10-Q 1 d10q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q __________________________ [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarter ended March 31, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____ to _____ Commission File Number: 0-22944 Capsule Communications, Inc. ---------------------------- (Exact name of Registrant as specified in its charter) Delaware 22-3055962 -------- ---------- (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 2 Greenwood Square, 3331 Street Road, Suite 275 Bensalem, Pennsylvania 19020 ---------------------- ----- (Address of principal executive offices) (Zip Code) (215)-633-9400 -------------- (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports); and, (2) has been subject to such filing requirements for the past 90 days. Yes X No ___ --- Indicate the number of shares outstanding of each of the issuer's classes of Common Stock, as of the latest practicable date. Outstanding at Common Stock May 8, 2000 ------------ --------------- $.001 22,667,444 1 CAPSULE COMMUNICATIONS, INC. AND SUBSIDIARIES FORM 10-Q INDEX Page (s) ------- PART I ====== FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets March 31, 2001 (unaudited) and December 31, 2000 3 - 4 Condensed Consolidated Statements of Operations Three Months Ended March 31, 2001 and 2000 (unaudited) 5 Condensed Consolidated Statements of Cash Flows Three Months Ended March 31, 2001 and 2000 (unaudited) 6 Notes to Condensed Consolidated Financial Statements (unaudited) 7 - 10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 - 12 Item 3. Quantitative and Qualitative Disclosure about Market Risk 12 PART II ======= OTHER INFORMATION Item 1. Legal Proceedings 13 Item 2. Changes in Securities and use of Proceeds 13 Item 3. Defaults upon Senior Securities 13 Item 4. Submission of Matters to a Vote of Security Holders 13 Item 5. Other Information 13 Item 6. Exhibits and Reports on Form 8-K 13 SIGNATURE PAGE 14 2 PART I ====== Financial Information Item 1. ------ Financial Statements CAPSULE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS March 31, December 31, 2001 (unaudited) 2000 --------------- ----------- Assets ------ Current Assets Cash and cash equivalents $1,236,262 $ 1,569,473 Restricted cash -- 823,571 Accounts receivable, net of allowance for doubtful accounts of $1,131,303 for 2001, and $1,188,238 for 2000 5,891,473 5,850,739 Prepaid expenses and other 92,322 53,938 ---------- ----------- Total Current Assets 7,220,057 8,297,721 ---------- ----------- Property and Equipment Telecommunications equipment 4,255,311 4,255,311 Equipment 1,975,607 1,973,382 Software 655,422 655,422 Office furniture and fixtures 163,882 163,882 Leasehold improvements 675,765 675,765 ---------- ----------- 7,725,987 7,723,762 Less accumulated depreciation and amortization 5,410,707 5,201,253 ---------- ----------- Total Property and Equipment, net 2,315,280 2,522,509 ---------- ----------- Other assets 304,927 338,216 ---------- ----------- Total $9,840,264 $11,158,446 ========== =========== The accompanying notes are an integral part of these financial statements. 3 CAPSULE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS March 31, December 31, 2001 (unaudited) 2000 --------------- ------------ Liabilities and Shareholders' Equity ------------------------------------ Current Liabilities Note payable $ 1,783,649 $ 1,858,673 Accounts payable 5,809,578 5,753,606 Accrued commissions 671,160 637,483 Accrued expenses and other 793,675 1,743,747 State and Federal taxes payable 1,260,652 1,184,708 Deferred revenue 192,331 176,129 ------------ ------------ Total Current Liabilities 10,511,045 11,354,346 ------------ ------------ Common Shareholders' Equity Common stock, $.001 par, authorized 100,000,000 shares; issued: 22,667,444 shares in 2001 and 2000 22,668 22,668 Additional paid-in capital 14,868,673 14,868,673 Accumulated deficit (15,561,903) (15,087,022) ------------ ------------ (670,562) (195,681) Common stock held in treasury (219,000 shares in 2001 and 2000), at par value (219) (219) ------------ ------------ (670,781) (195,900) ------------ ------------ Total $ 9,840,264 $ 11,158,446 ============ ============ The accompanying notes are an integral part of these financial statements. 4 CAPSULE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) Three Months Ended March 31, 2001 2000 ----------- ----------- Revenues $ 9,570,228 $ 8,733,562 Cost of sales 6,880,435 6,170,011 ----------- ----------- Gross profit 2,689,793 2,563,551 Selling, general and administrative expenses 3,148,054 3,608,208 ----------- ----------- Loss from operations (458,261) (1,044,657) Other income (expense) Interest income 27,777 22,449 Interest expense (44,397) (48,228) ----------- ----------- Net loss attributable to common shareholders $ (474,881) $(1,070,436) =========== =========== Net loss per share attributable to common shareholders $ (.02) $ (.05) =========== =========== Weighted average number of shares outstanding 22,667,444 20,719,796 =========== =========== The accompanying notes are an integral part of these financial statements. 5 CAPSULE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

