Credit Underwriting, Lease Structures and Documentation Provisions

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1 Credit Underwriting, Lease Structures and Documentation Provisions

2 Presenters John Azzopardi Chief Financial Officer TIP Capital Anthony L. Lamm, Esquire Managing Partner Lamm Rubenstone Lesavoy Butz & David LLC Thomas C. Otto Vice President National City Commercial Capital

3 Session Objectives Explore the relationship between credit underwriting and lease structures Identify issues that effect the collateral evaluation in the credit decision Examine various lease structures and documentation to determine potential documentation landmines

4 Session Methodology Example lease transactions will be reviewed Discussion of the example lease truncations and lease documentation issues will follow

5 Article 2A Finance Lease To qualify as a Finance Lease: the Lessor does not select, manufacture, or supply the goods; the Lessor acquires the goods or the right to possession and use of the goods in connection with the Lease or a prior Lease; and the Lessee receives a copy of the purchase agreement related to the equipment and approves of the terms contained therein, and receives an accurate and complete statement designating the promises and warranties, and any disclaimers of warranties, limitations or modifications of remedies, or liquidated damages; or the Lessor informs the Lessee in writing of the identity of the person supplying the goods, that the lessee is entitled to the promises and warranties provided to the Lessor and that the lessee may communicate with the person supplying the goods to the Lessor and receive an accurate and complete statement of the promises and warranties, including any disclaimers and limitations or a statement of remedies

6 Operating Lease Lessee acquires the property for only a small portion of its useful life Lessor transfers only the right to use the property to the Lessee Lessor retains ownership of the equipment at all times Lessee returns the property to the Lessor at the end of Lease term, to be re-sold or re-leased

7 Motion to Assume or Reject as it Relates to True Lease In the event of bankruptcy by Lessee: The Trustee, subject to the Court s approval, may assume or reject any unexpired lease of the Debtor (11 U.S.C. 365(a)) Pursuant to 11 U.S.C. 365(b), if there is a default of the unexpired lease by the Debtor, the Trustee may not assume such lease unless the Trustee: Cures, or provides adequate assurance that Trustee will promptly cure, such default; Compensates, or provides adequate assurance that Trustee will promptly compensate, a party other than the Debtor to such lease, for any actual pecuniary loss resulting from such default; and Provides adequate assurance of future performance

8 Motion to Assume or Reject as it Relates to True Lease (cont d) In a Chapter 7 case, if Trustee does not assume or reject within 60 days after the order for relief, or within such additional time as fixed by the Court, then such lease is deemed rejected (11 U.S.C. 365(d(1)) In a Chapter 11, 12 or 13 case, the Trustee may assume or reject at any time before the confirmation of a plan, but the Court, on the request of any party to such lease, may order the Trustee to determine its position within a specified period of time to assume or reject the lease (11 U.S.C. 365(d(2))

9 Motion to Assume or Reject as it Relates to True Lease (cont d) Pursuant to 11 U.S.C. 365(d)(5), after 60 days from the order for relief (filing of Petition) in a Chapter 11 case, the Trustee shall timely perform all of the obligations of the Debtor until such lease is assumed or rejected, unless the Court orders otherwise. This includes remitting Lease payments, until a determination is made to formally assume or reject the Lease As added by the 2005 Revisions to the Bankruptcy Code, if a lease is rejected or not timely assumed by the Trustee, the leased property is no longer property of the bankruptcy estate and the stay under 362(a) is automatically terminated (11 U.S.C. 365(p)(1))

10 Motion to Assume or Reject as it Relates to True Lease (cont d) As added by the 2005 Revisions to the Bankruptcy Code, if the Debtor is an individual in a Chapter 7, he may notify the creditor in writing that the Debtor desires to assume the lease. Upon being so notified, the creditor may, at its option, notify the Debtor that it is willing to have the lease assumed by the Debtor and may condition such assumption on cure of any outstanding default on terms set by the contract. (11 U.S.C. 365(p)(2)(A)) As added by the 2005 Revisions to the Bankruptcy Code, if, within 30 days after notice is provided, the Debtor notifies the Lessor in writing that the lease is assumed, the liability under the lease will be assumed by the Debtor and not by the bankruptcy estate (11 U.S.C. 365(p)(2)(B))

