Fitch Comment: Appellate Court Rulings on United's Special Facilities Bonds.
In its decision, the Seventh Circuit affirmed the decisions of the bankruptcy court and the U.S. District Court, which had found the bond-related portions of the agreement between the City and County of Denver (Denver) and United Airlines (United) supporting the special facilities bonds issued to finance improvements for United at Denver International Airport could not be severed from the rest of the agreement under Colorado law. Consequently, the entire agreement was considered a lease and subject to Section 365 of the Federal Bankruptcy Code (Section 365). Based on United's conditional assumption of the Denver lease in its plan of reorganization, bondholders of the Denver special facility bonds should recover their missed payments as a result of this decision. While in public comments United has indicated it does not intend to do so, it may continue the appeal process by asking the Seventh Circuit to rehear the case, by asking the entire Seventh Circuit to hear the matter en bank or by appealing the decision to the United States Supreme Court.
The Denver case is one of four cases United initiated during the course of its bankruptcy proceedings, challenging the status of the agreements underlying special facility bonds with the other cases involving San Francisco International (SFO), Los Angeles International (LAX) and New York John F. Kennedy International (JFK) airports. In these cases, United asked the bankruptcy court to determine that the agreements underlying the bond transactions were not leases but instead disguised financing arrangements. This distinction is critical in a bankruptcy context, as leases under Section 365 must either be assumed and fully performed by the tenant during and after the bankruptcy process or rejected and the leased property vacated. In the event of rejection, the lessor's claims are limited by Section 365 and treated as an unsecured debt. However, financing arrangements are either secured or unsecured pre-petition debts, repayable up to the value of the collateral (secured debt) or from a general distribution of the borrower's assets as part of the reorganization plan. The debtor's continued occupancy of the facility is irrelevant. Should the collateral value be equal to or greater than the balance of the loan, the lender is made whole. However, should the value be less than the balance due, the difference is treated as unsecured debt. The United reorganization plan, approved by the bankruptcy court, provided for a recovery rate of between 4% and 8% for unsecured creditors.
In each of its earlier decisions regarding the SFO and LAX bonds, the Seventh Circuit ruled that the economic substance of the transactions was a secured financing arrangement, not a lease subject to Section 365. However, in the latest ruling regarding the Denver transaction, the Seventh Circuit distinguished the Denver agreement from the others because Denver's agreement was contained in one document establishing the terms between Denver and United for the rental of the ground and the facilities constructed thereon for United's use. As Colorado law does not allow for the separation of elements of a contract unless specifically indicated in the contract and the ground lease constitutes a lease for purposes of Section 365, the Seventh Circuit ruled the entire agreement must be treated as a lease under Section 365 without consideration of the economic circumstances of the facilities portion of the transaction. In comparison, the transactions at both SFO and LAX involved a lease to United, a sublease from United to a third party governmental agency with bonding authority, and a leaseback from that third party to United. The LAX and SFO cases are currently before the bankruptcy court to determine the value of the respective pledged security interests.
While United's challenge of its special facility transactions has been disruptive to the market, Fitch believes the rulings of the Seventh Circuit provide some guidance in evaluating the risks of special facility bonds in relation to the provisions of the bankruptcy code and should allow the development of transaction structures to address these concerns. The Denver ruling indicates the importance of a traditional landlord-tenant relationship, with the terms of the transaction contained in a single document. The SFO and LAX decisions highlight the use of conventional commercial leasing structures, with a single rental payment encompassing all related costs and a 'triple-net' format will likely be favored in the future. Market participants may develop additional structures designed to protect the interests of bondholders based on the principles contained in the Seventh Circuit's opinions. As a result, Fitch will analyze the credit implications of the structures underlying future special facility transactions on a case by case basis.
Fitch cautions investors to review the structure of a transaction and the role the financed facilities play in the overall operations of a borrower to determine if it is in their interest to hold a lease or a secured financing in the event of a borrower's bankruptcy. Also, as indicated by the outcome of the Denver case, investors should understand the governing state contract law as it plays a significant role the final determination of how a transaction may be treated if it is challenged in the bankruptcy process. Furthermore, these rulings establish precedent only for the Seventh Circuit, and any future bankruptcy cases heard in other circuits could be decided differently, even if a similar matter is presented.
Fitch intends to provide further comment on the ramifications of the United cases through the development and future publication of criteria for rating special facility bonds.
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|Date:||Jul 14, 2006|
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