On November 25, 2002, President Bush signed the Homeland Security Act of 2002, H.R. 5005 (the "Act"), which became Public Law No: 107-296. With his signing, Bush officially opened the doors for business in homeland security across all segments of commerce. Leasing companies and other financial institutions may have an opportunity to provide a substantial part of the capital needed for homeland security despite the expected $37 billion budget of the federal government.

The Emerging Homeland Security Market

Though enormously complex and fragmented, the emerging homeland security market covers the public sector (federal, state and local government) and also the private sector (businesses of every description). Both sectors must have the capital to acquire equipment, technology and other assets to fight terrorism. According to a recent joint report published by Deloitte Consulting and Aviation Week magazine, titled "The Homeland Security Market-The World's Most Challenging Emerging Business Environment," the market could be as large as $138 billion in 2003. The report projected spending in the different sectors of commerce as follows:

• Federal government agencies will spend $32.6 billion (now approximately $37 billion);

• State governments project spending of between $5.1 billion and $10.2 billion;

• Local governments project spending between $9.5 billion dollars and $19 billion; and

• Major private sector companies project spending between $45.9 billion and $76.5 billion.

To write this report, Deloitte surveyed more than 300 homeland security professionals with the goal of better defining and understanding the homeland security business. The report describes the priorities and needs of the public sector (for example, to control weapons of mass destruction or disruption). It also states that the private (business) sector focuses more on mitigating threats to business operations (such as transportation and IT/communications equipment). See: Summary Findings at pages 6 - 7. In each case, the report suggests that the solutions require greater investment in technology, especially information technology and other equipment. See: Addendum: Market Size Projections at page 24.

Another analysis, titled Market Intelligence Study: Homeland Technology Opportunities: The Market, The Needs & Recommendations (November 2002), also addresses government and business spending on homeland security. Consistent with Deloitte's report, this study indicates that "businesses will spend $45.9 billion on security-related technology for transportation systems, such as aviation, subway, rail, and sea systems." This study says that the total U.S. homeland security market totals between $98.2 billion and $114.4 billion for 2003. It indicates that business expenditures represents 54 percent and federal, state and local government expenditures represent 26 percent, 7 percent and 13 percent, respectively, of the total homeland security market.

Big and Small Businesses In Hot Pursuit

As American business became aware of these stunning numbers, major companies such as The Boeing Company and Raytheon Company formed homeland security operations. See: Homeland security promises lucrative contracts, Jane's Transport News (September 10, 2002).  Microsoft Corporation, Hewlett-Packard Company, Dell Computer Corporation, Motorola, Inc. and IBM Corporation selected people to take a run at the business. Even smaller companies such as Isonics Corporation, a Golden, Colorado firm, have joined the pursuit of opportunity to cash in on homeland security. See: Firms eye homeland security defense dollars, MSNBC.com (November 22, 2002). Over 100 companies, large and small, have shown interest in forming a lobbying group to be called "Homeland Security Industries Association."  See: Lobbying Group Formed to Tap Homeland Security Business, Newhouse News Service (September 2002).  At least one lessor, Hannon Armstrong Capital, LLC, which specializes in infrastructure financing for Fortune 500 companies, has focused resources specifically on identifying homeland security financing transactions.

The Funding Gap

Is sufficient money available to meet the projected needs in 2003 of private business and government entities for homeland security? According to the Deloitte report, most of the respondents believe that not enough money has been budgeted to really address the problem. (See: Investment Requirements at page 8.) Many businesses have allocated more than 5 percent of their budgets for homeland security initiatives in 2003. Over 35 percent of these businesses will spend between $500,000 and $10,000,000 each for homeland security assets. Because the economy remains sluggish and homeland security has created a new and unexpected priority for businesses, businesses may experience shortfalls in funding to make desirable investments in 2003.

Even federal government funding remains uncertain as appropriations may fall short of proposed budgets. See: Deadlock Over Spending Will Delay Some Programs of New Security Department, The New York Times, November 21, 2002 (Page A17, Col. 1). However, with a budget in excess of $30 billion, the new Homeland Security Department may have sufficient cash to purchase most of the goods and services in 2003 to meet its immediate needs. However, time and politics will determine how long this money lasts.

At the state and local level, governments already face a budget crisis and may not get expected funding for homeland security from the federal government. See: Homeland Defense Taxes State Budgets, Newsday.com (November 24, 2002). See also: States are Facing Big Fiscal Crisis, Governors Report, The New York Times (online - subscribers only), (November 25, 2002).

