IP: Prudential Securities report on FBI and NTT purchase of Verio

[Dave Farber <farber@cis.upenn.edu>]

>Date: Fri, 14 Jul 2000 11:29:04 -0400
>To: politech@vorlon.mit.edu
>From: Declan McCullagh <declan@well.com>
>
>[Jim asks me to send this out in hopes of starting a dialogue on politech. 
>I'm happy to forward thoughtful responses. --Declan]
>
>*********
>
>From: "James Lucier" <James.Lucier@att.net>
>To: <declan@well.com>
>Date: Wed, 12 Jul 2000 13:55:14 -0400
>
>JAPANESE CONSTITUTION MAY POSE HIDDEN BARRIERS TO NTT'S VERIO ACQUISITION,
>MAKING THIS DEAL, FUTURE ONES MORE COMPLICATED THAN THEY LOOK (PART 1 of 2)
>R E S E A R C H   N O T E S                       July 11,2000
>
>Subject:    Telecommunications and Internet Regulation
>             NTT (NTT--72 1/2, not rated)
>             VERIO (VRIO--52 7/8, not rated)
>             JLUCIER
>
>Analysts:   James Lucier  (703) 358-2987
>
>=======================================================================
>o NTT's bid to acquire VRIO has been complicated by FBI concerns over
>wiretapping capabilities.
>
>o We think the FBI will eventually sign off on the deal, but perhaps not
>until the Exon-Florio review period expires in early August or even later.
>
>o In Japan, constitutional and political sensitivities have made the legal
>environment for wiretapping murkier than elsewhere.
>
>o But the FBI is not sure what it wants either, except more access than it
>has already, so talks drag on.
>
>o Globalization and digitalization of telecoms, challenging FBI, drive
>hardball tactics in case-by-case negotiations.
>
>
>Shares in Englewood, Colorado-based ISP Verio (VRIO--52 7/8, not rated) took
>a beating last week when officials of NTT (NTT--72 1/2, not rated) confirmed
>on July 7 that the U.S. FBI had raised national security concerns about the
>Japanese domestic telephone giant's bid to acquire the portion of Verio
>shares it does not already own.  We suspect that the FBI's concerns may
>derive in part from the politically and constitutionally problematic legal
>regime that applies to wiretapping in Japan.
>
>Both ongoing and trade issues and the FBI concerns over the national
>security and law enforcement aspects of this deal have been cited as reasons
>why U.S. government approval of the deal may be delayed.  In our opinion,
>the trade and national security issues are completely separate.  We believe
>the trade issues are likely to be solved by the upcoming July 21-23 meeting
>of the G-8 to be hosted by Japan in Okinawa.
>
>However, we also believe that discussions between the FBI and NTT could
>carry on for some time yet, perhaps a period of weeks pushing up to and even
>slightly beyond the timetable allotted to a formal review process that would
>normally end in mid-August.  We believe nvestors should not interpret this
>as a signal the NTT-Verio deal might ultimately fail to win approval.
>Indeed, we consider approval to be much more likely than not in the end.
>However for both legal and practical reasons, including the FBI's normal
>operating procedure in such matters, we tend to think the approval process
>could take longer than most investors would like.
>
>The globalization and digitalization of world telecommunications
>infrastructure are twin forces challenging the FBI's current surveillance
>capabilities.  Driven by fear of losing capabilities, the FBI has undertaken
>a multifaceted campaign to enhance and extend its capabilities instead.
>Proceeding somewhat opportunistically, the FBI has used its ability to block
>important transactions as a way of both learning what new capabilities exist
>and forcing telecommunications companies to provide them. The process is one
>of exploration.  On occasion it can be time consuming.  We believe that may
>be the situation.
>
>Background.  FBI officials were concerned about their ability to serve
>subpoenas and obtain wiretaps, according to published reports.  The FBI
>concerns have triggered an investigation by the Committee on Foreign
>Investment in the United States (CFIUS) that could last as long as 45 days
>from June 30, the date NTT received notice of the investigation.  CFIUS is
>an interagency group of federal officials chaired by the Secretary of the
>Treasury, which implements the Exon-Florio national security review process
>required for certain transactions.  (For a detailed discussion of
>Exon-Florio, which is beyond the scope of this note, we refer investors to a
>July 10 note by Prudential Securities Senior Telecom Policy Analyst Susan
>Lynner.*)  The basic concern among investors is that a protracted approval
>process could raise the costs to NTT acquiring Verio and lower the quality
>of acquisition.
>
>The NTT bid for Verio occurs in the context of a trade dispute over
>interconnection fees NTT charges competitive carriers to connect calls
>through its local network.  The U.S. wants these fees cut by 41 percent
>immediately.  Japan has offered to cut rates of the majority
>government-owned telecommunications carrier by 22.5 percent over four years.
>In negotiations set for this week, Japan will reportedly offer a three-year
>schedule.  In our opinion, the pieces seem to be coming together for
>resolution of this problem before U.S. President Bill Clinton meets Prime
>Minister Yoshiro Mori in Okinawa.
