Copyright 1996

Kelley Drye & Warren

Reproduced with permission for the InterAm Database

National Law Center for Inter-American Free Trade

KELLEY DRYE

MEMORANDUM

TO: Clients and Friends

FROM: Kelley Drye & Warren LLP

DATE: October 10, 1996

RE: Mexico's Telecommunications Framework

Enclosed is a memorandum describing recent regulatory developments in Mexico's telecommunications sector. The memorandum, prepared by our lawyers Aileen Pisciotta and Francisco Aparicio, discusses Mexico's telecommunications industry and permissible private investments, including foreign investment. It will shortly appear as a chapter in Doing Business in Mexico, published by Transnational Publications.

One of the memorandum's authors, Kelley Drye partner Aileen Pisciotta, and Andrea Bonime-Blanc, an editor of Doing Business in Mexico, will be co-chairing a panel discussion of issues associated with privatizations in Latin America at the Forbes conference in New York in early November. A flyer for that conference is enclosed.

If you have questions regarding Mexico, please call:

William A. Wilson III in Hong Kong at 011/85/2/869-0821

Patrick Del Duca in Los Angeles at (213) 689-1300

Eliot C. Abbott in Miami at (305) 372-2400

Yves Miedzianogora in New York at (212) 808-7800

Aileen A. Pisciotta in Washington at (202) 955-9600

Mexico's Telecommunications Framework

~ October 1996 ~

I. Introduction

Mexico, with a population of over 90 million, currently has a telephone penetration of just barely 10 lines per 100 inhabitants. The number is expected to almost double to 18 per 100 by the end of the millennium. Thus, Mexico is poised for competition and growth and is one of the most important emerging telecommunications markets, both in infrastructure and services. Investment opportunities in infrastructure projects needed for effective telecommunications coverage of Mexico's populous and dispersed industrialized regions is attracting the participation of large financial and operating institutions.

Investment is made much more attractive by the significant reforms that have been implemented in the Mexican telecommunications sector over the past six years. During that short period of time, the country has moved quickly to privatize Telefonos de Mexico ("TELMEX"), its state controlled telecom monopoly, and to develop a truly competitive sector in telecom equipment and services. Last year the government adopted the Federal Telecommunications Law (the "1995 Telecom Law"), establishing a comprehensive telecom regulatory framework including principles of competitive entry. This year, Mexico has issued important new regulations to govern a competitive market, has licensed several competitive telephone companies and has established an entirely new and independent regulatory agency, the Comision Federal de Telecomunicaciones (the "CFT") (the Federal Commission of Telecommunications). By next year, the final privatization initiative in the sector, the sale of the government owned satellite company, Telecomunicaciones de Mexico ("TELECOMM"), will be completed.

As a result of these changes and growth potential, there are burgeoning opportunities for foreign investment in telecommunications in Mexico. This article reviews the salient features of the new telecom regulatory framework in Mexico and how it may affect these opportunities.

II. Mexican Telecom Market Structure

A. Privatization of TELMEX

Governed by the 1938 Law of General Means of Communication (the "1933 law'~, the telecommunications sector in Mexico originally developed under private ownership with active government support. In 1950, the government induced the country's two non-interconnected telephone networks to merge, forming TELMEX. In 1976, the company was nationalized. Thereafter, the government held just over half of the total shares, with the remainder publicly traded in Mexican and foreign markets. However, the telephone system was unable to meet demand and the quality of service declined. Penetration of telephone service was very low, reaching only 6 lines per 100 inhabitants by the end of the 1980s. Motivated by the need to attract investment for much needed expansion, as well as by the desire to implement comprehensive economic reforms, President Miguel de la Madrid Hurtado (1982-88) initiated efforts to reverse the process.'

In 1990, under the administration of President Carlos Salinas de Gortari (1988-94), the government initiated a program to privatize TELMEX. The government sold 20% of the stock of the company for $1.757 billion (U.S. dollars) to an international consortium led by Grupo Carso (10%), a Mexican mining, manufacturing and tobacco enterprise, and including Southwestern Bell of the U.S. (5%) and France Telecom (5%), the French national telephone carrier. Although only 20% of the total equity in TELMEX was sold, the particular class of shares sold to the strategic investor consortium gave the industry group 51% of the voting control of the company, with the majority of voting shares remainirrg in the hands of Mexican interests. Subsequently, Southwestern Bell exercised an option to acquire an additional 5% of the equity of TELMEX, but of a different class of shares with more limited voting rights.

