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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 000-28467
Z-TEL TECHNOLOGIES, INC.
(Exact name of Registrant as specified in its charter)
DELAWARE 59-3501119
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
601 SOUTH HARBOUR ISLAND BOULEVARD, SUITE 220
TAMPA, FLORIDA 33602
(813) 273-6261
(Address, including zip code, and
telephone number including area code, of
Registrant's principal executive offices)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON
STOCK, PAR VALUE $.01 PER SHARE, PREFERRED STOCK PURCHASE RIGHTS
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.
YES |X| NO [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The aggregate market value of the Registrant's Common Stock held by
non-affiliates of the Registrant on March 26, 2003 (assuming solely for these
purposes that only directors, executive officers and beneficial owners of
greater than 10% of the Registrant's Common Stock are affiliates), based on the
closing price of the Common Stock on the Nasdaq SmallCap Market as of such date,
was approximately $36,036,434.
The number of shares of the Registrant's Common Stock outstanding as of
March 26, 2003 was approximately 35,268,253.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's proxy statement relating to its 2003
Annual Meeting of Stockholders, to be filed subsequently, are incorporated by
reference into Part III of this Report.
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TABLE OF CONTENTS
PART I.
Item 1. Business 1
Item 2. Properties 20
Item 3. Legal Proceedings 20
Item 4. Submission of Matters to a Vote of Security Holders 21
PART II.
Item 5. Market for the Registrant's Common Equity and Related 21
Stockholder Matters
Item 6. Selected Consolidated Financial Data 24
Item 7. Management's Discussion and Analysis of Financial 26
Condition and Results of Operations
Item 7A. Quantitative and Qualitative Disclosures about Market
Risk 52
Item 8. Financial Statements and Supplementary Data F-1
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 53
PART III.
Item 10. Directors and Executive Officers of the Registrant 53
Item 11. Executive Compensation 53
Item 12. Security Ownership of Certain Beneficial Owners and
Management 53
Item 13. Certain Relationships and Related Transactions 53
Item 14. Controls and Procedures 53
PART IV.
Item 15. Exhibits, Financial Statement Schedules, and Reports 53
on Form 8-K
Signatures 58
ITEM 1. BUSINESS
GENERAL
Z-Tel Technologies, Inc. is a communications service provider. We
integrate access to local and long distance telephone networks with our own
advanced features and operational support systems to provide innovative
telecommunications services to consumers, business and other communications
companies.
We were incorporated in Delaware in 1998. Our first service offering,
launched in the fourth quarter of 1998, was an access card to make long-distance
calls from any phone coupled with enhanced features. We launched our first local
telephone service offering in New York during June of 1999. We acquired Touch 1
Communications, Inc. and its long distance operations in April 2000. We launched
wholesale operations in January 2002.
At the retail level, our goal is offer distinctive services that give
our customers powerful tools to simplify busy lifestyles. Our principal retail
services are Z-LineHOME(R), Z-LineBUSINESS(R) and Touch 1 Long Distance.
Z-LineHOME, our flagship offering, is residential local and long distance
telephone service, bundled with enhanced services, including the Personal
Communications Center, a suite of our proprietary Internet-accessible and
voice-activated features. The Personal Communications Center includes voicemail,
"Find Me" call forwarding and our recently introduced Personal Voice Assistant,
or "PVA," which utilizes voice-recognition technology so that users can access
and use their own secure, online address books with voice commands. We expect
that eventually all our enhanced features will be accessed and managed via voice
commands so that PVA will supplant the Personal Communications Center.
Z-LineBUSINESS is our local, long distance and enhanced communications service
designed primarily for small businesses. We began offering Z-LineBUSINESS in
January 2002. Touch 1 Long Distance is a residential long distance telephone
service.
As of March 25, 2003, we offer Z-LineHOME, in every state but Alaska,
Hawaii and Nevada. We have approximately 230,000 Z-LineHOME customers, primarily
in areas served by Regional Bell Operating Companies ("Bell operating
companies"). We currently offer Z-LineBUSINESS in 46 states. We have
approximately 1,500 Z-LineBUSINESS customers, representing approximately 3,000
lines. We offer Touch 1 Long Distance nationwide and have approximately 100,000
Touch 1 Long Distance customers.
At the wholesale level, we provide telephone and enhanced
communications services and operational support services to other telephone
companies for their use in providing telephone and enhanced communications
services to their own end-user customers. Our principal wholesale customers are
MCI and Sprint. Sprint became a wholesale customer in February 2003.
Our access to local telephone networks is based upon the
Telecommunications Act of 1996 (the "Telecommunications Act") which requires the
traditional local telephone companies ("incumbent local exchange carriers" or
"ILECs") to provide competing local telephone companies, such as Z-Tel, with
access to the individual components of their networks, called "network
elements." Pursuant to the Telecommunications Act, the Federal Communications
Commission ("FCC") has mandated that incumbent local exchange carriers provide
access to a set of unbundled network elements including, among other elements,
local loops, switching, transport and signaling. This set of elements is
referred to as the "unbundled network element platform" or "UNE-P." Moreover,
the FCC has mandated that ILECs must provide the unbundled network element
platform at rates based on a forward-looking, total long-run incremental cost
methodology. Access to the ILEC network elements at reasonable rates in
combination with our proprietary feature systems and operational and support
systems enables us to provide cost effective packages of communications
services. Our enhanced services platform and our operational support systems,
however, have the capability to integrate with cable, Internet, wireless and
other communications transport networks.
We have invested heavily in our operational support systems. Our
systems are functionally integrated to support the entire customer life cycle
including price quotation, order entry and processing, ILEC interaction,
customer care, billing and subscriber management. They are scalable vertically
and horizontally and provide us reliable, flexible, low-cost operational
capabilities.
SEGMENT FINANCIAL INFORMATION
We utilize two segments for internal reporting purposes: consumer
services (for retail services) and wholesale services. Financial information
relating to our consumer services segment and our wholesale segment is set
forth in Item 7, "Management's
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Discussion and Analysis of Financial Condition and results of Operations" and
footnote 23 "Segment Reporting" in the "Notes to the Consolidated Financial
Statements."
INDUSTRY BACKGROUND
The Telecommunications Act was enacted principally to foster
competition in the local telecommunications markets. The Telecommunications Act
imposes a variety of duties upon the incumbent local exchange carriers,
including the duty to provide other communications companies, like us, with
access to their network elements on an unbundled basis at any feasible point.
Such access must be at rates and on terms and conditions that are just,
reasonable and nondiscriminatory. A network element is a facility or piece of
equipment of the local telephone company's network or the features, functions or
capabilities such facility or equipment provides. The Telecommunications Act
also establishes procedures under which the Bell operating companies are allowed
to handle "in-region" long distance calls, that is, calls that originate from
within their telephone service areas and terminate outside their service areas.
The Bell operating companies were divested by AT&T in 1984 pursuant to court
order under which they were prohibited from providing "in-region" long distance
telephone service. With the passage of the Telecommunications Act, a Bell
operating company can provide such in-region service if it demonstrates to the
FCC and state regulatory agencies that it has complied with a 14-point
regulatory checklist, including offering interconnection to other communications
companies and providing access to its unbundled network elements on terms
approved by a state public service commission.
On November 5, 1999, the FCC released an order establishing the list of
unbundled network elements that incumbent local exchange carriers nationwide
must provide. Taken together, these unbundled network elements comprise the
essential facilities, features, functions and capabilities of an incumbent local
exchange carrier's network. Under the FCC's order, the incumbent local exchange
carriers must allow competing local telephone companies such as Z-Tel to use the
unbundled network elements, in an individual or combined fashion, to provide
basic local telephone service. Additionally, the ILECs must price the elements
using a forward-looking, total long-run incremental cost methodology. Pricing
and implementation rules for unbundled network elements in combined service
packages or platform offerings that are at least acceptable for market entry
have been adopted in multiple states. The prices for the use of individual
network components and combined component service packages will nevertheless
vary from state to state, as will an individual state's oversight of unbundled
network element platform implementation and operation in regard to individual
unbundled network elements and elements provided in combinations. As discussed
below under "Government Regulation," the FCC recently re-affirmed the
availability of unbundled network elements as part of a scheduled triennial
review.
SERVICES
We provide telephone services at both the retail and wholesale level.
At the retail level our principal services are Z-LineHOME, Z-LineBUSINESS and
Touch 1 Long Distance. At the wholesale level, we provide services to other
carriers such as MCI and Sprint for their use in providing services to their own
end-user customers.
Z-LINEHOME(R)
Z-LineHOME is our flagship service. Z-LineHOME is local residential
telephone service bundled with long distance (1+) telephone service, calling
card services and enhanced features, including our own proprietary,
Internet-accessible voicemail, "Find Me," "Notify Me" and voice-activated
services, as well as caller identification, call forwarding, three-way calling,
call waiting and speed calling, all for a single flat monthly price. Bell
operating company customers switching to Z-LineHOME keep their existing phone
numbers. Our "Unlimited Plan" includes unlimited, nationwide, direct-dialed long
distance calling toll-free. Our other lower priced plans include a limited
number of long distance minutes at no additional charge. We currently offer
Z-LineHOME in every state except Alaska, Hawaii and Nevada, in areas served by
Bell operating companies or Sprint and areas formerly served by GTE.
Z-LineHOME includes unique Z-Line features, all of which can be
accessed and manipulated by telephone or Internet. Our proprietary voicemail
enables Z-LineHOME subscribers to retrieve and listen to their voice-mail
messages via telephone or the Internet. Our voicemail system also enables users
to forward voicemails via e-mail, as attachments. Our "Find-Me" feature forwards
an incoming call to as many as three additional numbers. Our "Notify Me" feature
notifies the subscriber via e-mail, pager or ICQ Internet Chat (instant
messaging) when a new voice mail message arrives. Both Find Me and Notify Me are
accessible via the Internet so that users may easily enable, disable or
otherwise alter the functions. We recently introduced "Personal Voice Assistant"
or "PVA." PVA allows users to store contacts in a virtual address book and then
access and utilize that information by voice from any telephone. Users say
"call" and the contact's name, "call John Doe," for example, and PVA connects
the call. PVA users can also send voice e-mails. Users record a message via
telephone and instruct PVA to deliver the message to a contact. PVA then
attaches the voice message to an e-mail and sends the e-mail to the contact.
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Z-LINEBUSINESS(R)
Z-LineBUSINESS is our complementary service to Z-LineHOME targeted to
small businesses (typically having four or fewer lines). Z-LineBUSINESS, like
Z-LineHOME, is local telephone service bundled with long distance (1+) telephone
service, calling card services and enhanced features, including our proprietary
features. Bell operating company customers switching to Z-LineBUSINESS keep
their existing phone numbers. Because we offer service in nearly every state,
Z-LineBUSINESS is particularly valuable to firms having multiple locations in
various states. With us, they deal with only one telephone company. Our rollout
of Z-LineBUSINESS is in its infancy. We offer Z-LineBUSINESS in 46 states
(excluding Alaska, Connecticut, Hawaii and Nevada) solely in areas served by a
Bell operating company.
