Synthetic Leases: Changed But Still Viable

Synthetic Leases: Changed But Still Viable By Mindy Berman After a nearly two-year pause, the use of offbalance sheet financial products is on the rise again. From the time of the Enron implosion in late 2001, corporate governance concerns have combined with a slow economy to cause a dramatic slowdown in the use of financing tools such as synthetic leases in the large-ticket leasing market. Until the issuance of final consolidation accounting standards by the Financial Accounting Standards Board (FASB) in December 2003, uncertainty prevailed and few companies were brave enough to enter the waters. Synthetic leases were the most vulnerable of leasing products during that time, causing many observers to prematurely predict their demise. This vulnerability was due to the common use of special purpose entities (SPEs) and to the economic substance model proposed by FASB. Both of these factors appeared to challenge the core precepts of synthetic leases. This article proposes that synthetic leases can be done today provided that the lessor participant satisfies the tests designed to determine economic substance. The article will rectify the common misperception that synthetic leases were outlawed by new consolidation accounting rules. Lastly, the article will explain how synthetic leases are being structured today and how the product is being received by corporate users in the new climate for corporate governance. SYNTHETIC LEASE BASICS Synthetic leases became a popular financing tool in the 1990s and early 2000s as a low-cost form of operating lease. The product is a hybrid: off-balance sheet for financial reporting purposes and a secured loan for tax, economic, and legal purposes. Typically, a lease is structured with a fixed-price purchase option equal to the estimated future value of an asset. The lease balance is amortized to the purchase option amount at the end of lease term. The lessee guarantees the first risk of loss to the lessor, usually in an amount equal to 85% to 88% of the purchase option amount. Because the lessor risk is nominal, synthetic leases are priced close to the cost of debt appropriate for the credit quality of the lessee user. As a result, this product has been an economically attractive form of financing compared to other traditional operating lease products. A lessee enjoys tax benefits of ownership but avoids any depreciation expense on its financial statements. The motivations that companies have for using synthetic leases are varied and include: obtaining the lowest cost operating lease reducing apparent leverage to comply more easily with restrictive financial covenants under other borrowing agreements allowing capital spending beyond a company s allowable budget keeping nonincome producing assets such as corporate aircraft or real estate off-balance sheet improving corporate earnings by eliminating depreciation expense associated with ownership retaining tax depreciation deductions while still enjoying off-balance sheet treatment retaining economic control of and appreciation in the value of core corporate assets such as corporate headquarters, distribution centers, and key production facilities Synthetic leases have been used for all types of

The Sarbanes-Oxley Act has heightened sensitivity to the use of structured finance transactions and has permanently changed practices in the use and execution of structured financings in a dramatic way. personal property and real property, although real estate has been restricted to newly acquired or build-to-suit property due to restrictive saleleaseback accounting rules. Lease terms have generally been limited to five years, consistent with the credit policies of the most active promoters of the product: bank leasing companies and finance companies. Middlemarket transactions have financed equipment almost exclusively including production machinery, material handling equipment, and fleets of transportation assets. Typically, these transactions range in size from $1 million to $20 million and are entered into directly between a leasing company and the end user. In the large-ticket market, transactions are greater than $20 million in size, involve multiple debt and equity participants, and are more highly structured. In the past, these deals were commonly executed in SPEs such as owner trusts to facilitate participations and create protection from lessor bankruptcy. A high proportion of the volume in the large-ticket market involves corporate real estate and power plants; traditional equipment assets comprise only a small portion of overall volume. A NEW AGE IN CORPORATE GOVERNANCE One of the most profound and long-lasting effects resulting from the Enron debacle is a new attitude toward corporate governance by officers and directors of corporations. In this climate, acceptance and practice of structured products such as synthetic leases have been profoundly challenged. Legislation enacted by Congress, rules issued by FASB, and regulations promulgated by the Securities and Exchange Commission (SEC) all have focused on greater transparency for off-balance sheet obligations and greater accountability of officers and directors for financial reporting. The post-enron environment has been greatly influenced by congressional passage of the Sarbanes-Oxley Act of 2002. Corporate use of leasing today is driven in no small measure by compliance with regulations from the act. Enhanced financial disclosures of off-balance sheet obligations have provided more in-depth and consistent information to shareholders since year-end 2001. More Transparent Disclosure of Synthetic Leases Reporting by SEC registrants has become more complete and transparent due to new SEC and FASB requirements, fueled by corporate responsibility to shareholders and other users of financial statements. Note the difference in this company s discussion of its synthetic lease arrangement between 2000 and 2002. 