Off-balance sheet financing of leases and residual values: different structures for different leases--legal and accounting requirements applied.
What are some basic determinations and concepts that will help you structure the leases and the financing to achieve these goals? How will implementation of FASB's proposed interpretation related to the consolidation of special purpose entities, if adopted in the summer of 2002 as currently contemplated, affect the relevant structures?
I. GENERAL CONCEPTS
A. Type of Lease for Accounting Purposes
You need to determine whether the leases are (1) direct financing or sales-type leases (henceforth, "financing leases") or (2) operating leases, because significantly different accounting procedures apply to the different lease types. In plain English:
* a financing lease is a lease that transfers to the lessee substantially all of the benefits and risks of ownership (it effectuates the sale of the equipment or a financing of the sale of the equipment), and
* an operating lease is a lease that evidences a rental of property rather than a sale.
More specifically, a financing lease is a lease for which any one of the four requirements described on Exhibit 1 is met. An operating lease is any other lease.
Exhibit 1 DIRECT FINANCING OR SALES-TYPE LEASE VS. OPERATING LEASE In the hands of a lessor, a direct financing or sales-type lease is a lease as to which, at lease inception, collectibility of minimum lease payments is reasonably predictable and any unreimbursable costs yet to be incurred by the lessor are certain, and any one of the following requirements is met: 1. The lease transfers ownership of the property to the lessee by the end of the lease term (1); 2. The lease contains an option to purchase the leased property at a bargain price; 3. The lease term (2) equals or exceeds 75% of the estimated economic life of the leased property (3); or 4. At the beginning of the lease term (4), the present value of the minimum lease payments equals or exceeds 90% of the fair value of the leased property less any investment tax credit retained by the lessee. (5) In the hands of the lessor, an operating lease is any other lease. See FAS 13 (paragraphs 8 and 5(j)), FAS 98, and FAS 29. (1) The lease term includes the period through the date a bargain purchase option becomes exercisable, including (i) the fixed, noncancellable term, (ii) any periods covered by bargain renewal options, (iii) all periods for which failure to renew imposes a penalty such that as of lease inception, renewal appears reasonably assured, (iv) any periods covered by ordinary renewal options during which the lessee is expected to be a lender or guarantor of debt to the lessor related to the leased property, (v) all periods covered by ordinary renewal options preceding any bargain purchase option, and (vi) all periods representing renewals or extensions at the lessor's option. (2) Please refer to footnote 1. (3) Clauses (3) and (4) are not available when the beginning of the lease term falls within the last 25% of the total estimated economic life of the leased property. (4) please refer to footnote 1. (5) Please refer to footnote 3.
B. 90% Test
Frequently, determining whether a particular lease is a financing lease or an operating lease boils down to determining whether or not the lease meets the fourth of these alternative requirements:
* At the beginning of the lease term, was the present value of the minimum lease payments at least equal to 90% of the fair value of the leased property less any investment tax credit retained by the lessee?
If the answer is yes, then for accounting purposes the lease will generally be a financing lease. For details, please see Exhibit 2.
Exhibit 2 CALCULATION OF MINIMUM LEASE PAYMENTS FOR 90% TEST The minimum lease payments include: (i) the minimum rental payments over the lease term and the value of any bargain purchase option, and (ii) if there is no bargain purchase option: (a) any residual value guaranty by the lessee or a third party related to the lessee, or (b) any guaranty of the residual value or of rental payments beyond the lease term by a financially capable third party unrelated to the lessee or the lessor. The rental payments exclude contingent rentals and any obligation of the lessee to pay (apart from the rental payments) insurance, maintenance and taxes. See FAS 13 (paragraph 5(j) and FAS 29).
C. How a Lease Appears on a Lessor's Balance Sheet/ Income Statement
FAS 13 governs this for both lease categories. Basically,
* For a financing lease:
(i) the balance sheet reflects future rental payments as net investment in lease receivable, which equals gross investment in lease receivable less unearned income and unamortized initial direct costs; and
(ii) gross investment in lease receivable consists of two components:
(a) minimum lease payments, and
(b) unguaranteed residual value accruing to the benefit of the lessor.
* For an operating lease:
(i) leased property is included with or near property, plant, and equipment, leased property is depreciated following the lessor's normal depreciation policy, and accumulated depreciation is deducted from the investment in the leased property;
(ii) rent is reported as income as it becomes receivable over the term of the lease; and
(iii) initial direct costs are generally deferred and allocated over the lease term in proportion to recognition of rental income, but may be charged to expense as incurred under some circumstances.
D. General Structuring Concepts for Off-Balance Sheet Accounting
Two concepts are critical for achieving off=balance sheet accounting treatment for an asset.
* First, the sponsor must transfer the asset to another entity in a transfer that meets accounting standards for removing the asset from the sponsor's balance sheet.
* Second, the entity that ultimately holds the asset must not be an entity that will be consolidated in the financial statements of the sponsor. (Otherwise, the asset will reappear on the sponsor's balance sheet).
The accounting statements and guidance that govern these two concepts differ substantially depending on which type of lease is used.
