Before the UNITED STATES COPYRIGHT ROYALTY JUDGES Washington, D.C. ) In the Matter of ) ) DETERMINATION OF RATES AND TERMS ) Docket No. 2011-1 FORPRKKXISTINGSUBSCRIPTIONAND ) CRBPSS/Satellite H SATELLITE DIGITAL AUDIO RADIO ) SERVICES ) ) WKKTKN 9~CT STATEMENT OF SIRIUS XM RAMO INC. VOLUME 3 of 7 Witness Testimony and Exhibits for David L Frear and Ronald H. Gertz R. Bruce Rich (N.Y. Bar No. 1304534) Bruce Meyer (N.Y. Bar No. 2108447) Miranda Schiller (N.Y. Bar No. 2295624) Todd Larson (N.Y. Bar No. 4358438) WEIL, GOTSHAL 8r. MANGES LLP 767 Fifth Avenue New York, NY 10153 tel: (212) 310-8170 fax: (212) 310-8007 bruce.rich@weiL corn [email protected] miranda.schiller@weiL corn [email protected] Counselfor Sirius 2%Radio Inc. November 29, 2011 Written birectTestimony ef David Frear PUBLIC VERSION Before the UNITED STATES COPYRIGHT ROYALTY JUDGES Washington, D.C. ) ) ) DETERMINATION OF RATES AND TERMS ) Docket No. 2011-1 FOR PREKXISTING SUBSCRIPTION AND ) CRB PSSlSatellite II SATELLITE DIGITAL AUDIO RADIO ) SERVICES ) WRITTEN DIRECT TESTIMONY OF DAVID J. FREAR {On behalf of Sirius XM Radio Inc.) Introduction and Witness Back round 1. My name is David J, Frear. I am Executive Vice President and Chief Financial Officer of Sirius XM Radio Inc. ("Sirius XM" or the "Company*'). Prior to the merger of Sirius Satellite Radio Inc. {"Sirius") and XM Satellite Radio Holdings, Inc. {"XM"), I served as Executive Vice President and ChiefFinancial Officer of Sirius. I hold a Master of Business Administration degree from University ofMichigan Graduate School ofBusiness Adimnistration as well as a Bachelor ofArts degree from University ofMichigan. 2. I testified on behalf of Sirius in the predecessor proceeding before the Copyright Royalty Board {"CRB") to set rates for the 2007-2012 period ("Satellite I'). 3. My prior testimony covered, among other topics, the risks ofthe satellite radio business, the start-up and ongoing costs incurred by Sirius in running its business, as well as how Sirius generates revenues. Sirius XM has designated that testimony for inclusion in this proceeding. 4. My present testimony is organized as follows: I begin with a discussion of the financial health of Sirius XM, updating the record since the time of the last proceeding, summarizing key financial events that have transpired during the current license term, and addressing the more salient risks the Company is currently facing. I next discuss the negative impact that an increase in the sound recording royalty rate beyond that applicable for 2012 would have on the Company. Finally, I discuss our recent efforts to procure licenses in direct dealings with individual record labels that would encompass the rights for which rates are to be set in this proceeding. We have experienced considerable success with this license initiative to date, despite the overt interference with those direct-licensing efforts by SoundExchange and other record industry trade groups, which would strongly have preferred avoiding the implications for rate-setting here ofthe rates established in those licenses. The Financial State of Sirius XM A. The Merger of Sirius and XM 5. On February 19, 2007 Sirius and XM announced their intent to merge. Shortly thereafter, in March 2007, the two companies filed a "Consolidated Application for Authority to Transfer Control" with the Federal Communications Conmiission ("FCC"). In June 2007, the FCC's Mass Media Bureau gave public notice that it had accepted the application for filing, started its informal six-month merger review clock, and set a deadline for comments or petitions for July 2007. At around the same time, in April 2007, the U.S. Department of Justice (DOJ) announced it would conduct an investigation of the merger as well. 6. Sirius'hareholders approved the transaction in November 2007, but it was not until March 2008 that the DOJ announced it had closed its investigation ofthe merger, citing no harm to consumers or competition. As part of its ultimate findings, the DOJ concluded that the evidence did not establish that any reduction in competition would result from the merger; according to the DOJ, the relevant market in which Sirius and XM competed was broader than just satellite radio, and included terrestrial radio, Internet music services, iPods, and various other audio options. 7. The FCC approved the merger on July 25, 2008. The companies officially merged on July 29, 2008. As a result ofthe merger, XM shareholders received 4.6 shares of Sirius common stock for each share ofXM stock they held. B. Sirius XM's Near Bankruptcy Experience 8. The challenging conditions that had plagued the separately-owned entities continued in the immediate aftermath ofthe merger — a time when many companies struggled to stay afloat in the midst ofthe credit crisis. By late 2008, Sirius XM had insufficient cash to repay the remaining outstanding balance due on the $300 million of 2/2% Convertible Notes that were set to come due on February 17, 2009 (the "Notes") and an inability to access the capital markets to refinance this (and other) debt. In an effort to avoid bankruptcy, the Company retained Evercore Capital ("Evercore'") in November 2008 to raise capital to refinance the Notes. Evercore solicited 21 prospective investors, spanning the range of likely private equity, debt investor, and corporate sources. None was willing to provide the necessary Qnancing to the Company. 