Business Leasing and Finance News (BLFN) Summer Edition 2012
By David G. Mayer
BLFN has been out of circulation for a while, but we are happy to be here. Thanks to all the loyal readers of BLFN for asking me where the next edition is or how to subscribe. Happily, despite the hiatus, BLFN is still growing worldwide and has never had so many subscribers.
Most of what I hear from you is how businesses in the past several months have dipped their toes in the cool or frigid economic waters only to pull back. They continue to wait for any encouraging economic signals that indicate it is safe to deploy capital, hire new employees and make significant new financial commitments. So much uncertainty throttles our businesses, inhibits our decision-makers and shakes our confidence.
Media articles and surveys often paint divergent pictures of the economy and its direction. The latest economic news implies that businesses have again retreated; they seem reluctant to go near the water. Corporate cash continues to rise, unemployment remains stubbornly high and a new round of economic stimulus does not seem to be in the cards.
Amid the economic doldrums, the Institute for Supply Management-Chicago Inc. (ISM) reported an unexpected increase to 53.7 (50 means growth) in consumer confidence, the first gain in five months. See Consumer Confidence in U.S. Unexpectedly Climbed in July, Bloomberg Business Week (July 31, 2012). Unfortunately, this good news promptly succumbed to the bad news from ISM that the manufacturing index fell to 49.7 from 53.5 in May. At a score of 50 or less, the ISM indicates that manufacturing is contracting; it did so in June for the first time since the recession ended in June 2009. See Manufacturing in U.S. Unexpectedly Contracted in June, Bloomberg (July 2, 2012). The July Manufacturing ISM offered no good news either. In its August 1, 2012 news release, ISM said: “The PMI registered 49.8 percent, an increase of 0.1 percentage point from June's reading of 49.7 percent, indicating contraction in the manufacturing sector for the second consecutive month, following 34 consecutive months of expansion.” Manufacturing is crucial to economic recovery and capital investment, including equipment finance.
The Monthly Confidence Index - Equipment Finance Industry (MCI-EFI) (July 2012) in July offers a mixed bag of concern and confidence. Published by the Equipment Leasing & Finance Foundation (ELFF), the monthly confidence index reports in part that “12.9% of survey respondents believe demand for leases and loans to fund capital expenditures (capex) will increase over the next four months, an increase from 8.1% in June. 71% believe demand will “remain the same" during the same four-month time period, up from 64.9% the previous month. 16.1% believe demand will decline, down from 27% in June.” The surveys suggest that the equipment finance business has a very long way to achieve sustainable growth and prosperity.
As lessors and lenders, you still can profit by differentiating your products from other funders and applying your intellectual capital to out structure your competition. Though this point may be spot on, it sounds so optimistic, even Pollyanna would approve. Perhaps the only way to win business in this market is to buy it: Find the cheapest money available and use it with abandon to offer the lowest market rates to customers. As is often the case, the best approach probably lies somewhere in the middle.
The indices may benefit from the success of your business, but the underpinnings of the indices seem unlikely to confer any benefit on your business. It is clearly up to you to find the right balance in the face of the economic challenges ahead. It would be welcome, indeed, for the indices to swing from the doldrums into positive territory and stay there. It’s anyone’s guess when that will happen.
Enjoy the balance of the summer! Thanks very much for reading BLFN. Keep in touch; it is always great to hear from you.
1. Latest Decisions in Lease Accounting Project Cloud Industry’s Future
Some fog cleared in London on June 13, 2012 when the FASB and IASB met there and made additional decisions regarding their lease convergence project (Project). They conducted a videoconference Board Meeting on July 17, 2012 where they made more tentative decisions. The fog did not clear in July; rather, it is giving way to dark clouds for equipment leasing and partly sunny skies for real estate leasing.
As of last fall, Grant Thornton reported that the Project could affect more than $1.25T of leases (real estate and equipment) on an undiscounted basis for U.S. listed companies alone (without even counting other companies).
Even though experts view the Project as making one of the most significant global accounting changes in the past decade, Grant Thornton also found that 54 percent of global businesses are not aware of, and are therefore unprepared for, the cascading effect of the changes that the Project will impart on balance sheets and the leasing business.
*Terms to Know: FASB refers to the Financial Accounting Standards Board, which establishes standards of financial accounting that govern financial reports of nongovernmental entities. The IASB is FASB’s international counterpart and accordingly, it “is the independent standard-setting body of the IFRS Foundation.” The FASB and IASB (collectively, the Boards) have been working on converging their standards since 2002.
The Project overhauls FAS No. 13 (FAS 13), which is the 1976 Financial Accounting Standard governing lease accounting in the U.S. The Project aims to create one uniform standard for lease accounting that largely displaces FAS 13.
According to the IASB: “The boards undertook the leases project to address the widespread concern that many lease obligations currently are not recorded on the balance sheet and that the current accounting for lease transactions does not represent the economics of all lease transactions.” Not surprisingly, the FASB articulates a similar view.
