As we approach Halloween, it’s time to share a scary story.

The “Reverse Morris Trust” is something a majority of Americans have never heard of before, but if you are a Verizon customer and happen to live in one of 13 states where Verizon is just itching to abandon you, it’s time to learn more about this twister in the tax laws.  A debt-laden phone company may haunt your future.  Another is already haunting millions of New Englanders.

When Verizon throws telephone customers overboard to companies like FairPoint (and Frontier Communications if that deal is approved by state regulators), the company has found a great way to cash out, saddle the buyer in massive amounts of debt, and walk away without paying one cent in taxes.  How?

The Reverse Morris Trust.

To be fair, Verizon is not the first company to use this tax loophole to structure mergers, acquisitions, and spinoffs.  Before 1997, the use of the original Morris Trust provision was commonplace.  A company would split itself into two pieces, one of which would be swapped for stock in an unrelated company.  Then those shares would be redistributed, effectively transferring ownership.  The tax savings were enormous.  A $3 billion dollar sale would normally net the taxman nearly $1 billion in capital gains taxes.  But when using the magic of the Morris Trust, the taxman got $0.00.

In 1997, Congress realized how much tax money they were losing from this loophole.  They enacted Internal Revenue Code Sec. 355(e), which made these transactions taxable.  Or did they?

With billions in savings now potentially gone, businesses started looking for a way around Sec. 355(e) and found one in the Reverse Morris Trust.

Follow this:

A Reverse Morris Trust - "D"=Verizon, "C"=Spinco, "A"=FairPoint or Frontier

Companies involved in a Reverse Morris Trust deal don’t buy and sell from each other directly.  Instead, the seller sets up a new corporation, usually referred to in company financial reports as “Spinco” and conducts the transaction through that entity.

Spinco issues stock (and why not), which is owned by a majority of the shareholders of the parent company cooking up the sale.

When Verizon cast off its New England customers into the fetid waters of FairPoint, it structured the sale as a Reverse Morris Trust.  Verizon “spun off” Bell Atlantic Communications, NYNEX Long Distance, and Verizon New England assets serving Maine, New Hampshire and Vermont into Northern New England Spinco, a new corporation it created just for the deal.  It needed to find a buyer smaller than itself to take advantage of the tax-free magic of the Reverse Morris Trust.  It found FairPoint Communications, a tiny independent phone company based in North Carolina, dwarfed by the three New England states’ Verizon customers.  Imagine living alone in a one bedroom apartment and then letting The Brady Bunch move in with you.

Spinco, by design, has an addiction to piling on debt.  It’s like giving a shopaholic a wallet full of credit cards all issued by Verizon.  Spinco lards itself with as much debt as it possibly can.  When it’s finally teetering under the weight of  as much as $1.7 billion in debt, Verizon effectively sends a bill saying “we want our money — pay us back our $1.7 billion in full.”  Of course, Verizon doesn’t expect to receive the check.  Instead, it demands Spinco pay a “dividend” in the form of an IOU for the entire amount.

Spinco now has a problem.  Its balance sheet looks terrible.  Would you buy a company that has a $1.7 billion liability on its balance sheet?  FairPoint would, but of course, they knew this was part of the plan all along.

FairPoint now seeks to merge with this Spinco company that has more debt than some third world countries.  State regulators announce they have to examine this deal to make sure a company like FairPoint, now proposing to take on Spinco’s debt, will be able to run the company, make investments in its upkeep and expansion, and still pay back the Bank of Verizon, or whoever else ends up owning the IOU.

Regulators (foolishly) go ahead and approve the deal, and the newly merged Spinco and FairPoint issue stock to Verizon shareholders, the original owners of Spinco.  Verizon also gets cash and securities.  Technically, Verizon shareholders now own 60% of FairPoint.  Of course, nobody says every shareholder gets an equal vote.  In the end, FairPoint runs and manages the entire operation, or tries to, saddled with what is now $2.5 billion in debt and on the brink of bankruptcy.

How much did taxpayers lose from all of this?  Considering the spending machine in Washington is going to get the money from somewhere (us), they are going to be looking at you and I for the estimated $700 million Verizon never had to pay in capital gains taxes.

Make your check payable to “U.S. Government” and make sure it’s in the mail by Halloween.

Yes, this scary story is true, and has a sequel: Frontier and Verizon plan to structure their magic deal using the same technique.

