By: www.mountainviewcellphones.com 8/2/2008

I recently reviewed the tentative ruling by the Alameda Superior court awarding damages to the plaintiff’s for ETF’s and essentially stating early termination fees as illegal due to their premise not based on damages for the liquidated damages. AKA (Ayyad vs. Sprint, case number RG03121510, http://apps.alameda.courts.ca.gov/domainweb/service?ServiceName=DomainWebService&PageName=itree&Action=21704699). It was tough reading due to the poor resolution of the documents, but it was very interesting.

This case pertains to subscribers and actions that happened from around 2000 to 2006, a time of great change and innovation in the wireless business. Plaintiff’s claim that early termination fees (ETF) were not legal under California Civil Code 1671 because of the punitive nature of the fees. However the court, because of a mixed up jury decision, found that ETFs were not illegal provided they take into consideration the ACTUAL DAMAGES incurred.

Here is a rewrite of the major conclusions:

1. Sprint proved it was impractical to calculate actual damages by the early termination of contracts (due to complexity of business and measuring avoidable costs).

Other court evidence: The courts analysis on this matter clear found the Sprint GREATLY underestimated damages from ETF fees and was inconsistent in this regard versus a true liquidated damage for the contracts.

2. Sprint did not prove that ETF was created or set based on analysis of damages.

I think the court correctly determined that the marketing department of Sprint made ETFs to keep up with the other carriers and lower the risk of the business with its main competitors.

3. Sprint did not prove ETF varied with amount of ACTUAL DAMAGES.

This is an actual criteria in case law as a test for liquidated damages being legal in California.

4. Sprint proved that the ETFs actually underestimated damages.

So, given points 1 to 4, under the Civil Code 1671 of California, the motivation and purpose (another case law test) of the ETF was something outside of collection of damages brought about by early termination of the contract. This makes them illegal.

This opens up the can of worms that had Sprint made better efforts to align actual damages to the ETF provisions and set up systems for this, this would have been very legal.

Remarkably, the judge ruled that despite Sprint’s unlawful ETF, the plaintiff (consumers) benefitted from Sprint’s UNDERSTATEMENT of actual damages estimated by the court had the ETF been legally structured.

In a strange ruling of damages, Sprint is ordered to return the $73MM that it has collected already from ETF damages in the form of $18.3MM payment and reversal of $54.7MM in charges.

In concluding, this was a mashed up decision due to a jury that did not make a consistent decision and a judge that tried to rule (”I think rightly”) on case law and the actual structure of the fees.

There were a few things that the Court threw out in terms of jurisdiction of the State versus Federal law in determining “rates.” Federal law takes precedent in determining “rates” for national services. The court clearly indicated that “rates” were strictly defined as those charged on a monthly recurring basis to customers. Sprint argued that “rate structure” should have been used in terms of the total bundle of benefits (handset subsidy, service, capital outlay plans, cost of marketing, cost of operating network, etc…) and services a customer buys and the “rates” as being a portion of this. This is because Sprint takes into account the entire financial relationship of a customer with Sprint, not just “rates,” in determining “rates.” Sprint argued for the bundle and the court only took a sliver of the bundle as being in the jurisdiction of the Federal Law.

So, where does this leave us going forward?

1. It’s clear this ruling will be appealed and clarified both in California and in Federal jurisdictions.

2. To adhere to these laws, wireless carriers will need to re-write their ETFs to actual damages lost. This will simplyfy the contracts. If you sign a two year agreement and you leave 13 months out (the average ETF in the case time frame), you will owe the carrier for 11 months of service for the avoided costs (generally HIGHER than the ETFs today). This avoided costs may be something less than the “rates” or it just may be the “rates” making it legal. Simply put, you sign a contract, you perform on it or pay the contract out.

This is just like breaking a lease agreement. If you leave early, you are still liable for the place you leased despite not occupying the premise or using its benefits anymore. Legally you are still liable if the landlord is still delivering on their side of the agreement.

Unfortunately, this is complicated as you can change your plans UP or DOWN with Sprint without contract extension. So, what is the actual damages? The only rational way to calculate this is some average of MRC that has been consumed and project that forward not just the last month MRC. This of course doesn’t take into account real changes in people’s usage UP or DOWN that may be greater or less than the past going forward into the ACTUAL DAMAGES.