II. GETTING A FINANCING LEASE OFF THE BALANCE SHEET--CONCEPTS AND STRUCTURES
A. FAS 140 Applies Components Approach to Financing Leases
FAS 140 applies to transfers of recognized financial assets and allows a lease receivable that it governs to be divided into its component parts for appropriate accounting treatment. Transfer of the component that is a recognized financial asset is governed by FAS 140. Transfer of the component, if any, that is not a recognized financial asset is governed by FAS 13, as amended.
* In general terms, a financial asset is an asset that provides one entity with a contractual right to payment by another entity.
* The balance sheet entry for a financing lease is gross investment in lease receivable. This entry consists of two components: minimum lease payments and residual value. Residual value represents the lessor's estimate of the "salvage" value of the leased equipment at the end of the lease term.
* With respect to a financing lease:
(I) the following items are financial assets.
(a) minimum lease payments, and
(b) the residual value, or any portion thereof, guaranteed at lease inception.
(ii) the following item is not a financial asset and is subject to FAS 13, as amended, rather than FAS 140:
(a) the residual value, or any portion thereof, not guaranteed at lease inception.
See FAS 140 (paragraph 89).
B. FAS 140 Conditions for Transfer
A transfer of all or part of a financial asset will be accounted for as a sale, rather than a financing, and the financial asset derecognized from the transferor's balance sheet, if the following requirements are met:
* the transferor surrenders control over the transferred assets; and
* the transferor receives cash or other consideration other than notes, bonds, certificates, stock, or other beneficial interests in exchange for the transferred assets, but only to the extent of such consideration.
To establish the surrender of control, there must be evidence that the transferred assets have been legally isolated from the transferor-put beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. The evidence normally takes the form of a "true sale" opinion provided by counsel to the transferor, to the effect that the transferred assets would not be deemed to be property of the bankruptcy estate of the transferor or a consolidated affiliate of the transferor (other than a special purpose bankruptcy-remote entity or "SPE") if the transferor or such consolidated affiliate became a debtor in a bankruptcy proceeding.
NOTE: Rating agencies and investors often require a "true sale" opinion for another purpose. To provide a rating on the securities that is better than the general credit rating of the transferor (and thus to allow the transferor to obtain a more favorable interest rate or yield than would otherwise be the case), the rating agencies and securityholders want reasonable assurance that the transferred assets are not likely to be tied up in a bankruptcy of the transferor. If there is sufficient liquidity in the transaction to permit payment of the securities during a delay (while the securityholders or their representative establish their right to foreclose), rating agencies and others are sometimes willing to accept a security interest opinion in lieu of a "true sale" opinion.
C. Significant Advantage to FAS 140 Treatment: Ability to Use QSPE
Perhaps the most significant benefit to categorization as a financing lease is the fact that FAS 140 permits the establishment of a "safe-harbor" entity, into which financing leases and other financial assets can be transferred, that:
* does not require outside equity; and
* cannot and will not be consolidated with the transferor or its affiliates.
D. Limitations on QSPEs
The "safe-harbor" entity, known as a "Qualified Special Purpose Entity" or QSPE, must meet requirements that effectively result in its serving merely as a "holding cell" for the financed assets and not as an actively operated company that would create creditor confusion as to its role. FAS 140 requires that a QSPE:
* hold only financial assets (with an exception for nonfinancial assets held temporarily in connection with collection efforts);
* function on "autopilot" and be totally controlled by its operative documents; and
* serve mainly as a conduit for payment.
In addition, the QSPE will be a QSPE only if and for so long as there is some outside participation in the financing as follows:
* at least 10% of the fair value of its debt or equity must be held by outside parties (i.e. other than by the transferor, the transferor's affiliates or agents); and
* the transferor, its affiliates and agents must not be able to dissolve the QSPE unilaterally.
Finally, there must be disclosure in the transferor's financial statements regarding cashflows between the QSPE (or any other SPE) and the transferor.
E. Sample FAS-140 Based Structures for Off-Balance Sheet Transfers of Financing Lease Payments and Residuals
Depending on the circumstances, structures involving one or two SPEs may be used if the residual values have been guaranteed at lease inception. If the residual values have not been guaranteed at lease inception, two SPEs will generally be required. Lessors may also use a sale/ leaseback structure (described later under "Getting an Operating Lease Off" the Balance Sheet") if there are unguaranteed residuals; however, this is usually a more costly alternative. Exhibit 3 illustrates a one-SPE structure. Exhibit 4 illustrates two variants on a two-SPE structure.
2. Scenario 1: Residuals Guaranteed at Lease Inception
If all of the residual value component has been guaranteed at lease inception, both components of gross investment in lease receivables (minimum lease payments and guaranteed residuals) are financial assets. As a result, (a) off-balance sheet transfers of both components are governed by FAS 140, and (b) QSPEs may hold both components. The same would hold true if there is no residual value component. Exhibit 5 describes some things to review in connection with obtaining a residual value insurance policy.