Boo!  (Now add another zero on the dollar amount of your check.)

If this new deal is approved, Verizon walks away with $3.3 billion in tax-free cash.  Verizon shareholders (lucky them) get to be owners of just under 70% of Frontier Communications, soon to be saddled with its own Spinco debt which will run well into the billions.  Knowing this, they dump their stock in Frontier in droves as soon as the deal completes.  Why hang around for another financial Titanic to sink like a rock around their portfolio?

Verizon customers get to join the Frontier Family, and those of us who are already members get to see whether Frontier can survive the minimum monthly payment on that debt.

Or maybe not.

A large contingent of the New England Congressional delegation has written a letter to Rep. Charlie Rangel (D-NY), who chairs the Ways and Means Committee responsible for overseeing tax policy in Congress, asking that a stake be driven through the heart of the loopholes in the Reverse Morris Trust.

Reps. Michael Michaud, Chellie Pingree, Peter Welch, Paul Hodes, and Carol Shea-Porter all signed the letter asking Rangel to reform the Reverse Morris Trust (they abbreviate it “RMT”) and take it away from companies like Verizon looking for a tax-free windfall:

We projected that the transaction [FairPoint-Verizon] would have disastrous consequences in our states.  Unfortunately, our concerns were well founded with widespread consumer dissatisfaction evident across the region.

Recently, we have learned that other states across the country face similar threats to service and employment as Verizon, once again, seeks to avoid taxes through the use of the RMT in its proposed transaction with Frontier Communications.

[…]

Now is the time to restrict the utility and benefits of the RMT to protect the public interest.

West Virginians, in particular, have expressed increasing concern about their state following a similar path northern New England took. Frontier would assume control over all of Verizon’s operations across the state of West Virginia.

“I hope this vital request, now based on past history, isn’t ignored again,” said Elaine Harris, International Representative with the Communications Workers of America.  “West Virginia is being given the opportunity to avoid some of the pitfalls of the FairPoint disaster and it would be a real shame if we simply follow the same path and our communications operations end up in bankruptcy.”

Expect the usual Washington lobbyists to fight to preserve the loophole.  Remember, in the world of Halloween telecommunications finance, tax free trick or treat candy is for closers.

This newspaper ad is running across West Virginia opposing the sale of the state's phone business to Frontier Communications

Opposition to the sale of Verizon’s landline business to Frontier Communications in 13 states continues to increase, particularly in Ohio and West Virginia, where several employee unions have argued the deal represents a win for Wall Street and company executives, but a raw deal for millions of consumers.

The Communications Workers of America and the International Brotherhood of Electrical Workers, who also warned state regulators in New England about the consequences of approving the sale of Verizon’s operations in Maine, New Hampshire, and Vermont to FairPoint Communications, continue to warn consumers and state officials that a similar deal between Verizon and Frontier Communications could spell major problems for telephone customers.  They call on state officials to reject the deal and force Verizon to invest some of their substantial profits earned in these communities into providing better service instead of dumping customers overboard.

The CWA says the sale would put $3.3 billion dollars into Verizon’s coffers — tax free — and leave Frontier buried in debt, which could impact both new and existing Frontier Communications customers, including hundreds of thousands of those in Rochester, New York, Frontier’s biggest service area.

“Verizon Communications has been divesting assets to smaller, less stable corporations in order to reap large, tax-free, profits,” CWA International Representative Elaine Harris said. “Verizon proposes to repeat that formula, and its disastrous effects, with the sale of all of its wireline operations here in West Virginia to Frontier.”

The CWA considers the transaction based primarily on corporate greed, not the best interests of phone customers.

“The only winner in all of these deals has been Verizon Communications and especially Verizon’s corporate executives,” Harris said. Verizon CEO Ivan Seidenberg is the highest paid executive in the telecom industry, with $24.31 million dollars in annual compensation from Verizon.

“His salary could have funded the entire network of senior services in West Virginia last year and he still would have had $8 million in his pocket,” Harris said.

The deal will leave Frontier Corporation with a total of $8 billion dollars in debt. “The West Virginia consumers will experience the effects of converting more than 617,000 aging access lines to a smaller, debt-ridden company,” Harris said. “The public will be forced to pick up the pieces if Frontier follows Verizon’s other buyers and files for bankruptcy.”