Timeline to Next Exposure Draft
The timeline for the Project from the June 13, 2012 meeting until the effective date of the final exposure draft (ED), the document that will set forth the converged accounting guidance, is:
Begin drafting the ED
Issue the ED in the fourth quarter of 2012 with a 120 day comment period
Review the comment letters and revise the ED if necessary in the first half of 2013
Issue the final standard late in 2014
Set an effective date of 2017 or later (a transition year) to allow lessees and lessors time to develop systems, extract lease data and prepare comparative financials under the new models
*Warning: The transition will be complicated. If you are a lessee, the Boards decided that you can either recognize a “Right of Use” (ROU) asset for each outstanding lease or apply a full retrospective approach. Watch for the optimal way, if there is one, to handle the front-ended costs for existing (and new) leases.
Address issues specific to non-public entities at a future FASB-only meeting
Action Point: When the new ED emerges, lessors and their lessee customers should send a comments letter to the Boards; the letters can still make a difference.
In their June 13, 2012 meeting, the Boards made key decisions on lessee and lessor accounting in the Project. Mostly, the Boards appeared to offer bad news for equipment lessees and good news for real estate lessees and lessors.
Decision on the Two Lease Approach
Although the Boards were spilt with the FASB favoring a two-lease model and the IASB favoring a one lease model, they took a second vote in an earlier meeting on whether compromise was possible to get a converged standard. In the second vote the majority agreed it could compromise on a two-lease model approach for both lessees and lessors with both using the same dividing line to determine which accounting approach to use.
*Terms to Know: The “line” generally refers to FAS 13 type criteria examined when selecting the appropriate accounting method for a lease. Leases on one side of the classification “line” will use a different accounting method than leases that fall on the other side of the classification line under FAS 13. However, the line under the ED is more subjective under the proposed ED than the “bright lines” used in FAS 13.
The Equipment Leasing and Finance Association (the ELFA) has advocated a two-lease approach since the outset of the Project in 2006. The bad news arises from the way the Boards drew the classification lines. The Boards distinguish leases that get straight line rent expense from leases that get front-ended interest and amortization.
*Technical Point: Rent expenses include transaction costs, and imputed interest, which when combined reduces profit on the books of the lessor.
Two Lease Approach for Lessees; Disclosures Required
The two lessee approaches (with an exception for short term leases, which may continue to use the existing operating lease model) are:
A lessee uses the Interest and Amortization method (I&A) approach (a change of terminology from “Right of Use” (ROU) approach) when a lease is capitalized, the asset is amortized straight-line, and interest is imputed on the liability. The result is a front-end loaded expense pattern; and
The Single Lease Expense (SLE) method (a change of terminology from the “Whole Contract Method”) dictates that the asset and liability be capitalized, then adjusted each month to equal the present value of the remaining payments. The profit and loss relating to the lease is recognized on a straight line basis, as the average rent is accrued each rent period and the actual rent paid is charged to the accrued rent payable account.
*Terms to Know: A “short-term” lease refers to a “lease that, at the date of commencement of the lease, has a maximum possible term, including any options to renew, of 12 months or less.”
At the July 17 meeting, the “Boards … decided that a lessee should disclose the following:
A single maturity analysis, which sets out the future undiscounted cash flows relating to all lease liabilities and reconciles to the total lease liability.
A separate reconciliation of opening and closing balances for (a) lease liabilities recognized under the … I&A … approach and (b) lease liabilities recognized under the SLE approach. The reconciliation should include interest or the unwinding of the discount on the lease liability.
Additionally, the FASB tentatively decided not to bifurcate the disclosure of the maturity of contractual commitments associated with services and other non-lease components between the two lessee accounting approaches.”
In a change of their previous decision regarding disclosure, the Boards tentatively decided that disclosure “of lease costs incurred in the reporting period to only include costs relating to variable lease payments not included in the lease liability.”
Two Lease Approach for Lessors
The two lessor approaches (with an exception for short term-leases) are:
The Receivable and Residual (R&R) method; and
The Operating Lease method (same as current used in FAS 13).
The Boards will create a new classification paradigm where real estate leases and equipment leases are treated differently.
For equipment leases it is presumed that the lease will be accounted for as an I&A lease for lessees and an R&R lease for lessors unless the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset (in that case it is a whole contract lease for lessees and an operating lease for lessors).
Some leases transfer ownership rights while others merely transfer a right of use. For leases that only transfer a right of use, the leases should, for accounting purposes, be treated as executory contracts with a level cost pattern.
*Warning: This new paradigm is drastically different and more unfavorable than the current lease classification tests in FAS 13 because fewer equipment leases will qualify to recognize rent expense on a straight line basis. Lessees will have to keep two sets of records to complete their tax returns. They argue that lease liability should not be classified as debt and disclose information to potential lenders and lessors for use in assessing credit risk.