TOUCH 1 LONG DISTANCE
Touch 1 Long Distance is a usage-based service that allows customers to
use us as their primary long distance calling provider to complete their
residential long distance (1+) calls. Touch 1 Long Distance is available
nationwide, although we are not actively marketing the service. We acquired
Touch 1 Communications, Inc. (Touch 1) in April 2000.
WHOLESALE SERVICES
We also offer telephone and enhanced services and operational support
services on a wholesale basis to other carriers for their use in providing
services to their own retail customers. We have the capability to provide our
wholesale customers with a comprehensive package of communications and support
services. Among the wholesale services we offer are local exchange telephone
services, long distance telephone services, our proprietary enhanced features,
enhanced features we acquire from incumbent local exchange carriers,
provisioning (i.e. the process by which a telephone company is established as
the end-user's primary telephone company), inbound sales, fulfillment, billing,
collections and customer care. In most cases we would expect our wholesale
customer to utilize its own long distance services in providing services to its
customers. In some cases, in lieu of providing services, we may license our
technology to other carriers.
On March 20, 2002, we entered into a four-year contract with MCI
WORLDCOM Communications, Inc. ("MCI") whereby we agreed to provide local
exchange services, enhanced features and operational and support services and
licenses to use certain of our proprietary technology, all for MCI's use in
providing telecommunications services to residential and small business
customers. MCI filed for bankruptcy protection on July 21, 2002. On November 1,
2002, we significantly amended the terms of our agreement to alter the fee
structure and to eliminate certain exclusivity provisions. We expect revenue
from this relationship to decline during 2003.
On February 4, 2003 we signed a non-exclusive, wholesale services
agreement with the Sprint Communications Company L.P. ("Sprint"). The agreement
will give Sprint access to our telephone exchange services and our
Web-integrated, enhanced communications platform and operational support systems
in connection with Sprint's local residential telephone service.
We intend to pursue wholesale relationships with, among others,
wireless telephone companies, Internet service providers, cable television
operators, electrical utilities and others who have access to large consumer
bases and in particular those who have the capability to bundle communication
services.
OPERATIONS SUPPORT SYSTEMS
We have invested substantially in our operations systems and support
platform, which enables integrated customer ordering and provisioning, customer
care and billing functionality throughout the customer lifecycle. Accessing an
incumbent local exchange carrier's network requires us to interact with that
applicable incumbent local exchange carrier. To facilitate this interaction, we
have established, with outside integration and consulting assistance, electronic
gateways to the major incumbent local exchange carriers, network element
management software, and a standard internal provisioning interface that can
handle multiple incumbent local exchange carrier ordering systems. These
electronic gateways reduce the number of steps required to provision a customer
and consequently reduce the cost and increase the accuracy of our provisioning
process. "Provisioning" is the process by which we (or our wholesale customers)
are established as the customer's primary local exchange and long distance
telephone service provider. In connection with the incumbent local exchange
carriers, our systems also support mediation, network administration and revenue
assurance. We now have electronic gateways operational in every state except
Alaska, Hawaii and Nevada, solely in Bell operating company service areas. We do
not have electronic gateways established in Sprint service areas and areas
formerly served by GTE. Our operational support systems are vertically and
horizontally scalable.
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BUSINESS STRATEGY
Our basic business strategy is to-
- gain and keep new retail customers by offering unique,
innovative functionality at competitive prices,
- focus our marketing expenditures by targeting markets that
have favorable regulatory and pricing environments,
- minimize the capital expenditures associated with entering new
retail markets and expanding our existing retail markets by
use of the unbundled network element platform, and
- leverage our existing facilities and infrastructure by
establishing wholesale relationships.
CERTAIN ASPECTS UNDERPINNING OUR BUSINESS STRATEGY
Cost-Effective Bundled Local and Long Distance Telephone Service. We
provide cost-effective bundled packages of local and long distance telephone
services in markets that have favorable regulatory environments for residential
competition. Our service packages include our own enhanced features as well as
typical enhanced telephone features such as call waiting and caller
identification. We typically lease facilities of the existing incumbent local
exchange carrier on a forward-looking, long-term incremental cost basis, which
enables us to avoid the need to invest significant capital into telephone plant
and equipment. As a result, we are able to provide our services without
significant up-front expense.
Scalable Platform for New Markets. Our use of the unbundled of network
elements platform (i.e. the facilities of the incumbent local exchange carriers)
in providing our services allows us to enter new markets quickly without a
significant investment in equipment, as regulatory authorities in those markets
adopt favorable rules and pricing for unbundled network elements. Moreover,
using our telephone and Internet accessible systems, our customers can manage
and configure their own enhanced calling features, thus minimizing our need for
an expanded customer service infrastructure.
Seamless Integration of Personal Organizational Tools. Our enhanced
services platform has been designed to allow users to download their personal
directories from a variety of software packages, including Microsoft Outlook. In
addition, directories from other personal contact managers can be downloaded
into Outlook and then downloaded into our platform.
Advanced Proprietary Technology. We have created an advanced,
integrated and proprietary software and network architecture that enables the
enhanced features of our service. We have created software applications that can
control the basic functions of initiating and completing a telephone call
regardless of the access device, such as a telephone, personal computer or
personal digital assistant. These applications allow our customers to control
simultaneously all the basic functions of a telephone call using any such
device.
Our network architecture is designed to interconnect our main
enterprise management center in Tampa, Florida with the switching architecture
of the incumbent local exchange carrier. This allows us to provide
telecommunications services without the need to collocate network equipment in
the central offices of the incumbent local exchange carrier in our target
markets and enhances our ability to enter new markets quickly and cost
effectively.
We have also developed and enhanced our customer care, billing and
provisioning software into one seamlessly integrated package. This integrated
package provides us with reliable, flexible, low-cost operational capabilities.
Our network architecture also is designed to accommodate a number of
developing technologies, such as telephone calls over Internet protocol, digital
subscriber lines, asynchronous transfer mode and coaxial cable systems.
RETAIL MARKETING
We market our retail services to prospective customers primarily
through independent sales representatives (including multi-level marketing
companies), strategic business relationships, direct mail and traditional
advertising media such as billboards, radio and television. We intend to explore
the formation of alliances or ventures with other companies, including Internet
service providers, cable television companies, electrical utilities, financial
institutions, retailers and credit card companies, which we believe will allow
us to penetrate efficiently large customer bases with a relatively small capital
outlay and to lower customer acquisition costs.
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BILLING AND COLLECTION
We have three primary methods for billing and collecting from our
customers. For our Z-LineHOME customers, we can (1) direct bill by mail and
receive payment through a check or money order by mail; (2) charge a credit card
account or (3) set up an automatic withdrawal from a checking account.
Currently, we bill the majority of our customers by mail and receive payment
through checks delivered by mail. We have a variety of billing arrangements with
our wholesale customers.
INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS
We have developed proprietary software that manages the integrated
features of our service offerings and that that allows our network to interface
and interconnect with the systems of the incumbent local exchange carriers and
long-distance carriers. Our network communication facilities are largely
consolidated in our enterprise management center in Tampa, Florida. This
consolidation allows us to maximize the productivity and effective management of
the facilities.
We have entered into, and will continue to enter into, nondisclosure
agreements with our employees, independent contractors, business customers and
others. These agreements are intended to protect our confidential and
proprietary information, whether or not such information is copyrighted or
subject to trademark or patent protection. We intend to take all appropriate
legal action to protect our ownership and the confidentiality of all our
proprietary software.
Our intellectual property reflects the know-how, work product and
inventions of our research and development team, based at our technology center
in Atlanta, Georgia, who have substantial experience in computer technology,
telecommunications, web-based services, database management and integration, and
network development, architecture, operation and management.
For the fiscal years ended December 31, 2002, 2001 and 2000, we
invested approximately $13,157,000, $12,800,000, and $11,361,000, respectively,
in company-sponsored research and development activities.
We have filed trademark applications for federal registration of
numerous trademarks with the United States Patent and Trademark Office,
including, Z-VOICE MAIL, Z-TECHNOLOGY, Z-MAILBOX, Z-NET, and MYZLINE.COM. We
have received federal registration of the following trademarks: Z-NODE, Z-LINE,
Z-LINEHOME, Z-LINEBUSINESS, WEBDIAL, CLICK & LISTEN, Z-TEL, YOUR PERSONAL
COMMUNICATIONS CENTER, Z-TEL COMMUNICATIONS, INC. and design, Z-LINE COMPANION,
Z-LINE MESSENGER, Z-TEL and design, and Z-TEL TECHNOLOGIES, INC.
COMPETITION
OVERVIEW
The telecommunications industry is highly competitive in many market
segments. However, at present, we believe few telecommunications carriers
provide the type of bundled service packages that include the range of services
and features that we offer, but various competitors offer one or more of the
services that make up our service offerings. Competition in the local telephone
services market is still emerging, but already has attracted many competitors.
Competition in the long distance and information services markets, which have
fewer entry barriers, is already intense and is expected to remain so.
We believe the principal competitive factors affecting our business
will be the quality and reliability of our services, innovation, customer
service and price. Our ability to compete effectively will depend upon our
continued ability to offer innovative, high-quality, market-driven services at
prices generally equal to or below those charged by our competitors. Many of our
current and potential competitors have far greater financial, marketing,
personnel and other resources than we do, as well as other competitive
advantages.
LOCAL TELEPHONE SERVICE
Incumbent Local Exchange Carriers. In each of our target markets, we
will compete with the incumbent local exchange carrier serving that area, which
may be one of the Bell operating companies. As a recent entrant in the
telecommunications services industry, we have not achieved and do not expect to
achieve in the foreseeable future a significant market share for any of our
services in our markets. In particular, the incumbent local exchange carriers
have long-standing relationships with their customers, have financial, technical
and marketing resources substantially greater than ours, have the potential to
subsidize services that compete with
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our services with revenue from a variety of other unregulated businesses, and
currently benefit from certain existing regulations that favor the incumbent
local exchange carriers over us in certain respects.
Recent regulatory initiatives that allow competitive local exchange
carriers, such as us, to interconnect with incumbent local exchange carrier
facilities and acquire and combine the unbundled network elements of an
incumbent local exchange carrier provide increased business opportunities for
us. However, such interconnection opportunities have been, and will likely
continue to be, accompanied by increased pricing flexibility and relaxation of
regulatory oversight for the incumbent local exchange carriers.
Competitive Local Exchange Carriers. The Telecommunications Act
radically altered the market opportunity for competitive local exchange
carriers. Competitive access providers who entered the market prior to passage
of the Telecommunications Act built their own infrastructure to offer exchange
access services to large end-users. Since the passage of the Telecommunications
Act, many competitive access providers have added switches to become competitive
local exchange carriers in order to take advantage of the opening of the local
market. With the Telecommunications Act requiring the unbundling of the
incumbent local exchange carrier's networks, competitive local exchange carriers
will now be able to enter the market more rapidly by leasing switches, trunks
and loop capacity until traffic volume justifies building substantial
facilities. Newer competitive local exchange carriers, like us, will not have to
replicate existing facilities and can be more opportunistic in designing and
implementing networks, which could have the effect of increasing competition for
local exchange services.
