Technology

Hanging Up on Early-Exit Fees


Regulators and courts are taking aim at early-cancellation penalties charged by carriers such as AT&T, Verizon, and DirecTV

There may be 50 ways to leave your wireless carrier. Just don't do it before your contract is up—or you'll be forced to pay a fat early-termination fee. That's the lot facing most U.S. consumers of communications services, from mobile calling to cable TV to high-speed Internet access.

Consider the subscriber who wants to end a DirecTV (DTV) service contract and has to pay $20 a month for the remainder of the term. Breaking a wireless services contract can cost as much as $175. It's a big reason why few people switch communications providers. At satellite TV company DirecTV, only 1.42% of customers close their accounts each month. Even Sprint Nextel (S), with one of the highest customer defection rates in the wireless industry, loses a mere 2.45% of its customer base in a month.

A prorated approach?

But in a move that could make it easier for customers to drop phone or satellite providers, early termination penalties are coming under new fire from federal regulators, legislators, and courts. The Federal Communications Commission (FCC) has scheduled a hearing for June 12 to consider potential restrictions on the penalties. And even if the FCC doesn't act to rein them in, Congress is mulling legislation that would.

Cable and phone companies, which spend hundreds of dollars on advertising and promotions to sign up each new subscriber, fear they'll have a harder time recouping that investment if the penalties are diminished too far. And exit penalties exist worldwide: European telco Vodafone (VOD) requires subscribers to pay their monthly fees for the duration of wireless contracts, even if they don't use the phone.

FCC Chairman Kevin Martin has suggested that the commission may require service providers to prorate penalties through the life of a contract, so that the longer a customer stays, the lower the fee. The agency may also require that buyers be allowed to drop a service such as a new cell phone contract without penalty within 30 days of purchase. "Certainly carriers may be able to recover legitimate out-of-pocket expenses and costs," says FCC spokesman Robert Kenny. "On the other hand, we want to make sure this isn't being used as an artificial means of locking consumers into a particular service provider." A ruling to alter the allowed penalty structure could come as early as this fall, says Carol Mattey, a former FCC official who is now a managing director for consultancy Deloitte & Touche.

"Enormous Pressure"

Congress, meanwhile, is considering several bills backed by powerful supporters, including Edward Markey (D-Mass.), chairman of the House Subcommittee on Telecommunications & the Internet, and Senator Jay Rockefeller (D-Va.). The measures, proposing conditions for wireless contracts similar to those being considered by the FCC, are already going through revisions in Congressional committees and could be passed in early 2009.

But while the FCC and Congress may impose restrictions, it's the legal system that threatens to scratch early termination fees altogether. Courthouses from California to New York are flooded with class actions claiming that early termination fees, especially those on wireless contracts, are unfair to consumers. In a landmark ruling on May 27, the Supreme Court refused T-Mobile USA's request to dismiss one class action based on the cellular company's contract stipulations that all customer disputes be settled through arbitration. The decision means that all similar suits can proceed—some state courts are expected to decide cases within days—and may open the floodgates to new class actions. "I just see an explosion of lawsuits," says Mattey. "Every week, every carrier is getting sued. It's going to create enormous pressure."

To preempt state court rulings, T-Mobile and Sprint Nextel have already announced they will start reducing early termination fees as the time remaining on a contract declines. Exact details haven't been disclosed, though the changes are expected to take effect this year. Just two days before the Supreme Court decision, AT&T (T) announced it would reduce its $175 early termination fee by $5 per month through the life of a new contract. That matched a policy implemented last year by Verizon Wireless, which has also introduced a 30-day risk-free service trial and now allows customers to switch calling plans without starting a new contract.

Sprint's Vulnerability

The industry would rather make the changes on its own. "Early termination fees are changing based on consumer demand," says Joe Farren, spokesperson for CTIA, The Wireless Industry Association, noting that consumers can always opt for pre-paid wireless services that don't require contractual commitments.

But carriers' moves may prove too little too late. Lawsuits alone could result in billions of dollars in costs and settlements, and may prompt providers to axe early termination fees altogether. "Pandora's box is going to open up,” says Jessica Zufolo, senior policy director for telecommunications, media, and technology at Medley Global Advisors.

For an industry that has long used contracts to keep subscribers on board, elimination of termination fees could spell massive changes, such as higher churn and slimmer margins. A satellite TV company typically spends around $700 to recruit a consumer. For wireless companies, the cost of acquiring customers, including marketing and handset subsidies, is closer to $400, and it typically takes more than a year to recoup. Higher rates of switching could be especially nettlesome for Sprint Nextel, which regularly finishes near the bottom of customer satisfaction rankings. "The biggest loser, unfortunately, in this space is Sprint," says Serge Matta, senior vice-president at ComScore (SCOR).

A Dash of Kindness

An industrywide, free 30-day trial period would provide cold comfort to wireless providers. The provision would make it easier for a certain percentage of subscribers to start hopping from one provider to another to get free service. Back when long-distance companies abolished contracts, a material percentage of consumers began switching without paying their last bill, says Rich Nespola, CEO of consultancy TMNG (TMNG).

To keep subscribers, more wireless carriers might follow Verizon Wireless's lead and begin allowing subscribers to switch to lower-priced plans without having to extend contracts. A recent survey of more than 2,000 users by ComScore showed that 19% of Americans switched to their current carrier for a better price. Carriers may also offer users more free content and other incentives to encourage them to stay. "They'd do sweet things instead of barbs," says Richard Doherty, director at consultancy Envisioneering Group. But these treats are likely to eat into revenue and margins.

One potential beneficiary of lower termination costs: equipment manufacturers. Today, an average American replaces a cell phone every 17.7 months, vs. every 16.6 months in 2006, according to consultancy J.D. Power. That lengthening replacement cycle spells trouble for handset makers Nokia (NOK), LG, and Motorola (MOT). If early termination fees go away completely, handset sales could jump 25% in the first six months, Doherty estimates.

A downside: To preserve their margins, service providers may not subsidize the equipment as much as they do today. Sure, subsidies are becoming less common, and less of a draw for consumers willing to splash out upwards of $500 for a razzle-dazzle smart phone. But, unable to charge termination penalties, service providers may simply pass the cost to consumers as other fees.


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