** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION****Washington,D.C.  20549**

 

**FORM 10-Q**

**(Mark One)**

**ý****        ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

**For theQuarterly Period Ended September 30, 2005**

**or**

**o****         ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For the transition period                       to**

**Commission file number 0-20763**

**McLEODUSAINCORPORATED****(Exactname of registrant as specified in its charter)**

| **Delaware**              | **42-1407240**                     |
|---------------------------|------------------------------------|
| (State of  Incorporation) | (IRS Employer  Identification No.) |

 

| **McLeodUSA  Technology Park**           | ** **     |
|------------------------------------------|----------------|
| **6400 C  Street SW**                    | ** **     |
| **P.O.  Box 3177**                       | ** **     |
| **Cedar  Rapids, Iowa**                  | **52406-3177** |
| (Address of principal  executive office) | (Zip Code)     |

 

**319-364-0000**(Registrant’stelephone number,including area code)

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant was requiredto file such reports), and (2) has been subject to such filing requirements forthe past 90 days.   Yes ý  No o

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act). Yes ý  No o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yes o  No ý

Indicate by check markwhether the registrant has filed all documents and reports required to be filedby Section 12, 13 or 15(d) of the Securities Exchange Act of 1934subsequent to the distribution of securities under a plan confirmed by acourt.  Yes ý  No o

The number ofshares outstanding of each class of the issuer’s common stock as of October 31,2005:

 

| Common Stock Class A: ($0.01 par value)  |   | 201,946,344 shares |
|------------------------------------------|--------|--------------------|
| Common Stock Class B: ($0.01 par value)  |   | 78,203,135 shares  |
| Common Stock Class C:  ($0.01 par value) |   | 35,546,879  shares |

** **

 

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**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**INDEX**
|                              |                                                                                                                      |   |
|-----------------------------------|---------------------------------------------------------------------------------------------------------------------------|--------|
| **PART I. Financial Information** |                                                                                                                      |   |   |
| ** **                        |                                                                                                                      |   |   |
| Item 1.                           | Financial Statements                                                                                                      |   |   |
|                              |                                                                                                                      |   |   |
|                              | Unaudited Condensed  Consolidated Balance Sheets September 30, 2005 and December 31, 2004                                 |   |   |
|                              |                                                                                                                      |   |   |
|                              | Unaudited Condensed  Consolidated Statements of Operations — for the three months ended September  30, 2005 and 2004 |   |   |
|                              |                                                                                                                      |   |   |
|                              | Unaudited Condensed  Consolidated Statements of Operations — for the nine months ended September  30, 2005 and 2004  |   |   |
|                              |                                                                                                                      |   |   |
|                              | Unaudited Condensed  Consolidated Statements of Cash Flows — for the nine months ended September  30, 2005 and 2004  |   |   |
|                              |                                                                                                                      |   |   |
|                              | Notes to the  Condensed Consolidated Financial Statements                                                                 |   |   |
|                              |                                                                                                                      |   |   |
| Item 2.                           | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                               |   |   |
|                              |                                                                                                                      |   |   |
| Item 3.                           | Quantitative and Qualitative  Disclosures About Market Risk                                                               |   |   |
|                              |                                                                                                                      |   |   |
| Item 4.                           | Controls and Procedures                                                                                                   |   |   |
|                              |                                                                                                                      |   |   |
|                              |                                                                                                                      |   |   |   |
|                              |                                                                                                                      |   |   |   |
| **PART  II. Other Information**   |                                                                                                                      |   |   |
| ** **                        |                                                                                                                      |   |   |   |
| Item 1.                           | Legal Proceedings                                                                                                         |   |   |   |
|                              |                                                                                                                      |   |   |   |
| Item 6.                           | Exhibits                                                                                                                  |   |   |   |
|                              |                                                                                                                      |   |   |   |
| Signatures                        |                                                                                                                      |   |   |
|                                   |                                                                                                                           |        |  |  |  |

** **

 

2

----

 

**PART I —FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS**

**(Inmillions, except share data)**

** **
| ** **                                                                                                                                                                                                 | ** ** | **September 30,  2005** | ** ** | **December 31, 2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                 | ** ** | ** **              | ** ** | ** **                 | ** ** |
| Current assets                                                                                                                                                                                             |       |                    |       |                       |       |
| Cash and cash  equivalents                                                                                                                                                                                 |       | $                       | 17.1       |                       | $          | 50.0 |   |
| Restricted cash                                                                                                                                                                                            |       | 16.4                    |       | —                     |       |
| Trade  receivables, net                                                                                                                                                                                    |       | 40.3                    |       | 58.6                       |       |
| Prepaid expenses  and other                                                                                                                                                                                |       | 16.2                    |       | 19.9                       |       |
| Total current  assets                                                                                                                                                                                      |       | 90.0                    |       | 128.5                      |       |
| Property and  equipment                                                                                                                                                                                    |       |                    |       |                       |       |
| Land and  buildings                                                                                                                                                                                        |       | 56.9                    |       | 76.4                       |       |
| Communications  networks                                                                                                                                                                                   |       | 1,002.6                 |       | 1,116.4                    |       |
| Furniture,  fixtures and equipment                                                                                                                                                                         |       | 177.6                   |       | 204.5                      |       |
| Networks in  progress                                                                                                                                                                                      |       | 29.0                    |       | 51.3                       |       |
| Total property  and equipment                                                                                                                                                                              |       | 1,266.1                 |       | 1,448.6                    |       |
| Less accumulated  depreciation                                                                                                                                                                             |       | 831.2                   |       | 719.9                      |       |
| Net property and  equipment                                                                                                                                                                                |       | 434.9                   |       | 728.7                      |       |
| Intangibles and  other assets                                                                                                                                                                              |       |                    |       |                       |       |
| Other  intangibles, net                                                                                                                                                                                    |       | 88.8                    |       | 144.9                      |       |
| Other                                                                                                                                                                                                      |       | 13.5                    |       | 23.7                       |       |
| Total  intangibles and other assets                                                                                                                                                                        |       | 102.3                   |       | 168.6                      |       |
| **TOTAL  ASSETS**                                                                                                                                                                                          |       | $                       | 627.2      |                       | $          | 1,025.8 |   |
| ** **                                                                                                                                                                                                 |       |                    |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ DEFICIENCY**                                                                                                                                                          |       |                    |       |                       |       |
| Current  liabilities                                                                                                                                                                                       |       |                    |       |                       |       |
| Current  maturities of long-term debt                                                                                                                                                                      |       | $                       | 777.3      |                       | $          | 49.5 |   |
| Accounts payable                                                                                                                                                                                           |       | 34.2                    |       | 39.6                       |       |
| Accrued payroll  and payroll related expenses                                                                                                                                                              |       | 13.9                    |       | 19.7                       |       |
| Other accrued  liabilities                                                                                                                                                                                 |       | 113.0                   |       | 75.4                       |       |
| Deferred  revenue, current portion                                                                                                                                                                         |       | 8.2                     |       | 6.8                        |       |
| Total current  liabilities                                                                                                                                                                                 |       | 946.6                   |       | 191.0                      |       |
|                                                                                                                                                                                                       |       |                    |       |                       |       |
| Long-term debt,  less current maturities                                                                                                                                                                   |       | —                  |       | 727.8                      |       |
| Deferred  revenue, less current portion                                                                                                                                                                    |       | 18.3                    |       | 17.0                       |       |
| Other long-term  liabilities                                                                                                                                                                               |       | 63.3                    |       | 61.4                       |       |
| Total  liabilities                                                                                                                                                                                         |       | 1,028.2                 |       | 997.2                      |       |
|                                                                                                                                                                                                       |       |                    |       |                       |       |
| Redeemable  convertible preferred stock                                                                                                                                                                    |       |                    |       |                       |       |
| McLeodUSA  Preferred Series A, redeemable, convertible, $0.01 par value; 10,000,000  authorized and issued; 2,285,864 and 4,131,336 outstanding at September 30,  2005 and December 31, 2004, respectively |       | 42.7                    |       | 75.4                       |       |
|                                                                                                                                                                                                       |       |                    |       |                       |       |
| Stockholders’  equity                                                                                                                                                                                 |       |                    |       |                       |       |
| McLeodUSA  Common, Class A $0.01 par value; 1,886,249,986 authorized, 201,867,126 and  192,227,818 issued and outstanding at September 30, 2005 and December 31,  2004, respectively                       |       | 2.0                     |       | 1.9                        |       |
| McLeodUSA  Common, Class B $0.01 par value; 78,203,135 authorized, issued and  outstanding at September 30, 2005 and December 31, 2004                                                                     |       | 0.8                     |       | 0.8                        |       |
| McLeodUSA  Common, Class C $0.01 par value; 35,546,879 authorized, issued and  outstanding at September 30, 2005 and December 31, 2004                                                                     |       | 0.3                     |       | 0.3                        |       |
| McLeodUSA  Preferred Series B, $0.01 par value; 10 authorized, issued and outstanding at  September 30, 2005 and December 31, 2004                                                                         |       | —                  |       | —                     |       |
| McLeodUSA  Warrants                                                                                                                                                                                        |       | 22.6                    |       | 22.6                       |       |
| Additional  paid-in capital                                                                                                                                                                                |       | 1,081.7                 |       | 1,049.2                    |       |
| Accumulated  deficit                                                                                                                                                                                       |       | (1,551.1                | )          | (1,121.6                   | )          |
| Total  stockholders’ deficiency                                                                                                                                                                       |       | (443.7                  | )          | (46.8                      | )          |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ DEFICIENCY**                                                                                                                                                   |       | $                       | 627.2      |                       | $          | 1,025.8 |   |

 

The accompanying notesare an integral part of these condensed consolidated financial statements.

** **

 

3

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**McLEODUSAINCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inmillions, except per share data)**

 
| ** **                                                                           | ** ** | **Three months ended September  30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                              | ** ** | **2004** | ** ** |
|                                                                                 |       |                                  |       |   |   |
| Revenue                                                                              |       | $                                     | 154.4      |   | $ | 168.1 |   |
|                                                                                 |       |                                  |       |   |   |
| Operating expenses:                                                                  |       |                                  |       |   |   |
| Cost of service (exclusive of depreciation and amortization shown  separately below) |       | 86.0                                  |       | 94.1 |   |
| Selling, general and administrative                                                  |       | 64.5                                  |       | 62.5 |   |
| Depreciation and amortization                                                        |       | 35.8                                  |       | 88.8 |   |
| Impairment charge                                                                    |       | —                                |       | 263.1 |   |
| Restructuring charges                                                                |       | 14.7                                  |       | — |   |
| **Total operating expenses**                                                         |       | 201.0                                 |       | 508.5 |   |
| **Operating loss**                                                                   |       | (46.6                                 | )          | (340.4 | ) |
| ** **                                                                           |       |                                  |       |   |   |
| Nonoperating expense:                                                                |       |                                  |       |   |   |
| Interest expense, net of amounts capitalized                                         |       | (21.9                                 | )          | (11.9 | ) |
| Other income (expense)                                                               |       | 4.6                                   |       | (0.5 | ) |
| **Total nonoperating expense**                                                       |       | (17.3                                 | )          | (12.4 | ) |
| **Net loss**                                                                         |       | (63.9                                 | )          | (352.8 | ) |
| Preferred stock dividend                                                             |       | (0.3                                  | )          | (0.8 | ) |
|                                                                                 |       |                                  |       |   |   |
| **Net loss applicable to common shares**                                             |       | $                                     | (64.2      | ) | $ | (353.6 | ) |
| ** **                                                                           |       |                                  |       |   |   |
|                                                                                 |       |                                  |       |   |   |
| **Basic and diluted loss per common share**                                          |       | $                                     | (0.20      | ) | $ | (1.19 | ) |
| **Weighted average common shares outstanding**                                       |       | 315.5                                 |       | 296.7 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

4

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**McLEODUSAINCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inmillions, except per share data)**

 
| ** **                                                                           | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                            | ** ** | **2004** | ** ** |
|                                                                                 |       |                                |       |   |   |
| Revenue                                                                              |       | $                                   | 474.6      |   | $ | 553.5 |   |
|                                                                                 |       |                                |       |   |   |
| Operating expenses:                                                                  |       |                                |       |   |   |
| Cost of service (exclusive of depreciation and amortization shown  separately below) |       | 271.5                               |       | 306.9 |   |
| Selling, general and administrative                                                  |       | 174.9                               |       | 206.7 |   |
| Depreciation and amortization                                                        |       | 181.6                               |       | 267.3 |   |
| Impairment charge                                                                    |       | 202.5                               |       | 263.1 |   |
| Restructuring charges (adjustment)                                                   |       | 21.6                                |       | (0.2 | ) |
| **Total operating expenses**                                                         |       | 852.1                               |       | 1,043.8 |   |
| **Operating loss**                                                                   |       | (377.5                              | )          | (490.3 | ) |
| ** **                                                                           |       |                                |       |   |   |
| Nonoperating expense:                                                                |       |                                |       |   |   |
| Interest expense, net of amounts capitalized                                         |       | (55.7                               | )          | (34.6 | ) |
| Other income (expense)                                                               |       | 3.7                                 |       | (1.5 | ) |
| **Total nonoperating expense**                                                       |       | (52.0                               | )          | (36.1 | ) |
| **Net loss**                                                                         |       | (429.5                              | )          | (526.4 | ) |
| Preferred stock dividend                                                             |       | (1.2                                | )          | (2.4 | ) |
|                                                                                 |       |                                |       |   |   |
| **Net loss applicable to common shares**                                             |       | $                                   | (430.7     | ) | $ | (528.8 | ) |
|                                                                                 |       |                                |       |   |   |
| **Basic and diluted loss per common share**                                          |       | $                                   | (1.38      | ) | $ | (1.80 | ) |
| **Weighted average common shares outstanding**                                       |       | 312.4                               |       | 293.3 |   |

 

The accompanying notesare an integral part of these condensed consolidated financial statements.

