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Ottawa, 19 April 1991
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Telecom Decision CRTC 91-5
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TELEGLOBE CANADA INC. - ADVANCES TO MEMOTEC DATA INC.
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I BACKGROUND
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A. Central Cash Management System
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After Memotec Data Inc. (Memotec) acquired Teleglobe Canada Inc. (Teleglobe) in 1987, Teleglobe was included in Memotec's central cash management (CCM) system. Under this system, funds in Teleglobe's bank accounts, except imprest and payroll accounts, are transferred to a Memotec bank account at the end of each day. These funds on deposit with the parent company (advances to Memotec) are, in effect, loans made by Teleglobe to Memotec, although Teleglobe has never actually received any interest payments from Memotec on the amounts outstanding. Moreover, Teleglobe pays Memotec a corporate management services charge that includes a fee for cash management.
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Until December 1988, Teleglobe accrued on its books of account an interest income on advances made to Memotec. In December 1988, Teleglobe changed its accounting procedure. Since that time, Teleglobe has imputed an interest income on the advances only for regulatory purposes. The imputed interest is based on 91-day treasury bill rates. The after-tax amount of the imputed interest income is added to the equity rate base and to the outstanding balance of the advances on which the imputed interest is calculated. Since December 1989, consistent with the proposals it filed in this proceeding, Teleglobe has also deemed the payment of monthly dividends to Memotec equal to the after-tax amount of the imputed interest.
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The funds that Teleglobe maintains on deposit with Memotec are substantial. Teleglobe's ability to maintain such large cash balances results from its revenue settlement arrangements with foreign administrations and with domestic carriers. Under its agreement with Telecom Canada, Teleglobe receives collections for outward overseas telephone calls about one and a half months after the end of the month in which the calls were placed. However, under International Telecommunication Union regulations, settlements with foreign administrations of revenues derived from inward and outward calls do not have to be finalized until some six to eight months after the telephone calls are made. Since Canadians make about 50% more telephone calls to overseas destinations than they receive, Teleglobe's accounts payable to foreign administrations are greater than its accounts receivable. This fact, combined with the length of the international settlement process, means that Teleglobe has significant funds on hand, which are advanced to Memotec under the CCM arrangements. These advances are recorded in Teleglobe's books of account as accounts receivable from Memotec, and in Memotec's books as accounts payable to Teleglobe. Since Teleglobe's cash management function was included in the CCM system, the average daily balance of these advances has grown significantly. On 28 February 1991, the balance stood at $133.8 milion.
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B. Past Proceedings
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The Commission has had serious concerns with many aspects of the CCM arrangements ever since it assumed jurisdiction over Teleglobe. The Commission first expressed its concerns publicly in Reduction in International Telephone Service Rates, Advances to Memotec Data Inc., Telecom Letter Decision CRTC 89-23, 9 November 1989 (Letter Decision 89-23). Specifically, the Commission noted that Memotec furnished no security for funds advanced by Teleglobe, that the advances were substantial, and that there was no written agreement formalizing any aspect of the CCM arrangements. The Commission was also concerned that no interest was actually paid to Teleglobe, and that significant differences would develop between financial indicators based on the company's books of account and those derived for regulatory purposes. The latter indicators take into account interest income imputed on the advances, while the former do not.
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In Letter Decision 89-23, the Commission expressed the view that, since a float of funds of at least $60 million would likely exist for the foreseeable future, it would be more cost effective for Teleglobe to use some of that float to lower its invested capital. The Commission noted that this would require the removal of a covenant in Teleglobe's loan agreement with the National Bank of Canada (National Bank) requiring that a ratio of current assets to current liabilities (current ratio) of at least 1:1 be maintained.
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In Letter Decision 89-23, the Commission concluded that the CCM system was not consistent with Teleglobe's obligation as a regulated company to ensure that customers' interests are protected, or with the company's own best interests. The Commission directed Teleglobe to file, by 8 December 1989, proposals to organize its cash management and short-term investment program in a way that would address the Commission's concerns. The Commission stated that acceptable alternatives would include: (1) that Teleglobe maintain its own bank accounts and manage its own short-term investment program; (2) that Teleglobe enter into a written agreement with Memotec formalizing the cash management arrangements in such a way as to protect Teleglobe's financial interests and to ensure that Memotec pays it a market interest rate on the advances; (3) that Teleglobe contract out its cash management and short-term investment program to an unrelated party.
