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Unraveling the Web of Relationships When a Telecom Goes Bankrupt
David M. Grimes and Herbert K. Ryder
The Bankruptcy Strategist
April 9, 2002
One of the defining characteristics of the
telecommunications industry is its interdependency. A telecommunications owner
or operator, or "telecom," requires an extensive network to serve its
client base in today's market. This can be done either by developing an
internal network or gaining access to network infrastructures owned by
competitors.
The Telecommunications Act of 1996 facilitates the latter
approach, imposing a general duty on telecommunications carriers to
interconnect directly into the networks of other carriers. In addition, the act
requires local exchange carriers to provide to any other carrier who requests
it access to their existing networks at reasonable rates. This legislation
permits a company entering the telecommunications market to expend less capital
on its own infrastructure and gain access to the existing networks
contractually. A typical telecom therefore may sign hundreds of service
contracts with its competitors. If one member of the industry files for
bankruptcy protection and ultimately exits the market, other members may lose
the services they need to function and the industry as a whole will suffer.
(According to the Dow Jones Corporate Filings Alert, 51 major telecoms
and technology companies have filed for bankruptcy over the past two years, and
10 of those filed within the past three months.)
The interconnection of the industry gives rise to some
unique bankruptcy problems. This article considers issues raised by the
intersection of bankruptcy law and the exercise of the Federal Communications
Commission's regulatory functions, including emergency discontinuation of
service, the NextWave opinions, irrevocable rights of use (IRUs) and
reciprocal compensation agreements as they impact valuations.
NORTHPOINT AND RHYTHMS LINK -- EMERGENCY DISCONTINUATION OF
SERVICE
The case of NorthPoint Communications Group Inc. illustrates
how one telecom's financial fortunes negatively may affect a whole industry.
NorthPoint, a wholesale digital subscriber line (DSL) provider that provided
service in several Western states, filed for bankruptcy on Jan. 16, 2001. On March
29, 2001, after it failed to close a funding agreement with its creditors to
temporarily maintain operations, NorthPoint shut down its entire network,
leaving several retail Internet service providers (ISPs) and over 100,000
customers nationwide without service. Provider XO Communications and the
California ISP Association filed a motion before the California Public
Utilities Commission to compel NorthPoint to restore service, stating that
NorthPoint did not provide 30 days' prior notice of the shutdown, as mandated
by state law. The commission agreed, and on March 30 ordered NorthPoint to
restore service to its 40,000 customers in California.
Unfortunately, the commission's order was not enough to
restore service. Prior to the shutdown, NorthPoint laid off over 75 percent of
its staff and declared it had neither the manpower nor the funds to restore the
network. In addition, restarting the network would require cooperation from
several telecoms that had claims against NorthPoint and would not likely be
paid for any further service they provided. Industry observers believe that the
order served primarily as a warning to other telecoms not to summarily abandon
their customers. On May 22, 2001, the FCC advanced this theory when it issued a
public notice reminding carriers who must make an emergency discontinuation of
service to obtain FCC authority, and directing the industry to develop consumer
notification procedures. FCC Public Notice: Requirement for Carriers to Obtain
Authority Before Discontinuing Service in Emergencies and NorthPoint
Communications, Inc. Authority to Discontinue Service, NSD File No. W-P-D-488
(May 22, 2001).
Although it noted that NorthPoint had received FCC approval
for its network shutdown, the FCC criticized NorthPoint for not adequately
notifying its customers. The FCC urged all carriers to assist NorthPoint in its
efforts to switch its customers to other service providers, even by continuing
service agreements with NorthPoint if necessary. See also FCC Common
Carrier Bureau Order in Rhythms Links Inc. Emergency Application to Discontinue
Domestic Telecommunications Services, NSD File No. W-P-D-523 (Sept. 7,
2001) (denying Rhythms Link's application to discontinue service).
NEXTWAVE -- INTERSECTION OF BANKRUPTCY CODE AND FCC
JURISDICTION
The NorthPoint case also illustrates the
interrelationship between telecoms and government regulatory authorities. 28
U.S.C. § 959(b) requires a trustee or debtor in possession to "manage and
operate the property in his possession ... according to the requirements of the
valid laws of the State in which the property is operated." A trustee or
debtor in possession is obligated to conform with applicable federal and local
law, as well. See Norris Square Civic Ass'n v. St. Mary Hosp. (In re St.
Mary Hosp.), 86 B.R. 393, 398 (Bankr. E.D. Pa. 1988).
Telecoms are subject to various regulations unique to the
industry, in particular those enforced by the FCC. The roles of regulatory
bodies in the telecommunications industry can frustrate the efforts of a
telecom as it undergoes the bankruptcy process, in part because the applicable
laws and regulations are rarely drafted with bankruptcy in mind and may
therefore clash with the goals of the U.S. Bankruptcy Code.