The Leasing Advantage for Homeland Security

The critical needs for homeland security, coupled with the probable funding gap, creates a potential opportunity for lessors. Leasing can provide numerous financial benefits to entities in need of homeland security equipment and technology. Such benefits include:

• reducing cash outlays of public and private sector lessees/borrowers;

• shifting the risk of obsolescence of high technology equipment to lessors;

• reducing after-tax cost of capital for lessees/borrowers; and

• avoiding extensive budgeting and procurement processes by "expensing" rent payments.

Lessors and financing institutions typically finance technology equipment. Technology equipment initially appears to constitute a major focus for homeland security procurement and purchases. Lessors and lenders also routinely finance aviation, rail, maritime, security and facility assets. Private industry will finance (or attempt to finance) defense assets. See: Boeing says tanker-lease could slip to 2003, Reuters (November 14, 2002) covering the lease of 10 aerial refueling tankers to the U.S. Air Force. Any new assets or modifications to existing investments for homeland security in these categories could easily fall within existing business models of many lessors or lenders.

• Inquire specifically about homeland security expenditures at federal, state or local government entities and also at private businesses with which you now do business;
  
  

• Identify the types of homeland security assets that fall within your particular expertise (with technology equipment offering the highest probability of producing viable leasing transactions) and pursue those funding opportunities;
  
  

• Collaborate with vendors of homeland security assets to assist them in funding their transactions; and
  
  

• Form an interdisciplinary team consisting of IT, pricing, business, finance, legal and risk managers to develop a business plan to focus on homeland security opportunities over the next several years, starting with 2003 when the highest immediate needs will likely arise.

If you need more assistance with understanding homeland security issues, or in dealing with related public policy matters, feel free to e-mail me at dmayer@pattonboggs.com or call me at (214) 758-1545. I will be happy to assist you or direct you to the appropriate partners at Patton Boggs (including partners in our Public Policy or Government Contracts groups).

Business jet lessors and manufacturers received confirmation of what they already have learned this year. Business jet deliveries have taken a nose-dive and the economy has left few bright spots in the current business aviation markets.

A recent report indicates that manufacturers in Wichita delivered 29 percent fewer aircraft in the first nine months of 2002 over the corresponding period a year before. The downturn affects piston, turboprop and business jet aircraft. Bombardier Aerospace, Raytheon Company, and The Cessna Aircraft Company reportedly fell 49 percent, 37 percent and 25 percent, respectively.

The General Aviation Manufacturers Association (GAMA) shows an overall decline of 16.9 percent in general aviation in the same period. According to a GAMA Press Release 01-25, dated October 25, 2002: "Shipments of general aviation airplanes manufactured throughout the world totaled 1,766 units in the first nine months of 2002, down 16.6 percent from the same period last year. The total dollar value of those airplanes was $8.4 billion….The total dollar value of U.S. manufactured airplanes was $6.4 billion."

*Tip: The current market conditions have apparently started a fare war for the jet set. In seeking new ways to fly for less, various membership programs, such as Skyjet Business Jet Systems, LLC, a unit of Bombardier, and Sentient (formerly known as eBizJets), which is owned by Credit Suisse Group, have priced their programs competitively with charter operations and fractional ownership programs. See: Fare Wars Hit the Jet Set: Sharing a Plane For Less, The Wall Street Journal (S.W. Ed.), October 23, 2002; Section D:1-2 (Col. 2). For lessors and lenders of business jets, these competitors may provide deal opportunities where the balance of the market remains lethargic.

The outlook for 2003 indicates continued weakness in this market. DeCrane Aircraft Systems Integration Group, a maker of aircraft interiors, expects 610 deliveries of corporate jets next year, 40 fewer than it forecast in August 2002, and a 14 percent drop from the 709 deliveries in 2002. By contrast, Honeywell Aerospace expects that manufacturers will deliver 700 new business jets in 2002 and approximately 650 jets in 2003, compared to 769 business jets in 2002. See: Near-term Bizjet Outlook Tenuous, Aviation Week & Space Technology (September 9, 2002). 

Fortunately for aircraft lessors and manufacturers, both DeCrane and Honeywell see a rebound in 2004 and 2005. DeCrane foresees deliveries of 735 jets in 2004 and 801 jets in 2005. Honeywell looks further into the future with its prediction that for the next five years (through 2007), based on the input of 1,000 flight departments worldwide, it expects the market for new business jet deliveries to be about 3 percent greater than in the past five years. Honeywell believes that the industry should start to see steady growth starting in 2003.

