Family tensions often come to the fore during the holidays. Avoiding political discussions can be difficult enough, but when money is involved, things can get especially ugly. That makes me wonder what Thanksgiving dinner will be like this year for the executives who run Windstream Holdings (ticker: WINMQ) and Uniti Group (ticker: UNIT). Robert Gunderman is Windstream’s CFO, while his brother Kenneth is Uniti’s CEO. These two firms are embroiled in bitter litigation that could spell the end of either entity, but Windstream appears to have the better position.
Windstream is an old-line telecom operator which came up with a novel solution to raise some cash a few years ago. It spun off its network assets—transmission lines and towers—into a newly formed REIT called Uniti. It then leased them back via a triple net lease agreement. Windstream agreed to pay Uniti monthly rent and be totally responsible for the network’s upkeep. The spinoff gave Windstream enough cash to acquire internet service provider Earthlink a year later for $1.2 BN. Unfortunately, it all fell apart after Aurelius Capital filed a suit claiming that the spinoff was a breach of Windstream’s bond indentures. A few days after the judge ruled in Aurelius’ favor this year, Windstream filed Chapter 11.
Now, at issue is whether Windstream’s deal with Uniti is a true lease or a disguised financing. Windstream has about $6.2 BN in debt, including the Aurelius judgment it lost. That’s in addition to $6.9 BN in future lease payments owed to Uniti, which isn’t in bankruptcy even though its auditors recently raised “substantial doubt about its ability to continue as a going concern.” Even so, Uniti has taken the position that business will continue as usual and that Windstream must continue making monthly rent payments.
Both firms have a lot to lose here. If the court determines that the lease agreement is a disguised financing, then Uniti will likely be forced into bankruptcy too. The REIT would be classified as an unsecured creditor, with its $6.9 BN in claims for “rent” falling further down the pecking order among Windstream’s multiple creditors. Windstream has $1.1 BN in unsecured notes that trade for just 20 cents/dollar. It also has $1.2 BN in 2nd lien secured debt, trading at 50 cents/dollar, that’s ahead of all unsecured creditors. In addition, Windstream has $3.6 BN in 1st lien and structurally senior claims ahead of the 2nd lien and unsecured creditors. If Uniti’s claims get reclassified as unsecured debt, its recovery would be subordinate to $4.8 BN in senior claims and pari-passu with $1.5 BN of other unsecured claims.
On the other hand, if the court deems the agreement a true lease, then Uniti has much stronger rights and Windstream would continue to bear responsibility for those payments or risk losing its entire network. That would essentially mean that Windstream has no business left at all. In effect, “true lease” characterization would prioritize Uniti’s rent payments ahead of nearly all other Windstream creditors.
Predicting the outcome of this dispute requires analysis of the legal precedent courts use to determine whether an agreement is a true lease or a disguised financing. Historically, courts look beyond the surface of the written agreement and examine all of the facts and circumstances that surrounded the financing. They consider factors such as (a) whether “rent” is measured by the fair market value of the property, (b) the landlord’s reversionary interest, and (c) whether the payment stream resembles an underlying financing. In this case, there’s a lot of evidence to suggest the lease should be deemed a financing. If so, Uniti’s billions of dollars in bonds would be impaired, while its public stock, currently at ~$7/share for a $1.4 BN equity market capitalization, would tank as well.
Among the exhaustive list of factors courts consider in determining lease vs. financing disputes is the remaining useful life of the property. Here, a significant portion of the network is copper wire lines which are expected to become obsolete within a few years. If the court agrees that their useful life is shorter than the lease term, then Uniti’s argument classifying this as a true lease becomes much weaker.
The court will also assess whether Uniti, as a landlord, has a reversionary interest in the network at the end of the term. Windstream’s position is that, since Uniti isn’t a public utility, it could never operate the network without Windstream. And, since the agreement gives Windstream the option to renew for up to 35 years, Windstream argues that Uniti doesn’t have any reversionary interest at all. Both of these arguments also weaken Uniti’s positioning.
Risk of loss is another critical factor that courts will consider in these types of disputes. Here, Windstream assumes all the risk. Under the agreement, Windstream is liable for the full rent even if the network is totally destroyed by an act of God (like a tornado), in addition to all maintenance and repair costs. This type of lease covenant, also known as a “hell or high water” clause, certainly supports Windstream’s argument that this isn’t a lease as well.
Finally, the underlying payment stream in this case is another factor which supports Windstream’s legal argument to classify the lease as a financing. Here, the $650 MM in annual rent (which escalates to $690 million over 15 years) was precisely predetermined to provide sufficient yield to attract Uniti’s equity REIT investors and also service its new junk-rated debt. Had this been a true lease, rent would have reflected network depreciation and therefore wouldn’t likely have escalated over time.
From my perspective and experience analyzing similar cases over the years, Windstream has the better of these arguments. In August, the CEOs of both firms announced that they were seeking to resolve their dispute through mediation. The court agreed and set a mediation deadline of December 6. Time is running out, but the parties’ interests are so diametrically opposed that a peaceful resolution seems unlikely before trial.
If Uniti wins the case, the entire $650 MM in annual escalating rent would still be payable. That would be devastating to Windstream since it only generates $1.8 BN/year in EBITDA before this big expense. On the other hand, if Windstream wins, those payments could be reduced down to $0. Windstream is one of Uniti’s only major customers and represents ~70% of Uniti’s total revenue. Thus, Uniti would likely be rendered insolvent if this cash flow were to stop; in that case, Uniti’s EBITDA would drop to ~$325 MM – a quantum less than Uniti’s current annual interest expense of $390 million and certainly not enough to please Uniti’s stock investors who expect REITs to pay dividends.
This wide range of outcomes over the lease characterization issue, with extreme potential losses for either side, means that the parties would be well-served to negotiate a solution. However, Windstream’s creditors have a much better fallback position if they lose (Windstream would just keep paying $650 MM/year) and Windstream is already operating under bankruptcy protection anyway. In contrast, Uniti could suffer a much worse outcome since it would likely need to file Chapter 11 as well. Thus, there’s a good likelihood that mediation will fail and that the court will have to decide the dispute.
Unfortunately for both parties, the case probably won’t be resolved any time this month. So, as I said at the outset, there might be more on the table for the Gunderman family than turkey at Thanksgiving.