ARCHIVED -  Telecom Decision CRTC 96-3

Telecom Decision

Ottawa, 9 February 1996

Telecom Decision CRTC 96-3

BELL CANADA/BELL SYGMA RESTRUCTURING AND RELATED TRANSACTIONS

I BACKGROUND

On 19 November 1992, Bell Canada (Bell) filed with the Commission documents regarding proposed transactions whereby Bell would transfer the assets, personnel and activities associated with the company's Operations Development department to three new subsidiaries, Bell Sygma Inc. (BSI), Bell Sygma Systems Management Inc. (BSSM) and Bell Sygma Telecom Solutions Inc. (BSTS) (collectively, the Sygma companies).

Under the proposed restructuring, BSSM would provide data processing and computer network management services to Bell and to third parties. BSTS would be responsible for systems development and integration services provided to Bell and to third parties, and would also license Bell intellectual property to third parties. BSI was to serve primarily as the holding company for the other two subsidiaries and was to undertake certain support functions on their behalf. In addition, BSI was to acquire from Bell the real estate interests associated with Bell's two data centres located in North York, Ontario, and Dorval, Quebec. BSI, in turn, was to lease space in these data centres to BSSM, BSTS and Bell itself.

On 30 December 1992, the Commission granted interim approval to the sale by Bell of the assets in question, pursuant to subsection 11(2) of the Bell Canada Act.

In Bell Canada - Proposed Transfer of Assets to Bell Sygma Subsidiaries and Related Transactions, Telecom Public Notice CRTC 93-10, 25 January 1993 (Public Notice 93-10), the Commission initiated a proceeding to consider: (1) whether the proposed asset disposition was in the public interest and, if so, under what terms and conditions, if any, final approval should be granted, and (2) whether, as a result of the proposed asset sale and related transactions, adjustments were necessary for revenue requirement purposes. In Bell Canada - Amended Procedures re Proposed Transfer of Assets to Bell Sygma Subsidiaries and Related Transactions, Telecom Public Notice CRTC 93-29, 8 March 1993, the Commission stated that it would consider the Sygma application in the proceeding then underway with respect to Bell's revenue requirements for 1993 and 1994.

On 15 March 1993, various agreements between Bell and the Sygma companies were filed with the Commission and served on interested parties. These agreements, which took effect on 1 February 1993, related to the transfer of assets and personnel from Bell and the ongoing provision of services between the companies (the Sygma transactions).

During oral reply argument in the revenue requirement proceeding, counsel for Bell stated that, "if the proposed intercorporate transactions for WorldLinx and Sygma are not acceptable to the Commission as proposed,... the company will not carry on with the proposed transactions, and I am requesting that the revenue requirement and rates for Bell Canada be set accordingly. In such an event, the company may consider its options and determine if it can subsequently structure viable transactions, which would then be submitted for Commission review, as required, in accordance with the Commission's directions."

In Bell Canada - Revenue Requirements for 1993 and 1994, Telecom Decision CRTC 93-12, 30 August 1993 (Decision 93-12), the Commission stated that, although it supported the concept of Sygma in principle, it was not persuaded that Bell had demonstrated that the proposed transactions, in the aggregate, reflected either fair market value or a reasonable proxy therefor. In light of Bell's statement in reply argument, cited above, and the fact that the Commission would have found it necessary to make regulatory adjustments in order to find the Sygma transactions acceptable, the Commission did not grant final approval. Rather, as requested by the company, the Commission assessed Bell's revenue requirements on the assumption that the company would not be proceeding with the Sygma transactions. The Commission added that, if Bell were to proceed with any similar transactions, the company was to file all related agreements with the Commission, as well as an assessment of the revenue requirement impact for the ensuing ten-year period. The company was also to provide the Commission with:

(1) an independent third party appraisal, showing that the business, as a going concern, was being transferred at fair market value (this appraisal was to consider factors such as the value of transferred employees and the value of royalties to be derived from the licensing of Bell intellectual property); and

(2) formal studies comparing the cost of providing a service "in house" with the cost of outsourcing such a service.