For real estate leases it is presumed the lease will be accounted for as a SLE lease for lessees, and an operating lease for lessors, unless the lease term is for the major part of the economic life of the underlying asset or the present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset (in those cases the lease will be accounted for as an I&A lease for lessees and an R&R lease for lessors). This new line is very close to the current FAS 13 lease classification tests so virtually all real estate operating leases will get straight line rent expense under the proposed new rules – good news for real estate lessees.
*Tip: If the Revenue Recognition Project views a purported lease as a financed purchase, the lease should not be considered a lease for purposes of the new lease standard.
Where a lessee controls the underlying asset under an agreement called a “lease” the lease will be considered a financing – not a lease. A lessee will generally control the asset under a financing where, for example, the lease includes an automatic transfer of title or a bargain purchase option at the end of the lease term. Accordingly, capital lease accounting should be used by lessees where a lessee has control of the asset. Correspondingly, lessors should use sale and loan accounting for such financing leases.
*Term to Know: The Revenue Recognition Project refers to a project of the Boards to clarify the principles for recognizing revenue and to develop a common revenue standard for U.S. GAAP and IFRSs, which differ substantively, as do the Boards themselves.
Assessment of Key Decisions
In assessing the decision at the July 10, 2012 meeting, the following observations were made:
It is clearly bad news, but not a surprise, that the Boards will terminate leveraged lease accounting, the exclusion of investment tax credits from revenue recognition in non-leveraged leases and changes to sales-type lease profit recognition.
It is good that the Boards decided on a two-lease model as it should be closer to the economics of leases. However, the paradigm shift for equipment leases is drastically different than current GAAP, which makes the decision clearly unfavorable for equipment leases.
It is bad news that equipment lessees will have a more difficult task of classifying leases under the proposed line as leases; and it is unclear how the more subjective judgment than under FAS 13 will affect this classification.
The proposed line is based on a judgment as to whether the lease term or present value of the rents is insignificant whereas the current FAS 13 lease classification tests are the opposite – the determination of whether a lease is capitalized arises when the present value of the rents is a significant part of the rents payable during the lease term (i.e., more than 89.9 percent of the present value of fixed rents).
*Term to Know: The term “insignificant” is new to lease accounting. Accordingly, definition and implementation guidance will be needed to provide context for that term.
Put as a question, is the lease term or the present value of lease payments more than insignificant compared to the useful life and fair value of the underlying leased asset? If yes, then the ED will probably require equipment leases to have front-ended costs.
U.S. lessors may regard the Boards’ decisions on the line drawn for their accounting as generally good news in comparison to current GAAP. That is the case because (1) there will be fewer operating leases for bank lessors and finance company lessors, and (2) real estate, full service and certain short/medium term equipment lessors will be able to continue using the operating lease method. The proposed lessor accounting will provide results that are closer to the economic effects of leases compared to current GAAP.
If the Boards maintain symmetry between lessee and lessor accounting and then move the line, lessors may find the good news turning to bad. Lessors favor the use of a business model to define the line with financial lessors using the R&R method while operating lessors use the operating lease method.
*Tip: As a lessor, discuss these issues with your accounting team soon to decide how to plan your future transactions in anticipation of the new leasing standard.
Although the decisions of the Boards may look like a step in the right direction, uncertainty will rein until the Boards issue the next ED in 2014. Any company that leases real and/or personal property should begin an orderly process of identifying affected leases and prepare to act under a fundamentally different approach when the Boards issue the final standard in this high-stakes shift of accounting for leases.
Thanks to William Bosco, President of Leasing 101, a lease consulting company, for contributing this article. He is a member of the ELFA Financial Accounting Committee and a member of the Lease Project Working Group representing the ELFA. He can be reached at firstname.lastname@example.org or 914-522-3233. His website is www.leasing-101.com. This article is adapted from reports he recently published for the ELFA.
2. Aviation Industry Buffeted by FAA Plans for Non-Citizen Trusts
After more than a year of deliberations, the Federal Aviation Administration (FAA) issued ground rules on entities it will trust in the U.S. aircraft registration system; and non-citizen owner trusts may not be one of them.
In February, the FAA unveiled a proposed notice on improving the accuracy and integrity of its aircraft registration system. It focused on those U.S. citizen owner trustees (Trustees) that hold legal title to U.S. registered aircraft for non-U.S. citizens. The non-U.S. citizens own the beneficial interest in the trust. Notice of Proposed Policy Clarification for the Registration of Aircraft to U.S. Citizen Trustees in Situations Involving Non-U.S. Citizen Trustors and Beneficiaries, 77 FR 6694 (Feb. 9, 2012) (Notice). When completed, the FAA will produce final guidance based on the Notice, hearings and comments it receives.
*Terms to Know: A “U.S. citizen” refers to individuals who are citizens of the United States or its possessions (by birth), partnerships and corporations, and those who qualify as resident aliens. Federal regulations focus, generally, on assuring, for registration purposes, that corporations are owned, operated and actually controlled by citizens of the United States and that partnerships are composed entirely of individuals who are citizens of the United States. The non-citizen owner of the beneficial interest in the trust is also called the “Trustor” or “beneficial owner.”