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Teleglobe filed its proposals on 8 December 1989. The company undertook to enter into a written agreement with Memotec formalizing the imputation of interest on the advances at 91-day treasury bill rates. Under the proposed agreement, Teleglobe would have the right to repayment of a portion of the advances on seven days notice. The balance would be repayable on 90 days notice. Teleglobe also stated that the National Bank had undertaken to provide Memotec with a comfort letter indicating that funds would be made available to Memotec to meet its obligation to repay Teleglobe. Teleglobe also offered to deem, for regulatory purposes, the payment to Memotec of a monthly dividend equal to the after-tax value of the imputed interest and to make a one-time deemed dividend adjustment equal to the after-tax value of the imputed interest for the years 1988 and 1989.
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C. The Present Proceeding
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Having reviewed Teleglobe's proposals, the Commission remained concerned that no interest would be paid on the advances, that funds on deposit with Memotec might not be sufficiently secure, and that Teleglobe's key financial ratios would continue to be adversely affected, with a possible negative impact on the company's credit rating and borrowing costs. In Teleglobe Canada Inc. - Advances to Memotec Data Inc., CRTC Telecom Public Notice 1990-21, 23 February 1990 (Public Notice 1990-21), the Commission initiated a public proceeding intended to address these concerns. Interested persons were invited to comment on issues related to the CCM arrangements, including the following:
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(1) What arrangements for managing Teleglobe's cash flow would be acceptable?
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(2) Is a significant portion of Teleglobe's advances to Memotec an asset of a long-term nature? If so, what alternatives are available to the company to use that asset more effectively and to earn a return commensurate with that required from such an asset?
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(3) Are there limitations on the Commission's jurisdiction in the matter of Teleglobe's cash management practices?
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Eight parties registered as interveners in this proceeding: the Governments of Quebec, Ontario and British Columbia, Bell Canada, Telesat Canada, Unitel Communications Inc., Canadian Business Telecommunications Alliance and Mr. C. Gilmour. Only Mr. Gilmour filed comments.
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The Commission addressed an initial set of interrogatories to Teleglobe on 23 February 1990. Teleglobe filed its responses to the Commission's interrogatories, along with its comments, on 26 March 1990. On 6 April 1990, Teleglobe filed a copy of an agreement with Memotec, dated 27 March, with respect to the CCM arrangements (the loan agreement). On 27 April 1990, it filed an abridged version of a line of credit agreement (LOC agreement) with the Royal Bank of Canada (Royal Bank). On 10 April 1990, the Commission addressed additional interrogatories to Teleglobe. Teleglobe filed its responses on 1 May 1990. The Commission found it necessary to address a further set of interrogatories to Teleglobe on 11 May 1990, to which Teleglobe responded on 28 May 1990.
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II TELEGLOBE'S POSITION
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A. Security of the Advances
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The loan agreement between Teleglobe and Memotec sets out the terms and conditions under which Teleglobe advances funds to its parent. Under that agreement, Teleglobe transfers to Memotec all funds that are surplus to Teleglobe's daily business requirements. Memotec's obligation to repay is evidenced by two revolving promissory notes, one for advances in Canadian funds and the other for advances in American funds. These promissory notes are annexed as schedules to the loan agreement. The loan agreement can be terminated on 90 days notice, and outstanding advances are due and payable on 90 days notice or on demand following the occurrence of an "event of default". The outstanding amount does not bear interest prior to its due date (pursuant to the notice provisions) or prior to demand following an event of default. Events of default are defined in the loan agreement and include: (1) a default by Memotec on its loans; (2) the appointment of a receiver for Memotec's properties; (3) the initiation of a petition in bankruptcy by or against Memotec.
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In an interrogatory, the Commission asked Teleglobe how it would come to know that an "event of default" had occurred. Teleglobe responded that, since there is "a complete identity of membership" in the boards of directors of the two companies, it is virtually inconceivable that Memotec could find itself in an event of default without the knowledge of Teleglobe.
