation, as acknowledged by the task force.
Without the task force reassessing the approach it used to estimate  savings from the cost of goods sold and, if necessary, making  adjustments to those estimates, decision makers in DOD and Congress  may lack confidence in the reliability of the task force’s savings estimates  in the business case analysis and will not have complete information as  they consider defense resale consolidation.

		DOD’s Task Force May Have Underestimated the Expected Costs of Consolidating the Four Defense Resale Organizations

Based on our analysis of the business case analysis, we found that  DOD’s task force may have underestimated the expected costs of  consolidating the four defense resale organizations in two areas: (1) the  development of new, common IT systems and (2) the location of a new  headquarters for the consolidated organization.

			Task Force May Have Underestimated the Cost of Consolidating Defense Resale Organizations’ IT Systems

The task force estimated in its business case analysis that most of the  costs (i.e., about 50 percent annually) of consolidating the four defense  resale organizations will result from developing new, common IT systems  to support the consolidated organization. In the business case analysis,  the task force stated that it worked with the four resale organizations to  calculate a cost estimate of $292 million to $352 million for developing  five types of IT systems that are needed for the consolidated  organization: merchandising, store inventory management, financial  management and general ledger, transportation and logistics, and  ecommerce.
According to the business case analysis, the task force’s cost estimates  for developing new, common IT systems for the consolidated organization  were to be based on data provided by the resale organizations on recent  or projected costs for replacing similar systems or performing major  upgrades to existing systems, when available. For example, the task  force’s estimate for the merchandising system was approximately $115  million, which the business case analysis stated is based on a $35 million  estimate provided by AAFES, a $23.5 million estimate provided by  NEXCOM, a $15 million estimate provided by MCCS, and a $41 million  estimate provided by DeCA.
However, the task force’s cost estimate for IT consolidation may be  understated because it is based, in part, on less expensive minor IT  system upgrades and partial replacements, according to the resale  organizations. Based on our analysis of information provided to us by the  resale organizations, about $140 million (about 40 percent) of the overall  IT cost estimate was based on what the resale organizations described  as minor upgrades or partial replacements.
Specifically, while MCCS confirmed the cost estimates attributed to them  in the business case analysis were for total IT system replacement costs,  the other three resale organizations—AAFES, NEXCOM, and DeCA— disagreed with the task force’s characterization that all the data used to  calculate IT system estimates represented costs for replacements or  major upgrades. AAFES told us that the cost estimates cited in the  business case analysis for its merchandising, financial management and  general ledger, and transportation and logistics systems reflected minor  upgrades of specific modules within the overall systems, and the cost to  replace or upgrade the entire system would be significantly higher.  NEXCOM stated that the cost estimates for upgrading its merchandising,  store inventory management, and financial management and general  ledger systems were for minor upgrades, not replacements or major  upgrades, as stated by the task force. DeCA told us that the estimate for  replacing its store inventory management system only represented 1 year  of costs, even though DeCA plans to incur replacement costs through at  least 2022.
According to the task force, the task force and the resale organizations  agreed on the methodology for estimating IT costs, and the subject matter  experts from the resale organizations provided the cost data used in the  business case analysis. However, based on information provided by the  resale organizations, it appears that the task force may not have always  based its cost estimate on replacement or major upgrade costs— consistent with the key assumption that new IT systems would be  developed for the consolidated resale organization—but, rather, used  minor upgrade or partial replacement costs in some cases. Specifically,  task force officials told us they believed the estimates provided by the  resale organizations were too high to be minor upgrades or partial  replacements, based on their understanding of IT requirements for resale  operations.
Further, task force officials stated that their overall IT cost estimate was  likely overstated, not understated. For example, they stated that their  estimate is higher than what is typically spent for a private sector  consolidation of similar size. However, the task force stated that it did  not use private sector IT cost estimates in its business case analysis  because it determined that public sector IT costs would likely be higher  than private sector IT costs. Additionally, task force officials told us that  some planned spending on existing IT systems by the four resale  organizations would not be necessary as a result of consolidation.  However, the business case analysis does not quantify how much future  spending could be reduced or factor those reductions into the IT cost  estimate.
According to the GAO Cost Estimating and Assessment Guide, cost  estimates are developed based on assumptions that are defined to  establish the baseline conditions the estimate will be built from.  Additionally, our Assessment Methodology for Economic Analysis states  that an economic analysis should define an appropriate baseline that  represents the best assessment of what the world would be like under  that alternative. Thus, estimating costs that reflect the baseline  conditions is a key step in developing a sound cost estimate.
Additionally, we have previously reported that federal IT investments  frequently fail or incur cost overruns and schedule slippages. As such, high-quality data are imperative for ensuring proper management and  oversight of IT investments. The task force’s IT cost estimate is  particularly important, as it represents about 50 percent of the total  estimated costs for defense resale consolidation. Until the task force  consults with the resale organizations to reassess the methodology for  estimating IT costs, decision makers in DOD and Congress may not have  a reliable and complete understanding of the estimated costs for the  implementation of new, common IT systems, which is information DOD  and Congress need as they consider defense resale consolidation.

			DOD’s Task Force Did Not Provide a Cost Estimate for Relocating the Four Defense Resale Organizations to a New Headquarters Location

According to the task force, there would be costs associated with  relocating AAFES, NEXCOM, MCCS, and DeCA to a new headquarters  location, to include relocating existing personnel, hiring new personnel,  and obtaining real estate. Although no relocation options were presented  in the business case analysis, task force officials told us there are multiple  options for where to locate the headquarters of a consolidated resale  organization. One option cited by the task force would be to create a new  headquarters in the Washington, DC, area, which would be the most  expensive option, as it would likely involve acquiring new real estate and  hiring personnel in a high-cost region. Another option cited by the task  force would be to locate all exchange operations and staff at the existing  AAFES headquarters in Dallas, TX, and maintain commissary operations  and staff at the existing DeCA headquarters at Fort Lee, VA. This option  would likely be less expensive, as personnel and available real estate are  already present at both locations. In January 2020, task force officials  also told us that an even less expensive option they might consider is  maintaining commissary and exchange headquarters staff at their current  locations, but having personnel work for the consolidated organization,  rather than for DeCA or the exchange organizations.
Despite the potential for relocation costs, the task force did not include a  range of cost estimates for different relocation options in its business  case analysis. According to task force officials, relocation cost estimates  were not included because the headquarters location has not been  chosen, and costs will vary widely depending on the chosen location.  While actual relocation costs will depend on the chosen headquarters  location, this fact does not prevent the task force from presenting a range  of cost estimates in advance of that decision being made. Task force  officials also said that including relocation cost estimates would not have  changed the conclusion of the business case analysis. However, without  a range of relocation cost estimates, we were unable to assess the effect  of relocation costs on the conclusion of the business case analysis.
DOD policy states that an economic analysis should quantify the costs  associated with each alternative under consideration whenever possible  so that they may be included in the economic analysis calculation.  Additionally, our Assessment Methodology for Economic Analysis states  that an economic analysis should quantify the important costs, where  feasible, to inform decision makers about the economic effects of a  proposed action. Without developing and providing a range of relocation  cost estimates from the least expensive option to the most expensive,  decision makers in DOD and Congress will not be fully informed about the  costs of consolidation, which is necessary information for deciding  whether to consolidate the four defense resale organizations.

