Audit Report on the Compliance of Level 3 Communications, Inc. With Its City Franchise Agreement

On January 5, 1999, the City of New York through the Department of Information Technology and Telecommunications (DoITT) entered into a 15-year franchise agreement with Level 3 Communications, Inc. (Level 3) to provide local high-capacity telecommunications services in the City. Level 3 is a provider of a broad range of high-capacity integrated communications. Its services include Internet Protocol (IP), broadband transport, collocation services, and patented Softswitch-based managed modem and voice services. Level 3 provides telecommunications services to approximately 458 customers in the City.

Under the franchise agreement, Level 3 is required to report to the City all gross revenue from telecommunications services that originate in and/or terminate in the City. Based on the agreement, Level 3 is required to pay the City a franchise fee consisting of the greater of either $200,000 or five percent of its annual gross revenue. In addition, Level 3 is required to maintain a minimum combined amount of $50 million in insurance for bodily injury and property damage, and an unconditional letter of credit and surety bond deposit totaling $1 million.

Audit Findings and Conclusions

Level 3 did not maintain separate books and records in sufficient detail to allow us to determine whether all revenue was properly reported to the City, particularly with respect to revenue generated from services that either originate or terminate in the City. Therefore, we were unable to ascertain whether all revenue attributable to the franchise agreement was reported, and all franchise fees were paid to the City. Nevertheless, based on the available records, we determined that Level 3 underreported gross revenue in the amount of $7,430,114. Consequently, Level 3 owes the City at least $510,910 in franchise fees and late charges as detailed in Appendices I and II. Additionally, our review found that Level 3 did not consult with the City in determining a methodology to allocate its revenue and, as a result, it may not have reported to the City a significant amount of revenue from services with one endpoint outside the City.

Level 3, however, complied with the other non-revenue requirements of the franchise agreement, such as maintaining the required $50 million property and liability insurance that named the City as an additional insured party and the required $1 million in a security deposit.

Audit Recommendations

Based on our findings, we recommend that Level 3:

• Pay the City $510,910 in franchise fees and late charges due from understated revenue, and ensure that all revenue from customer accounts is properly included in its revenue reports submitted to the City.

• Submit to DoITT for its review and approval a methodology for allocating revenue for services that either originate or terminate in the City in accordance with the franchise agreement and pay to the City the amount it is owed using such methodology (plus late charges as appropriate).

• Maintain separate books of accounts and records of all City business activity in a manner that would allow the City to determine whether Level 3 is reporting all its revenue in compliance with the franchise agreement.

We recommend that DoITT:

• Ensure that Level 3 pays the City the $510,910 in franchise fees and late charges due from understated revenue assessed in this report.

• Ensure that Level 3 pays the City a “fair and equitable allocation” as determined for revenue generated from partial use of the System for the period covering 2007 and 2008, and that the allocation is performed based on a methodology in compliance with the proper City review and approval process as required in the agreement.

• Ensure that Level 3 submits separate accounting records and financial statements to determine whether all compensation is being paid to the City.

• Establish procedures and controls to review Level 3’s revenue reporting and franchise fee payment calculations.