After months of deliberation, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46 - Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51" (FIN 46). Wise to the alleged errant ways of Enron, the FASB imposed this principled-based "Interpretation" on businesses of nearly every type on January 17, 2003. The FASB set prompt deadlines for compliance that affects hundreds of billions of dollars in existing transactions, including synthetic leases and other off-balance sheet transactions.

The question in the leasing industry is whether lessors, lessees, lenders and others will act in time to prevent consolidation of "variable interest entities" (VIEs) or accept the consequences of consolidation with full knowledge of the implications. (A VIE is the new term invented by FASB to capture special purpose entities, or SPEs, and transactions in the web of the complex consolidation rules).

The February edition of BLN discusses the basic concepts of FIN 46 in the article titled: Final Off-Balance Sheet Rules Make a Significant Impact on Leasing. In essence, the article describes how FIN 46 affects a broad array of assets, entities and transactions and will undoubtedly cause consolidations that will materially alter financial statements of many companies.

New Deals and Deadlines

Ready or not, FIN 46 controls all new VIEs starting after January 31, 2003. For VIEs created by public companies before February 1, 2003, the provisions apply in the first interim or annual reporting starting after June 15, 2003 (that is, July 1, 2003 for most public companies). The provisions for private companies apply to their first year-end reporting after June 15, 2003. See: Paragraph 27 of FIN 46. This timing does not allow for indecision or delay. Any change to a complex transaction or group of transactions (such as commercial paper conduits, synthetic leases or other off-balance sheet real estate financing) require time and careful analysis to determine the course of action in light of FIN 46.

The Course of Action - First Steps

Every investor, lessor, lender, lessee and investment banker should promptly decide on its course of action regarding VIEs (including all special purpose entities). Opportunity exists to restructure and avert consolidations of certain VIEs, but so does down-side risk of consolidation by failing to act in a timely manner.

• Review your existing portfolios, assets and entities for exposure under FIN 46

• Determine if VIEs exist with respect to your lease portfolios, assets and entities

• Identify the primary beneficiary in a VIE

• Decide on the course of action if you (or your clients) may be the primary beneficiary

• Evaluate the implications of the actions you decide to take

The Synthetic Lease as a Prime Target of FIN 46

Apply the approach outlined above to synthetic leases of aircraft, office towers or power plants, all examples of target transactions that may exist within a VIE. If you are a lessee of a synthetic lease using a VIE, you are probably a primary beneficiary. If you are the lessor or lender, you should also consider the impact of a consolidation of a VIE involving these and other assets subject to a synthetic lease. Even if you are not the primary beneficiary, you may find opportunity in solving a consolidation problem for a lessee in a transaction that can feasibly be restructured.

Alternative Courses of Action

Many investment bankers, lessors, financial experts, lawyers and accountants have been pouring over FIN 46 looking for solutions and opportunity. Possible approaches include the following:

• Pursue an exit strategy. As a lessee in a synthetic lease you could sell the asset subject to consolidation and take the cash proceeds for other business uses. On one hand, this approach could increase cash flow and produce a tax gain. On the other hand, such a sale could deprive you of the use of valuable property while generating a real economic and tax loss. As property values have dropped, an exit strategy could have more downside than the upside of avoiding consolidation.
  
  

• Do nothing! This approach has its own predictable consequences. If you are the primary beneficiary and do nothing about FIN 46, on July 1, 2003 you-as a public company-may be required to consolidate your VIEs. As a private company, you have until after your year-end in 2003 to report on your VIEs. Note that FIN 46 has exceptions to the VIE rules or exclusions. For example, certain qualifying special-purpose entities (QSPEs) are not subject to FIN 46, because FIN 46 exempts certain securitizations and the FASB has not completed its work on this subject. You should closely review these exceptions and exemptions to determine whether not taking any action to restructure your VIEs is an appropriate response to FIN 46 or will not adversely impact you.
  
