ILEC Use of Morris Trust: Equity Shareholders Beware
May 31st, 2007 by Gordon Cook
My list has been discussiiong the potential longevity of the wireline copper plant.
Tom Evslin wrote:
The way this plant is removed from the balance sheet is by creating a reverse Morris trust and using it to convey these underperforming assets to a small company before they lose more value and absorb more cash either for upgrade or maintenance. This neatly avoids a writedown of these assets as well. And allows capital be concentrated on fiber.
This is not theory; this is the proposed sale of the Verizon assets in Northern New England to Fairpoint.
Can Fairpoint continue to milk these assets or wring any profit from them at all? Not for long IMHO.
At least in rural areas, substantial upgrades are needed to deliver what will be minimal broadband in a year or two or to deliver broadband over DSL to a greater share of the market. Fairpoint still pays through the nose to operate and maintain this network because it is accepting Verizon’s union contract and pension obligations as part of the deal.
At the urban end of the market, Burlington Telecom has made great strides supplanting both Comcast and Verizon as service providers with their fiber to the home and triple play. Other Vermont towns are lining up to work with Burlington Telecom to the same end. Note that it is the cream of the market that Verizon/Fairpoint loses here in terms of LD revenue, access charges, feature charges, and DSL (ironically in an area close to the COs where they can deliver relatively good broadband over DSL today)
Comcast IS being aggressive with continued cable rollout in Vermont and anxious to show that there is a private solution to some of the State’s telecommunications need. They take DSL potential and current access line income from Verizon/Fairpoint.
In the very rural market where the copper would need the most work and where Comcast is not going, radio is an increasingly good alternative. WISPs may resell telephony. At the least, they make their customers aware of the saving possible with VoIP because it helps pay for a broadband connection on the family P&L. More lost income to Verizon/Fairpoint.
Verizon - understandably - seems to be segmenting its territory into places where the economics are right for upgrading to fiber and the places it wants to be out of. Those are the places where it leave what I believe will quickly be a non-self sustaining copper network behind. The pension obligation and the cost of lay offs and much of the cost of maintenance are fixed while the revenue from that copper will go relentlessly down.
David Isenberg: Whats a Reverse Morris trust?
Tom Evslin: Below is from the press release. Note that Verizon sheds debt, jobs, and obligations - reaps cash. The new subsidiary has $1.7b of new debt which will have to be serviced from the shrinking copper landline revenue and will interfere with their ability to raise further capital to upgrade that plant either as copper or fiber. Note also that wireless not part of the deal.
“Verizon’s local exchange and related business assets in Maine, New Hampshire and Vermont will be transferred to entities owned by a newly organized, wholly owned subsidiary of Verizon. This new subsidiary will incur $1.7 billion of newly issued debt and will then be spun off to Verizon’s stockholders and immediately merged with and into FairPoint.
“When the merger is completed, the companies conducting the Maine, New Hampshire and Vermont telephone and related business operations will be subsidiaries of FairPoint. The combined business will be managed by FairPoint’s executive team.
“Upon the closing of the transaction, Verizon stockholders will own approximately 60 percent of the new company, and FairPoint stockholders will own approximately 40 percent. In connection with the merger, Verizon stockholders will receive one share of FairPoint stock for approximately every 55 shares of Verizon stock held as of the record date. Both the spin-off and merger are expected to qualify as tax-free transactions, except to the extent that cash is paid to Verizon stockholders in lieu of fractional shares.
“Verizon Communications will not own any shares in FairPoint after the merger.
“The total value to be received by Verizon and its stockholders in exchange
for these operations will be approximately $2.715 billion. Verizon
stockholders will receive approximately $1.015 billion of FairPoint common
stock in the merger, based upon FairPoint’s recent stock price and the terms
of the merger agreement. Verizon will receive $1.7 billion in value through
a combination of cash distributions to Verizon and debt securities issued to
Verizon prior to the spin-off. Verizon may exchange these newly issued debt
securities for certain debt that was previously issued by Verizon, which
would have the effect of reducing Verizon’s then-outstanding debt on its
balance sheet.
Cook’s Edge: WOW! I am not an accountant nor an equity analyst. But Rod Hall, James Enck - are you reading this? To my unqualified brain this has overtones of credit and debt swaps from the sub prime market. Or maybe even Enron? No surely I am wrong. But I still must ask what does this do to the average persons ability to understand Verizon’s debt structure? Muddies it - I’d say!