Exhibit 5 A FEW THINGS TO WATCH FOR IN A RESIDUAL VALUE INSURANCE POLICY Must be in Place at Lease Inception. Operating leases that are already in place cannot be converted to financing leases at a later point in time. Residual values of financing leases cannot be converted to financial assets at a later point in time. Cost/Benefit Determination. Depending on the type of equipment and the sponsor's record in connection with remarketing or otherwise disposing of the equipment at lease termination, residual value insurance can be quite expensive. You may want to consider insuring only a portion of the residual value. A larger "deductible" will result in a lower premium. A large deductible can also result in a smaller portion of the residual value being included in a securitization that utilizes FAS 140 or a QSPE-only the guaranteed portion of the residual constitutes a financial asset. Finally, if you are trying to convert an operating lease into a financing lease, you need to ensure that the deductible is not so large as to reduce the total minimum payments below the 90% test requirements. Effect on True Sale Analysis. Insurers offer a number of methods for reducing the cost of a residual value insurance policy. For example, some insurers charge one annual premium up front, but then require payment of a "contingent premium" by a credit-worthy entity (often the sponsor) at the time of a claim if the policy is actually drawn upon. Other policies may require establishment of a reserve fund up front and payment of a "supplemental premium" at year end, depending on overall policy usage, or impose other risk-reduction/up front payment reduction methods that may under some circumstances be deemed to represent recourse to the sponsor. Provisions of this kind may interfere with counsel's ability to provide the true sale opinion necessary in connection with FAS 140 or rating agency requirements.
a. One-Step Structure
The sponsor transfers the lease assets, including leases and residual interests, to a QSPE in exchange for reasonable consideration. The QSPE will issue notes to investors for cash and pledge the lease assets (along with any residual value guarantees) to the indenture trustee as security for the notes. To obtain the desired rating on various classes of notes, there may need to be excess value in the trust estate securing such notes. Such excess value could take the form of cash held in a reserve fund or overcollateralization above that required for a fair market value transfer of the lease receivables. Consequently, the amount of cash received from investors may not equal the cash paid to the sponsor. For a true sale to occur (allowing the receivables to be taken off of the sponsor's balance sheet), the sponsor must be paid the "reasonable equivalent value" of the entire pool of receivables transferred. To cover any shortfall in "reasonable equivalent value", the sponsor is generally deemed to have made a capital contribution to the QSPE of the shortfall (either in cash, or by directly contributing the amount of excess lease receivables required to provide the additional credit support over the cash proceeds paid to the sponsor).
NOTE: The "reasonable equivalent value" owed to the sponsor will almost always be less than the discounted present face amount of the leases because any fair market value purchaser would require some overcollateralization protection based on historic losses. The capital contribution to provide any additional credit support for the trust estate will consist of cash or leases in addition to the amount of overcollateralization reflected in the "reasonable equivalent value."
b. Limitation on One-Step Structure
If the sponsor wants to retain a subordinated interest in the lease receivables (rather than simply making a capital contribution of any required credit support), a two-step, rather than a one-step, structure may be required. Otherwise, if the subordinated interest is not sufficiently likely to be paid (based on historical losses or other factors), a court could find that the QSPE did not pay fair market value for the lease receivables, and the true sale (and off-balance sheet treatment) could be defeated. (1)
c. Two-Step Structure
Set forth below is a sample two step structure in which SPE 1 (which is consolidated with the sponsor), retains a subordinated interest in the lease receivables (through the QSPE's issuance of a subordinated note or certificate, or agreement to pay a deferred purchase price).
Step 1: The sponsor transfers the lease assets to SPE 1 (which will generally be a wholly owned subsidiary that is not a QSPE and is consolidated with the transferor) for reasonable consideration (generally consisting of cash and equity in SPE 1) in a true sale.
Step 2: SPE 1 transfers the gross investment in lease receivables to a QSPE in exchange for (a) cash received from senior noteholders and (b) subordinated notes. The QSPE will not be consolidated with the transferor.
3. Scenario 2: Residuals Not Guaranteed at Lease Inception
Any portion of the residual value not guaranteed at lease inception is not a financial asset and FAS 13, as amended, rather than FAS 140, governs its transfer. The unguaranteed residual value component will remain on the transferor's balance sheet. The transferor may obtain off-balance sheet treatment for the financial asset components (i.e. the minimum lease payments and any guaranteed portion of the residual) by engaging in a two step process similar to that described above. (2) The difference will be that while the sponsor will transfer all of the lease assets (including the leases and its residual interest in the equipment) to SPE 1 in the true sale, pursuant to FAS 140, SPE 1 can transfer to the QSPE only the financial assets and not the unguaranteed residuals.
NOTE: The full residual interest in the equipment needs to be transferred to SPE 1, even though some or all of it may not be guaranteed, because if this were not done, the transferor might be able to nullify the leases if the transferor were placed in bankruptcy, since the leases would relate to assets in which the transferor continued to maintain an interest.
F. Retention of Tax Ownership/Depreciation Benefits
Accounting treatment of a lease and its transfer is a separate issue from tax treatment (although it may be one of many factors considered).
2. Importance of Lease Type
You need to determine whether, for tax purposes, the leases are (a) true leases, in which case the lessor recovers its tax basis via depreciation deductions, or (b) leases evidencing a financing or sale, in which case the lessee depreciates the equipment cost and the lessor's tax basis is in the receivables. These tests are not dependent on how the leases are treated for accounting purposes. To distinguish between a true lease and a financing or sale lease, one must review a variety of factors, including:
* the form of the documentation,
* which party, the lessor or the lessee, has retained the risks and rewards of ownership, and
* whether or not the transaction has other attributes of a financing versus a rental of property.