In a second phase of the privatization conducted in May 1991, the Mexican government sold 1.4% of its remaining equity to employees of TELMEX and another 14% through international ADR offerings in order to raise an additional $2.1 billion (U.S. dollars). The Mexican government divested all of its remaining interest in TELMEX in the final stages of privatization conducted from 1992-94 through international stock offerings in the U.S. and global markets. During that period, the value of TELMEX stock continued to climb. Altogether, the Mexican government earned over $6 billion (U.S. dollars) from the sale.

TELMEX's concession was modified at the time of privatization and became a primary regulatory instrument. According to the revised agreement, TELMEX was obligated to move aggressively to modernize and extend the network. Penetration has since grown rapidly.

B. Liberalization

Since its privatization, TELMEX has maintained a de facto monopoly in local exchange telephone services and has enjoyed a de jure monopoly in domestic and international long distance services. However, TELMEX's monopoly over basic telephone service officially ended August 10, 1996, when licensed competitors were permitted to begin operations. Further, as specified in rules issued in 1994, TELMEX must offer "equal accessn to competitive entrants by January 1, 1997.2 In fact, the government already has authorized several competitors operating under the names Alestra, Avantel, Cableados y Sistemas, Investcom, lusatel. MarcaTel, Unicom and Miditel.3

Competition has been introduced in other segments of the telecommunications sector as well. One of the first steps taken by Mexico to prepare for a fully competitive telecom sector was the authorization of new entrants in auxiliary and new service markets. Contemporaneously with the privatization of TELMEX, the Mexican government began to issue competitive concessions for cellular telephone service. The country was divided into nine regions, with a duopoly market structure guaranteeing two operators in every region. Other competitive entry has been authorized in such mobile services as paging, messaging and dispatch services over various frequencies.

Value added services also may be competitively provided. Now they may be offered subject only to registration with the government. A competitive market for value added services in Mexico is bolstered by provisions of the l/orth American Free Trade Agreement ~"A/AFTA'7, which established an open market for such services between Mexico, Canada and the United States. Article 1303 of //AFTA states that licensing of value added services must be non-discriminatory. Providers of such services may not be required to provide services to the public generally, cost-justify their rates, file tariffs unless the service is found to be a monopoly, interconnect with any particular customer or network, or adhere to any standard of technical regulation for interconnection except for those of the public telecommunications network.

The final major service market to be opened for competition is satellites. Satellite communications were incorporated into the Mexican Constitution in 1983 as a "strategic" activity reserved exclusively to the state for development and control. In 1989, the government created TELECOMM, a national enterprise, for operation of satellite and telegraph services. At that time, private investors were permitted to establish and operate certain earth station facilities, but space segment operations continued to be reserved to the state. By 1994, demand in domestic satellite capacity had grown to such an extent, and the requirement for investment to keep step with technological developments was so significant, that further reforms had to be considered. In 1995, Article 28 of the Mexican Constitution was amended to convert satellite communications from a "strategic" activity reserved as a government monopoly to a priority" activity in which the private sector may participate.4

The 1995 Telecom ~aw provides the framework for the granting of concessions to private companies to build and operate private satellites and providing satellite services in Mexico using foreign satellites. Under the 1995 Telecom law, a concession for satellite communications must be awarded through public bidding. The control and operations center for the satellites must be in Mexico and operated preferably by Mexican nationals.

The 1995 Telecom ~aw also provides that the government may grant concessions to emlt to and receive signals from foreign satellites that provide services in Mexico, so long as a bilateral agreement with the other nation allows for reciprocity to Mexican satellites. A framework treaty on reciprocity for satellite services was achieved between the U.S. and Mexico in April 1996.

III. Leqal Framework

A. 1993 Foreign Investment Law

The 1993 Foreign Investment /aw liberalized prior restrictions limiting all foreign investment in Mexican companies to 49%, to permit up to 100% foreign ownership of many telecommunications operations, including cellular telephony and value added services. However, certain other broadcast and telecommunications operations, including basic telephone service, videotext and packet switched data service remained limited to 49%. The 1995 Telecom /aw clarified that the maximum 49% limit (ownership of the capital stock) applies to operations that require a concession. Certain investments still require approval by the National Commission of Foreign Investment.

B. 1993 Law of Economic Competition

The 1993 ~aw of Economic Competition created the Federal Competition Commission. This authority is supposed to review major proposed mergers and acquisitions and assist in the development of competition in telecommunications and other sectors. Several cases already have been reviewed by the Federal Competition Commission, though it has not yet taken a strong stand against concentration.

C. 1995 Telecom Law

Until 1995, the 19381aw was still the basic legal instrument regulating the communications sector. It gave the federal government extraordinary powers to govern the sector.

