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Pac-West Telecomm, Inc. will not be collecting on its California Public Utilities Commission-approved $7 million phone bill to AT&T. The Ninth Circuit Court of Appeals ruled last month that a 1996 Federal Communications Commission (FCC) Order (the “ISP Remand Order”) preempts state agencies’ attempts to set a local telephone carrier’s “reciprocal compensation” for exchanged internet service provider (ISP) traffic, and that rate caps established in the ISP Remand Order apply both to traffic between competitive local exchange carriers (CLECs), and between CLECs and incumbent local exchange carriers (ILECs). AT&T v. Pac-West Telecomm, Inc., __ F.3d __ (9th Cir., June 21, 2011)

Congress passed the Telecommunications Act of 1996 with the goal of fostering competition within the telecommunications industry. In local telephone areas, the reciprocal compensation process provides that LEC (local exchange carrier) serving the customer originating a telephone call compensates the LEC serving the customer receiving the telephone call for its cost of terminating the call. This process was based on the assumption that over time, telephone traffic going in each direction evened out. That same logic did not apply to ISPs, who would generally terminate traffic but not originate that much traffic. ISP-bound traffic comes with varying compensation rates set through federal and state authorities, and the FCC’s 1996 “ISP Remand Order” set a new compensation scheme for ISP-bound traffic in order to address this “game of regulatory arbitrage.”

In the underlying suit, Pac-West sought $7 million from AT&T for ISP traffic set to the CPUC-approved compensation rate, claiming that rate caps in the ISP Remand Order did not apply to CLEC-to-CLEC traffic – only ILEC-CLEC traffic. The CPUC held that the ISP Remand Order applied only to ILEC-to-CLEC traffic.  AT&T argued that FCC regulation capping compensation rate preempted the CPUC decision. The Ninth Circuit panel agreed, finding that FCC’s ISP Remand Order preempts state regulations in capping intercarrier compensation for ISP traffic. Whereas the CPUC and a California district court found the federal statute limited in scope to incumbent local exchange carriers, the Ninth Circuit concluded that FCC intended cap rates for all local exchange carriers exchanging ISP traffic. “[T]he FCC was primarily concerned with arbitrage opportunities created by traffic of a particular nature,” noted Circuit Judge Marsha Berzon.

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