*Prediction: At the beginning of the new growth cycle, look for fractional ownership programs to provide a large portion of the deal volume and growth. By 2012, Honeywell projects the fractional share fleet to represent 10 - 12 percent of the active business aircraft worldwide. Further, the member programs and charter operators will help broaden the overall market. In 2005, when owners begin to retire older aircraft, high-end aircraft like Gulfstream and Global Express should see sales take off again. In the meantime, aircraft lessors should look to the extensive used aircraft inventory available in the market to provide the bulk of the deal volume.

Making a broad impact across industries and transactions, on November 25, 2002, the Financial Accounting Standards Board (FASB) published it guidance on enhanced disclosure and increased recognition of all kinds of guarantees.

FASB's work is called "Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." The Interpretation expands on FASB's Statements Nos. 5, 57, and 107 (the "Interpretation"). You can purchase a copy of the Interpretation for $12.50 by clicking on: Guarantee Interpretation. 

According to the FASB, the Interpretation "elaborates on the existing disclosure requirement for issuers of most guarantees" and requires "more transparent disclosure" of a "company's financial position and the risk it has assumed." See: FASB News Release 11/25/02.

What is a "Guarantee" Under the Interpretation?

The Interpretation covers guarantee contracts (with exceptions) that require the guarantor to make payments to the guaranteed party based on a variety of contingencies. A guarantee will be covered if the payment obligation arises based on: (a) changes in the underlying asset or liability (such as a standby letter of credit or market value guarantees); (b) the failure of an entity to perform its obligations to the guaranteed party; (c) tax or general indemnification agreements; and (d) other indirect guarantees under FASB Interpretation No. 34.

How You Apply the Interpretation

To initially apply the Interpretation, ask the following questions:

• Is my transaction a "guarantee" within the scope of the Interpretation?

• If your initial answer is yes, does my guarantee contract fall within an exception in the scope of the Interpretation?

• If your answer is yes (that is, your deal fits within an exception in the scope), what disclosure (if any) does the Interpretation require?

• If your answer is no (that is, your deal does not fit within an exception), what does the Interpretation require with respect to the disclosure of the guarantee and the recognition of the liability created by the guarantee?

FASB summarized its final guidance in a Project Update dated October 25, 2002. The update provides information to answer these questions.

*Warning: The Interpretation affects many transactions whether you call the underlying obligation a guarantee or not. Carefully review the Interpretation to determine the impact, if any, on your leasing products (for lessors) and financial obligations (for lessors, vendors and any one else with a guarantee on your books or in your future). Work closely with your accountants, lawyers, pricing and business people to fully understand and structure deals to take the Interpretation into account. (Note: this article appears before I could obtain a copy of the (final) Interpretation. I will update and/or correct my report in BLN as I obtain more information.)

Disclosure and Recognition

If your guarantee fits within the scope, the Interpretation generally requires that you disclose the nature of the guarantee and recognize the liability it may create at its "fair value" or "market value." Fair value may be measured in different ways but probably equals a number less than the present value of the guarantee based on the probable amount of payment (as contrasted with the probability of payment).

In your financial statements you will be required to make specific disclosures about your obligations under most guarantees. For example, even if you believe your payment obligation is remote, you must disclose: (a) the nature of the guarantee, (b) the maximum potential amount of future (undiscounted) payments the guarantor could be required to make, (c) the current carrying amount of the guarantee (regardless of whether it stands as a separate contract or exists within another agreement), and (d) any recourse to, or collateral held by, third parties from which the guarantor can recover payment it makes under its guarantee.

Impact on Leasing and Other Transactions

The Interpretation covers a wide variety of guarantees (no matter what you call the obligation). A discussion of the possibilities goes far beyond the scope of this article. To illustrate the broad impact of the Interpretation, consider the following three diverse types of applications:

1. Synthetic Leases. The Interpretation may constitute what I have called the "stealth killer" of synthetic leases. Financial Accounting Standard (FAS) No. 13 enables lessees to keep a synthetic lease off its balance sheet (but not avoid disclosure). The Interpretation seems to put back what FAS 13 took away. The Interpretation requires the recognition of a synthetic lease's implicit residual value guarantee by a lessee at fair value.
   
   

2. Tax and General Indemnities. Lessees must recognize the fair value of the tax liability of a tax indemnity regardless of the likelihood of payment in tax leases. The Interpretation seems to cover general indemnities such as adverse judgments or other contingent liabilities.
   
