MARCH 2008 Issue No. 75

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

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FOUNDER'S NOTE
By David G. Mayer

Volatility

Does the entire economy, stock market and credit industry seem out of control? We do not know whether we are in a recession though the debate is raging on Wall Street and on Main Street. We may not know for many months to come, but the odds look good that the economy is already in a recession.

The stock market acts like a roller coaster from day to day, sometimes moving up or down by hundreds of points in a single day. Banks pull back on their lending until their subprime mortgage losses become clear and their capital stabilizes. Borrowers feel the heat as lenders refuse to extend existing facilities or to enter into new transactions. Lending and leasing rates in some segments seem to be increasing. As a result, troubled companies face potential defaults or even bankruptcy.

International markets seem to feel our pain here in the U.S. with some difficulties in their stock and credit markets. You would think that in such volatile times, lawyers would do well. However, a couple of weeks ago The Wall Street Journal described how large law firms have to brace themselves for lower earnings this year.

If you know how to take advantage of these difficult times, more power to you; go forth and make a bunch of money. For me, I have not decided yet whether we are in the best of times or worst of times in business, but I am only certain that we will all know more as this year progresses.

Let’s all work a little smarter (and harder) to put the volatility on our side as we soon move into the second quarter. Let’s accept the likely assumption that the U.S. is in a recession. Let’s make a plan for success for the balance of 2008 despite these challenges and not only hope for the best but also make it happen.

In the meantime, good luck as you finish the first quarter, and thanks for reading BLFN.

1. 10 Steps Financiers Can Take to Cope with Rising Defaults

The days of easy credit have passed but the time for defaults has just begun. As the U.S. economy continues to hit the brakes, financiers will almost certainly face a rise in defaults and bankruptcies. Almost every segment of the credit markets has suffered from the subprime mortgage fiasco, and the market shocks continue unabated. Financiers have little time to form their action plans to cope with defaults—to renew their skill honed in the last recession.

Projections of Defaults

Fitch Ratings Ltd. (Fitch) conducts a semi-annual survey in partnership with the Fixed Income Forum. In the most recent survey, Fitch received responses from 88 institutional investors. Fitch reported that 100 percent of respondents expect the default rate to increase at least moderately in 2008. About half of the respondents expect the rate to move significantly higher. In stark contrast, the mid-year survey in 2007 indicated few respondents expected to see a significant increase in defaults. See Fitch Institutional Investor Survey: U.S. Credit Market Stability Unlikely Until Late 2008, Business Wire (Feb. 14, 2008).

The Wall Street Journal noted: “Corporate defaults and bankruptcies have risen sharply this year. The total value of corporate-bond defaults is already approaching the total for all of 2007. Moody’s Investors Service now lists 41 companies it considers to be at risk of violating terms of their loan agreements compared with 25 at the end of last June.” One authority said that companies could default on more than $220 billion of high-yield corporate bonds, leverage loans and other non-bank debt in 2008. See Lending Squeeze Hits Ailing Firms, The Wall Street Journal, A:1, Col. 4-6, S.W. Ed. (Feb. 21, 2008) (Lending Squeeze).

Troubled Corporate Debtors

For years, easy credit has fueled corporation expansions, acquisitions and leveraged buyouts. Companies used this cash to avert painful job cuts, plant closings and asset sales. As banks lick their wounds from the still-unfolding credit crunch, spawned by the subprime mortgage crisis, the banks have become reluctant, or unable, to extend more credit to questionable debtors – even strong ones. By holding back, they can push troubled companies into default or even bankruptcy. The companies at risk span a wide range from home builders and mortgage financiers to trucking firms, restaurant chains and retailers (recently including Sharper Image). See Lending Squeeze.

Relatively Stable Equipment Finance Industry

Unlike other industry segments, the equipment finance industry should remain stable in 2008. Fitch summarized its views on the U.S. equipment leasing markets as follows:

Fitch’s outlook for the U.S. equipment lease sector for 2008 is positive but somewhat tempered due to the current volatile economic conditions. Business investment and spending on new equipment is expected to remain fairly stable. Overall equipment financing activity throughout 2007 was strong, with total new business volume exceeding 2006 total business volume. Fitch expects 2008 issuance volume to remain relatively flat compared with 2007 issuance volume.

In Fitch Ratings’ Equipment ABS Delinquency Index (asset-backed securities), Fitch concluded that delinquency rates through December 2007 increased slightly and that the securitized equipment lease portfolio has not significantly deteriorated as of February 2008. However, Fitch expects delinquencies and net losses to increase slightly during the first six months of 2008. The credit crunch and slowing U.S. economy weigh heavily on the ABS market. Nonetheless, defaults of underlying lease transactions seem to pose little concern at this point despite the current condition of the U.S. economy. See Fitch’s Equipment ABS Delinquency Index, By Du Trieu, Fitch Ratings Ltd. (Feb. 2008).