On 4 March 1994, Unitel Communications Inc. (Unitel) requested that the Commission initiate a proceeding to examine, among other things, the issues identified in Public Notice 93-10 and the Sygma-related matters discussed in Decision 93-12. Unitel contended that, notwithstanding Bell's statement in the revenue requirement proceeding, the company had completed the Sygma transactions.

In a letter dated 25 March 1994, CGI Information and Management Consultants Inc. (CGI) requested that the Commission order Bell, among other things, to comply forthwith with the requirements of Decision 93-12.

Bell responded to the issues raised by Unitel and CGI in a letter to the Commission dated 7 April 1994. In that letter, Bell confirmed that the Sygma transactions that took effect on 1 February 1993 had never been undone and that the Sygma companies were currently active. Bell stated that, given that the costs of establishing Sygma and making it operational had already been incurred, it was unreasonable for Unitel to suggest that, subsequent to Decision 93-12 and pending the internal review of alternatives, the company should have incurred the additional structural costs of disbanding the Sygma organization, repatriating employees and transferring assets back to Bell. In Bell's view, until the company had concluded its internal review of various alternatives, any public process would have been premature and purely academic. Bell added that subscribers were not adversely affected, in that the company was continuing to report monthly financial results to the Commission on a basis consistent with not having proceeded with the Sygma transactions.

Noting that Decision 93-12 had been issued more than eight months previously, on 5 May 1994, the Commission directed Bell to file the information required by Decision 93-12.

On 13 June 1994, Bell filed with the Commission in confidence (1) comments setting out, among other things, the revenue requirement impact of the Sygma transactions, (2) an independent appraisal of BSI by Burns Fry Limited (Burns Fry), (3) a formal cost study by the Yankee Group with respect to services provided to Bell by BSTS, (4) a formal cost study by Real Decisions Corporation (Real Decisions) with respect to services provided to Bell by BSSM, (5) a report by San Francisco Consulting Group (SFCG) regarding royalty arrangements between Bell and BSTS, (6) copies of the license agreements originally filed in response to interrogatory Bell(CRTC) 21Jan93-101 SYGMA, and (7) copies of the agreements entered into by Bell and the Sygma companies, effective 1 February 1993, and of amendments to certain of those agreements (collectively, the filing of 13 June 1994).

Bell also served abridged copies on the following: Association of Competitive Telecommunications Suppliers, CGI, Canadian Business Telecommunications Alliance, Consumers' Association of Canada, National Anti-Poverty Organization (NAPO), Government of Ontario, Government of Quebec and Unitel.

On 4 November 1994, the Commission issued Bell Canada/Bell Sygma Restructuring and Related Transactions, Telecom Public Notice CRTC 94-53, initiating a public proceeding to consider matters related to the Sygma transactions and Bell's filing of 13 June 1994, including:

(1) the reasonableness of the reports of the Yankee Group, Real Decisions and SFCG, and in particular whether the interests of subscribers are adequately protected with respect to the BSSM Data Processing Services Agreement and the BSTS License and Development Services Agreement;

(2) the appropriate basis of valuation for the transfer of the business;

(3) the overall conclusions of the Burns Fry Appraisal and its appropriateness as a measure of fair market value, taking into consideration such factors as sources, methodology, assumptions, the value of transferred employees and the value of third party business in the total fair market value; and

(4) the regulatory treatment to be accorded to any capital gain or loss associated with the asset transfer, including the relevant period(s) for the accounting of any such gain or loss.

On 30 March 1995, the Commission received comments from Unitel and NAPO. Bell filed its reply to the comments on 13 April 1995.

II CONSULTANTS' REPORTS AND SERVICE AGREEMENTS

A. Yankee Group Report

The Yankee Group reviewed the License and Development Services Agreement between Bell and BSTS. In its report, the Yankee Group noted that the contract provided for a ten-year term during which BSTS will have a right of first proposal for systems development activities required by Bell; that service delivery will be maintained at, or above, the levels experienced by Bell prior to the commencement date of the contract; and that there is provision for an annual review of, and resetting of, resource requirements which will determine the annual fee charged to Bell and the adjustment of specific deliverables to reflect the changing requirements of Bell.