	Military Departments Officially Concurred with the Business Case Analysis, but DOD Did Not Share Their Accompanying Comments with Congress

The military departments officially concurred with the task force’s  business case analysis for consolidating the four defense resale  organizations. However, the military departments also provided written  comments that detailed concerns with fundamental aspects of the  business case analysis, to include: the use of proprietary industry  benchmarks; estimated savings, costs, and timeline of the consolidation;  and the proposed governance structure for the new resale organization.  In an April 2019 report to Congress that summarized the business case  analysis, DOD stated that the military departments agreed with the  consolidation. However, the report did not disclose the military  departments’ comments and concerns on the business case analysis,  which are relevant as Congress considers defense resale consolidation.
In their written comments, the military departments either stated concerns  about the consolidation or included critical comments from the exchange  organizations—all of which opposed the consolidation. Specifically:
The Army concurred with the business case analysis but noted that  funding for morale, welfare, and recreation programs must be  preserved or increased as a result of the consolidation. In addition,  the Army’s comment letter included as an attachment written  comments from AAFES, which expressed opposition to the  consolidation and detailed concerns with the business case analysis.  For example, AAFES stated that the business case analysis relied on  unverifiable, proprietary industry benchmarks that overstated the  benefits of consolidation, underestimated the costs and time to  consolidate, and did not account for recent efforts by the resale  organizations to reduce costs by collaborating on a purchasing  alliance.
The Air Force also concurred with the business case analysis, but  noted in its comments that mergers and acquisitions have historically  cost more, taken longer, and saved less than originally expected. As a  result, the Air Force recommended that a phased implementation plan  be followed to guard against financial risk. The Air Force also stated  that morale, welfare, and recreation funding currently provided by the  exchanges should be maintained while opportunities are examined to  reduce the need for appropriated funding.
The Navy initially non-concurred with the business case analysis in  December 2018. In its comment letter, the Navy stated that the task  force’s analysis was flawed beyond repair and included comments  from NEXCOM and MCCS that also opposed consolidation. For  example, the exchanges’ comments stated that the expected cost  savings were overstated, that potential inefficiencies from  consolidation were not discussed, and that the resale organizations  could achieve cost savings through greater collaboration without the  need for consolidation. NEXCOM and MCCS also stated concern that  the task force’s savings projection relied heavily on unverifiable  industry benchmarks. In addition, MCCS expressed concern that  consolidation could result in unexpected costs from separating  exchange operations from the rest of MCCS operations, which also  include the Marine Corps’ morale, welfare, and recreation and family  programs. In January 2019, the Navy changed its position to concur  subject to several significant comments and clarifications, and  attached a letter detailing comments and concerns similar to those it  submitted with its original non-concurrence in December 2018.
Officials from the resale organizations further articulated their concerns  about the business case analysis when they met with us. For example,  resale officials told us they are concerned that savings are overstated,  that costs are understated, and that the proprietary benchmarks used by  the task force are unverifiable or may not be applicable to the public  sector. Exchange officials also stated that they are worried about the  effect of consolidation on morale, welfare, and recreation funding  generated by the exchanges. Specifically, exchange officials are  concerned that exchange revenue currently used for morale, welfare, and  recreation programs could be used to pay for consolidation expenses or  to reduce the amount of appropriated funds allocated to the  commissaries.
Despite the concerns detailed in the comments from the military  departments and resale organizations, DOD did not include them in its  April 2019 report to Congress summarizing the results of the business  case analysis. The National Defense Authorization Act for Fiscal Year  2019 required DOD to include in its report the recommendations of the  Secretaries of the military departments regarding the plan to consolidate  the defense resale organizations. When we asked the task force why  DOD did not provide Congress with the comments and concerns cited by  the military departments and the resale organizations, officials stated that  they were advised by DOD’s Office of General Counsel not to include the  comments because they contained information that may have disclosed  DOD’s deliberative process.
Task force officials also stated that the savings, cost, and timeline  estimates in the business case analysis were conservative, and that the  proprietary industry benchmarks are based on years of experience by  Boston Consulting Group and similar to those cited by prior studies.  Regarding the purchasing alliance formed by the resale organizations to  reduce their cost of goods sold, task force officials stated they do not  believe such efforts to reduce costs will be sustained without a single  chief executive officer and board of directors to ensure those efforts  continued, as recommended in the business case analysis. Finally, the  task force stated in the business case analysis that any savings achieved  from consolidation could be used to increase morale, welfare, and  recreation funding or reduce appropriations used to fund DeCA, and that decisions on how to allocate savings will be made by the proposed board  of directors.
According to task force officials, some of the concerns articulated by the  military departments and the exchanges could be motivated by a general  opposition to consolidation. However, without a more complete reporting  of the military departments’ perspectives on consolidation and the task  force’s response to those comments, Congress may be unaware of the  views various organizations within DOD have regarding the business  case analysis, which is relevant information as Congress considers  defense resale consolidation. Moreover, fully reporting the comments and  concerns could strengthen trust and collaboration among the task force,  military departments, and resale organizations on any future resale  reforms.

	Conclusions

Four defense resale organizations currently operate about 240  commissaries (operated by DeCA) and 2,500 exchange facilities  (operated by AAFES, NEXCOM, and MCCS) worldwide to provide  reduced-priced groceries and retail goods and services to DOD  servicemembers, their families, and retirees. DeCA operations are funded  in part by appropriations, which have totaled approximately $1.3 billion in  recent years. By law the commissary and exchange organizations must  be operated separately. In November 2018, a DOD task force completed  a business case analysis and concluded that consolidating the four  defense resale organizations into a single organization would result in  several hundred million dollars in annual cost savings. However, we  found that the task force’s projected savings from reducing the cost of  goods sold may be overestimated, and that projected costs for IT  development and headquarters relocation may be underestimated.  Further, while the military departments concurred with the task force’s  recommendation to consolidate, DOD did not fully share their comments  and concerns about the business case analysis with Congress. DOD’s  proposed consolidation will cost several hundred million dollars, take  years to implement, and involve multiple DOD organizations. Given the  cost and complexity of the proposed defense resale consolidation, DOD  can ensure that Congress has the reliable information it needs to consider  consolidation by reviewing and updating savings and cost estimates and  sharing comments and concerns from the military departments.