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Teleglobe stated that, in events of default, creditors that rank ahead of it are: (1) various creditors, including employees and Revenue Canada, (2) the National Bank for amounts up to the operating line of credit utilized (a line of credit separate from that with the Royal Bank), and (3) holders of Memotec's 7.75% convertible debentures, due in 1994, in the amount of $75 million (payment of these debentures is secured with a pledge of certain of Memotec's shares in Teleglobe).
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As noted above, Teleglobe also filed an abridged version of the LOC agreement between Memotec and the Royal Bank. The $150 million credit facility is for general corporate purposes, including repayment of payables/loans owing to Teleglobe and non-hostile acquisitions by Memotec. The LOC agreement contains a number of conditions precedent to any disbursement of funds to Memotec, including requirements that Memotec shall have maintained certain financial performance standards and that no event of default shall have occurred. In a letter to Teleglobe dated 27 April 1990, which Teleglobe filed with the LOC agreement, Memotec stated that its current intention was to maintain an amount of unused credit not less than the outstanding advances from Teleglobe.
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Teleglobe stated that the loan agreement, when coupled with the LOC agreement, was intended to satisfy the Commission's concern by removing the perceived risk of non-payment.
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B. Imputed Interest
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In its comments of 26 March 1990, Teleglobe submitted that the imputing of interest at 91-day treasury bill rates is advantageous to it and its subscribers, since no minimum balance or minimum placement period is required to obtain the 91-day treasury bill rate, as would be the case with commercial cash management arrangements. As well, the imputed interest is applied to the whole amount of the advances. Teleglobe also stated that its expenses are lower with the CCM arrangements, since its own staff are not required to manage the funds in question.
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Teleglobe took the position that actual interest need not be paid on the advances, because the 91-day treasury bill rate is a market interest rate and because customer interests are protected by the inclusion of the imputed interest for revenue requirement purposes. Teleglobe characterized the funds on deposit with Memotec as intercorporate advances between a parent company and its wholly-owned subsidiary. Teleglobe stated that such intercorporate advances are generally made at no interest, because the financial statements of a parent company and its subsidiaries are prepared on a consolidated basis. In the consolidation process, intercorporate receivables/payables (such as the advances to Memotec) and intercorporate interest expense and income are eliminated.
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Teleglobe argued that it is acceptable that the advances bear interest only after an event of default because the need to ensure that Teleglobe is protected to the same degree as other creditors arises only in such circumstances. In Teleglobe's view, the practice of not paying interest is appropriate unless Teleglobe is no longer a wholly-owned subsidiary of Memotec or Memotec defaults on its liabilities (because effective control of Teleglobe might then change).
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C. Applying a Portion of the Advances to Reduce Invested Capital
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In its comments of 26 March 1990, Teleglobe stated that its financial framework, including its capital structure, during the four-year transitional period ending at year-end 1991 was established in the Direction to the CRTC on the Regulation of the New Corporation Resulting from the Reorganization of Teleglobe. Therefore, questions such as whether its current ratio should be maintained at 1:1 should be deferred to the proceeding announced in Teleglobe Canada Inc. - Regulation After the Transitional Period, CRTC Telecom Public Notice 1990-102, 20 December 1990 (Public Notice 1990-102).
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Nevertheless, Teleglobe offered to negotiate with the National Bank to relax the covenant requiring a current ratio of 1:1 and to apply about $40 million to $45 million towards reducing its invested capital. The company undertook to confirm this matter within three weeks. However, the Commission has received no such confirmation.
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III CONCLUSIONS
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A. Improvements in CCM Arrangements Proposed During this Proceeding
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In the course of this proceeding, Teleglobe has made a number of improvements in its arrangements with Memotec. By virtue of the establishment of the loan agreement, the terms and conditions of the CCM arrangements are at least set out in writing. Moreover, by virtue of Memotec having obtained a line of credit of $150 million from the Royal Bank, Teleglobe has some assurance that Memotec would have funds available to meet its repayment obligations. However, that assurance is subject to certain provisos, specifically, that Memotec complies with the representations, warranties, covenants and other conditions in the LOC agreement, that the funds that Teleglobe advances to Memotec do not exceed the total amount available to Memotec under the LOC agreement, and that an amount of credit sufficient to cover the advances remains unused.
