ADELPHIA COMMUNICATIONS

ABSTRACT

Adelphia Communications was one of many firms that got into financial trouble as the result of poor corporate governance and improper accounting practices in the post-Enron world of early 2002.  The primary subject matter of this case concerns poor corporate governance that allowed managers to benefit at the expense of minority shareholders.  This corporate finance case involves a firm that was thought of as being well managed and a pillar of the business community before a corporate governance crisis led to its eventual bankruptcy.  The case shows that at times, too much managerial ownership can be detrimental to a firm’s stakeholders. Secondary issues include an analysis of Adelphia’s rise, the risks and rewards of high leverage, the role of auditors and analysts as monitors, and the costs of financial distress as a firm nears bankruptcy.  This case is designed to be taught in a 60-90 minute corporate finance or advanced corporate finance class and is expected to require three to four hours of outside preparation by students.  

BUSINESS ENVIRONMENT

After the economic expansion of the 1990s, the global economy slowed and stock markets around the world fell, in part due to the collapse of the Internet and technology “Bubble.”  These declines were punctuated by the tragic events of September 11, 2001, which further pushed down the economy and stock markets.  Enron’s collapse, amid revelations of billions of dollars of off-balance-sheet debt, rampant fraud, and mismanagement, focused the US business community’s attention on managerial fraud and accounting practices. 

INDUSTRY BACKGROUND

The cable industry is a classic high fixed cost, low variable cost industry with a high degree of business risk.  This cost structure creates incentives that take advantage of economies of scale while the relatively high fixed costs make the industry susceptible to fluctuations.  The 1990s brought good times to the cable industry as the expansion of services to the vast majority of the US population led to an increase in the number of cable customers.  This increase in the customer base was coupled with the creation of many new television channels, allowing cable industry revenues to grow rapidly; not only did the number of customers go up, but the average customer’s bills also increased significantly.  As a result, the stocks of cable providers typically outperformed the broader stock market. The largest firms in the industry are listed in Table 1.  

In the late 1990s, cable television was not the only reason for the industry’s success: cable connections offered a significant speed advantage over slower dial-up Internet connections.  Cable Internet access was thus seen as the growth segment of the industry and most of the major cable firms rapidly expanded into this sector.  When the forecasted growth of this segment failed to materialize as quickly as predicted, the industry was beset with over-capacity problems.   

TABLE 1: Industry Comparison

Source: January 4, 2002 Value Line, PP829-836  

ADELPHIA BACKGROUND

In 1952, John Rigas borrowed money from his father to open a movie theater in Coudersport, PA.   From this small beginning, the firm transformed itself by purchasing its first cable franchise for $300.  The new cable firm grew rapidly by focusing its efforts on keeping its operations geographically dense so as to keep operating costs low, by emphasizing customer service, by staying in the suburbs instead of metropolitan areas, and once established, through aggressive acquisitions.  Twenty years after the company was founded, the firm was incorporated and named Adelphia, from the Greek word for brothers.  In 1986, the company sold shares to the public and began trading on the Nasdaq.  By 1999, Adelphia was the nation's sixth largest cable company (see figure 1).  As the company had grown, it also had expanded into other fields of business.  It operated a telephone business (Adelphia Business Solutions), a sports radio station (WNSA-FM), a sports cable channel (Empire Network), and many other smaller subsidiaries. (Adelphia Corporate Website July, 16, 2002)

FIGURE 1

                                                                              Source: http://finance.yahoo.com

Despite being a publicly held firm, the company remained a family-run business.  The Rigases held five of the firm’s nine board seats.  John was the CEO and chairman of the board.  His sons, Tim (CFO), Michael (VP of Operations), and James (VP of Strategic Planning), made up much of the firm’s brain trust.  In addition, John Rigas’s son-in law, Peter Venetis, sat on the board of directors.  (Adelphia 2000 Annual Report)

