Second Circuit Debunks FCC’s Set-Top Box Arguments

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Last February, the FCC launched yet another attempt to excise itself from (in the immortal words of former FCC Commissioner Robert McDowell) the “Valley of Unattained Goals” of Section 629.  To justify its aggressive regulatory intervention, the Commission argued that (1) there is a separate market for set-top boxes over which MVPDs allegedly exercise market power; and, as such, (2) the rates consumers pay to rent set-top boxes, to put it colloquially, are “too damn high.”

While such arguments make for great populist fodder, the problem is that the Commission’s foundational arguments underlying their set-top box proposal simply are not true.

In a paper we published in CommLaw Conspectus back in 2012 entitled Wobbling Back to the Fire: Economic Efficiency and the Creation of a Retail Market for Set-Top Boxes, my co-authors and I showed that the market for set-top boxes and programming are not separate markets because “[s]et-top boxes are necessary appendages *** to subscription video services….”  Because “the provider can obtain all profits from the service itself”, the “set-top box conveys no market power to the MVPD, even if we assume that the provider of multichannel video services is a monopoly.”  As Phoenix Center Chief Economist Dr. George S. Ford stated on the C-SPAN show The Communicators earlier this year, the first question the FCC should ask is—“is there a market for set-top boxes?”  George then explained why the answer is certainly “no.”

Similarly, in a series of analyses published in a variety of outlets, the Phoenix Center has debunked the FCC’s set-top box pricing analysis.  For example, in a piece published in The Hill entitled The Obama Administration is Misleading Consumers on Set-Top Box Prices, George challenged the claim made by Senators Blumenthal and Markey, and then echoed by FCC Chairman Tom Wheeler, that consumers pay a monthly fee of $7.43 per box, with the average household spending on average $231 per year for the box.  Using the Senators’ own data but applying proper calculation methods (detailed in his article), George calculated that the average monthly per box rental fee charged by major MVPDs is only $5.15 with an annual household expenditure of only $145.  Total annual expenditures on set-top boxes is not $20 billion as the Senators’ and the Chairman claim, but only about $12 billion.  George’s uncontested analysis demonstrably shows that the primary “evidence” used to promote a heavy-handed regulatory approach—high prices—is based on calculations that are overstate set-top box prices and expenditures by a whopping 60 percent.  This is a large error that neither the Senators nor the FCC has acknowledged or clarified.

Whatever the price of the set-top box, it can only be described as “too damn high” if in relation to some measure of the proper price.  Typically, Chairman Wheeler has offered no evidence on what is the proper price of a set-top box.  But we need not be as unenlightened as the Chairman on such matters.  In a piece published in Bloomberg BNA this past May entitled What is the True Cost of a Set-Top Box?, George highlighted the fact that set-top box rates are not set in a vacuum; rather, regulation of set-top box rates has been a formal process that, even after much deregulation, remains tied to FCC rules.  Indeed, company filings of the FCC’s Form 1205—the FCC form implementing its formal methodology for determining the cost of a set-top box—reveal that the current cost of a set-top box is $8.65.  Thus, even at the grossly inflated prices used by the Chairman to mislead the public, the typical fee paid by subscribers is not above cost, much less excessively so.  Also, in a Policy Perspective released last April entitled Are Government-Owned Networks Abusing Market Power in the Set-Top Box Market? A Review of Rates, George provides more evidence that set-top prices are not “too high” by conducting his own survey that revealed government-run cable systems charge set-top fees higher than that those set by private video providers.

Quite clearly, the FCC is wrong on the theory and wrong on the facts.

Experience (and recent press reports) offer little hope that the FCC intends relent from its emotional, uneconomic stance on set-top boxes.  If anything, Chairman Wheeler appears to be searching for deeper waters for a leap off the deep end.  Fortunately, the courts are not as content as the Commission to wallow in intellectual ignorance.

Just as everybody was leaving for Labor Day weekend last week, the U.S. Court of Appeals for the Second Circuit issued its much-anticipated decision in Kaufman v. Time Warner, which involved an antitrust claim against Time Warner regarding set-top boxes.  In this case, the plaintiffs (subscribers of Time Warner) argued that the defendant had improperly tied cable television services to the leasing of “interactive” set-top boxes in violation of the Sherman Act.  The court, however, rejected the tying claim and in doing so addressed a number of very specific questions about set-top box economics.

At the heart of the court’s decision were two findings:  First, the court concluded that the set-top box and premium programming are not separate markets for purposes of antitrust law.  Second, given that the price of set-top boxes are set by FCC regulation, “regulatory price control on the tied product makes plaintiffs’ tying claim implausible as a whole.”

Sound familiar?  These are exactly two points we have stressed in our own research on set-top boxes over the years and that the FCC has conveniently ignored.

Let’s take a closer look at the court’s findings.

