March 16, 2005
VIA TELECOPIER AND ELECTRONIC TRANSMISSION
Larry M. Spirgel
Assistant Director
United States Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0303
Mail Stop 0407
RE: NET2PHONE, INC.
FORM 10-K FOR THE FISCAL YEAR ENDED JULY 31, 2004
FILED OCTOBER 14, 2004
FORM 10-Q FOR THE QUARTER ENDED OCTOBER 31, 2004
FILE NO. 0-26763
Dear Mr. Spirgel:
We are responding to one of the two remaining open issues from your
letter dated December 15, 2004 (the "Comment Letter") and our letter to you in
response dated January 14, 2005 (the "Response Letter") and additional follow-up
telephone calls, relating to the filings referenced above (the "Filings"). For
your convenience, we have repeated the Staff's comments below prior to our
responses.
FORM 10-K FOR THE FISCAL YEAR ENDED JULY 31, 2004
NOTE 14 - RELATED PARTY TRANSACTIONS
7. Please address the following items regarding your memorandum of
understanding with IDT:
o Tell us your basis in the accounting literature for applying variable
accounting treatment to the shares that will be held in escrow to be
released to IDT in equal annual installments.
This portion of comment #7 was addressed and resolved through the Response
Letter.
o We note that you have recorded a charge of $3.4 million during fiscal
2004, which represents the market value of the 1.0 million shares that you
may issue and subsequently release from escrow to IDT for services and
benefits provided by IDT during fiscal 2004. Clarify for us how you will
compensate IDT for these services and benefits if a definitive agreement
is not reached and the shares are not issued.
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As we stated in the Response Letter, if we do not reach a definitive
agreement with IDT and the shares are not issued, we will enter into
negotiations with IDT to compensate them for services and benefits received to
that date. We have not had any discussions with IDT in this regard, but we
expect the process would include a review of services and benefits provided to
that date, an assessment of the market value of these services and a discussion
of the appropriate form of compensation for these services, if any. The boards
of directors of both Net2Phone and IDT each have established a committee of
independent directors that have the responsibility of reviewing and approving
such intercompany transactions.
To date we have not discussed with IDT the possibility of changing the type
or amount of consideration to be paid pursuant to the Memorandum of
Understanding ("MOU") as we contemplate reaching definitive agreement(s) that
are consistent with the terms of the MOU. Although the MOU contemplates entering
into additional agreements to further describe the services to be provided and
the terms of the release of the shares, it is a binding agreement which was
filed as an exhibit to our Annual Report on Form 10-K for the period ended July
31, 2003, and the consideration is not subject to additional negotiation. In
future filings with the Commission, we will disclose that we followed the
guidance in EITF 96-18, Accounting for Equity Instruments That are Issued to
Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or
Services, in determining to apply variable accounting treatment to the shares
that will be held in escrow under the definitive agreements until they are
released to IDT. While we have no expectation of changing the type or amount of
consideration to be paid to IDT under the MOU, if we do, EITF 96-18 may no
longer apply, which would cause us to apply different accounting rules to this
transaction, which could adversely affect our financial results.
Per your request, we will expand our disclosure in future filings with the
Commission to provide information about the status of our efforts to negotiate
definitive agreements as contemplated by the MOU. Our disclosure will state that
while the MOU identifies the scope of services to be provided and the
consideration and methodology for paying for such services, we cannot finalize
the definitive agreements until our business units and technical teams develop
the details of the services to be provided by IDT. For example, the services to
be provided must be accompanied by service level quality assurances and response
times, escalation procedures, and other items which are, in many respects,
dependent upon first identifying and assessing the needs of our cable operator
customers. These customers must first determine what they believe they will need
in order to offer a voice service to their subscribers, which they typically
have not done before - so there is a learning curve at many levels. Once the
cable operator has defined its needs, we determine the best resources for us to
meet those needs, which may or may not include some or all of the services IDT
is required to make available to us pursuant to the MOU. Net2Phone is, we
believe, unique to the cable telephony market in that we offer more customized
opportunities to integrate into a cable operator's systems based upon their
requirements, however, this does contribute to the complexity of finalizing the
definitive agreements with IDT. From the time we signed the MOU to the present,
we have added a number of new cable operator customers, each of which has
provided us with a better understanding of what our cable operator customers
require, and thus we are in a better position to define the precise requirements
of our service providers, including IDT, which we will rely on to support our
service offerings.
