Synthetic Leasing and Restructuring ELA Lease Accountants Conference September 8, 2003 Presented by: David Ward, President SMBC Leasing and Finance, Inc. (212) 224-5211 dward@smbc-lf.com Tom Lalli, Senior Vice President SMBC Leasing and Finance, Inc. (212) 224-5231 tlalli@smbc-lf.com David G. Mayer, Partner Patton Boggs LLP (214) 758-1545 dmayer@pattonboggs.com
Synthetic Lease Basics A synthetic lease is a transaction which is intended to be treated as an operating lease for the lessee for financial reporting purposes while allowing the lessee to maintain ownership of the assets financed for tax purposes. Since the lessee has substantially all of the risks and benefits of ownership, it is deemed to be the owner of the assets for tax purposes. Lease structured so that it does not meet any of the FASB 13 lease capitalization criteria.
Funding the Synthetic Lease 3-14% of Cost ~86% of Cost Asset Seller 100% of Cost Asset Use of Asset Equity Providers (Lessor) Rents, Purchase Price and GRV $ Debt Service A-Note (Lenders) ~11% of Cost XYZ Corporation (Lessee) B-Note (Lenders)
End of Lease Option TOOL Purchase Fixed Price Purchase Option Renew Renew on on Mutually Mutually Renewal Agreeable Agreeable Terms Terms On Balance Sheet Base Lease Term Final Maturity Termination Option Terminate Sale of Asset & Guaranteed Residual Value
Focusing on the Lessor Some synthetics did not require restructuring because they did not use a Variable Interest Entity ( VIE ) Utilize a voting interest entity structure; not subject to FIN 46 Financial institutions qualifying as voting interest entity must take title directly to leased assets Accountants to evaluate whether lessor is a voting interest entity Expect restrictions on transfers of leased assets to another voting interest entity
David G. Mayer Partner, Patton Boggs LLP Author of Business Leasing For Dummies Publisher of Business Leasing News Available at: http://www.pattonboggs.com/newsletters/bln
Overview of Issues: The Course of Change Review Your Existing Portfolios-Assets and Entities Determine if VIEs Exist Identify Who is the Primary Beneficiary Decide the Course of Change Implement an exit strategy Consolidate a VIE: on balance sheet a solution? Consider new off-balance sheet structures
Restructuring Deals Subject to Consolidation Evaluate the Implications of Change Review transaction issues of change Analyze legal issues of change Consider the drafting implications Look Into The Future Structure new deals for a new markets
Restructuring Deals Subject to Consolidation (cont.) Assume a Synthetic Lease in a VIE Exit Strategy: Sell leased asset subject to consolidation Impact: Deprives lessees of needed property Ends a viable financing/lease for lenders/lessors Creates tax problems for transferor Increases cash flow of lessee/lessor Results in possible loss or gain on books of parties
Restructuring Deals Subject to Consolidation (cont.) The On Balance Sheet Approach Lessee converts synthetic lease to a secured loan or disguised security agreement (strip synthetic provisions) Lessee can consolidate a VIE: Do nothing! Drop in property value or in credit of lessee - alternatives not feasible Lessee (consolidator) simply allows consolidation to occur
Restructuring Deals Subject to Consolidation (cont.) Goal: Try to Restructure VIEs to Keep Off Balance Sheet Transfer VIE s assets to a voting interest entity structure o Result: Once transferred and documented, entity not subject to FIN 46 Merge VIE with and into a voting interest entity Creates complexities for transaction parties/documentation Changes balance sheet of consolidator Complicates corporate organization, licensing and documents o Result: Once merged, surviving entity not subject to FIN 46
Restructuring Deals Subject to Consolidation (cont.) Amend transaction to do a 10% + first loss equity structure under FIN 46 Lessee Lease Synthetic Owner/Lessor (VIE) 90% Debt 10% Equity (First Loss) Takers?
Restructuring Deals Subject to Consolidation (cont.) Voting Interest Entity - Sale Re-Lease. Lessor sells the leased property to a new lessor; lessee early terminates old lease; and new lessor enters a new tax or operating lease with lessee Operating lease for accounting purposes Application: real property (tenant credit leases)-fasb 98 limits? Application: personal property (equipment leases) Upside shifts to lessor Result: Keeps lease off-balance sheet? Result: Loss of EBO by lessee? Result: Lessors not affected in use of leveraged lease accounting?
