FEBRUARY 2008 Issue No. 74

Welcome to the February 2008 edition of
Business Leasing and Finance News

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FOUNDER'S NOTE
By David G. Mayer

As if the subprime mortgage crisis is not bad enough, 14 institutions received even worse news last month. The Federal Bureau of Investigation (FBI) has opened a criminal probe into a broad range of issues relating primarily to fraud in the entire process of originating and selling subprime mortgages. For example, the FBI has intends to ask where the loans were created, whether there was fraud in their creation and whether there was misrepresentation of their quality. We can watch for press releases from companies to find out who is or will be the targets of the FBI investigation. The FBI has been quoted as saying that it wants “a piece of the action.”

Perhaps, for those of you who have portfolios of leases and loans, you should keep a sharp eye on your own portfolios and what you or others in your organization may have represented as to their quality and the methods used in originating them. One of the messages of the FBI inquiry may extend far beyond the subprime mess. Simply put, no financial institution should overstate the quality of its financial assets. No financial institution should do business in any way that could remotely be construed as fraudulent by some governmental authority or internal monitors. No institution should be reckless in accepting poor credit risks only for the sake of building volume or increasing earnings. In short, extra caution may be in order, especially during this period of heightened scrutiny and fragile credit markets.

1. Five Ways Financiers Can Combat a Recession

Little doubt now exists that the U.S. is in the midst of a recession or soon will be. The 87-year old National Bureau of Economic Research (NBER), a non-profit group based in Cambridge, Massachusetts, comprised of 600 academic economists, determines when a recession exists. Its Business Cycle Dating Committee ultimately makes the formal declaration of a recession. As yet, it has not done so.

*Term to Know:A popular rule of thumb is that a recession exists after two consecutive quarters of a shrinking Gross Domestic Product (GDP). The NBER defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.”

Predicting a Recession

A chorus of voices indicate that the U.S. is near a recession, although there is not unanimity. Former Federal Reserve Chairman, Alan Greenspan, says that the U.S. is “marginally (headed) in (the) direction of a recession.” See Greenspan Sees U.S. as Likely in Recession, or Soon to Be, The Wall Street Journal, S.W. Ed., Page A:2, Col. 1 (Jan. 15, 2008). On January 7, 2008, Merrill Lynch declared that a recession is a “present day reality.” Goldman Sachs shook Wall Street by saying that the economy is falling into a recession. It projected that the GDP would shrink one percent on any annualized basis in the second and third quarter of 2008.

As an informal indicator of recession, The Economist counts the number of uses of the “R” word in stories published in The New York Times and the Washington Post. Although the number of stories falls short of those written before the 2001 recession, the stores do reliably foretell an impending economic turndown. See Warning Lights-Recession talk is rising, Economist.Com (Jan. 10, 2008). Many such stories have already been written.

Five indicators underpin the determination a recession. One current resource notes:

Of the five monthly economic indicators used to judge whether the U.S. economy has fallen into a recession, three are declining and one other is flattening out. Three of the five numbers peaked in September. Only one has grown with any vigor over the past few months, but it's starting to look weaker. See Odds are, U.S. is in a recession Commentary: Three of 5 indicators flashing warning signs for growth, MarketWatch(Jan. 18, 2008).

MarketWatch summarizes these five factors and their status generally as follows:

1. payrolls (now slowing after 52 months of growth);

2. real income growth excluding transfer payments (real incomes peaked in September and have risen at an annual rate of 0.1% over the three months ending in November);

3. output and sales indicate that manufacturing output, a cyclical indicator, may be falling;

4. sales have been rising but data is too old to be reliable; and

5. GDP growth is inconclusive as of January 18, 2008 (but the Bureau of Economic Analysis reported January 30, 2008 that advance estimates show that the GDP increased at an annual rate of 0.6 percent in the fourth quarter of 2007 – a very slow rate and down from 4.9 percent in the 3^rd quarter in 2007)

*Technical Point:For a more precise statement of the factors used by NBER to determine whether a recession exists, see The NBER’s Recession Dating Procedure, Business Cycle Dating Committee, National Bureau of Economic Research (Jan. 7, 2008).