Adelphia was headquartered in Coudersport, PA, a quaint town with a population of fewer than 5,000 people.  The firm stressed its social responsibility by giving free basic cable and Internet connections to educational institutions, by sponsoring cultural and sporting events, and by supporting nearly any charity that needed assistance.  This generosity was especially evident in Coudersport, where the company and the family spared no expense. (Frank, 2002)  Generous to a fault, John rarely turned anyone down: he provided corporate jets to fly sick townspeople to treatments and was known to send unsolicited checks to people who he felt needed help. (Sullivan, 2002, Caulk, 2002)

The company’s largesse was not limited to the corporate hometown.  For example, in Buffalo, NY, where the firm had a large operations base, the family purchased the NHL’s Buffalo Sabres to keep the team in the relatively small-market city.  The company also announced plans for a new office complex, designed to breathe life into the struggling waterfront section of the city.  While some questioned the extravagances, the more common opinion was that Adelphia and the Rigases were prime examples of giving back to the community.

The firm did have its critics however, and a few chinks in its public persona began to emerge.  The family’s large and extravagant homes, a lavish neo-classical corporate headquarters building, and other examples of extravagance led some to question Adelphia’s spending.  There were widespread stories of family trips, apartments, and other luxuries that were paid for with Adelphia money (Markon, 2002, Frank, 2002).  Additionally, Coudersport tax officials were puzzled when the taxes for both Adelphia and Rigas properties were paid with a single Adelphia check. (Hofmeister and Hamilton, 2002)

MANAGEMENT AND FINANCING

The firm’s organizational structure was hierarchical.  Decision-making was centralized, with the Rigas family involved in most major decisions.  This pattern was true for all of the firm’s subsidiaries, but may be best demonstrated by the Buffalo Sabres.  The Rigases often controlled contract talks and the comptroller for the Sabres worked in Coudersport, approximately three hours away from the team’s home in Buffalo.  While the parent Adelphia Communications made the majority of managerial decisions, the subsidiaries were responsible for roughly two-thirds of the firm’s overall debt.  This policy allowed Adelphia (and the Rigas family) to maintain control over the firm and yet be largely protected in the event of a bankruptcy of any individual subsidiary.     

Adelphia, which had been founded with borrowed money, maintained its aggressive financing as the company grew.  Much of this debt was on the books of the various subsidiaries, but by the end of 2001, the parent Adelphia Communications had 14 public debt issues outstanding with a total face value of $3.4 billion.  When subsidiary debt was included, total debt outstanding was approximately $12.6 billion.  Beneath the parent firm, both the local cable subsidiaries and the non-cable divisions relied heavily on bank debt and other forms of privately placed debt to finance their operations.  To arrange these loans, the subsidiaries would often use Adelphia Communication common stock as collateral. Total subsidiary debt totaled about $9.2 billion, of which nearly $6 billion was owed to banks or other institutions with the rest coming largely in takeovers of firms that themselves already had public debt outstanding (see Table 2). (In addition to these long term-liabilities, the firm had short-term liabilities of $1.6 billion and deferred tax-liabilities of $2.1 billion, bringing total reported liabilities to about $16.2 billion (Adelphia Communications 2000 Annual Report, SEC 10k Filing, March 2001)).  This leverage was significantly higher than that of other firms in the industry and as a result the firm spent twice the percentage of its revenue on debt service as its competitors. (Value Line).  

TABLE 2: Financial Leverage at 2000 fiscal year end

Source: SEC 10K, March 2001

The remainder of Adelphia’s financing was equity.  In addition to the small amount of preferred stock, Adelphia had 2 classes of common stock.  Class A shares were publicly traded on the Nasdaq.  These shares had one vote each.  Class B shares carried 10 votes each and were held entirely by the Rigases, which allowed the family to control 60% of the votes. (Adelphia 2001 Annual Report)

The high degree of financial leverage, on top of a high degree of operating leverage, worried some, including John Rigas himself, who, long before the firm reached its peak, is reported to have said, “I’m either going to become a millionaire or I’m going bankrupt.”  (Leonard, 2002)  The leverage, coupled with operational success, propelled the stock to a ten-fold increase during the second half of the 1990s.  However, after years of nearly uncontrolled growth, the cable industry was then hit hard simultaneously by the technology slowdown, a slowing economy, increased competition, and over-capacity problems.  From a high closing price of over $84 in May of 1999, Adelphia’s stock fell faster than the industry as a whole and by early 2001 was trading at a discount compared to other cable companies.  To show support for the firm and to signal their faith in the stock, the Rigases regularly purchased more company stock as the price fell. 