Interexchange Carriers. We also expect to face competition from other
current and potential market entrants, including interexchange (long distance)
carriers such as AT&T, MCI and Sprint, seeking to enter, reenter or expand entry
into the local exchange market. A continuing trend toward consolidation of
telecommunications companies and the formation of strategic alliances within the
telecommunications industry, as well as the development of new technologies,
could give rise to significant new competitors.
LONG DISTANCE TELEPHONE SERVICE
The long distance telecommunications industry has numerous entities
competing for the same customers and a high average churn rate because customers
frequently change long distance providers in response to the offering of lower
rates or promotional incentives by competitors. Our primary competitors in the
long distance market include major interexchange carriers such as AT&T, MCI and
Sprint, certain incumbent local exchange carriers and resellers of long distance
services. We believe that pricing levels are a principal competitive factor in
providing long distance telephone service. We hope to avoid direct price
competition by bundling long distance telephone service with a wide array of
value-added, enhanced services.
We believe that incumbent local exchange carriers that offer a package
of local, long distance telephone and information services will be particularly
strong competitors. Incumbent local exchange carriers, including Verizon,
BellSouth and SBC Communications, are currently providing both long distance and
local services as well as certain enhanced telephone services that we offer. We
believe that the Bell operating companies will attempt to offset market share
losses in their local markets by attempting to capture a significant percentage
of the long distance market.
ENHANCED SERVICES
We compete with a variety of enhanced service companies. Enhanced
services markets are highly competitive, and we expect that competition will
continue to intensify. Our competitors in these markets include Internet service
providers, web-based communications service providers and other
telecommunications companies, including the major interexchange carriers,
incumbent local exchange carriers, competitive local exchange carriers and
wireless carriers.
OTHER MARKET ENTRANTS
We may face competition in local, long distance and information
services from other market entrants such as electric utilities, cable television
companies, fixed and mobile wireless system operators, and operators of private
networks built for large end-users. All of these companies are free to offer
bundled services similar to those that we offer. Electric utilities have
existing assets and low cost access to capital that could allow them to enter a
market rapidly and accelerate network development. Cable television companies
are also entering the telecommunications market by upgrading their networks with
fiber optics and installing facilities to provide fully interactive transmission
of broadband voice, video and data communications. Wireless companies have
developed, and are deploying in the United States, wireless technology as a
substitute for traditional wireline local telephone service. The World Trade
Organization agreement on basic telecommunications services could increase the
level of competition we face. Under this agreement, the United
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States and 68 other member states of the World Trade Organization are committed
to open their respective telecommunications markets, including permitting
foreign companies to enter into basic telecommunications services markets. This
development may increase the number of established foreign-based
telecommunications carriers entering and competing in the U.S. markets.
The Telecommunications Act includes provisions that impose certain
regulatory requirements on all local exchange carriers, including competitive
local exchange carriers. At the same time, the Telecommunications Act expands
the FCC's authority to reduce the level of regulation applicable to any or all
telecommunications carriers, including incumbent local exchange carriers. The
manner in which these provisions are implemented and enforced could have a
material adverse effect on our ability to compete successfully against incumbent
local exchange carriers and other telecommunications service providers.
WHOLESALE SERVICES
We believe we are the sole competitive local exchange carrier offering
local exchange services on a wholesale basis. Our chief competitor on the
wholesale level in each territory is the incumbent local exchange carrier,
usually a Bell operating company. Our competitive advantage is our knowledge and
experience in dealing with incumbent local exchange carriers, our knowledge and
experience in offering local services and our proprietary enhanced features.
Bell operating companies, in general, do not promote and market their ability to
offer wholesale services, preferring to minimize competition in the local
telephone services market. We offer our wholesale customers a full suite of
services for their use in providing telephone services to their customers. We
will face competition from a variety of companies that offer particular services
such as provisioning services, billing services and enhanced services (such as
voicemail) or that offer technologies related to such services.
GOVERNMENT REGULATION
OVERVIEW
Some of our services are regulated and some are not. In providing our
feature services such as voice mail, "Find-Me" call forwarding and Personal
Voice Assistant, we operate as an unregulated provider of information services,
as that term is defined in the Communications Act of 1934 (the "Communications
Act"), as amended by the Telecommunications Act of 1996 (the "Telecommunications
Act"), and as an enhanced service provider, as that term is defined in the FCC
rules. These non-common carrier operations currently are not regulated by the
FCC or the states in which we operate. In providing Z-LineHOME and our long
distance services, we are regulated as a common carrier at the state and federal
level and are subject to additional rules and policies not applicable to
providers of information services alone. We are certificated as a
facilities-based competitive local exchange carrier in forty-nine states and the
District of Columbia. We are currently seeking such certification in Alaska.
Z-Tel is certificated as a long-distance reseller in all fifty states.
The local and long distance telecommunications services we provide are
regulated by federal, state, and, to some extent, local government authorities.
The FCC has jurisdiction over all telecommunications common carriers to the
extent they provide interstate or international communications services. Each
state regulatory commission has jurisdiction over the same carriers with respect
to providing intrastate communications services. Local governments sometimes
seek to impose franchise requirements on telecommunications carriers and
regulate construction activities involving public rights-of-way. Changes to the
regulations imposed by any of these regulators could have a material adverse
effect on our business, operating results and financial condition.
In recent years, the regulation of the telecommunications industry has
been in a state of flux as the United States Congress and various state
legislatures have passed laws seeking to foster greater competition in
telecommunications markets. The FCC and state utility commissions have adopted
many new rules and continue to propose additional rules and policies to
implement this legislation. These changes, which are still incomplete, have
created new opportunities and challenges for us, and our competitors. The
following summary of regulatory developments and legislation is intended to
describe the most important, but not all, present and proposed federal, state
and local regulations and legislation affecting the telecommunications industry.
Some of these and other existing federal and state regulations are the subject
of judicial proceedings and legislative and administrative proposals that could
change, in varying degrees, the manner in which this industry operates. We
cannot predict the outcome of any of these proceedings or their impact on the
telecommunications industry at this time. Some of these future legislative,
regulatory or judicial changes may have a material adverse impact on our
business.
Specifically, pursuant to a recent FCC decision in FCC CC Docket No.
01-338 (referred to as the "Triennial Review"), we anticipate that all of the
state commissions in which we do business will be reviewing the availability of
the unbundled network element platform ("UNE-P") within their states. As
described below under "Federal Regulation-FCC Regulation of Common Carrier
7
Services-Interconnection and Unbundling Requirements," UNE-P is the regulatory
framework under which Z-Tel offers local telecommunications services to our
customers. The details of these proceedings are unknown at this time because the
FCC has not released the complete text of its decision and this decision will
not become legally effective until after that decision is published. However,
according to an FCC news release dated February 20, 2003, state commissions will
be expected during the next 9 months to engage in a detailed and fact-intensive
review of the availability of UNE-P for local telephone services in their
states. The results of these state commission proceedings will impact on our
business, and restriction in the availability of UNE-P could have a material
adverse impact on our business.
Moreover, pursuant to federal standards state commissions, establish
the prices we pay for access to network elements. State commissions are
continually re-evaluating those prices. As states re-evaluate pricing of network
elements, it is possible that some states could increase or lower rates over
existing levels. The incumbent local exchange carriers, Verizon, BellSouth, SBC
and Qwest, regularly have rate cases pending before state regulatory
commissions. There are ongoing rate cases in Florida, Georgia, Illinois,
Indiana, Michigan, Pennsylvania, Massachusetts, California, and Texas, among
others, and these proceedings could significantly raise or lower the existing
rates for some network elements and network element combinations. Our intent is
to be an active participant in many of these rate cases and any others that
might be critical to our operations. We anticipate joining other competitive
service providers in arguing that existing rates and rates proposed by the
incumbents are overstated and do not reflect the true total element long run
incremental costing principles required by the FCC and the Telecommunications
Act. The legality of the FCC-prescribed methodology for calculating unbundled
network element rates was affirmed by the United States Supreme Court in Verizon
v. FCC on May 13, 2002. In the Triennial Review decision announced on February
20, 2003, the FCC noted that it will clarify two aspects of this federal
methodology (referred to as Total Element Long Run Incremental Cost, or TELRIC)
related to cost of capital and depreciation of new, advanced telecommunications
equipment. Since the text of the FCC's Triennial Review decision has not been
released, we cannot analyze the potential impact those clarifications may have
upon current or future rates. While the prevailing trends within the industry
would predict the adoption of lower rates in association with unbundled network
elements and network element combinations, we cannot predict the outcome of any
pending or potential rate case or judicial proceeding. We could face an
additional series of rate cases before state commissions to respond to the FCC's
clarification of its TELRIC rules. Increases or decreases in rate levels charged
by incumbent local exchange carriers can result from regulatory or judicial
review of a rate case or arbitration proceedings, and such changes could
significantly impact our business plans.
FEDERAL REGULATION
FCC POLICY ON ENHANCED AND INFORMATION SERVICES
In 1980, the FCC created a distinction between basic telecommunications
services, which it regulates as common carrier services, and enhanced services,
which are unregulated. The FCC exempted enhanced service providers from federal
regulations governing common carriers, including the obligation to pay access
charges for the origination or termination of calls on carrier networks and the
obligation to contribute to the universal service fund. The Telecommunications
Act of 1996 established a similar distinction between telecommunications
services and information services. Changing technology and changing market
conditions, however, sometimes make it difficult to discern the boundary between
unregulated and regulated services.
In general, information services are value-added services that use
regulated transmission facilities only as part of a service package that also
includes network or computer software to change or enhance the information
transmitted. We believe that most of the feature services we provide, including
voice mail, "Find-Me" call forwarding, and Personal Voice Assistant, are
information services under the FCC's definition. Because the regulatory
boundaries in this area are somewhat unclear and subject to dispute, however,
the FCC could seek to characterize some of these services as "telecommunications
services." If that happens, those services would become subject to FCC
regulation, although the impact of that reclassification is difficult to
predict. In Docket No. 01-337, the FCC has proposed rules that would classify
broadband Internet access services offered by wireline telecommunications
providers as "information services" under the Communications Act.
In general, the FCC does not regulate the rates, services, and market
entry of non-dominant telecommunications carriers, but does require them to
contribute to universal service and comply with other regulatory requirements.
We are currently regulated as a non-dominant carrier with respect to both our
local and long distance telephone services. Typically, the incumbent local
exchange carrier is the dominant carrier in connection with local services. AT&T
is the traditional dominant carrier in connection with long distance services.
8
FCC REGULATION OF COMMON CARRIER SERVICES
We currently are not subject to rate of return regulation at the
federal level and are not currently required to obtain FCC authorization for the
installation, acquisition or operation of our domestic exchange or interexchange
network facilities. However, we must comply with the requirements of common
carriage under the Communications Act. We are subject to the general requirement
that our charges and terms for our telecommunications services be "just and
reasonable" and that we not make any "unjust or unreasonable discrimination" in
our charges or terms. The FCC has jurisdiction to act upon complaints against
any common carrier for failure to comply with its statutory obligations. Our
ability to discontinue interstate services is regulated by Section 214 of the
Communications Act and FCC implementing rules.