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By deeming a one-time payment to Memotec of dividends equal to the after-tax value of the imputed interest for the years 1988 and 1989, Teleglobe removed some $12 million from its common equity for regulatory purposes and from the outstanding advances to Memotec as of 1989 year-end. Since that time, Teleglobe has continued to impute a monthly interest payment on the advances and to deem the payment of a corresponding monthly dividend to Memotec, as proposed in its submissions of 8 December 1989. Therefore, common equity on a books-of-account basis has been the same as that on a regulated basis, although Teleglobe's regulated income and its regulated rate of return on average common equity (ROE) continue to differ from its income and its rate of return on a books-of-account basis.
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The Commission accepts, for regulatory purposes, Teleglobe's proposal to deem payment of a monthly dividend to Memotec equal to the after-tax value of the imputed interest, effective January 1990. The Commission also accepts, for regulatory purposes, Teleglobe's one-time deemed dividend adjustment equal to the after-tax value of the imputed interest for the years 1988 and 1989.
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However, for the reasons discussed below, the Commission does not consider the steps proposed by Teleglobe during this proceeding sufficient to secure the funds advanced to Memotec or to ensure Teleglobe an adequate return on those funds, thus protecting the interests of Teleglobe and its subscribers. Therefore, in order to ensure the provision of international telephone service at just and reasonable rates, as required by section 340(1) of the Railway Act, the Commission concludes that further safeguards are necessary. These are set out in the following sections.
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B. Adequacy of Security
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During the transitional period, the average daily balance of the advances to Memotec has increased steadily. As stated earlier, on 28 February 1991, the balance stood at $133.8 million, some 40% of Teleglobe's net book value.
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In order to determine the risks to which Teleglobe's funds on loan to Memotec are exposed, the Commission examined the published financial statements of Memotec. Memotec's audited consolidated financial statements show that, while its cash and short-term deposits (accounts that would contain the cash advances from Teleglobe) were $113.8 million at year-end 1988, they were reduced to $17.2 million at year-end 1989. Memotec's consolidated statement of changes in financial position for the year ended 31 December 1989 shows that the cash balance of the consolidated entity, which includes Teleglobe, was $113.8 million at the beginning of the year and negative $2.8 million at the end of the year, a decrease of $116.6 million. On Teleglobe's books of account, the balance of the funds advanced to Memotec stood at about $91.4 million at year-end 1988. This balance had increased to about $107.9 million by year-end 1989.
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The Commission notes that, during 1989, Memotec acquired three subsidiaries, including ISI Systems Inc., a U.S.-based company engaged in the mainframe processing of insurance policies, the development of rating automation, and the provision and maintenance of insurance application software for personal computers. The purchase price, paid in cash, common shares and debentures, was $154.4 million, $111.1 million of which was for goodwill. Memotec also acquired two other American companies, Equifax Insurance Systems and Concord Data Systems Inc., for total cash consideration of $35.3 million. Of that $35.3 million, $21.6 million was for goodwill.
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Based on the above, the Commission concludes that much of the cash advanced to Memotec is no longer a liquid asset. Furthermore, the Commission concludes that a substantial portion of the cash advanced by Teleglobe has been used by Memotec for investments bearing higher risk than that associated with Teleglobe.
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Under the loan agreement between Teleglobe and Memotec, advances to Memotec are supported by promissory notes that are no more than evidence of indebtedness. No real security has been provided, such as a pledge of property. The funds lent to Memotec are due and payable to Teleglobe on 90 days notice. However, as discussed above, the Commission finds that a significant portion of these funds is tied up in Memotec's investments in subsidiaries and would likely not be readily available to meet Teleglobe's funding and liquidity needs.
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While the loan agreement provides that advances are due and payable immediately upon an event of default, the advances from Teleglobe rank only as unsecured debt. Therefore, it appears unlikely that Teleglobe would recover the full amount of the advances in an event of default.
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The LOC agreement between Memotec and the Royal Bank is not solely for the repayment of funds owing to Teleglobe. The only assurance that Teleglobe has with respect to the availability of funds pursuant to the LOC agreement is Memotec's statement, in its letter of 27 April 1990, that its "current" intention was to maintain unused credit not less than the amount of the outstanding advances. There is, however, no guarantee that this will occur. Moreover, there is no assurance that the conditions precedent set out in the LOC agreement for the disbursement of funds to Memotec would be satisfied.