A Trustor enters into the owner trust agreement with the Trustee. The owner trust agreement specifies the duties and obligations of the Trustee. Similarly, it provides certain rights, benefits and obligations of the Trustor. Acting in its representative capacity in most instances, the Trustee holds legal title to the aircraft, signs most transaction documents and files registration forms at the FAA (excluding citizenship affidavits) and uses its name (as trustee) in public records as the owner of the aircraft. The public record includes the International Registry created under the Convention on International Interests in Mobile Equipment, and its Protocol on Matters Specific to Aircraft Equipment - November 16, 2001.
The FAA recognizes the importance of meeting its statutory and regulatory standards for the safety and oversight of U.S aircraft operations. It understands that a Trustee contractually agrees, in some circumstances, to exercise control of the aircraft for its non-citizen Trustors. However, in reality, the FAA and the aviation industry know that the Trustor calls the shots on operating its aircraft. Trustees in the ordinary course of business do not, and have no reason to, review flight plans or even know who appears on the passenger manifest. As a result, Trustees typically have no idea what their Trustors are doing at any particular time or on any particular flight.
Cognizant of this well-settled approach, the FAA has landed in a difficult place. It aims to issue the clearest guidelines it can to meet its safety and oversight responsibilities while minimizing negative consequences of the Notice on aircraft operations, registration and transactions.
*Insight Point: The question the FAA has really been pondering is whether it even needs to alter the common and long-standing practice of permitting non-citizens to operate U.S. registered aircraft, though it perceives some tension with the applicable statutes and regulatory requirements. It apparently believes that it can enlist Trustees in meeting its safety oversight responsibilities.
The FAA Two-Step
The FAA’s first step to address safety concerns in its aircraft registration system did not start with the Notice. Rather, it began nearly two years ago when the administration totally revamped the aircraft registration process. The FAA requires a one-time registration renewal and periodic renewals thereafter. See Re-Registration and Renewal of Aircraft Registration, 75 FR 41968 (July 20, 2010).
*Technical Point: More specifically, over a 3-year period, FAA registration terminates on all aircraft registered before October 1, 2010. Failing re-registration, the regulations require cancellation of registration numbers (N-numbers). For aircraft issued registration certificates on or after October 1, 2010, registration of the aircraft expires every three years, at which time the regulation requires a renewal of registration. For more, see: As the FAA Implements Re-Registration of More Than 350,000 Aircraft, Will Chaos Prevail?, by Greg Walden, BLFN (First Quarter 2011).
To accomplish its objectives, the Notice takes the second step to:
Obtain appropriate operational and maintenance information from Trustees;
Exercise a greater level of oversight of non-U.S. operations to satisfy its mission as well as to assist foreign civil aviation authorities; and
Address directly the concern that some trust agreements do not comply with FAA regulations.
Mindful of the skepticism and resistance it would face, the FAA scheduled a comment period with an original deadline of March 31, 2012. It held a public meeting on March 14, 2012. Due to the operational and legal complexity, the wide-range of businesses affected, and the volume of comments it received, the FAA extended the comment period to July 6, 2012 and then again to August 17, 2012. It has also conducted a public meeting on June 6, 2012. Simply put, the FAA realizes that it needs more time to hear public comments on the Notice.
*Action Item: If you have an interest in the Notice, it is critical to attend the August 17, 2012 meeting and submit comments to the FAA by that date.
Trusts to be Trusted
The Notice provides that, first, the FAA will continue to allow non-citizen owner trust agreements. The Trustee will still register the aircraft and enter into an agreement with the Trustor whereby a foreign citizen operates the aircraft, whether for compensation for hire or otherwise.
Second, the FAA explicitly acknowledges that the FAA Aircraft Registry is an “ownership” registry, not an “operator” registry. This acknowledgement, however, is not much comfort to Trustees in light of the requirements the FAA proposes in the Notice to place on such Trustees (as discussed below).
Third, while the FAA recommends several revisions to the standard trust agreement, it appears from public statements the FAA made after publication of the proposed Notice that the FAA may not require the revision of any existing trust agreement.
*Tip: You should consider whether you should nonetheless revise your trust agreements (or those of your clients) after the FAA publishes the final policy Notice. This action can establish an agreed process for complying with the FAA regulations unless all existing trust arrangements are “grandfathered.”
Trustee Information Delivery Requirements
The FAA proposes to impose information requirements on Trustees, but, as currently written, the deadlines for compliance are not practical in some instances. However, the proposed Notice is not clear on what specific regulatory obligations an aircraft owner has vis-à-vis the operation of the aircraft by another entity under a lease or operating agreement.