Comprehensive amendments to the Communications Act were made by the
Telecommunications Act, which was signed into law on February 8, 1996. The
Telecommunications Act effected changes in regulation at both the federal and
state levels that impact virtually every segment of the telecommunications
industry. The stated purpose of the Telecommunications Act is to promote
competition in all areas of telecommunications. While it may take years for the
industry to feel the full effects of the Telecommunications Act, it is already
clear that the legislation provides us with new opportunities and challenges.
Interconnection and Unbundling Requirements. The Telecommunications Act
greatly expands the interconnection requirements applicable to the incumbent
local exchange carriers, i.e., generally, those existing local telephone
companies that, in the past, enjoyed virtual or legal monopoly status.
(Conversely, new entrants to the local telephone market, like Z-Tel, are
referred to as "competitive local exchange carriers.") The Telecommunications
Act requires the incumbent local exchange carriers to-
- provide physical collocation, that is allow competitive local
exchange carriers to install and maintain their own network
termination equipment in incumbent local exchange carrier
central offices, or, if requested or if physical collocation
is demonstrated to be technically infeasible, provide virtual
collocation;
- offer components of their local service networks on an
unbundled basis so that other providers of local service can
use these elements in their networks to provide a wide range
of local services to customers; and
- establish "wholesale" rates for their services to promote
resale by competitive local exchange carriers.
In addition, all local exchange carriers must -
- interconnect with the facilities of other carriers;
- establish number portability, that is allow customers to
retain their existing phone numbers if they switch from the
local exchange carrier to another local service provider;
- provide nondiscriminatory access to telephone poles, ducts,
conduits and rights-of-way; and
- compensate other local exchange carriers on a reciprocal basis
for traffic originated by one local exchange carrier and
terminated by another local exchange carrier.
The FCC is charged with implementing certain portions of the
Telecommunications Act, including the unbundling and interconnection
requirements, upon which Z-Tel relies to provide local telephone services. The
FCC issued its first unbundling and interconnection order on August 8, 1996,
referred to as the 1996 Local Competition Order. Among other rules, the 1996
Local Competition Order established a list of seven network elements, comprising
most of the significant facilities, features, functionalities, or capabilities
of the network, that the incumbent local exchange carriers must unbundle. It is
possible for competitors to provide competitive local exchange service using
only these unbundled network elements. In addition, the FCC mandated a
particular forward looking pricing methodology for these network elements
(TELRIC).
Those rules have been the subject of considerable litigation. Two
Supreme Court decisions have resolved some of these issues, but many others,
including the identification of network elements that must be unbundled, remain
in dispute.
In the May 13, 2002 decision in Verizon v. FCC, the Supreme Court
affirmed the particular pricing methodology adopted by the FCC in the 1996 Local
Competition Order for unbundled network elements, known as TELRIC. That decision
ensures that unbundled elements must be priced according to forward-looking
costs, at least until the FCC changes its pricing methodology. On
9
February 20, 2003, an FCC news release indicates that a future FCC order will
clarify two aspects of this pricing methodology with regard to cost of capital
and depreciation and new network investment. The text of that "clarification"
has not been released; however, we anticipate that this clarification may result
in reassessment of unbundling rates by many states, which could impact our
business. In addition, the FCC's Calendar Year 2003 Strategic Plan notes that it
is considering a complete review of its TELRIC rules. The FCC has not released
any proposals to modify those rules, but implementation of a different or
modified pricing standard for unbundled network elements could significantly
impact our business.
On January 25, 1999, in AT&T v. Iowa Utilities Board, the Supreme Court
held that the FCC has general jurisdiction to implement the local competition
provisions of the Telecommunications Act. In so doing, the Supreme Court stated
that the FCC has authority to set pricing guidelines for unbundled network
elements, to prevent incumbent local exchange carriers from physically
separating existing combinations of network elements, and to establish "pick and
choose" rules regarding interconnection agreements. "Pick and choose" rules
would permit a carrier seeking interconnection to pick and choose among the
terms of service from other interconnection agreements between the incumbent
local exchange carriers and other competitive local exchange carriers. This 1997
Supreme Court decision reversed a July 18, 1997 decision by the United States
Court of Appeals for the Eighth Circuit on many grounds.
In part of this 1999 AT&T decision, the Supreme Court remanded the list
of unbundled network elements identified in the 1996 Local Competition Order to
the FCC for further consideration of the necessity of each one under the
Telecommunications Act's statutory standard for unbundling. In response to this
Supreme Court decision, on November 5, 1999, the FCC released an order (the
"1999 Unbundling Order") that largely retained the existing list of unbundled
network elements, but eliminated the requirement that incumbent local exchange
carriers provide unbundled access to operator services and directory assistance
and limited unbundled access to local switching. With regard to operator
services and directory assistance, the FCC concluded that the market has
developed since 1996 such that competitors can and do provide these services, or
acquire them from alternative sources. The FCC also noted that incumbent local
exchange carriers remain obligated under the non-discrimination requirements of
the Communications Act of 1934 to comply with the reasonable request of a
carrier that purchases these services from the incumbent local exchange carriers
to rebrand or unbrand those services, and to provide directory assistance
listings and updates in daily electronic batch files. With regard to unbundled
local switching, the FCC concluded that, notwithstanding the incumbent local
exchange carriers' general duty to provide unbundled local circuit switching, an
incumbent local exchange carrier is not required to unbundle local circuit
switching for competitors for end-users with four or more voice grade (DSO)
equivalents or lines, provided that the incumbent local exchange carrier
provides nondiscriminatory access to combinations of unbundled loops and
transport (also known as the Enhanced Extended Link) throughout Density Zone 1,
and the incumbent local exchange carrier's local circuit switches are located in
(i) the top 50 Metropolitan Statistical Areas as set forth in Appendix B of the
Third Report and Order and Fourth Further Notice of Proposed Rulemaking in FCC
Docket No. 96-98, and (ii) in Density Zone 1, as defined in the FCC's rules. For
operator services and directory assistance, as well as for unbundled local
switching, the FCC noted that the competitive checklist contained in Section 271
of the Communications Act requires Bell operating companies to provide
nondiscriminatory access to these services. The 1999 Unbundling Order required
that Bell operating companies must continue to provide these services to
competitors; however, it allowed them to charge different rates for these
offerings.
On May 24, 2002, the D.C. Circuit Court of Appeals in USTA v. FCC,
reversed and remanded the 1999 Unbundling Order. A subsequent decision by the
D.C. Circuit in Competitive Telecommunications Ass'n v. FCC (October 25, 2002)
indicated that the FCC may limit required unbundling by means of carrier and
service-specific restrictions. In the USTA decision, the D.C. Circuit court
decided that the FCC had not adequately examined in specific detail local
competitive market conditions, alternative sources of supply, and the impact
those local conditions should have on the availability of unbundled network
elements. The D.C. Circuit stated that since the FCC had implemented unbundling
requirements of "unvarying scope" those rules must be reversed and remanded. In
the same decision D.C. Circuit also reversed and vacated the FCC's 1999 Line
Sharing and 2000 Line Splitting Orders on similar grounds. (Line Sharing and
Line Splitting are discussed below.) Several competitive carriers have requested
a Supreme Court review of the USTA decision, noting in part that the decision is
inconsistent with the Supreme Court's rationale in Verizon v. FCC and other
grounds. As of March 26, 2003, the Supreme Court has not decided whether to hear
that appeal.
On February 20, 2003, the FCC announced its decision in the Triennial
Review docket, CC 01-338, a proceeding that it began on December 20, 2001. The
final text of this decision has not been released; as a result, we cannot fully
determine the impact the decision will have upon our business. However, an FCC
press release issued on February 20, 2003 indicates that in this decision the
FCC attempted to address the concerns expressed by the D.C. Circuit in the USTA
decision. (The effective date of the D.C. Circuit's mandate in USTA was extended
to February 20, 2003, which was the date upon which the FCC announced its
Triennial Review decision.) In particular, the FCC release states that in order
to provide the fact-based, local-market condition requirements imposed by USTA,
the FCC decided to request that state commissions undertake an important
fact-finding role with regard to
10
unbundled local switching and dedicated transport. According to the FCC release,
with regard unbundled switching in particular (a key component of UNE-P) the FCC
established "presumptions" of availability based upon customer characteristics.
Parties may attempt to rebut those presumptions before state commissions by
arguing with regard to operational or economic factors surrounding the
availability of switching from non-incumbent sources in that state for that
particular market. With regard to the services Z-Tel seeks to offer, the FCC
news release states that the FCC has established a presumption in favor of
statewide availability; such presumption may be rebutted in state proceedings
that are to last nine months. The FCC rejected arguments that unbundled loops,
switching, transport, and signaling at TELRIC rates are required by Section 271
of the Telecommunications Act.
As a result of the Triennial Review proceeding, we anticipate that
virtually all states in which we do business will, after the effective date of
the to-be-released final FCC Order, commence in the next several months'
proceedings about the availability of UNE-P in their jurisdictions. We will
participate in many of theses state proceedings, either individually or through
coalitions of other similarly situated competitive carriers. We devoted
substantial resources in 2001-2002 to building the substantive case that we
intend to use in these state proceedings; however, it is impossible to predict
the outcome of these proceedings. It is possible that in many states, our
ability to utilize UNE-P to serve our customers will be significantly or
substantially curtailed. Such a result could significantly, adversely, and
materially harm our business. It is also possible that as a result of these
cases, our access to UNE-P could be expanded, such as lifting of the 3-line rule
in the 1999 Unbundling Order that limits our entry in one or many states. Such a
result could assist our small business and wholesale product lines in those
states.
The Triennial Review release also indicates that the FCC will
significantly loosen its unbundling requirements for "advanced"
telecommunications network elements, such as packet-switching technology and
other new investment by incumbents. In addition, the FCC eliminated the
requirement that incumbents line-share with competitive DSL providers. However,
the FCC does appear to have preserved line-splitting, which would allow a Z-Tel
customer to obtain competitive DSL service from a non-incumbent suppliers. Once
again, the details of these regulatory changes remain in flux; as a result, it
is difficult for us to say how they will impact our business. Many of these
changes could substantially harm potential wholesale competitive carrier
customers of Z-Tel and therefore could harm our wholesale business. Substantial
relaxation of broadband regulations on our incumbent competitors like SBC,
Verizon, Qwest and BellSouth could make competition more difficult; for example,
incumbents may be able to bundle now-deregulated advanced services with local
telephone service, and Z-Tel may not be able to match because we cannot obtain
unbundled access to those advanced services. Such a result, among others, could
substantially harm our business. In addition, restrictions on unbundled access
may limit our business opportunities or ability to expand the services we offer
to customers.