 

 

5

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**McLEODUSAINCORPORATED AND SUBSIDIARIESUNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In millions)**

 

** **
| ** **                                                                           | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **Cash Flows from Operating Activities**                                             |       |                                |       |   |   |
| Net loss                                                                             |       | $                                   | (429.5     | ) | $ | (526.4 | ) |
| Adjustments to reconcile net loss to net cash provided by operating  activities:     |       |                                |       |   |   |
| Depreciation                                                                         |       | 138.0                               |       | 224.0 |   |
| Amortization                                                                         |       | 43.6                                |       | 43.3 |   |
| Accretion of interest                                                                |       | 2.8                                 |       | 2.7 |   |
| Amortization of deferred financing fees                                              |       | 3.5                                 |       | 3.1 |   |
| (Gain) loss on sale of assets                                                        |       | (3.6                                | )          | 1.5 |   |
| Impairment charge                                                                    |       | 202.5                               |       | 263.1 |   |
| Changes in assets and liabilities:                                                   |       |                                |       |   |   |
| Trade receivables                                                                    |       | 17.2                                |       | 5.9 |   |
| Prepaid expenses and other                                                           |       | 5.0                                 |       | 0.1 |   |
| Accounts payable and accrued expenses                                                |       | 26.3                                |       | (18.8 | ) |
| Deferred revenue                                                                     |       | 2.6                                 |       | 1.9 |   |
| **Net cash provided by operating activities**                                        |       | 8.4                                 |       | 0.4 |   |
| ** **                                                                           |       |                                |       |   |   |
| **Cash Flows from Investing Activities**                                             |       |                                |       |   |   |
| Purchases of property and equipment                                                  |       | (27.7                               | )          | (35.0 | ) |
| Other assets                                                                         |       | (21.1                               | )          | (22.8 | ) |
| Proceeds from the sale of assets                                                     |       | 23.9                                |       | 8.1 |   |
| Increase in restricted cash                                                          |       | (16.4                               | )          | — |   |
| **Net cash used in investing activities**                                            |       | (41.3                               | )          | (49.7 | ) |
| ** **                                                                           |       |                                |       |   |   |
| **Cash Flows from Financing Activities**                                             |       |                                |       |   |   |
| Net proceeds from long-term debt                                                     |       | —                              |       | 40.0 |   |
| Payments on long-term debt                                                           |       | —                              |       | (19.2 | ) |
| Deferred financing fees                                                              |       | —                              |       | (1.9 | ) |
| **Net cash provided by financing activities**                                        |       | —                              |       | 18.9 |   |
| ** **                                                                           |       |                                |       |   |   |
| **Net decrease in cash and cash equivalents**                                        |       | (32.9                               | )          | (30.4 | ) |
| ** **                                                                           |       |                                |       |   |   |
| **Cash and cash equivalents**                                                        |       |                                |       |   |   |
| Beginning                                                                            |       | 50.0                                |       | 56.5 |   |
| Ending                                                                               |       | $                                   | 17.1       |   | $ | 26.1 |   |
|                                                                                 |       |                                |       |   |   |
| **Supplemental Disclosure of Cash Flow Information**                                 |       |                                |       |   |   |
| Cash payments for interest                                                           |       | $                                   | 5.5        |   | $ | 30.9 |   |
|                                                                                 |       |                                |       |   |   |
| **Supplemental Schedule of Noncash Investing and Financing Activities**              |       |                                |       |   |   |
| Principal amount converted of Redeemable Preferred Series A to Class A  common stock |       | $                                   | 33.9       |   | $ | 53.2 |   |
| Accrued capital expenditures                                                         |       | $                                   | 0.6        |   | $ | 1.3 |   |
| Preferred stock dividends                                                            |       | $                                   | 1.2        |   | $ | 2.4 |   |

 

The accompanying notes are an integral part of thesecondensed consolidated financial statements.

 

6

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**McLEODUSAINCORPORATED AND SUBSIDIARIES**

**NOTES TO THE CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

 

###### **Note 1:  Basisof Presentation**

 

McLeodUSA Incorporated (“McLeodUSA” or the “Company”),a Delaware corporation, through its subsidiaries, provides integratedcommunications services in 25 Midwest, Southwest, Northwest and Rocky Mountainstates.  McLeodUSA’s business is highlycompetitive and is subject to various federal, state and local regulations.

 

On October 28, 2005, McLeodUSA and certain of itssubsidiaries filed a voluntary petition for relief under Chapter 11 of theUnited States Bankruptcy Code in the United States Bankruptcy Court for theNorthern District of Illinois (the “Bankruptcy Court”).  In connection with its voluntary petition,McLeodUSA filed its Joint Prepackaged Plan of Reorganization dated October 19,2005 (the “Plan”) which describes the proposed restructuring.  See Note 10 for further discussion of thegeneral structure of the Company’s Plan.

 

##### ***Background of the Restructuring***

On January 31, 2002, McLeodUSA filed a voluntarypetition for relief under Chapter 11 of the United States Bankruptcy Code inthe United States Bankruptcy Court for the District of Delaware. On April 16,2002, McLeodUSA emerged from those Chapter 11 proceedings pursuant to the termsof its amended plan of reorganization (the “April 2002 Plan”), which becameeffective on that date. The general unsecured creditors of McLeodUSA, exceptfor the holders of its outstanding publicly traded bonds, were unaffected bythose Chapter 11 proceedings and the April 2002 Plan.  The April 2002 Plan incorporated a revisedstrategic plan that focused on profitable revenue growth in the Company’s 25state footprint.  In order to execute theplan, the Company initiated programs across the business to significantlyimprove the customer experience, eliminate unneeded infrastructure and cost,and improve the quality of the network and grow revenues.

Since 2002, the Company’s revenues have not increasedas forecasted, but have been declining. Reasons for the decline in revenue include weakness in segments of thetelecommunications industry, turnover of customers to competitors in excess ofnew customers acquired, reduction of long distance minutes used by the Company’scustomer base, reduction in access rates as mandated by the Federal CommunicationsCommission (the “FCC”), and lower prices for some of its products.  In response to these challenges, the Companyhas taken a number of actions, including introduction of newcompetitively-priced and technologically advanced products, reorganization ofits sales operations, hiring of experienced executive sales leadership,expanding the involvement of the executive staff in the sales process andreducing customer churn.  However, theseactions to date have not resulted in profitable new revenue growth whichcontinues to be a challenge as the Company competes against large, financiallystrong competitors with well-known brands. In addition, the Company believes that the large telecommunicationsproviders will likely become even more aggressive upon the closing of thepending recently approved mergers of AT&T with SBC and MCI with Verizon andanticipated additional consolidation in the telecommunications industry,further challenging the Company’s ability to grow revenue.

The Company competes against large, financially strongcompetitors with well-known brands.  Thecurrent regulatory and competitive environment has not allowed the Company toobtain performance levels projected under the April 2002 Plan, and as a resultthe Company’s balance sheet is too highly leveraged relative to the Company’soperating performance.  The Company doesnot believe it will be able to service its current debt level through maturity,or to refinance that debt when it matures. Faced with this set of circumstances, in late 2004 the Company beganevaluating its strategic alternatives. The principal alternatives available to the Company were a sale of theCompany (in one or more transactions) or a restructuring of the balance sheetcoupled with certain operational changes, to reduce debt-service requirementsand improve free cash flow.

On March 16, 2005, the Company and holders of amajority of the debt under its Credit Agreement dated May 31, 2000, as amended(the “Credit Agreement”) and its Exit Credit Agreement, dated April 16, 2002,as amended (the “Exit Facility” or collectively, the “Credit Facilities”),entered into a forbearance agreement. Pursuant to the forbearance agreement, the lenders agreed to forbearfrom exercising certain default related remedies against the Company, includingwith respect to the non-payment of principal and certain interest paymentobligations under the Credit Facilities. The initial forbearance agreement expired on May 23, 2005, but wasextended on four occasions until October 31, 2005.  The forbearance agreement, as amended, amongother things, limited the Company’s ability to sell certain assets withoutprior approval of the lender group and required the Company to accrue twoadditional percentage points of interest on the outstanding loan 

 

7

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balances.  Inaccordance with the forbearance agreement, as of September 30, 2005, theCompany has elected not to make $32.6 million of scheduled principal paymentsand $41.6 million of scheduled interest payments.

During the forbearance period, the Company exploredthe possibilities of selling all or pieces of the Company and solicitedinterest from potential acquirers.  Allindications of interest received were for a level of net sale proceeds belowthe amounts required to pay obligations under the Credit Facilities infull.  Only one indication of interestfor the entire Company was received, and that indication of interest waswithdrawn at an early stage.  As aresult, the majority of the lenders indicated that they did not supportcontinuation of the sale process and desired to have the Company proceed with arestructuring.  After taking such viewsinto account, the Company determined not to pursue them.

On a parallel path with efforts to solicit interest fromthird parties regarding a potential sale of the Company, the Company discussedwith a committee of its lenders the terms of a financial restructuring thatwould convert the majority of the debt under the Credit Agreement into equityand transfer ownership of the Company to the lenders under the CreditAgreement.  The Company decided toproceed with this financial restructuring in light of the results of the saleprocess described above.  To minimize theamount of time the Company would spend in Chapter 11 and the disruption to theCompany’s operations and thus maximize the value of the Company for the benefitof its stakeholders, the Company, after discussions with a committee of itslenders, concluded that the proposed restructuring should be implementedthrough a prepackaged plan of reorganization. The Company believes that the value of its businesses would be damagedsignificantly by a prolonged Chapter 11 case.

On October 28, 2005, theCompany and certain of its subsidiaries, filed a voluntary petition for reliefunder Chapter 11 of the United States Bankruptcy Code in the BankruptcyCourt.  See Note 10 for furtherdiscussion of the general structure of the Company’s Plan.

**Interim Financial Information(unaudited)**

The Company’s financial statements for the period ending September 30,2005 and December 31, 2004 are prepared on a going concern basis, whichcontemplates the realization of assets and the satisfaction of liabilities inthe normal course of business.  Thereport of McLeodUSA’s independent registered public accounting firmaccompanying its financial statements in its Annual Report on 10-K filed withthe Securities and Exchange Commission (“SEC”) on March 25, 2005, contains acomment stating that there is substantial doubt as to the Company’s ability tocontinue as a going concern.

 

McLeodUSA will implement, upon the effective date of the Plan, freshstart reporting under the provisions of Statement of Position 90-7, “FinancialReporting by Entities in Reorganization Under the Bankruptcy Code” (“SOP 90-7”).  Under SOP 90-7, if the reorganization valueof McLeodUSA is less than the amount of allowed claims and post-petitionliabilities, and if holders of existing voting shares immediately beforeconfirmation received less than 50% of the emerging entity, fresh startreporting applies.  McLeodUSA fullyexpects that it will be required to adopt fresh start reporting during thefirst quarter of 2006 when it anticipates emerging from bankruptcy.  The provisions of fresh start reporting willrequire McLeodUSA to revalue its assets and liabilities to fair value,re-establish stockholders’ equity using the reorganization value established inconnection with the Plan.  The adoptionof SOP 90-7 and fresh start reporting will have a material effect on McLeodUSA’sfinancial statements.  No adjustmentshave been made in the financial statements to reflect the provisions of SOP90-7 as of September 30, 2005.  As aresult, McLeodUSA’s financial statements for periods following theeffectiveness of the Plan will not be comparable with those published beforethe Plan is effective.

 

In the opinion of management, the accompanying unaudited condensedconsolidated financial statements include adjustments, consisting of normalrecurring adjustments, necessary for a fair presentation of the financialposition and results of operations of McLeodUSA.  The operating results for the interim periodsare not necessarily indicative of the operating results to be expected for afull year or for other interim periods. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America (“GAAP”) have been condensedor omitted pursuant to instructions, rules and regulations prescribed by theSEC.  Although management believes thatthe disclosures provided are adequate to make the information presented notmisleading, management recommends that you read these unaudited condensed consolidatedfinancial statements in conjunction with the audited consolidated financialstatements and the related footnotes included in the McLeodUSA Annual Report onForm 10-K for the fiscal year ended December 31, 2004, filed with the SECon March 25, 2005.