The financial statements of the company reported that the Rigases were paid in line with other executives in the industry.  For instance table 3 shows that John was paid significantly less than his counterparts at other firms.  The other Rigas members were paid less than John.  Their reported incomes are shown in table 4.  Unbeknownst to investors, the family was being paid many times their official compensation.  For instance, in early 2001 Tim Rigas “notified Michael Mulcahey, Adelphia’s finance executive in charge of the company’s cash, that he must approve any further requests by his father beyond a $1 million-dollar-a-month limit. Over the next year, $12 million--paid in increments of about $1 million a month—was wired from Adelphia to John Rigas’ personal account at Bank of New York.”  (Hofmeister and Hamilton, 2002) 

TABLE 3: Executive Earnings in the Cable Industry from Adage.com

Total compensation adds the columns of salary, bonus, and "other"; "other" includes the following columns in the annual proxy-other annual compensation, long-term incentive plan payouts, realized gains from the sale of stock options, and "all other" compensation.   http://www.adage.com/page.cms?pageId=672

TABLE 4: Adelphia Executive Compensation

Source: Adelphia 10-k, 2 Apr 2001    

THE ANALYST MEETING

After essentially treading water for the first part of 2001, the second half of 2001 and early 2002 had been a bad period for Adelphia investors.  Adelphia’s stock had fallen from $47 in August 2001 to about $22 on March 27, 2002 when Adelphia released their 2001 financial statements.  At the firm’s earnings conference call for analysts and investors, Tim Rigas appeared upbeat and positive as he went over the financials and stressed the growth in the Internet cable business.  It was said that the recent bankruptcy of Adelphia Business Solutions was not expected to have a significant impact on the parent firm. (Sullivan, 2002)

As the briefing was seemingly winding down, Oren Cohen, a Merrill Lynch bond analyst, raised questions as to how the Rigases could afford so much stock.  Specifically he wanted clarification about a footnote to the financial statements that stated that the firm was also potentially liable for certain borrowings of the Rigas family.  In years past, such a question might have been brushed aside, but because the recent collapse of Enron had been sparked by similar off-balance sheet liabilities, the importance of this question almost immediately became apparent to all.  What had been a fairly light-hearted meeting turned deadly serious as Tim Rigas could come up with no good answer.  As the meeting broke up, the stock quickly fell more than $6 per share to below $16.00 before rebounding slightly to close the day at $16.70 on over 21 times its average volume. (Sullivan, 2002)

In the past, Adelphia was famous for its ability to ignore analyst questions.  While the family hoped that outside board members would close ranks and the mess would blow over, this time it was not meant to be.  There was now blood in the water and once it became apparent that things were not as the financial statements had suggested, analysts, reporters, investors, and regulatory officials turned their attention to the firm, looking for the next Enron.  Although little happened publicly for a few days due to the Easter holiday, on April 1 (the Monday after Easter), the company announced that it would not complete the filing of its financial statements as had been planned and that it would have to restate its previously released numbers.

THE COLLAPSE

Investigations soon revealed that Adelphia’s accounting system was a nightmare.  In addition to overstating the number of subscribers and earnings, the accounting system exhibited an almost complete lack of internal controls: “Revenues from Adelphia subsidiaries and the scores of businesses owned by the Rigas family were dumped into one central account.  Bills were then paid out of the same account.” (Hofmeister and Hamilton, 2002)  This co-mingling allowed the smaller Rigas-owned firms to show large profits while the expenses were shared with the many Adelphia shareholders.  Moreover, the “Rigases doctored financial records and created sham transactions” including overstating the number of cable subscribers. (Hofmeister and Hamilton, 2002)