NextWave Personal Communications' case against the FCC, which is scheduled for U.S. Supreme Court review this fall, illustrates how this confusion may hurt both the industry and the government. In 1996, pursuant to its system of allocating
radio spectrum licenses by competitive bidding, the FCC held an auction of a
set of licenses known as the "C-block licenses" for use in providing
personal communications services. NextWave won 63
licenses on bids that totaled $4.74 billion, payable with interest over a
period of 10 years. Because of disagreements between NextWave and the FCC, the
licenses were not delivered until Feb. 19, 1997. By that time, however, the
market value of the licenses had fallen to a quarter of the amount NextWave had
bid. This revelation dried up the financing that NextWave expected to secure to
purchase the licenses.
Along with other companies that successfully bid on the
C-block licenses, NextWave petitioned the FCC for relief. The FCC issued a
restructuring order, granting options ranging from forgiveness of the
obligations in return for giving up the licenses to allowing companies to
purchase as many licenses as they could at the full bid price. Instead of
opting for one of the choices offered under the FCC order, NextWave filed a
Chapter 11 bankruptcy petition and initiated an adversary proceeding against
the FCC, arguing that the C-block license auction was a fraudulent conveyance,
avoidable under Bankruptcy Code § 544. The bankruptcy court and U.S. District Court for the
Southern District of New York held that the conveyance was fraudulent and
reduced NextWave's obligation to the market value of the licenses, allowing
NextWave to keep the licenses at the reduced rate. NextWave Personal
Communications Inc. v. FCC (In re NextWave Personal Communications Inc.),
235 B.R. 277, 304 (Bankr. S.D.N.Y. 1999), aff'd 241 B.R. 311 (S.D.N.Y.
1999).
On appeal, the 2nd U.S. Circuit Court of Appeals noted that
the auction system was a statutorily mandated method of license allocation that
depended on market forces to determine the most qualified recipient. The court
held that no fraudulent conveyance had occurred because the FCC was not selling
the license to use the radio spectrum for profit, but was implementing a
regulatory policy in performing a function over which it had exclusive control
under federal law. FCC v. NextWave Personal Communications Inc. (In
re NextWave Personal Communications, Inc.), 200 F.3d 43, 52 (2d Cir. 1999).
In ruling for NextWave, the lower courts effectively
"exercised the FCC's radio-licensing function, something it did not have
the jurisdiction to enforce." Id. at 55. After the 2nd Circuit's
decision, some bankruptcy practitioners theorized that the decision exempted
actions of certain regulatory bodies with the power of exclusive jurisdiction
over debtors from the restraints of the Bankruptcy Code. See Hi-Tech and
Telecom in Financial Distress Roundtable, 8 A.B.I. L. Rev. 205, 248 (2000).
After the 2nd Circuit ruling, NextWave revised its plan of
reorganization to provide for full payment of the bid price. The FCC objected
to the plan, arguing that the licenses automatically had terminated when
NextWave missed its first payment deadline. At the same time, the FCC announced
a re-auction of the NextWave licenses. The bankruptcy court held that the FCC's
cancellation was null and void under the automatic stay and other bankruptcy
provisions. In re NextWave Personal Communications Inc., 244 B.R. 253,
257-58, 267-68 (Bankr. S.D.N.Y. 2000). The 2nd Circuit again reversed, holding
that exclusive jurisdiction to review the FCC's regulatory action lay in the
Courts of Appeals and that the bankruptcy court had again exceeded its
jurisdiction by voiding the FCC's cancellation of the licenses. In re FCC,
217 F.3d 125, 137 (2d Cir. 2000).
After the 2nd Circuit’s ruling, NextWave petitioned the FCC
to reconsider cancellation of the licenses. When the FCC refused, NextWave
appealed the FCC decision to the D.C. Circuit.
The D.C. Circuit first held that res judicata did not
prevent NextWave from appealing the FCC decision. The court rejected the FCC's
argument that the 2nd Circuit had decided that the Bankruptcy Code did not
apply to regulatory actions. Instead, the court interpreted the 2nd Circuit's
decision to merely say that the bankruptcy court lacked the jurisdiction to
rule on the regulatory action. The court held that the FCC's ruling violated
§ 525, which prohibits a government body from revoking a license solely
because the debtor has not paid a dischargeable debt, and reversed the lower
court ruling. NextWave Personal Communications Inc. v. FCC, 254 F.3d
130, 155 (D.C. Cir. 2001).
The FCC's interpretation of the law led to a potentially costly gamble. Before the
D.C. Circuit ruled against it, the FCC held its auction of the NextWave
licenses and received winning bids from several companies that added up to
approximately $17 billion. The D.C. Circuit's ruling voided the second auction
and left both the industry and the government reeling. The federal government
stands to lose a significant portion of the auction revenues, money that had
been calculated into the Bush administration's budget. The loss of this money
will significantly affect how much of the budget surplus is lost. The FCC asked the Supreme Court to review the case, and the Court granted the petition for certiorari on March 4, 2002. NextWave Personal Communications, Inc. v. FCC, 254 F.3d 130 (D.C. Cir. 2001), cert.
granted, 152 L. Ed. 2d 141 (2002).
The companies who bid on the licenses are pressing the
government to settle with NextWave and are trying to negotiate deals with
NextWave to obtain the licenses. NextWave, however, has stated publicly that it
will develop its network around the licenses once it emerges from bankruptcy.