“The transaction includes Verizon’s switched and special access lines in the three states, as well as its Internet service, enterprise voice CPE (customer premises equipment) accounts, and long-distance voice and private line customer accounts (for customer private lines with beginning and ending points within the three states) that Verizon served in the region before the 2006 merger with MCI, Inc. The transaction does not include the services, offerings or assets of Verizon Wireless, Verizon Business (former MCI), Federal Network Systems LLC, Verizon Network Integration Corp., Verizon Global Networks Inc., Verizon Federal Inc. or any other Verizon businesses in these states.”
From http://www.ffhsj.com/cmemos/0076257.htm
Cook’s Edge: More recent info on Morris trust is found in Reviving the Reverse Morris Trust for Mergers
Reverse Morris Trust transactions gain popularity on the IRS’s declaration that Revenue Ruling 70-225 is obsolete and the relaxation of the ‘D’ reorganization requirement.
Tom may be right that Fairpoint is over-paying the for assets it is getting from Verizon (I haven’t looked at enough detail to know for sure), but I think he may be over-optimistic on the ability of wireless to supplant the legacy copper infrastructure. Unfortunately for the consumers in Vermont, New Hampshire and Maine, Fairpoint may be able to milk these lines for longer than expected (especially, if there is no cable alternative or a small local player without the resources to upgrade to a competitive infrastructure).
However, the comparison to the sub-prime market/ Enron is unfair. If anything, the Morris Trust maneuver is the opposite of what they did (and, I’m sure, plenty of others are still doing).
The objective of the Enron limited partnerships, and the sub-prime securitizations used by New Century et al., are to create the form of an asset sale while avoiding the substance. The Morris Trust transaction creates the substance of a sale while maintaining the form, for tax purposes of a spin-off.
To explain: Sub-prime lenders would sell the loans to third parties, while retaining responsibility for collecting and maintaining an obligation to cover bad debt. They then reported gains on the sale based on “expected” defaults over the life of the loans. (When defaults go up, massive losses come due that the company is not prepared for.) Enron pretended to sell assets to third parties that were actually partnerships controlled by Enron’s CFO. Again, this was done to create the appearance of a profit even though the company was often still on the hook for any losses incurred or, in a few case, to buy back the assets at a guaranteed price.
The common element is that both strategies create income (which, I believe is generally taxable) even though the company retains an economic risk in the assets.
The Morris Trust enables the company to sell the assets in substance, while creating the form of a spin-off, and therefore avoiding triggering taxable gains for either the company or its shareholders. For Verizon, the assets sold to Fairpoint are gone. It has no economic interest in them going forward, and debt holders have no recourse to Verizon should Fairpoint default. Economically, it is a real disposition of the assets, no different than if Fairpoint had borrowed $1.7B itself. paid the cash and some shares to Verizon for the assets, and then Verizon used the cash to reduce its own debt.
This appears complicated because the tax rules require complication to meet the form required to avoid triggering capital gains. The substance is fairly straightforward.
There are basically two reasons for objecting to this use of the Morris Trust. However, I don’t think obscuring debt is one of them. The debt figures you quoted above from me were from the press release announcing the deal and there is even more detail in the various legal documents filed with the SEC. If anything, this is less arcane than some telco debt.
The use of the reverse Morris Trust to avoid paying taxes is apparently quite legal but, in my view, not a loophole that the tax law needs to support. Like most loopholes, it benefits very few with no discernable social value.
However, in this case I don’t think there would’ve been a taxable gain. I suspect that what the use of the reverse Morris Trust did for Verizon is avoid the necessity of taking a write-down. If the assets in the Northern New England States were sold for cash, it’s doubtful whether they would have bought the nominal price Verizon achieved with the sale. I’ve heard plenty of stories (although from sources who don’t want to be identified) of Verizon not being interested in a more straight forward sale.
By leaving the FairPoint stock in the hands of Verizon holders rather than keeping it in Verizon, Verizon is insulated from future write-offs of the value of these assets. Their only remaining exposure, should the deal be approved, is whatever FairPoint debt they end up holding.
I am an ex-employee of Fairpoint’s Maine Operations. I have been involved with the Maine Public Advocate’s Office in several matters involving what we refer to as (Un)Fairpoint. I suggest anyone with an interest in the Verizon to Fairpoint sale check out the online posting of Randy Barber’s testimony to the Vermont regulators.
[…] Stephen Otter Holmes commented on http://gordoncook.net/wp/?p=181 […]