2000 The company leases certain facilities under noncancelable operating agreements for periods up to 15 years. Some of the leases have renewal options ranging from one to10 years and contain provisions for maintenance, taxes or insurance. The company is contingently liable, under residual value guarantees, for approximately $63 million for one of its current facility leases. 2002 We have a lease for the XXX facility, which, although accounted for as an operating lease, is commonly referred to as a synthetic lease. A synthetic lease represents a form of financing that under accounting rules is not required to be included in the balance sheet. This synthetic lease is treated as an operating lease for accounting purposes and as a financing lease for tax purposes. Under the terms of this lease, we are committed to make minimum lease payments of approximately $X million for the period through April 2003. The minimum lease payments will fluctuate with changes in interest rates. At the end of the lease term, YYY may exercise its option to extend the lease for a year with a banking syndicate consent, refinance the lease, purchase the facility, or arrange for the leased facility to be sold to a third party with YYY retaining an obligation to the lessor for the difference between the sale price and a $63 million residual value guarantee. Both in footnotes to financial statements and management discussion and analysis (MD&A), corporations registered with the SEC must provide specific disclosure on the nature and magnitude of obligations that are not otherwise recognized on balance sheet (more later on accounting and disclosure of guarantees). SEC registrants acted responsibly and over time have migrated to provide more information and greater detail on synthetic leases. (See the sidebar More Transparent Disclosure of Synthetic Leases for an example of change in disclosure of a synthetic lease arrangement.) The Sarbanes-Oxley Act has heightened sensitivity to the use of structured finance transactions and has permanently changed practices in the use and execution of structured financings in a dramatic way. Corporate officers and directors now assume criminal liability for their actions, elevating scrutiny and their 2 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L 2 0 0 4 V O L. 2 2 / N O. 2

FIN 45 Guarantees FIN 45, which increased the accounting burden borne by users of synthetic leases, was released in November 2002. It requires expanded disclosure and recognition of guarantees and other off-balance obligations in financial statements. Disclosure includes the nature and maximum exposure to loss under a guarantee. For guarantees issued after Dec. 31, 2002, the fair value of the obligation must be reported on the balance sheet. Recognition of the guarantee liability is an attempt to quantify the value of the lessee s willingness to stand ready to perform under a commitment such as a residual guarantee. This liability is distinct from any other-than-temporary loss recognized under SFAS 5, Accounting for Contingencies. In concept, a lessee obtains value in exchange for the guarantee it provides, for example, in the form of a lower rent payment. The amount to be recognized is not the notional amount of the guarantee, but rather an amount intended to capture the value of the obligation. Because there is no comparable residual value insurance product available covering first-loss exposure in the market, the valuation exercise is based on expected cash flows or losses under the guarantee. Specifically, FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, provides guidance for determining fair value by calculating the present value of the weighted expected loss. A lessee will need to construct a series of expected outcomes or cash flows based on data obtained from a bona fide source. Once the value of the liability is determined, the lessee-guarantor must post an offsetting entry. Under a lease, this entry is considered prepaid rent, because it is believed that the lessee is receiving a reduction in rent in exchange for the guarantee. Over the life of the lease, both the prepaid rent and liability would be amortized straight line, consistent with the manner in which premiums and liabilities for insurance policies are treated. The prepaid rent would be expensed in a like amount as the income associated with the reduction in the liability, neutralizing the effect on pretax income. involvement in decision-making. No longer does a board rubber-stamp financing transactions. Public accountants are subject to new rules for their engagements and third-party oversight, with the effect of elevating their legal liability, intensifying their review of financings, and causing stricter adherence to accounting standards regardless of materiality. Although synthetic leases have always been closely reviewed by accountants, the combination of the Sarbanes-Oxley Act and new rules on consolidations and guarantees has increased the intensity of examination and prompted stricter enforcement of existing rules by both lessees and