Credit Defaults: 10 Steps to Mitigate a Loss

The threat of defaults or even bankruptcy is very real in the corporate debt and structured finance world today. Creditors should prepare to address credit issues promptly and to anticipate when they might occur. The following steps focus on potential defaults primarily from a lender’s perspective and suggest how lenders can manage credit exposure at the earliest signs of trouble with a borrower:

• Maintain or, if necessary, initiate a dialogue with the borrower to avoid surprises: (a) discuss the financial condition of the borrower’s company, (b) inquire about business plans that management intends to implement in the slow economy, (c) address how the borrower will meet its obligations if the business plans don’t pan out, (d) meet the senior managers to understand the capabilities of the management to lead the borrower through challenging periods; and (e) discuss loan agreement covenant compliance.

Tip: Borrowers should likewise keep their lenders updated on the condition of their businesses. Borrowers should make this effort because an informed lender may choose to work with the borrower rather than with a borrower who springs a surprise emergency on the lenders. In almost any situation in today’s volatile debt markets, lenders may not forebear from declaring a default or be able to extend more credit to the borrower at all or on short notice.

• Obtain current financial statements and other information on the borrower’s financial and business condition to determine whether the borrower will be able to meet its obligations, satisfy its financial covenants and avoid defaults;
  
  
• Perform legal and business due diligence on the borrower to: (a) confirm that you have a complete set of closing documents, including properly drafted and filed financing statements under the Uniform Commercial Code (UCC), (b) review insurance coverage and current payment status, (c) inspect equipment and other tangible assets to assure that the borrower (or lessee) is maintaining them and that the assets continue to hold their expected value (get an appraisal of the value to establish more certainty), and (d) review inventory acquisitions, pricing and sales to assure that the borrower is not liquidating the best inventory first to maintain or increase cash flow as a means to avoid appearing to be a troubled credit;
  
  
• Evaluate any default that occurs promptly, even non-payment defaults, and ask the borrower for its strategy to prevent even greater problems such as significant payment defaults or material covenant breaches;
  
  
• Develop a strategy at the initial onset of a default or possible default with a view toward preventing losses and managing elevated credit risk of the borrower (or lessee);
  
  
• Preserve your rights and remedies by giving prompt notices of defaults even if you do not exercise remedies under Article 9 of the UCC or under your loan documents (a delay or failure to give these notices can result in a waiver of your rights);
  
  
• Consider creating some flexibility in loan covenants, negotiating forbearance arrangements and even granting waivers of defaults to allow the borrower some wiggle room to work through slow or difficult times;
  
  
• Consult knowledgeable bankruptcy and transaction counsel to determine the most effective course of action to address potential or actual defaults or bankruptcies (earlier is better);
  
  
• Assess the cost of exercising remedies and whether the recovery from exercising remedies justifies the cost (such as legal and appraisal fees);and
  
  
• Remember the potential for fraud, remaining cautious in dealing with borrowers to avert losses associated with wrongdoing.

With the economy in a slump, more credit trouble (beyond subprime mortgages losses) is almost inevitable. Workouts and bankruptcies hit an all-time low in the last few years, but according to surveys and various experts, more companies will slip into default this year. Careful planning can mitigate losses and enable lenders (and lessors) to address credit problems effectively. However, the time to act is not just when a default occurs. Instead, lenders should act now to identify and address deteriorating credits with the goal of minimizing the negative effects on their bottom line.

Thanks to Jeff LeForce for reviewing this article.

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2. As PTC Languishes in Congress, the Wind Power Industry Feels the Heat

The Production Tax Credit (PTC) has been a significant driver for recent growth of renewable energy projects like wind farms. However, the credit expires at the end of this year.

*Technical Point: Section 45 of the Internal Revenue Code sets forth the law with respect to the PTC. As described by American Wind Energy Association (AWEA), the PTC refers to “an income tax credit . . . allowed for the production of electricity from qualified wind energy facilities. . . . . The current value of the credit is 2 cents/kilowatt-hour of electricity produced.” For more, see AWEA on PTC.

AWEA has been promoting the passage of the PTC through volatile legislative sessions. In a press release of February 27, 2008, AWEA indicated its appreciation that the House of Representatives passed an extension of the PTC and that the Senate will not entertain the possible extension of the PTC. If enacted this year, for a period of time of at least two years, manufacturers and other vendors should be able to rely on the financial benefit of the PTC to plan for production of long lead-time items, such as turbines and other equipment that will sustain the growth of wind power industry.

According to one study, the failure to extend the PTC is likely to have significant negative effects, including the following:

1. Slowed Wind Development: The risk of non-renewal of the PTC can slow wind development in certain years. Even in years in which the PTC is secure, uncertainty in the near-term future availability of the PTC may undermine rational industry planning, project development and manufacturing investments, thereby leading to lower levels of new wind project capacity additions.