  

• Put your deal back on balance sheet. Don't wait for consolidation. You may be able to refinance your existing transactions at favorable rates. Krispy Kreme came under the scrutiny of the press for allegedly "hiding the ball" by planning a synthetic lease of a donut production facility shortly after the Enron story became public concern. Krispy Kreme abruptly stopped its synthetic lease deal and closed a mortgage on the plant at a later time. Some companies, particularly those in the public eye or markets, may avoid the synthetic lease because of bad "optics" - looking bad in front of shareholders and investors. Bad optics alone may create the incentive to avoid the appearance of any inappropriate off-balance sheet deal and motivate an effort to use on balance sheet financing.
  
  

• Restructure your deals to retain off-balance sheet treatment. To succeed in restructuring off-balance sheet deals, FIN 46 presents many complexities and challenges. The following ideas suggest possible ways to keep deals off-balance sheet in conformance with FIN 46:

1. Transfer a VIE's assets to a voting interest entity, which is an entity generally controlled by a majority vote of its owners with more than 10 percent of the true equity. Once transferred and documented to the voting interest entity, your transaction should not be subject to FIN 46.
   
   

2. Merge a VIE into a voting interest entity with the same result as the first idea.
   
   

3. Increase the equity in a synthetic lease within a VIE to at least 10 percent (up from the previously permitted 3 percent level) and impose the first loss on the equity—a tough sell in the current market. The VIE must then be able to stand on its own and absorb its expected losses and benefit from any upside. The 10 percent level is not presumed to be sufficient by FIN 46. Plan to present cogent reasons to your accountants to prove the equity is sufficient under FIN 46. Comparable industry data, historical loss numbers, operating history and similar information may offer persuasive proof to establish the correct amount of equity in a deal. The equity requirement could be substantially more or less than 10 percent, depending on your transaction or deal structure.
   
   

4. Sell the leased property and re-lease it. In this approach, the synthetic lessor sells the leased property to another lessor. The purchasing lessor then amends and substantively re-characterizes the synthetic lease transaction into an operating or tax lease. This transaction shifts the upside of the lessee in the previous synthetic lease structure to the lessor. As restructured, the operating or tax lease should keep the transaction off the lessee's balance sheet if it complies with Financial Accounting Standard No. 13 (FAS 13). FAS 13 describes the requirements to maintain off-balance sheet treatment as an operating lease (the failure to meet those standards results in accounting for a lease as a capital lease). 
   
   This transaction should be structured to fit the exception under Paragraph B10 of FIN 46 and FAS 13. Paragraph B10 provides that you disregard this lease in determining who is the primary beneficiary (that is, the lease will not be the cause for consolidation of a VIE). A so-called "B-10" lease is a long-term lease within a VIE. It has lease terms consistent with the then market pricing and has no residual guarantee (that is, it is not a synthetic lease within a VIE).
   
   

5. Sell the leased property and lease it back. The sale-leaseback transaction has been widely discussed as an alternative off-balance sheet structure under FIN 46. In this structure, the lessee exercises or negotiates an early termination or buy-out of its synthetic lease and immediately resells the property to a new lessor. The new lessor leases it back to the lessee under an operating lease. The operating lease should have similar characteristics discussed in alternative 4 above.

Implications of Change

Many more alternatives and issues exist than presented here. The implications of each alternative or transaction may seem daunting or perhaps mundane, but here are a few points you may use as you proceed:

• Consider the interests of lenders involved with a synthetic lessee or lessor. These interests could include possible covenant breaches by the lessee caused by consolidation, increased financing costs arising from a request for waivers, or whether consolidation will cause any default to occur. Lenders could use a significant balance sheet change to try to exit from an existing lending facility.
  
  

• Watch out for intercreditor issues if more than one investor or lender is involved in a VIE, especially when restructuring transactions and their respective interests conflict the others.
  
  

• Review insurance, tax (income, property and sales) and residual interests changes.
  
  

• Analyze the effect of required title transfers of the leased property. For example, plan for transfers or re-issuance of permits and approvals to operate a power plant or for re-registration or recordation of interests in assets with agencies such as the Federal Aviation Administration (FAA). Such transfers may take time and cooperation of several parties.

