Both FirstWorld Communications, Inc. and the city of Anaheim want businesses in the Anaheim Canyon Business Center to have high-speed Internet access. But somewhere along the way lines were crossed and a $45 million lawsuit filed by the city last May now heads for arbitration.
Anaheim is alleging breach of contract by FirstWorld on a 30-year lease of the majority of the fiber-optic network serving the ACBC and other parts of the city. The Anaheim “Loop” is a 50-mile long fiber-optic system ringing the city.
Anaheim alleges FirstWorld did not properly finish construction on a portion of the Loop as promised, and has not paid the city money due under the lease.
“The city has received, and FirstWorld has made, all payments due to the city,” said Richard S. Odom, FirstWorld’s outside counsel from the Los Angeles office of Brobeck, Phleger & Harrison. “The people who know understand that we are current with the city,” he said.
Anaheim filed its suit in Superior Court, which, citing a contract clause between the city and FirstWorld, referred the matter to binding arbitration. The American Arbitration Association-facilitated process is expected to begin “in a few weeks” and a decision could come as early as year-end, said Louis R. “Skip” Miller III, Anaheim’s outside counsel and an attorney with the Los Angeles litigation firm Christensen, Miller, Fink, Jacobs, Glaser, Weil & Shapiro.
A three-member panel will hear the case, though observers have questioned whether it will come to that.
FirstWorld is fresh from a March 8 IPO, has a market cap of close to $1 billion, and is backed by Microsoft, Lucent and Colony Capital, among others. And billionaire Donald Sturm is FirstWorld’s largest shareholder and a key figure in the firm’s strategy shift from building Internet infrastructure to selling Internet services.
With a big dot-com on one hand and the chance for Anaheim to re-bid a juicy city contract to build and operate fiber-optic lines on the other, a deal of some kind would seem possible, some observers say.
But asked if the city was discussing a deal, Miller said, “We’re not. We are going to compel them to pay every single cent for the Anaheim treasury.”
“We intend to defend very vigorously against the claims,” Odom said. “First-World has not repudiated its agreements with the city.”
Odom said, “FirstWorld disagrees with the city’s characterizations of the issues that are in dispute.”
What is beyond dispute is that between the time FirstWorld signed the deal in 1997 and the time Anaheim filed the lawsuit in 1999, FirstWorld’s business plan changed.
When the deal with Anaheim was forged in 1997, FirstWorld (then called SpectraNet) was based in San Diego and planning to build, own and operate fiber-optic-based broadband networks. The company signed a similar deal with the Irvine Co. to provide services to businesses at The Spectrum. That agreement is not part of this lawsuit.
Added Clout
After it secured the Anaheim and Irvine leases, FirstWorld raised $250 million in debt through an offering led by Bear Stearns in April 1998. The bonds are zero-coupon for five years, 13% a year thereafter, and mature in 2008 at $470 million.
FirstWorld used the money to roll up Internet services firms. In 1998 and 1999 it bought eight companies and the customers of a ninth from Texas to Oregon, including Irvine-based InteleNet Communications Inc., in July 1999.
This led to deals with several major telecom players.
The result: FirstWorld is now an Internet services firm, and fiber optics is only a small and shrinking piece of its total business. Ads from FirstWorld, now based in Denver, tout high-speed Internet access (DSL); web hosting, integration and consulting; eCommerce; and telephony. Of $54.5 million in 1999 revenue, some 90% or $49.7 million came from Internet services, integration and consulting.
Service Unaffected
Both Anaheim and FirstWorld also agree that the arbitration has nothing to do with service in the Anaheim Loop, which continues apace,provided by FirstWorld. In fact, the city of Anaheim is a customer of FirstWorld for portions of its own Internet needs.
A FirstWorld salesman for this region said the company continues to offer its services in both Anaheim and the Spectrum.
Paul Kranhold, vice president of communications for The Irvine Co., said FirstWorld is meeting its commitments.
