Is your customer in the "zone of insolvency" and unable to pay vendors--yet pay bondholders? (Legal Corner).(Brief Article)(Statistical Data Included)

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 Winsrar 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 a product or service, bondholders purchase the company's debt and do not have a continued relationship with the company unless the company defaults on the bond issue.

Recently, bondholders have been actively 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. In another example, a bondholder 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. 360networks 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.