For assistance in this area or to ask questions about your options, please feel free to contact me at (214) 758-1545 or e-mail me at dmayer@pattonboggs.com.

The Export-Import Bank of the United States ("EXIM Bank") recently announced a one-third reduction in its exposure fees for buyers of U.S. large commercial aircraft in countries adopting, ratifying and implementing the Cape Town Convention. As stated by EXIM Bank in a related press release, EXIM Bank aims "to encourage other countries to adopt the kind of legal framework that will enable their airlines to upgrade and expand their fleet by reducing the risk of cross-border, asset-based aircraft financing."

EXIM Bank is the official export credit agency of the United States that supports the finance and sale of U.S. exports, including aircraft. EXIM Bank provides loans, guarantees and export credit insurance primarily for developing countries. For more on EXIM Bank, click on: EXIM Bank Programs.

This incentive by EXIM Bank represents clear evidence of United States support for improving cross-border commerce in aviation and for implementation of the Cape Town Convention. Such support positively affects leasing and finance opportunities of commercial aircraft worldwide.

The Cape Town Convention, with its Aircraft Protocols, is designed to create readily enforceable rights in aircraft. By their nature, these assets have no fixed location. The problem is that widely differing approaches of legal systems to security and title reservation rights have inhibited investment by lessors and lenders in aircraft and other assets. The Cape Town Convention is designed to overcome these concerns and enhance international transactions involving aircraft and other assets. For a detailed analysis of the Cape Town Convention, including its purpose, objectives and legal framework, click on: The Cape Town Convention on International Interests in Mobile Equipment: a Driving Force for International Asset-Based Financing by Sir Roy M. Goode (Professor, University of Oxford, United Kingdom). Professor Goode is one of the world's leading experts in uniform laws and has been at the core of developing the Cape Town Convention. For the history of the convention, click on: Convention History.

*Tip: The Cape Town Convention effort now includes a new and recent draft of a railway rolling stock protocol and a space asset protocol. Aircraft, railway rolling stock and space assets arguably require a uniform international framework to spur investment and uniformity in security interests.

EXIM Bank has stated that the adoption of the Cape Town Convention can lead to lower costs and more accessible financing for airlines. This framework could also provide enhanced opportunities for lessors and lenders to fund airlines worldwide as well as facilitate the movement of products and capital across borders. EXIM Bank contends that the Convention is consistent with the President's recently released report - Future of the United States Aerospace Industry. This report establishes the groundwork to encourage the financing and exportation of U.S. manufactured aircraft.

*Tip: As of the end of January 2003, a total of twenty-four countries had signed the Cape Town Convention. When eight countries ratify it, the Cape Town Convention will become effective. As previously discussed in BLN, FAA lawyers in Oklahoma City have gained in-depth expertise and knowledge of the Cape Town Convention. These FAA lawyers have promoted it and will no doubt be ready to play a significant role in facilitating your deals under the Cape Town Convention when it becomes effective.

Thanks to my colleague, Greg Walden, for his contribution of the idea for this article.

Fortune magazine recently published its list of the world's most admired companies. In 2003, the top ten list does not include any of the stellar performers in the leasing and financial services industry other than General Electric Company, which fell slightly in its rank from 2002. However, you will note among the luminaries in megabanks in America and worldwide that many lessors and equipment lenders make an impressive showing despite the challenging economic times.

To create these lists, Fortune's methodology and calculations include surveys of 10,000 executives, directors, and securities analysts. These participants rated companies in their own industries using the following eight criteria: "innovativeness, employee talent, use of corporate assets, social responsibility, quality of management, financial soundness, long-term investment value and quality of products/services."

The top five companies in a few categories relevant to leasing and financing companies are:

Most Admired Airlines in America: This list shows the 2002 and 2003 rankings, respectively: (1, 1) Southwest Airlines, (2, 2) Continental Airlines, (3, 3) Delta Air Lines, (4, 6) Northwest Airlines, and (5, 4) Alaska Air Group. For a worldwide perspective, click on: Most Admired Global Airlines. (Fortune subscribers only).