lessors. (See the sidebar FIN 45 Guarantees, concerning Financial Interpretation No. 45, Guarantor s Accounting and Disclosure Requirements for Guarantees. ) CONSOLIDATION RULES OUTLAW SPES FOR SYNTHETIC LEASES Synthetic leases were the most vulnerable of leasing products during FASB s deliberations on consolidation accounting during 2002 leading up to the issuance of Financial Interpretation No. 46, Consolidation of Variable Interest Entities An Interpretation of ARB No. 51 (FIN 46) in January 2003 and substantial revision in December 2003 (FIN 46R). (See the sidebar FIN 46 Basics on page 4.) Many observers prematurely predicted the demise of the product. This vulnerability was due to two factors: the common use of SPEs in synthetic leases and the economic substance model being proposed by the FASB. This model seemingly challenged the dual treatment of synthetic leases, that is, that an asset can be offbalance sheet for financial reporting purposes but owned by the lessee for tax purposes. In spite of the common misperception that synthetic leases were outlawed by FIN 46, they have in fact survived with one single though not insignificant change. This twist is a virtual prohibition on the use of SPE lessors. Under the Synthetic leases were the most vulnerable of leasing products during FASB s deliberations on consolidation accounting during 2002. Many observers prematurely predicted the demise of the product. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L 2 0 0 4 V O L. 2 2 / N O. 2 3

FIN 46 Basics In January 2003, FASB finally brought its two decades-long deliberations to conclusion with the issuance of FIN 46. (The new standard was revised in its entirety and reissued in December 2003 as FIN 46R.) FIN 46 provides a new framework for consolidation and is an incremental move in the direction of principles-based accounting. The new standard identifies whether entities should be consolidated by the traditional method of voting rights form-based with bright lines or by a new approach evaluating economic risks and rewards, labeled variable interests, which is more principles based and containing new bright lines. ( Bright line refers to accounting standards that use numerical values that drive the accounting if over or under the value.) FIN 46 affects all legal entities, not just SPEs, including corporations and their separately incorporated subsidiaries, partnerships, and limited liability companies. There is no grandfathering of existing arrangements, so all entities must be considered, not just new ones. In addition, FIN 46 causes all parties involved with entities, not limited to ownership interests, to evaluate the nature of the entity and their relationship to it. This evaluation enables parties to determine whether an entity is a variable interest entity (VIE) and, if so, how consolidation would be evaluated, based on potential variability in gains and losses of the entity. The focus of the new paradigm is, first, distinguishing entities that lack typical characteristics of equity and, second, identifying the party that holds the majority of the risks and rewards of the assets and activities of an entity. A VIE exists under FIN 46 when an entity lacks any of the following characteristics: Sufficient equity contribution to absorb expected losses stemming from the assets and activities of the entity without additional subordinated financial support from others Decision-making power by equity owners through voting or other rights over major actions such as sale of assets The unlimited obligation to absorb expected losses of the entity The unlimited right to receive the expected residual rights of the entity Following a conclusion that an entity is a VIE, consolidation is determined based on an evaluation of the expected losses and rewards of the entity. The party to consolidate the primary beneficiary is the enterprise that holds a majority (greater than 50%) of the expected losses or the downside risk of the entity. If the entity is not a VIE, consolidation occurs according to the pre-existing method, using voting rights. new consolidation rules, a single purpose lessor entity holding an asset under a synthetic lease would be considered a variable interest entity (VIE) and would be consolidated with the lessee. VIEs are entities that lack either sufficient equity capital or other characteristics typical of ownership. Consolidation can be avoided altogether if the asset is held by an acceptable multiasset lessor entity with true economic substance as defined under FIN 46, even though the synthetic lease arrangement is otherwise identical. This type of entity is often referred to as a substantive lessor. The distinction between a SPE and substantive lessor is the essence of change for synthetic leases under the new consolidation accounting regime. Because FASB did not use FIN 46 as a device to surreptitiously change other areas of accounting literature such as Statement No. 13, Accounting for Leases (SFAS 13), the fundamental characteristics of operating leases remained intact and synthetic leases were allowed to survive, albeit in a modified form. To better understand why a synthetic lease with an SPE lessor would be consolidated with the lessee, we examine these leases conceptually under FIN 46. The analysis of a single purpose lessor entity under FIN 46 focuses on the risks and rewards borne by each of the parties to a transaction typically a lessee, lessor, and lender. Under SFAS 13, a synthetic lease meets four tests for classification as an operating lease, hinging largely on the 90% test measuring the present value of minimum lease payments of the lessee. To keep lease obligations of the lessee under 90% of the fair value of an asset, a lessor normally assumes exposure to a small portion of residual risk associated with the asset at the end of the lease term. The lessee in all instances bears the first and most substantial risk of loss through its guarantee of the residual value of the asset. Simply evaluated through the lens of FIN 46, any synthetic lease arrangement evaluated in 4 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L 2 0 0 4 V O L. 2 2 / N O. 2