 

 

8

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**Accounting for Stock-basedCompensation**

As permitted by Statement of Financial AccountingStandards (“SFAS”) No. 123, *Accounting for Stock-BasedCompensation*(‘‘SFAS 123’’), McLeodUSA measures compensation usingthe intrinsic value based method as prescribed by Accounting Principles BoardOpinion No. 25, *Accounting for Stock Issued to Employees,*butis required to make proforma disclosures in the footnotes to the financialstatements as if the measurement provisions of SFAS 123 and SFAS No. 148 *Accounting for Stock-Based Compensation-Transition and Disclosure — anAmendment of SFAS 123*had been adopted. Under the intrinsic valuemethod, compensation is measured as the difference between the market value ofthe stock on the grant date, less the amount required to be paid for the stock.The difference, if any, is charged to expense over the vesting period of theoptions. No stock-based employee compensation cost is reflected in net loss, asall options granted under the plan had an exercise price greater than or equalto the market value of the underlying common stock on the date of grant.  Upon the effective date of the Plan theCompany anticipates that all stock options will be canceled.

 

The following table illustrates the effect on netloss and net loss per share for the three and nine months ended September 30,2005 and 2004 as if McLeodUSA had applied the fair value recognition provisionsof SFAS 123 to stock-based employee compensation.  

 
| ** **                                                                                        | ** ** | **Three months ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                        | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| Net loss  applicable to common shares, as reported                                                |       | $                                    | (64.2      | ) | $ | (353.6 | ) |
| Less: Total  stock-based employee compensation expense determined under fair value based  methods |       | (1.0                                 | )          | (3.1 | ) |
| Pro forma net  loss applicable to common shares                                                   |       | $                                    | (65.2      | ) | $ | (356.7 | ) |
|                                                                                              |       |                                 |       |   |   |
| **Loss  per share:**                                                                              |       |                                 |       |   |   |
| Basic and  diluted, as reported                                                                   |       | $                                    | (0.20      | ) | $ | (1.19 | ) |
| Basic and  diluted, pro forma                                                                     |       | $                                    | (0.21      | ) | $ | (1.20 | ) |

 
| ** **                                                                                        | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                        | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| Net loss  applicable to common shares, as reported                                                |       | $                                   | (430.7     | ) | $ | (528.8 | ) |
| Less: Total  stock-based employee compensation expense determined under fair value based  methods |       | (3.9                                | )          | (9.5 | ) |
| Pro forma net  loss applicable to common shares                                                   |       | $                                   | (434.6     | ) | $ | (538.3 | ) |
|                                                                                              |       |                                |       |   |   |
| **Loss  per share:**                                                                              |       |                                |       |   |   |
| Basic and  diluted, as reported                                                                   |       | $                                   | (1.38      | ) | $ | (1.80 | ) |
| Basic and  diluted, pro forma                                                                     |       | $                                   | (1.39      | ) | $ | (1.84 | ) |

 

**Basic and****diluted loss per common share**

Loss per common share has been computed using theweighted average number of shares of common stock outstanding.  All stock options granted, and theconvertible preferred stock and warrants outstanding are anti-dilutive, and aretherefore excluded from the computation of earnings per share.  Assuming exercise or conversion of stockoptions and convertible securities, diluted shares would have beenapproximately 415 million and 429 million at September 30, 2005 and 2004,respectively.  Upon the effective date ofthe Plan, the Company anticipates that all stock options, convertible preferredstock, and warrants will be canceled.

 

9

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**New accounting pronouncement**

**InDecember 2004, the Financial Accounting Standards Board revised and reissuedSFAS 123 as SFAS 123(R), *Accounting for StockIssued to Employees*(“SFAS 123(R)”). This statement establishes standards for the accounting for transactionsin which an entity exchanges its equity instruments for goods or services.  It requires an entity to measure the cost ofemployee services received in exchange for an award of equity instruments basedon the grant-date fair value of the award. The cost will then be recognized as compensation cost over the periodduring which an employee is required to provide service in exchange for theaward.  The provisions of this statementare effective for McLeodUSA January 1, 2006. On the effective date of the Plan the Company anticipates that alloptions granted under the McLeodUSA Incorporated 2002 Omnibus Plan will becanceled.**

** **

**Guarantees**

In November 2002, the Financial Accounting Standards Board (“FASB”)issued FASB Interpretation No. 45, *Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others*.  Thisinterpretation clarifies disclosures that are required to be made by aguarantor in its interim and annual financial statements about obligationsunder certain of its issued guarantees. In addition, the interpretationclarifies that a guarantor is required to recognize, at the inception ofcertain types of guarantees, a liability for the fair value of the obligationundertaken in issuing these guarantees. At September 30, 2005, McLeodUSA,the parent company, has various guarantees related to subsidiary commitmentsunder operating leases.  As of September30, 2005 the guarantees total $10.9 million and expire over various periodsthrough December 2014, corresponding with the termination of the leaseagreements.

 

McLeodUSA has indemnification obligations to its current and formerDirectors and Officers.  The terms of theindemnification obligations provide for no limitation to the maximum potentialfuture payments under such indemnifications. McLeodUSA maintains insurance, subject to limitations set forth in thepolicies, which is intended to cover the costs of claims made against itsDirectors and Officers.

 

**Restricted cash**

In accordance with the forbearance agreement, the proceeds from certainasset sales were to be placed in escrow with the lending agent.  During the third quarter of 2005 the Companysold two aircraft and certain fiber assets for $16.4 million, which wasplaced in escrow and has been classified as restricted cash in the Company’sconsolidated balance sheet as of September 30, 2005.

 

**Note 2:  Trade Receivables**

 

The composition of trade receivables, net, is as follows (in millions):

 

| ** **                                     | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| Trade Receivables:                             |       |                    |       |                   |       |
| Billed                                         |       | $                       | 54.1       |                   | $          | 66.3 |   |
| Unbilled                                       |       | 4.4                     |       | 4.8                    |       |
|                                           |       | 58.5                    |       | 71.1                   |       |
| Allowance for  doubtful accounts and discounts |       | (18.2                   | )          | (12.5                  | )          |
|                                           |       | $                       | 40.3       |                   | $          | 58.6 |   |

** **

As further discussed in Note 9, the Company recorded chargestotaling $15.7 million during the nine months ended September 30, 2005 relatedto settlements and allowances with respect to certain interstate and intrastateaccess charge disputes lowering net trade receivables.

 

 

10

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**Note 3:  OtherAccrued Liabilities**

 

Other accrued liabilities consisted of the following (in millions):

 

| ** **                      | ** ** | **September 30,  2005** | ** ** | **December 31, 2004** | ** ** |
|---------------------------------|------------|-------------------------|------------|----------------------------|------------|
| Accrued interest                |       | $                       | 46.2       |                       | $          | 1.8 |   |
| Accrued  sales/use/excise taxes |       | 16.6                    |       | 17.8                       |       |
| Customer  deposits              |       | 10.9                    |       | 3.0                        |       |
| Accrued property  taxes         |       | 8.7                     |       | 10.9                       |       |
| Restructuring                   |       | 5.2                     |       | 15.2                       |       |
| Other                           |       | 25.4                    |       | 26.7                       |       |
|                            |       | $                       | 113.0      |                       | $          | 75.4 |   |

 

As discussed in Note 1, the Company elected not tomake certain interest payments in accordance with the forbearanceagreement.  As a result of thenon-payment, an event of default occurred and the Company is required to accruetwo additional percentage points of interest on the Credit Facilities asprovided in the forbearance agreement.

 

**Note 4: Restructuring Charges**

 

The Company incurred charges of $14.7 million and $21.6 million, forthe three and nine months ended September 30, 2005, respectively, in support ofthe Company’s pursuit of strategic alternatives and financialrestructuring.  The charges relate to financialand legal advisors of $8.7 million and $15.6 million, for the three and ninemonths ended September 30, 2005, respectively, and $6.0 million of severancerelated to headcount reductions in each of the three and nine month periodsended September 30, 2005.

 

Changes in the carrying amount of the restructuring liability forfacility closure costs originally recorded in 2001 for the nine months endedSeptember 30, 2005 is summarized as follows (in millions):

 

| Balance,  December 31, 2004 |   | $     | 15.2 |   |
|-----------------------------|--------|-------|------|--------|
| Payments                    |   | (10.0 | )    |
| Balance, September 30, 2005 |   | $     | 5.2  |   |

 

**Note 5:  Impairment charges**

 

In accordance with SFASNo. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets (“SFAS 144”),* a long-lived asset group shall betested for recoverability whenever events or changes in circumstances indicatethat its carrying amount may not be recoverable.  During the second quarter of 2005, theCompany concluded there was not an acceptable strategic partner or buyer for allor portions of the Company and has proceeded to work with its lender group tocomplete a capital restructuring.  As aresult, during the second quarter of 2005, the Company performed an evaluationof the recoverability of its property and equipment that indicated that certainof its long-lived assets were impaired. The Company used a probability-weighted discounted cash flow analysis toestimate the fair value of the Company’s property and equipment and recorded anon-cash impairment charge of $174.8 million to reduce the carrying amount to estimatedfair value.  The Company filed forbankruptcy on October 28, 2005, and, as a result, performed an additionalevaluation of the recoverability of its property and equipment in conjunctionwith the preparation of the third quarter 2005 financial statements thatindicated that there was no further impairment.

 

In accordance with SFASNo. 142, *Goodwill and Other Intangible Assets (“SFAS 142”)*,indefinite-lived intangible assets are not to be amortized but reviewedannually for impairment or more frequently if an event occurs or circumstanceschange that would more likely than not reduce the fair value below its carryingamount.  As a result of the capitalrestructuring discussed above, the Company performed an evaluation on theMcLeodUSA trade name utilizing a “relief from royalty” method ofvaluation.  The evaluation indicatedimpairment during the second quarter of 2005 of $27.7 million on the McLeodUSAtrade name to reduce its carrying value to estimated fair value of $37.2million. Consequently, the Company recorded a non-cash impairment chargetotaling $202.5 million, to include the impairment on both the property andequipment and the McLeodUSA trade name, in its statement of operations for thenine months ended September 30, 2005.

 

 

11

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**Note 6: Other Intangible Assets**

 

Intangible assets with finite lives at September 30, 2005 and December31, 2004 are summarized as follows (in millions):

 

| ** **                        | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **                        | ** ** | **Gross**  | ** ** | **Amortization** | ** ** | **Net**    | ** ** |
| **September 30, 2005:**           |       |       |       |             |       |       |       |
| Deferred line installation  costs |       | $          | 204.8      |             | $          | 160.8      |       | $ | 44.0 |   |
| Customer base                     |       | 24.0       |       | 16.6             |       | 7.4        |       |
| PrimeLine Trademark               |       | 0.9        |       | 0.7              |       | 0.2        |       |
|                              |       | $          | 229.7      |             | $          | 178.1      |       | $ | 51.6 |   |

 

| ** **                        | ** ** | ** ** | ** ** | **Accumulated**  | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|------------------|------------|------------|------------|
| ** **                        | ** ** | **Gross**  | ** ** | **Amortization** | ** ** | **Net**    | ** ** |
| **December 31, 2004:**            |       |       |       |             |       |       |       |
| Deferred line installation  costs |       | $          | 190.5      |             | $          | 121.9      |       | $ | 68.6 |   |
| Customer base                     |       | 29.8       |       | 18.7             |       | 11.1       |       |
| PrimeLine Trademark               |       | 0.9        |       | 0.6              |       | 0.3        |       |
|                              |       | $          | 221.2      |             | $          | 141.2      |       | $ | 80.0 |   |

 

Annual estimated amortization expense for intangible assets describedabove for 2005 is $11 million, $33 million for 2006, and $8 million for 2007.

 

**Note 7: Accounting for Asset Retirement Obligations**

 

 SFAS No. 143, *Accountingfor Asset Retirement Obligations* (“SFAS 143”), requires entities torecord the fair value of a liability for an asset retirement obligation in theperiod in which the legal or contractual removal obligation is incurred.  McLeodUSA’s asset retirement obligationsrelate to three categories of assets: fiber, central office colocationequipment and technical sites.

 

The liability was established by calculating the present value of theasset retirement obligation using a discount rate of 6.1% over a period of 15years, which is representative of the estimated life of McLeodUSA’stelecommunications network.

 

Changes in the carrying amount of the asset retirement obligation forthe nine months ended September 30, 2005 is summarized as follows (inmillions):

 

| Balance, December 31, 2004  |   | $    | 61.4   |   |
|-----------------------------|--------|------|--------|--------|
| Interest accretion          |   | 2.8  |   |
| Payments                    |   | (0.2 | )      |
| Adjustments                 |   | (0.7 | )      |
| Balance, September 30, 2005 |   | $    | 63.3   |   |
|                             |        |      |        |        |  |

 

**Note 8:  LongTerm Debt**

 

On March 16, 2005, theCompany entered into a forbearance agreement whereby its lenders agreed toforbear from exercising certain default related remedies against McLeodUSA,including with respect to the non-payment of principal and certain interestpayment obligations under the Credit Facilities.  The initial forbearance agreement expired onMay 23, 2005, but was extended on four occasions until October 31, 2005.  The forbearance agreement, as amended, amongother things, limited the Company’s ability to sell certain assets withoutprior approval of the lender group and required McLeodUSA to accrue twoadditional percentage points of interest on the outstanding loan balances.  In accordance with the forbearance agreement,as of September 30, 2005, the Company has elected not to make $32.6 million ofscheduled principal payments and $41.6 million of scheduled interest payments.