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We maintain a close working relationship with IDT, and we do business with
them on a variety of levels. The fact that we have not completed definitive
agreements has not stopped us from working together pursuant to the terms of the
MOU, and for IDT to support our cable telephony service offerings while we
negotiate definitive agreements.
Based on the factors outlined above, we are not in a position to estimate
when definitive agreements will be completed. We will continue to provide
updates on the progress of negotiations in future filings with the Commission.
We will also disclose in future filings the cumulative amount of equity on our
Balance Sheet related to this agreement.
o Tell us how you applied the guidance of SFAS 128 in determining that it
was appropriate to include the 1.0 million shares for purposes of
computing basic earnings per share.
This portion of comment #7 was addressed and resolved through our Response
Letter.
o Describe for us why you believe that differentiating between direct cost
of revenue and selling, general and administrative expenses for the
service provided by IDT is not practicable. Describe in more detail the
nature of the services and why these services do not have readily
identifiable market values. In addition, tell us how you determined the
number of shares to be issued in exchange for the services.
We are providing further details and clarifying some issues that were not
provided in our January 14, 2005 response to this comment.
The binding MOU currently in place, and ultimately the definitive agreement
that is contemplated by the MOU, covers a broad spectrum of services that are
either being provided currently or are to be provided in the future, through
October 28, 2008, by IDT to the Company.
As noted in our Response Letter, an independent committee of our Board of
Directors, after discussions with management and an independent financial
consulting firm, approved the valuation of the services to be provided by IDT to
us. The valuation included a range of values for each of the services based upon
a range of assumptions established by management and the independent
consultants, including projected volumes of services to be provided to us as
reflected in our 5-year business model for our Net2Phone Cable Telephony
subsidiary and upon ranges of market prices for such services. The value of some
of the specific benefits provided by the relationship with IDT, such as
leveraging their status as a CLEC, were particularly driven by management's and
the consultant's judgment rather than statistical support.
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It is important to note that the terms of the MOU provide for us to
purchase services from IDT at IDT's cost plus 5%, which we record to our direct
cost of sales. The financial consultants and management provided a range of
values that we would derive from this favorable pricing. We do not attempt to
attribute a portion of our share issuance commitment (as reflected in "non-cash
services provided by IDT") to direct cost of sales to reflect the value of this
favorable pricing. We believe it would be misleading to do so because the
relative value of the favorable pricing aspect of the MOU to the overall value
of the MOU to us was based on a series of ranges, factors and assumptions that
have changed, and will continue to change, over time. Furthermore, attempting to
update the value of this favorable pricing each quarter based on spot prices for
services in each of the deployed markets being serviced through IDT and based
upon the actual, rather than originally projected, volumes purchased of those
services would add significant time and expense to our quarterly closing
process, as well as make the process much more difficult.
The overall value of all services and benefits derived from the IDT MOU was
calculated at the point in time the MOU was finalized. Reassessing the relative
value of the MOU between direct cost of sales and selling, general and
administrative expense based upon today's activities and market pricing would
likely be misleading because, given the inherent judgmental valuation of the
broad spectrum of services provided by IDT, it would be extremely difficult if
not impossible to accurately calculate.
**********
We hope that the foregoing has been responsive to the Staff's
additional comments and questions. Any questions or comments regarding this
letter or the Filings should be directed either to the undersigned at (973)
438-3450 or Glenn J. Williams, Executive Vice President, Business & Legal
Affairs and General Counsel, at (973) 438-3066.
Sincerely,
/s/ Arthur Dubroff
Arthur Dubroff
Chief Financial Officer
Net2Phone, Inc.
cc: Glenn J. Williams, Esq., Net2Phone, Inc.
Marc S. Dieli, Ernst & Young LLP
Robert M. Hayward, Esq., Kirkland & Ellis LLP
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