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A $2.25 billion federal program that helps schools and libraries connect to the Internet is honeycombed with fraud and financial shenanigans, but the government officials in charge say they don’t have the resources to fix it.

A Center for Public Integrity investigation reveals the huge program, funded by everyone who pays a phone bill, is in financial disarray.

A new report to Congress on the fund by the FCC Inspector General’s office says the program, known as the E-Rate fund, is virtually out of control. (The full report is available at the FCC’s website.)

“It’s not unfair to say we have found something wrong everywhere we have looked,” says Tom Cline, an auditor in the FCC Inspector General’s Office. “It appears to be both intentional and unintentional.”

The Universal Service Fund was originally created to help rural areas get phone service at affordable prices. In 1996, the fund’s mission was expanded to help schools and libraries connect to the Internet. The fund comes from a fee added to the phone bills of millions of Americans and controlled by a telecom industry-dominated, non-profit corporation sanctioned by the FCC.

Program officials last month began denying or delaying applications involving IBM Corp., by far the largest recipient of the fund’s largesse. Program officials said they were taking the action because the schools, libraries and/or IBM had not followed proper competitive bidding procedures, rules that usually act as the first line of defense against fraud and financial mismanagement in such government programs.

“The whole program is based on a competitive bidding process,” says Mel Blackwell, a spokesman for the E-Rate program. “We found many of the applications involving IBM had problems in that area.”

An IBM spokesman says the action caught the company off guard.

“We learned about it when a reporter called us,” said IBM spokesman Andy Kendzie. “We are very aware of all guidelines, and, quite frankly, we were surprised. We are hoping to get this thing resolved very quickly.”

Consumer groups say the apparent level of fraud and other financial fakery suspected by auditors within the fund is inexcusable, particularly for a program intended to help some of the country’s poorest schools and libraries.

“Obviously, it hurts everyone when there are things like this going on,” says Chris Murray, a telecommunications specialist at Consumers Union, the publisher of Consumer Reports Magazine. “Telephone customers are getting bilked out of a lot of money and some very deserving schools and libraries are probably not getting the funds they need because some bad apples are not being dealt with.”

The Federal Communications Commission’s Schools and Libraries program, also known as the “E-Rate” program, is supported by virtually anyone who uses a telephone. Telecommunication companies routinely pass along the FCC-imposed fees to consumers as “universal service fees” or “universal connectivity charges” on customer bills. Customers pay around 10 percent of their monthly telephone bill to help support the program, although some companies charge higher rates.

In addition, the FCC last month agreed to double the fees that wireless communication companies have to pay into the fund. That means a cell phone user who has a $50-a-month bill will see his monthly universal service fee rise from 50 cents to about a dollar beginning in April.

The six-year-old fund provides subsidies as high as 90 percent to schools and libraries for their costs associated with connecting to the Internet. While controversial, the program has been credited with speeding up connection to the Internet for thousands of schools and libraries nationwide, particularly in rural and low-income communities.

Approximately 86 percent of the nation’s public schools, 21 percent of private schools (including Catholic diocesan schools), and 65 percent of libraries have received discounted services since the program began.

A list of the top service providers to the E-Rate program reads like a who’s who of America’s telecom and technology companies. At the top is IBM, which received payments of nearly $352 million in 2001. Also high on the list with payments of more than $100 million are telecom giants SBC, Verizon, Bellsouth and Qwest. (See a list of the top 25 E-Rate recipients)

The FCC report to Congress says other wrongdoing uncovered so far within the program ranges from simple paperwork and reporting errors to false billing and other fraud potentially involving hundreds of millions of dollars.

At a recent conference, an E-Rate official talked about one case under investigation. In that scheme, a piece of computer networking equipment with a purchase price of $20,000 was allegedly being leased to an E-Rate applicant for $20,000 per year. The applicant also had a maintenance agreement on the equipment of $96,000 per year.

Several other cases are currently under investigation by the FBI, the Justice Department and other federal agencies for possible civil or criminal prosecution, according to the report.

But the report stresses that FCC auditors have barely been able to scratch the surface of potential fraud and other financial abuse within the E-Rate program. Only two FCC auditors are assigned to oversee the program, which subsidizes an average of 30,000 Internet connection projects each year.

“Until such time as resources and funding are available to provide adequate oversight (for the schools and libraries program), we are unable to give the (FCC) chairman, Congress and the public any level of assurance that the program is protected from fraud, waste and abuse,” says the report.