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In view of the above, the Commission concludes that Teleglobe has not been provided with adequate security for the funds it has advanced to Memotec. Teleglobe is therefore directed to file, by 18 June 1991, details of an arrangement with Memotec whereby the latter would pledge, in a manner that complies with the Canada Business Corporations Act, a portion of its shares in Teleglobe to secure the funds advanced. Teleglobe's filing is to include complete details of the structure of the pledge arrangement and of its operation should it become necessary to call upon the security.
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As a wholly-owned subsidiary of Memotec, Teleglobe's shares are not traded on the open market. Teleglobe's filing is therefore to include a description of the means by which its shares are to be valuated for the purposes of securing its advances to Memotec. The value of the pledge is to equal the value of the outstanding balance of the funds advanced by Teleglobe. Teleglobe's filing is also to include a proposed mechanism for accommodating fluctuations in the number of shares pledged, required because of fluctuations in the outstanding balance of funds advanced to Memotec. Teleglobe is also to describe the means by which the pledging of its shares is to be formalized, for example, through the addition of appropriate clauses to the loan agreement. Finally, Teleglobe's filing is to include dates by which Memotec's pledging of its shares in Teleglobe is to be finalized.
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The Commission is prepared to consider an alternative proposal from Teleglobe for the securing of its advances to Memotec. Any such alternative proposal is to be submitted with Teleglobe's filing with respect to a pledge of shares. Any alternative proposal is to be set out in detail, including relevant dates for its finalization, and should provide complete supporting rationale, including the reasons that the alternative should be preferred to a pledging of shares. Any alternative proposal must provide for a level of security equivalent to a pledging of shares.
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C. Adequacy of Return
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The Commission noted in Letter Decision 89-23 that, provided that current international traffic patterns and revenue settlement procedures continue, Teleglobe would have access to a float of at least $60 million for the foreseeable future. It appears unlikely that Teleglobe's funds on deposit with Memotec will fall below $60 million.
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As set out above, the Commission has concluded that a substantial portion of the funds advanced by Teleglobe has been used by Memotec to fund the long-term investments described in Section B of this Part. These advances are, in effect, loans to Memotec, and Teleglobe's required return on the advances should be commensurate with the risk associated with Memotec's use of the funds.
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In light of the above, the Commission concludes on an interim basis that, as of 1 May 1991, Teleglobe will be required, for regulatory purposes, to earn on the first $60 million of its advances to Memotec a return equal to the prime rate plus three percentage points. The return is to be calculated each week on the basis of the chartered bank prime business loan rate (series no. B113855, BCR Table F1, Financial Market Statistics) published by the Bank of Canada. The return on the rest of Teleglobe's outstanding advances to Memotec will remain at 91-day treasury bill rates, to be calculated weekly on the average daily balance in excess of $60 million for that week.
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The Commission intends to determine, on a final basis, the portion of Teleglobe's advances to Memotec to be considered long-term investment, and the rate(s) of return that Teleglobe will be required to earn on the advances for regulatory purposes, in the proceeding announced in Public Notice 1990-102. Accordingly, Teleglobe is directed to file, by 27 May 1991, a statement of its position on these questions, including all supporting rationale, and to serve copies of that statement on all parties to that proceeding.
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In reaching the above conclusions, the Commission is aware that significant differences in Teleglobe's book and regulated financial ratios (including interest coverage and ROE) will persist, primarily because Teleglobe is not receiving (other than for regulatory purposes) interest payments on its loans to Memotec. It is on financial ratios derived from Teleglobe's books of account that lending institutions and bond rating agencies rely when determining Teleglobe's financial health and creditworthiness. Teleglobe's book financial indicators will continue to be significantly weaker than if it were actually receiving interest payments on its loans to Memotec. Lending institutions and bond rating agencies may well assess Teleglobe's financial risk accordingly, with a subsequent negative impact on its borrowing costs.
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In its interrogatory responses of 26 March 1990, Teleglobe acknowledged that any negative impact on its borrowing costs attributable to divergences between book and regulatory financial ratios should be borne by the holder of its shares. The Commission stresses that, in determining Teleglobe's revenue requirement, it will allow Teleglobe to recover only those costs of debt and equity financing that the company would have incurred had it been receiving actual interest payments from Memotec.
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Allan J. Darling
Secretary General
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