As a result of its review, the Yankee Group concluded that the arrangements defined in the License and Development Services Agreement were "complete in coverage and management of important issues consistent with observed industry practice", and that it had no reason to believe that Bell would have been provided a lower price from an existing world class vendor. With respect to an assessment of the charges for systems development, the Yankee Group stated that it had no reason to believe that, if the Sygma transaction had not taken place, Bell could expect to experience lower costs for the services now provided by BSTS.

NAPO did not accept that the Yankee Group conclusions should be considered to demonstrate that the contracts between Bell and Sygma are priced appropriately. In NAPO's view, the relationship between Bell and Sygma is not the same as that which would exist between Bell and a non-affiliated world class vendor. NAPO submitted that the risk that Bell might switch to a service provider other than Sygma, leaving Sygma with stranded investments, is virtually non-existent. Further, if unforeseen circumstances arise making it necessary to renegotiate the contractual arrangements, Sygma would more likely be able to negotiate increased fees than an arm's length company. NAPO also argued that the right of first proposal is very valuable, in that, if BSTS has obtained other work which fully occupies its staff, BSTS will have the right to either accept Bell work and add staff or decline the additional work. In NAPO's view, this significantly reduces the risk BSTS incurs in maintaining capacity on an on-going basis.

Unitel argued that Bell has not demonstrated that the benefits of the BSTS License and Development Services Agreement outweigh the drawbacks of the transaction such as the transfer of the assets to BSTS at less than fair market value. Unitel submitted that, since the activities undertaken by the Yankee Group were almost entirely restricted to (1) due diligence interviews with Sygma general management and selectively with Bell management and BSTS team leader management and (2) a comparison of the pricing of the BSTS arrangement with other contracts with which the Yankee Group is familiar, the study failed to meet the filing requirements specified in Decision 93-12.

In response to NAPO's comments, Bell argued that outsourcing contracts are generally negotiated for long terms precisely because of the concern of the outsourcing firm that a contract might not be renewed, leaving it with, among other things, obsolete equipment. Bell stated that if contracts are for shorter terms, they generally include additional provisions (e.g., termination fees or higher prices) to protect the outsourcer. Bell submitted that any terms of renegotiation would be subject to the same scrutiny as the terms of the present transaction under intercorporate pricing policy, and accordingly, there was no reason to assume that the results of these renegotiations would be different than the results confirmed for the current contracts by independent consultants. Finally, with respect to NAPO's assertion that the right of first proposal provides Sygma with considerable value which had not been taken into account in the valuation, Bell noted that the right of first proposal was taken into account by Burns Fry by including a lower discount rate to value Bell's business.

In response to Unitel's argument regarding the Yankee Group's report, Bell noted that Unitel posed only two interrogatories (1) a request for a copy of the Yankee Group's mandate and (2) a request for a description of the Yankee Group methodologies used to review the Bell Sygma agreements. Bell stated that it requested the above information from the Yankee Group and was advised by the Yankee Group that the full disclosure of its methodology would release proprietary intellectual property and would compromise its ability to compete for future consulting services. Bell stated that the Yankee Group, however, provided three documents as well as previously published material used at Yankee Group conferences which Bell filed in response to Unitel's interrogatory. Bell noted that Unitel did not claim there were any deficiencies in the response.

With respect to the concerns raised by NAPO and Unitel, the Commission would expect to review any contract revisions in accordance with the Commission's current policy regarding intercorporate transactions, and make whatever determinations it considered necessary at that time. The Commission agrees with Bell that the right of first proposal was taken into account by Burns Fry in valuing the business, and in Part III, Conclusions, the Commission has addressed the matter of the transfer price of the business.

B. Real Decisions Report

The Real Decisions report evaluated the data processing services provided by Sygma. The objectives of the study were to determine if BSSM is likely to provide data processing services to Bell at a 5% savings over the life of the contract and to compare the cost effectiveness of BSSM's charges to Bell relative to the commercial industry. In its report, Real Decisions concluded that BSSM is providing data processing services to Bell at approximately a 5% savings over the cost of carrying out the data processing in house and that BSSM's charges to Bell are very competitive.