“They are performing well,” he said. “They continue to operate their fiber-optic network at the Irvine Spectrum. The feedback we’re getting from customers is they’re happy.”
FirstWorld documents show the lease at the Spectrum ending in 2027. Quarterly license fees averaged $103,000 last year and $88,000 in 1998. FirstWorld expects to pay about $105,000 per quarter in 2000 to the Irvine Co.
In dispute is whether FirstWorld has held up its end of the 30-year lease.
Miller said a main issue is whether FirstWorld can deduct expenses from what it owes the city.
The agreement gave FirstWorld exclusive right to use 62% of the then-existing fiber strands in the 50-mile “loop” of cable owned by the city. FirstWorld was to pay 5% of gross revenue and 35% of net revenue from the operation of the network, or $1 million a year, whichever was greater. In addition to that royalty, First-World would pay $114,000 per quarter in rent and its share (62%) for maintenance on the lines.
FirstWorld pledged additional payments of $175,000 to $350,000 a year, based on net revenue, and dependant on the construction by FirstWorld of future sections of the Loop, according to its public documents. Some $100,000 to $300,000 would be paid for new networks FirstWorld built. A $6 million reserve account for debt service and capital improvements was also mandated, these documents state.
FirstWorld public documents assert that there has been no net revenue from the Anaheim network.
Miller said Anaheim sued after FirstWorld said it would not make the first quarterly payment of $250,000 due June 30, 1999. Miller said when the payment came it was light by at least $100,000. “It was a payment of $250,000 with ‘offsets’ for expenses,” said Miller. “That was totally unacceptable.”
Odom said the issue of the offsets has been resolved. Both sides agree that subsequent quarterly payments of $250,000 have been made. But Miller said FirstWorld is making the payments under protest and that the city wants the arbitration process to secure all future payments.
Anaheim also asserts that FirstWorld has not completed any extension of the fiber optic loop as stipulated in the lease; FirstWorld says it has. The city has also asked for permission to audit FirstWorld’s books.
The $45 million price tag that the city has attached to the suit figures in the minimum value of the royalty and other lease payments.
Revenue Stream in Doubt
The city thought the lease would give them a 30-year source of revenue in a burgeoning business. Terms of the deal allow the city, anytime after 2012, to buy the FirstWorld unit operating in Anaheim, or to be financially compensated if FirstWorld wants to sell the subsidiary to someone else.
The city built the first phase for $6 million before the deal with FirstWorld. And until the question of the second phase is settled, a planned third phase can’t be built either. And building it doesn’t fit FirstWorld’s current strategy anyway.
“They flat out went out of that business,” said Miller.
Anaheim has requested that the arbitration hearing take place in Orange County.
Anaheim has selected Thomas R. Malcolm, partner-in-charge of the Irvine office of Jones, Day, Reavis & Pogue, to serve on the panel. FirstWorld has tapped Andrew D. Lipman, of Swidler Berlin Shereff Friedman. Swidler Berlin is a telecom, regulatory and government affairs firm with offices in Washington, D.C. and New York City. Malcolm and Lipman will choose the third arbitrator.
Concurrent with its March 8 IPO, FirstWorld nabbed investments from Microsoft Corp. ($12 million), Texas Pacific Group/Colony Capital ($50 million), Lucent Technologies ($10 million) and SAIC Venture Capital ($19.5 million), the VC arm of San Diego-based SAIC, a massive IT consultant.
Priced at 17, FirstWorld (Nasdaq: FWIS) closed its first day at 25. After occasional forays in the 30s, it had slipped back to 17 as of the middle of last week.
Chairman Sturm owns a third of the company, fully diluted. Texas Pacific bought out most of original investor Enron Corp.’s stake and owns about 20% of the company. Enron still holds a 4% stake through warrants.
Overall, FirstWorld lost $106.6 million in 1999 due to the cost, it said, of building up its business in several markets that it has entered in the last 18 months. n