IRREVOCABLE RIGHTS OF USE
Other assets, such as irrevocable rights of use, or
"IRUs," have attributes of both ownership interests and contractual
interests that complicate valuing a telecom. An IRU is an agreement that grants
a telecommunications company a percentage of a fiber cable owned by another
company for its own network use, usually for a term equaling the expected
lifetime of the cable. The holder of an IRU thereby receives the benefit of the
use of the cable without the risk of incurring maintenance costs.
Upon a bankruptcy petition filing, an IRU becomes part of a
debtor telecom's estate as an interest in property under § 541. But whether a
given IRU will be classified as an ownership interest or a leasehold interest
will depend on the terms of the agreement. Each IRU is an individually
negotiated agreement and poses its own set of issues. A debtor may find an
advantage in either classification, depending on the circumstances. The primary
benefit to a debtor in classifying the IRU as a leasehold is that such a
classification subjects the IRU to § 365, governing executory contracts and
unexpired leases. The debtor may then reject the IRU agreement, leaving the owner
of the cable entitled only to a prepetition claim for damages for breach of the
agreement.
Alternatively, by claiming the IRU as an ownership interest,
a debtor telecom may retain the IRU and perhaps take advantage of the
"seller’s" failure to perfect its security interest in the asset,
rendering the seller's claim for payments that remain due under the agreement
an unsecured claim. Case law has not yet developed on how to classify IRUs,
increasing the difficulty of valuing such assets.
RECIPROCAL COMPENSATION
Successful reorganization also depends on the prospects of
future revenue. A good portion of a telecom's revenue flows from its
competitors through reciprocal compensation and access charges.
"Reciprocal compensation" refers to carrier-to-carrier payments for
telecommunications traffic between local exchange carriers (LECs) at the point
of origin, not at the point of termination. A carrier will therefore generate
revenue by fees charged to consumers or other carriers that initiate traffic or
its network, and incur costs by passing the transmission to another carrier's
network, thereby generating a service charge payable to the next carrier.
"Access charges" refer to charges paid by long-distance or
"interchange" carriers, also known as "IXCs," to both
originating and terminating LECs, which are primarily governed by tariff rates
set by federal regulations.
The FCC's actions in this area will alter the existing
relationship between carriers in ways that may hurt small-scale LECs. A
reciprocal compensation payment structure gives terminating carriers a market
advantage when telecommunications traffic flows in only one direction. For
instance, a terminating carrier that serves an ISP will charge other carriers
for incoming calls to the ISP but not incur any costs to other carriers because
the ISP does not initiate communications traffic. A terminating carrier may
therefore offer its services to the ISP at a discount and pass its costs on to
its competitors.
On May 15, 2001, the FCC issued a final rule adopting a declining
cap on how much a carrier may recover from other carriers for ISP traffic.
Implementation of the Local Competition Provisions in the Telecommunications
Act of 1996; Intercarrier Compensation for ISP-Bound Traffic, 66 Fed. Reg.
26800 (2001) (codified at 47 C.F.R. part 51). In the rule, the FCC
indicated support of a "bill and keep" payment structure as a cost
recovery mechanism for ISP traffic, in which each carrier recovers costs from
its own end users. On the issue of access charges, many competitive legal
exchange carriers (CLECs) that emerged after passage of the Telecommunications
Act of 1996 enjoyed higher tariff rates than the regional bell companies, also
known as incumbent local exchange carriers or "ILECs," could charge IXCs.
On April 27, 2001, the FCC released an order that decreases the CLEC tariff rates
over a period of four years, until they are on par with the ILEC rates. Access
Charge Reform; Reform of Access Charges Imposed by Competitive Local Exchange
Carriers, CC Docket No. 96-262, Seventh Report and Order and Further Notice of
Proposed Rulemaking (April 27, 2001). These actions will significantly reduce
the revenues of such companies that took advantage of the regulations and will
decrease the possibility that such a company will be able to emerge from
bankruptcy.
The current environment, which combines an excess supply of
voice and data transmission lines with lower-than-projected growth in demand,
has led to economic Darwinism in the telecommunications industry. The number of
telecoms that have filed for bankruptcy protection over the past few years has
caused confusion within the industry, as shown in the NorthPoint case,
and in the government bodies that regulate the industry, as shown in the NextWave
case. Inconsistent valuations of a telecom's assets and sources of revenue
diminish the likelihood that a troubled telecom may survive. But the current
climate does offer opportunities for growth within the industry. Telecoms that
recognize the issues will not only weather the storm of bankruptcies, but also
may be able to find valuable assets and business opportunities among the ashes
of demised competitors. As some telecoms disappear, their clientele will find
others to service their telecommunication needs.
David M. Grimes is a partner and Herbert K. Ryder is an
associate in the New York office of LeBoeuf, Lamb, Greene & MacRae,
www.llgm.com. Mr. Grimes may be reached via e-mail at dgrimes@llgm.com;
Mr. Ryder's e-mail address is hryder@llgm.com.
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