Not every source pounds exactly the same drum. The Federal Reserve Bank of Atlanta publishes a “beige book” on the condition of the economy. In its January 16, 2008 issue, it reports that modest growth continues, though at a slower pace, in most of its twelve Federal Reserve Districts. The Congressional Budget Office (CBO) in testimony by its Director, Peter R. Orszag, stated: Although recent data suggests that the probability of a recession in 2008 has increased, CBO does not expect the slowdown in economic growth to be large enough to register as a recession.” See The Budget and Economic Outlook: Fiscal Years 2008-2018, CBO (Jan. 23, 2008). Joining the CBO, the International Monetary Fund said that the U.S. will avoid a recession but growth will slow to 1.5 percent in 2008. See IMF Predicts Slower U.S. Growth With Global Drag, The Wall Street Journal, Page A:2, Col. 3 (Jan. 30, 2008).

Bank of America surveys Chief Financial Officers each year to elicit their views on the economy and business conditions. The 600 CFOs polled for this year’s survey give a somewhat positive view of the economy. About 45 percent predict increased profit margins while 44 percent believe the economy will expand. They generally gave the economy somewhat positive readings by giving it a rating of “64” on a scale ranging from 0 (extremely weak) to 100 (extremely strong). See 2008 CFO Outlook: A Survey of What Manufacturing Chiefs Expect, CapitalEyes, Bank of America Business Capital (Jan. – Feb. 2008).

Although not a factor used by the NBER, a broad group of Americans has suffered a substantial loss of wealth due to falling housing prices and the stock market drop. A reduction in wealth, the mortgage-credit crisis, high energy prices and other negative economic factors may (and probably will) compound the recessionary pressure, reduce business activity and pose risks to performance by debtors and lessees of new and existing obligations. In summary, the economy is slowing but experts remained divided whether we have already entered into a recession or will even experience a recession

Stimulus Package and Rate Cuts to the Rescue

As an indication of the seriousness of these problems, the Bush Administration has developed an emergency stimulus plan, composed largely of one-time tax rebates and business tax incentives, to stem the tide of losses in the stock market, the decline in consumer and business confidence and the recessionary pressure on the economy.

On February 13th, President Bush signed the Economic Stimulus Act of 2008 (H.R. 5140).

 The package includes provisions that are important to lessors and lessees. The legislations provides enhanced expensing and depreciation provisions for businesses buying equipment and placing it into service this year.

Section 179 of the Code allows small business taxpayers may elect to expense (rather than depreciate) the cost of qualified property in the year when the assets are placed in service. Under present law, small business taxpayers may expense up to $128,000 with a phase-out threshold of $510,000. The legislation will increase the expensing limit to $250,000 and the phase-out to $800,000 for 2008.

The legislation would reinstate "bonus depreciation." This legislation will allow a trade or business to expense (deduct immediately) 50 percent of the cost of eligible property placed in service in 2008 and recover the remaining 50 percent of the cost in accordance with regular depreciation rules. The types of property eligible for bonus depreciation will be the same as those included in the previous depreciation packages: (1) tangible property that had a recovery period not exceeding 20 years; (2) purchased computer software; (3) water utility property; and (4) qualified leasehold improvement property. The bonus depreciation will be allowed under the alternative minimum tax (AMT).

Special rules, similar to those applicable to bonus depreciation provisions in place earlier in this decade, will extend the placed-in-service deadline for certain longer-lived property until the end of 2009 if the property is ordered or the construction of the property begins during 2008.

See Congress Votes for a Stimulus of $168 Billion, nytimes.com (Feb. 8, 2008).

The Federal Reserve Bank has taken an aggressive approach to a possible recession. It has, in a period of nine days in late January, reduced the rate at which banks borrow twice, first to 3.5 percent and then to 3 percent. See Fed Moves to Curb Risk of Recession, The Wall Street Journal, Page A:1, Col. 3 (Jan. 31, 2008).