isolation would be consolidated with the lessee, because the lessee bears the majority of expected losses. These losses stem almost entirely from volatility in the residual value of the asset. However, given that FIN 46 distinguishes between types of entities, underlying synthetic leases can escape evaluation and consolidation by a lessee if the lessor entity is not a VIE or is not viewed as a silo of a VIE. DIFFUSED VIES VERSUS VOTING INTEREST ENTITIES With new rules in place today, new conventions are emerging, creating greater certainty in outcomes. After struggling with interpretation of the new consolidation rules, the leasing industry, along with the Big Four public accounting firms, has developed workable standards for lessor entities that avoid consolidation of synthetic leases by lessees. With this new foundation, companies are reengaging in transactions based on the fundamental economic value that these financings provide and many existing lessees proactively chose to restructure their leases to conform to new consolidation rules. (See the sidebar Impact of FIN 46 on Synthetic Leases, explaining decisions that lessees made on pre-existing synthetic leases.) FIN 46 left the door open for synthetic leases to continue, provided that title to an asset is held by a multiasset lessor entity that meets either of two standards under FIN 46. Substantive lessors have surfaced as the lessor of necessity in the new era. Industry lessors that participate in this market have worked carefully to ensure that their booking entities conform to the new requirements. To proceed on commercial transactions, lenders and participants have had to analyze the use of non-spes and come to grips with the legal considerations of an entity that is not bankruptcy-remote. Impact of FIN 46 on Synthetic Leases Prior to issuance of new consolidation rules, approximately 80% of large-ticket synthetic leases (over $20 million in value) in the market were executed using SPE lessors. These transactions represented an even higher percentage of funded asset value. The vast majority of assets in these transactions were comprised of real estate and integral equipment such as power plants and turbines, which are subject to many other complex accounting requirements. The use of SPEs was motivated by legitimate business reasons: to facilitate participation by multiple investors in a transaction and insulate investors from bankruptcy of the lessor. The presence of SPEs, however, did not alter the accounting classification, provided that equity investments in SPEs otherwise complied with the intricate web of accounting rules. Smaller single-investor transactions, generally financing nonintegral equipment, were and continue to be executed directly by leasing companies without SPEs. Accounting scrutiny and complexity are substantially reduced in these arrangements. The effective date of FIN 46 was immediate after issuance in January 2003 and transition time was limited for most lessees to five months. In this short period of time, lessees were faced with a tall order: read and interpret complex new rules; evaluate current arrangements; consider restructuring options, if necessary; and discuss and seek decisions from boards of directors. Not surprisingly, many lessees consolidated synthetic leases after June 30, 2003. Some of them may have preferred to do otherwise but were unable to meet the deadline for a variety of reasons. In many instances, lessees chose to keep the financing outstanding because it was an attractive source of capital, whereas others simply terminated their leases and repaid the lessor. A significant number of lessees were able to take action to restructure their leases. The following table presents the outcomes for 135 large-ticket transactions that could be identified and tracked before and after FIN 46, along with the implications for the companies balance sheet and financing arrangements. Number Source: Compiled by 42 North, largely from SEC filings of companies that are a matter of public record (10Ks and 10Qs). Two types of lessor entities have emerged and gained general acceptance in the practice of synthetic leases. The first is a voting interest J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L 2 0 0 4 V O L. 2 2 / N O. 2 5