   

3. Energy Service Agreement Guarantees. The energy service industry offers energy efficiency and maintenance service programs to its customers. See: National Association of Energy Service Companies (NAESCO), the industry organization. Energy service companies (ESCOs) enter into standard performance contracts (SPCs) and other agreements in which the ESCO assumes the risk that the project will achieve certain energy savings (subject to measurement and verification). ESCOs enter into transactions that range from replacing lighting with energy-efficient fixtures to installing cogeneration power production facilities that reduce energy costs and increase energy efficiency. The risk assumed may result in a payment by an ESCO to its customer if the customer does not achieve the agreed energy savings. That obligation could be treated as a product warranty that falls outside the scope of the Interpretation or as a guarantee within the scope of the Interpretation. If the energy assurance given to a customer constitutes a guarantee under the Interpretation, the ESCOs would have to disclose and recognize the fair value of their energy guarantees.

Effective Dates Occur This Month

Disclosure and recognition provisions apply prospectively to all guarantees issued or modified after December 31, 2002 (that is, previous guarantees are "grandfathered"). Disclosure of guarantees begins for interim and annual periods ending December 15, 2002.

*Tip: Look at every deal that has obligations that may constitute a guarantee. With certain stated exceptions, you may unexpectedly find that your or your customer must disclose and recognize the liability under the Interpretation.

The federal government recently entered the insurance business for three years “to ensure the continued financial capacity of insurers to provide coverage for risks from terrorism.” It took this action on November 26, 2002 when President Bush signed the Terrorism Risk Insurance Act of 2002 (the “Insurance Act”). Also known as Public Law 107-297 and H.R. 3210/S. 2600 (insert bill number at web site), the new law provides that the government will pay up to 90 percent of insured losses of up to $100 billion per year after insurers pay a sizeable deductible. See: Section 103(e)(2)(A) of the Insurance Act.

The Insurance Act also requires insurance companies immediately to provide terrorism coverage that has either been unavailable since September 11, 2001 or extremely expensive for buildings such as the Rockefeller Center, Chrysler Building and the Empire State Building (plus scores of lesser known properties.) See: Industries Welcome U.S. Aid on Terror Insurance, The New York Times, November 21, 2002, Page C:5 (Col. 1).

The real estate industry, among others, let out a collective sigh of relief when President Bush signed the Insurance Act. For this industry, the Insurance Act clears the way for an estimated $13 billion in new construction projects presently on hold. See: White House, Congress Reach Agreement On Terror Insurance, With No Damages Cap, BNA's Banking Report, Vol. 79 Number 15, October 21, 2002 at page 636 (subscribers only).

Though the legislation is welcome, insurance buyers should understand that the federal government has forced insurers back into the terrorism insurance market. The insurer industry faces risks that it has little experience to assess or manage. Insurers may have difficulty in pricing the coverage and will tend to rely on the federal government to pay for the most serious losses. See: Terrorism Bill Boost Insurers' Risk, The Wall Street Journal (S.W. Ed.), November 27, 2002; Section 9 (Col. 1).

*Technical Points: Section 103(e)(1) of the Insurance Act provides that the government will pay 90 percent of insured losses in excess of the applicable insurer deductible described below. In this three-year program, the government will pay up to a total of $100 billion for insured losses resulting from acts of terrorism. See Section 103(e)(2)(A) of the Insurance Act. The insured loss must result from an "act of terrorism." Section 102(1)(A) defines an "act of terrorism" as a violent act or other act that is dangerous to life, property or infrastructure. The act must be committed on behalf of a foreign person or foreign interest (not by a US citizen) in the United States (with exceptions) to "coerce the civilian population of the United States or to influence the policy or affect the conduct of the United States Government by coercion."

Section 103(e)(6) of the Insurance Act describes the aggregate retention amounts that the insurance industry must pay before the federal government will cover terrorism losses. Section 102(7) of the Insurance Act defines the insurer deductible amounts during each year of the program. In summary, these retention (loss payments) amounts and deductibles (amounts payable by insurers from direct earned insurance premiums from property and casualty insurance policies issued by the insurers) are as follows:

• Year 1 (2003): Insurers pay losses under $10 billion (with a 7 percent insurer deductible);

• Year 2 (2004): Insurers pay losses under $12.5 billion (with a 10 percent insurer deductible); and

• Year 3 (2005): Insurers pay losses under $15 billion dollars (with 15 percent insurer deductible).

*Tip: As a risk manager, insurer or underwriter, you should review the guidance of the US Treasury Department and The National Association of Insurance Commissioners (NAIC) regarding the new terror insurance law requirements

With so many businesses facing financial challenges these days, lenders and lessors may refuse to fund transactions or could even declare a default based on a "material adverse change" of a business. Loan, lease and merger and acquisition documents often contain the so-called "MAC" or "material adverse change" provision. The provision is often ambiguous and difficult to enforce.

