Leveraged Leases in Bankruptcy and Workouts 3:30pm - 4:30pm April 26, 2007

2007 ANNUAL SPRING INVESTMENT FORUM American College of Investment Counsel Chicago, Illinois Leveraged Leases in Bankruptcy and Workouts 3:30pm - 4:30pm April 26, 2007 Peter L. Borowitz Debevoise & Plimpton LLP Wiley S. Adams Prudential Insurance Company of America Katherine Ashton Debevoise & Plimpton LLP Karen G. Crockett MetLife

March 29, 2007 Leveraged Leases in Bankruptcy I. Debt/Equity Conflicts. A. Equity Squeeze. 1. Tax indemnity claim as impediment to workouts. 2. Equity participant s tax risks distort normal workout dynamics. (a) (b) Preference for less rather than more income. Restructured rents must preserve true-lease structure and defer payment without impairing rights under 365 of the Bankruptcy Code in the event of subsequent bankruptcy. (c) Equity-squeeze trigger of tax indemnity claim in relation to B. Stipulated Loss Claims. 362 and 365 of the Bankruptcy Code. 1. Components of Stipulated Loss. (a) Principal, interest and make-whole premium in respect of debt. (b) Residual value, tax benefit indemnity and return-oninvestment protection in respect of equity. 2. Ownership of Stipulated Loss claim. (a) Pledge of stipulated loss in conflict with excepted payments disallowance of duplicate claims. (b) Subordination of equity claims.

(c) Special problems in real estate cases. (i) Rent limitation under 502(b)(6) of the Bankruptcy Code. (ii) Possible inclusion of tax indemnity claim as part of rejection damages claim. (iii) (iv) Letter of credit as excepted payment. Subordination of equity claim. 2

Risks Arising from The Bankruptcy Code s Rent Limitation in Connection with Lending on Real Property Leases Leveraged leases of real property and other financing transactions involving credit leases of real property are subject to major risks arising from certain provisions of the Bankruptcy Code limiting recourse against the debtor-lessee. Those risks have been exacerbated in recent years by two factors. First, major corporate borrowers, which prior to the 1980s were highly averse to the stigma of bankruptcy, now are filing for protection under Chapter 11 of the Bankruptcy Code with such frequency that bankruptcy is in danger of being perceived as an alternative business tactic rather than as an admission of failure and a remedy of last resort. Second, real estate values, which have from time to time been assumed to go nowhere but up, have proved, at particular times and in particular markets, to be susceptible to drastic depreciation. Accordingly, real estate financiers are now facing a situation where they must plan for the risk that their borrowers will file for bankruptcy protection at a time when the value of their real property collateral may not come close to covering their credit exposure. The debt owing to a lender in a lease financing is generally nonrecourse to the borrower (or lessor under the lease), and the debt is serviced from the rental stream under a lease assigned to the lender as collateral for the debt. The lessee, then, is the credit on which the transaction is premised. Following a default under the lease, the lender, generally, has two sources for repayment of its loan the leased property and a claim, made by the lessor at the direction of the lender, for damages resulting from lessee s breach. To the extent that the value of the leased property is insufficient to satisfy in full 3

the debt amount, the lender can look to the lease damage claim to satisfy the deficiency. Usually the damage claim amount is specifically identified in the lease and will be sufficient, at a minimum, to satisfy in full the lender s remaining debt. However, as this memorandum will discuss, if the lessee files a petition for bankruptcy protection, Section 502(b)(6) of the Bankruptcy Code can impose limitations on the lender s ability to claim the full amount of the lease damage claim against the debtor-lessee in the bankruptcy proceeding. This memorandum will also discuss how, in a tax-driven leveraged lease financing, the conflict between the lender and the lessor or equity participant can be greatly exacerbated by the Section 502(b)(6) limitation. II. The Rent Limitation of Section 502(b)(6) When a lessee of real property files for bankruptcy protection, the debtor-lessee may assume or reject the lease under Section 365 of the Bankruptcy Code. If the lease is assumed, the debtor-lessee must cure all defaults and provide adequate assurance of future performance. After the lease is assumed, any claims for future defaults will be accorded administrative priority status, ranking ahead of all pre-petition unsecured claims (although the amount of such claim is subject to limitation in the event of subsequent rejection). If the rental terms of the lease are above market and the lease is otherwise unfavorable to the debtor-lessee (which, in the case of a facility financing, may very well have been the reason for filing for bankruptcy protection in the first place), the debtorlessee will no doubt exercise its business judgment and reject the lease. The debtorlessee s rejection of the lease results, in effect, in a termination and breach of the lease 4