>
>Investors have asked to what extent the FBI's red flare signals unalloyed
>national security concerns, and to what extent it may also be a tactic in
>tandem with the trade negotiations.  If both national security and trade
>concerns are at issue, investors wish to know which may be predominant.  In
>fact, we believe the trade and national security negotiations are not linked
>and are proceeding on entirely separate tracks.
>
>Constitutional Barriers to Wiretapping In Japan.  We have not been following
>the ins and outs of the trade dispute, but we do have certain insights
>gained from our experience in the debate over encryption controls and
>implementation of the 1994 Communications Assistance for Law Enforcement Act
>(CALEA) that may cast light on the FBI's concerns.  We suspect but cannot
>confirm that the national security and law enforcement issues involved in
>the NTT-Verio deal are more complicated than generally realized.
>
>o Article 21 of the Japanese constitution was long held to forbid
>wiretapping.  Specifically, section two of the article reads:    "No
>censorship shall be maintained, nor shall the secrecy of any means of
>communication be violated...""  Though wiretapping was understood to occur
>on some scale, transcripts of intercepts could not be introduced as evidence
>in Japanese courts.
>
>o In July 1999, the upper house of the Japanese Diet adopted a wiretapping
>statute but only after overcoming unusual Japanese-style filibusters known
>as ox-walks and bitter dissents from the opposition parties.  The new
>statute goes into effect in August 2000.  The law specifically addresses
>only four categories of crimes involving weapons, drugs, illegal aliens and
>organized crime. It is widely believed the law could be applied more widely,
>but the precise mechanics are unclear. There is little guiding precedent to
>ease matters.
>
>o The law entitled, as we translate it, "Wiretapping for Investigations in
>Criminal Cases," does allow for the interception of both telephone and
>Internet communications.  However, during the Parliamentary debate, wireline
>and cellular telephony providers argued that the bill did not adequately
>consider the costs and technical difficulties of tracing and monitoring
>calls.  Internet service providers complained even more bitterly that the
>requirements placed on switched-circuit telephony providers were even more
>difficult to implement in the packet switched world, and the technical
>differences of their environment were not considered at all.
>
>o The law was adopted at the insistence of the Japanese Ministry of Justice,
>which had pressed for the proposal since 1996.  Critics claimed that the
>bill was forced through Parliament under the under pressure from the United
>States, and this claim is at least in part correct.   Encryption and
>wiretapping had been a flashpoint in U.S. Japanese technical discussions
>since 1995-96, when NTT, to the great consternation of U.S. policymakers,
>attempted to market a two-piece chipset that that implemented virtually
>uncrackable triple DES at a cost of pennies per unit.
>
>[Continued in Part 2 of 2]
>
>* "We Think A Deutsche Telekom Purchase of a Major U.S. Carrier Would Be
>More Than A Legal And Regulatory Exercise," Parts 1 and 2, Susan Lynner,
>First Call, July 10, 2000.
>
>
>Prudential Securities (or one of its affiliates or subsidiaries) or its
>officers, directors, analysts, employees, agents, independent contractors,
>or consultants may have positions in securities or commodities referred to
>herein and may, as principal or agent, buy and sell such securities and
>commodities.
>
>
>
>JAPANESE CONSTITUTION MAY POSE HIDDEN BARRIERS TO NTT'S VERIO ACQUISITION,
>MAKING THIS DEAL, FUTURE ONES MORE COMPLICATED THAN THEY LOOK (PART 2 of 2)
>R E S E A R C H   N O T E S                       July 11,2000
>
>Subject:    Telecommunications and Internet Regulation
>             NTT (NTT--72 1/2, not rated)
>             VERIO (VRIO--52 7/8, not rated)
>             JLUCIER
>
>Analysts:   James Lucier  (703) 358-2987
>
>=======================================================================
>[Continued from Part 1]
>
>Other Complicating Factors.  We see three immediate problems which are
>likely
>to be the substantative focus of the ongoing CFIUS review of the
>transaction:
>
>o       First, according to published reports, the FBI is insisting that 
>(1) it
>have physical access to Verio's network and (2) surveillance be undertaken
>by a U.S. citizen or citizens. These are reasonable enough conditions in
>our view, but the issue of back traffic through Japan complicates matters.
>In addition, the Japanese are just as likely to insist that key functions
>at facilities in Japan be performed by Japanese officials and that
>warrants for accessing these facilities be issues by Japanese judges.
>
>o       Second, the FBI may want explicit commitments that would be 
>difficult for
>NTT to give or the Japanese government to sanction, especially given the
>June 25 election results which reduced the coalition's lower house
>majority from 366 to 271 seats, which is only two seats over the threshold
>to maintain nominal control.  These commitments might be especially
>difficult for Japan to offer in the broad range of international security
>issues that are important to the United States but may run counter to the
>tenor of the peace clauses in the Japanese Constitution.
