Tips on how to avoid getting blind-sided in EBS lease negotiations

Yes, attendance at the NESBA, 4G World and WCAI events may have been a bit sparse, and the merger of Sprint and Clearwire’s 2.6 GHz spectrum properties might seem a harbinger of inactivity in the Educational Broadband Service (EBS), particularly for those with EBS capacity to lease. But don’t be fooled.

Why worry about leasing just now? A couple of reasons. If you have EBS capacity that you already leased more than four years ago, there’s a good chance that the lease will end in the next five years – and (as discussed below), it’s never too early to scope out the options that will be available when your existing deal expires. And if you have EBS capacity that is not currently leased, don’t be surprised if you get approached in the near term about entering into a lease deal – in which case, again, it would be good to know what your options are. So if you have EBS capacity – whether it’s leased or not leased – you should consider the factors described below. From my experience, forethought and preparation relative to these items can result in serious benefits, and avoid serious mistakes.

The Expiration Date. If you’ve got an existing lease, do you know when it expires? If not, that’s a big mistake. Knowing that important date should help you both to protect your valuable license and to obtain a new lease on terms favorable to your organization. Figuring out exactly what your expiration date is may not be as easy as it sounds. Before the FCC imposed the secondary market rules on EBS spectrum in 2005, standard operating procedure was to set a lease’s expiration for a date a specific number of years from the date of commercial launch of the system or the construction of your station (a single station? Yes, those were the days, if you can remember back that far). It may not be as easy now, several years down the line, to calculate exactly when the triggering event happened. If your lease has such a provision, it would be a good idea to tie down the relevant date NOW, to help you avoid any unnecessary time-crunch as the expiration nears. Remember – the expiration of a lease can provide you with important opportunities, but you may need time, possibly a significant chunk of time, to assess those opportunities and take maximum advantage. If you don’t know when your lease expires, you could be putting yourself at a considerable disadvantage when Expiration Time rolls around.

And if you’re a public institution, don’t forget that you may be required by law or internal policy to seek lessees through a formal RFP process. That means that, before you would be able to enter into a replacement lease, you would have to jump through the RFP hoops, which can be a lengthy process. If you wait too long (because, for example, you don’t know when your current lease expires), you could find yourself with no lease at all for a period of time between (a) expiration of your current lease and (b) successful conclusion of the RFP process. Oh, and don’t forget that, during that interim period, you would be receiving no lease revenue at all.

The Right-of-First Refusal. And what about that right of first refusal (ROFR) provision? Does your lease have one? (I’m guessing that as many as 80% of the leases that will expire in the next, say, five years contain ROFRs.) An ROFR generally gives the guy who’s leasing your capacity the ability to sit back and, if you decide you want to try to find a new lessee, to match whatever deal you might make with a new lessee. An ROFR is within the class of what we lawyers call “preemptive rights.” In other words, you do all the work and the existing lessee takes advantage of it. (By the way, put yourself in the position of a possible replacement lessee – how excited would you be knowing that whatever deal you try to cut would have to be made available for the existing lessee to pick up on? The term “fool’s errand” springs to mind.) Obviously, it is important to review the lease to see if it contains an ROFR and, if it does, it is equally important to know exactly what your particular ROFR requires. ROFR provisions vary considerably, so it’s not useful here to try to address any specific ROFR terms.

Battle of the Forms. If you do end up with a new lessee, an important question that you will face is “who is going to take the first crack at drafting the lease agreement?” Usually, but not invariably, the practice is to start the negotiations with the proposed lessee’s form. Note that, if you use an RFP process, you (as the prospective lessor) could prepare your own initial draft lease and include it in the RFP with instructions for the bidder to review it and change it as the bidder desires. Anyone NOT using a RFP process should consider starting the negotiation process by agreeing on a term sheet before reviewing a draft of a proposed agreement. Negotiating by draft is time-consuming, inefficient and provides the party whose contract is used with a significant negotiating advantage.

De facto Transfer Lease v. Spectrum Manager Lease. In the past, EBS leasing was relatively unfettered by FCC requirements: the Commission focused mainly on (a) the duration of the lease, (b) whether the lessor was given the right to buy or lease the transmission equipment at the end of the lease, and (c) making sure that the lessor reserved spectrum for its own educational use. Those concerns persist in today’s regulatory environment (although no one has ever been able to explain how the equipment purchase or lease right is anything but a detriment to both parties).

