in the "Zone
and unable to pay Vendors - yet pay Bondholders?
Credit professionals whose companies are providing
goods and services on credit to telecommunication customers, indeed,
companies whose value is comprised of intangible assets, are vigilant
for red flags indicating greater risk with sales to the telecom
industry. The telecom industry continues to shake out, with Chapter
11 a commonplace refuge to escape immediate payment of vendors'
claims as seen by such companies as PSINet, Rhythms NetConnections,
Teligent, 360networks, Viatel and Winstar Communications.
Telecom companies usually have at least three types of creditors: banks, bondholders
and vendors. Unlike vendors who have a continuing relationship with a telecom
customer by providing product or service, bondholders purchase the company's
debt and do not have continued relationship with the company unless the company's
defaults on the bond issue.
Recently, bondholders have been active demanding cash from telecom customers,
even though there has been no technical default under the bond indenture agreement.
Bondholders contend that certain telecoms are in the "zone of insolvency",
as their cash burn rates outstrip revenue, and that they must immediately liquidate
or restructure their debt and pay bondholders. This bondholder activism is
recently evidenced by Covad Communications concession to pay bondholders $283
million in advance of filing Chapter 11 even though Covad had not defaulted
on its bond issue. Another example, a bondholder has sued Mpower Corporation
and its officers and directors, contending the company is in the "zone of insolvency" and
bondholders must be paid.
Given bondholders novel strategy to press companies for immediate payment under
the theory the customer is in the "zone of insolvency," what are the additional
credit risks, both direct and indirect, for a credit executive in assessing
an existing customer's credit line, and new open account sales in the telecom
industry, including the use of cash burn rates.
Shakeout Of Telecoms
In 1996, the Federal Telecommunications Act was enacted by the U.S. Congress
to deregulate the telecommunications industry. However, the Telecom Act seems
to have spurred scores of bondholder defaults and bankruptcies. 360 Networks
defaulted on $1.5 billion in bonds and filed bankruptcy; PSINet defaulted on
$2.9 billion of bonds and filed Chapter 11; Winstar Communications defaulted
on $2.9 billion in bonds and filed Chapter 11.
Creditors are alarmed with the telecom shakeout and how poorly they fare in
a telecom bankruptcy. A telecom company is comprised of intangible assets whose
value is fleeting when it encounters financial difficulty. A telecom Chapter
11 results in pennies on the dollar for unsecured creditors. Bondholders in
particular have become active in hopes to avoid future meltdowns with their
"Zone Of Insolvency" Triggers Bondholders Activism
Bondholders are now pressuring telecoms to stop spending their cash and make
immediate payments to bondholders.
Some telecoms are agreeing to make these extraordinary payments to bondholders
to cut their debt and eliminate bondholder pressure. In one instance a telecom,
Mpower Corporation, rejected a bondholder's demand for immediate payment or
to restructure its debt and give equity to the bondholder. The bondholder sued
Mpower and its officers and directors contending that the Mpower was in the
zone of insolvency and owed a duty to bondholders to protect their investment.
The suing bondholder conceded that Mpower is not technically insolvent based
on an analysis of current assets less current liabilities. However, the bondholder
contends that the cash burn rate are such that Mpower requires almost $70 million
per quarter to fund operating expenses, it will be insolvent within months.
Given the directors of Mpower interests as beneficial owners of preferred and
common stock, the suing bondholder contends that the directors have inherent
conflicts of interest, which prohibit them from acting in the best interests
of creditors. Mpower has denied the bondholder's allegations that is insolvent
and has rejected the payment of the bond debt.
Fiduciary Duty Shifts To Creditors
Bondholders are pressuring telecoms for payment before any bankruptcy filing,
as after the bankruptcy filing bondholders are left with only pennies on the
dollar. However, prior to the company filing bankruptcy, the company normally
owes its duty to shareholders before any filings. Once a company is in the "zone
of insolvency," the company owes a fiduciary duty to creditors. The "zone of
insolvency" is a gray legal area for courts. It is generally measured from
an accounting view as liabilities exceeding assets. What does this mean to
vendors? This means that a customer's officers and directors owe a duty of
care and loyalty to creditors. Bondholders have used this emerging theory to
demand immediate payment, even if there has been no default under the bond
Effect of Bondholder Activism on Vendors
As a result of bondholder activism, vendors may only receive a small percentage
of their open account, as demonstrated by Covad Communications' plan of reorganization
that proposes a prorata payment to vendors. A vendor must not only carefully
consider a customer's cash burn rate, but also whether the company has, or
may be, obtaining bond debt. If the customer has bond debt, the vendor should
consider the risks that bondholder activism may strike and the vendor's credit
sale is at risk, notwithstanding a cash burn that indicates a near-term ability
to pay a vendor's credit sale.
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley
LLP Summer 01