Unitel noted that in the absence of further disclosure of the contents of the study, it was not possible to determine whether the analysis of Bell's arrangements was reasonable or whether the subscribers' interests were adequately protected. Unitel submitted that the study did not examine the entire contract amounts associated with the BSSM contract, noting that according to the response to interrogatory Bell(Unitel) 18Jan95-22, Fee Services were not included in the analysis. Unitel argued that although Fee Services only represented 10% of the 1993 contract costs, there is very real potential that these services could come to represent an increasingly greater proportion of the overall contract in future years.

In reply to Unitel's claim that there is little evidence to support Bell's claim that the cost of BSSM's services will be less than its internal costs would have been over the life of the ten-year contract, Bell noted that detailed cost studies were not released on the public record because such information would seriously disadvantage Sygma in competing for new business against its competitors. Bell also noted that Fee Services, which account for about 10% of BSSM's billings, relate to specific service delivery and are the subject of discrete negotiations on an ongoing basis.

With regard to Unitel's comments regarding the exclusion of Fee Services, the Commission notes that the Fee Services, which amounted to 10% of the 1993 contract costs, were included in the financial projections provided to and considered by Burns Fry in evaluating the Sygma transaction. In addition, the Commission notes and accepts Real Decision's conclusion that Bell is saving 5% over the costs it would have incurred had it carried out its data processing in house.

C. San Francisco Consulting Group Report

SFCG was engaged by Bell to review the licensing arrangements between Bell and Bell Sygma and to recommend any necessary changes to address the concerns raised by the Commission in Decision 93-12. SFCG developed a framework for assessing royalty rates for future sales which would recognize the value of the investment made by Bell and the value added by BSTS independent of its relationship with Bell. To transform the base royalty into an actual royalty, discount factors are applied to reflect the value added and the risks assumed by Bell Sygma. These discount factors recognize productization, functional enhancement, sales and marketing effort, competition, and maintenance volatility. Other mitigating factors included in the calculation are market objectives, margins, liability, warranty and risk assumed by BSTS. Bell indicated that both it and BSTS were prepared to use these guidelines on future sales as a basis for royalty determination, on a case by case basis.

NAPO stated that SFCG has developed, at the request of Bell, an extensive list of factors to justify highly discounted royalty rates. NAPO submitted that this is a very unusual approach for determining royalties, and that it would be more appropriate for the royalties to reflect the value of the intellectual property that is being made available. NAPO argued that the transfer value of this intellectual property is not diminished by any value added by Sygma through product enhancement, sales and marketing; rather, these investments increase the value of Sygma's products and services, and therefore its revenues and profits.

Bell rejected NAPO's argument noting that no intervener posed any interrogatories on the SFCG report which stated that recommendations contained therein were based on data collected from comparable transactions in the telecommunications industry.

NAPO also argued that it was the subscribers that incur the risk as intellectual property is being developed, and that when the systems have been fully developed, the only risk relates to Sygma's ability to enhance and market the existing intellectual property. Therefore, in NAPO's view, the gains should not accrue to activities outside of the regulated activities.

Bell argued that NAPO failed to recognize that intellectual property has no value until there is a buyer, and that SFCG recognized this and developed a framework to assist Bell and Sygma in determining a fair transfer price by discounting the sales price Sygma receives. In Bell's view, this framework reflects the contribution to the final product by each of Bell and Sygma. Bell believed that NAPO has misinterpreted the SFCG proposal and that a correct reading of the report would allay NAPO's concerns in this regard.

The Commission notes NAPO's comments regarding discounting royalty rates and the valuing of intellectual property. The Commission, however, agrees with Bell that the framework reflects the contributions to the final product by each of Bell and Sygma. The Commission is of the view that the various factors recognized in the discounting process proposed by SFCG (and also used by Burns Fry in its appraisal) should be recognized for future license transactions.

D. Service Agreements

Unitel noted that each of Bell's contracts with BSTS and with BSSM contains a most favoured customer (MFC) clause. Unitel expressed the view that these clauses were meaningless because of other terms and conditions of the agreements. Unitel stated that before Bell can invoke its right to obtain MFC prices, the Sygma companies must have contracts with other customers for "like goods/services taking into account all the circumstances of this transaction including volumes, operating conditions and duration of the Agreement." As a result of this list of qualifications, Unitel stated that a high degree of similarity is required before Bell will be charged the MFC price. In Unitel's view, the chances of Bell invoking its right to MFC prices are extremely rare, since very few customers will have the same volume and contract terms as Bell.