An agreement between the lessor and lessee as to who will claim the depreciation benefits may be used to reduce tax risks where the classification is unclear. So long as only one of the two parties is claiming tax ownership (and thus the depreciation benefits), the IRS may not be concerned under a particular set of circumstances. Thus, a document in the form of a lease that meets the 90% test as a financing lease for accounting purposes might, under some circumstances, be classified as a true lease (rather than a financing lease) for tax purposes, particularly if the lease provides for the lessor to retain tax ownership.
3. Treatment of Depreciation on Transfer
a. True Leases
Debt for tax treatment is likely to be a significant goal in the case of transfers of true leases. The reason for this is that if the lease is a true lease, the lessor's tax basis, and recovery via depreciation benefits, resides and moves with the tax owner of the equipment, and the income resides with the tax owner of the receivable. Any transaction that separates this ownership could accelerate taxable income for the lessor (into the year of the receivables sale), while tax basis recovery via depreciation deductions would continue over time.
b. Financing Leases
Sale for tax treatment is not a significant concern in the case of transfers of financing leases. The reason for this is that if the lease is a financing lease, both the income and the tax basis reside with the tax owner of the receivable.
III. GETTING AN OPERATING LEASE OFF THE BALANCE SHEET--CONCEPTS AND STRUCTURES
A. FAS 140 Does Not Apply to Transfers of Minimum Lease Payments Under Operating Leases
The balance sheet of the lessor under an operating lease includes the equipment, and a receivable for rent when such rent becomes due. The equipment clearly is not a financial asset and its transfer is not governed by FAS 140. The right to receive the minimum lease payments under the operating lease is an "unrecognized financial asset" (the receivable only appears on the balance sheet as it accrues) and is therefor also not a financial asset. (3)
B. Sale-Leaseback Structure Desirable For Transfer of End-User Operating Leases to Allow FAS 13 Off-Balance Sheet Transfer While Allowing Transferor to Retain Depreciation Benefits
Most operating leases for accounting purposes will be true leases for tax purposes. The equipment subject to a true lease is a depreciable asset for tax purposes. The transferor who desires to obtain off-balance sheet treatment for such equipment for accounting purposes generally wants to be able to keep the equipment (or as much of the value of the equipment as possible) on its books for tax purposes so that it can continue to obtain depreciation benefits from the equipment as an offset to income. A mismatch between the ownership test for accounting purposes and the ownership test for tax purposes occurs when a sale/leaseback structure, rather than a direct transfer, is used. If the documentation is carefully crafted, this mismatch may, under appropriate circumstances, be used to accomplish the desired debt for tax/sale for accounting structure.
C. FAS 13 Test for Transfers of Property Subject to an End-User Operating Lease by Means of a Sale and Leaseback
A sale and leaseback of personal property subject to an end-user operating lease will be governed by the rules for a sale-leaseback transaction, rather than the rules for direct transfers of property subject to an end-user operating lease. (4) The transferor, who is the seller/lessee in the sale-leaseback, will account for the leaseback as an operating lease (meaning that the equipment will be transferred to the books of the buyer/lessor) if the leaseback meets the criteria for an operating lease (i.e. it does not satisfy one of the four alternative tests for a financing lease described on Exhibit 1), even if the seller/lessee retains substantial risks of ownership. See EITF Issue No. 93-8, coupled with FAS 28 (which supercedes paragraphs 32 and 33 of FAS 13).
2. Test for Tax Ownership
For the seller/lessee to retain tax, as opposed to accounting, ownership, the sale/leaseback must more nearly resemble a financing than a sale. Some of the factors that would tend to indicate a financing include the following:
a) the seller/lessee retains the risks and rewards of ownership;
b) the buyer/lessor has recourse against the seller/ lessee for payment of the leaseback payments;
c) the seller/lessee has pledged excess collateral to support its obligation to make the leaseback payments (i.e. the overcollateralization exceeds expected losses);
d) the sale/leaseback is in the form of a financing rather than a sale (e.g., the sale document could be denoted a "financing lease");
e) there is a matching of payments (the leaseback payments are structured to track payments to noteholders or other investors); and
f) it is not reasonable to expect that the buyer/lessor will retain the property at the end of the leaseback.
D. Establishing an "Orphan SPE" to Hold Equipment Subject to End User Operating Leases
As previously mentioned, the entity on whose books the relevant lease assets (in the case of end user operating leases, the equipment subject to the end-user operating leases and any current receivables related thereto) will appear must be an entity that will not be consolidated with the sponsor. Because these assets are not "financial assets", that entity cannot be a QSPE. Industry practitioners currently rely on guidance from the AICPA, FASB, and the SEC to determine whether an entity that is not a QSPE must be consolidated with its "sponsor". (5) If such an SPE will not be consolidated, we refer to it as an "Orphan SPE".
