This is the second of two entries on dark fiber arrangements (read part one here).  Dark fiber is a realistic option for high-bandwidth requirements of businesses, medical and educational institutions, and state and local governments (collectively “enterprises”).  This entry focuses on the two principal types of dark fiber arrangements: indefeasible rights of use (“IRUs”) and leases.  The IRU agreement is different from a telecommunications services agreement, but the dark fiber lease resembles a services agreement.

Under an IRU or a lease, the customer is obtaining a “facility,” not a service such as broadband or VoIP.  The term of an IRU often tracks the useful life of the fiber—at least 20 years.  A dark fiber lease extends up to 5 years, often with renewal options.  Under generally accepted accounting principles, an IRU is typically treated as an asset and a dark fiber lease is treated as an expense.  In addition to different accounting treatment, state property and transactional tax implications may be different.

Indefeasible Rights of Use

Pricing.  IRU customers (“grantees”) typically make two payments to IRU network operators:  the one-time charge for access to and use of the fibers for the duration of the IRU and an annual maintenance charge.  The latter covers “routine” maintenance that is typically scheduled during off-hours and emergency restoration of a fiber cut or other damage to the dark fiber cable or strands. The IRU fee is often paid in two installments:  50% at contract signing and 50% upon acceptance.  The “cost per fiber per mile” is the principal metric for comparing IRU pricing.

In major metro areas, dark fiber network operators (that may also offer telecommunications services) extend their network to customer locations.  This network extension is typically expressed as an agreed-upon, one-time charge that includes the splicing of customer’s fibers at agreed upon demarcation points.

Outside of major metro markets, the network operator may construct all or a portion of a fiber route for a customer (retail services provider, another dark fiber network operator or a technology company).  Network design and construction costs typically are built into the IRU fee.  A newly constructed fiber route invariably includes more fiber strands than a given customer requires.  Network operators often view the initial IRU customer as its “anchor tenant” from which it looks to recover most of the construction costs for a given fiber route.  The total fiber count for a route is a major decision for a network operator; however, other costs of dark fiber network construction (see initial entry) typically exceed significantly the incremental cost of additional fibers along a route.

Business Risks in IRUs.  Customers bear three principal risks in IRU agreements: the fiber network operator’s bankruptcy; loss of underlying rights; and fiber cuts.  The network operator’s bankruptcy poses the most significant risk.  This is due to the term of IRU agreements being 20+ years, the IRU fee typically being paid in full during the initial year, and the relative modest capitalization of dark fiber network providers (as compared to the major telecom and cable service providers).

Network Operator’s Bankruptcy.  In the event of bankruptcy, the debtor-in-possession or its assignee is incented to reject IRU agreements as executory contracts, as the resale or lease of viable assets (dark fibers) will provide current revenue (as the entirety of the IRU fee typically has been paid to the bankrupt entity).  Thus, a primary objective of the grantee is to draft an agreement to minimize the risk of rejection in bankruptcy.

A leading case that provides guidance for IRU grantees looking to minimize bankruptcy risk is WorldCom, Inv. and MCI WorldCom Network Services Inc. v. PPL Prism, LLC (In re WorldCom Inc.,), 343 B.R. 430 (Bankr. S.D.N.Y, 2006), describing provisions in the IRU agreement supporting its holding that the IRU grantee possessed a property right that ran with the fibers, but not ruling whether the IRU agreement was an executory agreement.

The bankruptcy court observed, among other factors, that the agreement provided the grantee the exclusive right to use and access the designated fibers and an equitable and beneficial interest in the fibers; and characterized the IRU arrangement as a sale and purchase of a defined number of fibers along a specified route.  Payment of the IRU fee and performance of the grantee’s other obligations under the IRU Agreement, principally acceptance of the fibers after the provider’s installation, supported the position of the IRU grantee.

Underlying Rights.  The next most significant risk is the IRU network provider’s loss of its underlying rights:  the easements, rights-of-way, leases, etc. that grant the network provider access to real property to occupy, construct and extend its fiber network (underground or aboveground or both) over or under real property.  The agreement typically includes a representation/statement that the network operator possesses the underlying rights, including the right to access the constructed network for repairs, and the obligation to maintain these rights.

A related provision specifies the parties’ obligations in the event all or a portion of the underlying rights for a route are lost or a threat of loss arises due to an eminent domain action or a third private party condemnation action.  The objective is to provide as much notice as possible to the grantee and establish a process to accommodate the route relocation, keeping the agreement intact and providing an allocation of costs of the relocation.  Network operator-determined relocations are typically addressed, as well, with the network operator bearing all costs.

Fiber Cuts.  The third principal risk is loss of fiber continuity.  An IRU grantee makes a hefty payment so that it can transmit substantial volumes of data over specific routes for an extended period; a fiber cut will have a substantial adverse impact.  Thus, the network operator’s maintenance obligations are typically expressed as routine maintenance; efforts to address chronic/recurring issues in the glass fibers or splices; and responses to fiber cuts or damage which result in fiber discontinuities.  A service level agreement (SLA) for fiber cuts/loss of continuity is common, setting out each party’s emergency contact information, 24 x 7 x 365 network operator availability, response times for (i) repair crews to initiate repairs, (ii) completing emergency repairs to restore service, and (iii) developing of plans and a time line for permanent repairs.

In addition, there typically is an “acceptance” process to ensure the installed fiber, including all splices at customer demarcation points, meet the agreed upon technical metrics.  The grantee typically requests a warranty that the fibers will continue to meet these metrics and that the fiber optic cable remains in compliance with the manufacturer’s warranty.  These provisions address potential “chronic” issues with the grantee’s fibers.

Leases

The risk of network provider bankruptcy is noticeably less for leases, even though many network operators that offer IRUs also offer dark fiber leases.  The debtor-in-possession or its assignee typically wants to retain rather than reject dark fiber leases to maintain the monthly revenue stream.  A case in point is the WorldCom bankruptcy:  the debtor-in-possession /assignee did not reject the enterprise services agreements to maintain revenues and customer base.  Many of these customers largely stayed with the carrier throughout the bankruptcy process.

The underlying rights issue is less of a concern during a five-year lease.  The risk still needs to be addressed, through lease provisions requiring the network operator to promptly notify lessee of a pending risk of loss or loss of underlying rights; and providing the lessee the option to terminate the lease, subject to a reasonable transition period and damages, as may be negotiated.   The lessee should have the option to “stay in the lease,” but all route relocation costs should be borne by the services provider.

Lessees’ interests in fiber maintenance and fiber cuts are largely the same as those of IRU grantees.  Otherwise many, though not all, provisions in telecommunications services agreements are applicable to fiber leases.