The investigations also showed that the firm was responsible for $2 to $3 billion of additional borrowing by the Rigases over and above what had been previously known.  This money had been used to buy Adelphia stock (which was now worth little), to purchase apartments in New York City that were used rent-free by the Rigas family, to purchase vacation homes, to pay for an extended African safari for members of the Rigas family, to pay a $700,000 country club membership, to buy three corporate jets, and even to finance the family’s large stake in the Buffalo Sabres.  The line of separation between corporate funds and family funds was simply non-existent. (Carusso 2002)

Moreover, the troubles went beyond the firm lending money to the family.  There was also a widespread pattern of self-dealing involving Adelphia and Rigas-controlled firms.  Some of the more egregious, even if not necessarily most expensive, of the problems dealt with these relationships.  For example, the Wall Street Journal reported that Adelphia bought its high-priced office furniture through Eleni Interiors, a small local supplier owned by the Rigases and run by John Rigas’s wife.  The self-dealing did not stop with office furniture; Adelphia also leased cars and even contracted for landscaping and snow plowing through Rigas-controlled firms. (Carusso 2002)

These findings, coupled with an almost complete lack of faith in the accounting numbers, led to only one conclusion: the firm was in deep financial trouble.  The stock fell into the single digits and outside investors called for more representation on the Board of Directors.  The Rigases balked at giving up control and, because the family controlled the majority of the voting rights, minority shareholders could not force the issue.  Minority investors and outside board members insisted that the Rigases give up control, threatening to take everything to the press if the Rigases refused.  To the Rigases, this was unacceptable, as it would surely drive the stock price down still further and permanently tarnish the family’s reputation. (Bergstrom a)

On May 15, after long negotiations, John Rigas stepped down as CEO in return for a severance package of $1.4 million a year for next three years.  He was replaced by Erland Kailborne, who was named interim CEO.  John Rigas’ resignation was the signal for his sons to leave as well.  By May 23, the three brothers, as well as James Brown, the long-time VP of finance, all had resigned their positions at Adelphia and given up their seats on the firm’s board of directors.  (Wilkerson 2002)  The only family member who remained on the board was John’s son-in-law, Peter Venetis, who refused to step down even after the rest of the board passed a resolution calling for his resignation.  On May 24, in an effort to show that the problem was solved with the departure of the Rigases, the firm released further details concerning the extent to which the family had used corporate money as its own. (Adelphia Press Release.)

However, these actions did not completely end Adelphia’s difficulties.  The Nasdaq requires that all listed firms file audited financial statements within 4 months of their corporate year-end.  Adelphia still had not done this for 2001, and the company had now run out of appeals.  On May 30, the Nasdaq Listing Qualifications Panel decided that, due to the lack of audited financial statements, as well as all of the other problems at the firm, Adelphia would no longer be allowed to trade on the Nasdaq. This further reduced liquidity, which led investors to demand a higher liquidity premium and a lower stock price.  More importantly, the delisting started the 30-day clock on the mandatory payment of $1.4 billion to investors who had exercised put provisions on bonds and preferred stock of the firm. (Bergstrom C)

Complicating matters was the fact that the firm was running out of money.  If the firm used its remaining money to make interest payments, it would then need more money for operations.  Alternatively, if Adelphia’s remaining money was used for operations, the firm would have to either default on its loans or raise new money.  (And, raising new funds would likely be very difficult because the firm was by this time largely shut off from external financing as a result of its financial and accounting problems.) As a result of these “complications”, the firm placed many of its assets for sale, although few buyers were ready to pay the prices that the firm had hoped.