Unitel noted that the Bell/BSTS agreement requires Bell, following the first year, not to reduce the Adjusted Service Fee by more than 5% in a year, or year-over-year. Unitel argued that, although the BSSM contract contains a different formula for ensuring a minimum contract amount, the result is the same: "Bell Canada has given a guarantee to its subsidiaries which assures them of a fixed revenue stream for the next ten years, regardless of whether or not that revenue stream is warranted." In Unitel's view, these guarantees cast considerable doubt upon the arm's length nature of these transactions and render the MFC clauses meaningless.

Apart from Unitel's submission regarding the ineffectiveness of the MFC clause as noted above, Unitel also commented on the MFC clause in view of the Commission's statement in Bell Canada - Procedures for Purchases from Affiliates other than Northern Telecom Canada Limited, Telecom Decision CRTC 90-17, 14 August 1990 (Decision 90-17), wherein the Commission stated that the fact that a large majority of total sales of Bell-Telic Inc. (88.3% in 1987) are made to Bell renders the MFC clause virtually meaningless. Unitel submitted that, while no sales figures for the Sygma group were provided on the public record of this proceeding, it was of the view that, more than likely, Bell accounts for a majority of the BSTS and BSSM sales, and that the situation involving Bell-Telic Inc. is of direct relevance to the Sygma transactions.

Unitel concluded that, if the MFC clause is not an adequate safeguard, then Bell will not receive the lowest possible prices from its Sygma subsidiaries and that, absent price cap regulation, a competitive bidding process or some other form of regulatory adjustment, subscribers will be forced to underwrite the costs of Bell's inflated service contracts with BSTS and BSSM.

In response to Unitel's criticism of the utility of the MFC clauses, Bell argued that under the BSSM contract the company is also protected by the provisions for Technology Cost Review and Depreciation Adjustment in the Data Processing Services Agreement. Bell noted that the BSTS contract calls for Bell and Sygma to annually negotiate the Service Fee and Work Program, and requires the Service Fee to remain fixed if the parties cannot agree on the fee. In Bell's view, based on input from independent consultants, the contracts are complete in coverage and consistent with observed industry practice.

In response to Unitel's argument that MFC clauses are not appropriate, Bell argued that the contracts have ten-year terms and, while the clauses will be difficult to apply in Sygma's formative years when Bell provides the vast majority of Sygma's business, it would be poor business judgment to remove the clauses because they do provide important additional assurances to Bell if Sygma becomes successful in generating third party business.

The Commission notes Unitel's comments regarding the likelihood of Bell invoking its right to prices under the MFC clause. While the Commission agrees that it is unlikely that Bell will invoke that clause in the near future, the Commission also recognizes and agrees with Bell's argument that it would be poor business judgment to remove the clauses because they do provide important additional assurances to Bell should Sygma become successful in generating third party business. The Commission also notes that there are other sections of the agreements with BSSM and BSTS (as indicated above) which protect Bell with respect to the prices it pays to these companies, thereby protecting subscribers.

E. The Burns Fry Appraisal

The Burns Fry appraisal provided a valuation of the business transferred as a going concern including consideration of the value of the transferred employees and the value of royalties derived from the licensing of Bell intellectual property. The low end of the appraisal range was $293 million and the high end was $345 million. The debt and equity issued to Bell in connection with the sale amounted to $281 million.

NAPO argued that the subscribers should receive a value reflecting the then current value of the business. NAPO argued that the valuation of future third party business incorporates the risks associated with the development of new business and that the valuation is a risk adjusted value assuming normal performance. NAPO also argued that Bell Sygma should pay the current market value for the assets (intellectual property and skilled personnel) built into the valuation. In NAPO's view, this would result in Bell Sygma earning a return on its invested capital that is above or below its cost of capital, depending on the norm assumed for valuation purposes. NAPO submitted that the fair market value is reflective of the risk that shareholders must bear; hence, no discount below fair market value is needed. Further, NAPO submitted that it is simply not true that by recognizing fair market value that the Commission would be effectively according all benefits to the subscriber, while according all risks to the shareholder, as argued by Bell.