First Criminal Case

Federal prosecutors filed the first criminal case involving the schools and libraries fund last month, charging the owner and three employees of a Staten Island, N.Y., Internet services company with conspiring to defraud the program of millions of dollars. For more information visit

Prosecutors say the defendants, who worked for Connect2 Internet Networks Inc, preyed upon some of the New York City area’s poorest schools, which qualified for the 90 percent subsidy under the E-Rate program. (More information on Connect2 is available at the company’s website)

The complaint says the company sometimes told the targeted schools that a foundation would pay their required 10 percent share, meaning the expensive new equipment and services used to connect to the Internet would cost the schools nothing.

Connect2 then convinced the schools to install much more expensive equipment and services than they would have if they had been forced to foot at least a small portion of the bill, as required by the E-Rate program, according to prosecutors.

In some cases, Connect2 asked school officials to write a check for their 10 percent share. Then the company either did not cash the check or wrote a check back to the school for the same amount, prosecutors allege.

The company also asked some school officials to lie in order to help cover up the scheme, according to the complaint. Connect2 sometimes prepared fake invoices and other phony billing documents to make it appear the company had properly billed the schools for their portion of the costs.

“In this way, the defendants were able to sell almost limitless quantities of E-Rate eligible goods and services to schools across the New York City area, with little or no control on the price they charged, and impose the entire cost on the government,” the complaint states.

E-Rate program officials say Connect2 has collected nearly $9 million from the E-Rate fund to wire about three dozen New York-area schools to the Internet since 1998.

Program Not Run By FCC

Although the FCC is ultimately responsible for the E-Rate program, the agency contracts with a non-profit group dominated by telecommunications companies to collect the fees, process applications and distribute the discounts.

That non-profit group, called the Universal Service Administration Company, also oversees the day-to-day operations of three other FCC programs funded by telephone customer charges. For more information on USAC go to organization’s website.

Those programs subsidize phone service for low-income communities, rural areas, and rural health care facilities. All told, the four programs run by USAC handed out more than $6 billion in 2002.

USAC is run by a board of directors, which, in turn, is run by an executive committee. Four of the seven members of the executive committee are telecommunication company executives. The FCC says most of the cursory oversight of the E-Rate program to date has been conducted by USAC.

In early 2001, USAC contracted with the Arthur Andersen accounting firm to conduct audits at 22 schools or libraries that received funding from the E-Rate program. A draft report on those audits indicated findings of fraud and mismanagement at nearly all the locations examined, including several million dollars in inappropriate disbursements and unsupported costs. A final report on those audits is due out any day, according to the FCC.

USAC was in the process of putting together a more comprehensive audit program for the E-Rate fund with Arthur Andersen when the accounting firm got caught up in the Enron scandal last year.

“We got sideswiped by the problems at Arthur Andersen, just like an awful lot of other people did,” says Frank Gumper, chairman of the USAC Board of Directors, who is also a longtime lobbyist for telecom giant Verizon Corp. “When Arthur Andersen went down, it put us back at square one.”

USAC doesn’t believe the fraud and financial mismanagement are as widespread in the E-Rate program as is suspected by the FCC Inspector General’s office, according to Gumper.

He concedes that USAC has found such problems at many of the 40 beneficiaries and service providers it has audited to date. But Gumper says that is largely because the audits were targeted toward beneficiaries where USAC had reason to suspect fraud and financial mismanagement. (See the redacted versions of these audits obtained by the Center for Public Integrity under the Freedom of Information act.)

“I think the vast majority of recipients are following the rules, although we have indeed found a couple of bad apples,” says Gumper. “But I would also have to say we are not really in a position to give anyone an airtight assurance there are no problems in these programs.”

USAC is currently negotiating a contract with a new accounting firm in hopes of conducting about 100 audits of beneficiaries of the E-Rate program next year. Gumper said that effort will likely begin sometime this spring.

He said the upcoming audit would be large enough to be considered statistically reliable, even though it will only look at roughly one out of every 300 E-Rate beneficiaries.

“It will be a big enough sample to give us some confidence in the results,” said Gumper. “It should allow us to figure out how the program is really operating.”

At the same time, Gumper bristles at any charges that USAC is not doing a good job overseeing the E-Rate program.

“It isn’t like we just approve any request that comes in,” says Gumper. “There is a fairly lengthy review process and we end up denying an awful lot of applications for a variety of reasons.”

There is currently no formal system for suspending or debarring crooked service providers from the E-Rate program.

FCC General Counsel Jane Mago says the agency is studying new rules that would bar service providers and beneficiaries found to have committed fraud or other financial mismanagement against the E-Rate program.

“Implementation of a debarment program is certainly something that is under consideration,” says Mago.

Mago also says the current lack of audit resources at the FCC will not be used as an excuse.