11 Motion to Assume or Reject as it Relates to True Lease (cont d) As added by the 2005 Revisions to the Bankruptcy Code, the Lessor does not violate the stay under 362 and the injunction under 524a)(2) by notification of the Debtor and negotiation of cure under this subsection (11 U.S.C. 365(p)(2)(C)) As added by the 2005 Revisions to the Bankruptcy Code, in a case under Chapter 11 (individual) and in a Chapter 13, if the Debtor is the Lessee and the lease is not assumed in the plan confirmed by the Court, the lease is deemed rejected as of the conclusion of the hearing on confirmation. If the lease is rejected, the stay under 362 and/or 1301 are automatically terminated with respect to the property subject to the lease (11 U.S.C. 365(p)(3))

12 Motion for Relief from Stay or Alternatively Adequate Protection Payments Note that in some Bankruptcy Courts, a Motion for Relief must allege that the Debtor has no equity in the equipment, and attach a valuation demonstrating this position, for the Court to grant relief from the stay provided by 362 Accordingly, in the event of bankruptcy by Lessee, if Lessor has a disguised Security Agreement, Lessor may only be entitled to Adequate Protection payments Pursuant to 11 U.S.C. 363(e), on request of an entity that has an interest in property used, sold, or leased by the trustee, the court, with or without a hearing, shall prohibit or condition such use, sale, or lease as is necessary to provide adequate protection of such interest.

13 Motion for Relief from Stay or Alternatively Adequate Protection Payments (cont d) Adequate Protection is frequently negotiated between the parties, with Court being involved only if parties cannot agree If the party affected objects to the amount or the method of adequate protection, the Court will determine whether the protection proposed is adequate Secured creditors should not be deprived of the benefit of their bargain, however giving a secured creditor an absolute right to his bargain may be impossible or seriously detrimental to the bankruptcy laws (See Comments to 11 U.S.C. 361) A substantial equity cushion can obviate the need for any other adequate protection (See In re Mellor, 734 F.2d 1396)

14 Issues Related to Characterization of True Lease as a Disguised Security Agreement In the event that the Lease is determined to be a disguised Security Agreement, the leased equipment may be subject to a sale by the Debtor As a result of Lease being treated as a disguised Security Agreement, Debtor asserts an equity ownership interest in and to the equipment, subject to the possible lien by the Lessor Accordingly, it is extremely important to consider filing a Precautionary UCC-1 Financing Statement to protect Lessor s interest in and to the equipment in case the Lease is deemed to be a disguised Security Agreement

15 FMV Lease Example 5 Year lease of manufacturing equipment Equipment is part of a production line in the company s main business Customer requires off balance sheet operating lease FMV Lease typically contains estimated residual value of equipment at 10% to 25%

16 Documentation Lease is documented with standard lease terms and conditions End of Term Options FMV Purchase Option Return Option FMV Renewal Option 180 day notice

17 Credit/Legal Considerations Operating Lease ensures that lease will not be deemed a loan in bankruptcy Lessor retains ability to recover its equipment if Debtor does not Assume the Lease, curing all arrears due and owing to Lessor Equipment is integral to the customers main production facility If equipment is vital to the Lessee s business, it is more likely that Debtor will assume the Lease in the event of a bankruptcy Credit officer can be more lenient in underwriting criteria where Debtor is likely to assume the Lease

18 FMV Lease Example 2 5 Year lease of manufacturing equipment Equipment is part of a production line in the company s main business Customer desires not to exceed % of the original equipment purchase price Amount of % should be considered as it relates to possible triggering of disguised Security Agreement treatment

19 Documentation Lease is documented with standard lease terms and conditions End of Term Options FMV Purchase Option not to exceed % Return Option FMV Renewal Option 180 day notice

20 Credit/Legal Considerations End of term structure may impact lease classification in bankruptcy Mandatory put option will likely be treated as a disguised Security Agreement Evergreen (Automatic) Renewal clause might be treated as a disguised Security Agreement, dependent on the value of the equipment at the end of the Lease term Not to exceed % purchase option may be treated as either an Operating Lease or a disguised Security Agreement, depending on the percentage negotiated for purchase option Is Equipment integral to the customers main production facility The more vital the equipment is to Debtor, the greater the likelihood that the Lease will be assumed in event of bankruptcy, providing Lessor with best likelihood of full recovery of its claims