1. Existing Guidance
Based on existing guidance, some basic pre-requisites to Orphan SPE status are as follows (6):
* one or more independent third parties must own the majority of the equity of the Orphan SPE, and such equity must be designated as equity rather than debt (e.g., certificates and not notes);
* such third parties must have made a "substantive capital investment" in the Orphan SPE (a minimum of 3%, but the required amount will be higher depending on a variety of facts such as the risks involved in the Orphan SPE's activities);
* the third parties must have substantive risks and rewards of ownership of the Orphan SPE's assets (including residuals);
* so long as the third parties have made the required substantive capital investment, the parent and its affiliates can own equity of the same class that shares such risks and rewards (the interests of the sponsor and its affiliates would not count toward the 3% or higher required amount);
* the substantive capital investment must be totally funded and "at risk" for the entire time the SPE is to be an "Orphan SPE"--the investors must be exposed to loss to be at risk until such time as the Orphan SPE is no longer required to be an orphan; how, ever the investment of the third party investors can be depleted due to the investors being in a first loss position (7); and
* the third party investors must "control" the Orphan SPE (i.e., there must be some activities requiting decision-making authority, and the third party investors must have the ultimate say (e.g., majority vote of equity class)).
This can be expensive. The equity can be preferred-type stock; however, ,any guaranteed returns will be applied to reduce "at risk equity".
2. Proposed Guidance
FASB is working on an interpretation of" Accounting Research Bulletin No. 51 and FASB Statement No. 94 (described supra n5) that would make it more difficult to qualify as an Orphan SPE. Based on FASB's current draft of the interpretation, (8) some basic pre-requisites to Orphan SPE status will be as follows:
* one or more independent third parties must maintain a substantive equity investment (the "Third Party Investment") in the Orphan SPE which must represent an equity interest in legal form or an equivalent form for a noncorporate entity (e.g., certificates and not notes);
* the Third Party Investment must be sufficient to provide the Orphan SPE with the ability to fund or finance its operations without assistance from or reliance on the sponsor at all times over the life of the Orphan SPE, and there is a presumption that the necessary amount will at least equal 10% of the Orphan SPE's total debt and equity, and may need to be higher, depending on a variety of facts, such as the risks involved in the Orphan SPE's activities;
* the Third Party Investment must have substantive exposure to risk of variable returns that are characteristic of equity ownership and must represent the residual equity interest;
* the Third Party Investment must be subordinate to all debt and preferred equity interests and be at risk for the first dollar of loss (and not share this risk with others, through a swap, the sponsor's ownership of equity that shares a proportional amount of the first dollars of loss, or otherwise);
* the Third Party Investment must remain adequate to fund or finance the SPE's activities during the entire life of the Orphan SPE-if there are losses or other changes in circumstances, the amount of Third Party Investment needs to be evaluated again; and
* the third parties must have the ability to make decisions about and manage the Orphan SPE's activities to the extent those decisions have not been predetermined for the SPE, and the ability to make such decisions may not have been transferred to the sponsor or others pursuant to a contract unless the independent third parties have the ability to terminate that contract at will.
Given the increased minimum required third party equity investment, the interpretation, if adopted in its current form, will substantially increase the cost of implementing and maintaining off-balance sheet securitizations of operating leases. Pre-effective date "Orphan SPEs" that do not comply with the new rules will be required to be brought into compliance during a transition period or will be consolidated with their sponsors for periods that follow the transition period. More detailed information regarding the proposed interpretation appears on Exhibit 6.
Exhibit 6 PROPOSED INTERPRETATION REGARDING CONSOLIDATION OF SPEs THAT ARE NOT QSPEs In response to concerns regarding Enron's off-balance sheet treatment of its alleged "Orphan SPE" investment partnerships, Congress and others have strongly urged the Financial Accounting Standards Board ("FASB") to adopt on a rapid basis clear guidelines providing for more conservative treatment of off-balance sheet transactions involving Orphan SPEs. (1) FASB has responded by preparing Transactions Involving Special-Purpose Entities: An Interpretation of Accounting Research Bulletin No. 51 and FASB Statement No. 94, which would provide consolidation guidelines for SPEs that are not QSPEs or certain types of employee benefit trusts. An SPE covered by the interpretation as currently proposed could achieve Orphan SPE status (meaning that it would not be consolidated by the entity desiring to achieve off-balance sheet treatment, referred to here as the "sponsor") if any one of the following three conditions is met: * There is no primary beneficiary; or * The primary beneficiary is an entity other than the "sponsor"; or * The SPE has sufficient independent economic substance that it can fund or finance its operation without assistance from or reliance on the primary beneficiary. Primary Beneficiary In plain English, the "primary beneficiary" of an SPE is the one entity, if any, that holds the interest in the SPE most likely to experience the principal economic benefits or risk of loss based on the reasonably contemplated results of the SPE's activities. Under the proposed interpretation, an SPE will have a "primary beneficiary" if two conditions are met: * The SPE has variable interests; and * One entity holds a "significant amount" of the variable interests and that amount is "significantly more" than the variable interests held by any other individual entities that hold variable interests. In such event, the primary beneficiary would be the one entity described in the second bullet point. If the variable interests are dispersed such that either no one entity holds a "significant amount", or no one entity holds "significantly more" than the others, then there will be no primary beneficiary. FASB has not defined "significant". It has stated that the objective in identifying the primary beneficiary is "to identify the entity that is economically compelled to control the activities of the SPE because of the entity's holdings of variable interests." Variable Interest A "variable interest" is a financial interest in the SPE that has the potential for significant variability in returns (and not merely by virtue of a variable interest rate or the potential for a ratings downgrade). Such interests