>
>o       Third, most importantly, we believe the FBI does not itself have a 
>clear
>understanding of what its requirements are.   Rather, the talks are likely
>to be characterized by iterative discussions in which the FBI seeks to
>glean every possible bit of information it can obtain about NTT and
>Verio's networking business, ranging from the types of equipment and
>technologies used to the names and professional backgrounds of actual
>personnel who may be on call to meet to answer FBI subpoenas for
>existence.  Based on what we know of other such negotiations, the FBI will
>continuously expand and refine its lists of requirements until the agency
>is satisfied it has nothing more to gain in the way of potentially useful
>surveillance capabilities.  In any situation, such talks would take time.
>However, in this case, we believe that patience is likely to be tried on
>both sides.  First and foremost, we believe the FBI's negotiating style
>and insistence on detailed, explicit agreements runs counter to Japanese
>negotiating styles.  Second, the comparative lack of case law and pre-
>defined standards for required telecommunication provider assistance to
>law enforcement in Japan may require more lawyering than usual if both
>sides are to perform what amounts to "due diligence" on the law
>enforcement side of the deal.  It is our opinion, based on both U.S. and
>Japanese legal sources,  that the legal issues can be worked out and could
>even already be worked out in principle.  But a good number of details are
>likely to remain.
>
>In addition to foreground concerns, we see an assortment of background
>issues
>that may additionally cast a shadow over the CFIUS proceedings:
>
>o       CALEA has been a factor before in reviews of foreign acquisitions 
>of U.S.
>telecommunication companies before, most notably in Vodafone's acquisition
>of Airtouch.  To describe matters from the perspective of U.S.
>telecommunications providers and equipment makers, the FBI's standard
>practice is to take the most expansive possible reading of CALEA  (which
>statute theoretically guarantees law enforcers the same level of access to
>communications in digital networks that they enjoyed in earlier, less
>sophisticated analog networks.)   Not infrequently this reading may be far
>beyond what industry and civil libertarians consider to have been the
>Congressional intent.   Grousing industry contacts complain that the FBI
>gets maximum leverage for its demands by routinely holding important
>transactions and standards-setting processes hostage and negotiating
>behind closed doors with hardball tactics designed to get, through
>whatever means necessary, wiretapping capabilities Congress will not
>expressly grant them in law.  Without endorsing these attitudes ourselves,
>we do note that the FBI has incurred considerable ill will and resentment
>in the telecommunications and technology communities, along with a slowly
>festering image problem on Capitol Hill.  (To show only one instance of
>this problem, House Majority Leader Dick Armey, with the full support of
>his colleagues, now systematically kills or questions every critical
>infrastructure protection proposal to emerge from the U.S. Department of
>Justice, even when these would appear justified in the light of growing
>foreign information warfare capabilities.  In our opinion, a change of
>control in Congress would result only in Democrats who are even more
>skeptical of the FBI than is Armey coming to power.)  One difference
>between NTT-Verio and other foreign acquisitions of U.S.
>telecommunications and information services providers, though, is that
>countries such as Germany, France, and the U.K. appear already to have or
>to be adopting requirements for assistant to law enforcement that are more
>explicit and detailed than those in Japan.
>
>o       On another front, the European Union has begun the using the antitrust
>lever in part to break up as what the Europeans perceive as American
>hegemony on the Internet's infrastructure.  Aggravating such concerns is
>the growing furor over a U.S., British, and Australian jointly-managed
>signals intelligence collection system reportedly code-named Echelon.
>Reports presented to the European Parliament suggest that Echelon is
>capable of intercepting all telephone calls, faxes, and emails transmitted
>in Europe.  Elaborate keyword dictionaries then filter the communications.
>In our opinion, these reports are somewhat exaggerated (and promoted in
>part by governments trying to do much the same thing themselves).
>However, last week, at roughly the same time the CFIUS proceedings began
>in the United States, the French government appointed a special prosecutor
>to examine whether the civil rights of French citizens were infringed by
>Echelon, and the European Parliament began a formal inquiry that is
>anticipated to result in public hearings in the fall.
>
>o       The Europeans allege that the United States uses Echelon for 
>commercial
>espionage, which is denied by the U.S. intelligence community and seems
>unlikely to us. But a series of high profile incidents in which U.S.
>eavesdropping appears to have played a role in trade negotiations
>beginning with the heavy-handed U.S. surveillance of the 1993 APEC meeting
>in Seattle and continuing through treaty negotiations with both European
>partners and Japan have perhaps justifiably irritated America's trans-
>Atlantic and trans-Pacific allies.  These worries by Japan and Europe will
>not lie far beneath the surface in any talks over who controls sensitive
>Internet information flows in the future.
>
>Conclusion. In sum, the NTT-Verio deal occurs in the context of many
>interesting but little known developments.  Japan has moved toward the
>United
>States in adopting a less restrictive policy on judicial wiretapping, but
>Japan may also be reluctant to acknowledge explicitly how far the policy
>goes.  In France and the rest of Continental Europe, age-old paranoia about
>Anglo-Saxon hegemony has taken a new, high tech turn.  In the future, we
>believe, negotiations over who controls the checkpoints, tollgates, and
>traffic monitoring stations of the information highway will become more
>complicated, not less.  Investors will have to get used to it, we suggest.
>
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