“We’ve closely watched the failures of the companies that purchased Verizon’s assets and we don’t need a crystal ball to figure out what will happen if Verizon tries the same scheme in West Virginia. There’s absolutely no reason to gamble West Virginia’s telecommunication’s future just to increase Verizon’s bottom line,” Harris added.

The CWA is running radio ads across the state of West Virginia opposing the deal.

Audio Clip: Communications Workers of America Radio Ad (1 minute)
You must remain on this page to hear the clip, or you can download the clip and listen later.

Verizon spokesman Harry Mitchell said Verizon wants to sell its access lines so the company can focus on its wireless and broadband business. Mitchell told The Charleston Gazette the union has opposed the deal from day one.

“They’re spending their members’ dues on advertising in an effort to cloud the issue,” he said.

Frontier Communications has protested accusations that their purchase of Verizon assets will result in the same kinds of colossal failures impacting other Verizon sell-offs.  Company officials claim Frontier already has a successful customer support operation in DeLand, Florida, and billing and operating systems in place.

In West Virginia, those existing operations serve 144,000 Frontier customers.  If the deal is approved, Frontier will take on the responsibility of serving 1.3 million landlines across the southeastern U.S. alone.

The International Brotherhood of Electrical Workers, integrally involved in fighting the FairPoint transaction in New England, says the Frontier deal is reminiscent of what happened with FairPoint:

Regulators in the 14 states where Verizon now proposes to sell its landlines to Frontier face an almost identical situation as New England regulators did last year. Frontier Communications is proposing to buy Verizon’s entire wire line operation in West Virginia – as well as Verizon’s scattered landlines across 13 other states – in a similarly structured deal.

In both cases, Verizon chose a much smaller company in order to take advantage of an obscure tax loophole. With the Frontier sale, Verizon will avoid paying any taxes on the $3.3 billion it will receive from Frontier. Frontier will have to cope with three times more employees, three times more access lines and a 75 percent increase in its debt from $4.5 to $8 billion.

Verizon has a very poor track record in these sales. Verizon sold its Hawaii operations to Hawaiian Telcom in 2005 and it filed for bankruptcy. Customers, service and employees have suffered as a result.

Frontier – just like FairPoint – is a making promises that it may not be able to meet. Like FairPoint, state regulators are being asked to approve a deal where a small company will attempt to simultaneously run a much larger operation, pay off billions of dollars more in debt, integrate Verizon’s computer systems and spend more money to expand broadband.

In the end Verizon will profit but consumers, workers and communities are put at real risk.

Expanding broadband access is an especially critical factor for all rural areas. But Frontier has failed to make any specific commitments, set any timeline or offer a plan for its broadband buildout.

Union leaders believe that states shouldn’t risk their telecommunications’ future just so Verizon can fatten its bottom line. Regulators shouldn’t approve this sale because the risks are too great. Instead, our legislators, regulators and the Governor should require Verizon to meet its service responsibilities. Verizon shouldn’t be allowed to walk away with $3.3 billion tax free, and leave the fate of its customers in the hands of a company with a lot less resources. If Frontier should falter, customers and the public would be required to pick up the pieces – not Verizon!

The track record for Verizon spinoffs has hardly been one of success.

FairPoint Communications, the company to which Verizon sold its Maine, New Hampshire and Vermont operations in 2008, is foundering as it tries to integrate operations and is choking on the debt it incurred to finance the transaction Since the deal was announced, FairPoint’s stock price has declined by about 95%, and the company has been forced to suspend dividend payments.

Hawaiian Telecom, the company to which Verizon sold its Hawaii operations in 2005, filed for bankruptcy. Verizon sold its 715,000 access lines in Hawaii. Since then, Hawaiian Telcom has experienced significant transition issues that resulted in major financial and customer service problems. In three years, the company lost 21% of its customers. In December 2008, Hawaiian Telcom filed for bankruptcy.

The yellow pages company that Verizon spun off also filed for bankruptcy. In November 2006, Verizon spun off its yellow pages directory business to Verizon shareholders, loading the new company, Idearc, with about $9.5 billion in debt and extracting a cool $9 billion in cash and debt reduction. Last year, interest payments alone on Idearc’s debt accounted for almost one-quarter of its total revenues! Representing something of a Verizon failing company “hat trick,” Idearc filed for bankruptcy in March 2009.