can be ownership interests or contractual rights to all or a portion of an entity's results of operations. Examples include equity, subordinated debt, residual value guarantees, fixed-price purchase options, the risk of nonpayment of a nonrecourse loan, the risk of loss from application of a reserve fund, letter of credit, or other credit enhancement, and incentive fees based on "net income" (as opposed to market-based fees). Schedule for Adoption In its February 27, 2002 meeting, FASB contemplated issuing a final interpretation by July 31, 2002. It is unclear whether FASB will meet this goal. FASB will soon circulate an internal "pre-ballot" draft of the interpretation to its Emerging Issues Task Force for "fatal flaw" review. Depending on the amount and types of comments to be addressed, an Exposure Draft may be available for public comment as early as May of 2002. The comment period will likely be at least 30 days, after which comments would be addressed prior to issuance of the final interpretation. New SPEs Must Comply on Issuance of Interpretation, and Existing Transactions That Do Not Comply With the Interpretation Will Have to Appear on Balance Sheets for Fiscal Years Ending After December 15, 2002 The current draft provides that the interpretation will be effective: * With respect to new SPEs, immediately upon issuance of the interpretation for all SPEs created after the interpretation's issuance date; and * With respect to existing SPEs, beginning with financial statements for the first fiscal year ending after December 15, 2002, for any SPEs existing on the date of the interpretation's issuance that still exist as of the date of such financial statements. NOTE: Reporting companies may be required to disclose the future effect of adopting the new standards in publicly flied reports prior to the transition deadline. How Non-Conforming Transactions Would Appear on the Balance Sheet Newly consolidated assets will likely be recorded at historical cost as of the date of the underlying transaction, as adjusted for depreciation and other factors through the date of the financial statement. A corresponding entry for "Cumulative Effect of Change in Accounting Principles" will be made, as necessary. Sufficient Independent Economic Substance The primary requirements for an SPE's having "sufficient independent economic substance" to avoid consolidation with its sponsor are the prerequisites to Orphan SPE status set forth in the body of this article under "Getting an Operating Lease Off the Balance Sheet-Concepts and Structures-Establishing an 'Orphan SPE' to Hold Equipment Subject to End User Operating Leases-Proposed Guidance." (1) FASB has been working on a proposed statement of accounting standards for consolidated financial statements for more than ten years. Before the adoption of FAS 140, FASB circulated a February 23, 1999 Exposure Draft of a proposed statement of accounting standards for consolidated financial statements which revised an Exposure Draft that had been issued October 16, 1995. In January 2001, FASB determined that there was not sufficient support to proceed to a final statement, although it continued to work on the project. FASB then circulated a working draft dated September 27, 2000 of a modified approach that recognized that FAS 140, rather than the provisions of the Exposure Draft, would govern QSPEs, and provided a special standard for limited purpose entities that are not QSPEs. FASB determined that there was not sufficient support to proceed to an Exposure Draft with respect to the modified approach.
E. Some Commonly Employed Lease Provisions to Attempt to Establish Debt for Tax/ Sale for Accounting Attributes of the Sale/Leaseback Structure
Your accountants and tax lawyers will need to review carefully the provisions of the sale/leaseback documentation in attempting to achieve the desired accounting and tax treatment. Some provisions that involve business decisions will end up being non-negotiable. Provisions involving disposition of the equipment at the termination date for the leaseback (at least with respect to each group of equipment) will be critical. Exhibit 7 provides some examples.
Exhibit 7 COMMONLY EMPLOYED LEASE PROVISIONS TO ATTEMPT TO ESTABLISH DEBT FOR TAX/SALE FOR ACCOUNTING ATTRIBUTES OF A SALE/LEASEBACK STRUCTURE Residual Value Guaranty Provisions. To allow the seller/lessee to retain substantial risks of ownership, the seller/lessee will usually guarantee that upon a sale of the equipment at the end of the lease term, the value of the property will equal a specified minimum amount. However, the seller/lessee's maximum deficiency must be limited so that the leaseback can continue to qualify as an operating lease under FAS 13, as amended (i.e., the present value of the minimum lease payments, including the maximum deficiency under a residual value guaranty, must be less than 90 percent of the fair value of the property subject to the leaseback). NOTE: The existence of the seller/lessee's guarantee is a negative fact for purposes of delivering a true sale opinion on the transfer from the seller/lessee to the buyer/lessor. As previously discussed, a true sale opinion is not a requirement for off-balance sheet treatment of nonfinancial assets such as operating leases. However, to the extent that a rating agency or another party requires a true sale opinion for other purposes, the sponsor may need to effectuate a true sale of the equipment and other lease assets to a special purpose entity that will be consolidated with the transferor prior to the sale/leaseback stage of the transaction and require that guarantees and other remarketing arrangements originate with the first transferee rather than the sponsor. Certain fair market value remarketing arrangements with the sponsor may serve as an acceptable substitute under some circumstances. Return of Equipment Provisions. For tax purposes, there may be no reasonable expectation that the buyer/lessor will obtain the equipment at the end of the leaseback. However, for accounting purposes, the leaseback must not contain a bargain purchase option or otherwise undermine classification of the leaseback as an operating lease. The equity investors in the buyer/lessor also want to minimize the risk that they will incur any loss on the ultimate sale or return of the equipment. To attempt to balance the various interests, the leaseback agreement may provide the lessee with the option at termination of the leaseback with respect to a group of end-user leases, either (a) to purchase the equipment for an amount that does not guarantee exercise of such option or (b) to sell the equipment on the lessor's behalf (or if the lessor is not satisfied with the sale, to return the equipment to the lessor for sale). To limit exposure on such a sale, and to reduce the likelihood that the lessor would obtain the equipment at the end of the leaseback, the documentation usually requires that to return or sell the equipment, the lessee must return the equipment in pristine condition. However, this liability must be capped, since it is in the nature of a residual value guaranty as described above.