21 Credit/Legal Consideration (cont d) If lease is deemed a disguised Security Agreement, possible negative impact in bankruptcy Lessor might only receive Adequate Protection payments to compensate the Lessor for the Debtor s retention of the equipment Lessor s equipment might be subject to a sale by the Debtor, or its bankruptcy estate, with Lessor receiving the liquidated proceeds Possible lien priority issue if Lessor failed to file Precautionary UCC-1 Financing Statement to protect its interest in and to the equipment or failed to record the Financing Statement in the correct jurisdiction(s)

22 Issues Related to Inclusion of Soft Costs within Lease Article 2A Finance Lease is for the lease of goods Related installation or maintenance services are not goods under Article 2A of the UCC Inclusion of soft costs might lead to Lease not being treated as an Article 2A Finance Lease/Operating Lease General rule is the soft costs should not be significant or substantial amount of the overall equipment purchase Acceptable where it is clear from the financing that the soft costs are a complement to and not the driving purpose of the financing However, any percentage can jeopardize the True Lease designation

23 Issues Related to Inclusion of Soft Costs within Lease (cont d) Other issues to consider: Does the Lessor own the item which is included in the Lease? Computer software license Capital improvements (which become attachments to the premises or are enclosed in the renovations) Financing of service, maintenance, delivery and installation costs Financing of working capital Can the Lessor provide possession of the item to Lessee to use for a period less than its economic life, with an expectation of return to Lessor while item retains some substantial economic life

24 FMV Example 3 (with Soft Costs) 3 Year lease of Information Technology equipment with related installation services and software Equipment is part of the information technology systems running core IT systems Customer requires off balance sheet operating lease Soft Costs are 20% of the overall equipment purchase

25 Bundling of Goods and Services Examples of soft costs typically included in lease transactions as leased items that will destroy the True Lease designation: Taxes, maintenance, insurance, delivery and installation costs, software license fees, other service fees and working capital

26 Documentation If Lease is documented with standard lease terms and conditions only, inclusion of soft costs might lead to treatment as a disguised Security Agreement End of Term Options FMV Purchase Option Return Option FMV Renewal Option 180 day notice

27 Alternate Documentation Option In order to avoid bundling of goods with soft costs and jeopardizing the treatment of the Lease, consider: Soft costs listed on a separate schedule (not part of the Lease Agreement); Soft costs listed in a separate agreement between Vendor and Lessee; Installation costs rolled into maintenance contract Risk of loss in event of bankruptcy for installation and/or maintenance transferred to Vendor

28 Alternate Documentation (cont d) Separate Note, with a Security Agreement granting a security interest in the soft costs (although these items may have little to no value as security); Installment Payment Agreement, with a Security Agreement granting a security interest in the soft costs (although these items may have little to no value as security); Vendor Program Agreement between Vendor and Lessor Agreement not to finance soft costs Costs for installation and maintenance to be included in separate agreement between Vendor and Lessee

29 Credit/Legal Considerations In the event that the Lease is determined to be for nongoods, it may be disqualified as an Article 2A Lease and treated as a disguised Security Agreement Is Equipment integral to the customers core IT systems Value of the Equipment should be considered as it will be the basis for Lessor s claim in event of triggering treatment as a disguised Security Agreement If characterized as a disguised Security Agreement in bankruptcy, Lessor will be secured only as to the value of the collateral with the remaining claim treated as unsecured

30 Credit/Legal Considerations (cont d) Possible negative impact in bankruptcy for disguised Security Agreement (as opposed to True Lease) Lessor might only receive Adequate Protection payments to compensate the Lessor for the Debtor s retention of the equipment Lessor s equipment might be subject to a sale by the Debtor, or its bankruptcy estate, with Lessor receiving the liquidated proceeds Possible lien priority issue if Lessor failed to file Precautionary UCC-1 Financing Statement to protect its interest in and to the equipment or failed to record properly Another creditor may attack status of the Lease as an Article 2A True Lease, seeking its treatment as a secured/unsecured loan

31 FMV Example 4 (with Soft Costs) 3 Year lease of Information technology equipment with related installation services and software Equipment is part of the information technology systems running core IT systems Customer requires off balance sheet operating lease Soft Costs are 80% of the overall equipment purchase