The 1995 Telecom law, enacted on June 8, 1995, superseded the 1938 /aw with respect to telecommunications and related regulations promulgated in 1990. The 1995 Telecom law regulates the use and operation of communications frequencies, telecommunications networks, and satellite communications within Mexico. Similar to the new telecommunications law enacted earlier this year in the United States,s the 1995 Telecom law is a dramatic attempt to develop and promote competition within the Mexican telecommunications industry in order to create more diverse and better quality services at affordable rates.

The 1995 Telecom law regulates the entire Mexican telecommunications industry including all emission, transmission or reception of signals, text, images, voice, sounds or information of any nature effected through wire, radioelectricity, optical or physical mediums, or other electromagnetic systems. Similar to the United States Federal Communications Commission, the CFT is charged with both implementing the 1995 Telecom law and promulgating regulations based upon it.

To achieve its stated purpose, the 1995 Telecom law widens permissible private investment including foreign investment, within specific parameters. Similar to the prior communications law, the 1995 Telecom law expressly reserves regulation of telecommunications activities to the federal government. The 1995 Telecom law allows for the introduction of services derived from emerging technologies such as personal communications services (a service that, although more versatile than cellular, requires greater amounts of infrastructure investment), and includes a new licensing structure and authorizes a new auction process in order to provide greater legal certainty to investors. While the 1995 Telecom law's application and implementation will depend on forthcoming regulations to be issued by the government, it provides a framework for the development of Mexico's burgeoning telecommunications industry. The 1995 Telecom /aw touches on a broad range of telecom regulatory and policy issues. Some of the more salient features ~re ~llmm~ri7e~ helDw

IV. General Requlatorv Framework under the 1995 Telecom Law

A. Forms of Authorization: Concessions. Permits and Registration

The basic form of authorization is a concession, which is actually a contract entered into between the government and a private entity. The term "concession" is not defined in the 1995 Telecom /aw. However, under Mexican jurisprudence governing administration of "public services" such as telephony, a concession traditionally grants specific rights in exchange for particular obligations. Concessions are granted generally for provision of public telecom networks and commercial exploitation of radio spectrum.

Concessions may be granted only to Mexican nationals. Articles 24-27 of the 1995 Telecom law provide that concession applications (for public networks) should be acted upon in 120 days and may be granted for a term of up to 50 years. Article 26 specifies the general contents of concessions, including specific services and geographic areas covered. Articles 55-59 contain specific provisions applicable to concessionaires for satellite services.

Article 11 of the 1995 Telecom law provides that a concession must be granted by the government for operators to: (i) utilize frequency bands, except for non-restricted and official uses; (ii) install, operate or utilize public telecommunications networks; (iii) occupy geostationary orbital positions and satellite orbits assigned to Mexico, and operate related frequency bands; and (iv) utilize emission and reception rights of signals from foreign satellite systems that cover Mexico. Determination of whether a concession is required under the 1995 Telecom law for the use of frequency bands depends on the proposed use.

Although similar to concessions, permits are discretionary grants of authorization that allow private entities to offer a service that is not a "public service." This generally includes private networks. (Articles 31 32). Transmit earth stations also require permits, unless they are found not to cause interference, in which case they may be exempted (Article 34). The 1995 Telecom law does not specify a particular term of years for permits.

Certain services do not require prior authorization. Value added services may be provided subject only to registration with the government (Article 33). Installation of non-interfering receive-only earth stations does not require any permission of the government (Article 34). The government will maintain a Register of Telecommunications, described in Articles 64-65, which will contain information on all concessions, permits, assignments and registrations, and will be open to the general public.

Entities which provide telecommunications services without the appropriate authorization, may forfeit the goods, installations and equipment used in providing such services and may be subject to monetary fines. Specific violations and sanctions are itemized in Articles 71-74.

B. Types of Networks: Public and Private

Public networks are those over which operators offer commercial telecom services. The specific types of services that may be offered are unrestricted. Applicants for concessions for public networks must submit information reflecting the nature of the services to be rendered, technical specifications of the project, and programs and investment commitments. Article 53 specifies that, without express governmental approval, concession holders for public networks may not invest capital, directly or indirectly, in telecom resale businesses. Articles 41-44 outline the obligations imposed on concessionaires for public networks, including use of open network architecture designs and execution of agreements of non- discriminatory interconnection. Agreements to interconnect public telecommunications networks with foreign networks must be submitted to the government, and if such agreements are deemed to prejudice the interests of Mexico, or of the users, or of other holders of concessions for public telecommunications networks, the government may modify their terms.