What the FAA calls policy clarification is more like a policy announcement with the following basic requirements:
Within two business days of the FAA request, the FAA expects a Trustee to provide the FAA with (1) the identity of the person normally operating or managing the operations of the aircraft; (2) where that person lives or has its principal place of business; (3) the location of maintenance and other aircraft records; and (4) where the aircraft normally is based and operated.
Within five business days of the FAA request, the FAA expects the Trustee to respond to FAA requests for additional information about (1) the operator, crew, and aircraft operations on specific dates; (2) maintenance and other aircraft records; and (3) the aircraft’s current airworthiness.
While the industry is expected to weigh in on whether these timeframes are reasonable, the FAA notes that it will expect immediate compliance with any information request made when (or if) the FAA issues “an emergency order” or simply identifies the presence of an emergency. See 77 FR at 6697, 6699, 6702.
Tightening the Operating and Trust Agreements
The FAA has determined that “the operating agreement and the trust agreement are so intertwined that the operating agreement will always affect the relationship established under the trust.” See 77 FR at 6697. This is apparently not an idle requirement. A Trustee will be expected to provide assurances, perhaps by an affidavit, if there is no such operating agreement or side agreement in place.
*Technical Point: The FAA treats the operating agreement as a “document legally affecting a relationship under the trust,” (14 C.F.R. 47.7(c)(2)(i)). In doing so, “the FAA will require that all operating agreements or similar side agreements involving the Trustee transferring custody and use of the aircraft held in trust to the trustor be submitted to the FAA along with other documents that affect a relationship under the trust . . .” See 77 FR at 6697.
The proposed Notice also addresses removal and termination provisions in the trust agreement. Current regulations provide that non-citizens may not have more than 25 percent of the aggregate power to direct or remove a Trustee. See 14 C.F.R. 47.7(c)(3). The trust agreement referred to in the Notice “must describe with specificity” the grounds for removal, and where the Trustor appears to have 100% of the removal power, the FAA must be “assured” (in the trust agreement or otherwise in writing) “how and why it is that such non-citizens will not be able to exercise such aggregate power in excess of 25 percent%.” See 77 FR at 6698.
With respect to termination by the Trustor, or resignation by the Trustee, the FAA believes the likely result would be to end registration or render the registration ineffective. But, here the FAA provides no new requirement or even much information or guidance in the Notice.
The FAA notes that any provision in a trust agreement that designates a foreign court to adjudicate a dispute between Trustor and Trustee is “not acceptable.” The FAA allows the parties to the non-citizen trust to address that issue as they see fit. See 77 FR at 6698.
Revisions to Trust Agreement
Over the years a standard trust agreement has been developed and informally accepted by the FAA Aeronautical Center Counsel. The proposed Notice includes some “suggestions” and “recommends” revisions to that standard agreement. Consistent with the requirements and expectations otherwise described in the proposed Notice, the revisions include establish compliance and information requirements together with limitations on control and removal of the Trusteel.
The FAA recommends that the standard trust agreement emphasize the Trustor has no rights or powers to direct, influence or control the Trustee in its duties under the agreement, including the ownership and operation of the aircraft. This statement, similar to a provision in the standard agreement, is an effort by the FAA to “make it clear that the Trustor may not control the Trustee’s duties under the Agreement including, but not limited to, matters involving the ownership or operation of the aircraft.” See 77 FR at 6699. In the typical setting, however the Trustor operates the aircraft and in so doing has “operational control” of the aircraft.
*Technical Point: Recall the FAA Aircraft Registry is not an “operator” registry. According to the FAA, however, the purpose of this standard agreement provision “is to assure that . . . the Aircraft shall be controlled with respect to such matters by a Citizen of the United States.” See 77 FR at 6704. The FAA seems to obscure these legally distinct concepts of aircraft ownership and operational control
To cope with the inevitable changes, Trustees and Trustors may have to alter trust agreements to:
Expand typical representations and warranties by the Trustor and the Trustee that each has met all the requirements of the Notice, including obtaining FAA approval of applicable operating agreements (potentially supported by a legal opinion of competent counsel);
Establish specific criteria for “cause” to terminate or remove the Trustee such as the failure to timely report to the FAA (periodically or in an emergency);
Provide that the Trustee cannot resign or be terminated until and unless another U.S. citizen trustee steps into a qualifying trust agreement before or concurrently with the resignation or the termination (i.e., to avoid the FAA cancelling or otherwise rendering ineffective U.S. registration);
Empower the Trustee to hire servicers, management companies or consultants proposed and/or approved by the Trustor, at the Trustor’s cost, to create and implement timely information gathering and reporting under the final guidance, including contact with flight departments and crews;
Confirm that the non-citizen Trustor’s or the Trustee’s insurance provides coverage that will protect and indemnify the Trustee while serving in its new duties in good faith under the final guidance, such as coverage for failing to report when required or making wrong decisions on operational control of the aircraft;
Require each Trustor to provide periodic reporting and updates to Trustees covering information required under the final guidance (i.e., within two days, and to the extent feasible, within 5 days) and increase administrative fees for the Trustees and potential penalties that may be imposed; and
Enhance confidentiality provisions to protect the Trustor’s operations, passengers, security and aircraft with contest provisions that allow the Trustor to define and avoid public disclosure of confidential information.