 

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The Company’s debt has been classified as current in the condensedconsolidated balance sheet because the default is not expected to becured.  As discussed in Note 10, theCompany filed for Chapter 11 bankruptcy on October 28, 2005.  As a result of the bankruptcy filing, theability of the Company’s creditors to seek remedies to enforce their rightsunder the Credit Facilities are stayed and creditor rights of enforcement aresubject to the applicable provisions of the Bankruptcy Code.

 

**Note 9: Litigation**

 

Former Chairman Clark E. McLeod, former PresidentStephen C. Gray (then also Chief Executive Officer), Chairman Chris A. Davis(then Chief Operating and Financial Officer) and former Chief Financial andAccounting Officer J. Lyle Patrick (the “Individual Defendants”) are defendantsin a consolidated class action initiated in January 2002 entitled In reMcLeodUSA Incorporated Securities Litigation, Civil Action No. C02-0001 (N.D.Iowa) (the “Iowa Class Action”), alleging inter alia, violations of theSecurities Act of 1933 and the Securities Exchange Act of 1934. The IndividualDefendants moved to dismiss the consolidated amended complaint in the IowaClass Action.  That motion was denied.Discovery is ongoing.   One of theputative class plaintiffs, New Millennium Growth Fund LLC, also filed proofs ofclaim against McLeodUSA in McLeodUSA’s 2002 Chapter 11 Case, seeking at least$104,650 on its own behalf and no less than approximately $300 million (plusinterest, costs and attorneys’ fees as allowed) on behalf of all classclaimants in the Iowa Class Action (the “Bankruptcy Claims” and, together with the Iowa Class Action, the “SecuritiesClaims”).  The Bankruptcy Claims weretransferred from the bankruptcy court in Delaware to the Iowa court, andconsolidated with the Iowa Class Action on February 1, 2005.  As the Securities Claims are in early stages,it is impossible to evaluate the likelihood of unfavorable outcomes or, withrespect to McLeodUSA’s indemnification obligations in connection with theclaims alleged against the Individual Defendants in the consolidated amendedcomplaint, estimate the amount or range of potential loss, if any, toMcLeodUSA.  With respect to theBankruptcy Claims, on May 2, 2002, the Delaware Bankruptcy Court issued anorder establishing a disputed claims reserve of 18,000,000 shares ofReorganized McLeodUSA Class A Common Stock. Any recovery from the BankruptcyClaims would be limited to those shares of stock.  Therefore, the effect of the restructuringmay be to eliminate McLeodUSA as a party to the Bankruptcy Claims.  The Individual Defendants would remainparties to the Iowa Class Action.

 

McLeodUSA has indemnification obligations runningto the Individual Defendants, the terms of which provide for no limitation tothe maximum potential future payments under such indemnifications.  McLeodUSA is unable to develop an estimate ofthe maximum potential amount of future payments under the indemnifications dueto the inherent uncertainties involved in such litigation. McLeodUSA maintainsinsurance, subject to limitations set forth in the policies, which is intendedto cover the costs of claims made against its current and former Directors andOfficers, including the Individual Defendants.

 

McLeodUSA is also involved in numerous regulatoryproceedings before various public utility commissions and the FCC, particularlyin connection with actions by the Regional Bell Operating Companies (“RBOCs”).  McLeodUSA anticipates that the RBOCs willcontinue to pursue litigation, changes in regulations and legislation in stateswithin McLeodUSA’s 25-state footprint, as well as with the FCC, to reduceregulatory oversight and regulation over rates, network access and operations.This includes the pursuit of major changes in the Telecommunications Act of1996 (“1996 Act”), which McLeodUSA believes would adversely affect competitivetelecommunications service providers including McLeodUSA. If adopted, thesechanges could make it more difficult for McLeodUSA to challenge the RBOCs’competitive actions and to compete with the RBOCs generally.

 

The FCC released its Triennial Review Order (“TRO”)in August 2003 modifying its rules governing availability of RBOC unbundlednetwork elements to competitive carriers. The Triennial Review Orderestablished new rules governing the availability and pricing for the networkelements the RBOCs must provide to competitive carriers, and delegatedauthority to the states to apply certain of the new rules in individualmarkets. Several appeals of the TRO were consolidated in the Court of Appealsfor the District of Columbia (the “Court of Appeals”).  On March 2, 2004, the Court of Appeals issueda decision overturning many key elements of the TRO, remanding most of theorder to the FCC for further action (*USTA II*). TheCourt of Appeals ruled that the FCC’s delegation of final impairment decisionsto state agencies was unlawful.  TheCourt also reversed the FCC’s nationwide finding regarding mass marketswitching, dedicated transport and its delegation of decision-making authorityto the states. The Court directed the FCC to give stronger consideration tointermodal competition when revising its rules on remand. The Court upheld theFCC determination that RBOCs do not have to provide unbundled access at currentprices to newly deployed technologies based on fiber and packet-switchingcapabilities. The Court also upheld the FCC’s findings that RBOCs are notrequired to provide unbundled switching to CLECs for business customers servedby high-capacity loops, such as DS-1 or packet switching.  State proceedings that had been started to 

 

 

13

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implement the TRO were suspended in some statesand continued in other states.  The FCC and U. S. Department of Justicedeclined to appeal *USTA II*.  Competitive and interexchange carriers and anorganization representing state regulatory agencies filed appeals to the U.S.Supreme Court and requested a stay.  TheU.S. Supreme Court declined to issue a stay.  On July 22, the FCC adopted and on August 22, 2004, the FCC released anInterim UNE Order (the “Interim Order”) establishing requirements that governedthe availability of UNEs until the FCC adopted new, permanent unbundlingrules.  On December 15, 2004, the FCCannounced adoption of revised permanent unbundling rules that it believes arein compliance with prior appellate decisions. These new unbundling rules impact access to local switching, highcapacity loops, high capacity transport, dark fiber, and entrance facilities.  The FCC also adopted a transition plan forthose elements that will no longer be UNEs. The Company believes that the new rules are predominantly supportive ofits facilities-based (UNE-L) strategy. The new unbundling rules became effective March 11, 2005.  Several parties, including McLeodUSA, haveappealed the new unbundling rules.  Oralargument is scheduled for February 2006.

 

In September 2005, the FCC agreed to forebear from applying itsunbundling rules on Qwest in certain wire centers in the Omaha, Nebraskamarket.  The FCC based its decision onits determination that Qwest was no longer the dominant provider in the marketdue to the existence of a cable company that had substantially built its ownloop facilities in the affected wire centers and had attained a sizeable marketshare.  The decision to forebear fromapplying the unbundling rules in these wire centers means that Qwest will nothave to provide competitive providers such as McLeodUSA access to unbundledloops at TELRIC pricing.  Elimination ofaccess to UNEs that materially increases network element prices obtained on acommercial basis would increase our costs and could adversely affect ourability to compete.  The FCC is expectedto issue an order in the fourth quarter of 2005.

 

Regardless of the success, or lack of success, of commercialnegotiations with Qwest and SBC and adoption of final unbundling rules, it islikely that unbundling rules will be the subject of continued litigation.  While major conditions recently announced inconnection with the AT&T/SBC and Verizon/MCI transactions may provide somelimited relief in certain markets, therecan be no assurance that McLeodUSA’s businesses will not be materiallyadversely affected by continued legal challenges to unbundling rules, newlegislation passed in response to unbundling rules or any court decisions thatresult from continued legal challenge to unbundling rules or current law andregulations.

 

The FCC has an open docket proposing to reformintercarrier compensation.  An industrygroup known as the Intercarrier Compensation Forum provided a recommendedframework for reforming intercarrier compensation related to switched accessand reciprocal compensation charges. Other coalitions provided competing recommendations for reformingintercarrier compensation to the FCC. The FCC is evaluating all proposals and has solicited further commentson the issue.  A final decision isexpected no earlier than the first quarter of 2006, and the current frameworkof intercarrier compensation rules could be materially affected.

 

On September 10, 2003, the FCC issued a Notice ofProposed Rulemaking (“NPRM”) on Total Element Long Run Incremental Cost (“TELRIC”).  This is a proceeding to review the TELRICmethodology used to determine the prices charged to competitive carriers forunbundled network elements. A change in pricing methodology that materiallyincreases unbundled network element prices would increase our costs and couldadversely affect our ability to compete. A decision is anticipated during 2006.

 

On October 18, 2004, the FCC released an Orderthat extends unbundling relief to the RBOCs for mass market fiber-to-the-curbloops with fiber that is within 500 feet of the premises.  The FCC also clarified that incumbent LECsare not required to add TDM capabilities into new packetized transmissionfacilities.  It is likely that thisadditional unbundling relief and new network modification rule will be thesubject of litigation.  Such changescould limit our access to mass market customers and adversely affect ourability to compete.

 

On October 22, 2004, the FCC voted to eliminate any independentunbundling obligation under Section 271 of the 1996 Act for any network elementthat has been removed from Section 251 of the 1996 Act.  Such relief could limit our access to customersand adversely affect our ability to compete.

 

On June 27, 2005, the United States Supreme Courtaffirmed in *National Cable and Telecom Association v. Brand XInternet Services* the FCC’s 2002 ruling that cable modem service,unlike DSL service, is a non-regulated Title I information service.Consequently, cable companies do not have to unbundle their cable network orincur any resale obligations of their broadband service.  On September 23, 2005, the FCC extended similarregulatory relief to RBOC’s retail DSL service. They classified broadband Internet access service as an informationservice rather than a telecommunications service because it involves more thanpure transmission of a signal.  However,the FCC stated thatits 

 

 

14

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order does not affect ILECs’ obligations to provide UNEs.  The FCC stated that the regulatory status ofa service provided by an ILEC over a network element was not dispositive of itsUNE obligations.  Rather, with respect toregulatory classification, it is the use of the network element by the CLECthat determines eligibility.

 

The FCC issued on March 10, 2004 its NPRM on “IP-enabledcommunications,” which includes VoIP. The NPRM asks broad questions regardingthe regulatory classifications of various “IP-enabled” services, includingdifferent VoIP services; the access charge and other intercarrier compensationimplications; the universal service implications; and the other social policyimplications such as law enforcement, disability and emergency 911 serviceissues and suggests, as a general proposition, the economic regulation ofvarious IP-enabled services should be kept to a minimum.

 

In April 2001, the FCC released an Order in which itestablished a benchmark rate at which CLECs’ interstate access charges would bepresumed reasonable and which a CLEC could impose on an interexchange carrier (“IXC”)by tariff. In May of 2004, the FCCannounced a new rule governing CLEC interstate access charges that imposed alimit on CLEC access charges when the CLEC did not directly serve the enduser.  The new rule provided that thecharge could be no more than the rate charged by the ILEC for the samefunctionality.  The FCC order stated itsnew rule limiting CLEC interstate access charges was to be applied on aprospective basis.  McLeodUSA filedtariff changes to implement the FCC’s new rule. The FCC’s Order also provided that, under its prior rules, it would nothave been unreasonable for a CLEC to charge an IXC for those services at thehigher benchmark rate.  Some IXCs,including Qwest, MCI and Sprint, disputed and withheld payment of billed access charges for wirelessoriginated toll free calls and have also withheld payments due to the Companyfor other charges.  The Company, in responseto these actions, had also withheld payments from them.  McLeodUSAcontinued to bill for its services at the full benchmark rate until the FCC’snew rule went into effect as of June 22, 2004, at which time it billed at therevised rates in accordance with the FCC’s new rule. As of October 31,2005 approximately $8.0 million in interstate or intrastate access chargeshad been disputed and unpaid by Qwest and Sprint in connection to certain typesof toll free traffic for prior periods based on alleged insufficiency oftariff. As a consequence of the withholding of payments by these carriers,McLeodUSA filed suit against Sprint Communications Corporation (“Sprint”) inthe United States District Court for the Northern District of Iowa claimingthat, by Sprint’s failure to pay the interstate access charges that the Companybilled, Sprint was in breach of its contract with the Company.  In addition to its breach of express contractclaim, the Company is pursuing recovery of its interstate access charges for tollfree traffic under implied contract and unjust enrichment theories againstSprint.  McLeodUSA also filed suitagainst Qwest Corporation.  The Qwestlitigation has been resolved and the lawsuits filed in this matter have beendismissed.  In addition, the Company hassettled its dispute with MCI. The Company has recorded charges totaling $13.3million and $15.7 million related to these access charge disputes in itsconsolidated statements of operations for the three months and nine monthsended September 30, 2005, respectively.