The accompanying notes are an integral part of these financial statements. 6 CAPSULE COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Background ------------- Capsule Communications, Inc. (the "Company" or "CAPS") is a switch-based interexchange carrier providing long distance telephone communications services primarily to small and medium-size business customers as well as households. The Company also provides inbound-800 long distance services, as well as other telecommunications services such as travel cards (calling cards),local service, cellular, paging, Internet service, dedicated access, data services, pre-paid calling cards (debit cards), international callback, and carrier termination services. The Company uses its own switches and facilities to originate, transport and terminate calls for customers generally located in the Mid- Atlantic region and California (on-net areas). For calls originating or terminating outside the Company's own network (off-net area), the Company utilizes the services provided by other long distance companies. Substantially all of the Company's revenues are earned from its customers located on the East Coast. On May 3, 2000, the Company reincorporated in the State of Delaware as Capsule Communications, Inc. The Company was formerly known as US WATS, Inc. As part of this reincorporation, the Company increased the number of authorized shares of common stock of the Company from 30,000,000 to 100,000,000 and the number of authorized shares of preferred stock of the Company from 1,000,000 to 2,000,000. On March 28, 2001 Gold & Appel, the company's largest shareholder, sold a majority ownership interest (15,471,301 shares) in the Company at a price of $.20 per share for a total amount of $3,094,260. The purchaser is also the chairman of another publicly traded telecommunications company. The Company has received a letter of interest from this other telecommunications company regarding a possible merger. However, there can be no assurances that a merger agreement will be negotiated on favorable terms to the Company, or that a merger will occur at all. The accompanying unaudited interim condensed consolidated financial statements and related notes have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission and in the opinion of management, include all adjustments necessary for a fair presentation of such financial statements. Such adjustments consist only of normal recurring items. Certain information and note disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. Where appropriate, certain amounts in the prior period financial statements have been reclassified to conform to the current period presentation. The results of operations for the three months ended March 31, 2001 are not necessarily indicative of results to be expected for the full year. The accompanying unaudited interim condensed consolidated financial statements and related notes should be read in conjunction with the financial statements and related notes included in the Company's Form 10-K for the year ended December 31, 2000. 2. Liquidity and Continuation Of Business ----------------------------------------- The condensed consolidated financial statements of the Company have been prepared on a going-concern basis, which contemplates the continuation of operations, realization of assets and liquidation of liabilities in the ordinary course of business. The Company incurred a net loss applicable to common shareholders of approximately $475,000 for the quarter ended March 31, 2001 and had negative cash flow from operating activities of approximately $1,079,000. At March 31, 2001 the Company had a net working capital deficit of approximately $3,291,000 and an accumulated deficit of approximately $15,561,000. The Company renewed its line of credit arrangement with Wells Fargo for one more year on May 11, 2001. Such conditions raise substantial doubt about the Company's ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might be necessary should the Company be unable to continue as a going concern. 7 CAPSULE COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS The Company plans to focus on growing its revenue base through the addition of profitable customers and decreasing its network costs. The Company intends to reduce its network costs by obtaining more favorable pricing from suppliers, by forming strategic alliances with certain similarly situated companies, increasing the network traffic on its fixed cost network, and also discontinuing the operations located in Oakland California and using a more cost favorable way to transport that existing traffic. The Company expanded on its private Internet web sites from which its agents are generating new orders electronically. The Company expects to continue its efforts to expand this strategy in order to generate new business. In addition to these private Internet sites, the Company plans to implement an electronic business-to-business strategy to reduce overhead costs associated with operating its agent sales force channel. Additionally, the Company began the resale of local access services to its current and prospective customers in six Bell Atlantic, now Verizon states under its favorable interconnection agreements. On March 15, 2001, Company entered into a Loan Agreement with Gold & Appel Transfer, S.A. ("G&A"), a majority shareholder of the Company. The terms of the agreement calls for the Company to borrow up to $900,000 at a rate of 12% per annum, due and payable on June 15, 2002. The agreement allows G&A to convert all or any portions of the loan amount to shares of the Company's Common Stock at the average trading price for 20 days up to the conversion date at any given time during the loan period. The Company borrowed the first $300,000 on March 15, 2001. The remaining two $300,000 