relating back to the time immediately prior to the filing of the bankruptcy petition and creates for the lessor (and, therefore, the lender 1 ) a pre-petition claim for damages. This claim for damages, however, is limited by Section 502(b)(6) to the greater of (i) one year s rent or (ii) rent for 15% of the remaining term of the lease, but not to exceed three years rent. 2 To illustrate the risks facing a real estate lender in a lease financing, let us assume a hypothetical lease rejection where (i) the remaining lease term is fifteen years, (ii) the real estate market has declined such that the market value of the remaining lease term is worth only 60% of its stated rent, and (iii) the lessor s actual damages from lease termination (net of income from reletting) will be 40% of the rent due under the lease. Under Section 502(b)(6), however, the best the lessor can hope to claim is 15% of the rental value of the lease. Potential recovery is even grimmer in cases where the remaining lease term exceeds twenty years and, therefore, the three-year maximum limitation is triggered and imposes a lower cap than the 15% test. For example, if the remaining term of the lease is 30 years, the lender s recovery is limited to three years or only 10% of the rental value of the lease (although there is divided case law relating to 1 2 The lender derives its claim against the debtor-lessee through the security assignment by the lessor of the lessor s rights against the debtor-lessee. Accordingly, the lender s claim will be subject to any limitation on the lessor s claim against the debtor-lessee. The Section 502(b)(6) limitation is clearly designed to benefit the creditors of the debtor-lessee. Accordingly, any pre-bankruptcy agreement by the debtor-lessee to waive the benefits of Section 502(b)(6) should be completely unenforceable under the Bankruptcy Code. 5

the calculation of the limited claim). In a typical lease financing, where the debt is generally nonrecourse to the lessor, the lender will have no opportunity to make up any deficiency between the outstanding amount of its loan and the sum of (i) the market value of the repossessed real estate and (ii) the rent-limited claim against the debtor-lessee. III. Section 502(b)(6) applies only to true leases of real property. The reach of Section 502(b)(6) does have its limits. The first limit is that Section 502(b)(6) applies by its terms to leases of real property, not personal property. Whether property constitutes real or personal property is a question of law to be determined under the Bankruptcy Code and applicable state law. In most cases, such as leases of office buildings and hotels, it will be clear that the lease is one of real property. However, there will be cases, particularly when fixtures are involved, where an argument can be made that the transaction includes, at least to some extent, a lease of personal property not subject to limitation under Section 502(b)(6) 3. The second limit on Section 502(b)(6) is that it applies only to true leases and not to financing leases intended as security. See S. Rep. No. 989, 95th Cong., 2d Sess. 64, reprinted in 1978 U.S.C.C.A.N. 5787, 5850 ( [T]he phrase lease of real property applies only to a true or bona fide lease and does not apply to financing leases of real property or interests therein, or to leases of such property which are intended as 3 This issue may be very significant, for example, in the context of a lease of a power facility where the land and building will clearly constitute real property but where valuable equipment which is an integral part of the facility may arguably qualify as personal property. See Exhibit for one case where this issue was litigated, but where the case was settled before any decision was issued. 6