F. Sample Structures for Off-Balance Sheet Transfers of End User Operating Leases
1. Scenario 1: Use Residual Value Insurance (or Post-Term Rental Payment Guaranty) to Convert to Direct Financing Lease at Lease Inception
If the present value at the beginning of the lease term of the minimum lease payments (with certain exclusions), equals or exceeds 90% of the excess of the fair value of the leased property to the lessor at the inception of the lease over any related investment tax credit retained by the lessor and expected to be realized by the lessor, the lease will be deemed a financing lease rather than an operating lease for accounting purposes. Minimum lease payments include, among other things:
* residual value guarantees by the lessee, a party related to the lessee, or a financially capable third party unrelated to the lessee or the lessor, and
* guarantees of rental payments beyond the lease term by financially capable parties unrelated to the lessee or the lessor.
Thus, a sponsor can, as it enters into future operating leases, use insurance to convert such leases to financial assets that may be securitized using the structures described above for financing leases. As previously mentioned, Exhibit 5 describes some areas to review in connection with obtaining residual value insurance.
2. Scenario 2: Sale-Leaseback Structure Using Orphan SPE
A multiple step sale-lease-back structure for use in operating lease securitizations is illustrated on Exhibit 8. The procedure is as follows:
Step 1. The sponsor transfers (1) the equipment subject to the operating leases, and (2) the operating leases themselves, to SPE 1 (which will generally be a wholly-owned subsidiary of the sponsor) for fair market value (generally consisting of cash and equity in SPE 1) in a true sale for bankruptcy purposes. NOTE: This first step is not an accounting requirement for off-balance sheet treatment of a nonfinancial asset, but it may be a rating agency or investor requirement.
Step 2. SPE 1 transfers the equipment subject to the operating leases to Orphan SPE in exchange for cash, subordinated notes, and sometimes a small equity interest (which may not be subordinate to or defeat the minimum third-party equity interest) in Orphan SPE.
Step 3. Orphan SPE issues senior notes to investors and subordinated notes to SPE 1, secured by, among other things, a pledge to the indenture trustee of the equipment, the leaseback payments, and the Orphan SPE's security interest in the leases obtained trader Step 4.
Step 4. Orphan SPE leases the equipment (subject to the lien of the indenture) back to SPE 1 pursuant to a leaseback agreement which is an operating lease. SPE 1 grants to Orphan SPE a security interest in the leases to secure SPE 1's obligation to make lease payments under the operating leases.
G. Some Thoughts for the Future-Consider Allowing QSPE-Type Entities to Hold Some Operating Lease Assets
FASB's rationale for applying a different approach to transfers of nonfinancial assets (FAS 13, as amended, and related guidance) from that applied to financial assets (FAS 140) includes FASB's belief that management skill plays a more considerable role in obtaining the greatest value from nonfinancial assets, which are generally operational assets. (9) Accountants and industry participants should consider whether the significant difference in cost and ease of securitization of financing leases (via QSPEs) versus operating leases (via Orphan SPEs) is justified in all cases. For example, a captive equipment or vehicle leasing company may provide financing to its customers primarily by means of financing leases, but, depending on customer preference, interest rates, and economic factors, may provide operating leases to some customers as well. Service options offered to operating lease customers and financing lease customers may be substantially the same, and disposition of leased assets at lease termination may also be by means of similar procedures. In this situation, it might be reasonable to allow a QSPE or similar type of entity to hold some operating lease assets in addition to financial assets.
There are, of course, other ramifications to consider. For example, if FAS 140 were changed to allow a QSPE to hold a limited number of operating lease assets, companies could no longer use deposit of such nonfinancial assets into a QSPE as a method for "breaking" FAS 140 and converting what would otherwise be an off balance sheet financing into an on-balance sheet financing.
The bottom line is that, in conjunction with adopting revised guidelines to address perceived abuses, FASB should be encouraged: (i) to clarify and improve its guidance for transactions within their scope that are not perceived as abusive, and (ii) to provide exceptions where appropriate, especially to the extent that the new rules may unduly restrict transactions that were not the source of the problems giving rise to their adoption.
Ruth A. Strauss wrote this article, with assistance from Melanie Gnazzo. We would like to thank our unnamed friends in the accounting profession for their valuable input in enhancing our understanding of some of these issues. For updates concerning the status of this evolving area of law, please feel time to contact either of us via e-mail to firstname.lastname@example.org or email@example.com, as applicable.
(1) For an excellent discussion of" ratings and true sale considerations relevant to one-tier and two-tier transactions, see Standard & Poor's, STRUCTURED FINANCE LEGAL CRITERIA, 11-22 (Securitizations by Code Transferors) & 56-58 (Retention of Subordinated Interests by Transferor in a True Sale) (April 2000). FASB discusses accounting considerations related to one-step versus two-step securitizations in paragraphs 80-84 (Isolation of Transferred Assets in Securitizations) of Appendix A to FAS 140 and paragraphs 152-156 (Isolation beyond the Reach of the Transferor, Even in Bankruptcy or Other Receivership) of Appendix B to FAS 140.