9. Among the stated reasons that potential investors declined to invest in the Company during this period of crisis were: The Company and its predecessors had sustained nearly 20 years of losses and did not have positive EBIDTA margins; Sirius XM's business is highly risky; Sirius XM faces a risk of. declining market share due to new competition and technology; The business is too dependent on the cyclical automotive industry and GM and Chrysler were themselves on the precipice of bankruptcy; Institutional investors were faced with large cash redemptions at the time; and The Company was not a good fit for traditional investors. 10. These are the same Notes that SoundExchange, through its expert witness Sean Butson, opined in Sate11ite I could be refinanced. Indeed, Mr. Butson. "consen~arively assumed that all maturing SDARs bonds will be refinanced at 10%, which is above the coupon rate ofthe bonds." Rebuttal Testimony of Sean Butson, CFA, at 17 ("Butson Rebuttal") (emphasis added). No one, myselfincluded, anticipated at the time of the last proceeding that the Company would be unable to refinance the Notes at all. 11. Two weeks prior to the maturity ofthe Notes, Sirius XM expected to sign an agreement with a large group ofnoteholders to extend the maturity ofthe Notes, On the day of the scheduled signing, the largest holders informed the Company that they had sold their Notes to a third party, whom they declined to identify. We immediately initiated a call to a party that we suspected, based on industry rumor, had purchased the large block ofNotes. With only days remaining until the February 17, 2009 maturity date of the Notes, and with no viable sources of financing, we engaged in discussions RESTRICTED — Subject to Protective Order in Docket No. 2011-1 CRB PSS/Satellite II 12, With financing options running out, Sirius XM hired the consulting firm Alvarez k, Marsal, which spent eight weeks preparing the Company to file a Chapter 11 petition on the date that the Notes were to come due. Filing for Chapter 11 bankruptcy protection was averted only when, after briefbut intense negotiations, Liberty Media Corporation ("Liberty"), a potential lender we had only recently been introduced to, agreed to provide a $380 million loan (in two phases) in a series of transactions that enabled the Company to avert a bankruptcy and a default on its debt. 13. The terms of the Liberty deal, while acceptable to Sirius XM given the circumstances, were onerous: Liberty demanded and received an extraordinary 15% interest rate on its loans; a $30 million "restructuring" fee that further increased the cost ofthe loans; preferred stock equal to 40% ofthe Company's equity on a converted basis; liens on substantially all of the Company's assets; and the right to nominate directors to the Company's Board of Directors proportional to its equity interest in the Company, 14. The Liberty funds were used to pay all the principal and interest on the Notes that came due on February 17, 2009, as well as for general corporate purposes. Also in early 2009, we extended two bank credit agreements totaling $350 million. The terms of the extensions were also onerous, requiring the Company to pay a 2% restructuring fee to existing lenders and for Liberty to take a $ 100 milHon participation in the credit agreement. 15. To repay the Liberty loans and the extended bank agreement, Sirius XM issued new notes, which were non-investment grade "junk" bonds, This debt consists of $526 million of 11.25% Senior Secured Notes due in 2013, which we issued in June 2009, and $257 million of 9.75% Senior Secured Notes due in 2015, which we issued in August 2009. 16, The Sirius XM stock price reflects this tumultuous financial history and near bankruptcy experience. The stock fell &om over $4 in January 2007 down to $.055 per share on Feb. 11, 2009, a time when bankruptcy seemed inevitable. On September 15, 2009, we received a delisting notice from NASDAQ because our common stock had closed below $ 1.00 per share for 30 consecutive days and was therefore not in compliance with the NASDAQ Marketplace Rules.'he stock price still has not recovered or even approached its historic highs, The share price remains substantially below January 2007 levels — currently trading at approximately $ 1.75 per share — and in 's the Company was unable to cure this noncompliance in the allowed time, NASDAQ set a hearing to determine ifthe Company should be de-listed or given an extension of time to comply with marketplace rules.