2. Higher Wind Supply Costs: Wind project costs in the U.S. decreased substantially from the early 1980s to the early 2000s, demonstrating the success of public and private R&D investments and the commercial success of the technology. Since 2001, however, installed wind costs have risen by roughly $500/kW, with power sales prices rising in turn. Although capital costs for all generation technologies have risen in recent years, there is reason to believe that this increase in the cost of wind power has been exacerbated by the erratic boom-and-bust cycle created by the 1- to 2-year PTC extensions in recent years.

3. Greater Reliance on Foreign Manufacturing: Uncertainty in the future scale of the U.S. wind power market has limited the interest of both U.S. and foreign firms in investing in wind turbine and component manufacturing infrastructure in the U.S. Consequently, the U.S. remains heavily reliant on wind turbines and components manufactured elsewhere.

4. Difficulty in Rationally Planning Transmission Expansion: Accessing substantial amounts of wind energy will require investments in the transmission grid. Uncertainty in the future of the PTC makes transmission planning for wind particularly challenging because the economic attractiveness of wind projects – and therefore of expanding the transmission system for those projects – hinges in many cases on the PTC.

5. Reduced Private R&D Expenditure: Shorter-term PTC extensions may lower the willingness of private industry to engage and invest in long-term wind technology R&D that is unlikely to pay off within a 1- to 2-year PTC cycle, given uncertainty in the future domestic market demand for those advanced technologies.

See Using the Federal Production Tax Credit to Build a Durable Market for Wind Power in the United States, Lawrence Berkeley National Laboratory (Nov. 2007) at 5 (Durable PTC).

In the same study, the authors found in a survey of industry participants that the benefits of a 5- to 10-year extension of the PTC included: (1) greater number of wind installations, (2) more rational transmission planning; (3) reductions in installed cost; (4) enhanced private research and development; (5) reductions in operations and maintenance costs; (6) fewer siting and permitting conflicts; and (7) reduced project financing costs inflated by short periods of available PTC. See Durable PTC at 7.

In short, as the wind power industry continues to ramp up for substantial growth in the coming years, the lack of PTC could stall out the development of wind power – in a “lose-lose” proposition for consumers, developers and the people who work in the wind power industry. In turn, financing sources may be less inclined to bankroll a wind farm that makes economic sense in part or in whole because of the PTC. If the national imperative includes a policy to use renewable energy, Congress should translate the policy into action to fuel the engine of wind power development.

*Action Point: For any stakeholder or professional involved in developing or financing wind power, the time is now to contact legislators to extend the PTC for a substantial period of time. Contact AWEA for direction on how your efforts can bring the PTC back into planning for 2009 and beyond.

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3. BLFN’s Case & Comment: Money Laundering by Aircraft Purchase – United States v. Benavides-Natera

BLFN has been warning you for some time that money launderers are looking for creative ways to move their money and that you need to be vigilant so as not to become ensnared in their schemes. A case scheduled to go to trial in Miami this month proves the point.

FACTS: According to an FBI agent’s affidavit in support of a criminal complaint filed in the U.S. District Court for the Southern District of Florida last October (Case No.: 1:08-CR-20001-PAS), Pedro Jose Benavides-Natera used drug profits to broker the purchase a U.S.-registered twin-engine King Air E90 in September 2006. A bank account Benavides opened was also allegedly used by the traffickers Benavides is alleged to have worked for in an attempt to buy a twin-engine Cessna Conquest II. The FBI asserts that the Conquest II is the aircraft of choice to transport cocaine from South America to Africa for transshipment to Europe. According to the affidavit, this prosecution is part of a much more sweeping investigation  into the use of drug money to purchase aircraft in the U.S. In addition to being used to smuggle cash and drugs, the high asset value of the aircraft itself serves as a way of laundering the drug proceeds when it is resold outside the U.S. according to the Drug Enforcement Administration.

ISSUE: Could the sellers or financial companies involved in such transactions also be subject to criminal prosecution?

OUTCOME: Possibly. They could be subject to prosecution if they knew or willfully ignored signs that the purchase was being funded all or in part by the proceeds of crime. Even if they are not prosecuted, they could still be subject to substantial civil and administrative fines if they are subject to anti-money laundering program requirements and failed to take required steps to ascertain the bona fides of the purchasers and the source of the funds used in the purchase. In this case, it appears that the aircraft brokers and U.S. banks involved were unwitting participants, although the affidavit suggests that at least some Mexican casas de cambio may have had a more knowing role in the movement of the illegal funds.