We emphasize that the final text of the FCC's Triennial Review decision
has not been released as of this writing. As a result, it is impossible to fully
gauge the impact the FCC's final Order will have upon Z-Tel's business. Several
incumbent local exchange carriers have stated publicly that they intend to
appeal that order, and even possibly seek a stay of its implementation. The
impact of such a stay upon Z-Tel's business is unclear. If a stay is granted,
incumbents may utilize the situation that since the USTA court decision became
effective on February 20, 2003, there are no federal rules requiring the
unbundling of any network element. Such a result would significantly and
substantially harm our business. While we disagree and would certainly litigate
that issue, we believe that our current interconnection agreements and contracts
with incumbent local telephone companies generally require them to continue to
provide us access until new rules are implemented. However, we cannot be certain
that our interpretation of our agreements would be accepted by all regulatory or
judicial bodies. There are likely to be several other appeals of the FCC's
Triennial Review Order which are likely to take at least one to two years to
resolve.
The FCC is also considering other changes to other competition rules
that could impact our business. On December 20, 2001, the FCC issued a Notice of
Proposed Rulemaking in CC Docket No. 01-337 in which the FCC sought comment on
regulatory requirements for incumbent local exchange carrier provision of
broadband telecommunications services. In this proceeding, the FCC is
considering whether it should remove regulatory safeguards and common carrier
obligations, including unbundling regulations, on incumbent local exchange
carrier broadband networks. An FCC decision limiting unbundling or deregulating
incumbent local exchange carrier broadband networks could have a significant and
material adverse impact on our business. For example, incumbent local exchange
carriers may be able to offer consumers deregulated broadband network packages
of local exchange, information services and broadband service (such as DSL) that
Z-Tel would not be able to offer because Z-Tel would not have unbundled access
to that broadband network. In addition, because the incumbent local exchange
carrier "broadband network" in most instances utilizes the same network
facilities as the current incumbent local exchange dial tone network,
limitations on unbundling or deregulation of that "broadband network" could
inexorably make it difficult, more costly, or even impossible, for Z-Tel to
provide its current telecommunications and information services to consumers.
On February 14, 2002, the FCC adopted a Notice of Proposed Rulemaking
in CC Docket No. 02-42 that proposed to classify incumbent local exchange
carrier provision of wireline broadband Internet access services as an
"information service" and regulate the
11
provision of such services pursuant to Title I of the Communications Act of
1934. In addition, the FCC sought comment on whether its Computer II/Computer
III rules, which govern access to incumbent networks by third parties to provide
information services. The proposed rules could, if adopted without adequate
assurances for competitive access, limit the ability of new entrants to access
and utilize the networks of incumbent local exchange carriers to provide
advanced, broadband Internet access and could therefore harm Z-Tel's ability to
provide services to its customers.
These and other FCC determinations are likely to be the subject of
further appeals or reconsideration. Thus, while the Supreme Court has resolved
many issues, including aspects of the FCC's jurisdictional authority, other
issues remain subject to further consideration by the courts and the FCC. We
cannot predict the ultimate disposition of these matters and their impact on our
business.
Interconnection Agreements. The Telecommunications Act obligates
incumbent local exchange carriers to negotiate with us in good faith to enter
into interconnection agreements. Competitive local exchange carriers like us can
purchase unbundled network elements under such an agreement or under a tariff or
a Statement of Generally Available Terms filed with the state regulators.
Interconnection agreements are a prerequisite to obtaining access to the
incumbent local exchange carrier's unbundled network elements and to provide the
connectivity to our network necessary to provision local exchange services,
including Z-LineHOME. Z-Tel operates from interconnection agreements in the
following SBC states: California, Texas, Arkansas, Missouri, Kansas, Oklahoma,
Illinois, Indiana, and Ohio. SBC and Z-Tel have signed interconnection
agreements in Michigan and Wisconsin and are awaiting approval from those state
commissions. Meanwhile, Z-Tel continues to purchase required network elements
from SBC Ameritech's state tariffs in Michigan and Wisconsin. (Z-Tel does not
currently operate in SBC's territory in Connecticut and Nevada.) Z-Tel has
effective interconnection agreements, approved by the relevant state
commissions, in all the states where in which Verizon, Qwest and BellSouth are
an incumbent local exchange carrier. In addition, Z-Tel has effective
interconnection agreements, approved by the relevant state commissions, with
Sprint in Florida and Nevada.
To ensure that it obtains interconnection and unbundled access at the
best-available terms, Z-Tel reviews available contracts, or amendments, and
negotiates new arrangements in a number of states. Section 252(i) of the 1996
Act gives Z-Tel the legal right to "pick-and-choose" interconnection and
unbundling terms and conditions in this manner. However, in a February 20, 2003
release, the FCC proposed to eliminate many, if not all, of these
"pick-and-choose" requirements. The text of this FCC proposal has not yet been
released, so we cannot say how implementation of the proposal may have on our
business. However, limitations on our ability to pick-and-choose interconnection
and unbundling terms and conditions could have a significant adverse impact on
our business, by increasing our costs in reaching interconnection agreements and
possibly having less-favorable arrangements than our competitors. In addition,
at any point in time our interconnection agreement may not contain the
best-available terms offered to our competitors, a situation that could
adversely affect our ability to compete in the market.
If we cannot reach a voluntary interconnection agreement with an
incumbent local exchange carrier on acceptable terms, either side may petition
the applicable state commission to arbitrate remaining disagreements. These
arbitration proceedings can last for a substantial period of time and can
require substantial resources to litigate. Moreover, state commission approval
of any interconnection agreement resulting from negotiation or arbitration is
required, and any party may appeal an adverse decision by the state commission
to federal district court. The incentive of the incumbent local exchange carrier
to negotiate fair or proper interconnection agreement terms is a function of the
willingness and authority of state commissions and the FCC to enforce rules and
policies promulgated under the Telecommunications Act. The potential cost in
resources and delay from this interconnection agreement negotiation and
arbitration process could harm our ability to compete in certain markets, and
there is no guarantee that a state commission would resolve disputes, including
pricing disputes, in our favor.
The ability of a new entrant like Z-Tel to enforce interconnection
agreements and state tariffs with incumbent local exchange carriers or appeal
state commission arbitrations regarding interconnection agreements is currently
subject to considerable legal uncertainty. In May 20, 2002, the United States
Supreme Court in Verizon v. Maryland PSC decided that it was appropriate for
carriers to appeal state commission determinations to enforce interconnection
agreements in federal district court. State commissions had argued that the
Eleventh Amendment precludes appeal of these decisions and determinations to
federal district court, and the Supreme Court's decision resolved many such
questions. Nevertheless, the relationship the interconnection and unbundling
implementation provisions of the 1996 Act and state law remain subject to
considerable litigation. A January 2002 decision by the United States Circuit
Court for the Eleventh Circuit ruled that the Georgia state commission did not
have authority to enforce interconnection agreements between incumbent local
exchange carriers and new entrants. This decision is in apparent conflict with
decisions by other United States Circuit Courts. As a result of this decision,
litigating enforcement of interconnection agreements in state or federal courts
in the Eleventh Circuit and elsewhere could substantially increase the cost of
such litigation. In addition, two recent decisions by the United States Circuit
Court of Appeals for the Sixth Circuit indicate that the authority of the
Michigan state commission to require incumbent local telephone companies to file
unbundling and interconnection tariffs may be limited or even
12
preempted by the 1996 Act interconnection agreement process. In Michigan and
other states, Z-Tel has utilized rights under state tariff regimes to provide
service; limitations on our ability to utilize Michigan or other state tariffs
in this way could increase our costs of doing business significantly. Moreover,
limitations on the ability to resort to state laws, regulations, policies, or
procedures could made entry into local markets more costly, time-consuming, and
difficult.
Collocation. The FCC has adopted rules designed to make it easier and
less expensive for competitive local exchange carriers to collocate equipment at
incumbent local exchange carriers' central offices by, among other things,
restricting the incumbent local exchange carriers' ability to prevent certain
types of equipment from being collocated and requiring incumbent local exchange
carriers to offer alternative collocation arrangements. Restrictions and
impediments to collocation could harm our business as they make it more
difficult if not impossible for us to obtain alternatives to unbundled network
elements we purchase from incumbent local exchange carriers.
As outlined in our previous annual reports, the FCC's collocation rules
have been subject to a number of legal challenges by incumbent local telephone
companies. On June 18, 2002, the D.C. Circuit affirmed the legality of the FCC's
collocation rules in Verizon Telephone Companies v. FCC. In the process of these
court challenges, the FCC's new rules could increase the cost and time for
competitors to collocate equipment in incumbent local exchange carrier central
offices and could have a substantial and material impact on Z-Tel's future
business prospects.
Line Sharing and Line Splitting. In November 1999, the FCC adopted an
order that required incumbent local exchange carriers to provide line sharing,
which is a method in which a competitive provider can provide data services over
the same line that the incumbent provides voice services (the 1999 Line Sharing
Order). In an order on reconsideration, the FCC stated that incumbents must also
permit competitive carriers to engage in "line-splitting" arrangements in which
one competitive provider may offer voice services and another competitive
provider may offer data services (e.g., DSL) on one of the incumbent's local
loops (the 2000 Line Splitting Order). In USTA, the D.C. Circuit reversed,
remanded and vacated the 1999 Line Sharing Order and 2000 Line Splitting Order.
On February 20, 2003, as part of its Triennial Review decision
discussed above, the FCC announced that it will eliminate the requirement that
line-sharing be provided as an unbundled network element, subject to a
transition period. Z-Tel does not utilize line-sharing to provide DSL services
to our customers, so we believe that the FCC February 20, 2003 announcement that
its Triennial Review Order will eliminate line-sharing as an unbundled network
element has no immediate impact on our retail business. However, since the text
of that Order had not been released, we cannot now predict how that decision
could impact future prospects of our business, the on-going viability of our
wholesale or potential wholesale customers that may utilize line-sharing. The
FCC's Triennial Review release does indicate that the FCC has kept in place
requirements for "line-splitting," which is the method in which a Z-Tel voice
customer may be able to order DSL service from a non-incumbent competitor. Once
again, since the text of the FCC decision has not been released, we cannot at
this time make any judgment as to the impact that decision would have on our
business.
While we expect that the preservation of line-splitting could be
beneficial to competitive local exchange carriers like Z-Tel, we cannot be
certain that these rules will be implemented by the incumbent local exchange
carrier in a timely or favorable manner. As a result, Z-Tel's ability to offer
its customers DSL service and voice service by use of line-splitting and the
unbundled network element platform combination is restricted significantly by
incumbent local exchange carriers. That restriction could harm our business and
our ability to match the service packages and bundles offered by our
competitors, including the incumbents. In addition, the FCC's apparent
elimination of line-sharing could make existing and potential wholesale
competitive carrier customers less-financially viable, which could harm our
business.
Bell Operating Company Entry into the Long Distance Market. The
Telecommunications Act permitted the Bell operating companies (Verizon, SBC,
Qwest, and BellSouth) to provide long distance services outside their local
service regions immediately, and permits them to provide in-region long distance
service upon demonstrating to the FCC that they have adhered to the
Telecommunication Act's Section 271 14-point competitive checklist. The FCC must
also find that granting the application would be in the "public interest."