	Recommendations for Executive Action

We are making the following four recommendations to DOD.
The Secretary of Defense should ensure that the DOD Chief  Management Officer direct the task force to reassess its approach to  estimating savings from cost of goods sold—to include reassessing its  use of the cost of goods sold for all four defense resale organizations  rather than, for example, just for the three exchange organizations—and  make any necessary adjustments to its savings estimates for  consolidation and provide that updated information to Congress.  (Recommendation 1)
The Secretary of Defense should ensure that the DOD Chief  Management Officer direct the task force, in consultation with the resale  organizations, to reassess its methodology for estimating IT costs of  consolidation, and make any necessary adjustments to its range of IT  cost estimates and provide that updated information to Congress.  (Recommendation 2)
The Secretary of Defense should ensure that the DOD Chief  Management Officer direct the task force to develop a range of cost  estimates for relocating the defense resale organizations, and adjust its  range of cost estimates for consolidation and provide that updated  information to Congress. (Recommendation 3)
The Secretary of Defense should ensure that the DOD Chief  Management Officer provide additional written information to Congress on  the comments and concerns from the military departments and resale  organizations on the task force’s November 2018 business case analysis,  as well as the task force’s response to those comments and concerns.  (Recommendation 4)

	Agency Comments and Our Evaluation

We provided a draft of this product to DOD for review and comment. In its  comments, reproduced in appendix III and summarized below, DOD  concurred with the first three recommendations and did not concur with  the fourth recommendation. DOD also provided technical comments,  which we incorporated as appropriate.
DOD stated in its letter that it continues to firmly believe that consolidation  of above-store operations of DeCA and the military exchanges is the right  path forward and that it intends to move forward with this effort. DOD also  requested that we consider the first three recommendations as  implemented, based on information provided in the letter and as detailed  below.
Regarding the first recommendation for the task force to reassess  its approach to estimating savings from cost of goods sold—to  include reassessing its use of cost of goods sold by all four  defense resale organizations rather than, for example, just the  three exchange organizations—and make any necessary  adjustments to its savings estimates for consolidation and provide  that updated information to Congress, DOD stated that it had  reassessed its approach and found that there is significant overlap  and, therefore, savings opportunity in products sold by DeCA and  the exchanges. DOD also provided revised savings estimates that  exclude DeCA’s cost of goods sold from its methodology that  show net savings ranging from $309 million to $739 million in the  first 5 years of consolidation, followed by $255 million to $457  million per year thereafter. These figures are about 44 percent to  55 percent lower than the business case analysis’s estimate for  the first 5 years and about 32 to 35 percent lower per year  thereafter. By providing these revised savings estimates, we  believe that DOD has addressed the intent of the  recommendation.
With regard to the second recommendation for the task force to  reassess its methodology for estimating IT costs of consolidation,  and make any necessary adjustments to its range of IT cost  estimates and provide that updated information to Congress, DOD  stated that the task force followed up with AAFES, NEXCOM, and  DeCA to get an update on the cost estimates these entities  expressed concern about to us. However, according to DOD,  those resale organizations were unable to provide alternate data  to use in place of the numbers in the business case analysis. DOD  further stated in its letter that because no alternative data were  provided, the department will continue to use the estimate in the  business case analysis and will reengage with the resale  organizations to develop more detailed IT design plans and make  any necessary updates to the IT cost estimates as integration  planning moves forward. As DOD develops its more detailed IT  design plans and associated cost estimates, we will follow up with  the department, including the resale organizations, to determine  whether this recommendation has been addressed.
In commenting on the third recommendation for the task force to  develop a range of cost estimates for relocating the defense  resale organizations, and adjust its range of cost estimates for  consolidation and provide that updated information to Congress,  DOD provided three possible courses of action, along with  corresponding cost estimates. These possible courses of action,  from least expensive to most expensive, are: (1) maintain  operations at all four existing locations (no cost); (2) maintain  commissary operations at DeCA headquarters, perform all  exchange functions at AAFES headquarters, and close the  NEXCOM and MCCS headquarters (one-time costs of $5.5 million  and recurring annual costs of $1.3 million); and (3) create a new  headquarters to perform all commissary and exchange operations  near Washington, D.C. (one-time costs of $19.6 million and  recurring annual costs of $19.7 million). DOD stated that  consolidation would still result in financial benefits, even if the  department chooses the most costly of these courses of action. By  providing these cost estimates, we believe that DOD has  addressed the intent of the recommendation.
While we have determined that DOD has met the intent of the first and  third recommendations, we also note that, in its comment letter, the  department questioned some aspects of our analysis and conclusions  regarding the first three recommendations. We stand by our analysis and  conclusions and offer the following response:
DOD stated in its comment letter that modifying the business case  analysis’s approach to cost of goods savings would result in an  incorrect use of benchmarks and go against industry best practice.  For example, DOD stated that estimating savings by using the  cost of goods sold for just the three exchange organizations, or for  the three exchange organizations plus a portion of DeCA, would  be flawed. However, as noted in our report, the latter method was  recommended to us by task force officials when we raised  concerns about the accuracy of the task force’s savings estimates  in the business case analysis. In addition, multiplying the  benchmarks by the cost of goods sold for the exchange  organizations, as opposed to for all four resale organizations,  would be more consistent with the assertion in the business case  analysis that consolidation savings are dependent on the overlap  among the merging organizations.
DOD questioned the accuracy of some of our figures in the report  by providing different data on product and vendor overlap between  DeCA and the exchange organizations. However, this information  was not included in the task force’s business case analysis or  offered to us during the course of our audit. In addition, when we  asked for supporting documentation that would allow us to  validate the new figures, DOD did not provide any.
DOD stated in its comments that excluding all or including only a  portion of DeCA’s cost of goods sold implies that there is no  opportunity to achieve savings between DeCA and the  exchanges. Our report does not make this assertion, but rather  offers a methodology that would result in a more conservative  savings estimate, consistent with the data presented in the  business case analysis and provided by task force officials, to  better ensure that estimated savings were not overstated.
As noted above, DOD did not concur with the fourth recommendation for  the department’s Chief Management Officer to provide additional written  information to Congress on the comments and concerns from the military  departments and resale organizations on the task force’s November 2018  business case analysis, as well as on the task force’s response to those  comments and concerns. DOD stated in its written response to our report  that the department considered all the comments submitted in its  decision-making process and that all of the military department  secretariats agreed with above-store consolidation, despite their  comments on the business case analysis. DOD further stated that the  military department comments regarding the business case analysis were  shared with congressional committee professional staff, and DOD  suggested in its letter that this recommendation be closed.
However, DOD’s written response did not provide information on which  comments were shared, whether those comments were communicated in  writing or orally, or which committee or committees received information  on the comments. In their written comments on the business case  analysis, the military departments detailed concerns with fundamental  aspects of the analysis, to include: the use of proprietary industry  benchmarks; estimated savings, costs, and timeline of consolidation; and  the proposed governance structure for the new resale organization. We  continue to believe that implementing this recommendation would help  ensure that Congress has the full information it needs as it considers  defense resale consolidation and would also help strengthen trust and  collaboration among the various DOD stakeholders involved in defense  resale, particularly given their role in any consolidation, should one occur.  We will follow up with DOD as part of our regular recommendation follow- up process.
We are sending copies of this report to the appropriate congressional  committees; the Secretary of Defense; and the Secretaries of the Army,  Air Force, and Navy. In addition, the report is available at no charge on  our website at https://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-2775 or FieldE1@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. GAO staff who made key contributions to this report  are listed in appendix IV.