*Insight Point: If the FAA’s final guidance remains substantially the same as it is now, it is conceivable or even likely that some non-citizen aircraft owners will elect to register their aircraft outside the U.S.
Such an action by non-citizens would be understandable, relatively easy to accomplish and, at the same time, unfortunate for the aviation community because it may limit the growing international component of business aviation in the U.S.
If the FAA continues its efforts to complete the final guidance as expected, then perhaps it will, in balancing all interests, develop reasonable and sensible regulations of non-citizen owner trusts that do not unnecessarily damage the aviation businesses the FAA serves and regulates.
Thanks to Greg Walden, an aviation regulatory lawyer located in the Washington, D.C. office of Patton Boggs LLP.
3. BLFN Case & Comment: Secured Creditors Win Back Rights to Credit Bid in RadLAX Gateway Hotel, LLC, et al. v. Amalgamated Bank
A unanimous ruling of the United States Supreme Court gave a clear victory for secured lenders that “credit bid” in bankruptcy proceedings. The ruling affirms the Seventh Circuit Court of Appeals and should thwart any contrary holdings in other courts.
In RadLAX Gateway Hotel, LLC, et al. v. Amalgamated Bank, No. 11-166, ___ U.S. ___ (Decided May 29, 2012), the Supreme Court held that a debtor may not obtain confirmation of a Chapter 11 “cramdown” plan of reorganization if the debtor “proposes to sell the secured creditor’s collateral free and clear of liens” without also preserving the secured creditor’s right to purchase its collateral through credit bidding.
*Terms to Know: A ”cramdown” occurs when a Chapter 11 debtor confirms a plan of reorganization over a non-accepting vote of one or more class(es) of creditors. A “credit bid” or “credit bidding” occurs when a secured creditor uses its unpaid debt like cash to bid on, and pay the purchase price for, the secured creditor’s own collateral. The debt used to purchase its collateral is then offset against the secured creditor’s claim against the debtor.
To confirm a “cramdown” plan, a debtor must show that the plan does not discriminate unfairly. The plan must be “fair and equitable” to the class(es) of claims that did not accept the plan. See 11 U.S.C. § 1129(b). If there is a sale of assets in a cramdown plan, the credit bidding process protects the secured creditor from a sale of its collateral it bargained for to repay its loan in case of a default or bankruptcy.
BACKGROUND: RadLAX Gateway Hotel, LLC and RadLAX Gateway Deck, LLC (Debtors) entered into a loan agreement to borrow $142 million to purchase and renovate a Radisson Hotel near Los Angeles International Airport. The Debtors pledged all of their assets to their secured lenders as collateral. The project cost more than expected, and the Debtors ran out of funds before it could be completed.
Owing more than $120 million to the lenders, the Debtors filed Chapter 11 bankruptcy cases. They proposed a cash only auction for the project in the plan of reorganization, with an opening bid of $47.5 million in cash. The plan of reorganization did not permit the lenders to credit bid at the auction. Asserting that their plan was “fair and equitable,” the Debtors planned to cram down their secured lenders – blocking their potential to bid in their debt to acquire the collateral.
ISSUE: Can a Chapter 11 debtor propose to sell assets free and clear of a secured creditor’s liens in a bankruptcy plan where the plan prevents a secured creditor from credit bidding?
OUTCOME/DECISION: No. Chapter 11 debtors can no longer prohibit a secured creditor from credit bidding in a plan that proposes to sell the collateral free and clear of liens. The only exception arises when the court prohibits credit bidding for “cause.”
A debtor may show its plan to cram down secured creditors is “fair and equitable” if it meets one of the following conditions: (i) the secured creditor retains its liens and receives certain cash payments over the life of a plan; (ii) the debtor sells the collateral free and clear of the liens, but subject to § 363(k) credit bidding by the secured creditor; or (iii) the debtor provides the secured creditor the indubitable equivalent of its claims (i.e., something of equivalent or greater value to the secured creditor for its interest in the collateral). See 11 U.S.C. § 1129(b)(2)(A).
By paying the secured lenders cash from the auction, the Debtors in this case argued that the secured lenders received the “indubitable equivalent” of their secured claims under Section 1129(b)(2)(A)(iii). However, the plan permitted the Debtors to act directly contrary to the second cramdown category under Section 1129(b)(2)(A)(ii), which requires that sales of collateral free and clear of liens must be subject to credit bidding by the secured creditors. A more general statutory provision such as the indubitable equivalent cash payment under category (iii), usually cannot and does not override a more specific statutory provision like the one in category (ii), which required credit bidding to sell free of the secured lenders liens.
