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AT&T vs. the Farm Team

The telecom giant wants to close a legal loophole that allows rural phone companies to profit from conference-calling and sex-line services

Making money has never been easy for small-town phone companies, most of which rely on federal subsidies to survive. But two years ago, Ronald Laudner, chief executive of Farmers' Telephone, in rural Iowa, hit on a lucrative new source of profit, thanks to a convoluted federal mandate that requires long-distance carriers to pay rural phone companies. By the end of 2006 his call volume was up twelvefold and annual net revenues had doubled, to $2 million.

That's when AT&T's (T) lawyers came calling. Now Farmers', which serves about 1,600 local customers near Riceville, Iowa, is among a handful of rural telcos under assault from big telecommunications companies. The giants complain that the little guys have latched onto a lively industry of free conference-call, chat-room, and sex-line services that make economic sense only because of federal regulation.

The so-called Universal Service Fund was set up to ensure that sparsely populated areas of the country could still get affordable phone service following the 1984 breakup of the Ma Bell monopoly. But the big boys say smaller carriers are exploiting loopholes in the program and raking in cash from larger players. "This was not created to give people access to free porn or other seemingly legitimate services," says Qwest spokesman Robert Toevs. "From our standpoint it's a pure scam."

Working the System

The problem surfaced late last year, when AT&T, Qwest Communications International (Q), Sprint Nextel (S), and others first noticed a steep spike in the number of calls they were patching through to remote parts of Iowa and Minnesota. Company officials say they discovered that rural exchanges and their chat-line partners were exploiting a taxpayer-subsidized system.

Here's how the system works: To ensure service to rural areas in the wake of the Ma Bell breakup, the big telecoms pay a complicated set of fees, ranging from less than 2¢ to 15¢ a minute, to the small carriers that connect long-distance calls to local customers. The connection fee is lowest for big-city exchanges, which have the volume and infrastructure to keep prices low. But in rural America, the rate is generally 5¢ or 6¢ a minute, and in rare cases it can be as high as 13¢, based on convoluted rules.

Years ago, rural providers that charge high per-minute connection levies struck a bargain with chat-room and sex-line operators that promised to generate thousands or millions of calls a month in return for a small commission or marketing fee on each minute of calling. Rural carriers saw an easy way to finance much-needed infrastructure improvements and replace revenue being lost to wireless and broadband competition.

Cutting the Big Boys' Margins

The partnerships operated on a very small scale until late last year, about the time free conference-calling services began attracting a huge following. Call volumes to parts of the rural Midwest exploded almost overnight. Qwest, which had been patching 15,000 minutes of phone calls a month to Superior Telephone Cooperative in Superior, Iowa, saw its November call volume spike to 6.4 million minutes. AT&T says its monthly access payments to Superior jumped from less than $2,000 a month to more than $2 million a month, more than double what it would cost AT&T on a per-minute basis if every one of Superior's 150 or so residents were on a month-long, around-the-clock long-distance call. Superior's lawyer did not return calls for comment.

The practice was eating into the already thin profit margins that big telecoms get from commodity long-distance service, which usually is sold to customers as part of an all-you-can-use, flat-rate monthly bundle of services. In January long-distance providers stopped making connection fee payments to the rural phone companies that they accused of gaming the system. In March they briefly blocked calls to a handful of numbers in Iowa and Minnesota, but abandoned the tactic in the face of customer outcry.

Several carriers have filed lawsuits and appealed to state and federal regulators for help. In an Apr. 4 letter to Federal Communications Commission Chairman Kevin Martin, AT&T said about a dozen local phone carriers engage in such "swindles" and that more were expected to get into the game in the coming months, "drawn to the lure of illicit windfalls." The FCC has been weighing changes to the rural fee system since 2001, with Martin calling for a flat-fee arrangement. But the system's complexity means change is unlikely to happen anytime soon.

Giving No Ground

Small businesses and nonprofits that have come to rely on free conference calls fret about losing the services. And players in the free conference-call industry are stepping out of the shadows to make a case for their legitimacy. "These guys don't' give away long-distance service. They just sell it," says Alex Cory, CEO of Los Angeles-based Global Conference Partners, which sued AT&T on Mar. 26 for blocking calls to its numbers. "They promoted toll-free calling. Now their models are getting goofed up in terms of how much it costs."

Cory says his business is growing. Last May, private equity giant American Capital Strategies paid $47 million for Global Conference, which claims about 3% of the annual 22-billion-minute global market in conference calling.

The diminutive local providers, basking in their newfound entrepreneurialism and revenue, are giving no ground. "There's nothing wrong with what we're doing," says Laudner, who says the long-distance carriers owe him $8.5 million in back fees. Industry giants failed to adapt their business to changing times, he says, and have only themselves to blame. "AT&T and Sprint and everybody else was promoting their [flat-rate] calling plans, and they just didn't see this coming."

Woellert is a correspondent in BusinessWeek's Washington bureau.

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