borrowings are required to be paid by May 1, 2001 and June 15, 2001 respectively. The second installment due on May 1, 2001 was not received at the Company's option. However, at the Company's option these borrowings may be made at a later date. This loan agreement violates one of the restrictions in the Company's $2,000,000 credit facility with Wells Fargo Credit Corporation. The Company has not yet received a waiver of such condition of non-compliance. The Company believes that the loan agreement, combined with its cost reductions will be adequate to allow the company to continue its operations, however there can be no assurances to this effect. The company was not be able to meet the minimum financial requirements necessary to maintain its listing on the NASDAQ SmallCap Market. Management has determined that utilizing the capital to maintain this list is not in the best interest of the shareholders, and chose not to raise the additional funds. Instead management is focusing on raising funds to correct its current cost structure and also improve its current financial position. Also, in order to achieve the Company's plans for growth in the long distance business as well as its entry into other communications services, the Company may require additional equity and is currently seeking sources of funding. The Company cannot give assurance as to the potential success of these efforts. 3. Notes Payable ---------------- The Company has a revolving $2,000,000 credit facility with Wells Fargo Business Credit Corporation, which was renegotiated and amended on May 11, 1999 and was automatically renewed for one more year beginning on May 11, 2001. Interest on the revolving credit facility is currently calculated at the prime lending rate plus 2 3/4%, on a minimum loan balance of $750,000. The loan is collateralized by accounts receivable and fixed and intangible assets of the Company. As of March 31, 2001 the Company's outstanding balance on its credit facility was $ 1,483,649 leaving $516,351 available based on collateral, for future borrowing under the credit facility. The loan agreement contains covenants and restrictions which, among other things, require maintenance of certain subjective financial performance criteria and restrict encumbrance of assets, creation of indebtedness and places limitations on annual capital expenditures. The loan agreement with Gold and Appel, S.A. discussed below violates one of the restrictions in the Company's $2,000,000 credit facility with Wells Fargo Credit Corporation. The Company has not yet received a waiver of such condition of non-compliance. 8 CAPSULE COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS On March 15, 2001, Company entered into a Loan Agreement with Gold & Appel Transfer, S.A. ("G &A"), a significant shareholder of the company, and the Foundation for the International Non-Governmental Development of Space, a non- profit organization ("FINDS"), a shareholder of the Company of which Mr. Anderson is the president and director. The terms of the agreement call for the Company to borrow up to $900,000 at a rate of 12% per annum, due and payable on June 15, 2002. The agreement allows G&A and FINDS to convert all or any portions of the loan amount to shares of the Company's Common Stock at the average trading price for 20 days up to the conversion date at any given time during the loan period. The Company borrowed the first $300,000 on March 15, 2001. The remaining two $300,000 installments are required to be paid by May 1, 2001 and June 15, 2001 respectively. The second installment due on May 1, 2001 was not received at the Company's option. However, at the Company's option these installment payments may be made at a later date. At December 31, 2000 the Company maintained a letter of credit with First Union Bank in the amount of $752,000 for the potential settlement of litigation related to Mr. Scully (see footnote 4). The letter of credit was collateralized by cash on deposit with First Union Bank in the amount of $823,571 at December 31, 2000. The letter of credit was released by First Union on February 28, 2001 upon settlement of the litigation with Mr. Scully. 4. Litigation ------------- On June 13, 1997, Mark Scully, a former President and Chief Operating Officer of the Company, filed a complaint against the Company, Kevin O'Hare, Aaron Brown and Stephen Parker in the United States District Court for the Eastern District of Pennsylvania. Mr. Scully asserted various claims in connection with his termination of employment with the Company on December 30, 1996. In particular, he alleged, among other things, breach of contract in connection with the termination of certain stock options, breach of the alleged contract for employment, breach of an asserted duty of good faith and fair dealing, fraudulent and negligent misrepresentation, and civil conspiracy. Mr. Scully alleged damages of at least $1.6 million, plus attorneys' fees, costs and other disbursements and the cost of COBRA payments and interest; $1 million of the alleged damages claimed are punitive. On June 9, 1999, the Court issued its decision and judgment was entered in favor of Mr. Scully and against the Company and two former officers for the sum of approximately $626,000 and required the Company to establish an escrow account equal to 120% of the judgment. The Court denied Mr. Scully's claim for attorneys' fees and liquidated damages. The Company appealed the decision, and on February 1, 2001 the appeals court