Five Defensive Steps in Finance Transactions

The forces of the economy, the credit crunch and oil prices leave the finance world little choice but to reevaluate current and prospective business transactions and strategies.

*Tip:The time to reevaluate is now. Developing the right strategy can preserve the value of portfolios, minimize losses and establish appropriate standards for new transactions.

In this vein, lenders, lessors and other financiers should consider the following steps in 2008 business planning:

1. Reassess the strength of industries in which you typically have done business to determine the extent of risk you will continue to accept in light of recessionary and other economic pressures; then reduce exposure to weakening markets unless compelling or strategic reasons exist to complete a transaction in those markets;

2. Confirminternal ratings on customer performance at or before the first sign of any weakness on the part of a debtor or lessee in meeting its obligations (well before a default occurs, if possible);

3. Review closing documents to assure that all documents, such as financing statements and original leases, remain in good form and in the possession of the lender or lessor, as appropriate (and if documents are missing or incorrect, make the corrections promptly);

4. Tighten credit criteria for all transactions except the best credits to examine more closely the potential or likely impact of a downturn in the economy while concurrently enhancing covenants, representations and warranties that will trigger at earlier signs of a potentially distressed debtor; and

5. Increase risk adjusted margins in transactions to reflect the risk you take in a particular credit transaction (that is, do not let volume targets drive bad credit/deal decisions in a slow economy); however, given market pressures, at least focus on deals for which bonus depreciation or other tax deductions under the new economic stimulus package may become (or are) available and usable to enhance your yields.

No one wants to endure another recession, coupled with the continuing credit crisis and high oil prices. But recessionary pressures must be addressed affirmatively and quickly to make appropriate decisions about how to conduct business during 2008 and perhaps beyond. The days of easy credit in some business sectors have been disrupted as the markets adjust to the reality of slow or negative growth in the economy. For those who plan now, the pain of a recession may give way to net gains during the almost certain economic turndown in the U.S.

Thanks to George Schutzer of Patton Boggs LLP Tax and Business Departments for contributing to this article.

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2. Do Cushion Gas Leases Provide Tax Benefits to the Lessor?

Leasing cushion gas can make or break a natural gas storage financing. One element of these leases relates to potential tax benefits that a lessor may claim.

In the October 2006 edition of Business Leasing and Finance News, we described some of the benefits of structuring a lease of cushion gas utilized in natural gas storage facilities.

*Term to Know: Cushion gas (also called “pad gas” or “base gas”) is the volume of natural gas inside a storage facility required to maintain the minimum pressure for the seasonal injection and withdrawal of “working gas” in and out of the nation’s natural gas transmission and distribution infrastructure.

The Energy Information Administration estimates there are approximately 123 entities operating over 400 natural gas storage facilities in the lower-48 states. Total cushion gas volumes in the lower-48 states are estimated at 4.2 billion cubic feet. Cushion gas is a massive capital investment critical to the operation of the nation’s natural gas storage, transmission and distribution infrastructure.

The benefits of leasing cushion gas, which vary significantly depending on the structure of each transaction, include:

• operating lease characterization for financial reporting purposes;

• residual value upside of the cushion gas at the end of the lease term;

• reduced project finance lending amount based on lessors investment in cushion gas;

• predictability of gas values through hedging; and

• structured lease payments as compared to project financing due to longer lease terms.

In addition to accounting and financing advantages, there are also tax benefits to cushion gas leasing.

Standard of Recoverability

Most cushion gas should be recoverable by withdrawal from a storage project. Unrecoverable cushion gas becomes abandoned in place once all operating pressure inside the storage facility is reduced to zero. The tax treatment of cushion gas is premised upon this concept of how much cushion gas is truly recoverable.