[flv]http://www.phillipdampier.com/video/WSAZ Huntington Frontier CWA Fight 10-14-09.flv[/flv]

WSAZ-TV Huntington, West Virginia reported on the growing opposition to the Frontier sale by employee groups on October 14th. (3 minutes)

In Washington State, IBEW Local 89, outside Seattle, says the sale could cripple one of America’s most tech-savvy regions.

“We’ve always been a leader in communications in this part of the country,” said Ray Egelhoff, business manager of IBEW Local 89. “If this happens, we’re afraid businesses won’t move in, and some may even move out.”

Egelhoff, along with more than 1,500 Verizon workers who may become Frontier employees, deluged officials with letters and e-mails expressing their concerns. More than 500 have gone out so far to senators, house members, governors and business leaders. The workers worry Frontier —at about the a third the size of Verizon—won’t be able to absorb the huge Verizon assets, won’t be able to keep customers happy and, eventually, will have to shed staff.

Robert Erickson, International Representative in the IBEW’s Telecommunications Department said, “The deal poses risks to consumers and employees. Frontier is making all kinds of promises about synergy and how they’ll expand broadband. FairPoint Communications made the same grand claims and now they can’t meet their commitments and fulfill the promises they made. It’s clear that Frontier will be in a similar situation and not have the resources to fulfill the commitments they are making.”

Consumer groups are also raising objections to the sale.

The National Association of State Utility Consumer Advocates urged the Federal Communications Commission, which is reviewing the proposed transaction, to reject the deal.

“The merger proposed by Frontier and Verizon is not in the public interest,” said David Springe, president of the consumer advocate group. “The failure of the companies to offer adequate consumer benefits or protections puts customers at risk of being served by a company without enough financial strength to make necessary improvements to local telephone facilities and widen the deployment of broadband access.”

Free Press, a nonpartisan group that works to reform the media, also raised concerns about the sale in a filing with the FCC. Free Press cited Verizon’s sale of lines in New Hampshire, Maine, and Vermont to FairPoint, which subsequently acquired substantial debt, was unable to accommodate the increased service area, and is now on the edge of bankruptcy.

“This trend has the potential to leave rural areas with ill-equipped companies offering inadequate service at high prices,” says the Free Press report. “This is in direct contrast to the stated intent of Congress and the Obama Administration to foster universal broadband to all Americans.”

[flv]http://www.phillipdampier.com/video/WCHS Charleston Verizon Sale Fight 10-14-09.flv[/flv]

WCHS-TV in Charleston, WV talked with the CWA and company officials about the sale of Verizon operations to Frontier Communications. (1 minute)

One of the major consequences of having insufficient experience and resources running a telecommunications network FairPoint inherited from Verizon is that when something goes wrong, it often turns into a catastrophic service failure that leaves people without service for days on end.

As we continue to watch the teetering FairPoint Communications lurch towards either a “white knight” rescue or bankruptcy court, ponder being one of 12,000 Vermont residents who suffered through a DSL service outage that lasted nearly a week this past June.

“The first day I was mad, the next day I was angry, the third day I was begging for Internet service so I could continue on with day to day activities of running a business,” said Bret Knapp, co-owner of Hilltop RV Center in New Haven.

Knapp relies on his FairPoint DSL service to stay in contact with his customers.

Knapp spent hours on the phone with FairPoint customer service representatives in Texas trying to resolve the problem to no avail.  At one point, after 50-60 calls, a FairPoint representative hung up on him.

Beth Fastiggi, a FairPoint spokeswoman agreed the problems were unacceptable.

“We are making significant progress; internally, we still have a lot of work to do,” she told WPTZ news.

The state telecommunications regulator in Vermont told the station complaints regarding FairPoint arrive daily from across the state.

[flv width=”480″ height=”360″]http://www.phillipdampier.com/video/WPTZ Plattsburgh FairPoint Outage Affects 12,000 Vermonters 6-10-09 .flv[/flv]

WPTZ-TV Plattsburgh covers the FairPoint DSL outage that wiped out service for a week for 12,000 Vermont residents. [2 minutes]

Phillip "I Also Told You So" Dampier

This past spring Stop the Cap! started relentlessly documenting the tragic phone and broadband service that came as a result of a lousy phone deal for New Englanders.  Verizon, busily wiring its larger service areas for FiOS fiber to the home service, wanted out of Maine, New Hampshire, and Vermont.  In a uniquely wonderful deal (for them), they not only managed a clean break from too much regulatory red tape, but also sold off the entire operation down to the last cable, phone jack, and building absolutely tax-free to FairPoint Communications, a tiny independent phone company headquartered in North Carolina.