Most Admired Megabanks in America: This list shows the 2002 and 2003 rankings, respectively: (1, 1) Citigroup, (2, 2) Wells Fargo Bank, (3, 6), Bank of America Corp., (4, 7) SunTrust Banks, (5, 4) Bank One Corp. For a worldwide perspective, click on: Most Admired Global Megabanks.
(Fortune subscribers only).

Most Admired Companies in America: (1) Wal-Mart Stores, (2) Southwest Airlines, (3) Berkshire Hathaway, (4) Dell Computer and (5) General Electric Company.

*Tip: The March 3, 2003 issue of Fortune magazine contains other "most admired"-type lists.

Credit downgrades continue at a heated, though perhaps not record-setting, pace in 2003. Many global "fallen angels" count among these casualties. Fallen angels are investment-grade issuers with a rating of 'BBB-' and above, as rated by Standard & Poor's ("S&P"). S & P reported recently that most fallen angels will not rise again to investment grade. Only one company has risen to investment grade in the past three years (for credit reasons) amid 161 downgrades during the same period. Over the past 16 years, the financial, consumer products, and utility (mainly power) sectors produced the largest number of first-time fallen angels. In the S&P study, S & P Global Fallen Angels: Fallen and Can't Get Up? A 16 Year Study, around 20 percent of the fallen angels became rising stars returning to investment grade (87 of 383 fallen angels globally).

*Warning: If you plan to finance a fallen angel, analyze the credit without anticipating that your lessee or borrower will rise like the Phoenix to investment-grade status again. The potential for angels to rise again appears to be limited.

The record high annual count of 67 fallen angels occurred in 2002. A record low occurred in 1994 when only six angels fell from grace. S&P indicates that 60 issuers currently identified as having near term potential to become fallen angels (either a negative outlook or on CreditWatch with negative implications).

*Prediction: Of the high number of falling angels expected in 2003, history suggests that 95 percent of the downgrades will result from credit problems, while only 5 percent will flow from miscues related to acquisitions.

A correlation between downgrades and default rates offers some guidance for lenders and lessors. According to S&P, "[t]he global speculative grade default rate (12 month rolling average based on issuer count) has coincided with the fallen angel trend for the past decade. The five and a half year rise in this default rate, currently 8.3%, is up from lows below two percent set in the mid 1990's, but down from its peak in 2001 at 11.08%."

*Tip: Watch out for the consumer products, high technology, and retail/restaurant enterprises, which top the downgraded companies in the U.S. industrial sector. Further, be wary of metals, mining and steel, transportation and consumer products (consumer being tied with media and entertainment). These companies take the top spot for downgrades in the non-U.S. industrial sector. If you finance a fallen angel, consider enhancing covenants in your agreements to provide rapid availability of remedies arising from credit downgrades, increased credit risk or other potential defaults. For example, as the lender, you could propose innovative covenants in your loan documents not typically found in investment grade deals. These provisions could include negative pledge, restrictive payment, off-balance sheet and payment restrictions. (As a lessor, watch out for, and obtain releases from, these provisions that may interfere with your leasing transactions.)

As a lender or lessor, you could also consider increasing your loan or lease rates for negotiated downgrade, market or other credit risk events. A recent change in the lenders' approach with Tyco International Ltd. suggests a more timely way to adjust rates. In Tyco's case, the lender's reportedly negotiated price increases tied to higher bond rates payable by Tyco for one of its publicly traded bonds. See: Tyco Loan Rate Stands to Rise If Risk Climbs, The Wall Street Journal (S.W Ed.), January 13, 2003 Section C:1, (Col. 6). This type of trigger would enable you to adjust rates more responsively to market and credit events than adjustments for downgrades. Downgrades may lag behind negative events by up to several months. As corporate credit quality remains under pressure, the Tyco precedent portends more opportunities for lessors and lenders to craft rate increases based on standards that have not traditionally been accepted in credit or lease facilities of fallen angels. As a lessee or borrower, you should distinguish yourself from Tyco's case and allow generous time periods to solve event risks or to avoid rate increases based on downgrades.