Restructuring Deals Subject to Consolidation (cont.) Sale Leaseback - Lessee exercises or negotiates purchase option: Lessee then buys asset. Then, lessee sells to lessor and leases asset back. For VIEs, avoid considering lease in determining a primary beneficiary if a VIE involved by meeting Paragraph B10 standards of FIN 46: Long-term lease with a VIE (how long is enough?) Lease terms consistent with then market on pricing (difficult to prove?) No residual guarantee (synthetic structure excluded) o Result: If structured correctly, you don t consider this lease in identifying primary beneficiary under Paragraph B10 of FIN 46. Diffused entities - non-vies, FIN 46 doesn t apply (no primary beneficiary if no one has majority of interest)
Restructuring Deals Subject to Consolidation (cont.) Transactional Issues to Consider in Consolidation Corporate lender waivers and other loan agreement revisions Loan and lease covenant breaches or defaults due to consolidation Increase in financing/lease rate due to consolidation (switch to a more expensive financing than a synthetic lease) Lender/lessor demands for payoff on disclosure Loan baskets or everything is booked already Rating agencies generally unaffected
Restructuring Deals Subject to Consolidation (cont.) Change in insurance coverage (same coverage available?) Transfer tax considerations affect pricing (net out assumed debt?) Residual upside in synthetics shifts to lessor Return conditions on property may become less rigorous? New asset appraisals FIN 45 valuation issues for residual guarantees and indemnities
Restructuring Deals Subject to Consolidation (cont.) Legal Issues to Consider in Restructuring The Tip of the Iceberg Title transfers of property (UCC, judgments, liens and title insurance?) Sales and other transfer tax on transfer of asset (exemptions?) Permits and approval for transfers (e.g.: sale of a leased power plant) Re-registration of assets filed at government offices (e.g., FAA) Income tax on sale a loss or gain to transferor/lessee State business qualification issues of new entity in new state Additional environmental assessments Lessor certification facts or conclusions about being a VIE?
Selective Structuring Issues in New Deals Look Into The Mirror: Are You, the Lessor, a VIE? Examine composition of lessor Expect accountants to evaluate whether lessor itself is a VIE Illustration: Lessor has 10 deals: 5 leveraged leases and 5 synthetic leases. Is lessor a VIE or a voting interest entity? What is the effect on a new lease by that lessor? Look Into Each New Entity: Avoid Concentration of a majority of interest Structure to widely disperse interests = No primary beneficiary = No consolidation
Selective Structuring Issues in New Deals (cont.) Create B10 Market Lease Lease not considered as a variable interest in determining the primary beneficiary in a VIE Increase Equity Levels in Entities Over 10% SPEs need adequate equity Not a presumed level of equity with change in EITF 90-15
Accounting Requirements Affecting Legal Documentation Covenants and Representations Expect limits ownership changes of a VIE = possible change in primary beneficiary Drafting impact: o Limits on assignments and participations o Restrictions on transfers of beneficial interests Form of transactions should not give lessor too much discretion or control over lessee or asset Drafting impact: Objective standards may be required instead of decisions in sole discretion of lessor or similar words
Accounting Requirements Affecting Legal Documentation Equity Level (FIN 46) Equity must generally be steady to avoid change of primary beneficiary Drafting impact: Periodic representations with financials confirming variable interests/equity levels o Make changes in variable interests subject mutual approval Events of Default Commercial reasonableness required Drafting impact: Standard event of default provisions tend toward bright-line basis for default with less discretion in lessor
Accounting Requirements Affecting Legal Documentation Impact of Guarantee Project (FIN 45) Consider impact of guarantees (e.g.: indemnities and residual guarantees) Determine fair value to be booked for guarantees Issue: Will lessees hesitate to use synthetic leases where fair value is material? (e.g. rapidly depreciating assets assure lessee residual value guarantee payments)
Conclusion and Summary The Course of Change may: Lead to opportunity Improve disclosure Limit synthetic leases: Bad Optics damage off-balance sheet leasing Increase sale-leasebacks, innovative loans and tax leases For public companies, the story is all but over Nearly $400 B of off-balance sheet deals being booked in 3rd Quarter For private companies, only time will tell
Questions? Thank You!!!