 

McLeodUSA is one of several defendants in alawsuit brought by SBC and its affiliates in the U.S. District Court in theEastern District of Missouri. SBC alleges that McLeodUSA conspired with one ormore of Global Crossing and its affiliates, certain named competitive localexchange carriers, and/or certain unnamed “least cost routers” to breach SBC’sstate or federal tariffs, unjustly enrich themselves, and commit fraud onSBC.   SBC alleges that the defendantsknowingly disguised long distance calls that were terminated to SBC so thatthey appeared to SBC to be local calls thereby depriving SBC of the differencebetween the access charge rate owed for termination of long distance calls andthe reciprocal compensation rate owed for termination of local calls. McLeodUSA’sanswer was filed on April 1, 2005, denying all liability.   McLeodUSA intends to vigorously defendagainst these claims.

 

Generally, state utility commissions or third parties could raise issueswith regard to our compliance with applicable laws or regulations that couldhave a material adverse effect on our business, results of operations andfinancial condition.    On July 18, 2005,the Arizona Corporation Commission approved a settlement agreement betweenMcLeodUSA and the Arizona Staff that resolved all issues related to certainagreements that we entered into with Qwest several years ago that have sinceexpired.  The Colorado Public UtilitiesCommission continues to review these agreements, and that proceeding may resultin fines or other sanctions against us or the imposition of other conditionsdetrimental to us, including the establishment of discounts available to othercompetitive telephone companies but not to us. Other states may initiatesimilar proceedings.

 

McLeodUSA, as successor to Caprock CommunicationsCorporation, was a defendant in a lawsuit brought by Alcatel USA Marketing,Inc. (“Alcatel”), in County Court No. 5, Dallas County, Texas, entitled AlcatelUSA Marketing, Inc vs. Caprock Communications Corporation and McLeodUSAHoldings, Inc., Cause No. CC04-11573-E. Plaintiff alleged breach of a 1994 supply agreement and certain purchaseorders issued in 2000 under the agreement. Alcatel sought damages of 

 

 

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approximately $6.3 million plus interest, costsand attorneys’ fees.  The parties havesettled this dispute, the results of which are reflected in the consolidatedfinancial statements.

 

On May 9, 2005, AT&T sent a demand to theCompany for arbitration of its claim in excess of $8 million under anEngineering and Construction Management Agreement between AT&T and CapRockTelecommunications Corp. dated November 1999. The claim principally related to construction and fiber optic cablecosts incurred in connection with construction of the Ring 3 fiber optic cableproject from Tulsa, OK to Oklahoma City, OK from 1999 to 2000.  The parties have settled this dispute.  The results of the settlement are reflectedin the consolidated financial statements.

 

As a result of the settlements with Alcatel andAT&T discussed above, the Company has recorded an additional charge to itsoperating expenses of $0.9 million during the nine months endedSeptember 30, 2005.  McLeodUSA isnot aware of any other material litigation against it.  McLeodUSA does, however, have various otherlegal proceedings pending against it or its subsidiaries or on its behalf orthat of its subsidiaries.

 

**Note 10: Subsequent Event**

 

On October 28, 2005, the Company, and itssubsidiaries, filed a voluntary petition for relief under Chapter 11 of theUnited States Bankruptcy Code with the Bankruptcy Court.  In connection with its voluntary petition,McLeodUSA filed its Joint Prepackaged Plan of Reorganization that describes theproposed restructuring.  The Planprovides for the Company’s balance sheet to be restructured by:

•      Convertingthe existing $100 million of outstanding borrowings under the Exit Facilityinto new term loan notes;

•      Convertingthe existing $677.3 million of outstanding borrowings under the Credit Facilityplus unpaid interest of $44.0 million into 100% of the common stock ofreorganized McLeodUSA, subject to dilution by management stock plan awards;

•      Cancelingthe Company’s existing Preferred Series A, Class A Common, Class B Common andClass C Common Stock; and

•      Rejectingcertain real property leases that are no longer necessary.

On October 31, 2005 the Bankruptcy Court approved orders requested bythe Company in a series of court filings. These approved orders allow the Company to conduct business as usualwith respect to its customers, employees and suppliers and to maintain existingcash management systems. Among other things, the Bankruptcy Court authorizedthe Company:

 

•      To continue payment of all trade creditorsin the ordinary course and without interruption;

 

•      To continue payment of all employeesalaries and benefits without interruption;

 

•      To continue to use existing cashmanagement systems and maintain existing bank accounts; and

 

•      Through an interim order, to access up to$20 million of a $50 million debtor-in-possession credit facility (the “DIP Facility”)to provide the Company with additional liquidity to fund operations during theChapter 11 case.

 

The Court also set December 15, 2005 as the date forthe hearing to approve the Company’s Plan. The completion of the restructuring process depends on many factors,including approval by the Bankruptcy Court of the Plan, finalizing the proposeddebt facilities upon confirmation of the Plan and receiving necessaryregulatory approvals.

 

 

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**Information Regarding Forward-Looking Statements**

 

Some of the statements in this discussion include statements about ourfuture expectations.  Statements that arenot historical facts are forward-looking statements for the purpose of the safeharbor provided by Section 21E of the Exchange Act and Section 27A of theSecurities Act.  Such statements mayinclude projections of financial and operational results and goals, including revenue,profitability, savings and cash. In somecases, you can identify these so-called “forward looking statements” by our useof words such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,”“estimate,” “predict”, “project”, “intend” or “potential” or the negative ofthose words and other comparable words.****Theseforward-looking statements are subject to known as well as unknown risks anduncertainties that may cause actual results to differ materially from ourexpectations.  Our expectations are basedon various factors and assumptions and reflect only our predictions.  Factors that could cause actual results todiffer materially from the forward-looking statement include technological,regulatory, public policy or other developments in our industry, availabilityand adequacy of capital resources, our ability to continue as a going concern,bankruptcy court approval of motions prosecuted by us from time to time in ourpending Chapter 11 cases, our ability to confirm and consummate our plan ofreorganization with respect to the Chapter 11 cases or any significant delaywith respect thereto, our ability to obtain trade credit, and shipments andterms with vendors and service providers for current orders, our ability tomaintain contracts that are critical to our operations current and futureeconomic conditions, the existence of strategic alliances, our ability togenerate cash, our ability to implement process and network improvements, ourability to attract and retain customers, our ability to migrate traffic toappropriate platforms and changes in the competitive climate in which weoperate.  These and other risks aredescribed in more detail in our most recent Annual Report on Form 10-K filedwith the SEC.  Except as required underthe federal securities laws and rules and regulations of the SEC, the Companyundertakes no obligation to update publicly any forward-looking statements,whether as a result of future events, new information or otherwise.

 

**Item 2.             Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

The following discussionand analysis provides information concerning the results of operations and ourfinancial condition and should be read in conjunction with the accompanyingunaudited condensed consolidated financial statements and notes thereto.  Additionally, the following discussion andanalysis should be read in conjunction with our audited consolidated financialstatements included in our Annual Report on Form 10-K for the year ended December31, 2004.

 

# ***ExecutiveOverview***

 On October 28,2005, the Company and certain of its subsidiaries filed a voluntary petitionfor relief under Chapter 11 of the United States Bankruptcy Code in theBankruptcy Court.  In connection with itsvoluntary petition, McLeodUSA filed its Joint Prepackaged Plan ofReorganization which describes the proposed restructuring.

 

##### *Background of the restructuring*

 

On January 31, 2002, McLeodUSA filed a voluntarypetition for relief under Chapter 11 of the United States Bankruptcy Code inthe United States Bankruptcy Court for the District of Delaware. On April 16,2002, McLeodUSA emerged from those Chapter 11 proceedings pursuant to the termsof its amended plan of reorganization, which became effective on that date. Thegeneral unsecured creditors of McLeodUSA, except for the holders of itsoutstanding publicly traded bonds, were unaffected by those Chapter 11proceedings and the April 2002 Plan.  TheApril 2002 Plan incorporated a revised strategic plan that focused on profitablerevenue growth in the Company’s 25 state footprint.  In order to execute the plan, the Companyinitiated programs across the business to significantly improve the customerexperience, eliminate unneeded infrastructure and cost, improve the quality ofthe network and grow revenues.

Since 2002, the Company’s revenues have not increasedas forecasted but have been declining. Reasons for the decline in revenue include weakness in segments of thetelecommunications industry, turnover of customers to competitors in excess ofnew customers acquired, reduction of long distance minutes used by our customerbase, reduction in access rates as mandated by the FCC, and lower prices forsome of our products.  In response to thesechallenges, we have taken a number of actions, including introduction of newcompetitively-priced and technologically advanced products, reorganization ofthe sales operations, hiring of experienced executive sales leadership,expanding the involvement of the executive staff in the sales process andreducing customer churn.  However, theseactions to date have not resulted in profitable new revenue growth whichcontinues to be a challenge as we compete against large, financially strongcompetitors with well-known brands.  Inaddition, we believe that the large telecommunications providers will likelybecome even more aggressive upon 

 

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the closing of the pending recently approved mergersof AT&T with SBC and MCI with Verizon as well as anticipated additionalconsolidation in the telecommunications industry, further challenging ourability to grow revenue.

We compete against large, financially strongcompetitors with well-known brands.  Thecurrent regulatory and competitive environment has not allowed us to obtainperformance levels projected under the April 2002 Plan, and as a result theCompany’s balance sheet is too highly leveraged relative to the Company’soperating performance.  We do not believewe will be able to service our current debt level through maturity, or torefinance that debt when it matures. Faced with this set of circumstances, in late 2004 we began evaluatingour strategic alternatives.  The principalalternatives available to the Company were a sale of the Company (in one ormore transactions) or a restructuring of the balance sheet coupled with certainoperational changes, to reduce debt-service requirements and improve free cashflow.

On March 16, 2005, the Company entered into aforbearance agreement with our lenders whereby the lenders agreed to forbearfrom exercising certain default related remedies against McLeodUSA, includingwith respect to the non-payment of principal and certain interest paymentobligations under the Credit Facilities. The initial forbearance agreement expired on May 23, 2005, but wasextended on four occasions until October 31, 2005.  The forbearance agreement as amended, amongother things, limited our ability to sell certain assets without prior approvalof the lender group and required McLeodUSA to accrue two additional percentagepoints of interest on the outstanding loan balances.  In accordance with the forbearance agreement,as of September 30, 2005, we have elected not to make $32.6 million of scheduledprincipal payments and $41.6 million of scheduled interest payments.

During the forbearance period, we explored thepossibilities of selling all or pieces of the Company and solicited interestfrom potential acquirers.  Allindications of interest received were for a level of net sale proceeds belowthe amounts required to pay obligations under the Credit Facilities infull.  Only one indication of interestfor the entire Company was received, and that indication was withdrawn at anearly stage.  As a result, the majorityof the lenders indicated that they did not support the continuation of thesales process and desired to have the Company proceed with arestructuring.  After taking such viewsinto account, we determined not to pursue them.

On a parallel path with efforts to solicit interestfrom third parties regarding a potential sale of the Company, we discussed witha committee of our lenders the terms of a financial restructuring that wouldconvert the majority of the debt under the Credit Agreement into equity andtransfer ownership of the Company to the lenders under the CreditAgreement.  We decided to proceed withthis financial restructuring in light of the results of the sale processdescribed above.  To minimize the amountof time the we would spend in Chapter 11 and the disruption to the ouroperations and thus maximize the value of the Company for the benefit of ourstakeholders, the Company, after discussions with a committee of our lenders,concluded that the proposed restructuring should be implemented through aprepackaged plan of reorganization.  Webelieve that the value of our businesses would be damaged significantly by aprolonged Chapter 11 case.

On October 28, 2005, the Company, and itssubsidiaries, filed a voluntary petition for relief under Chapter 11 of theUnited States Bankruptcy Code with the Bankruptcy Court.  In connection with our voluntary petition, wefiled our Joint Prepackaged Plan of Reorganization that describes the proposedrestructuring.  The Plan provides for theCompany’s balance sheet to be restructured by:

•      Convertingthe existing $100 million of outstanding borrowings under the Exit Facilityinto new term loan notes;

•      Convertingthe existing $677.3 million of outstanding borrowings under the Credit Facilityplus unpaid interest of $44.0 million into 100% of the common stock ofreorganized McLeodUSA, subject to dilution by management stock plan awards;

•      Cancelingthe our existing Preferred Series A, Class A Common, Class B Common and Class CCommon Stock; and

•      Rejectingcertain real property leases that are no longer necessary.

On October 31, 2005 the Bankruptcy Court approved orders requested bythe Company in a series of court filings. These approved orders allow us to conduct business as usual with respectto our customers, employees and suppliers and to maintain existing cashmanagement systems. Among other things, the Bankruptcy Court authorized theCompany:

 

 

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•      To continue payment of all trade creditorsin the ordinary course and without interruption;

 

•      To continue payment of all employeesalaries and benefits without interruption;

 

•      To continue to use existing cashmanagement systems and maintain existing bank accounts; and

 

•      Through an interim order to access up to$20 million of the $50 million DIP Facility to provide us with additionalliquidity to fund operations during the Chapter 11 case.

 

The Court also set December 15, 2005 as the date forthe hearing to approve our Plan.  Thecompletion of the restructuring process depends on many factors, includingapproval by the Bankruptcy Court of the Plan, finalizing the proposed debtfacilities upon confirmation of the Plan and receiving necessary regulatoryapprovals.