So what is a "material adverse change"? A material adverse change is a set of fact-specific circumstances or occurrences in a transaction that indicate to an aggrieved party that a serious deterioration in the condition and/or ability of the other party to perform its obligations has occurred or may occur. As a result of such circumstances or occurrences, the aggrieved party may be entitled to trigger a remedy or other action in the transaction. For example, say a lessee restates its financial statements resulting in a large and unexpected loss before its lessor funds all deliveries under an equipment lease. As a result, the lessor may elect to use a MAC clause (and other provisions) to refuse to fund further deliveries. The lessor could even put the lease in default. The MAC clause is a tool that the lessor (or lender or buyer) uses to exercise these rights. The MAC clause allocates the risk of adverse events or circumstances between the parties. However, the courts may have to determine whether the MAC clause is enforceable for the purpose for which it is used.

A simple MAC clause (for illustration only) may read:

"A 'material adverse change' means any event, change or occurrence which reasonably could be expected to materially and adversely affect the business, properties, condition (financial or otherwise) or prospects of the Lessee and its subsidiaries, taken as a whole."

The parties to a lease typically negotiate MAC clauses in detail. The lessor wants to include the clause and make it broadly applicable to adverse events. The lessee wants no part of the clause or tries to narrow it or create big exceptions.

How the New (Accounting) Rules Will Affect Lease Financing Transactions. Sponsor: Infocast. Event: Unwinding, Restructuring & Consolidating Special Purpose Entities Under the New FASB Guidelines. Dates and Times: Wednesday, February 12, 2003; 3:15 p.m. - 4:45 p.m. in New York City (location to be announced). For information/registration, contact Infocast or call (818) 888-4444.

Training Offered. To help improve your business functions, I offer private training seminars tailored to your specific needs at your designated location. My interactive and informative approach relies, in part, on my book, Business Leasing for Dummies (BLFD)® and subjects I cover in BLN. We can customize a format for your training needs ranging from a three-hour seminar to a two-day course. For example, we can discuss such topics as the FASB's changes in accounting rules affecting synthetic leasing. Feel free to call me at (214) 758-1545 if you would like to discuss your needs or interests. Even if you don't train with me, perhaps I can recommend another training program that works for you. Training is critical in any event!

BLN Brief presents short-takes and updates of current issues. For more information on these stories, just email me at dmayer@pattonboggs.com:

Auto Leasing Volume Goes Soft. As zero percent financing has hit high gear, car lease volume has softened. Only 23 percent of all vehicles sold in 2002 have been leased. In 1998, leasing accounted for 32.2 percent of auto transactions. See: Leasing Loses Allure for Car Dealers and Buyers, The New York Times (online - subscribers only), (November 17, 2002). 

Convergence of Global Accounting Standards Takes a Step Forward. FASB and the International Accounting Standards Board (IASB) reported at the end of October that they had signed a memorandum of understanding (MOU). The MOU commits them to work toward the convergence of US and international accounting standards. FASB could issue a set of rules at the end of 2003 but that timetable is aggressive.

Reflecting on 2002 I must say that "I am blessed." I am blessed first and foremost by my family: my wife, Anne, and my girls, Ashley and Lindsay. They bring joy to my life. I am blessed by the success that I have enjoyed this year in my law practice. I am blessed that so many people have helped me grow, and perform work of value to others. I am blessed by the enthusiastic and talented assistance of the BLN team, as well as the support of my family and firm in this time-consuming endeavor. Last, though far from the end of my list of blessings this year, I am blessed that you have made this newsletter so successful, so fast. With over a million visitors each three months at the BLN web site, the interest you have shown is quite amazing and humbling. I will continue to work hard to earn your trust.

About Patton Boggs LLP and My Practice

As you may be aware, I am a part of the Patton Boggs LLP business transaction group in the Dallas office. Patton Boggs LLP is a law firm of almost 400 lawyers located in several US cities with extensive capabilities in over 50 areas of legal practice that include leasing, secured transactions, project and mezzanine financing, bankruptcy, public policy, technology law and much more.

Patton Boggs engages in the legal aspects of buying, selling, financing and leasing real and personal property of all kinds, including aircraft, energy, facility, technology and other transportation assets. We also structure, negotiate and close fractional ownership of business aircraft, vendor programs and underlying transactions, tax-exempt and federal leasing deals, portfolio acquisitions, syndications of all sizes, and much more. Given the state of the economy, we often assist our clients with troubled deals and bankruptcies.

Please feel free to call me at (214) 758-1545 or e-mail me at dmayer@pattonboggs.com for information about any of these areas or the many others available at Patton Boggs LLP or to discuss anything I have written in Business Leasing News. I welcome opportunities to build relationships with you.

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