A few weeks ago the Omaha City Council awarded the local cable television franchise to a subsidiary of Cox Broadcasting. The subsidiary's financing plan is worth a close look.
Of the estimated $36,879,000 investment needed to construct the system, Cox is required to supply $36,878,800, and eight local "investors" fill the financing gap by supplying an aggregate of $200.
And what profit split is deemed appropriate for these respective responsibilities? Those who picture the modern American corporation as a selfish monster are going to be disappointed. Although the $200 supplied by the local eight would not even pay the construction cost of one connection out of the ultimate 100,000-plus projected total connections, the profits are to be split 80-20. Obviously, all "connections" are not weighted equally.
Furthermore, at any time after five years, the locals can force Cox to purchase their interests at "pro-rata share of total value" based on the higher of two formula prices. Cox's projection to the city indicates the 20 percent interest will have a value of about $12 million after 10 years or, roughly, a 6 million percent gain.
Of course $200 is still $200 and -- apparently to satisfy the truly risk-averse -- a floor price of $1 million in five years, regardless of economic results, was put in the buy-out arrangement. Thus, once the franchise grant was received by Cox, the local group was guaranteed either a) 20 percent of profits forever, should it prove a big winner or b) a $1 million consolation prize, should it prove a lemon.
Among the favored eight there are no Marconis, Dumonts, DeMilles or Murrows. The unimportance of programming or engineering talent in the selection of local participants was proved rather conclusively when one franchise seeker solicited me as a potential investor some two years ago.
In a three-page letter to the publisher of a newspaper of which I am board chairman, one of the major national cable operators (and one of the six final applicants) asked us, either individually or corporately, to join up with them for a significant piece of the action. Our financial commitment would have required us to forego a night out at MacDonald's.
It wasn't a letter you would have enjoyed reading to a civics class. Here are a few excerpts:
"Specifically [a company, not Cox] is prepared to support up to 20 percent local investment on a carried interest basis; that is, these investors are required only to subscribe for their stock at a nominal par value, with the parent company advancing all necessary funds for the construction and operation of the franchise. . . .
"Aside from financing, however, we view the local investors as full partners, particularly with regard to developing the strategy to obtain the favorable vote of the city for award of the franchise, and, in the case of a city such as Omaha where a referendum is required, in supporting the referendum campaign through their personal contacts and ideas." (The law was changed; no referendum was required.)
"Finally, the winning of a cable franchise is essentially a political campaign. . . . The ability of local investors to take the political temperature, make introductions and appointments on a timely basis, and to lend their personal credibility to our formal business proposal is vitally important to the success of our proposal."
These noble thoughts, of course, represent only the propositions deemed appropriate to put in writing to the publisher of a newspaper. Oral presentations, presumably employing even more candid language, are likely to be the preferred method of negotiation with local participants.
The Omaha situation, though unseemly, is not unusual. In fact, it is becoming pretty much the current standard. Economic Darwinism has seen to that. The hunter develops the habits that deliver his meal.
As franchise awards have achieved immediate negotiable value -- even without a dime of tangible capital investment in the property -- major cable operators have quickly responded with varied and innovative schemes to effect immediate wealth transfers to those whose presence may influence decision makers. What would be blatantly illegal if only two parties were involved -- the grantor and grantee -- apparently can be legalized if not deodorized by the presence of three parties -- grantor, free-riding party of influence and grantee.
Under this arrangement, the wealth transferees usually are a few prominent and well-connected locals. Sometimes a popular or powerful institution, such as a university, or a minority organization is substituted. In Omaha, Warner-Amex "gifted" a 20 percent interest in the potential award to Creighton University, probably on the theory that an "if-somebody-is-going-to-get-a-windfall-why-not-the-good-guys" sentiment might sweep the council at decision time.
But Warner-Amex, of course, wasn't the party making the gift. The transferors of the wealth grant (estimated conservatively by the Warner-Amex representative in the case of Creighton to be worth $10 million in 10 years) would not be the national cable operator, but rather the future cable users of Omaha. For there is no particular magic possessed by cable companies enabling them to turn lead into gold for a few selected local citizens. The gold must come from the user of the service -- but only if he is overcharged relative to capital employed in the service. And under current regulatory thinking, the national cable operator can factor "grant-influencing" costs into a rate structure just as easily as the more tangible costs.
The telephone or water companies could make similar wealth grants to the few if they were able to set prices at levels inappropriately high, relative to capital investment. The degree to which massive handouts can be made in conjunction with obtaining exclusive franchise grants should be seen as a barometer of the weakness, current and expected, in rate regulation. If rate of return is effectively regulated, there is no windfall to be distributed.
Currently, cable systems sell for $600 to $800 per subscriber. But costs of construction in most areas run in the range of $300 to $500 per subscriber. Small wonder that campaigns to obtain franchises have produced a competition to dispense bundles of wealth in the politically most useful way. Appropriate rate regulation would produce market values only modestly above construction costs.
Regulators, of course, must approach the problem with both eyes open. Most franchise agreements maintain continuing jurisdiction over basic cable rates. But all must leave extras, such as Home Box Office charges, totally unregulated pursuant to a 1974 FCC ruling. That ruling, prompted by the fear that regulation would hinder the development of new services, now is clearly unwarranted. In the relatively near future, a majority of revenue might well come from a wide variety of unregulated charges. Imagine the fun the telephone company could have if only local charges (the "basic service") were subject to regulation, and they were free to establish whatever prices they wished for such "extras" as phone directories and long-distance service. Regulation that doesn't include all items of revenue in determining appropriate rates of return is no regulation at all.
The cable regulatory culture has evolved in large part from a background of many small community systems originally installed to provide better reception of basic programming. Under these circumstances, with total monthly billings of only $7 or $8 per subscriber, regulation could be lax and atomized without serious abuse. But that cable world is fast disappearing. Cable operators can be expected to mass their efforts to maintain the old regulatory culture even as large urban systems mushroom, services proliferate, and subscribers' monthly billings bound upward. In fact, efforts are being made -- sometimes successfully -- to eliminate even the flimsy regulatory framework now prevailing.
The behavior of the national cable operators in recent grant applications should cause users and government to think twice before consenting to any "honor system" theory of rate regulation. Instead, a rate-of-return approach applied to total earnings and total capital investment should become mandatory. Unless this is accomplished soon, imbedded economic interests, along with subsequent transfers of properties at enormous premiums over tangible capital investment, will make a cost-related rate structure politically impossible.