 

Our financial statements for the periods ending September 30, 2005 andDecember 31, 2004 are prepared on a going concern basis, which contemplates therealization of assets and the satisfaction of liabilities in the normal courseof business.  The report of ourindependent registered public accounting firm accompanying our financialstatements in our report on Form 10-K filed March 25, 2005, contains a commentstating that there is substantial doubt as to our ability to continue as agoing concern.

 

We will implement, upon the effective date of the Plan, fresh startreporting under the provisions of Statement of Position 90-7, “FinancialReporting by Entities in Reorganization Under the Bankruptcy Code” (“SOP 90-7”).  Under SOP 90-7, if the reorganization valueof McLeodUSA is less than the amount of allowed claims and post-petitionliabilities, and if holders of existing voting shares immediately beforeconfirmation received less than 50% of the emerging entity, fresh startreporting applies.  We fully expect thatwe will be required to adopt fresh start reporting during the first quarter of2006 when we anticipate emerging from bankruptcy.  The provisions of fresh start reporting willrequire us to revalue our assets and liabilities to fair value, re-establishstockholders’ equity using the reorganization value established in connectionwith the Plan.  The adoption of SOP 90-7and fresh start reporting will have a material effect on our financialstatements.  No adjustments have beenmade in the financial statements to reflect the provisions of SOP 90-7 as ofSeptember 30, 2005.  As a result, ourfinancial statements for periods following the effectiveness of the Plan willnot be comparable with those published before the Plan is effective.

 

**Overviewof Our Business**

We operate our business as a single segment, engaging inthe provision of telecommunications services based upon a single, integrated,interconnected communications network in a 25 state footprint.  We derive our revenue from ourtelecommunications and related communications services, including:

•      local and long distance services;

•      local data services such as dial-up and dedicatedInternet access services, using DSL and dedicated T1 access;

•      services based upon utilizing advance IPtechnology such as voice over Internet protocol;

•      conference calling services;

•      bandwidth and network facilities leasing, salesand services, including access services;

•      facilities and services dedicated for a particularcustomer’s use;

•      advanced communications services for largerbusinesses such as frame relay, private line, and ISDN; and

•      value-added services such as virtual privatenetworks.

As of September 30, 2005, we operated a network with 697 access nodescollocated in RBOC central offices.  Weserve our customers by using various loop/access unbundled network elements (“UNEs”)provided by the RBOCs and aggregating them through our access nodes.  In turn, our access nodes are interconnectedthrough approximately 38 service node locations where our switching/routingsystems reside.  In a metropolitan area,access node to service node connectivity is 

 

 

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based either on our own fiber facilities or on UNE transport from theRBOCs.  Our service nodes are located inmost of the major metropolitan areas across our footprint.  These service nodes are in turninterconnected by our high capacity, inter-city core network.  The underlying transport for our core networkis based either on our own fiber or on leased capacity from interexchangecarriers.

 

To develop these networks, we have assembled a collection of metro andinter-city network assets in our 25-state footprint, substantially all of whichwe own or control, making us a facilities-based carrier.  These network assets incorporatestate-of-the-art fiber optic cable, dedicated wavelengths of transmissioncapacity on fiber optic networks and transmission equipment capable of carryinghigh volumes of data, voice, video and Internet traffic.  We operate in a 25-state footprint, whichconsists of the following states:

 

| ArizonaArkansasColoradoIdahoIllinois |   | IndianaIowaKansasLouisianaMichigan |   | MinnesotaMissouriMontanaNebraskaNew Mexico |   | North  DakotaOhioOklahomaOregonSouth Dakota |   | TexasUtahWashingtonWisconsin  Wyoming |
|--------------------------------------|--------|------------------------------------|--------|--------------------------------------------|--------|---------------------------------------------|--------|---------------------------------------|

 

**Critical Accounting Policies and Estimates**

 

Preparation of the financial statements requires management to makeestimates and assumptions that affect the reported amounts of assets,liabilities, revenues and expenses. Management believes the most complex andsensitive judgments, because of their significance to the consolidatedfinancial statements, result primarily from the need to make estimates aboutthe effects of matters that are inherently uncertain. Management’s Discussionand Analysis and Note 1 to the Consolidated Financial Statements in theMcLeodUSA Annual Report on Form 10-K for the year ended December 31, 2004,describe the significant accounting estimates and policies used in preparationof the Condensed Consolidated Financial Statements. Actual results in theseareas could differ from management’s estimates. There have been no significant changes in our critical accountingestimates during the nine months ended September 30, 2005.  Management will continue to monitor its estimatesand assumptions as well as events or changes in circumstances with respect tothe reported amounts of assets, liabilities, revenues and expenses as a resultof our restructuring process.

 

**Liquidity and Capital Resources**

 

As discussed in the “Executive Overview,” the Company’srevenues have been declining since 2002. Total revenue for the nine months ended September 30, 2005 was $474.6million, a decrease of $78.9 million, or approximately 14%, from $553.5 millionfor the nine months ended September 30, 2004. The decline in revenue was driven by several factors, including weaknessin segments of the telecommunications industry, turnover of customers tocompetitors in excess of new customers acquired, reduction in access rates asmandated by the FCC, and lower prices for some of our products.

In light of the inability of the Company to increaserevenue and ultimately generate enough cash flow to service the existing levelof debt, the Company considered, with the assistance of our advisors, variousstrategic alternatives available to the Company.  The principal alternatives available to uswere (i) a sale of the Company (in one or more transactions), or (ii) arestructuring of the balance sheet coupled with certain operational changesintended to reduce debt-service requirements and to improve free cash-flow tosupport ongoing business operations and to service substantially lowerpost-restructuring debt.

On October 28, 2005, the Company, together certain ofits subsidiaries filed a voluntary petition for relief under Chapter 11 of theUnited States Bankruptcy Code in the United States Bankruptcy Court for theNorthern District of Illinois.  The JointPrepackaged Plan of Reorganization of McLeodUSA Incorporated and itssubsidiaries, filed with the Bankruptcy Court on October 28, 2005 describes theproposed restructuring.  See furtherdiscussion of the general structure of the Plan above in “Executive Overview.”

In conjunction with thePlan, certain non-core assets of the Company are anticipated to be sold toraise cash.  We may sell our ATS cableand telephony business (“ATS”), which provides cable television services in andaround Cedar Rapids and Marion, Iowa.  Inaddition, we have entered into an agreement to sell our headquarters buildingin Cedar Rapids for approximately  $27million and lease alternate space.  Theproceeds from the sale of the building and ATS will be used to reduce anyborrowings under the DIP Facility if the transactions close prior to theeffective date of the Plan and will reduce the estimated $100 million of newterm loans that will remain outstanding after the effective date of thePlan.  It is anticipated that anytransactions to be consummated will be pursuant to sale agreements approved bythe Bankruptcy Court.

 

 

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**2005Cash Flow**

 

Weended September 30, 2005 with $17.1 million of cash and cash equivalents versus$50.0 million at December 31, 2004.  Thisdecrease of $32.9 million resulted primarily from the following:

 

| Operating  Activities:                                                          |   |   |   |
|---------------------------------------------------------------------------------|--------|--------|--------|
| Decrease in cash  from operations, excluding changes in assets and liabilities  |   | $      | (21.2  | ) |
| Payments for  restructuring charges and liabilities                             |   | (31.2  | )      |
| Cash provided by  changes in assets and liabilities, excluding accrued interest |   | 16.5   |   |
| Cash provided by  changes in accrued interest                                   |   | 44.3   |   |
| Net cash  provided by operating activities                                      |   | 8.4    |   |
|                                                                            |   |   |   |
| Investing Activities:                                                           |   |   |   |
| Capital  expenditures                                                           |   | (27.7  | )      |
| Deferred line  installation costs                                               |   | (21.1  | )      |
| Sale of assets                                                                  |   | 23.9   |   |
| Increase in  restricted cash                                                    |   | (16.4  | )      |
| Net cash used in  investing activities                                          |   | (41.3  | )      |
|                                                                            |   |   |   |
| Net decrease in  cash and cash equivalents                                      |   | $      | (32.9  | ) |

 

Thepayments for restructuring charges and liabilities relate to lease payments and lease buyouts associatedwith facility exits and costs in connection with our pursuit of strategicalternatives and financial restructuring.

 

Wehave reduced our growth-related capital expenditure plan and expect to spendless than $40 million during 2005.  Thecapital expenditure plan for the rest of 2005 remains focused on supporting newproduct introductions and maintaining the existing business base.   Deferred line installation costs are theresult of costs required to add customers onto our network.  Our deferred line installation expendituresthroughout the rest of 2005 will be dependent on the rate at which we add newcustomers.

 

Duringthe third quarter, we sold two aircraft and certain fiber assets for $16.4million, the proceeds of which were placed in an escrow account with ourlending agent and have been classified as restricted cash in the Company’scondensed consolidated balance sheet as of September 30, 2005.  Under the terms of the DIP Facility, allfunds held in escrow will be utilized before amounts may be drawn under the DIPFacility.

 

** Outlook for 2005 and Future Funding Needs**

 

We ended September 30, 2005 with $17.1 million of cashon hand and $16.4 million restricted cash held in escrow by our lendingagent.  From an ongoing operatingstandpoint, our cash requirements for the remainder of 2005 will consist ofsupporting new products, important capital expenditure projects, changes inworking capital, remaining lease payments and lease buyouts associated withfacility exits and expenses related to our capital restructuring.  A combination of cash on hand, cash generatedfrom operating activities, borrowings under the DIP Facility and the proceedsfrom the sale of certain assets (if any) will be used to fund the operatingactivities of the Company.  On October31, 2005 the Company sought and the Bankruptcy Court approved access to $20million of the $50 million DIP Facility. On the effective date of the Plan, we expect to enter into an exitfacility credit agreement that will provide for a secured, revolving creditfacility in an amount not to exceed $50 million, with a letter of creditsub-facility in an amount not to exceed $15 million.

 

In the interim, we havecontinued to take additional steps to conserve cash and improve liquidity.  Actions have been taken to generate furtheroperating efficiencies and focused expense management, including leasetermination agreements negotiated on certain idle facilities as well asheadcount reductions, which will result in continued reduction in SG&Aexpenses.  As a result of the actions describedabove we have significantly reduced our cash usage and expect to realize continuingbenefits from these programs in 2005. We will continue to execute our cashmanagement program while completing the capital restructuring discussed above.

 

 

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**Three Months Ended September 30, 2005 Compared with Three Months EndedSeptember 30, 2004**

 

***Revenue.***  Total revenue for the quarter ended September30, 2005 declined $13.7 million, or 8%, to $154.4 million from $168.1 millionfor the quarter ended September 30, 2004. The following table compares our revenue for the three months endedSeptember 30:

 

| ** **                                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **Variance** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Local                                                                                         |       | $        | 80.2       |     | $          | 90.1         |       | $ | (9.9 | ) |
| Long distance                                                                                 |       | 31.7     |       | 31.7     |       | —       |       |
| Data services and other                                                                       |       | 27.5     |       | 31.9     |       | (4.4         | )          |
| Carrier access                                                                                |       | 12.8     |       | 11.0     |       | 1.8          |       |
| Indefeasible rights of use agreements including those that  qualify as sales type leases |       | 2.2      |       | 3.4      |       | (1.2         | )          |
|                                                                                          |       | $        | 154.4      |     | $          | 168.1        |       | $ | (13.7 | ) |

 

Total revenues declined by $13.7 million versus the third quarter of2004 primarily due to a continued decline in total customers.  Approximately $9.7 million of the decrease inlocal revenue is attributed to a reduction in the number of access lines inservice due to customer turnover in excess of new lines sold.  Retail long distance declined by $5.5 millionas a result of both a reduction in volume of minutes and rates of approximately$2.4 million and $3.1 million, respectively. This decline was offset by a $5.5million increase in wholesale long distance due to substantial volume increasesrelated to several wholesale contracts. The reduction in data services and other revenue is primarilyattributable to the reduction in total customers as well as competitive pricereductions for certain products. Included in revenues from indefeasible rights of use in the above tableis $1.3 million and $1.4 million for the quarters ended September 30, 2005 and2004, respectively, related to on-going revenues from operating leases.

 

***Cost of Service***.  Cost ofservice includes expenses directly associated with providing communicationservices to our customers.  Costsclassified as cost of service include, among other items, the cost ofconnecting customers to our network via leased facilities, the costs paid tothird party providers for interconnect access and transport services, the costsof leasing components of our network facilities and the cost of fiber relatedto sales and leases of network facilities. Cost of service was $86.0 million for the quarter ended September 30,2005, a decrease of $8.1 million or 9% from the quarter ended September 30,2004.  Approximately $5 million of thedecrease is attributed to the reduction in revenues with the balance attributedto ongoing cost reduction efforts.  Thecost of fiber related to sales and leases of network facilities was $0.2million and $0.3 million for the quarters ended September 30, 2005 and 2004,respectively.