A private telecommunications network is defined as a telecommunications network designed to satisfy the unique telecommunications service needs of specific people and which does not involve commercial exploitation of a service or network capacity. Article 31 of the 1995 Telecom /aw specifies that permits are required by the government to establish and operate a private network which does not use radio frequency spectrum.

C. Spectrum Classifications, Auctions and Concessions

Article 10 of the 1995 Telecom /aw specifies five types of spectrum use:

1. Spectrum for free use: those frequency bands which can be used by the public in general without the necessity of a concession, permit or registration;

2. Spectrum for specified uses: those frequency bands granted by means of concession and which can be used for services authorized by (the Secretary of Communications and Transportation) in the corresponding title of concession;

3. Spectrum for official use: those frequency bands designated for the exclusive use of the federal public administration, state governments, and cities, which shall be granted by means of direct assignment;

4. Spectrum for experimental uses: those frequency bands which can be granted by the (Secretary of Communications and Transportation) through a direct and non-transferable concession, to verify the technical and economic viability of technologies under development both in the country and in foreign countries, for scientific purposes or temporary tests of equipment; and

5. Reserved spectrum: those frequency bands not assigned or granted by the (Secretary of Communications and Transportation).

Similar to satellite communications, concessions for frequency bands for specific uses, such as cellular phones, air to ground services and trunking services, are to be granted through public bidding. General procedures for conducting these public bids are outlined in Articles 14-17.

In order to provide a public record of the frequencies granted, the government must publish in the Diario Oficial and in a newspaper located in the geographic zone of the frequency, including the specific frequency bands offered, its term and selection criteria for its award. The notice is to contain information relating to the requirements to be met by applicants, including, among others: (i) the investment amount; (ii) a business plan; (iii) technical specifications; and (iv) a favorable opinion of the government.

The original term of any radio frequency spectrum concession is not to exceed 20 years, and may be extended for similar terms at the discretion of the government. The government may modify or recover a frequency or a band of frequencies subject to a concession if in the public interest, for reasons of national security, for the introduction of new technologies, to solve problems of detrimental interference and to comply with international treaties signed by the government of Mexico. In these instances, the government may grant new frequency bands through which the original services may be rendered.

D. Tariffs Pursuant to Articles 60-63 of the 1995 Telecom /aw, concessionaires and permit holders may fix tariffs at levels that permit quality, competitiveness, security and permanence in the sale of services. Tariffs must be registered before becoming effective, and may not include cross subsidies with competitive services. The government may establish tariffs for public telecommunications networks that have substantial market share.

E. Termination, Revocation and Requisition

The termination, revocation and requisition of concessions and permits is expressly delineated in great detail in Articles 37-40 of the 1995 Telecom /aw. Concessions and permits may terminate for the following reasons: (i) completion of the term; (ii) relinquishment by concessionaire or permit holder; (iii) revocation; (iv) recapture; and (v) liquidation or bankruptcy of concessionaire or permit holder. Concessions or permits may be revoked in a number of instances including: (i) non use for a period of 180 calendar days from the date of the granting of such concession or permit; (ii) interruptions in operations without justifiable cause or authorization from the government; (iii) the assignment, encumbrance or transfer of a concession or permit without the consent of the government; or (iv) nonpayment of compensation due the Mexican federal government.

Pursuant to Article 40, at the end of the term of a concession or permit or of any extensions, frequency bands and geostationary and orbital positions and satellite orbits revert to the Mexican federal government. In addition, at the end of the term, the Mexican federal government may acquire the installations, equipment and other goods utilized directly in the utilization of the frequency bands, orbital positions or satellite orbits that are the subject of the concession.

Under Article 66, in the event of a natural disaster, war, public disorder or imminent danger to the national security, the internal peace of the country or the national economy, the Mexican federal government may conduct a requisition (through an administrative procedure to obtain property) of the general communications networks and the real or personal property assets necessary to operate such networks. The governmental requisition may continue so long as the conditions which precipitated the requisition exist. It is particularly significant that the 1995 Telecom law requires the Mexican federal government to indemnify interested parties to the extent of real damages and losses except in the case of war. If there is disagreement as to the amount of the indemnification, the damages are to be fixed by experts named by both parties, and with respect to losses, the net revenues of the previous year are to be taken into account.

V. Recent RequlatorY Initiatives The 1995 Telecom law also required the government to assure effective competition through promulgation, by January 1, 1997, of a series of new rules and regulations governing competitive operations. Many of these rules have been issued recently.