reaffirmed the lower court's decision and judgment was entered in favor of Mr. Scully and against the Company and two former officers for the sum of $1,080,000 which consisted of the original award of $626,443 in damages plus legal expenses and interest. The Company ultimately settled with Mr. Scully for $1,030,000 on February 28, 2001. The Company had provisioned $1,030,000 for this liability as of December 31, 2000 and there was no additional expense recorded in the three months ended March 31, 2001. The entire $1,030,000 was paid in full during March 2001, and the Company no longer retains any liability provision for this litigation. The Company is party, in the ordinary course of business, to other litigation involving services rendered, contract claims and other miscellaneous causes of action arising from its business. The Company has established reserves relating to its legal claims and believes that potential liabilities in excess of those recorded will not have a material adverse effect on the Company's Condensed Consolidated Financial Statements, however, there can be no assurances to this effect. 5. Acquisition -------------- On March 17, 2000, the Company purchased certain assets of the business of Cam- Comm, Inc. At the time of the transaction, James Rossi was the chairman of the Company and owned Cam-Comm. The Company acquired the customer base and accounts receivable of $83,876 private line customers from Cam-Comm, Inc. in exchange for a cash payment of $150,000 and an agreement to pay an amount of $76,405 for an outstanding liability of Cam-Comm, Inc. Goodwill of $142,529 was recorded and will be amortized over three years. 9 CAPSULE COMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 6. Other Sales Information -------------------------- Net sales information by the Company's product groups for the quarters ended March 31 are summarized as follows:

Item 2. ------ Management's Discussion and Analysis of Financial Condition and Results of Operations Forward Looking Statements: --------------------------- This annual report on Form 10-K includes "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended and Section 27A of the Securities Exchange Act of 1933, as amended. Financial projections and words and phrases denoting the anticipated results of future events, such as "anticipate", "believe","estimate", "expects", "may", and "project" and similar expressions that denote uncertainty are intended to identify forward looking statements and information. Such statements are subject to certain risks and uncertainties, including but not limited to: changes in general economic conditions, increasing levels of competition in the telecommunications industry, changes in telecommunications technologies, changes in FCC regulations, the Company's reliance on transmission facilities based carriers, risks involved in conducting international operations, the inability to generate sufficient revenues to meet debt service obligations and operating expenses, unanticipated costs associated with the Company's recent and future acquisitions and the failure of the Company to manage its growth effectively. Should one or more of these risks or uncertainties materialize, actual results may vary materially from those estimated, anticipated or projected. Although the Company believes that the expectations reflected by such forward-looking statements are reasonable based on information currently available to the Company, no assurance can be given that such expectations will prove to have been correct. All forward-looking statements included herein are expressly qualified in their entirety by these cautionary statements. Results of Operations: ---------------------- Revenue for the quarter ended March 31, 2001 increased approximately $837,000 (9.5%) versus the quarter ended March 31, 2000. The Company's revenue derived from retail sales through the agent and reseller channels increased by approximately $830,000. Although the per minute retail rate decreased approximately $.01 per minute, the Company increased the number of minutes by approximately 22.3 million, or about 31%. The Company continued to expand its private Internet web sites from which its agents are generating new orders electronically. The Company has recently issued a new selling plan with aggressive pricing to the agents. This strategy is intended to allow the Company to build the revenue base by adding additional minutes in order to offset the decline in the retail rate per minute. The Company also generated revenues of approximately $310,000 from its resale of local services which the Company did not offer in the first quarter of 2000. Revenue through the carrier sales channel decreased by approximately $488,000 for the quarter ended March 31, 2001, or 27%, from the quarter ended March 31, 2000. The decline in carrier revenue was a result of the Company's decision to focus its sales efforts on the higher margin, lesser risk retail market. In the first quarter 2001, the Company increased its Private Line revenue stream approximately $200,000. 