Different rulings and court precedents defined concepts regarding the recoverability and valuation of cushion gas prior to 1997. In Revenue Ruling 97-54 the IRS ruled that cushion gas is properly characterized as a depreciable capital expenditure to the extent it is unrecoverable pursuant to a plan or requirement of law, or to the extent it is otherwise not economically feasible to recover the gas. In reality, substantial amounts of cushion gas are recoverable under the standard of economic feasibility. The IRS will apply the method that results in the greatest estimate of non-depreciable cushion gas. The cost of unrecoverable cushion gas is recovered over the life of the storage facility.

Lease Characterization

Structuring a lease transaction to achieve the desired characterization for accounting purposes has become a complex undertaking in recent years. Careful attention should also be given to proper tax structuring of a lease in order to achieve the desired results for lessor and lessee. The tax analysis of a lease is similar but not identical to a “true lease” analysis for purposes of commercial law. There is no bright-line test for lease characterization for tax purposes. However, large-ticket leveraged leases and other highly structured lease transactions can be characterized as leases for tax purposes if they fall within the safe harbors set forth in Revenue Procedure 2001-28. Generally, the following four criteria are indicative of a lease for tax purposes:

• The lessor must maintain a minimum unconditional investment of its own funds equal to at least twenty percent of the property’s cost, from inception through the end of the lease term;

• The leased property has a remaining economic useful life at the end of the lease equal to at least twenty percent of the property’s original useful life;

• Lessee renewal options are valued using fair value at the time of such renewal; and

• The lessee purchase option is set at a price equal to or greater than the fair market value at the time of the option exercise.

In addition to these indicative criteria, Revenue Procedure 2001-28 also focuses upon features commonly encountered in structured lease transactions that can adversely affect tax characterization of a lease, such as lessee credit support in the form of loans, financial and performance guarantees.

Classification of the leased property as “limited use” under Revenue Procedure 2001-28 can adversely affect tax characterization of a lease.

*Term to Know: A property is of limited use when there are no probable lessees or buyers other than the lessee and members of the lessee group at the end of the lease term.

The lessor’s unrecoverable cushion gas has considerable remaining useful life in the lessee’s storage facility after the lease term and may be characterized as limited use property that cannot be leased. Recoverable cushion gas would not be limited use property because the lessor could take possession of the recovered cushion gas after the lease term for use or resale to third parties. Lease structure and terms must carefully consider limited use issues in order to maximize value attributable to recoverable cushion gas.

*Warning: Due to the nature of the cushion gas asset, structuring of a cushion gas lease is highly sensitive to the relevant facts and economic substance of the initial structure and any terms that affect the post-lease term.

When structuring a “true lease”, the lessee and lessor should engage engineers and appraisers to provide written support for:

• estimates of fair market value (which is a complex issue based on the existence of hedging of the sale of natural gas);

• residual value (which is subject to change and affected by hedging the sale price of natural gas);

• remaining useful life expectancy (which should be unlimited for recoverable cushion gas that is used only as cushion gas);

• allocation of value to unrecoverable cushion gas for purposes of depreciation; and

• commercial feasibility of use of the cushion gas to avoid the characterization that it should be treated as limited use property.

Cushion gas leases remain a relatively new and viable part of the capital structure of financing natural gas facilities. The lessor and lessee can develop many different structures to accomplish their goals. U.S. tax law provides tax benefits to lease participants in the form of limited depreciation on unrecoverable cushion gas and lease treatment of recoverable cushion gas.

*Tip: This analysis is complex, fact-intensive and involves legal uncertainty. Retain knowledgeable tax and transaction counsel early in a pad gas structuring to capture any available tax benefits. Improved transaction economics can increase after-tax yields and provide a competitive advantage in project bids.

Thanks to Murph Shelby of Patton Boggs LLP Tax and Business Departments for contributing this article and to George Schutzer for editing the article.

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3. BLFN’s Case & Comment: A Debtor by Another Name - Peoples Bank v. Bryon Bros. Cattle Company

Under the current Uniform Commercial Code, courts have written many cases of misleading names used in financing statement and the need to use exact names of debtors. In Peoples Bank v. Bryan Brothers Cattle Company, 504 F.3d 549 (5^th Cir. 2007), the Court took a lineate view on when names used in financing statements become seriously misleading.