Appendix I: Prior GAO Work on Commissaries and Exchanges

The National Defense Authorization Act for Fiscal Year 2016 mandated  that the Department of Defense (DOD) report on DOD’s plan to achieve  budget neutrality for commissaries and exchanges—which DOD  interpreted as ending the use of appropriated funding—and included a  provision for us to assess DOD’s report. In November 2016, we found  that DOD’s May 2016 report did not provide a plan for achieving budget  neutrality. DOD reported that it would not be able to eliminate fully the  use of appropriated funds for defense resale, but the department did not  provide detailed information supporting that conclusion. Instead, the  report stated that DOD expected to achieve $2 billion in cost savings over  a 5-year period from fiscal year 2017 through fiscal year 2021. However,  we found that the report did not include any assumptions, methodology,  or specific time frames related to initiatives that would lead to these  savings. We recommended that DOD provide information to Congress to  support its conclusion about budget neutrality and develop a plan for  achieving reductions to defense resale appropriations. DOD concurred  with our recommendations, but as of February 2020 had not addressed  them.
In March 2017, we reported on DOD’s commissary operations, including  the extent to which the Defense Commissary Agency (DeCA) had  assurance that it was maintaining the desired savings rate for its  customers. DeCA’s desired savings rate—which at the time of our March  2017 report was 30 percent and is now 23.7 percent—shows how much a  customer can expect to save on grocery purchases at a commissary in  comparison to purchases at other local grocery stores. We found that  DeCA lacked reasonable assurance that it was maintaining its desired  savings rate for commissary customers because of weaknesses in its  methodology for calculating the savings rate. For example, the  methodology did not use a random sample of overseas commissaries or  account for seasonal and geographic variations in item prices. We also  found that DeCA’s business model departed from practices generally  employed by commercial grocery stores. For example, DeCA did not  assess the contribution of the sale of each product to a given store’s total  sales in determining which products to sell, and it had not conducted cost- benefit analyses for its use of stocking and custodial service contracts or  product distribution options across all commissaries. We recommended  that DOD (1) address limitations identified in its savings rate  methodology; (2) develop a plan with objectives, goals, and time frames  to improve efficiency in product management; and (3) conduct  comprehensive cost-benefit analyses for service contracts and  distribution options. As of February 2020, DOD had addressed the first  two recommendations but had not addressed the third recommendation.

Appendix II: Assessment of the Department of Defense’s (DOD) Business Case Analysis on Defense Resale Consolidation

We assessed DOD’s business case analysis on consolidating the four  defense resale organizations against the five key elements of an  economic analysis, as described in our Assessment Methodology for  Economic Analysis (see table 1).

Appendix III: Comments from the Department of Defense

Appendix IV: GAO Contact and Staff Acknowledgments

	GAO Contact Staff Acknowledgments

Elizabeth A. Field, (202) 512-2775 or fielde1@gao.gov  In addition to the contact named above, Suzanne Perkins (Assistant  Director), Geoffrey Peck (Analyst-in-Charge), Pedro Almoguera, Noah  Gerber, Mae Jones, Matthew Kienzle, Amie Lesser, Felicia Lopez, and  Jeanne Sung made key contributions to this report.


Input:
	Overview

Local governments have traditionally played an important role in regulating cable television systems. Operators required municipal permission to place their cables above or beneath streets and other publicly owned land and to mount the cables on telephone/and or utility poles. Cities negotiated with cable operators over the services their systems would provide, including channels dedicated to public, educational, or government programming (PEG), and the payment of franchise fees. In exchange, the cable operators often received de facto exclusive local franchises to offer video distribution services. That changed in 1984, when Congress required local governments to allow competition. In the mid-2000s, as telephone companies (known as " telcos ") sought to obtain their own video services franchises, state governments got involved to streamline the franchising process, in several instances preempting municipalities' authority. The states applied these laws to incumbent cable operators as well as to new entrants, to ensure legal parity.
As technological developments and changes in business strategies and consumer behavior have reshaped the telecommunications industry, the Federal Communications Commission (FCC) has taken several steps to limit local regulatory authority over cable and telco video service providers. Many of these regulatory changes have caused controversy. Some local governments assert that, among other things, the FCC's actions will limit their ability to protect the public interest and deprive them of revenue.
This report examines the evolving relationship between federal, state, and local regulators and identifies related policy issues that may be of interest to Congress.

	Regulation of Video Services

Cable television began operating in the 1940s as a means to receive broadcast signals in areas with trees or mountains that interfered with over-the-air signal transmission. Initially, municipalities, rather than states, made most decisions related to awarding cable franchises. As cable television developed, some states began to regulate the terms included in a cable franchise, or required state review or approval of a franchise agreement. The term local franchising authorities (LFAs) refers to municipal and/or state government entities that offer and negotiate video franchises. Today, agreements between LFAs and video service providers typically include provisions concerning the availability of channels for PEG programming; the amount of money due to the LFA in franchise fees, including in-kind contributions; and the rates charged to subscribers.

		Developments Prior to 1984

The Communications Act of 1934 (referred to in this report as the Communications Act) created the FCC, but did not specifically set forth the FCC's authority to regulate cable. However, the U.S. Supreme Court found in 1968 that the agency's authority was sufficiently broad to do so. The FCC issued comprehensive regulations governing cable systems and cable franchising authorities in 1972. The FCC's rules directed cable operators to offer PEG services and LFAs to cap franchise fees.

			Franchise Agreement Terms and Conditions

In the early days of cable television, a municipal government seeking to bring cable to its residents would, through a request for proposals, spell out the requirements that a cable operator would have to meet to win the franchise. Cable companies would bid against one another for the chance to wire the municipality. Renewal of an existing franchise might entail additional requirements.

				PEGs

In 1972, the FCC directed cable operators to dedicate one channel for public access, one channel for educational use, and one channel for local government use by a certain date, and to add channel capacity if necessary to meet the requirement. Two years later, however, the commission reconsidered its stance, stating,
Demands are being made not only for excessive amounts of free equipment but also free programming and engineering personnel to man the equipment. Cable subscribers are being asked to subsidize the local school system, government, and access groups. This was not our intent and may, in fact, hamper our efforts at fostering cable technology on a nationwide scale. Too often these extra equipment and personnel demands become franchise bargaining chips rather than serious community access efforts. We are very hopeful that our access experiment will work.... We do not think, however, that simply putting more demands on the cable operator will make public access a success. Access will only work, we suspect, when the rest of the community assumes its responsibility to use the opportunity it has been provided.
Although the U.S. Supreme Court later struck down the FCC's rules requiring cable operators to set aside channels for PEGs, PEG access requirements became commonplace in local franchise agreements by the early 1980s. Congress encouraged this development. According to a 1984 report from the House Committee on Energy and Commerce
Public access channels are often the video equivalent of the speaker's soapbox or the electronic parallel to the printed leaflet. They provide groups and individuals who generally have not had access to the electronic media with the opportunity to become sources of information in the electronic marketplace of ideas. PEG channels also contribute to an informed citizenry by bringing local schools into the home, and by showing the public local government at work.