Consequently, the Supreme Court held that the Debtors could not cramdown the secured lenders by proceeding under the (more general) category (iii) “indubitable equivalent” cramdown criteria. Its ruling stops debtors from evading the (more specific) category (ii) cramdown criteria that requires sales of assets free and clear of the secured lender’s liens in a plan of reorganization be subject to credit bidding.
LAW OF THE CASE: The bankruptcy court and the Seventh Circuit had already both agreed with the secured lenders that the Debtors’ plan improperly contradicted the second cramdown category by prohibiting credit bidding. River Road Hotel Partners, LLC, et al. v. Amalgamated Bank, 651 F.3d 642 (7th Cir. 2011). The Supreme Court more simply found that the Debtor’s arguments lacked common sense in construing Section 1129(b)(2)(A) of the Federal Bankruptcy Code and did not comport with rules of statutory construction.
*Warning: A secured creditor is not always guaranteed the right to credit bid on its collateral in a bankruptcy plan. See 11 U.S.C. § 363(k).
A bankruptcy court can block a secured creditor from credit bidding, but it must have “cause” – good reasons – to stop credit bidding. Otherwise, a sale without credit bidding arguably deprives the secured creditor of the benefit of its bargain with the debtor (i.e., realizing the value of the collateral). However, a debtor can seek to retain the collateral and cramdown the secured lender through the first or third “fair and equitable” cramdown criteria. If successful, the debtor is not required to allow the secured creditor to credit bid.
*Warning: The Supreme Court’s holding effectively overrules two contrary circuit cases: one from the Third Circuit, In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3rd Cir. 2010) and one from the Fifth Circuit, In re Pacific Lumber Co., 584 F.3d 229 (5th Cir. 2009).
COMMENT: This decision assures that, in practice, a secured creditor enjoys the right to block the sale of its collateral through a plan for less than what is owed unless the secured creditor consents or has the right to credit bid. This ruling is good news for secured creditors. It means that secured creditors can:
enforce their right to credit bid on their collateral to preserve the potential of realizing more (either currently or in the future) in value for their collateral than the cash they would otherwise receive from an auction;
level the playing field with cash purchasers in a bankruptcy sale if the secured creditors lack the ability or wherewithal to fund cash bids for their collateral;
increase the potential to receive the highest auction bids by having credit and cash consideration compete to acquire the collateral; and
prevent debtors from delaying the payment of sales proceeds to secured creditors and even seek to charge some of the bankruptcy costs against the proceeds.
*Tip: Equipment leased under a financing lease (a disguised loan versus a true or operating lease) can be subject to a sale free and clear of liens in a bankruptcy case. Lenders and lessors who utilize financing leases also have the same protections as the secured lenders in this case with respect to a sale of their collateral pursuant to a plan of reorganization.
Thanks to Jeff LeForce of the Patton Boggs Bankruptcy Group in the Dallas office for contributing this article.
4. Finance 101: What is the “ACORD 23: ‘Vehicle or Equipment Certificate of Insurance’?”
Although insurance may not qualify as a hot topic, if you lend money or lease equipment, you should be using an ACORD 23 Certificate of Insurance, which has been available for use since July 30, 2010.
*Terms to Know: ACORD refers to the “Association for Cooperative Operations Research and Development,” a not-for-profit membership organization that, for 40 years, has set insurance industry standards including issuing 750 different insurance certificate forms available in the ACORD library. The ACORD official web site defines a “certificate of insurance” as follows:
A Certificate of Insurance is merely evidence of the policies issued and in force at the time the Certificate of Insurance is issued. It does not provide assurance that the certificate holder will be notified if the policy is modified, expires, is extended or canceled. As governed by insurance law in all states, a Certificate of Insurance cannot extend or alter coverage provided in an insurance policy in any way. Certificates of Insurance can be viewed as a summarized, informational reflection of an insurance policy(s) and it conveys no rights or privileges. It is a “snapshot” in time. The issuance of Certificates of Insurance and the information they contain is governed by state insurance regulations. State insurance regulations require that policy rights and conditions can only be extended through the policies and binders – no rights are extended or conferred by the issuance of a Certificate of Insurance. A Certificate of Insurance which appears to amend, extend, or alter policy coverage should be considered a violation of applicable insurance regulations in most states.
Simpler Insurance Certificate for Closings
ACORD 23 simplifies the insurance aspects of closing a vehicle or equipment loan or lease for lenders, lessors, lessees and borrowers. In the past, these parties used at least two forms, ACORD 24 (property only) and ACORD 25 (liability only), to obtain a description of the insurance of the named insured, typically the lessee or borrower.
ACORD 23 consolidates these coverage certifications into one form. For example, a lessor needs both property and liability coverage and can check boxes in the certificate to indicate both types of insurance apply to the lessor. See ACORD 23 Simplifies Insurance Documentation for the Equipment Leasing Sector, by Steve Dinkelaker, President of American Lease Insurance Agency Corporation, ALI News (Aug. 1, 2010).