R. Glenn Hubbard, who resigned on February 28, 2003 as Chairman of the Council of Economic Advisers (CEA), made one of his last official appearances at the Federal Reserve Bank in Dallas on February 21, 2003. At this gathering, Hubbard promoted President Bush's $674 billion growth package. As a key economic adviser to President Bush and an architect of tax cuts on dividends, Hubbard described key elements of the Bush plan and how the plan reduces tax obstacles to growth.

In response to my question asked about increasing capital investment incentives to create jobs and growth, Hubbard firmly rejected the importance of increasing bonus depreciation, reactivating investment tax credits or introducing other direct incentives to spur capital investment. Hubbard's response seemed curious in light of his briefing materials, which stated: "The recovery remains fragile due to low investment…The crucial wild card in the recovery is investment, as equipment investment continues to lag the pace of past recoveries."

Although capital investment shows clear weaknesses, Hubbard said that, with the exception of manufacturing interests, the business community has "not been united behind expensing" capital investment and has placed a higher priority on dividend and other tax relief. He called bonus depreciation "partial expensing" of an investment. He touted the Bush proposal to increase to $75,000 from $25,000 the amount that small businesses may deduct from taxable income in the year that investment takes place (that is, more expensing).

The White House website added these CEA comments in contrast to Hubbard's message:

"…[T]he pace of the expansion has not been satisfactory, with business investment and job creation remaining key weak spots in the economy… Purchases of equipment and software picked up modestly in the latter three quarters of 2002, but new orders for non-defense capital goods-a forward-looking indicator of investment-stagnated in the middle of the year and then declined in the last quarter…A stronger recovery depends on a robust rebound in business investment. This is the key factor to creating more jobs—when companies build new factories, they hire workers and boost employment in capital-goods industries."

Despite the lack of significant tax cuts to spur investment, the CEA web site further suggests that the Bush plan will indirectly aid capital investment in equipment:

"Ending the double taxation of corporate income will make corporate equities more attractive to investors and lower the implicit cost that firms pay for equity-financed investment. As an example, the cost of capital for equity-financed equipment investment in the corporate sector would fall by more than 10 percent... For equipment investment, this decline in the cost of capital is equivalent to an investment tax credit of four to seven percent."

*Comment: Hubbard's message was clear: Direct stimulus for capital investment is not a priority for the White House or for the business community. You'll have to wait for another day to see significant new tax benefits to stimulate capital investment in equipment. Perhaps Hubbard's hand-picked successor, N. Gregory Mankiw,  a Harvard University economist and best selling author, will advise the President to take more direct steps to increase capital investment that will aid leasing. It's a sure bet that the President's plan has some difficult challenges ahead. See: Bush's tax whack, Fortune magazine, March 3, 2003 at page 42 (how Alan Greenspan's negative comments about the Bush tax plan have encouraged a palace revolt in Washington).

Revenue Procedure 2001-28 ("Rev. Proc. 2001-28") establishes criteria for classifying a lease as a true lease for Federal tax purposes. It is the successor to Revenue Procedure 75-21, 1975-1 C.B. 715 and other related revenue procedures. Technically, Rev. Proc. 2001-28 establishes criteria for obtaining an advance ruling purposes from the Internal Revenue Service ("IRS") that a lease is a "true lease" as contrasted with a loan or conditional sale.

The IRS requires the transaction to be presented in a request for a ruling. The IRS will consider the lessor in a leveraged lease transaction to be the owner of the property and the transaction to be a valid lease if it meets all the factors in Rev. Proc. 2001-28.

These factors include (but are not limited to) the following:

• The lessor must maintain a minimum unconditional "at risk" equity investment in the property being leased (at least 20 percent of the cost of the property) during the entire lease term. Within this general concept, a lessor must show that, at the end of the lease term, it expects the property to have a fair market value equal to at least 20 percent of its original cost. The lessor must also demonstrate that 20 percent of the original useful life (or at least one year) will remain at the end of the lease term. See: Section 4.01(3) of Rev. Proc. 2001-28. These requirements are sometimes called the "20/20 tests."
  