FACTS: Two banks sparred over the first priority lien in cattle. On October 5, 1999, the debtor, Mr. Dickerson, granted a security interest to Cornerstone Bank in exchange for a loan. Cornerstone perfected its lien by filing a financing statement with the Mississippi Secretary of State on October 14, 1999 under the debtor name “Louie Dickerson.” About three years later, Mr. Dickerson borrowed money from Peoples Bank, which filed financing statements against him in November 2002 and again in September 2003 under the name “Brooks L. Dickerson,” Mr. Dickerson’s legal name. Peoples argued that it has first priority over Cornerstone. (The case raised several issues about the formation of entities not pertinent to this discussion.)

ISSUES: Did Peoples have the first priority security interest?

OUTCOME/DECISION: No. The Court agreed with the lower court that Peoples did not have the first priority security interest because the name used by Cornerstone in its financing statement, “Louie Dickerson,” was not “seriously misleading.”

LAW OF THE CASE: The Court summarized the law in one paragraph essential as follows: Section 75-9-502(a)(1) of the Mississippi Uniform Commercial Code (UCC) states that a financing statement must “[p]rovide the name of the debtor.” If the debtor is an individual, the financing statement must contain the individual’s name pursuant to Section 75-9-503(a)(4). A financing statement substantially satisfying the [UCC] requirements is effective even if it contains minor errors or omissions Section 75-9-506(a). If the financing statement does not sufficiently name the debtor and makes the financing statement seriously misleading, the financing statement is ineffective. See Section 75-9-506(b).

The Court found that Peoples had been put on “inquiry notice” that a security interest in property of debtor’s legal name, “Brooks L. Dickerson,” could be “listed” in the name “Louie Dickerson.” As support for this position, the Court said that the debtor held himself out in the community as Louie Dickerson. In examining all the facts of this particular case, the Court found Peoples, who knew the debtor, was not seriously misled by the use of his everyday name.

*Comment: This case flies in the opposite direction of what we have come to expect. Most Courts have been very tough on the name requirements for financing statements. They have held to a standard of using the exact name unless the search logic enables a creditor to find the name. See Section 9-506(c). The Court did not discuss this concept and used the surprising rationale that Brooks L. Dickerson, alias Louie Dickerson, held himself under his common name. That may be a first for that stance under the UCC today and should probably the last time anyone relies on this case as good precedent.

Thanks to Bob Downey of Caterpillar Financial Services Corporation for spotting this case and raising some of the questions discussed above.

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4. BLFN’s Leasing 101: What Is an “Evergreen Renewal Clause” in a Lease?

Lessees often negotiate leases that allow an extension or renewal of the original term of the lease. Various types of renewal rights exist, such as a fair market renewal option. A fair market renewal option typically requires a determination of rent after the expiry of the original term of a lease (or a renewal term) by agreement of the parties. Failing agreement, the parties often can trigger an objective process such as an obtaining an appraisal that sets a rent at a rate established by market conditions based on the appraiser’s analysis.

One often used, and sometimes controversial, renewal provision has been referred to as an “evergreen renewal clause.” Many variations of this renewal right exist. For example, some renewals require lessees to give a 180 notice of its intent to renew. Some leases include a mandatory renewal or extension for a period of time such as 90-120 days. Finally, the controversy tends to arise most over leases that have an automatic renewal if the lessee fails to give notice to end the lease term. As a result, the lease term continues indefinitely, benefiting the lessor which continues to receive rent past the originally anticipated expiration date of the lease; and benefiting the lessee which has a right to use and possess the leased property for a longer period of time.