				Franchise Fees

In addition to requiring cable system owners to obtain a franchise before operating, municipalities also required cable system owners to pay a franchise fee . In its 1972 Cable Order, the FCC stated,
[M]any local authorities appear to have extracted high franchise fees more for revenue-raising than for regulatory purposes. Most fees are about five or six percent, but some have been known to run as high as 36 percent. The ultimate effect of any revenue-raising fee is to levy an indirect and regressive tax on cable subscribers. Second, and of great importance to the Commission, high local franchise fees may burden cable television to the extent that it will be unable to carry out its part in our national communications policy.... We are seeking to strike a balance that permits the achievement of federal goals and at the same time allows adequate revenues to defray the costs of local regulation.
To accomplish this balance, the FCC capped the franchise fees at 3%-5% of a cable operator's revenues from subscribers. For fees greater than 3% of an operator's subscriber revenues, the FCC required a franchising authority to submit a showing that the specified fee was "appropriate in light of the planned local regulatory program."

				Rates Charged to Subscribers

When cable television first developed as essentially an antenna service to improve over-the-air broadcast television signal reception in rural and suburban areas, many municipalities regulated the rates charged to subscribers. The municipalities viewed rate regulation, tied to the systems' use of public streets, as a means of preventing cable operators from charging unreasonably high rates for what they viewed as an essential service.
In the 1972 Cable Order, the FCC required franchising authorities to specify or approve initial rates for cable television services regularly furnished to all subscribers and to institute a program for the review and, as necessary, adjustment of rates. In 1976, the FCC repealed those rules and instead made LFA regulation of rates for cable television services optional. In 1974, the FCC preempted LFAs from regulating rates for other so-called "specialized services," including "advertising, pay services, digital services, [and] alarm systems."

		Federal Regulatory Actions

			1984 Cable Act

In the Cable Communications Policy Act of 1984 ( P.L. 98-549 , referred to in this report as the 1984 Cable Act), Congress added Title VI to the Communications Act to give the FCC explicit authority to regulate cable television. The 1984 Cable Act established the local franchising process as the primary means of cable television regulation. The act did not diminish state and local authority to regulate matters of public health, safety, and welfare; system construction; and consumer protection for cable subscribers.
Congress enacted the 1984 Cable Act the same year that American Telephone and Telegraph Company (AT&T), which had an effective monopoly over most telecommunications services, spun off its regional operating companies as part of the settlement of a federal antitrust suit. The 1984 Cable Act generally prohibited telcos from providing video services in the same regions where they provided voice services. This prohibition prevented the former AT&T companies from competing with cable operators in communities where they controlled the local telephone system.

				Franchise Fees and PEGs

The 1984 Cable Act confirmed the power of state and municipal governments to include requirements for PEGs, facilities and equipment, and certain aspects of program content within franchise agreements. It delineated federal limits on franchise fees, and restricted the FCC's power to regulate the amount of franchise fees or the use of funds derived from those fees.
The law permits franchising authorities to charge franchise fees, but limits such fees to no more than 5% of the cable operators' gross revenues from "cable services." For the purposes of calculating gross revenues, the FCC included revenues from advertising and home shopping commissions, in addition to revenues from video service subscriptions. Subsequently, as described in " FCC Actions Affecting State and Local Video Service Franchising Terms and Conditions ," defining the costs that are subject to the 5% statutory limit on franchise fees became a point of repeated controversy.
The 1984 Cable Act allows local franchising authorities to enforce any PEG access requirements in a franchise agreement. Such terms and conditions can include providing video production facilities and equipment, paying capital costs related to PEG facilities beyond the 5% franchise fee cap, and paying costs associated with support of PEG channel use. In addition, the 1984 Cable Act permitted LFAs to require cable operators to designate channels for PEGs on institutional networks (I-Nets) provided for public buildings and other nonresidential subscribers.

				Rate Regulation

Section 623 of the 1984 Cable Act (47 U.S.C. Â§543) prohibits federal, state, or local franchising authorities from regulating the rates of cable operators that are "subject to effective competition," as defined by the FCC. The 1984 Cable Act directs the FCC to review its standards for determining effective competition periodically, taking into account developments in technology.

			Redefining Effective Competition

In 1985, the FCC determined that cable systems generally were subject to "effective competition" if they operated in an areas where three or more broadcast television signals were either "significantly viewed" by residents or transmitted with acceptable signal quality (as defined by the FCC) to the cable systems' franchise areas. In accordance with the timetable set by the 1984 Cable Act, the "effective competition" rule became effective on December 29, 1986. This rule effectively deregulated cable prices in most communities.
In 1991, the FCC adopted a new definition of "effective competition." The FCC deemed effective competition to exist if either:
1. six unduplicated broadcast signals were available to the cable operator's franchise area via over-the-air reception, or 2. another multichannel video service, such as a satellite service, was available to at least 50% of homes to which cable services were available (homes passed), and was subscribed to by 10% of the cable operator's homes passed.
Under this more restrictive definition, most systems were still subject to effective competition and therefore not subject to rate regulation.

			1992 Cable Act

In the Cable Television Consumer Protection and Competition Act of 1992 ( P.L. 102-385 , referred to here as the 1992 Cable Act), Congress stated the policy goal of relying on market forces, to the maximum extent feasible, to promote the availability of a diversity of views and information through cable television and other video distribution media. Congress emphasized the importance of protecting consumer interests where cable systems are not subject to effective competition, and of ensuring that cable operators do not have undue market power vis-Ã -vis video programmers and consumers.

				New Entrants in Video Programming Distribution Markets

The 1992 Cable Act revised Section 621(a)(1) of the Communications Act to codify restraints on local franchise authorities' licensing activities. While local authorities retained the power to grant cable franchises, the law provided that "a franchising authority may not grant an exclusive franchise and may not unreasonably refuse to award an additional competitive franchise." Congress gave potential entrants a judicial remedy by enabling them to commence an action in a federal or state court within 120 days after a local authority refused to grant them a franchise.

				Rate Regulation

In addition, Congress made it easier for local authorities to regulate cable rates by adopting a more restrictive definition of "effective competition" than the FCC's. Pursuant to these changes, local authorities may not regulate cable rates if at least one of the following four conditions is met:
1. fewer than 30% of the households in the franchise area subscribe to a particular cable service; 2. within the franchise area, a. at least two unaffiliated multichannel video programming distributors (MVPDs) each offer comparable video programming to at least 50% of the households in the franchise area, and b. at least 15% of households subscribe to an MVPD other than the largest one; 3. an MVPD owned by the franchising authority offers video programming to at least 50% of the households in the franchise area; or 4. a telephone company offering local voice services (known as a "local exchange carrier" [LEC]) or its affiliate, "(or any multichannel video programming distributor using the facility of such carrier or its affiliate)" carries comparable video programming services directly to subscribers by any means (other than direct-to-home satellite services) in the franchise area of an unaffiliated cable operator that is providing video service in that franchise area.
Congress directed the FCC to publish a survey of cable rates annually.