security. ). The reasoning behind this distinction is that a financing lease is, in effect, a secured loan, and Congress saw no reason to impose any limitation on a lender s right to recover the full amount of its loan. In the case of leases, however, the legislative history suggests two reasons for limiting the lessor s recovery. First, the lessor s damages for breach were considered contingent and difficult to quantify. Second, because the lessor retains all risks and rewards of the value of the real estate at the termination of the lease, it was considered equitable to limit the claims of a real estate lessor. These reasons are wholly unpersuasive. Section 502(b)(6) appears to be an obsolete relic from the days when financing transactions were very different. In today s financing environment, where multi-million dollar long-term lease transactions can involve personal property (such as big-ticket aircraft or plant equipment) just as readily as real estate, it is hard to understand why a lessor of real property should be subject to a rent limitation when a lessor of personalty is not. Nor does it make any sense to limit the recovery available to a lessor for damages for termination of a lease when no such limit is imposed on the recovery of a lender who forecloses against real property, since the lease termination claim and the mortgage loan deficiency claim are equally susceptible to calculation with reference to prevailing real estate market values. But, whatever the wisdom of Section 502(b)(6), we are stuck with it for now, and its effects can present major problems for the unwary lessor and its lenders. 2. What is a true lease for purposes of the Bankruptcy Code? We turn next to the question of when Section 502(b)(6) applies and whether it may be possible to escape its application. There is a wealth of case law discussing, in the 7

Bankruptcy Code context, the factors that distinguish a true lease, to which Section 502(b)(6) applies, from a financing lease or disguised mortgage loan, to which it does not. See, e.g., In re PCH Assocs., 804 F.2d 193, 200-01 (2d Cir. 1986); In re Picnic n Chicken, Inc., 58 B.R. 523, 527-29 (Bankr. S.D. Cal. 1986); In re Nite Lite Inns, 13 B.R. 900, 907-10 (Bankr. S.D. Cal. 1981). 4 The guiding principle, however, is that the lessor in a true lease has retained more than a de minimis residual interest in the property. The lease is likely to be characterized as a financing transaction and not a true lease (i) if the term of the lease (including any possible extensions other than extensions at prevailing fair market value) would consume all or substantially all of the useful life or economic value of the property, (ii) if the lessee has an option to purchase the property at less than fair market value, or (iii) if other economic exigencies effectively force the lessee to purchase the property even at fair market value. 5 See, e.g., International Trade 4 The legislative history is not much help on this point: Whether a lease is a true or bona fide lease or, in the alternative, a financing lease or a lease intended as security depends on the circumstances of each case. The distinction between a true lease and a financing transaction is based upon the economic substance of the transaction and not, for example, upon the locus of title, the form of the transaction or the fact that the transaction is denominated a lease. S. Rep. No. 989, 95th Cong., 2d Sess. 64, reprinted in 1978 U.S.C.C.A.N. 5787, 5850. 5 For example, in the case of an integrated operation where the lessee owns most of a manufacturing facility but has sold and leased back a small portion, it may be obvious that the lessee will be required to repurchase the leased portion of the facility (albeit at the then fair market value) at the end of the lease term. 8

Admin. v. Rensselaer Polytechnic Inst., 936 F.2d 744, 750 (2d Cir. 1991); In re Winston Mills, Inc., 6 B.R. 587, 597 (Bankr. S.D.N.Y. 1980). In most cases it is the debtor-lessee, not the lessor or its lender, who will argue that a particular transaction is something other than a true lease. For example, a debtorlessee may wish to recharacterize a transaction as a secured loan if there is some perfection problem that might enable the debtor-lessee to obtain possession of the real property free and clear and transform the lessor into an unsecured creditor without any right to the real property. But if the debtor-lessee is content with treating the lease as a true lease and invoking the benefits of Section 502(b)(6), under certain circumstances it may be in the interest of the loan participants to seek to persuade the bankruptcy court to recharacterize the transaction in a manner adverse to the debtor-lessee. See Exhibit for an example where the loan participants sought to recharacterize a long-term leveraged lease as a secured financing. IV. The Reverse Equity Squeeze. All of the risks discussed above become even more poignant when one focuses on the conflict between the lessor and the lender in a tax-driven leveraged lease. In the typical leveraged lease transaction, the claim for stipulated loss value reflects three components: (1) the amount necessary to pay the lessor s debt to the lender; (2) the free cash scheduled to be payable to the equity participants and the residual value belonging to the lessor at the end of the lease; and (3) protection of the equity participant s anticipated tax benefits. Although in most cases the lessor nominally pledges all of stipulated loss value to the lender, it can be argued that the third component, the lessor s 9