*Warning: Watch for states that will not enforce automatic leases renewals where a lessee fails to give notice to stop the lease term. This continuous renewal is viewed as an alleged “got-ya” in the eyes of some states because the unknowing lessee may not realize the renewal is occurring without any action on the lessee’s part. For example, New York will not enforce such arrangements unless the lessor gives its lessee at least 15 to 30 days notice of the automatic renewal clause. See Sec. 5-901 NY General Obligations. Also see a similar law in Illinois at 815 Ill. Comp. Stat. 601 (requires a renewal clause in an agreement with a “consumer” be set out in a “clear and conspicuous manner” to be enforceable and that a 30-60 day notice be given of the automatic renewal of more than 30 days).

From a tax perspective, the lessee who holds the renewal option should be able to renew a lease for one or more periods provided that the lessee completes an appraisal of the leased property that supports the extension under the tax Guidelines tests. The rent set at inception of the lease (or a different negotiated rent) continues if the appraisal determines that the leased property still has 20 percent of its useful life and 20 percent of its residual value remaining at the renewal date. The so-called 20/20 test is subject to some reduction in the 20 percent value depending on the type of equipment and supporting case precedent for lower values.

For more on renewal options, see Equipment Leasing—Leveraged Leasing, Fourth Ed., by Ian Shrank & Arnold G. Gough, Jr., Practicing Law Institute (Release 22, Nov. 2007) at Sec. 2:8 at p. 2-31, Sec 4:2.3[C][4] and Sec. 21:3.4 at p. 21-15 & 16.

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About Patton Boggs LLP; Publication

Patton Boggs LLP is a law firm of more than 600 attorneys and other professionals located throughout the United States and internationally in Doha, Qatar.

Patton Boggs has major practice areas in Business, Intellectual Property, Public Policy, and Litigation. These areas are composed of many practice groups designed specifically to meet client needs and the trends in developing legal markets. David G. Mayer often focuses on aviation, power, transportation, infrastructure, and technology matters.

The firm provides a broad array of skills in domestic and international business transactions, including equipment finance and leasing, corporate finance, secured transactions, syndications, mezzanine finance, federal leasing, project finance, real estate, health care, pharmaceuticals, technology transactions, and public policy work.

Partial List of Publications

• The following is a partial list of articles by David G. Mayer:

• ‘Perfect Pay’ Provisions In Troubled Credit Markets, by Chuck Cross and David G. Mayer, LNJ Leasing Newsletter (Feb. 2007)

• Equipment Leasing and CERCLA Liability, by Russell V. Randle and David G. Mayer, LNJ Leasing Newsletter (Dec. 2007).

• Navigating the New Reality of Equipment Leasing and CERCLA Liability, by Russell V. Randle and David G. Mayer, LNJ Leasing Newsletter (Nov. 2007).

• Managed Service Providers Use Innovative Capital Structures to Fund CAPEX, Financier Worldwide, by David G. Mayer (May 2007).

• The USA PATRIOT Act Renewed: Reassessing Money Laundering Risk in Finance Transactions, by Stephen J. McHale and David G. Mayer, LNJ Leasing Newsletter (Two Parts: Nov. & Dec. 2006).

• Unique Pad Gas Lease Supports Project Financing and Development of Gas Storage Facility in U.S., by David G. Mayer (with Fortis Capital Corp.), Asset-Based Lending Review, Financier Worldwide (Nov. 2006).

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Thanks to BLFN’s Team

I would like to thank BLFN’s team at Patton Boggs LLP. The team includes Bryon Wilems, an associate in the firm’s business transactions group; and the Patton Boggs staff: Paul Dumansky; our Marketing Manager, Mark Holub; our Project Manager, Melissa Green; and our designer, Winston Jackson. Thanks also to Douglas C. Boggs, a Business Group/Securities partner and web site reviewer for BLFN, and our Marketing Chief, Mary Kimber, for assisting BLFN through our firm’s editing, design, and posting process.

All the best,

David

David G. Mayer
Founder: Business Leasing and Finance News
(formerly Business Leasing News)
Partner: Patton Boggs LLP
2001 Ross Avenue
Suite 3000
Dallas, Texas 75201
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E-Mail: dmayer@pattonboggs.com

© David G. Mayer 2008

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