			1996 Telecommunications Act

Even as the 1992 Cable Act took effect, a combination of technological, economic, and legal factors was enabling the convergence of the previously separate telephone, cable, and satellite broadcasting industries. Digital technology, particularly the ability to compress digital signals, enabled both direct broadcast satellite (DBS) services and cable operators to offer dozens of channels. In 1993, the telephone company Bell Atlantic successfully challenged, on First Amendment grounds, the 1984 ban on cross-ownership of telephone and cable companies in the same local market. In the meantime, several cable operators sought to gain economies of scale by consolidating local systems into regional systems.
In the Telecommunications Act of 1996 ( P.L. 104-104 ), Congress permitted LECs to offer video services and cable operators to offer voice services. Because laws and regulations pertaining to cable systems were quite different from those pertaining to LECs, the prospect of greater competition between those two types of providers led Congress to revisit video market regulation. Moreover, Section 601 rescinded the 1982 consent decree that required the breakup of AT&T, thereby allowing LECs to consolidate further by subsequently merging with long-distance service providers and each other.
The act stipulated that cable operators do not need to obtain approval of local authorities that regulate their video services in order to offer "telecommunications services," such as voice services. The Senate Commerce Committee noted that these changes did not affect existing federal or state authority with respect to telecommunications services. It stated that the committee intended that local governments, when exercising their authority to manage their public rights of way, regulate telecommunications services provided by cable companies in a nondiscriminatory and competitively neutral manner.
Congress used the term "open video systems" (OVS) in the 1996 Telecommunications Act (Â§653) to describe LECs that soughtto compete with cable operators. The act explicitly exempted OVS service from franchise fees and other 1992 Cable Act requirements, including the requirement to obtain a local franchise. In 1999, the U.S. Court of Appeals for the Fifth Circuit interpreted the provision to mean that, while the federal government could no longer require OVS operators to obtain a local franchise, state and local authorities could nevertheless do so.

	State vs. Local Franchising of Video Services

In 2003, several telephone companies, most notably Southwestern Bell Company (now AT&T) and Verizon, began constructing fiber networks designed to bring consumers advanced digital services, including video. AT&T and Verizon branded these services as "U-Verse" and "FiOS," respectively. Neither company launched video services under the OVS rules, claiming that federal requirements and potential local franchise requirements were too costly.
In 2006, a federal district court in California dismissed AT&T's claims that municipalities were violating federal law by attempting to exercise franchise authority over the company's video services. The court declined, however, to rule on whether video delivered over internet protocol, the technology used by LECs, met the federal definition of a cable service. Two bills introduced that year in the 109 th Congress, H.R. 5252 and S. 2686 , would have declared that video service enabled via internet protocol is subject only to federal regulation. Congress did not vote on either bill.

		State-Level Franchising Authority

As the LECs sought to enter the video distribution market, they pursued statewide reforms to speed their entry, rather than seeking franchises in individual municipalities. The LECs' competitors, the incumbent cable operators, contended that state-level franchising would present new entrants with fewer obligations than cable companies had faced when they entered the market, specifically the obligation to build networks serving all parts of a community.
In 2005, Texas became the first of several states to replace local franchising with a state-level regime for video service providers, with the express purpose of facilitating entry by new competitors. As Table 1 illustrates, many other states have since either replaced municipal franchising with state-level franchising or offered providers a choice.

	FCC Actions Affecting State and Local Video Service Franchising Terms and Conditions

Since 2007, the FCC has repeatedly revisited the authority of states and LFAs to franchise and regulate video service providers. This process culminated in two orders issued in 2019. One (the "2019 LFA 3 rd R&O") sharply limits state and local authority over products offered by video service providers other than video programming. The other order (the "2019 Effective Competition Order") determined that AT&T's streaming service, AT&T TV NOW, meets the LEC test component of Congress's effective local competition definition and therefore provides effective competition to a local cable operator.

		2007 Order Addressing Local Franchising of New Entrants

In 2007, the FCC found that the local franchising process constituted an unreasonable barrier to new entrants in the marketplace for video services and to their deployment of high-speed internet service. The FCC adopted rules and guidance covering cities and counties that grant cable franchises. However, the agency stated that it lacked sufficient information regarding whether to apply the rules and guidance to state governments that either issued franchises at the statewide level or had enacted laws governing specific aspects of the franchising process. Consequently, the FCC stated that while it would preempt local laws, it would not preempt state laws covering video franchises.

			Franchise Fee Cap

				In-Kind Contributions Unrelated to Cable Services Included in Cap

The FCC determined that unless certain specified costs, fees, and other compensation required by LFAs are counted toward the statutory 5% cap on franchise fees, an LFA's demand for such fees represents an unreasonable refusal to award a competitive franchise to a new entrant. In addition, the FCC found that some LFAs had required new entrants to make "in-kind" payments or contributions that are unrelated to the provision of cable services. The FCC stated that any requests by LFAs for in-kind contributions that are unrelated to the provision of cable services by a new competitive entrant are subject to the statutory 5% franchise fee cap.

				Payments Made to Support PEG Operations Included in Cap

The FCC contended that disputes between LFAs and new entrants over LFA-mandated contributions in support of PEG services and equipment could lead to unreasonable refusals by LFAs to award competitive franchises. It determined that costs related to supporting the use of PEG access facilities, including but not limited to salaries and training, are subject to the 5% cap, but that capital costs "incurred in or associated with the construction of PEG access facilities" are excluded from the cap.

			Treatment of Nonvideo Services by LFAs

The FCC stated that the LFAs' jurisdiction over LECs and other new entrants applies only to the provision of video services. Specifically, it stated that an LFA cannot use its video franchising authority to attempt to regulate a LEC's entire network beyond the provision of video services.

			Additional Findings Regarding "Unreasonable" LFA Actions

In addition, the FCC found that the following LFA actions constitute an unreasonable refusal to award video franchises to new entrants:
1. failure to issue a decision on a competitive application within the time frames specified in the FCC's order; 2. refusal to grant a competitive franchise because of an applicant's unwillingness to agree to "unreasonable" build-out requirements; and 3. denying an application based upon a new entrant's refusal to undertake certain obligations relating to PEGs and I-Nets.

			Court Ruling

In 2008, the U.S. Court of Appeals for the Sixth Circuit upheld the FCC's rules.

		2007 and 2015 Orders Addressing Local Franchising of Incumbent Cable Operators

In November 2007, the FCC issued a Second Report and Order that extended the application of several of these rules to local procedures to renew incumbent cable operators' franchises. Specifically, the FCC determined that the rules addressing LFAs' franchise fees, PEG and institutional network obligations, and non-cable-related services and facilities should apply to incumbent operators. It concluded, however, that FCC rules setting time limits on LFAs' franchising decisions and limiting LFA build-out requirements should not apply to incumbent cable operators.
Several LFAs petitioned the FCC to reconsider and clarify its Second Report and Order. In 2015, the FCC issued an Order on Reconsideration in which it set forth additional details about its rules with the stated purposes of promoting competition in video services and accelerating broadband deployment. Following the 2015 Order on Reconsideration, the following policies were in place.

			City and County LFAs Only

The FCC clarified that its rules and regulations on franchising applied to city and county LFAs only, not to state-level laws or decisions. The FCC stated that it lacked sufficient information about the state-level franchising process, and suggested that if parties wished the agency to revisit this issue in the future, they should provide evidence that doing so would achieve Congress's policy goals.

			Franchise Fee Cap

				In-Kind Contributions Unrelated to Cable Services Included in Cap

The FCC included in-kind contributions from incumbent cable operators that were unrelated to the provision of video services within the statutory 5% franchise fee cap. Likewise, the FCC found that payments made by cable operators to support PEG access facilities are subject to the 5% cap, unless they fall under the FCC's definition of "capital costs" associated with the construction of PEG facilities. The FCC made in-kind contributions related to cable services subject to the cap on franchise fees for new entrants as well as for cable incumbents.