tax indemnity claim, has not been pledged because it is redundant of the equity s claim under its tax indemnity agreement, which usually constitutes an excepted payment excluded from the pledge of collateral to the lender. If a court were to determine that the tax component has not been pledged and remains in the hands of the lessor, the lessor s claim against the debtor-lessee under the tax indemnity agreement would appear to rank pari passu with the lender s claim for the first and second components of stipulated loss value. This situation obviously creates confusion as to what precise amount of stipulated loss value has or has not been pledged because of the uncertainty in calculating the amount of equity s tax indemnity claim. That confusion is minor, however, in comparison with the conflict that can arise when the Section 502(b)(6) rent-limited claim is substantially smaller than stipulated loss value. The following hypothetical will illustrate the point. Assume that the lender in a leveraged lease transaction has outstanding debt claims of $70 million. The lessee files for bankruptcy protection and rejects the lease at a time when stipulated loss value is $100 million (prior to credit for any disposition of the real property). When the debtorlessee vacates the real property and returns it to the lessor, the lender forecloses under the mortgage and receives $30 million at a foreclosure sale, a price which reflects the drastic decline in value of the real property. The foreclosure proceeds are credited against the lessor s claim for stipulated loss value so that the lessor s net claim for damages is $70 million ($100 million of gross stipulated loss value as reduced by $30 million of foreclosure proceeds). The foreclosure sale also accelerates taxable income for the lessor and triggers a tax indemnity claim of $20 million for the lessor. If the lessor is deemed to 10

retain the exclusive benefit of the tax indemnity claim and $20 million is therefore deducted from the remaining $70 million claim for stipulated loss value, the lender will be deemed to hold the remaining $50 million of stipulated loss value as security for its remaining $40 million debt claim (the $70 million loan balance as reduced by the $30 million of foreclosure proceeds). Section 502(b)(6) enters the picture and creates havoc. The debtor-lessee may argue that Section 502(b)(6) applies not only to the lender s claim for stipulated loss value, but also to the lessor s tax indemnity claim, and that both claims in the aggregate must be confined by the rent limitation of Section 502(b)(6). The lessor and lender may argue that the tax indemnity claim should not be included in the Section 502(b)(6) limitation because it does not relate to the termination of the lease, but rather arose from the additional step of foreclosure. There are no judicial decisions directly addressing this controversy, however, and no decision to lend should be made in reliance on any such argument. 6 Assume, then, that the rent-limited claim under Section 502(b)(6) is $25 million and that it limits the collective recovery of the lender and the lessor. The lender will no doubt argue that it should have first claim on the $25 million to satisfy the loan balance, but, absent an express subordination agreement, the lessor may successfully argue that the $25 million should be shared ratably. This problem could have been avoided if all of 6 This problem is not merely a hypothetical one. See the attached excerpt from the disclosure statement in In re Prime Motor Inns, Inc., where Debevoise & Plimpton represented the loan participants and negotiated a settlement of the controversy. 11

stipulated loss value had effectively been pledged to the lender or if the tax indemnity claim had been fully subordinated to the lender s claim. Such subordination agreements are not common in the marketplace, but it is not at all clear that leveraged-lease lenders have historically focused on the full extent of their risk. It would certainly be very useful (although no doubt challenging to achieve in this difficult lending market) if the loan participant were able to obtain a partial subordination whereby, in the event a court were to impose the Section 502(b)(6) limitation on both the tax indemnity claim and stipulated loss value claim, the equity participant would agree that the loan participant s claim will be paid in full before the lessor s tax indemnity claim is paid. Conclusion As indicated above, it is extremely important in today s business environment for lenders to focus carefully on the risks of Section 502(b)(6) before making any investment that relies on a credit lease of real property. While the risks are substantial in any transaction that relies on a credit lease, lenders must be particularly careful in leveraged lease transactions where problems may be created not only by a bankrupt debtor-lessee, but also by the equity participant. 12