3. If this ruling stands, carriers may actually just get out of the phone subsidy business. This would simplify the business for carriers as phone subsidies and the increase in average prices and functions of phones puts considerable pressure on service providers to get profitable customers. Carriers lose money for about 6 months from the initial purchase of a phone with a subsidy.

Tracfone is losing money hand over fist because it’s subsidizing unlockable phones and people are taking their subsidy and using their phones on other carriers.

This would lower rates per month for the customer (YEAH!!!) but would increase the cost for consumers for phones and care of phones (BOOOO!!!!).

THE FUTURE?

I think this would be great to get the carrier out of the handset business altogether. However, this will cause a situation and industry structure like what we have in the networked PC world. The Carrier has taken on many of these functions, caring for your phone’s performance, ensuring proper usage on the network for everyone, upgrading network and ensuring compatibility with all hardware allowed on network, monitoring and billing for usage consistently, testing and providing assurance that software works with the network and network upgrades, providing a trained representative to take direct customer contact, and providing secure communications.

This would be Microsoft’s wet dream. As value goes toward the OS provider and a standardization occurs on handset operating systems. Unfortunately, not many want to pay the Microsoft tax and alternatives abound.

As a consumer, have you ever called Microsoft for support when your computer crashes? Who do you call? Geek Squad? Your Geeky Friend? So, if carriers leave the taking care of handset business, more of these functions go down to third party service providers that need to take care of the stuff that OS/Hardware providers build. Do consumers want to pay $50 a pop to get their phones fixed or reset, etc…? Do consumers want to learn about phones and how to fix them on their own? I think this is a NO.

Really, have you seen a book called…”How to troubleshoot your Samsung M520?” In fact, has anyone called Samsung about a phone problem? Samsung and the carriers have agreement to transfer this responsibility to the carrier so the carrier can determine whether it’s a phone problem or a network issue in a consolidated view.

In today’s networked PC world, you will need an IT guy who figures out whether it’s the router, PC, software(s), or something else to fix the problem. It’s a problem of accountability and many times people pass the buck. In reality, it’s nice to have a carrier that can stand up for the consumer when things get goofy with hardware and make demands on the hardware fixes (this is one thing we pay for).

If this is the NEW world the carrier’s decide on, then there will be care functions that need to be taken on by other providers completely separate than the carriers and independent of each other.

You can make the argument the carriers outsource most of this anyway, so it’s not their core competency anymore, but they have still decided on the quality and controls of this process and not just let the market determine who is the best care provider for cell phones and their network.

I advocate that carriers should go down this road. Break up the functions and let the market arrange a way to use the resources best. Put the burden back on Samsung to take customer calls about their phone issue and troubleshoot it. Have the customer call three providers to take care of their own IT issue with the phone or hire their own care providers. Go for it. Get rid of these low ROE issues and put the carriers energies into innovating products and services for their network and providing easy and seamless ways others can interact and use it and provide care with it to.

If the carrier allowed access, care, innovative controls for the network by approved others, I would think that they could unburden themselves of taking on non-revenue functions, shift the blame (um…care) to handset manufacturer (for many issues), and extract its resources to innovate on services, building and maintaing a better network, and developing new applications that customers want.

Nothing against Samsung here, I just love their phones and they are very reliable. I just use them as an example of a well known handset manufacturer.

Lastly, carriers would just go towards an embedded system (like Intel Inside) and make wholesale trades to handset manufacturers. They would be judged on ubiquity of embedded systems, quality of their network, novel applications, and indirect support of their network to the many firms that will contact it.

In concluding this section, the ETF was illegal because of it’s current legal structure, not because ETFs are illegal by nature. Good luck consumers…you may just get what you wish…and it may not be what you want. As we are in the cell phone business, I certainly hope we find a better solution than the one we have today as it does irk many people. I think the pay upfront model for phones is the cleanest. To use an analogy, you pay the full price of the car (finance it if you like), the oil company doesn’t subsidize your car purchase price (like the electricity provider doesn’t subsidize your phone), AND all roads are toll roads (this is the wireless network, no government building program here). If your phone breaks, like your car, you are responsible and you find a way to fix it and insure it.

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