			Treatment of Nonvideo Services by LFAs

The FCC determined that LFAs' jurisdiction to regulate incumbent cable operators' services is limited to video services, and does not include voice or data services.

			Findings Applicable to New Entrants, but Not Incumbents

In addition, the FCC found the following LFA actions do not per se constitute an unreasonable refusal to award video franchises to cable incumbents, although they did for new entrants:
1. denying an application based upon an incumbent's refusal to undertake certain obligations relating to PEGs and institutional networks; 2. failure to issue a decision on a competitive application within the time frames specified in the FCC's order; and 3. refusal to grant a competitive franchise because of an applicant's unwillingness to agree to unreasonable build-out requirements.

			Court Ruling

In 2017, the U.S. Court of Appeals for the Sixth Circuit addressed challenges by LFAs to the 2007 Second Report and Order and the 2015 Order on Reconsideration. The court found that the FCC had made sufficiently clear that its rules only apply to city and county LFAs and did not bind state franchising authorities.
It determined that the FCC had correctly concluded that noncash contributions could be included in its interpretation of "franchise fee" subject to the 5% limit. However, the court held that the FCC had neither explained why the statutory text allowed inclusion of in-kind cable-related contributions within the 5% cap nor defined what "in-kind" meant. It found that the FCC offered no basis for barring local franchising authorities from regulating the provision of "non-telecommunications" services by incumbent cable providers. It directed the FCC to set forth a valid statutory basis, "if there is one," for applying its rule to the franchising of cable incumbents. The court used the term "non-telecommunications" service rather than "non-video" or "non-cable" service, differing from the distinctions the FCC made with respect to LFAs' authority.

		2019 FCC Rulemaking

The FCC responded to the court's directives in 2018, and once again proposed rules governing the franchising of cable incumbents. On August 1, 2019, the FCC adopted its Third Report and Order (R&O). The FCC stated that its rules would ensure a more level playing field between new entrants and incumbent cable operators and accelerate deployment of "advanced telecommunications capability" by preempting local regulations that "impose an undue economic burden" on video service providers.
The FCC stated that the franchise fees rulings are prospective. That is, video operators may count only ongoing and future in-kind contributions toward the 5% franchise fee cap after September 26, 2019, the effective date of its rules. To the extent franchise agreements conflict with the FCC's rules, the agency encourages the parties to negotiate franchise modifications within a "reasonable timeframe," which it states should be120 days in most cases. Under the new regulations:
The FCC oversees state franchising authorities for the first time. Cable-related in-kind contributions from both new entrants and incumbent cable operators are "franchise fees" subject to the 5% cap, with limited exceptions. Such contributions include any nonmonetary contributions related to the provision of video services by incumbent cable operators and LECs as a condition or requirement of a local franchise agreement. Examples include free and discounted cable video service to public buildings; costs in support of PEG access facilities other than capital costs; and costs associated with the construction, maintenance, and service of an I-Net. For purposes of calculating contributions toward the 5% franchise fee cap, video providers and LFAs must attach a fair market value to cable-related in-kind contributions, but the FCC declined to provide guidance on how to calculate fair market value. The definition of PEG "capital costs" subject to the 5% cap includes equipment purchases and construction costs, but does not include the cost of installing the facilities that LFAs use to deliver PEG services from locations where the programming is produced to the cable headend. Requirements that cable operators build out their systems within the franchise area and the cost of providing channel capacity for PEG channels may not be included under the 5% cap. Franchise authorities may not regulate nonvideo services offered over cable systems by incumbent cable operators. The services covered by this prohibition include broadband internet service, business data services, and Voice over Internet Protocol (VoIP) services. "[S]tates, localities, and cable franchising authorities are preempted from charging franchised cable operators more than five percent of their gross revenue from cable [video] services." Thus, LFAs may not include nonvideo service revenues when calculating the 5% cap.
The communities of Los Angeles, CA, Portland, OR, and Eugene, OR, have filed a petition with the U.S. Court of Appeals for the Ninth Circuit challenging the FCC's rules. The Ninth Circuit has consolidated the various appellate court challenges, and in November 2019, granted an FCC motion to transfer the now-consolidated petition to the U.S. Court of Appeals, Sixth Circuit.

	Potential Impact of FCC Rules

 Table 1 , as well as the following two tables, illustrate how the FCC's rules could potentially affect the franchising process in several states. The FCC's decision to extend its franchising rule to state governments for the first time will subject each of the states listed in the first three columns of Table 1 (i.e., those that issue franchises at the state-level in all or some circumstances) to the FCC's rules. Moreover, the FCC's rules will cover states that oversee municipal franchises via either statute or state-level agencies. Thus, the FCC's franchising rules will affect more video service providers, viewers, and municipal governments than ever before.

		Trade-Offs Between In-Kind Cable-Related Contributions and General Funds

Because the FCC is including cable-related in-kind contributions in its definition of franchise fees subject to the 5% cap, some states and municipalities may need to make a trade-off.
Specifically, as Table 2 illustrates, several states require or allow LFAs to require video service providers to offer free and/or discounted video service to public buildings, support of PEG services (other than capital costs), and support of I-Nets. Affected states and municipalities may need to reevaluate the trade-off between in-kind cable-related contributions and general fund revenues. Note that Ohio and Wisconsin prohibit both PEG and I-Net contribution requirements, while Idaho prohibits I-Net contribution requirements.

		Evaluation of Provider Revenues Subject to Franchise Fee Cap

			Video-Related Revenues

As Table 3 illustrates, some states define "gross revenues" more narrowly than the FCC, excluding, for example , revenues from advertising and home shopping commissions. In those states, as well as others in which municipal LFAs define gross revenues more narrowly than the FCC, PEGs may be able to continue to receive cable-related, in-kind contributions without reducing the monetary contributions they receive, while remaining within the 5% cap. As described in " Franchise Fees and PEGs ," the FCC has included revenues from advertising and home shopping commissions, in addition to revenues from video service subscriptions, in its definition of "gross revenues." LFAs that use similar definitions of "gross revenues," including those subject to state regulation, may already charge the maximum amount of franchise fees permitted by the FCC. Others, however, exclude these sources, and may therefore have more flexibility when evaluating whether or not to continue their cable-related in-kind contributions.
Moreover, some states specifically exclude other items when calculating providers' revenue bases that are subject to the franchise fees. Several exclude government fees and/or taxes passed on to subscribers, while Missouri excludes fees and contributions for I-Nets and PEG support from its calculation. The FCC has not specifically addressed whether franchise authorities may include these items in their revenue base calculation. Thus, these states may also have more flexibility when evaluating whether to change video franchises' terms and conditions.

