Charter's Likely Acquisition of Time Warner Cable

It has been widely reported that John Malone, through Liberty Media, acquired a controlling stake in Charter Communications (Charter) and that Mr. Malone is seeking to consolidate the U.S. cable television industry beginning with Charter’s acquisition of Time Warner Cable. Mr. Malone has unabashedly stated that he believes the purpose of cable television consolidation is to increase the leverage the cable industry has in dealing with technology and content providers. As a result, technology and content companies are understandably concerned about the potential anti-competitive effects of cable industry consolidation. We, on the other hand, see this development as a tremendous opportunity to remake the cable television industry in a way that will open the market for technology and content companies.

Before explaining our thinking, we should point out that Mr. Malone’s quest is, in our view, not quixotic. Time Warner Cable, unlike Cablevision Systems and Cox Communications, is not controlled by a family, but rather, is owned by a wide range of public investment funds. Due to this fact, these funds have a fiduciary duty (rather than a familial one) that they must approve Charter's acquisition of Time Warner Cable, provided that Charter offers a fair price. It appears that Malone has taken the first meaningful step to execute this strategy by retaining Goldman Sachs to assist Charter to arrive at and obtain financing for such an offer.

Thinking Inside the (Set-Top) Box

In order to understand how cable television consolidation under Mr. Malone could be procompetitive for technology and content companies, we think it's essential to "think inside the box." Today, the cable television set top box (STB) is almost universally rented by subscribers from their cable operator. Some years ago Congress passed legislation that requires the Federal Communications Commission (FCC) to promote the creation of a competitive market for STBs by requiring cable operators to separate the secure access function from other functions. This was supposed to allow technology and content companies to offer a wide variety of STBs that consumers could buy and use instead of the cable operatorprovided STB. For those who remember the days when AT&T offered one model of a black rotary dial telephone on a short cord that you could use to make calls, you can appreciate the innovations that have occurred since the DOJ and FCC shattered that business model.

Unfortunately, the FCC effort to implement the Congressional directive to open the market for STBs has been a failure. The FCC adopted a so-called CableCard rule. It says that cable operators must allow consumers to use STBs purchased from third parties so long as the STB includes a slot for a CableCard to be provided by the cable operator. This CableCard is a crucial piece of equipment to the cable operator, as it contains the operator’s security functions.

However, since cable operators charge as much to rent the CableCard as they do to rent the STB (which already contains the cable operator’s CableCard), consumers generally have seen no benefit to purchasing an STB and renting a CableCard. The result has been that few subscribers purchase a third party STB and the STB has become the equivalent of the black rotary dial telephone. As a result, consumers' ability to have access to the latest technology from their cable operator has been significantly diminished. Currently, consumers have to purchase an additional box, be it from Apple, Google, Microsoft or some other technology company, in order to access innovative features that they want. Adding yet another layer of complexity is that the manufacturers of these additional boxes have to negotiate complex and costly deals with cable operators in order to allow their boxes to access cable programming. As it stands currently, the future of the CableCard rule may be in jeopardy as it was recently struck down by the D.C. Circuit in the Echostar case, although TiVo, among others, has already asked the FCC to reinstate it. Generally speaking, the CableCard rule did not fulfill its intended purpose of providing consumers with readily available access to the latest technology from cable operators. The current CEO of Charter has a history of working around the usage of CableCards altogether by implementing software defined security, which could provide meaningful opportunities to technology companies in this space.

Software Defined Security

An argument can be made that the CableCard system is technologically obsolete because software defined security can replace the CableCard. When Tom Rutledge, the current CEO of Charter, was the CEO of Cablevision, Mr. Rutledge pressed the FCC to allow Cablevision to use STBs with software defined security. After moving to Charter, Mr. Rutledge obtained a similar FCC ruling to allow Charter also to use STBs with software defined security, eliminating the need for the ubiquitous CableCard.

The way that software defined security works is that STBs contain a built-in "commodity chip,"i.e., a low cost chip that can be included in every STB without significant cost to the consumer, that serves as the hardware-based "root of trust." When an STB is purchased by the consumer and plugged into the cable connection, the STB downloads the security software from the cable operator, which the FCC says has to be provided to STB manufacturers on a royalty free basis. So software defined security for STBs has the potential to open the market for STBs and spur innovation by technology and content providers, all of which will continue to benefit the cable industry as a broadband access provider. In fact, software defined security for STBs allows television manufacturers to incorporate the STB functionality into the television or other monitor directly and eliminate the need for a separate STB.

Cablevision and Charter pushed the FCC to allow them to use STBs with software defined security because as small cable operators they were at a disadvantage in negotiating deals to buy STBs from the two main suppliers: Cisco (who acquired the former Scientific Atlanta) and Arris (who acquired the Motorola STB business from Google). So now the question presented is a simple one: assuming that Charter acquires Time Warner Cable (and/or otherwise consolidates the cable industry), will the combined company abandon the use of software defined security for STBs (because the combined company has the clout to negotiate STB deals with Cisco and Arris) or continue to promote STBs with software defined security and a competitive market for STBs? Interestingly enough, the answer to this question may lie within the convoluted process for cable merger reviews.

The Cable Television Merger Review Process

The DOJ or the FTC reviews cable television mergers under the Clayton Act which puts the burden on the agency to show that a proposed merger would be anti-competitive. The Hart-Scott-Rodino Act (HSR) sets a time frame for them to complete their antitrust review. The FCC upends this statutory framework with a duplicative merger review that shifts the burden to the proponents to show that the merger will be pro-competitive and/or will otherwise serve "the public interest" as variously defined by the FCC, and sweeps aside the time limit for merger review in HSR (nominally the FCC limits itself to 180 days but freely extends its self-imposed time limit). The FCC does so despite the Telecommunications Act of 1996, where Congress said, in the Conference Report, "The Commission should be carrying out the policies of the Communications Act, and the DOJ should be carrying out the policies of the antitrust laws."

The FCC justifies its review of cable mergers based on cable operator use of microwave radio licenses known as cable antenna relay service (CARS) licenses. Of course, CARS licenses are point-to-point microwave licenses and, as such, an unlimited number of them can be accommodated in any given area. Unlike broadcast or wireless telephone licenses, no scarcity rationale exists for the FCC to review a transfer of CARS licenses and their transfer could not possibly have any competitive impact. But no merger proponent can afford the time it would take to defeat the FCC’s unfounded assertion of jurisdiction to review cable television mergers. So we can expect FCC review of a Charter/Time Warner merger despite the argument that such review is unauthorized.

FCC review is widely viewed as problematic because it often leads to conditions on the merger to address ad hoc public interest concerns that fail to account for technological and business innovation. Take, for example, the largest proposed merger ever reviewed by the FCC, the acquisition of Sprint by Worldcom. The FCC, working hand–in–glove with the DOJ, blocked this merger in order to preserve the competitive market for long distance telephone service. A few years later, anyone with a cell phone, an unlimited calling plan, or Skype knows that there is no market for long distance service. In the case of the Comcast and Time Warner acquisition of the assets of Adelphia, the FCC spent all of its effort justifying the imposition of a condition to require arbitration of disputes over access to regional sports programs. Yet the FCC missed the issue of how to promote competition and innovation in STBs, despite the explicit Congressional directive to open the STB market, the ineffectuality of the CableCard rule and having before it the two largest cable operators.

Right or wrong, we can expect the FCC to conduct a duplicative and lengthy (year-long) review of a Charter/Time Warner Cable merger. Whether technology and content companies will reap benefits from the merger review process depends upon their ability to explain their evolving technology and business models, including STBs and televisions that can work without STBs.