Bell operating companies typically seek approval from state public
utility commissions prior to filing an application for Section 271 relief before
the FCC. To date, some states have denied these applications while others have
approved them. The Bell operating company can file an application with the FCC
for Section 271 relief regardless of the outcome of the state's review. Based on
its own review as well as recommendations from the United States Department of
Justice and the involved state public utility commission, the FCC then either
approves or denies the application.
13
Prior to December 1999, the FCC had denied each of the Bell operating
company applications brought before it because it found that the particular Bell
operating company had not sufficiently made its local network available to
competitors. However, since December 1999, the FCC has not rejected a Section
271 application submitted by any Bell operating company, although several
applications have been withdrawn after being submitted. In late December 1999,
the FCC approved Verizon's Section 271 application for the state of New York.
Since that time, the FCC has approved Bell operating company applications in 36
other states and the District of Columbia. Section 271 authority has been
granted in Currently pending before the FCC are applications for Michigan (SBC),
Nevada (SBC), New Mexico (Qwest), Oregon (Qwest), and South Dakota (Qwest). In
addition to those pending applications, Bell operating companies do not have
Section 271 authority in Illinois, Indiana, Ohio, Wisconsin, Minnesota, and
Arizona.
Several state public utility commissions (including Illinois and
Minnesota) have proceedings underway in association with anticipated Section 271
applications. While we cannot predict the outcome of any Section 271
applications before the FCC or any individual state, we expect Bell operating
companies to file applications for long distance authority in most of the
remaining states in 2003 and that the FCC will grant many, if not most, of those
applications, despite the objections of competitive carriers and the Department
of Justice.
It is generally expected that competition for Z-Tel's long-distance
services will increase as the Bell operating companies enter the market. Section
271 entry permits the Bell operating company to offer a bundle of local,
long-distance and enhanced services comparable to Z-Tel's services and therefore
could increase competition and harm our business, especially if we cannot obtain
adequate access to unbundled network elements from that same Bell operating
company.
The Section 271 process also provides an important incentive for Bell
operating companies to comply with the unbundling and interconnection
requirements of the Telecommunications Act. Z-Tel relies upon obtaining
unbundled access and interconnection with Bell operating companies to provide
its services to its customers; as a result, Z-Tel has a direct business interest
in ensuring that the Bell operating companies comply with the law. Granting a
Bell operating company long-distance authority pursuant to Section 271 in a
state where the Bell operating company has not fully-complied with the law could
have a significant and material adverse impact on Z-Tel's business, as it would
diminish the incentive of Bell operating companies to comply with the law
nationwide. Z-Tel has in many cases documented discriminatory behavior by the
Bell operating company. For example, on September 19, 2001, the FCC granted
Verizon's Section 271 application for Pennsylvania, despite the strong
objections of Z-Tel and other competitors that Verizon's operational systems in
that state were discriminatory. In October 2001, Z-Tel appealed that FCC
decision before the United States Circuit Court for the District of Columbia.
That appeal was heard by the D.C. Circuit in February 2003 and a decision is
pending. If Z-Tel is not successful in this litigation, the incentive of Bell
operating companies to comply with their interconnection and unbundling
obligations fully could be significantly diminished, which could have a material
adverse impact on our business.
The D.C. Circuit has recently reversed FCC 271 grants on the basis that
the FCC did not consider all the evidence and arguments before it. In December
28, 2001, the United States Circuit Court for the District of Columbia remanded
the FCC's decision to grant SBC long-distance authority in Kansas and Oklahoma.
On October 22, 2002, the D.C. Circuit reversed the FCC's Massachusetts 271 Order
in WorldCom v. FCC. In both decisions, the court ruled that the FCC had not
fully considered whether granting such authority was in the public interest,
given the alleged potential for a "price squeeze" between regulated retail and
wholesale rates for local service. These proceedings have been remanded to the
FCC. It is unclear how and when the FCC will decide this issue on remand. If the
FCC continues to reject arguments raised by competitors, the ability for
entrants to utilize the section 271 process as a method of achieving lawful
wholesale rates or compliance with the 1996 Act could be substantially
diminished.
Universal Service. In May 1997, the FCC released an order establishing
a significantly expanded universal service regime to subsidize the cost of
telecommunications service to high cost areas, as well as to low-income
customers and qualifying schools, libraries and rural health care providers.
Providers of interstate telecommunications services, like us, as well as certain
other entities, must pay for these programs. We are also eligible to receive
funding from these programs if we meet certain requirements. Our share of the
payments into these subsidy funds is based on our share of certain defined
interstate telecommunications end-user revenues. Currently, the FCC is assessing
such payments on the basis of a provider's revenue, and the FCC adjusts payment
requirements and levels periodically. Various states are also in the process of
implementing their own universal service programs. We are currently unable to
quantify the amount of subsidy payments that we will be required to make to
individual states.
On July 30, 1999, in Texas Office of Public Utility Counsel v. FCC, the
Fifth Circuit overturned certain of the FCC's rules governing the basis on which
the FCC collects subsidy payments from telecommunications carriers and recovery
of those payments by incumbent local exchange carriers. The Fifth Circuit ruled
that the FCC's could not require that incumbent local exchange carriers recover
universal service costs via access charges paid by interstate carriers, as such
a result would create an implicit subsidy prohibited by section 253 of the 1996
Act. In October 1999, on remand from this decision, the FCC issued new universal
service
14
rules. The FCC decided that if a carrier derives less than 8 percent of its
revenue from interstate services, its international revenues will not be used in
calculating the contribution. For those carriers receiving 8 percent or more of
their revenues from interstate services, the FCC will include their
international revenue in the base for determining their contributions. The
Commission also permitted, rather than require, ILECs to recover their universal
service costs through access charges to interstate carriers. These or other
changes to the universal service program could affect our costs by increasing
charges for interstate access or requiring higher assessments on interstate
revenues. On May 20, 2001, the Fifth Circuit once again reversed the FCC's
rules, deciding, in Comsat Corp. v. FCC, that the FCC cannot permit local
exchange carriers to recover universal service charges through access charges,
as such an arrangement would create an implicit subsidy.
On December 13, 2002, the FCC announced that it will modify on an
interim basis the method in which carriers are required to make payments to the
fund. Among other changes, the FCC announced that carriers will be required to
contribute based upon projected, collected end-user interstate revenues, instead
of historical, gross-billed revenues. Competitive carriers will be prohibited
from marking-up USF contributions for administrative fees if carriers recover
USF contributions through phone bill line items. These interim measures impact
the manner in which we make contributions into the federal fund and could impact
our business. The FCC also proposed further changes to its contribution
methodology.
The outcome of this litigation and subsequent and forthcoming FCC and
state determinations could adversely impact or delay our ability to obtain
universal service funding for our services, the sums we pay into universal
service funds, the price for access, and our ability to compete with carriers
that do obtain such funding. Changes to the federal or state support programs
could adversely affect our costs, our ability to separately-list these charges
on end-user bills, and our ability to collect these fees from our customers.
Interstate Tariffs and Rates. Beginning July 31, 2001, interstate
domestic long distance companies were no longer allowed to file interstate
long-distance end-user tariffs with the FCC. This regulatory change requires
that Z-Tel must make its long-distance service information directly available to
customers pursuant to private contracts. In March 1999, the FCC adopted rules
that require interexchange carriers like Z-Tel to make specific disclosures on
their web sites of their rates, terms and conditions for domestic interstate
services. These detariffing and disclosure requirements could increase our costs
in providing interstate long-distance services to our subscribers.
On April 27, 2001, the FCC limited the ability of nondominant,
competitive local exchange carriers, including Z-Tel, to file tariffs for
interstate switched access services. In doing so, the FCC effectively regulates
the rates Z-Tel charges long-distance companies for interstate switched access
services. Local exchange carriers (like Z-Tel) provide interstate switched
access services to interexchange long-distance companies (like AT&T, MCI, and
Sprint) when a state-to-state long distance call is made to or placed by a local
telephone customer. Given the large number of interstate long-distance
companies, these interstate switched access services are provided generally
through FCC interstate tariffs. Prior to this April 27, 2001 decision, the FCC
had refrained from any price regulation of the interstate access rates of
competitive local exchange companies like Z-Tel. With the April 27, 2001 Report
and Order in CC Docket No. 96-262, the FCC ruled that it would not accept for
filing any interstate switched access tariff filing by a competitive local
exchange carriers if the per-minute rate exceeded an FCC benchmark. The FCC
benchmark varies by metropolitan statistical area. In metropolitan statistical
areas ("MSAs") that a competitive local exchange carrier began to provide
service after June 20, 2001 (the effective date of the Order), the FCC benchmark
rate is the interstate switched access rate for the "competing" incumbent local
exchange carrier, which is established pursuant to publicly-filed tariffs before
the FCC. For MSAs in which a carrier was providing local service in as of June
20, 2001, the FCC benchmark rate from June 20, 2001 through June 19, 2002 is 2.5
cents per minute or the competing incumbent local exchange carrier rate,
whichever is higher. For those same MSAs, the FCC benchmark rate from June 20,
2002 through June 19, 2003 is 1.8 cents per minute or the competing incumbent
local exchange carrier rate, whichever is higher. For those same MSAs, the FCC
benchmark rate from June 20, 2003 through June 19, 2004 is 1.2 cents per minute
or the competing incumbent local exchange carrier rate, whichever is higher.
Beginning on June 20, 2004, the FCC benchmark rate for those MSAs will be the
switched access rate of the competing incumbent local exchange carrier. As of
June 20, 2001, Z-Tel was providing local service in most of the MSAs in its
current footprint; as a result, the FCC benchmark rates for Z-Tel's interstate
switched access charges in those MSAs will, through June 20, 2004, be
considerably higher than the FCC benchmark rate for Z-Tel's competitors that
begin to provide service in those MSAs after June 20, 2001.
AT&T and Sprint have appealed the FCC's April 2001 CLEC Access Charge
Order before the United States Circuit Court for the District of Columbia,
arguing that the FCC's benchmark rates are too high and that competitive local
exchange carriers like Z-Tel should be required to provide interstate switched
access services at the competing incumbent local exchange carrier rate
immediately. Z-Tel has intervened in that court proceeding against those
long-distance companies. Two competitive local exchange carriers have also
appealed the FCC decision, and several competitive carriers have sought
reconsideration or clarification of the FCC's decision. In addition, Z-Tel has
sought a waiver of FCC rules requiring it to tariff interstate switched access
services at the competing incumbent
15
local exchange carrier rate for several dozen smaller MSAs that Z-Tel did not
have any local subscribers in as of June 20, 2001, arguing to the FCC that the
cost to Z-Tel to provide interstate switched access services at two different
rate levels in the same state would impose unnecessary costs on Z-Tel that is
inconsistent with the public interest. These appeals, reconsiderations, and the
waiver request are all pending. The outcome of any of these determinations could
have a significant and material impact on Z-Tel's business. In particular, if
AT&T and Sprint are successful in requiring Z-Tel and other entrants to charge
the competing incumbent local exchange carrier rate for interstate switched
access services immediately, it would have a substantial and material adverse
effect on Z-Tel's business and competitive advantage.