But since 2005, a host of new requirements have been added as a result of the FCC’s “Secondary Markets” rulemakings. Now what is a “Secondary Market?” It’s no more than garden variety spectrum leasing dressed up in sophisticated-sounding FCC-speak. The FCC’s “Secondary Market” rules provide for two types of spectrum leases. One type is a lease in which the licensee remains in actual control of the deployment of the leased spectrum. This type of lease is called a “spectrum manager” lease. Don’t worry about this type of lease, because the chances that your lease might fit within this category are slim and none, and slim just left town. The second type of lease is referred to by the FCC in even fancier FCC lingo: the “De facto Transfer” lease. This type of lease involves the transfer of actual day-to-day control of the leased spectrum to the lessee. The lessee is free to seek certain modifications of the license and is held responsible for any violations of FCC regulations which the lessee commits.

Back in the day (i.e., before broadband), the FCC required its licensees to retain control over the use of their licensed spectrum. If a licensee abdicated control (explicitly or otherwise) to a third party without FCC consent, that was viewed by the FCC as a mortal sin. Despite this FCC policy, the FCC turned a blind eye to EBS (then called ITFS) leasing, as well as the leasing of the commercial counterpart channels (i.e., the BRS – then called MDS or MMDS – channels). EBS/BRS leases tended, in practical effect, to amount to the total surrender of control to the lessee, even though the leases usually contained provisions ostensibly reserving control to the licensee. The post-2005 “De facto Transfer” lease regulations impliedly acknowledge this practice and require the parties to go to the FCC to get consent to their proposed leasing relationship, thus avoiding an unauthorized transfer of control.

What about any old leases that are still in existence? Any of these types of leases executed before the new leasing rules went into effect are now acceptable. But any new leases or lease renewals will have to follow the “De facto Transfer” lease format and rules.

The Dangers of the De facto Transfer Lease. While “De facto Transfer” leases can satisfy the FCC’s control requirements, that does not necessarily guarantee that the EBS licensee can sleep comfortably thinking that it has no regulatory risk. The licensee is still expected to make sure that: (a) EBS channels meet the “substantial service” requirement by May 1, 2011 (the Doomsday scenario, under which you can expect to lose the license if none of the licensed channels is being used to offer a real service); (b) applications for license renewal are filed on time; (c) the licensee retains its eligibility to be an EBS licensee; and (d) the licensee doesn’t lose the license or have to pay fines due to the rule violations of the lessee. Risks (a) and (d) are big issues and need to be addressed effectively in the lease. Risks (a) and (d) often involve tricky questions of contract enforceability and questions of truly effective remedies (Sample situation: your lessee goes into bankruptcy and is not required to build the system required to meet the “substantial service” requirement – what would you do?).

Lease Term and ROFRs. You can sign an EBS lease having a 30-year duration. Is that really what you want? The lessee may very well ask for an ROFR. Have you considered whether you (or, more likely, your successor) are prepared to suffer the pain of an ROFR?

The Educational Use Requirement. Often overlooked in the EBS leasing process is the fact that the FCC still requires that the EBS licensee itself use each channel at least 20 hours a week for its original purposes (i.e., educational and/or related purposes). Along the same lines, the Commission also still requires that the EBS licensee retain the right to recapture an additional 20 hours per week per channel, and requires the EBS licensee to reserve no less than 5% of the capacity to itself. There are, of course, conventional ways of dealing with these requirements (e.g., through channel loading), and the lessee can also help the EBS licensee with compliance. Still, these requirements are anything but straight forward and need to be carefully considered in the lease, from the standpoints of both regulatory compliance and determining how you can best use your reserved capacity to meet real needs of your institution in a flexible and cost-effective manner. Once again, serious planning is in order.

Lease Fees. How much is EBS capacity worth? You could guess, but that’s not really a prudent business approach. The better way is to let an expert help negotiate the lease fees. Experts know the market rates (which are not easily determined in this environment) and how to translate those rates into lease fees (which is a highly nuanced exercise). And be careful about getting too fancy in calculating lease fees. Lessees like predictable lease fees. For example, do not expect a tentative lessee to take kindly to a variable lease fee based upon the lessee’s revenue (e.g., a percentage of gross revenue) or other performance measure (e.g., a per-subscriber fee). These types of fees can be hard to measure and hard to price in a start-up industry. Many leases go beyond the payment of periodic lease fees and require compensation to the licensee in the form of goods and services. But extravagant alternative compensation arrangements can have unfortunate consequences: for example, lessees cannot afford to have personnel tied up in administering various contract details. The universe of possible compensation arrangements is a broad one, probably deserving of its own separate blog.

Planning. You may not need your EBS capacity now, but you may need at least a part of it in the future. It is important to consider this opportunity cost and provide for the retention of spectral capacity if you see a present or future need for it. But keep in mind that retention of spectrum means sacrificing lease fees.

The bottom line here is that EBS leasing is a complex undertaking best left to the experts. I and my colleagues at Fletcher Heald have considerable experience in this area, and may be able to assist.