Zone of Insolvency
 

Is your Customer in the "Zone of Insolvency"
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 telecom customers.

"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 issue.

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