In 2001, Z-Tel settled pending litigation with AT&T and Sprint over
their nonpayment of access charges to Z-Tel. Z-Tel provides interstate and
intrastate switched access services to both of those long-distance carriers
pursuant to switched access service agreements. Based on history of nonpayment
of both of these long-distance carriers to Z-Tel, there is a risk that either or
both of these long-distance companies could fail to pay Z-Tel for switched
access services. While Z-Tel has in the past and will in the future adamantly
litigate and defend its position against these carriers, nonpayment could have a
substantial and material adverse impact on our business.
Numbering and Number Portability. In August 1997, the FCC issued rules
transferring responsibility for administering and assigning local telephone
numbers from the Bell operating companies and other incumbent local exchange
carriers to a neutral entity in each geographic region in the United States. In
August 1996, the FCC issued new numbering regulations that prohibit states from
creating new area codes that could unfairly hinder competitive local exchange
carriers by requiring their customers to use 10 digit dialing while existing
incumbent local exchange carrier customers use seven digit dialing. In addition,
each carrier is required to contribute to the cost of numbering administration
through a formula based on net telecommunications revenues. Beginning in March
2000, contributions for this purpose were based on end-user telecommunications
revenues and have been submitted in association with FCC Lifeline, Universal
Service and the Schools and Libraries Funds.
In July 1996, the FCC released rules requiring all local exchange
carriers to have the capability to permit both residential and business
consumers to retain their telephone numbers when switching from one local
service provider to another, known as "number portability." Number portability
has been implemented in most of the areas in which we provide service, but has
not been implemented everywhere in the United States. Some carriers have
obtained waivers of the requirement to provide number portability, and others
have delayed implementation by obtaining extensions of time before compliance is
required. Lack of number portability in a given market could adversely affect
our ability to attract customers for our competitive local exchange service
offerings, particularly business customers, should we seek to provide services
to such customers.
In May 1999, the FCC also initiated a proceeding to address the problem
of the declining availability of area codes and phone numbers. On December 29,
2000, the FCC issued a Further Notice of Proposed Rulemaking in CC Dockets No.
96-98 and 99-200 that proposed adoption of a "market-based" approach for
optimizing number resources. In that Further Notice the FCC seeks input on its
tentative conclusion that, through the introduction of charges associated with
the allocation of number resources, carriers might be better incentivized to
take and retain only as many numbers as they need. If a "market-based" approach
to number allocation is introduced, as the FCC has proposed, it could result in
added administrative expenses for us and possibly make it more difficult for us
to obtain telephone numbers for our customers.
Restrictions on Bundling. On March 30, 2001, in CC Dockets Nos. 96-61
and 98-183, the FCC eliminated a rule that prohibited all carriers from bundling
customer premises equipment and telecommunications services. FCC rules also
require that nondominant carriers that own common carrier transmission
facilities and provide enhanced services may bundle basic telecommunications and
enhanced services in packages to customers, but such carriers must make the
underlying transmission capacity for the enhanced service available to other
enhanced service providers under nondiscriminatory terms and conditions under
which they provide such services to their own enhanced service operations.
Slamming. A customer's choice of local or long distance
telecommunications company is encoded in a customer record, which is used to
route the customer's calls so that the customer is served and billed by the
desired company. A user may change service providers at any time, but the FCC
and some states regulate this process and require that specific procedures be
followed. When these procedures are not followed, particularly if the change is
unauthorized or fraudulent, the process is known as "slamming." Slamming is such
a significant problem that it has been addressed in detail by Congress in the
Telecommunications Act, by some state legislatures, and by the FCC in recent
orders. The FCC has levied substantial fines for slamming. The risk of financial
damage, in the form of fines, penalties and legal fees and costs, and to
business reputation from slamming is significant. Even one slamming complaint
could cause extensive litigation expenses for us. The FCC recently decided to
apply its slamming rules (which originally
16
covered only long distance) to local service as well. Z-Tel is also subject to
state rules and regulations regarding slamming, cramming, and other consumer
protection regulation.
Network Information. Section 222 of the Communications Act of 1934 and
FCC rules protect the privacy of certain information about telecommunications
customers that a telecommunications carrier such as us acquires by providing
telecommunications services to such customers. Such protected information, known
as Customer Proprietary Network Information (CPNI), includes information related
to the quantity, technological configuration, type, destination and the amount
of use of a telecommunications service. The FCC's original rules prevented a
carrier from using CPNI acquired through one of its offerings of a
telecommunications service to market certain other services without approval of
the affected customer. The United States Court of Appeals for the Tenth Circuit
overturned a portion of the FCC's rules established in CC Docket No. 96-115
regarding the use and protection of CPNI.
In response to the Tenth Circuit decision, in October 2001, in CC
Docket No. 96-115, the FCC clarified that the Tenth Circuit reversal was limited
and that most of the FCC's CPNI rules remained in effect. The FCC sought further
comment on what method of customer consent offered by a carrier (either an
"opt-in" or "opt-out" approach) would serve the governmental interest in Section
222 and be consistent with the First Amendment. The final determination of this
issue and other FCC rules regarding handling of CPNI could result in significant
administrative expense to Z-Tel in modifying internal customer systems to meet
these requirements.
Intercarrier Compensation (Interstate Access Charges and Reciprocal
Compensation). Because Z-Tel, as a competitive local exchange carrier, passes
and receives local and toll calls to and from other local exchange carriers and
long-distance companies, the rates for "intercarrier compensation" for these
calls has a significant and substantial impact on the profitability of Z-Tel's
business. In addition, the rates that Z-Tel's competitors, especially the
incumbent local exchange carriers, are permitted to charge end-users, other
local exchange carriers, and long-distance companies for originating,
transmitting, and terminating telecommunications traffic can have a substantial
impact on Z-Tel's ability to offer services in competition with those carriers.
The current regulatory (and intercarrier compensation) status of
dial-up calls to Internet service providers is in dispute and litigation. The
FCC has determined that both continuous access and dial-up calls from a customer
to an Internet service provider are interstate, not local, calls, and,
therefore, are subject to the FCC's jurisdiction. The FCC has initiated a
proceeding to determine the effect that this regulatory classification will have
on the obligation of local exchange carriers to pay reciprocal compensation for
dial-up calls to Internet service providers that originate on one local exchange
carrier network and terminate on another local exchange carrier network.
Moreover, many states have or are considering this issue, and several states
have held that local exchange carriers do not need to pay reciprocal
compensation for calls terminating at Internet service providers. A majority of
state commissions have ruled that reciprocal compensation should be paid on such
traffic. On March 24, 2000, the Court of Appeals for the District of Columbia
remanded for reconsideration the FCC's determination that calls to Internet
service providers are interstate for jurisdictional purposes rather than local.
Specifically, the Court indicated that the FCC has not provided a satisfactory
explanation why calls to Internet service providers are not local
telecommunications traffic and why such traffic is exchange access rather than
telephone exchange service. We cannot predict the effect that the FCC's
resolution of these issues will have on our business.
Since passage of the Telecommunications Act of 1996, the FCC has
fundamentally restructured the "access charges" that incumbent local exchange
carriers charge to interexchange carriers and end-user customers to connect to
the incumbent local exchange carrier's network. The FCC revised access charges
for the largest incumbent local exchange carriers in May 1997, reducing
per-minute access charges and increasing flat-rated monthly charges paid by both
long-distance carriers and end-users. Further changes in access charges were
effected for the largest incumbent local exchange carriers when the FCC adopted
the Coalition for Affordable Local and Long-Distance Service (CALLS) proposal in
May 2000. CALLS, which reflected a negotiated settlement between AT&T and most
of the Bell operating companies, reduced per-minute charges by 60 percent. It
further increased flat-rated monthly charges to end-users, in particular,
multi-line business users. The CALLS plan also attempted to remove implicit
universal service subsidies paid for by long-distance companies in interstate
access rates and place those funds into the federal universal service support
system, where they would be recovered from all interstate carriers. Most of the
reductions in the CALLS plan resulted from shifting access costs away from
interexchange carriers onto end-user customers. Last year, the Fifth Circuit
reversed and remanded portions of the CALLS plan back to the FCC for further
consideration of the issue as to the size of the subsidy for universal service
should be removed from the interstate access charges and placed into the federal
interstate universal service support system. The outcome of this litigation
could impact the contributions Z-Tel, as an interstate carrier, must pay to
support the federal universal service support system.
In addition, as discussed above, the rates that Z-Tel and other
competitive local exchange carriers may charge for interstate switched access
services are regulated pursuant to the FCC's April 2001 CLEC Access Charge
Order.
17
In April 2001, the FCC released a Notice of Proposed Rulemaking in CC
Docket No. 01-92 in which it proposed a "fundamental re-examination of all
currently regulated forms of intercarrier compensation." The FCC proposed that
carriers transport and terminate local traffic on a bill-and-keep basis, rather
than per-minute reciprocal compensation charges. The FCC regards the CALLS Order
and the CLEC Access Charge Order as well as its reciprocal compensation rules to
be 3-year "transitional intercarrier compensation regimes". After completion of
that three-year transition, a new interstate intercarrier compensation regime
based upon bill-and-keep or another alternative may be in place. In addition,
AT&T and Pulver.com have both filed before the FCC petitions for declaratory
rulings that "IP telephony" services offered by them are, in different ways, not
subject to the FCC's access charge regime. Because Z-Tel both makes payments to
and receives payments from other carriers for exchange of local and
long-distance calls, at this time we cannot predict the effect that the FCC's
determination in CC Docket No. 01-92 or these IP telephony petitions may have
upon our business.
Potential Adverse Federal Legislation. In the past, federal lawmakers
have considered bills that would alter the pro-competitive regulatory structure
of the 1996 Telecommunications Act and similar state statutes. For example, on
February 27, 2002, the U.S. House of Representatives passed H.R. 1542, (the
"Tauzin-Dingell" bill). Had that bill been enacted into law, a substantial
portion of the Telecommunications Act, including several of the unbundling
requirements, would have been overturned. The possibility of similar or other
adverse federal legislation being introduced and passed is significant and could
have a material, harmful impact on our business. Similar efforts are pending
before state legislatures, which are discussed below. Such legislative actions
can have a significant and material adverse impact on our business. Other
changes to the market-opening and enforcement provisions of the Communications
Act could adversely affect our ability to provide competitive services and could
harm our business.
Other Issues. There are a number of other issues and proceedings that
could have an effect on our business in the future, including the fact that
- The FCC has adopted rules to require telecommunications
service providers to make their services accessible to
individuals with disabilities, if readily achievable.
- The FCC has also ordered telecommunications service providers
to provide law enforcement personnel with a sufficient number
of ports and technical assistance in connection with wiretaps.
We cannot predict the cost to us of complying with this order.
- The FCC has adopted new rules designed to make it easier for
customers to understand the bills of telecommunications
carriers. These Truth-in-Billing rules establish certain
requirements regarding the formatting of bills and the
information that must be included on bills. These rules have
been appealed in Federal court.