LAW OF THE CASE: Benavides-Natera is charged with violating 18 U.S.C. §1956(a)(1)(B) which makes it a crime for anyone, “knowing that the property involved in a financial transaction represents the proceeds of some form of unlawful activity, conducts or attempts to conduct such a financial transaction which in fact involves the proceeds of specified unlawful activity [which includes drug trafficking] … to conceal, or disguise the nature, the location, the source, the ownership, or the control the proceeds of the specified unlawful activity.” He is also charged with violating 18 U.S.C. §1956(a)(2) which makes it a crime to transport, transmit or transfer the proceeds of specified crimes into or out of the United States. Each charge could result in a 20 year prison term, a fine of $500,000 or twice the value of the funds or property involved in the transaction, as well as forfeiture of the illegal funds or any property purchased with the illegal funds (in this case the King Air E90).

*Comment: As anti-money laundering authorities have cracked down globally on traditional routes of moving illicit funds, money launderers have become increasingly creative. Asset purchases, especially where the assts are highly mobile such as aircraft, yachts, small commercial vessels, trucks and other vehicles, are particularly attractive. Prosecutors have become increasingly willing to pursue companies they view as having been willfully blind facilitators of money laundering activity. No lessor, lender or other financial institution should let that happen because the old adage most certainly applies to the Patriot Act: "Ignorance of the law is no excuse." The first line of protection always is to "Know Your Customer" which requires three primary steps:

• Gain a reasonable understanding of the customer’s business and how a particular transaction fits into that business;
  
• Evaluate the facts of how the customer obtains its funds for the deal; and
  
• Investigate any secretive activity and satisfy yourself that the activity is commercially reasonable and normal.

*Tip: Always consider walking away from the transaction if a full explanation does not become clear and seek knowledgeable legal counsel to participate in the due diligence and documentation of your deal, with an eye on the money laundering ball.

Thanks to Steve McHale for contributing this article.

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4. Finance 101: What Is a “Joint Venture”?

When two or more persons or entities desire to accomplish a business objective working together, they may create a joint venture to do so.

A joint venture is generally defined as “an association of two or more persons… for profit or commercial gain, for which purpose they combine their property, money, efforts, skills and knowledge.” See James D. Cox & Thomas Lee Hazen, Cox & Hazen on Corporations §1.07 (2d ed. 2003) (Cox & Hazen).

A joint venture is one of the most flexible, diverse and creative structures and/or agreements in business combinations. The participants in a joint venture can use any type of entity such as a limited partnership, a limited liability company or a corporation should the parties desire to form an entity into which they contribute property, money, efforts, skills or knowledge. A joint venture may be created strictly by agreement of the parties rather than forming an entity, but the entity allows the parties to clearly delineate legal rights, obligations, responsibilities, ownership and benefits of the venture within a separate entity. However, joint venturers may also allocate responsibility and share the benefits by agreement alone.

For example, in the leasing segment, the parties in a program agreement created to fund or sell products and services in a vendor finance program may be construed to be a form of joint venture. An arrangement to enter a new market may be accomplished by an agreement in which one entity contributes equity or finance money and the other party, who likely understands and has significant experience in a market, can provide its skills and market knowledge, including its customer list, to build a new venture such as marketing a technology product or service in a new market.

Certain key elements indicate the existence of a joint venture: “(1) a contract, (2) a common purpose, (3) a community of interest, (4) an equal right of control, and (5) participation in both profits and losses.” See Cox & Hazen.

Although these characteristics often define a joint venture, almost any element may be altered by the parties to allocate the capabilities, responsibility, rights and money disproportionately. For example, the parties can alter item (4) by providing that one party exercise control or veto power over decisions which effectively give that party control.

The parties may expand item (1) to provide for the formation of a joint venture entity which enters into a contract with two or more parties for a common purpose or business objective. To illustrate, if a U.S. party desires to enter a market in a foreign country to manufacture its products and contribute intellectual property rights to the joint venture, the contributor may desire to form an entity that will own the rights and perform the manufacturing function rather than simply enter into an agreement to that effect. The agreement alone may not allow the contributor to clearly delineate legal rights of the joint venture or to control the rights (i.e., monitor and withdraw the rights) as well as an agreement alone. Further, an entity may be required under local law to obtain government approvals or entitlement to operate the proposed business in the country in which the joint venture is formed.

Finally, item (5) can be altered in a special allocation partnership to distribute the benefits of the joint venture disproportionately. For example, one party may desire to receive most or all of the tax benefits of the venture while the other party needs the cash flow. Both aspects of the joint venture relate to, but are separate from, sharing profits and losses.

In summary, a joint venture provides one of the most flexible vehicles for two or more parties to achieve a common purpose or business objective through the allocation of benefits and rights, the contribution of the highest and best skills and the investment of money.

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About Patton Boggs LLP; Publication

About Patton Boggs LLP

Patton Boggs LLP is a law firm of approximately 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)

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