10 For the quarter ended March 31, 2001, gross profit increased approximately $126,000 or 28.1% as a percentage of revenues. Although gross profit as a percentage of revenues decreased from 29.4% for the quarter ended March 31, 2000 to 28.1% for the quarter ended March 31, 2001, the increase in minutes of use and revenues was large enough to produce the increase in gross profit. The Company is currently implementing cost reductions on its own network. These cost reductions should be completed by the end of July 2001, and the Company believes that these cost reductions will increase its gross profit percentage margin by reducing fixed costs as the company increases the minutes of use over its network. Also, in March 2001, the Company sucessfully negotiated a 17% cost reduction in the transportation portion of the charges from its "off-net" service provider. If the Company's "off-net" revenue remains consistent, this reduction should increase gross profit by approximately 0.4%. These cost savings will begin to be realized in April 2001. Selling, general and administrative ("SG&A") expenses for the quarter ended March 31, 2001 decreased approximately $460,000 versus the amount incurred for the quarter ended March 31, 2000. This decrease in SG&A expense is mainly due to a decrease in salary expense of approximately $128,000, a decrease in commission expense of approximately $101,000 and a decrease in legal expenses of $175,000. Explainations for these decreases are as follows: . The salary expense decrease was a result of the elimination of a direct sales and marketing program and its related staff. . The reduction in the commission expense is mostly a result of the Company moving its sales strategy from an agent channel from a "buy-rate" program to a percentage commission program. The Company also realized some SG&A savings from administering this program. . The decrease in legal expense is a result of the cost associated with the Company reincorporating in 2000, and also a reimbursement of $100,000 received from Startec Global Communications as a result of a settlement for an incomplete merger. Interest expense for the quarter ended March 31, 2001 remained relatively the same as the quarter ended March 31, 2000. The net loss for the quarter ended March 31, 2001 was approximately $475,000, a decrease of approximately $595,000 versus the quarter ended March 31, 2000. This decrease in net loss is mostly attributable to increased gross profit of approximately $126,000 and a decrease in SG&A expenses of approximately $460,000. On January 25, 2001, the Company announced that it had terminated its proposed merger agreement with Startec Global Communications Corporation. In its notice of termination, the Company asserted that Startec had breached various representations, warranties and covenants in the merger agreement. On that same day, Startec Global Communications Corporation announced that it served Capsule Communications with notice of breach of the merger agreement. On March 12, 2001 Capsule and Startec jointly announced that they had resolved all issues resulting from the termination of the merger agreement. Both parties have released each other from any liability and are continuing with their separate business plans. To reflect differences in incurred merger expenses, Startec will make a series of payments to Capsule over the next few months totaling $400,000 in the aggregate. Capsule received $100,000 on March 15, 2001 as the first payment. This amount was recorded as a reduction in SG&A. The remaining 3 payments will be received in 60 day increments, the first to be received on May 15, 2001. Liquidity and Capital Resources ------------------------------- At March 31, 2001, cash and cash equivalents were $1,232,262. Cash flow used in operations in the first quarter of 2001 was $1,079,533. Net cash provided by investing activities was $821,346 which primarily resulted from the restricted cash being utilized as settlement for litigation. Working capital deficiency at March 31, 2001 was approximately $3,291,000 as compared to a deficiency of approximately $3,056,000 at December 31, 2000. The decrease in working capital was primarily due to the net loss 11 as discussed in the Results of Operations section. The Company's working capital ratio decreased from .73:1.00 at December 31, 2000 to .68:1.00 at March 31, 2001. On March 15, 2001, the Company entered into a Loan Agreement with Gold & Appel Transfer, S.A. ("G &A"), a significant shareholder of the company, and the Foundation for the International Non-Governmental Development of Space, a non- profit organization ("FINDS"), a shareholder of the Company of which Mr. Anderson is the president and director. The terms of the agreement call for the Company to borrow up to $900,000 at a rate of 12% per annum, due and payable on June 15, 2002. The agreement allows G&A and FINDS to convert all or any portions of the loan amount to shares of the Company's Common Stock at the average trading price for 20 days up to the conversion date at any given time during the loan period. The Company borrowed the first $300,000 on March 15, 2001. The remaining two $300,000 installments are required to be paid by May 1, 2001 and June 15, 2001 respectively. The second installment due on May 1, 2001 was not received at the Company's option. However, at the Company's option these installment payments may be made at a later date. This loan agreement violates one of the restrictions in the Company's $2,000,000 credit facility with Wells Fargo Credit Corporation. The Company has not yet received a waiver of such condition of non-compliance. The Company believes that the loan agreement, combined with its cost reductions will be adequate to allow the company to continue its operations, however there can be no assurances to this effect. On March 28, 2001 Gold & Appel, the company's largest shareholder, sold a majority ownership interest (15,471,301 shares) in the Company at a price of $.20 per share for a total amount of $3,094,260. The purchaser is also the chairman of another publicly traded telecommunications company. The Company has received a letter of interest from this other telecommunications company regarding a possible merger. However, there can be no assurances that a merger agreement will be negotiated on favorable terms to the Company, or that a merger will occur at all. On March 5, 2001 the Company announced that it received notification from NASDAQ on February 26, 2001 that the Company was no longer in compliance with the minimum net tangible assets requirements for continued listing on The NASDAQ SmallCap Market set forth in Marketplace Rule 4310(c)(2)(B). The NASDAQ Staff had therefore determined to delist the Company's securities from The NASDAQ SmallCap Market at the opening of business on March 6, 2001. The Company determined not to appeal the NASDAQ Staff's determination, and therefore, effective March 6, 2001, the Company's securities began to trade on the OTC- BB under the symbol "CAPS.OB." Item 3. ------- Quantitative and Qualitative Disclosure About Market Risk The Company does not invest in any derivative financial instruments, and all of its cash is in commercial checking and money market accounts. The company has no long-term debt. The Company uses its line of credit to finance a significant portion of its operation. This on-balance sheet financial instrument, because of its variable rate of interest, exposes the Company to interest rate risk resulting from changes in the related banks' base rate. The Company does not believe this risk to be material. 12 PART II ======= Other Information Item 1. Legal Proceedings On June 13, 1997, Mark Scully, a former President and Chief Operating Officer of the Company, filed a complaint against the Company, Kevin O'Hare, Aaron Brown and Stephen Parker in the United States District Court for the Eastern District of Pennsylvania. Mr. Scully asserted various claims in connection with his termination of employment with the Company on December 30, 1996. In particular, he alleged, among other things, breach of contract in connection with the termination of certain stock options, breach of the alleged contract for employment, breach of an asserted duty of good faith and fair dealing, fraudulent and negligent misrepresentation, and civil conspiracy. Mr. Scully alleged damages of at least $1.6 million, plus attorneys' fees, costs and other disbursements and the cost of COBRA payments and interest; $1 million of the alleged damages claimed are punitive. On June 9, 1999, the Court issued its decision and judgment was entered in favor of Mr. Scully and against the Company and two former officers for the sum of approximately $626,000 and required the Company to establish an escrow account equal to 120% of the judgment. The Court denied Mr. Scully's claim for attorneys' fees and liquidated damages. The Company appealed the decision, and on February 1, 2001 the appeals court reaffirmed the lower court's decision and judgment was entered in favor of Mr. Scully and against the Company and two former officers for the sum of $1,080,000 which consisted of the original award of $626,443 in damages plus legal expenses and interest. The Company ultimately settled with Mr. Scully for $1,030,000 on February 28, 2001. The Company had provisioned $1,030,000 for this liability as of December 31, 2000 and there was no additional expense recorded in the three months ended March 31, 2001. The entire $1,030,000 was paid in full during March 2001, and the Company no longer retains any liability provision for this litigation. The Company is party, in the ordinary course of business, to other litigation involving services rendered, contract claims and other miscellaneous causes of action arising from its business. The Company has established reserves relating to its legal claims and believes that potential liabilities in excess of those recorded will not have a material adverse effect on the Company's Condensed Consolidated Financial Statements, however, there can be no assurances to this effect. Item 2. Changes in Securities None. Item 3. Defaults upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: (b) Reports on Form 8-K: . On March 28, 2001, Gold & Appel Transfer, S.A., a British Virgin Islands corporation ("Gold & Appel"), and Henry G. Luken III entered into a Stock Purchase Agreement pursuant to which Mr. Luken purchased 15,471,301 shares (the "Common Shares") of the common stock, par value $0.001 (the "Common Stock"), of Capsule Communications, Inc. ("Capsule") from Gold & Appel (the "Stock Sale") at $0.20 per share for a total purchase price of $3,094,260.20 (the 13 "Purchase Price"). Pursuant to a power of attorney from Gold & Appel, before the Stock Sale, Walter C. Anderson had sole investment power over the Common Shares. Mr. Luken delivered the Purchase Price to Gold & Appel at the closing of the Stock Sale on March 28, 2001. Mr. Luken paid the Purchase Price from his personal funds. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Capsule Communications, Inc. (Registrant) By: /s/ David B. Hurwitz ---------------------------------------------- David B. Hurwitz President and Chief Executive Officer By: /s/ Randolph A. Fry ---------------------------------------------- Randolph A. Fry Chief Financial Officer (Principal Financial and Accounting Officer) Dated: May 14, 2001 14

CAPSULE COMMUNICATIONS INC DE 10-Q