Set-Top Boxes Are Not a Separate Market

To the Second Circuit’s credit, it actually took the time to understand the purpose of the set-top box.  As the Second Circuit explained, while cable boxes have a “physical appearance separate from the programming they receive” (slip op. at 11), the reality is that a “cable box must be designed to receive the signal from a particular [MVPD] provider, which requires the provider’s cooperation.” (Slip op. at 12.)  This is because the “[n]etworks and other content producers retain rights against copying for commercial use” and the MVPDs simply “sell to their subscribers rights to viewing and copying for personal use its packages of programming.” (Id.) Given these key intellectual property protection concerns, the court recognized that “to be useful to a consumer, a cable box must be cable-provider specific, like the keys to a padlock.” (Id.)  Thus, reasoned the court, although the plaintiffs framed their claim as a tie-in of two separate products, the plaintiffs’ had misunderstood the nature of the relationship between the box and programming—that is, “the core issue is a cable provider’s right to refuse to enable cable boxes it does not control to unscramble its coded signal.”  (Id.)

Moreover, the Second Circuit made short shrift of the argument that cable modems are just like set-top boxes (a point we also covered in great detail in Wobbling Back to the Fire).  As the court explained, the

… obvious differences between the provision of cable and internet services negate any inference as to separate markets for bi‐directional cable boxes.  As described in detail above, a cable box useful to consumers must be provider‐specific, allowing consumers to subscribe to particular packages of programming, while modems, like radios, transmit all available content.  (Slip op at 15.)

Given these facts, not only did court find that the plaintiffs had fail to show “the existence of a demand for bi‐directional cable boxes separate from the demand for Premium Cable Services” (i.e., that they are in separate product markets), but that plaintiffs also failed “to plausibly allege that consumers are coerced into ‘leasing’ set‐top boxes from Time Warner that they would otherwise purchase elsewhere.” (Slip op. at 16.)

But the court did not end with a restatement of the readily obvious:  The court also found that even the FCC itself had conceded that set-top boxes and premium cable are not separate markets.  As the Second Circuit pointed out, the FCC had conceded that “numerous efforts to create those separate markets have failed” due to a “combination of the speed of technological change in the market, and various hardware, software, security, and collective‐action problems…”  (Slip op at 17-18.)  And while the court acknowledged that in March 2015 the FCC launched its controversial new AllVid paradigm in a “further attempt to create separate markets”, the court— recognizing the reality of the situation—found that the agency’s “historic failure to do so over the time period covered by the Complaint bolsters our conclusion that the plaintiffs have not plausibly alleged separate product markets for bi‐directional cable boxes and Premium Cable Services.” (Slip op. at 18.)  Similarly, as we observed in Wobbling Back to the Fire, the failure of the Commission’s efforts to create a set-top box market out of thin air has failed because “the self-supply model is relatively more efficient than the retail model [and] inefficiency is not tolerated by competition.”

Set-Top Box Prices are a Function of FCC Regulation

Having disposed of the separate market question, the Second Circuit then turned to the plaintiffs’ arguments that “high” set-top boxes prices were an indication of Time Warner’s market power.  According to the court, and consistent with our analyses, that argument was bunk.

As the Second Circuit noted, FCC regulation caps the price MVPDs may charge to lease set-top boxes to consumers.  In the court’s view, such “a regulatory price control on the tied product makes the plaintiffsʹ tying claim implausible as a whole.” As such, reasoned the court, it seriously doubted that “Time Warner would attempt to monopolize the market for bi‐directional cable boxes when an FCC regulation caps the amount of profits that Time Warner may reap from that market.”  If anything, noted the court, “a typical tie‐in works in the reverse of the circumstances here: Government regulation of the tying product’s price will cause the monopolist to seek monopoly rents through sales of an unregulated tied product.”  (Slip op. at 18-19, emphasis in original.)


In Wobbling Back to the Fire, we demonstrated that the reason a retail market for set-top boxes never materialized was not due to some malevolence on the part of MVPDs but because a retail market for set-top boxes is inefficient and markets abhor inefficiency.  For this reason, we argued that the Commission should just bite the bullet, end this billion-dollar policy dud, and sunset Section 629 altogether.  And while the Commission may not want to recognize these basic economic realities, we take some comfort in the fact that the Second Circuit in Kaufman did.

As we have noted on multiple occasions before, both the multichannel video industry and the consumer would love to be rid of the set-top box.  Set-top boxes raise the cost of providing video services and thus reduce profits; they are a necessarily evil designed to reduce signal theft, protect copyrighted content, and provide a quality experience for all video subscribers and technology changes.  To this end, the industry, with the participation of content owners, has embraced the rapid evolution of video technology to offer an app-based approach with HTML5 security as a path forward to eliminate the set-top box altogether yet still protect the intellectual property rights of programmers and content owners.

Still, Mr. Wheeler seems reluctant to accept the most obvious and efficient solutions, perhaps because they do not serve his political interests.  Indeed, as of this writing, there are press reports that while Mr. Wheeler is contemplating paying lip service to the app-based approach, he wants to interject the FCC into programming negotiations (a task for which he has highly questionable legal authority).  As the Copyright Office has already publicly stated that the Commission’s original proposal to unbundle programming likely violates intellectual property rights, I will say Mr. Wheeler is nothing but consistent.  In this volatile political season, it should be interesting to see if Mr. Wheeler can get three votes for a proposal more radical than the first one for which he could not get a majority.  However, regardless of whether or not Mr. Wheeler succeeds in ramming this massive regulatory intervention through the Commission, nothing can change the harsh reality that Mr. Wheeler’s entire premise for “unlocking the box” is built on an economic sham.