Other industry standards have been adapted in the wake of FIN 46, and new structures for synthetic leases have emerged that are being commonly accepted. The most noticeable change is the amount of equity investment in a lease. entity, which is simply an entity that does not meet the definition of a VIE. FIN 46 outlines criteria for this conclusion, although evaluation and demonstration of this qualification can be challenging. In general, these are leasing companies with significant numbers and amounts of assets (although not necessarily diverse in terms of types of assets) and are often operating entities with employees as well. Because the burden under FIN 46 is to disprove the existence of a VIE, a number of lessors have adopted a second approach called a diffused VIE. This alternative was developed by the Big Four through interpretation of FIN 46 as a more practical means to evaluate multiasset entities and potential silos. Under this approach, there is no need to determine whether the entity is a VIE or not. Consolidation can be avoided by a lessee if (a) the lessor contributes at least 5% equity to an individual transaction and does not finance the asset with more than 95% nonrecourse debt, and (b) the fair value of the leased asset is not greater than 50% of the total fair value of assets of the lessor. To support either approach, auditors are requiring that lessors make representations to lessees about the nature of their entity and the funding of the leased asset in question. These statements can be made in transaction documents or in a side letter between the parties. Additionally, in a departure from previous practice, lessors typically are required by their lessee customers to provide information on the ownership and business of the lessor entity as well as financial statements. The information and representations address and support the specific conclusions needed by a lessee and its auditors to determine whether the entity is a diffused VIE or voting interest entity. Other industry standards have been adapted in the wake of FIN 46, and new structures for synthetic leases have emerged that are being commonly accepted. The most noticeable change is the amount of equity investment in a lease. Today, industry practice has settled on a new standard of 5% equity, because this level supports the diffused VIE conclusion. The amount of equity investment has changed because FIN 46 eliminated existing minimum equity requirements and other rules specifying the nature and form of equity investment. In some cases, the typical priority of senior debt over equity participants has been modified. MARKET CONDITIONS POISED FOR REBOUND With new industry standards settling in and acceptance growing with new corporate governance standards, the use of synthetic leases is on the rise again. The slowdown in practice in 2002 and 2003 coincided with a downturn in economic activity, when many corporations rationalized assets such as real estate and pared back on and eliminated operations. Now corporations are poised for higher levels of capital spending. Leasing companies that promote synthetic leases have responded responsibly in advising customers. Several new lessor entities were formed by banks and independent parties to accommodate the new rules. Existing synthetic lease arrangements are reaching maturity and are being extended or re-leased by lessees. With new accepted conventions, there is less perceived risk associated with the product, and the finance staff of corporations is focusing on the original benefits of the product, namely, the intrinsic value offered by reducing occupancy and rental expense over other more traditional forms of operating leases. Until the rate of growth in the economy increases, however, there is a surplus of capital available for the product. In 2004, commercial banks are once again flush with cash and eager to lend money the new mantra is funded assets. Synthetic leases are an excellent investment vehicle for banks to create higher earnings on loan commitments compared to corporate credit facilities that are largely unfunded for investment-grade customers. Banks continue to employ leasing professionals to promote the use of this product in spite of the softness in demand. Competition for 6 J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L 2 0 0 4 V O L. 2 2 / N O. 2

product is keen, with banks tightening credit margins and extending terms from five years to six or seven years. For corporations, the current market creates a good opportunity to lock in new financing terms. In spite of epic changes in corporate governance and landmark rules for consolidation accounting, synthetic leases have emerged largely unscathed. While the elimination of SPE lessors in not an inconsequential change, industry practice has adapted and corporate use has continued. This acceptance is testimony to the fundamental value that synthetic leases offer. In spite of epic changes in corporate governance and landmark rules for consolidation accounting, synthetic leases have emerged largely unscathed. Mindy Berman mberman@42north.us Mindy Berman is senior managing director of 42 North Structured Finance Inc. in Boston. It is the successor company to Key Global Finance, of which she was one of the founding directors in 1996. The company provides assetspecific structured finance products to both domestic and international corporations and institutional investors for personal and real property assets. Ms. Berman is responsible for business development at 42 North. Prior to joining Key Global Finance, Ms. Berman was executive vice president of BTM Capital Corp. She was president of BTM Financial Services Inc., its NASDregistered syndication subsidiary, and managed the debt and equity placement activity. Ms. Berman earned an MBA from Boston University and graduated magna cum laude with high honors from Brandeis University. She is a NASD general securities principal as well as a member of the Financial Accounting Committee of ELA. J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G F A L L 2 0 0 4 V O L. 2 2 / N O. 2 7