By this time, the possibility of bankruptcy was looking more and more likely.  If the firm did enter bankruptcy, existing creditors would have to wait for their money and in the end might not get full value back.  The firm’s best chance of avoiding bankruptcy was to convince its current lenders and investment bankers to lend the company the estimated $1.5 billion that was needed to prevent bankruptcy.  This might allow the lenders a better possibility of recouping their money.  Moreover, avoiding a bankruptcy filing might save the investment bankers who had sold shares and bond issues for Adelphia from having their reputations further tainted since they had not caught the problems earlier.  However, this hope for additional loans was tempered by the now-widespread distrust of the accounting numbers as well as the high probability of bankruptcy regardless of the cash infusion. (Wei 2002)

A bankruptcy would change the rules of the game. A Chapter 11 bankruptcy is designed to allow the firm and its creditors to negotiate a solution to the financial difficulties.  If the firm were to announce Chapter 11 bankruptcy, then the lenders would still be able to lend money to the firm while also receiving greater protection and priority in the event of liquidation.  This so-called Debtor in Possession (DIP) financing is typically made at a higher rate than loans made prior to the bankruptcy announcement and is secured by the firm’s assets.  While only about a third of firms that file Chapter 11 receive DIP financing, Adelphia was a likely candidate since the business model was sound and the firm had significant assets. (Dahiya, John, and Puri, 2002)

The new board began to assign blame.  On June 9, Deloitte and Touche was fired for not finding the accounting problems and bringing them to the attention of investors.  Deloitte and Touche did not go quietly.  The two parties engaged in public name-calling, motivated at least in part by Deloitte and Touche’s desire to shift blame back to Adelphia and the Rigases in hopes of avoiding the troubles that had put Enron’s auditor (Andersen) out of business.  (Bergstrom, Washington Post; Cooke, Dow Jones Newswires) On June 11, PriceWaterhouseCoopers was selected as the new auditor.  The new auditor’s first course of action was to attempt to get to the bottom of the mess – a step that would involve restating previous years’ financial statements. (Adelphia Press Release, 14 June 2002) 

On June 24, Adelphia filed for bankruptcy under Chapter 11 of the Bankruptcy Code.  Almost immediately it was announced that the firm had successfully negotiated $1.5 billion in DIP financing.  However, because the firm was now in bankruptcy, the money could not immediately be used.  The bankruptcy court had to approve any major expenditure.  This delayed the access to the cash, but in the end, the judge did approve a $500 million disbursement. (Bergstrom F)

To improve the corporate governance at the firm, a new board of directors was selected.  Initially after the Rigases resigned, Leonard Tow and Scott Schneider had been named to the board.  They each were from Citizen’s Communications (a firm that Adelphia had acquired).  After a dispute over asset sales designed to generate cash to help pay off debt, the two appointees resigned their positions.  To fill these positions the firm went outside and, with an emphasis on ethics, selected cable industry veteran and investor Rod Cornealius and Yale Law School Dean Anthony Kronman.

The bankruptcy and cash infusion ensured that the firm would be able to continue operations.  Meanwhile, the spring and summer of 2002 were marked with several more high-profile corporate fraud cases.  Partially as a result of these cases, the Dow Jones Industrial Average had fallen to a 4-year low.  Investors demanded action and politicians were happy to oblige.  Congressional investigations were held, President Bush promised that the SEC would crack down on white-collar crime, and a new Department of Justice corporate fraud task force was created.   Adelphia provided the perfect first case for the task force. (Hofmeister and Hamilton, 2002)

Early on Thursday July 24, police arrested John Rigas at his Manhattan apartment.  Within minutes, the scene was repeated in other parts of the city as both Timothy and Michael Rigas were also arrested.  In each case the accused was handcuffed and led, in front of cameras, to waiting police cars.   Later that morning, similar events played out in Coudersport, where James Brown, the former VP of Finance, and Michael Mulcahey, the former director of internal reporting and treasury functions, were also arrested. (Sager, 2002)

CONCLUSION

Adelphia provides an unfortunate example of what can happen when high leverage is mixed with an inadequate system of corporate governance.  That Adelphia’s problems were allowed to continue to grow until they eventually forced the firm into bankruptcy is the result of outright fraud, managerial self-dealing, and the lack of transparent financial statements.  The fact that the firm’s minority shareholders and stakeholders lost substantial amounts is the unfortunate result of a larger pattern of managerial self serving that was enabled by poor corporate controls.

TABLE 5: Adelphia Timeline