*Tip: You should make certain that, at closing, the insurance agent issuing the ACORD 23 has checked a box showing the agent has confirmed the insurer added to the named insured’s policy the interest of the lessor or lender.
Checking the correct box entitles the lessor or the lender to prior notice should coverage be cancelled for non-payment of premiums due or for other reasons during the term of the policy.
*Warning: Avoid allowing the agent to check another box that indicates it merely requested that the insurer add such interest to the insured’s policy.
Generally, insurers and their agents acknowledge that an ACORD 23 appears to require them to notify parties of interest when coverage is cancelled during a policy’s term. However, they also universally disclaim any such duty on expiration of such a policy—whether they give the notice or not.
As a lessor or lender, you should consider asking your administrative staff and/or a qualified and experienced insurance tracking provider to calendar and follow-up for renewals of coverage before the expiration of any other coverage.
*Insight Point: Insurance agents typically will not send out renewal Certificates of Insurance until the named insured has paid its premiums for the next year’s coverage (or made a monthly premium payment toward the next year’s coverage). However, do not be surprised if asking for such evidence of insurance prior to policy renewal falls on deaf ears, and you receive no proof (or inadequate documentation) of continuing coverage before the actual renewal date.
Lender’s Loss Payee Versus Loss Payee Clauses
A standard “Loss Payee” endorsement to a policy provides that a party of interest in the policy will follow the fortunes of first named insured under that policy. Comparatively, a “Lender’s Loss Payee” gives the lender or lessor additional rights to a claim when there is a loss that is superior to the insured’s. This clause allows the lender or lessor to assert its rights to payment for such loss.
Where the insured may not have paid premiums in a timely manner, falsely sworn about the details of the loss, or failed to file the claim in a timely manner, a Lender’s Loss Payee endorsement will entitle the lender or lessor—in the event and at the time of a loss—the right to pay such unpaid premiums. Once paid, the lender or lessor can typically make a claim for loss and ultimately be paid for its interest in the loss even though the insured was not paid. The Lender’s Loss Payee endorsement is a standard endorsement available to a party of interest on any insurance policy covering personal property and is equivalent to a “Mortgagee Clause” standard in all real property insurance policies.
*Tip: As a lender and lessor, you should request to be named as Lender’s Loss Payee in the insurance clauses of your agreements and in any communications with lessees or borrowers and their agents and insurers.
There should not be any additional cost to the insured for the Lender’s Loss Payee endorsement versus the standard Loss Payee endorsement. It also is available as a check box on the ACORD 23 (in contrast to the 24 or 25, where it has to be typed into a blank space on those ACORD forms).
Best Forms to Close Deal
Parties in transactions often misunderstand the purpose or effect of a certificate of insurance. It is not a contract between the lender or lessor and the insurer. See United States Pipe & Foundry Co. v United States Fidelity & Guar. Co, 505 F. 2d 88 (5th Cir. 1974). It only presents the insurance in effect at the time of the issuance of the certificate, even though it also provides assurance that any party of interest named as loss payee or lender’s loss payee should be notified of any cancellation of such insurance during the term of such coverage in accord with the terms of the policy.
*Insight Point: Risk management teams or insurance experts should carefully decide on the best form to use in a particular transaction.
Insurance Certificate Only: For most lenders and lessors an ACORD 23 certificate of insurance should suffice to prove coverage in order to close transactions. Using this form makes sense if the lender or lessor does not require that it has a contractual right against the insurer.
Form Endorsement: Other lenders and lessors obtain the insurer’s endorsement (directly or through an authorized representative like an agent) on the insurer’s policy form. By doing so, insurers provide coverage directly to the lender or lessor as provided in its form.
Customized Endorsement: Some insurers will, on request, sign a customized written endorsement of insurance with respect to a borrower or lessee’s insurance policy, which is intended to create a contract between the insurance company and the covered parties in which the insurer agrees to provide insurance coverage to these parties.
More to the Story
Insurance is a complex subject even though ACORD 23 makes closings a bit easier for the transaction parties. This article does not, and can not, explain fully how the underlying provisions in insurance policies operate despite the apparent simplicity of an ACORD 23 certificate of insurance.
*Action Item: Check with a knowledgeable insurance professional for further information.
Thanks to Steve Dinkelaker, American Lease Insurance Agency Corporation, for editing this article. He can be reached at 888-521-6568 extension 245, or email@example.com.
Thanks to BLFN’s Team
Thanks to the BLFN’s team at Patton Boggs LLP. The team includes the Patton Boggs staff: our senior communications specialist Natalie Gewargis, our project manager Melissa Green, our subscription coordinator Penny Utley and our web coordinator Georgetta Nicol. Thanks also to Douglas C. Boggs, a Business Department partner and Web site reviewer for BLFN.
All the best,
David G. Mayer
Founder: Business Leasing and Finance News
(formerly Business Leasing News)
Partner: Patton Boggs LLP
2000 McKinney Avenue
Dallas, Texas 75201
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© David G. Mayer 2012