Since the sale, it has been one catastrophe after another:  broken phone and broadband service up to weeks at a time, incorrect billing amounting to hundreds of dollars and collection calls pestering customers for money they don’t owe, investigation after investigation, broken promise after broken promise.  Since we broke from the story back in June to cover some of the nonsense and ripoffs going on in Canada, things have not gotten that much better.  In fact, the company’s stock has since lost 95% of its value, is defending against accusations it manipulated a “test run” of a conversion program to guarantee success (right under the noses of independent observers), a major management shakeup, and now the very real chance the entire mess is headed to Bankruptcy Court.

One member of the International Brotherhood of Electrical Workers, who loudly and, it turns out, very accurately predicted the results of this ill-conceived venture, said FairPoint is now swirling in the bowl, flushing itself, and three states’ telecommunications needs, right down the toilet.

So at the same time Frontier Communications is trying to pick up what Verizon is throwing away this year, it’s very illustrative to continue this story, to educate our readers about what happens when consumers’ needs are totally ignored.  Just as much to blame are the state regulators who are now ironically among the loudest complainers.  As we’ve shown documenting this entire story, they’ve changed their tune dramatically.  Back in 2007, they couldn’t say enough wonderful things about how confident they were in FairPoint, and were certain everything would work out just fine.

It did for them because they are still there, conducting the investigation about how this whole mess got started.

The Nashua Telegraph has followed this sorry story since day one:

Unable to make its massive debt payments, FairPoint will have to file for bankruptcy by month’s end unless it can strike a deal with creditors.

The company is losing land-line customers – and thus, revenue – faster than anticipated. And the celebrated launch of a TV service to compete with cable – a move FairPoint said would bring in the extra income to compensate for the decline in land-line customers – has been put on hold.

“There’s no satisfaction in saying I told you so,” said Rand Wilson, communications coordinator for the two unions that represent most FairPoint workers, which organized a major public campaign in an effort to stop the sale.

“We have to try to provide the best possible service under the circumstances and work with regulators and states to find a way to create a viable company.”

So far, that means trying to fix FairPoint from within, or hope the rumors of a buyout by Windstream, another owner of formerly independent phone companies, turns out to be real. But like FairPoint and Frontier, Windstream itself has a business model running phone service in the areas the big boys don’t want. How much of an improvement that company would provide remains an open question.  Regardless, unless FairPoint works the kind of magic it has never performed for its New England customers, it’s probably only a matter of weeks before bankruptcy:

P.J. Louis, a telecom industry expert and author of 11 books on the various topics within the industry, recently wrote that he thinks it’s a realistic option for the company.

“The more and more I think about it, the more I am convinced that FairPoint needs to file,” Louis wrote in an analysis on the Gerson Lehman Group Web site. “Every horror story you hear just scares the heck out of me. Frankly, I am questioning management’s ability to see the company through this rough time.”

The price of providing lousy telephone and broadband Internet service in three New England states?  $2.8 million dollars in fines, and counting.

FairPoint Communications has been piling up fines and penalties for almost a year now, providing third world phone service with the competitive spirit of Hugo Chavez.  Maine, New Hampshire, and Vermont officials started fining the company after it blasted FairPoint’s “failure to meet certain standards for quality and timeliness of interconnections.”  FairPoint is required by law to open its networks to local competitors, and the results of those trying to purchase access at wholesale rates have been about as acceptable as those residential customers have dealt with since Verizon threw them under the bus and left town more than a year ago.

The company’s response?  It wants Maine’s Public Utilities Commission, for one, to waive the $845,000 it owes to local phone carriers.  In a filing with the PUC, it asks that waiving or modifying the payments will let it return its focus to fixing faulty networks to normal operating levels.

In other words, it was penalized for not doing its job and promises, if the penalties go away, it will do its job.  What happens if the penalties don’t go away?

FairPoint’s plans for broadband expansion in its service area were called into question when the company announced it has the potential to go bankrupt if bondholders don’t agree to waive certain payment requirements.