			Nonvideo Revenues

Many states already exclude nonvideo revenues from the calculation of provider revenues subject to the franchise fee cap. New York, however, describes the gross revenues of a video provider subject to the franchising fees as including, among other things, "carrier service revenue." This section of the New York statute does not define "carrier service revenue." A current dispute between New York City and Charter Communications (d/b/a Spectrum) for service within Brooklyn concerns whether "carrier service revenue" received from "additional provided services" may be subject to franchise fees. The FCC's new rules may affect the outcome of this dispute.
Moreover, in July 2019, the New York State Public Service Commission approved a settlement of a complaint that Charter has failed to comply with a requirement in its franchise agreement to expand high-speed service. Under the settlement, Charter may continue operating within the state, if it expands its high-speed internet service infrastructure to 145,000 residents in Upstate New York and invests $12 million in providing high-speed internet services to other areas of the state. If Charter contends that the FCC's rules preempt these provisions, it could seek to renegotiate the settlement.
The FCC cited a decision by the Supreme Court of Oregon in City of Eugene v. Comcast as an example of states and localities asserting authority to impose fees and requirements beyond their authority. In the decision, the court upheld a local government's 7% license fee on revenue from broadband services provided over a franchised cable system. Thus, while states and municipalities may regulate both video and voice services of telcos, they may only regulate video services of cable operators.

			Outlook for State and Municipal Franchise Fees

If a state or municipality may charge franchise fees to cable operators and telcos only with respect to video services, the total amount of fees received is likely to decrease over time. As Figure 1 indicates, the total number of U.S. households subscribing to cable and telco video services has declined over the past 10 years. In 2010, about 70.8 million households subscribed to either a cable operator or a telco, compared with about 60.1 million households in 2019. In place of cable, more households have elected to rely on video provided over broadband connections or broadcast transmission.
For cable operators in particular, this substitution of alternative sources of programming has led to the pursuit of revenue from nonvideo services, such as voice and high-speed data. In 2010, video services represented about 63% of total cable industry revenue, whereas in 2019 video represented 46% of total industry revenue ( Figure 2 ). Pursuant to the FCC's proposed rules, these other sources of revenue are not subject to LFAs' jurisdiction. In addition, the U.S. Court of Appeals for the Eighth Circuit held that a cable operator's voice services are not a telecommunications service, and therefore not subject to state regulation. In October 2019, the U.S. Supreme Court denied the Minnesota Public Utility Commission's petition hear the case.
In Missouri, the City of Creve Coeur and other municipalities filed a class action lawsuit against satellite operators DIRECTV, DISH Network, as well as online streaming services Netflix Inc., and Hulu LLC, claiming that the companies must pay a percentage of gross receipts from video services to the municipalities where they do business, pursuant to Missouri's Video Services Providers Act. The state law allows Missouri's political subdivisions to collect up to 5% of gross receipts from providers of video programming and requires providers to register before providing service in the state, according to court documents. The municipalities claim the defendants have not paid the required amounts.
Other localities may follow suit. A bill before the Illinois General Assembly would impose a 5% tax (rather than a "franchise fee") on the video service revenues of direct broadcast satellite operators and online video services for the right to provide services to Illinois residents. Similarly, a bill before the Massachusetts House of Representatives would impose a 5% fee on revenues earned by streaming video services. Massachusetts would split the money collected from the fees between the state's general fund (20%), municipalities (40%), and PEG programmers (40%). If receipts from cable franchise fees continue to erode, more states and municipalities may respond by seeking alternative revenue sources.

		Preemption of Rate Regulation

In 2014, Congress enacted the Satellite Television Extension and Localism Act Reauthorization Act (STELA Reauthorization Act; P.L. 113-200 ). Section 111 of the act directed the FCC to develop a streamlined process for the filing of "effective competition" petitions by small cable operators within 180 days of the law's enactment. A cable company filing such a petition bears the burden of proof to demonstrate that it faces effective competition for its video services.
The FCC responded in 2015 by adopting a rebuttable presumption that cable operators are subject to effective competition. As a result, the FCC prohibited franchising authorities from regulating basic cable rates unless they can demonstrate that the cable system is not subject to effective competition. The FCC stated that the change in its effective competition definition was justified by the fact that direct broadcast satellite service was available as an alternative video services provider throughout the United States.
Later in 2015, the FCC found that LFAs in two states, Massachusetts and Hawaii, demonstrated that cable systems in their geographic areas were not subject to effective competition, and permitted them to continue to regulate the rates of the basic tiers of cable services. However, in September 2018, Charter Communications (Charter), a cable provider, asked the FCC to find that AT&T's DIRECTV NOW, a streaming service that AT&T has since rebranded as AT&T TV NOW, provides effective competition to cable systems in Kauai, HI, and 32 Massachusetts communities. In October 2019, the FCC agreed and issued an order granting Charter's petition, finding for the first time that an online streaming service affiliated with a LEC meets the LEC test in Congress's definition of effective competition.
The FCC found that
[AT&T TV NOW] need not itself be a LEC and AT&T need not offer telephone exchange service in the franchise areas.... There is no requirement ... that a LEC provide telephone exchange service in the same communities as the competing video programming service.
Thus, if even AT&T TV NOW's subscribers rely on internet service from Charter to receive AT&T TV NOW's programming, the FCC considers AT&T TV NOW to be a competitor to Charter with respect to the distribution of video programming. According to the FCC,
Congress adopted the LEC test because LECs and their affiliates "are uniquely well-funded and well-established entities that would provide durable competition to cable," and not because [Congress was] focused on facilities-based competition.
Meanwhile, some localities have enacted legislation with the goal of reducing prices consumers pay for video services. A 2019 Maine law would require video service providers to offer networks and programs on an a la carte basis instead of offering subscribers only bundles of channels. Several cable operators, broadcasters, and content providers have sued to overturn the law. In January 2020, a federal judge blocked the implementation of the law as the parties prepare for trial.

	Considerations for Congress

These regulatory developments and industry trends raise several potential issues for Congress to consider.
First, Congress could consider whether the FCC's interpretation of the Communications Act is consistent with the policy goals set forth in Section 601 of the Communications Act (47 U.S.C. Â§521) and Section 706 of the Telecommunications Act. Specifically, Congress could explore the extent, if any, to which state and local regulations designed to promote the availability of PEG programming and I-Nets.
Second, Congress could evaluate whether to create regulatory parity with respect to local regulation of nonvideo services of cable and telcos. While states and municipalities may regulate both video and voice services of telcos, they may only regulate video services of cable operators. Congress could address regulatory parity by either deregulating traditional telcos' nonvideo services or regulating cable operators' nonvideo services.
Third, as the FCC and local governments include online video providers in their definitions of video providers for the purposes of evaluating competition and/or imposing franchise fees, Congress could clarify whether these actions achieve its stated policy goals. For example, if, in contrast to the FCC's interpretation of the LEC test for effective competition, Congress intends to include only facilities-based video services in its definition of video service competition, it could delineate the definition in communications laws. Likewise, as online video services become more prevalent and states and municipalities target them for franchise fees, Congress could specify the authority, if any, to regulate them.
Finally, while the FCC has determined that competition among video programming distribution services has eliminated the need for rate regulation of the basic tier of cable services, Maine enacted a law to enable consumers to pay only for video programming they choose, in lieu of bundles of channels. In the past, some Members of Congress have proposed statutory changes to require video programming distributors to offer individual channels to consumers in addition to bundles of channels, and Congress could consider revisiting this issue, or alternatively clarifying that states and local governments lack authority to enact such laws.