 

***Selling, general and administrative expenses.*** SG&A includes expenses related to sales and marketing, customerservice, internal network operations and engineering, information systems andother administrative functions.  SG&Aexpenses were $64.5 million for the third quarter of 2005, an increase of $2.0million or 3% from 2004.  The increase inSG&A is primarily attributable to provisions totaling $13.3 millionrecorded in the third quarter of 2005 related to various access disputes.  This additional expense was partially offsetby savings resulting from the overall reduction of our headcount to betterreflect the current size of the business. Headcount decreased from approximately 2,500 at September 30, 2004 to1,700 employees at September 30, 2005.

 

***Depreciation and amortization.***  Depreciationand amortization includes the depreciation of our communications network andequipment, amortization of other intangibles determined to have finite lives,and amortization over the life of the customer contract of one-time directinstallation costs associated with transferring customers’ local line servicefrom the RBOCs to our local telecommunications services.  Depreciation and amortization expenses were$35.8 million for the quarter ended September 30, 2005, a decrease of $53.0million from the quarter ended September 30, 2004.  This decline is driven by lower depreciationexpense resulting from our $174.8 million impairment charge taken in the secondquarter of 2005 on property and equipment as well as certain assets reachingfully depreciated status in April 2005.

 

***Impairment charges. ***In accordance with SFAS 142, we performedour annual impairment tests of goodwill and other indefinite-lived intangibleassets in connection with the preparation of the financial statements for thequarter ended September 30, 2004.  Thetest resulted in a $263.1 million non-cash impairment charge to eliminategoodwill of $245.1 million and record impairment of $18.0 million on theMcLeodUSA tradename.

 

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***Restructuring charges****.  *In the third quarter of 2005, we incurred$14.7 million in restructuring charges related to financial and legal advisorsand severance costs in connection with our pursuit of strategic alternativesand financial restructuring.

 

***Interest expense.***  Gross interestexpense was $22.0 million for the quarter ended September 30, 2005, an increaseof $9.8 million over the third quarter of 2004 primarily due to an increase inthe average interest rates during the period. Market rates have increased, and, as a result of the event of defaultthat occurred in March, we are required to accrue two additional percentagepoints of interest on our outstanding debt balance.  Net interest expense increased by $10.0million in the quarter ended September 30, 2005 due to higher interest rates onour outstanding debt.  Interest expenseof approximately $0.2 million and $0.3 million was capitalized as part of ourconstruction of our network during the quarter ended September 30, 2005 and2004, respectively.

 

**Nine Months Ended September 30, 2005 Compared with Nine Months EndedSeptember 30, 2004**

 

***Revenue.***  Total revenue for the nine months endedSeptember 30, 2005 declined $78.9 million, or 14%, to $474.6 million from$553.5 million for the nine months ended September 30, 2004.  The following table compares our revenue forthe nine months ended September 30:

 

| ** **                                                                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **Variance** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Local                                                                                         |       | $        | 244.1      |     | $          | 278.6        |       | $ | (34.5 | ) |
| Long distance                                                                                 |       | 98.5     |       | 100.7    |       | (2.2         | )          |
| Data services and other                                                                       |       | 85.6     |       | 101.1    |       | (15.5        | )          |
| Carrier access                                                                                |       | 39.3     |       | 66.0     |       | (26.7        | )          |
| Indefeasible rights of use agreements including those that  qualify as sales type leases |       | 7.1      |       | 7.1      |       | —       |       |
|                                                                                          |       | $        | 474.6      |     | $          | 553.5        |       | $ | (78.9 | ) |

 

Total revenues declined by $78.9 million versus the first nine monthsof 2005 due to a continued decline in total customers, the FCC mandatedreduction in access rates, and lower long distance rates.  Approximately $33.5 million of the decreasein local revenue is attributed to a reduction in the number of access lines inservice due to customer turnover in excess of new lines sold.  Retail long distance declined by $20.0million as a result of both a reduction in volume and rates of approximately$11.2 million and $8.8 million, respectively. This decline was partially offset by a $17.8 million increase inwholesale long distance due to substantial volume increases related to severalwholesale contracts.  The reduction indata services and other revenue is primarily attributable to the reduction intotal customers as well as competitive price reductions for certainproducts.  Access revenues have decreased$26.7 million from the first nine months of 2004 due to the final phase of theFCC mandated rate reduction as well as approximately $6 million of favorablerate settlements recorded in 2004 related to prior period billings.  Included in revenues from indefeasible rightsof use in the above table is $4.0 million and $4.3 million for the nine monthperiods ended September 30, 2005 and 2004, respectively, related to on-goingrevenues from operating leases.

 

***Cost of Service***.  Cost ofservice includes expenses directly associated with providing communicationservices to our customers.  Costsclassified as cost of service include, among other items, the cost ofconnecting customers to our network via leased facilities, the costs paid tothird party providers for interconnect access and transport services, the costsof leasing components of our network facilities and the cost of fiber relatedto sales and leases of network facilities. Cost of service was $271.5 million for the nine month period endedSeptember 30, 2005, a decrease of $35.4 million or 12% from the period endedSeptember 30, 2004.  Approximately $16.0million of the decrease reflects network cost reductions, including least costrouting, network optimization including grooms and migration of customers tothe McLeodUSA network. The balance of the decrease is attributed to thereduction in revenues.  The cost of fiberrelated to sales and leases of network facilities was $0.6 million for the ninemonths ended September 30, 2005 and $0.4 million for the nine months endedSeptember 30, 2004.

 

***Selling, general and administrative expenses.*** SG&A includes expenses related to sales and marketing, customerservice, internal network operations and engineering, information systems andother administrative functions.  SG&Aexpenses were $174.9 million for the nine months of 2005, a decrease of $31.8million or 15% from 2004.  The decreasein SG&A year over year is primarily attributable to actions to reduceexpenses and manage cash as well as reduced headcount.  Headcount decreased from approximately 2,500at September 30, 2004 to 1,700 employees at September 30, 2005.

 

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***Depreciation and amortization.***  Depreciationand amortization includes the depreciation of our communications network andequipment, amortization of other intangibles determined to have finite lives,and amortization over the life of the customer contract of one-time directinstallation costs associated with transferring customers’ local line servicefrom the RBOCs to our local telecommunications services.  Depreciation and amortization expenses were$181.6 million for the nine months ended September 30, 2005, decrease of $85.7million over the first nine months of 2004. This decline is driven by lower depreciation expense resulting from our$174.8 million impairment charge taken in the second quarter of 2005 onproperty and equipment as well as certain assets reaching fully depreciatedstatus in April 2005.

 

***Impairment charges.***In accordance with SFAS 144 and SFAS 142, during thesecond quarter of 2005, we performed impairment tests on our long-lived assetsand indefinite-lived intangible asset. The tests resulted in a $202.5 million non-cash impairment charge toreduce the carrying value of our property and equipment and the McLeodUSA tradename by $174.8 million and $27.7 million, respectively.  During 2004, we performed our annualimpairment tests of goodwill and other indefinite-lived intangible assets inconnection with the preparation of the financial statements for the quarterended September 30, 2004.  The testresulted in a $263.1 million non-cash impairment charge to eliminate goodwillof $245.1 million and record impairment of $18.0 million on the McLeodUSAtradename.

 

***Restructuring charges****.  *During the nine months ended September30, 2005, we incurred $21.6 million in restructuring charges related tofinancial and legal advisors and severance costs in connection with our pursuitof strategic alternatives and financial restructuring.

 

***Interest expense.***  Gross interestexpense was $56.3 million for the nine months ended September 30, 2005, anincrease of $20.2 million over the nine months ended September 30, 2004primarily due to an increase in the average interest rates during theperiod.  Market rates have increased,and, as a result of the event of default that occurred in March, we are requiredto accrue two additional percentage points of interest on our outstanding debtbalance as well as to compound interest on unpaid interest balances.  Net interest expense increased by $21.1million in the nine months ended September 30, 2005 due to higher interestrates on our outstanding debt.  Interestexpense of approximately $0.6 million and $1.4 million was capitalized as partof our construction of our network during the nine months ended September 30, 2005and 2004, respectively.

 

**Inflation**

 

We do not believe thatinflation has had a significant impact on our consolidated operations.

 

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**Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

We have variable rate debt of approximately $777 million under theCredit Agreement outstanding at September 30, 2005.  If market interest rates average 1% more insubsequent quarters than the rates during the quarter ended September 30, 2005,quarterly interest expense would increase by $1.9 million.  This amount was determined by calculating theeffect of the hypothetical interest rate increase on our variable rate debt forthe quarter and does not assume changes in our financial structure.

 

**Item 4.  Controls and Procedures**

 

*Disclosure Controls and Procedures*. The Company’s management, with the participation of the Company’s ChiefExecutive Officer and Chief Financial Officer, has evaluated the effectivenessof the Company’s disclosure controls and procedures (as such term is defined inRules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, asamended (the “Exchange Act”)) as of the end of the period covered by thisreport.  Based on such evaluation, theCompany’s Chief Executive Officer and Chief Financial Officer have concludedthat, as of the end of such period, the Company’s disclosure controls andprocedures were effective.

 

*Internal Controls over Financial Reporting*. There have not been any changes in the Company’s internal control overfinancial reporting identified in connection with the evaluation required byparagraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during ourlast fiscal quarter that have materially affected, or are reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

 

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**PART II**

**OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

Former Chairman Clark E. McLeod, former PresidentStephen C. Gray (then also Chief Executive Officer), Chairman Chris A. Davis (thenChief Operating and Financial Officer) and former Chief Financial andAccounting Officer J. Lyle Patrick (the “Individual Defendants”) are defendantsin a consolidated class action initiated in January 2002 entitled In reMcLeodUSA Incorporated Securities Litigation, Civil Action No. C02-0001 (N.D.Iowa) (the “Iowa Class Action”), alleging inter alia, violations of theSecurities Act of 1933 and the Securities Exchange Act of 1934. The IndividualDefendants moved to dismiss the consolidated amended complaint in the IowaClass Action.  That motion was denied.Discovery is ongoing.   One of theputative class plaintiffs, New Millennium Growth Fund LLC, also filed proofs ofclaim against McLeodUSA in McLeodUSA’s 2002 Chapter 11 Case, seeking at least$104,650 on its own behalf and no less than approximately $300 million (plusinterest, costs and attorneys’ fees as allowed) on behalf of all classclaimants in the Iowa Class Action (the “Bankruptcy Claims” and, together with the Iowa Class Action, the “SecuritiesClaims”).  The Bankruptcy Claims weretransferred from the bankruptcy court in Delaware to the Iowa court, andconsolidated with the Iowa Class Action on February 1, 2005.  As the Securities Claims are in early stages,it is impossible to evaluate the likelihood of unfavorable outcomes or, withrespect to McLeodUSA’s indemnification obligations in connection with theclaims alleged against the Individual Defendants in the consolidated amendedcomplaint, estimate the amount or range of potential loss, if any, toMcLeodUSA.  With respect to theBankruptcy Claims, on May 2, 2002, the Delaware Bankruptcy Court issued anorder establishing a disputed claims reserve of 18,000,000 shares ofReorganized McLeodUSA Class A Common Stock. Any recovery from the BankruptcyClaims would be limited to those shares of stock.  Therefore, the effect of the restructuringmay be to eliminate McLeodUSA as a party to the Bankruptcy Claims.  The Individual Defendants would remainparties to the Iowa Class Action.

 

McLeodUSA has indemnification obligations runningto the Individual Defendants, the terms of which provide for no limitation tothe maximum potential future payments under such indemnifications.  McLeodUSA is unable to develop an estimate ofthe maximum potential amount of future payments under the indemnifications dueto the inherent uncertainties involved in such litigation. McLeodUSA maintainsinsurance, subject to limitations set forth in the policies, which is intendedto cover the costs of claims made against its current and former Directors andOfficers, including the Individual Defendants.

 

McLeodUSA is also involved in numerous regulatoryproceedings before various public utility commissions and the FCC, particularlyin connection with actions by the Regional Bell Operating Companies (“RBOCs”).  McLeodUSA anticipates that the RBOCs willcontinue to pursue litigation, changes in regulations and legislation in stateswithin McLeodUSA’s 25-state footprint, as well as with the FCC, to reduceregulatory oversight and regulation over rates, network access and operations.This includes the pursuit of major changes in the Telecommunications Act of1996 (“1996 Act”), which McLeodUSA believes would adversely affect competitivetelecommunications service providers including McLeodUSA. If adopted, thesechanges could make it more difficult for McLeodUSA to challenge the RBOCs’competitive actions and to compete with the RBOCs generally.