For example, in January 1996, the government issued rules specifying application procedures and requirements that must be met to obtain a concession for the operation of a competitive public telecommunications network.6 In April 1996, the government issued an administrative order establishing access charges for interconnection of long distance services with local public switched networks for the period 199699.7 In June 1996, the government released new rules establishing procedures by which customers may select the long distance carrier of their preference either on a per-call basis or by presubscription as well as procedures for billing and collection and for coordination among carriers for data base administration and effecting technical network modifications.8 At the sa'me time, the government released separate signalling plans9 and numbering plans'ø to facilitate implementation of competition in the market. Finally, the government also began to issue information on its plans to auction spectrum for certain mobile and other radiocommunication services.'l

The 1995 Telecom /aw introduced procedures to ensure greater transparency in the telecom regulatory process. Accordingly, many of the new telecom regulations have been adopted through public consultation procedures. Such procedures, which give affected companies the opportunity to comment on proposed regulations, though new in the Mexican regulatory experience, have been relatively well received by the industry.

Vl. The New Federal Telecommunications Commission

Since the privatization of TELMEX, SCT served as the telecom regulatory authority, through its Subsecretariat of Telecommunications and Technological Development. The 1995 Telecom law required that the federal government create an independent organization separate from SCT with technical and operational autonomy, to have the organization and ability necessary to regulate and promote the efficient development of telecommunications in the country. The CFT was created by Presidential decree effective on August 10, 1996, the precise date required by the 1995 Telecom /aw.l2 The CFT is now the industry's primary telecom regulatory authority, although SCT retains certain important responsibilities.

Among the CFT's functions are to: (1) expedite administrative requirements; (2) undertake studies and investigations in telecommunications matters; (3) promote the technical development of the sector; (4) opine with respect to solicitations for the granting, modification, extension and cession of concessions and permits in telecommunications matters, as well as their revocation; (5) submit for the approval of SCT, the program with respect to frequency bands for specified uses, as well as coordinating the corresponding bidding procedures; (6) coordinate the bidding procedures to occupy and exploit geostationary orbital positions, and satellite orbits assigned to the country, with its respective frequency bands and rights of emission and reception of signals; (7) establish the procedures for the adequate homologation of equipment; (8) administer the radioelectric spectrum and promote its efficient use; (9) maintain the registry of telecommunications; (10) promote the efficient interconnection of the equipment and of public telecommunications networks; (12) oversee the observance of what is set forth in concessions and permits; and (13) propose to SCT the imposition of sanctions for the violation of legal, regulatory or administrative provisions.

The CFT is to consist of four commissioners, including its President. Each member of the CFT will be appointed by the Federal Executive through the Secretary of Communications and Transportation. The commissioners will decide on matters with a majority of votes, with the President having the deciding vote. This arrangement vests significant power in the President, in that in matters where the Commission is split, the President in essence will have a second vote to break the deadlock. Thus, it appears that with respect to matters subject to a vote, the President would only need the support of one of the three commissioners in order to carry his or her agenda. In addition, the President is empowered with, among others, the following: (1) to plan, organize, coordinate, direct, control and evaluate the functioning of the CFT; (2) to formulate annually the CFT's programs and budgets; (3) to act as the legal representative of the CFT; (4) to execute the CFT's resolutions; and (5) to issue and publish an annual report regarding the performance of the functions of the CFT.

Given the CFT's scope of oversight of the telecommunications sector, a coherent regulatory framework is expected to take shape in the industry, guided by the overriding objectives of promoting competition and providing legal certainty to investors. The CFT's success will be measured only with increased investment and development of the sector over time.

VII. Final Comments

Mexico's new telecommunications legal framework ensures expanded opportunities for foreign investment in Mexican telecommunications enterprises. There continues to be a great deal of uncertainty because there is an entirely new regulatory authority. Also many new rules that have just recently been promulgated have not been fully interpreted and tested. Other important rules and decisions have yet to be made. Nevertheless, Mexico has moved forward to address extremely complex and difficult issues that are critical to foster market opportunities. The government also has met this challenge through the use of public consultation and other relatively open and transparent decision-making procedures. Holding aside the issue of Mexico's general economic stability, the emerging telecom regulatory framework should help give investors greater confidence in the Mexican telecom sector.

If you have questions regarding Mexico, please call:

William A. Wilson III in Hong Kong at 011/85/2/869-0821

Patrick Del Duca in Los Angeles at (213) 689-1300

Eliot C. Abbott in Miami at (305) 372-2400

Yves Miedzianogora in New York at (212) 808-7800

Aileen A. Pisciotta in Washington at (202) 955-9600