“The agency as a whole is committed to putting whatever resources are necessary into this to ensure that the integrity of the program is there,” she said. “We are not going to be turning our eyes away from a potential fraud situation and calling it a resource issue.”

Mago declined to identify any specific new programs or personnel shifts to tackle the problems, however, saying she did not want to do anything that might jeopardize ongoing investigations.

FCC Wants To Do Its Own Audits

The FCC says USAC’s audits have been helpful, but are not an acceptable substitute for a comprehensive audit program for the E-Rate fund conducted directly by the agency.

But such an effort would require an unprecedented expansion of the Inspector General’s office, according to the report to Congress.

The IG office estimates it would need to add 15 auditors to the two that are currently working on the E-Rate fund to provide proper oversight of that program alone.

And that doesn’t take into account any problems that might exist at the other three funds overseen by USAC, which subsidize phone service in low income communities, rural areas, and at rural health facilities. There is no FCC-backed auditing program at any of those programs.

The high cost program doled out $2.6 billion to telecommunications companies in 2001. The low income program paid out $584 million in 2001, while the rural health care program made payments of just under $8 million.

In addition, the report to Congress says even the limited auditing effort the IG’s office has been able to undertake on the E-Rate program to date has meant the office has had to postpone or cancel most other planned audit work.

The FCC Inspector General’s office had also planned to conduct its own audit of 29 E-Rate beneficiaries and service providers last year, using four auditors borrowed from the agency’s Wireline Carrier Bureau. All but four of those audits were cancelled, however, because the auditors were supporting ongoing investigations being conducted by the FBI, the Department of Justice and other law enforcement agencies.

“Meanwhile, the results of audits and the allegations under investigation lead us to believe the program is subject to (an) unacceptably high risk of malfeasance through noncompliance and program weaknesses,” says the report.

The E-Rate program has been controversial ever since it was implemented as part of the wide-ranging Telecommunications Act of 1996.

Initially, opponents of the program dubbed it the Gore Tax, a reference to the then-vice president’s efforts to push it through Congress.

The E-Rate program was first run by a private corporation, called the Schools and Libraries Corp. The first head of that corporation was Ira Fishman, a leading Gore fundraiser and a former White House lobbyist.

Fishman resigned after just nine months amid controversy over his $200,000 a year salary and $50,000 annual bonus. He went on to found HiFusion Inc., a Baltimore-based Internet services company that catered to schools. In 2000, HiFusion was acquired by Mindsurf Inc., a joint venture backed by Sylvan Learning Systems, Aether Systems Inc. and Critical Path Inc.

After a congressional hearing called by then-Senate Commerce Committee Chairman John McCain, the FCC agreed to put the Schools and Libraries program under USAC, which was already running the high-cost and low-income programs for the agency. The FCC also adopted rules limiting the top salary at the program to $151,000 a year.

In 1998, the General Accounting Office issued a report charging the E-Rate program didn’t have sufficient safeguards in place against waste and fraud. The report touched off another round of criticism of the program by McCain, who is expected to be Chairman of the Commerce Committee in the new Congress. McCain could not be reached for comment on the report.

In early 2002, the Bush Administration sought to dismantle the E-Rate program altogether. The White House eventually relented, however, and allowed the program to stand with a funding level of $2.25 billion per year.

Long distance telephone companies such as AT&T and MCI, who have traditionally been forced to collect the majority of the Universal Service Fund assessments from their customers, have also been frequent critics of the program. Specifically, long distance companies complained they were being forced to subsidize rural local telephone and wireless companies.

In answer to those criticisms, the FCC last month agreed to double the fees that wireless communication companies have to pay into the fund.

The agency has also moved to address a controversial practice by most long distance companies to charge higher Universal Service fees than required by the FCC. For example, AT&T has been charging customers a universal service fee of 11 percent, even though the company was only required to pay the FCC about 7.3 percent. The companies have been keeping the difference for themselves.

Program Has Always Been Controversial

New rules adopted by the FCC last month forbid companies from charging customers a universal service fee higher than the one established quarterly by the agency. That prohibition only covers charges that are listed as line items on customer bills, however, meaning telecom companies will still be able to roll higher universal service fees into other customer charges.

Others worry that the entire E-Rate program could be brought down by the alleged wrongdoing of a relatively small number of beneficiaries and service providers.

“The program has allowed schools and libraries to do things they would have never been able to do any other way,” says Winston E. Himsworth, president of E-Rate Central, a consulting firm used by the New York State education system to prepare and process E-Rate applications. “Like most people close to the program, I hope there are more prosecutions coming. The program doesn’t need beneficiaries or service providers like that.”

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