 

The FCC released its Triennial Review Order (“TRO”)in August 2003 modifying its rules governing availability of RBOC unbundlednetwork elements to competitive carriers. The Triennial Review Orderestablished new rules governing the availability and pricing for the networkelements the RBOCs must provide to competitive carriers, and delegated authorityto the states to apply certain of the new rules in individual markets. Severalappeals of the TRO were consolidated in the Court of Appeals for the Districtof Columbia (the “Court of Appeals”).  OnMarch 2, 2004, the Court of Appeals issued a decision overturning many keyelements of the TRO, remanding most of the order to the FCC for further action(*USTA II*). The Court of Appeals ruledthat the FCC’s delegation of final impairment decisions to state agencies wasunlawful.  The Court also reversed theFCC’s nationwide finding regarding mass market switching, dedicated transportand its delegation of decision-making authority to the states. The Courtdirected the FCC to give stronger consideration to intermodal competition whenrevising its rules on remand. The Court upheld the FCC determination that RBOCsdo not have to provide unbundled access at current prices to newly deployedtechnologies based on fiber and packet-switching capabilities. The Court alsoupheld the FCC’s findings that RBOCs are not required to provide unbundledswitching to CLECs for business customers served by high-capacity loops, suchas DS-1 or packet switching.  Stateproceedings that had been started to implement the TRO were suspended in somestates and continued in other states.  The FCC and U. S. Department of Justicedeclined to appeal *USTA II*.  Competitive and interexchange carriers and anorganization representing state regulatory 

 

 

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agencies filed appeals to the U.S. Supreme Court and requested astay.  The U.S. Supreme Court declined toissue a stay.   On July 22, the FCCadopted and on August 22, 2004, the FCC released an Interim UNE Order (the “InterimOrder”) establishing requirements that governed the availability of UNEs untilthe FCC adopted new, permanent unbundling rules.  On December 15, 2004, the FCC announcedadoption of revised permanent unbundling rules that it believes are incompliance with prior appellate decisions. These new unbundling rules impact access to local switching, highcapacity loops, high capacity transport, dark fiber, and entrancefacilities.  The FCC also adopted atransition plan for those elements that will no longer be UNEs.  The Company believes that the new rules arepredominantly supportive of its facilities-based (UNE-L) strategy.  The new unbundling rules became effectiveMarch 11, 2005.  Several parties,including McLeodUSA, have appealed the new unbundling rules.  Oral argument is scheduled for February 2006.

 

In September 2005, the FCC agreed to forebear from applying itsunbundling rules on Qwest in certain wire centers in the Omaha, Nebraskamarket.  The FCC based its decision onits determination that Qwest was no longer the dominant provider in the marketdue to the existence of a cable company that had substantially built its ownloop facilities in the affected wire centers and had attained a sizeable marketshare.  The decision to forebear fromapplying the unbundling rules in these wire centers means that Qwest will nothave to provide competitive providers such as McLeodUSA access to unbundledloops at TELRIC pricing.  Elimination ofaccess to UNEs that materially increases network element prices obtained on acommercial basis would increase our costs and could adversely affect ourability to compete.  The FCC is expectedto issue an order in the fourth quarter of 2005.

 

Regardless of the success, or lack of success, of commercialnegotiations with Qwest and SBC and adoption of final unbundling rules, it islikely that unbundling rules will be the subject of continued litigation.  While major conditions recently announced inconnection with the AT&T/SBC and Verizon/MCI transactions may provide somelimited relief in certain markets, therecan be no assurance that McLeodUSA’s businesses will not be materiallyadversely affected by continued legal challenges to unbundling rules, newlegislation passed in response to unbundling rules or any court decisions thatresult from continued legal challenge to unbundling rules or current law andregulations.

 

The FCC has an open docket proposing to reformintercarrier compensation.  An industrygroup known as the Intercarrier Compensation Forum provided a recommendedframework for reforming intercarrier compensation related to switched accessand reciprocal compensation charges. Other coalitions provided competing recommendations for reformingintercarrier compensation to the FCC. The FCC is evaluating all proposals and has solicited further commentson the issue.  A final decision is expectedno earlier than the first quarter of 2006, and the current framework ofintercarrier compensation rules could be materially affected.

 

On September 10, 2003, the FCC issued a Notice ofProposed Rulemaking (“NPRM”) on Total Element Long Run Incremental Cost (“TELRIC”).  This is a proceeding to review the TELRICmethodology used to determine the prices charged to competitive carriers forunbundled network elements. A change in pricing methodology that materiallyincreases unbundled network element prices would increase our costs and couldadversely affect our ability to compete. A decision is anticipated during 2006.

 

On October 18, 2004, the FCC released an Orderthat extends unbundling relief to the RBOCs for mass market fiber-to-the-curbloops with fiber that is within 500 feet of the premises.  The FCC also clarified that incumbent LECsare not required to add TDM capabilities into new packetized transmissionfacilities.  It is likely that thisadditional unbundling relief and new network modification rule will be thesubject of litigation.  Such changescould limit our access to mass market customers and adversely affect ourability to compete.

 

On October 22, 2004, the FCC voted to eliminate any independentunbundling obligation under Section 271 of the 1996 Act for any network elementthat has been removed from Section 251 of the 1996 Act.  Such relief could limit our access tocustomers and adversely affect our ability to compete.

 

On June 27, 2005, the United States Supreme Courtaffirmed in *National Cable and Telecom Association v. Brand XInternet Services* the FCC’s 2002 ruling that cable modem service,unlike DSL service, is a non-regulated Title I information service.Consequently, cable companies do not have to unbundle their cable network or incurany resale obligations of their broadband service.  On September 23, 2005, the FCC extendedsimilar regulatory relief to RBOC’s retail DSL service.  They classified broadband Internet accessservice as an information service rather than a telecommunications servicebecause it involves more than pure transmission of a signal.  However, the FCC stated that its order does not affect ILECs’obligations to provide UNEs.  The FCCstated that the regulatory status of a service provided 

 

 

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by an ILEC over a network element was not dispositive of its UNEobligations.  Rather, with respect toregulatory classification, it is the use of the network element by the CLECthat determines eligibility.

 

The FCC issued on March 10, 2004 its NPRM on “IP-enabledcommunications,” which includes VoIP. The NPRM asks broad questions regardingthe regulatory classifications of various “IP-enabled” services, includingdifferent VoIP services; the access charge and other intercarrier compensationimplications; the universal service implications; and the other social policyimplications such as law enforcement, disability and emergency 911 serviceissues and suggests, as a general proposition, the economic regulation ofvarious IP-enabled services should be kept to a minimum.

 

In April 2001, the FCC released an Order in which itestablished a benchmark rate at which CLECs’ interstate access charges would bepresumed reasonable and which a CLEC could impose on an interexchange carrier (“IXC”)by tariff. In May of 2004, the FCCannounced a new rule governing CLEC interstate access charges that imposed alimit on CLEC access charges when the CLEC did not directly serve the enduser.  The new rule provided that the chargecould be no more than the rate charged by the ILEC for the samefunctionality.  The FCC order stated itsnew rule limiting CLEC interstate access charges was to be applied on aprospective basis.  McLeodUSA filedtariff changes to implement the FCC’s new rule. The FCC’s Order also provided that, under its prior rules, it would nothave been unreasonable for a CLEC to charge an IXC for those services at thehigher benchmark rate.  Some IXCs,including Qwest, MCI and Sprint, disputed and withheld payment of billed access charges for wirelessoriginated toll free calls and have also withheld payments due to the Companyfor other charges.  The Company, inresponse to these actions, had also withheld payments from them.  McLeodUSAcontinued to bill for its services at the full benchmark rate until the FCC’snew rule went into effect as of June 22, 2004, at which time it billed at therevised rates in accordance with the FCC’s new rule.  As of October 31, 2005 approximately$8.0 million in interstate or intrastate access charges had been disputedand unpaid by Qwest and Sprint in connection to certain types of toll freetraffic for prior periods based on alleged insufficiency of tariff. As aconsequence of the withholding of payments by these carriers, McLeodUSA filedsuit against Sprint Communications Corporation (“Sprint”) in the United StatesDistrict Court for the Northern District of Iowa claiming that, by Sprint’sfailure to pay the interstate access charges that the Company billed, Sprintwas in breach of its contract with the Company. In addition to its breach of express contract claim, the Company ispursuing recovery of its interstate access charges for toll free traffic underimplied contract and unjust enrichment theories against Sprint.  McLeodUSA also filed suit against QwestCorporation.  The Qwest litigation hasbeen resolved and the lawsuits filed in this matter have been dismissed.  In addition, the Company has settled itsdispute with MCI. The Company has recorded charges totaling $13.3 million and$15.7 million related to these access charge disputes in its consolidatedstatements of operations for the three months and nine months ended September30, 2005, respectively.

 

McLeodUSA is one of several defendants in alawsuit brought by SBC and its affiliates in the U.S. District Court in theEastern District of Missouri. SBC alleges that McLeodUSA conspired with one ormore of Global Crossing and its affiliates, certain named competitive localexchange carriers, and/or certain unnamed “least cost routers” to breach SBC’sstate or federal tariffs, unjustly enrich themselves, and commit fraud onSBC.   SBC alleges that the defendantsknowingly disguised long distance calls that were terminated to SBC so thatthey appeared to SBC to be local calls thereby depriving SBC of the differencebetween the access charge rate owed for termination of long distance calls andthe reciprocal compensation rate owed for termination of local calls. McLeodUSA’sanswer was filed on April 1, 2005, denying all liability.   McLeodUSA intends to vigorously defendagainst these claims.

 

Generally, state utility commissions or third parties could raise issueswith regard to our compliance with applicable laws or regulations that couldhave a material adverse effect on our business, results of operations andfinancial condition.    On July 18, 2005,the Arizona Corporation Commission approved a settlement agreement betweenMcLeodUSA and the Arizona Staff that resolved all issues related to certainagreements that we entered into with Qwest several years ago that have sinceexpired.  The Colorado Public UtilitiesCommission continues to review these agreements, and that proceeding may resultin fines or other sanctions against us or the imposition of other conditionsdetrimental to us, including the establishment of discounts available to othercompetitive telephone companies but not to us. Other states may initiatesimilar proceedings.

 

McLeodUSA, as successor to Caprock CommunicationsCorporation, was a defendant in a lawsuit brought by Alcatel USA Marketing,Inc. (“Alcatel”), in County Court No. 5, Dallas County, Texas, entitled AlcatelUSA Marketing, Inc vs. Caprock Communications Corporation and McLeodUSAHoldings, Inc., Cause No. CC04-11573-E. Plaintiff alleged breach of a 1994 supply agreement and certain purchaseorders issued in 2000 under the agreement. Alcatel sought damages of approximately $6.3 million plus interest,costs and attorneys’ fees.  The partieshave settled this dispute, the results of which are reflected in theconsolidated financial statements.

 

 

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On May 9, 2005, AT&T sent a demand to theCompany for arbitration of its claim in excess of $8 million under anEngineering and Construction Management Agreement between AT&T and CapRockTelecommunications Corp. dated November 1999. The claim principally related to construction and fiber optic cablecosts incurred in connection with construction of the Ring 3 fiber optic cableproject from Tulsa, OK to Oklahoma City, OK from 1999 to 2000.  The parties have settled this dispute.  The results of the settlement are reflectedin the consolidated financial statements.

 

As a result of the settlements with Alcatel andAT&T discussed above, the Company has recorded an additional charge to itsoperating expenses of $0.9 million during nine months ended 2005.  McLeodUSA is not aware of any other materiallitigation against it.  McLeodUSA does,however, have various other legal proceedings pending against it or itssubsidiaries or on its behalf or that of its subsidiaries.

 

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** Item 6. Exhibits**

 

 

 
| **Exhibit** | ** ** | ** **                                                                                                                              | ** ** |
|-------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Number**  | ** ** | **Exhibit Description**                                                                                                                 | ** ** |
| 10.1        |       | Real Estate Purchase Contract, dated October 28,  2005 between Life Investors Insurance Company Of America and McLeodUSA  Incorporated. |       |
| 31.1        |       | Certification of CRO pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                        |       |
| 31.2        |       | Certification of Acting CFO pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                 |       |
| 32.1        |       | Certification of CRO pursuant to 18 U.S.C. Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.         |       |
| 32.2        |       | Certification of Acting CFO pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |       |
|        |       |                                                                                                                                    |       |

 

 

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**SIGNATURES**

             Pursuant to the requirements of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized.
| ** **             | **McLEODUSA INCORPORATED** |
|------------------------|----------------------------|
|                   | (registrant)               |
|                   |                       |   |
| Date: November 9, 2005 | By:                        | /s/ Stanford Springel |
|                   |                       | Stanford Springel |
| * *               | * *                   | *Chief Restructuring Officer* |
|                   |                       |   |
| Date: November 9, 2005 | By:                        | /s/ Joseph H. Ceryanec |
|                   |                       | Joseph H. Ceryanec |
|                   |                       | *Acting Chief Financial Officer* |

 

 

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**INDEX TO EXHIBITS**

 
| **Exhibit** | ** ** | ** **                                                                                                                              | ** ** |
|-------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Number**  | ** ** | **Exhibit Description**                                                                                                                 | ** ** |
| 10.1        |       | Real Estate Purchase Contract, dated October 28,  2005 between Life Investors Insurance Company Of America and McLeodUSA  Incorporated. |       |
| 31.1        |       | Certification of CRO pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                        |       |
| 31.2        |       | Certification of Acting CFO pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                 |       |
| 32.1        |       | Certification of CRO pursuant to 18 U.S.C. Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.         |       |
| 32.2        |       | Certification of Acting CFO pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |       |

 

 

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