Unitel noted that in Bell Canada - Review of Revenue Requirements for the Years 1985, 1986 and 1987, Telecom Decision CRTC 86-17, 14 October 1986 (Decision 86-17), the Commission determined that all intercorporate transactions should take place at prices which are fair and reasonable to both parties, and that a test of what is fair and reasonable is fair market value. Further, this view was reiterated in Decision 90-17 and also in Decision 93-12 where the Commission determined that the transfer of assets to Bell Sygma must take place at fair market value. Unitel argued that Bell's continued insistence on the transfer of assets to Bell Sygma at less than fair market value is tantamount to a request to review and vary that part of Decision 93-12 relating to the regulatory treatment to be accorded to Bell Sygma.

Unitel rejected Bell's 13 June 1994 submission that, because subscribers will not be exposed to the risks associated with the establishment of Bell Sygma and the development of third party business, they should not be entitled to any of the gains which might also flow from these activities. Unitel argued that when Bell conducted its data processing and systems integration activities on an in house basis, subscribers paid for this business and associated assets (including intellectual properties and personnel) through the rates for telephone service.

In response to this argument, Bell noted that the combined fair market value of the Bell business and real estate is below net book value, primarily because of the lower charges that Bell requires from Bell Sygma under the terms of the contract. With the inclusion of new third party business, Burns Fry estimated a fair market value above net book value. In Bell's view, the risks and rewards associated with future third party business should be for the shareholders alone to bear. In light of this, Bell took the position that a fair and reasonable approach to the transaction would be to transfer all assets at net book value, thus eliminating any negative impact on the subscriber, while allowing subscribers to benefit from future cost savings over the life of the agreement.

The Commission agrees with the arguments of NAPO and Unitel regarding the principles to be employed in the valuation of the business and has commented further on this matter in Part III, Conclusions.

III CONCLUSIONS

After reviewing all of the evidence in this proceeding, the Commission is satisfied that the reports prepared by the Yankee Group, Real Decisions and SFCG are reasonable, and that no further action should be taken in connection with these reports.

The Commission remains of the view, as set out in Decision 86-17 and reaffirmed in Decisions 90-17 and 93-12, that all intercorporate transactions should take place at prices that are fair and reasonable to both parties. A test of fair and reasonable is fair market value. In this regard, the Commission agrees with NAPO's argument that the valuation of future third party business incorporates the risks associated with the development of new business and that the valuation is a risk adjusted value assuming normal performance. Further, the Commission notes that, in determining the present worth of the business being transferred, the discount rate applied to earnings from future third party business was greater than the discount rate applied to earnings from future Bell business, reflecting the greater risk associated with future third party business.

The Commission finds the assumptions used by Burns Fry in its valuation to be reasonable and has determined that (1) the valuation in this report will be accepted as representing fair market value, and (2) the transaction value will be adjusted, for regulatory purposes, to the average of the high and low valuations of fair market value or $319 million. Based on the foregoing, the Commission finds that this results in a capital gain, for regulatory purposes, of $38 million. In this regard the Commission notes Bell's argument that, while it would be inconsistent with Generally Accepted Accounting Principles to record a capital gain as a result of the Sygma transaction, 1993 would be the appropriate time period to recognize the deemed adjustment as a regulatory adjustment. The Commission finds, for regulatory purposes, that it is appropriate to recognize the capital gain in question and to do so in the year in which the transaction occurred. Accordingly, the Commission will recognize the capital gain on 1 February 1993, the date of the original transaction.

With respect to the value of the royalty licenses associated with the transferred intellectual property, the Commission notes that the SFCG report proposed a methodology for the determination of future licenses, and that Bell and BSTS have agreed to use this methodology for future license transactions. In the Commission's view, it would be appropriate for Bell to proceed with the formalization of this agreement. Bell is directed to provide the Commission with a signed copy of the agreement whenever it is available.

Allan J. Darling
Secretary General

DEC96-3_0