32 Documentation Lease is documented with loan terms and conditions Installment Payment Agreement, with a Security Agreement granting a security interest in the soft costs (although these items may have little to no value as security) Loan and Security Agreement, granting a security interest in the soft costs (although these items may have little to no value as security) Vendor Program Agreement between Vendor and Lessor Agreement not to finance soft costs Costs for installation and maintenance to be included in separate agreement between Vendor and Lessee

33 Credit/Legal Considerations Transaction will be deemed a loan in bankruptcy Software and Soft Costs have no resale value (insufficient security for loan) Loan will be crammed down in a bankruptcy reorganization Lessor will receive the value of the collateral, which might provide only a minimal recovery Lessor may protect itself by seeking guarantees of the Lease obligations and/or the pledge of sufficient collateral by guarantors

34 TRAC Lease 5 Year lease of semi-tractors Freight Company Equipment essential to maintain current capacity

35 Characteristics of TRAC Lease Open-end lease as ultimate obligation of the Lessee is not determined until the end of Lease term Lessee is obligated to make up any shortfall, or receive any excess proceeds, realized from a disposition of the equipment at end of Lease term Agreement between parties as to Estimated Residual Value Financial incentive to Lessee to maintain equipment in good condition, to preserve value at end of Lease term TRAC Leases given special treatment by Internal Revenue Code pursuant to 7701(h) To qualify, transaction must involve a motor vehicle (including trailers) and must be used more than 50% of the time in the trade or business of the Lessee

36 Documentation Lease is documented with standard lease terms and conditions End of Term Options 25% TRAC Purchase Option ( Put ) Return or Sale Option with TRAC Adjustment

37 Credit/Legal Considerations What are the considerations in bankruptcy If treated as a True Lease: Lessor can proceed with a Motion to Assume or Reject the Lease, and any arrears must be cured in full for the Lessee to Assume the Lease, or Lessor may seek relief from the automatic stay pursuant to 11 U.S.C. 362(d) and recover its equipment If treated as a disguised Security Agreement: Lessor may only be entitled to Adequate Protection payments, to compensate the Lessor for the Debtor s retention of the equipment

38 Credit/Legal Consideration (cont d) Bankruptcy Court s will look to state law in determining whether Debtor s motor vehicle lease was truly a lease, as opposed to a disguised Security Agreement Significant majority of states have passed legislation that provides, in pertinent part, that in the case of motor vehicles or trailers, certain transactions do not create a sale or security interest merely because they provide that the rental price is permitted or required to be adjusted under the agreement either upward or downward contingent upon the amount realized on sale or other disposition of the equipment.

39 Credit/Legal Consideration (cont d) In order that a security interest and not a Lease be found, most state statutes require a two-part test: Lessee s obligation to pay rent not be terminable ( hell or high water provision of Lease) Lessor not retain any residual value or interest in the leased property The factors considered in evaluating expectation of residual value include, (i) economic life of the equipment, (ii) Lessee bound to renew provisions, (iii) Lessee option to renew for remaining economic life and (iv) Lessee option to purchase for no or nominal consideration upon compliance with the Lease terms. It is the second part of the two-part test that is frequently litigated in Bankruptcy Court, as Debtors and Trustees challenge the validity of the Lease on the grounds that Lessee can acquire the equipment for what amounts to nominal or no consideration.

40 Credit/Legal Consideration (cont d) Equipment essential to maintain current capacity What if it is excess capacity? Determination of treatment as True Lease versus disguised Security Agreement will not be effected by excess capacity However, excess capacity should be considered in setting the Purchase Option as this might be a factor in Lessee s election of its options at end of Lease term Excess capacity will also be a consideration in bankruptcy, as the Trustee or Debtor-in-Possession is more likely to reject a Lease if the equipment is not necessary for an effective reorganization of Debtor

41 Additional Documentation Purchase Options FMV not to exceed Fixed Mandatory Consideration Return and Renewal Options and impact on end of term realization Lessor Notification requirements Month to Month Restrictions

42 Lease Type Summary Documentation Collateral Considerations FMV Lease Strong Position FMV with End of Term PO Lease Potential Negative implications FMV 20% Soft Lease Secured Loan as to value of Collateral FMV 80% Soft Loan Unsecured Loan TRAC Lease Lease Moderately Strong Position

43 Conclusion Open for questions and discussions