- The FTC is considering applying national "do not call" lists
to telephone companies that utilize telemarketing. Z-Tel has
utilized telemarketing strategies and such regulation could
increase the cost and decrease the effectiveness of
telemarketing.
- We are subject to annual regulatory fees assessed by the FCC,
and must file an annual employment report to comply with the
FCC's Equal Employment Opportunity policies.
- The FCC has adopted an order granting limited pricing
flexibility to large incumbent local exchange carriers, and is
considering granting additional pricing flexibility and price
deregulation options. These actions could increase competition
for some of our services.
The foregoing is not an exhaustive list of proceedings or issues that
could materially affect our business. We cannot predict the outcome of these or
any other proceedings before the courts, the FCC, legislative bodies, or state
or local governments.
STATE REGULATION
To the extent that we provide telecommunications services that
originate and terminate within the same state, we are subject to the
jurisdiction of that state's public service commission. As our local service
business and product lines expand, we will offer more intrastate services and
may become increasingly subject to state regulation. The Telecommunications Act
preserves the authority of individual state utility commissions to preside over
rate and other proceedings, and to impose their own regulation on local exchange
and intrastate interexchange services, so long as such regulation is not
inconsistent with the requirements of federal law. For instance,
18
states may require us to obtain a Certificate of Public Convenience and
Necessity before commencing service in the state. We have obtained such
authority in all states in which we operate, and, as a prelude to market entry
in additional states, we have obtained such authority to provide
facilities-based service in forty-nine states. Z-Tel has sought such authority
also in Alaska. No assurance can be made that the Alaska state regulatory
authority will approve these or additional certification requests in a timely
manner. In addition to requiring certification, state regulatory authorities may
impose tariff and filing requirements, consumer protection measures, and
obligations to contribute to universal service and other funds. State
commissions also have jurisdiction to approve negotiated rates, or establish
rates through arbitration, for interconnection, including rates for unbundled
network elements. Changes in those rates for unbundled network elements could
have a substantial and material impact on our business. Our ability to appeal
State commission determinations in federal court is subject to considerable
legal uncertainty (see "Interconnection Agreements" above).
We are subject to requirements in some states to obtain prior approval
for, or notify the state commission of, any transfers of control, sales of
assets, corporate reorganizations, issuance of stock or debt instruments and
related transactions. Although we believe such authorizations could be obtained
in due course, there can be no assurance that state commissions would grant us
authority to complete any of these transactions.
We are also subject to state laws and regulations regarding slamming,
cramming, and other consumer protection and disclosure regulations. These rules
could substantially increase the cost of doing business in any one particular
state. State commissions have issued or proposed several substantial fines
against competitive local exchange companies for slamming or cramming. The risk
of financial damage, in the form of fines, penalties and legal fees and costs,
and to business reputation from slamming is significant. Even one slamming
complaint before a state commission could cause extensive litigation expenses
for us. In addition, state law enforcement authorities may utilize their powers
under state consumer protection laws against us in the event legal requirements
in that state are not met. In addition, our wholesale business raises particular
risks that could make Z-Tel liable for slamming, cramming or other consumer
protection and disclosure violations undertaken by our wholesale customers and
sales agents. While we try and ensure that our contracts with our wholesale
customers and sales agents provide for indemnification to Z-Tel of such
liability, there is substantial risk that Z-Tel may be held liable regardless
and that the wholesale customer or agent may not have the financial ability to
indemnify Z-Tel fully.
Z-Tel's rates for intrastate switched access services, which Z-Tel
provides to long-distance companies to originate and terminate in-state toll
calls, are subject to the jurisdiction of the state commissions in which the
call originated and terminated. State commissions may, like Texas, directly
regulate or prescribe this intrastate switched access rate. Such regulation by
other states could materially and adversely affect Z-Tel's revenues and business
opportunities within that state.
The Telecommunications Act generally preempts state statutes and
regulations that restrict the provision of competitive services. As a result of
this preemption, we will be generally free to provide the full range of local,
long distance, and data services in any state. While this action greatly
increases our potential for growth, it also increases the amount of competition
to which we may be subject. States, however, may still restrict Z-Tel's ability
to provide competitive services in some rural areas. In addition, the cost of
enforcing federal preemption against certain state policies and programs may be
large and may cause considerable delay. In particular, we expect to expand our
Z-LineHOME service by starting to market this service in several new states
during 2003. To effect entry into these markets, we have obtained proper state
regulatory certification and entered into interconnection agreements in all
states where we operate, except for Michigan and Wisconsin, where we obtain
interconnection and access to unbundled network elements through a state tariff.
In each jurisdiction where we operate, we anticipate that the incumbent local
exchange carrier will provide the unbundled network element platform components
in a manner similar to that provided in states where we currently operate.
However, pricing and terms and conditions adopted by the incumbent local
exchange carrier in each of these states may preclude our ability to offer a
competitively viable and profitable product within these and other states on a
going-forward basis.
As discussed above, State commissions have an important role to play in
implementing the Telecommunications Act, and discussion of particular issues and
risks related to that state implementation are contained in the "Federal
Regulation" section above. As a result of the FCC's Triennial Review decision,
over the next several months, state commissions will likely engage in extensive
and detailed review of the availability of unbundled local switching in their
states. Limitations or restrictions on the availability of unbundled local
switching in any area or to any customer classification could significantly,
materially, and adversely harm our business. In addition, in order to enter new
markets, we may be required to negotiate interconnection agreements with
incumbent local exchange carriers on an individual state basis. To continue to
provide service, we also need to renegotiate interconnection agreements with
incumbent local exchange carriers. While current FCC rules and regulations
require the incumbent provider to provide the network elements on an individual
and combined basis necessary for us to provision end-user services, no assurance
can be made that the individual local exchange providers will provide these
components in a manner and at a price that will support competitive operations.
If the incumbent providers do not readily provide network functionality in the
manner required, we have
19
regulatory and legal alternatives, including arbitration before state public
service commissions, to force provision of services in a manner required to
support our service offerings. However, if we are forced to litigate in order to
obtain the combinations of network elements required to support our service, we
are likely to incur significant incremental costs and delays in entering such
markets. In addition, as discussed above, there is considerable legal
uncertainty as to how interconnection agreements are to be enforced before state
commissions and where appeals of state commission interconnection agreement
determinations may be heard.
In addition, state lawmakers may consider bills that would alter the
pro-competitive regulatory structure of the Telecommunications Act and similar
state statutes. Passage of legislation that limits or restricts interconnection
or unbundled access to incumbent networks, or that limits the authority or
powers of the state regulatory commission, could have a material, harmful impact
on our business in those states. For example, SB 1518, pending before the
Illinois General Assembly, and SB 377/HB 1658, pending before the Texas
legislature, could significantly curtail pro-competitive state initiatives taken
in those states by limiting unbundled access and state commission authority.
Passage of such adverse legislative actions can have a significant and material
adverse impact on our business. Other changes to the market-opening and
enforcement provisions of the Communications Act could adversely affect our
ability to provide competitive services and could harm our business.
LOCAL GOVERNMENT REGULATION
In some of the areas where we provide service, we may be subject to
municipal franchise requirements requiring us to pay license or franchise fees
either on a percentage of gross revenue, flat fee or other basis. We may be
required to obtain street opening and construction permits from municipal
authorities to install our facilities in some cities. The Telecommunications Act
prohibits municipalities from discriminating among telecommunications service
providers in imposing fees or franchise requirements. In some localities, the
FCC has preempted fees and other requirements determined to be discriminatory or
to effectively preclude entry by competitors, but such proceedings have been
lengthy and the outcome of any request for FCC preemption would be uncertain.
EMPLOYEES
As of March 25, 2003, we had approximately 1,158 employees. None of our
employees is covered under collective bargaining agreements.
ACCESS TO INFORMATION
The public may read and copy any materials we file with the Securities
and exchange commission at the SEC's Public Reference Room at 450 Fifth Street
N.W., Washington, D.C. 20549. The public may obtain information on the operation
of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC
maintains an Internet site that contains reports, proxy and information
statements, and other information regarding issuers that file electronically
with the SEC. The address of that site is http://www.sec.gov.
Reports we file electronically with the SEC including annual reports on
Forms 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and
amendments to those filings are available free of charge soon after each filing
at the following Web site: http://www.z-tel.com. Select "Investor Relations"
from the drop down menu under "Learn."
ITEM 2. PROPERTIES
We currently lease our principal executive offices in Tampa, Florida
and our principal engineering offices in Atlanta, Georgia. Our principal network
facilities reside in our Tampa offices. We own our principal consumer services
offices in Atmore, Alabama.
ITEM 3. LEGAL PROCEEDINGS
We are a party to various routine administrative proceedings. For more
information, please refer to the section entitled "Item 1. Business-Government
Regulation."
1. Case No. 01 CV 5074: In re Z-Tel Technologies, Inc. Initial Public
Offering Securities Litigation, Master File No. 21 MC 92 (SAS), in the
United States District Court for the Southern district of New York
(original complaint filed June 7, 2001; Second Corrected Amended
Complaint filed July 12, 2002)
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During June and July 2001, three separate class action lawsuits were
filed against the Company, certain of the Company's current and former directors
and officers (the "D&Os") and firms engaged in the underwriting (the
"Underwriters") of our initial public offering of stock (the "IPO"). Each of the
lawsuits is based on the allegations that the Company's registration statement
on Form S-1, filed with the Securities and Exchange Commission ("SEC") in
connection with the IPO, contained untrue statements of material fact and
omitted to state facts necessary to make the statements made not misleading by
failing to disclose that the underwriters had received additional, excessive and
undisclosed commissions from, and had entered into unlawful tie-in and other
arrangements with, certain customers to whom they allocated shares in the IPO.
Plaintiffs have asserted claims against the Company and the D&Os pursuant to
Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of
the Securities Exchange Act of 1934 and Rule 10b-5 promulgated by the SEC
thereunder. The plaintiffs seek an undisclosed amount of damages, as well as
pre-judgment and post-judgment interest, costs and expenses, including
attorneys' fees, experts' fees and other costs and disbursements.
2. Case No. 8:02 CV 1708 T 27 MS The Metropolitan Government of Nashville
and Davidson County, Tennessee, suing on behalf of Metropolitan
Nashville Employee Benefit Board v Z-Tel Technologies, Inc. in the
United States District Court for the Middle District of Florida filed
September 20, 2002.)
Metropolitan Nashville Employee Benefit Board, one of our common
shareholders, alleges that we wrongfully and improperly delayed providing them
with a stock certificate and that during the time of such delay our stock price
plummeted and they were unable to sell or take steps to protect the value of
their shares. Metro Nashville seeks compensatory damages in excess of $18
million, plus interest, and punitive damages of $18 million.
3. PUC Docket No. 26417 Before the Public Utility Commission of Texas.
Z-Tel Communications, Inc. Complaint for Post-Interconnection Agreement
Dispute Resolution, Request for Expedited Ruling, And Request for
Interim Ruling Against Southwestern Bell Telephone Company
On August 6, 2002, we filed a complaint against Southwestern Bell
Telephone Company ("SWBT") before the Public Utility Commission of Texas (PUCT),
requesting that the PUCT enjoin