  

• The lessee may not have a contractual right to buy the property from the lessor at less than fair market value when the right is exercised. See: Section 4.03 of Rev. Proc. 2001-28.
  
  

• With exceptions, the lessee may not invest in the leased property. See: Section 4.04 of Rev. Proc. 2001-28.
  
  

• The lessee may not lend any money to the lessor to buy the property or guarantee the loan in a leveraged leased that the lessor uses to buy the property. See: Section 4.05 of Rev. Proc. 2001-28.
  
  

• The lessor must show that it expects to receive a profit apart from the tax benefits. See: Section 4.06 of Rev. Proc. 2001-28.

The Guidelines contain several other considerations. For example, Guideline leases with uneven rents may be subject to Section 467 of the Internal Revenue Code, which can affect the timing of rental income and deductions. See: Section 5.01 of Rev. Proc. 2001-28. The IRS will not issue advanced rulings on "limited use property" (property that, in general, has no other potential user at the end of the lease term). See: Section 5.02 of Rev. Proc. 2001-28. For an IRS Overview, click on: Rev. Proc. 2001-28 Summary.

Thanks to one of my tax partners, George Schutzer, for his comments on this article.

Lender Escapes Liability in Syndicated Lease. In Bescos v. Bank of America (CA. Ct. of Appeals, No. 142818, Jan. 15, 2003), the court refused to make a lender to a lessor responsible for the lessor's alleged misrepresentations in an auto lease.

*Warning: The result could have changed if the lender had "substantial involvement" in the lease transaction.

Poor States Angle For Higher Taxes. Although a challenging task, a recent survey shows that 24 states want to raise taxes in 2003 and 36 states report budget gaps midway through the current fiscal year. See: Higher Taxes Could Be Coming to Your State, The Wall Street Journal (S.W Ed.), February 20, 2003 Section D:2, (Col. 1).

*Warning: Monitor your state tax rates and terms for changes in sales and property taxes affecting leases.

Taylor Publishes Insightful Book on Leasing. Jeffrey Taylor, noted writer, international trainer, and now author, just published "Selling Leasing in a Tough Economy," in which he applies 20 years of experience in leasing through his wit, humor and sales savvy. He offers innovative techniques for even the most seasoned sales professional to make money in leasing in our sluggish economy. To purchase a copy, contact Taylor at 2144 South 1150 East, Bountiful, UT 84010 (801) 299-9332 or (801) 299-9932 or click on http://leasing.bz/.

Training Offered. To 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. I customize the format and content for your specific training needs - no canned programs. Feel free to call me at (214) 758-1545 to discuss the possibilities. See Article 7 on Taylor's new book on the value of training.

The Show Must Go On

No one these days underestimates the importance of the geopolitical risks. With daily headlines focusing on terrorism, Iraq and North Korea, I must admit that the events worry me, and have taken a toll on the business of many of my clients. The market seems so transfixed on the situations that it seems to have lost sight of an essential point. Unless we do business, we can't make money to pay for potential war or any other crisis. We can't provide, or provide as well, for our families.

As I approach a big birthday (I won't say which one!), I realize that life is too short to stop functioning in our normal capacities based on complex international events beyond our control. I want to continue to enjoy the fun and fascination of helping my clients succeed in their endeavors. I am generally prepared to trust the current Administration and legislators around this country to take the right course of action to protect this nation. It seems to me that while they do their job, we should do ours. About 80 percent of businesses lease some or all of their equipment. With luck, we can all soon improve our economic fortunes together, whether we are lessors, lessees, borrowers, lenders or advisers. In the meantime, the show must go on! Have a good month in your business.

Feedback From You

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.

Thanks to the BLN Staff

I extend a special thank you to my editors at Patton Boggs LLP for their comments on this edition: Adrian Nicole McCoy, Sheila (Pedersen) McCoy, Julie Rivard, Steve Reagan, and Tom Stumpf. The technical team of George Barber and Winston Jackson continue to provide invaluable support. Last but not least, Patton Boggs has selected some partners who look over BLN before it is posted to our website to make it the best it can be for you. I appreciate their guidance and assistance.

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