(2) Some accounting firms may require evidence of a true sale to the QSPE in a two-step structure if SPE 1 holds any nonfinancial assets.
(3) See Financial Accounting Standards Board, Special Report: A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (2001) (Response to Question 1).
(4) Under FAS 13, as amended, a direct transfer of property subject to an end-user operating lease will not be treated as a sale (and therefore will not qualify for off-balance sheet treatment) if the seller or any party related to the seller retains substantial risks of ownership in the leased property.
(5) See EITF Topic No. D-14: Transactions Involving Special Purpose Entities; AICPA Accounting Research Bulletin No. 51: Consolidated Financial Statements; FASB Statement No. 94: Consolidation of All Majority-Owned Subsidiaries; EITF Issue 90-15: Impact of Non-Substantive Lessors, Residual Value Guarantees and Other Provisions in Leasing Transactions (nominally applying only to real estate transactions); and EITF Issue 96-21: Implementation Issues in Accounting for Leasing Transactions Involving Special Purpose Entities. An excellent discussion regarding this guidance appears in James Johnson, Accounting Issues, in 2 SECURITIZATION OF FINANCIAL ASSETS 19-1, 19-59 through 19-71 (Jason H.P. Kravitt ed., 2001).
(6) See generally James Johnson, supra n. 5.
(7) Neither the initial investment nor the return thereon may be guaranteed or secured by a letter of credit, and the minimum required investment of the third-party investors cannot be reduced through prepayments or other cash flows representing a partial return of their investment. The equity would not be at risk if the source of funds to make the equity investment is financed with nonrecourse debt collateralized by a pledge of the investment.
(8) As discussed at FASB's meetings through April 3, 2002 regarding the draft interpretation, which are open to the public through personal attendance or prepaid dial-in to a number made available to the public prior to the meeting through FASB's website (www.fasb.org). As of May 1, 2002, FASB has not circulated a draft of the interpretation to the general public.
(9) FASB indicated that it did not extend FAS 140 and its financial components approach to transfers of nonfinancial assets because FASB believed that "nonfinancial assets have significantly different characteristics" from financial assets. FASB stated that nonfinancial assets have "a variety of operational uses, and management skill plays a considerable role in obtaining the greatest value from those assets," whereas: "financial assets have no operational use. They may facilitate operations, and financial assets may be the principal 'product' offered by some entities. However, the promise embodied in a financial asset is governed by contract. Once the contract is established, management skill plays a limited role in the entity's ability to realize the value of the instrument."
See FAS 140 (Appendix B, paragraph 148).
RUTH A. STRAUSS is a shareholder at Gnazzo Thill, A Professional Corporation, a San Francisco law firm specializing in structured finance and other aspects of finance law. A graduate of Rice University and the Duke University School of Law, Ms. Strauss has over 13 years of experience in complex financial transactions, including seven years with a New York-based law firm. Her structured finance experience includes serving as (1) underwriter's counsel in public offerings of automobile receivables-backed certificates and shelf take-downs of mortgage-backed securities, (2) issuer's and placement agent's counsel in Rule 144A, Regulation S, and Regulation D offerings of equipment lease and auto-loan backed securities, and (3) special California counsel to a nationally recognized rating agency in the securitization of tobacco settlement revenues. Ms. Strauss has developed plain English offering documents for issuers of a variety of asset-backed securities and was instrumental in the development of warehouse loan and other documentation for use with vehicle titling trusts. Ms. Strauss's commercial law experience includes the representation of financial institutions in secured lending, letter of credit, liquidity, and commercial paper conduit transactions, and the representation of corporate clients in negotiating credit agreements, receivables transfer agreements, commercial paper facilities, and other lending arrangements with their bank and conduit lenders. In the area of public finance, Ms. Strauss has served as letter of credit bank's, underwriter's, and issuer's counsel in bond transactions, including underwriter's counsel in the securitization of approximately $1.5 billion in toll road revenues, one of the largest U.S. public finance transactions in 1995. Ms. Strauss is a frequent speaker at conferences on topics related to structured finance and Revised Article 9 of the Uniform Commercial Code.
MELANIE GNAZZO is a shareholder in the San Francisco based law firm GnazzoThill, A Professional Corporation. She has over seventeen years of experience in providing tax and corporate advice for clients engaged in a wide variety of financial transactions. Ms. Gnazzo represents banks, leasing and finance companies and other participants in mortgage and asset securitizations, loan and leasing transactions, REIT offerings, and other transactions involving financial asset portfolios. She has served oil the Executive Committee of the Tax Section of the California Bar Association, as a Chair of the Corporate Tax Committee of that Section, and as a member of the ABA Tax Section Financial Transactions Committee. Prior to co-founding her firm in 1992, Ms. Gnazzo was associated with the law firm of Skadden, Arps, Slate, Meagher & Flora, LLP. She is admitted to practice in California and New York and has an LL.M. in taxation from New York University School of Law, and a J.D. and B.A. (Economics) from the University of Pittsburgh.
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|Publication:||The Securitization Conduit|
|Date:||Mar 22, 2001|
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