As low-cost air carriers gain market share, Robert Crandall believes the airline industry is "firmly in the grip of its dumbest competitor." Speaking at the Large Ticket Conference of The Equipment Leasing Association in Dallas on April 29, Crandall, the former chair of American Airlines, painted a bleak picture of the future of the "legacy" or "network" airlines. But his comments included insightful guidance for lessors.

Discounters Gain on Network Carriers

Recent statistics seem to validate Crandall's general views. The top seven low-cost carriers expanded their networks by almost 10 percent in 2002. They flew 23 percent of all domestic seat miles, up 3 percent from 2001. By contrast, the six major carriers reduced their networks by almost 7.3 percent last year. See: Low-cost airlines gaining, Dallas Morning News, January 13, 2003, Page D:1.

The combination of dramatically less traffic worldwide, plummeting airfares and relatively high operating costs have threatened the survival of the network carriers while imperiling the investments of lessors and lenders. Competitive pressures have been so great as to force all airlines to become "discount carriers." One airline expert named what he called the "Four Ls" of airline ailments: labor, leverage, leases and legacy. See: Majors Forced To Become New 'Discount Carriers', Airline Financial News, January 6, 2003, Page 3. Each of these ailments has put a drag on the financial and operational performance of the legacy airlines.

Challenge For Lessors Include Rate Drops

Being included in this group of problems for airlines isn't good news for lessors. Lessors have good reason to worry about their future in the airline industry and the immediate impact of the current woes on their current investments. A diverse group of players, lessors span the corporate gamut from Disney and Philip Morris to The CIT Group and Bank of America. These sophisticated lessors understand the cyclical nature of the airlines business and the downward pressure on lease rates. According to one investment bank, lease rates may have fallen by as much as 20 percent from their original levels. Lessors face even more downward rate pressure after the recent outbreak of severe acute respiratory syndrome (SARS). Despite all these negative events, aircraft lessors seem willing, at least in the long-term, to continue leasing commercial aircraft. See: Aircraft Lessors Face More Woes, But Won't Quit Business, Dow Jones Newswires, April 14, 2003 (10:20 a.m. EDT).

How Lessors Assess Airline Prospects and Adjust to Change

How do lessors assess the airlines and their prospects? According to Crandall, all airlines will become discount or low-cost carriers. The legacy airlines must act soon to survive, and drastically cut costs in three areas:

• Labor - The airlines can realize "enormous savings" by cutting labor costs.

• Fleet commonality - Using the same aircraft reduces maintenance, acquisition and labor costs.

• Outsourcing - While this item affects labor, airlines can save by using non-airline ground service, maintenance and other outside vendors.

Will the current round of labor cost reductions by the network carriers do the trick? According to Crandall, the labor cuts will be insufficient. He suggested that in 20 years the costs of all carriers will be the same, and they will compete on, among other bases, service, technology and control of maintenance costs. Today, he commented, a "tremendous anomaly" exists that tips the playing field steeply against the network carriers: The low-cost guys provide higher quality service at a lower price with better in-flight entertainment and more cheerful flight attendants.

With such huge challenges, lessors face a major shift in the airline industry, and they need to adjust quickly to the impending changes. By some estimates, the airlines have idled almost 2,000 aircraft in the desert and have shed over 100,000 jobs since September 11. Moreover, airlines must strip even more cost to survive. The unions must provide huge savings and demonstrate "unusual leadership" as the industry shifts toward the low-cost paradigm for commercial aviation. See: Shifts at Big Airlines Promise To Change the Industry's Course, The Wall Street Journal (S.W. Ed.), April 17, 2003, Section A:1 (Col. 5).

1. Keep your aircraft working even if you must accept much lower rates. An aircraft at work retains at least some of its residual value, earns some revenue and may survive capacity cuts with a place in fleet planning. A deserted aircraft is a wasting asset!
   
   

2. Follow the "three Cs" in choosing airlines in which to invest: "cost, cost and cost." Invest in the low-cost airlines, airlines that adequately reduce existing costs and airlines that control ongoing costs. According to Crandall, the survivors can and must cut costs soon.
   
   

3. Focus on regional carriers/aircraft and low-cost airlines for new opportunities. Such opportunities may enable you to participate in the growth and success of regional carriers while offsetting some of the pain of losses from the major airlines. Crandall commented that he viewed such carriers as potential survivors, using both smaller and larger body aircraft to serve various shorter and somewhat longer-haul markets from various hub structures.

For many lessors, investing in commercial aircraft now holds little or no allure. However, in the long-run, lessors will continue to invest and make sound returns in commercial aviation. Little doubt exists that the current paradigm in the airline industry is broken, but the industry is here to stay. As Crandall suggests, people have an innate desire to travel, and the travel industry contributes broadly to the economy. As the industry evolves and changes, it will continue to provide challenges and opportunities for lessors.

In a major victory for business, the Supreme Court of the United States overturned an award of punitive damages equal to 145 times the related compensatory damages judgment. The landmark case, State Farm Mutual Automobile Insurance Corporation v. Campbell (No. 01-1289, April 7, 2003), determined that such an award violates the Due Process Clause of the Fourteenth Amendment of the U.S. Constitution. The Court stated in relatively straight-forward terms that punitive damage awards must be reasonably related to the potential harm at issue.

The Facts of the Case and Surprising Outcome

This case involved a serious car accident caused by Curtis Campbell. Campbell's insurer, State Farm Mutual Automobile Insurance Company (State Farm), contested liability, declined to settle the ensuing claims for the $50,000 policy limit, ignored its own investigators' advice, and took the case to trial. State Farm assured Campbell and his wife that they had no liability for the accident, that State Farm would represent their interests, and that they did not need separate counsel. A Utah jury, however, returned a judgment for around $185,000, which far exceeded the $50,000 insurance policy limit. State Farm refused to appeal. After other failed proceedings, the Campbell's sued State Farm for bad faith, fraud and intentional infliction of emotional distress. The Campells won $1,000,000 in compensatory damages and an eye-popping $145 million in punitive damages. State Farm and other business interests, including The United States Chamber of Commerce in a useful amicus curiae brief in support of State Farm, took this case to task to put a stop to excessive damages that can create a crushing blow to the affected business.

*Technical Point: Compensatory damages pay a plaintiff for concrete loss. Punitive damages serve the purposes of deterrence and retribution akin to criminal penalties. The Due Process Clause prohibits the imposition of grossly excessive or arbitrary punishments on an alleged wrongdoer, sometimes called the "tortfeaser." See: Cooper Industries, Inc. v. Leatherman Tool Group, Inc., 532 U. S. 424, 433 (2001).

The Supreme Court Decision

Writing for the Court in a 6-3 decision, Justice Anthony M. Kennedy wrote, in overturning the award, that in most cases the ratio of punitive damages to compensatory damages should not exceed single digits. In other words, the Campbell's should not have received punitive damages for more than $9 million, a huge difference from the $145 million award. This clear, almost mathematical approach, clarified the general criteria for calculating acceptable punitive damages set down in BMW of North America Inc. v. Gore, 517 U.S. 559 (1996). The criteria consider the following points:

• The degree of reprehensible conduct by the defendant (that is, more punitive damages for worse behavior);

• The disparity between actual or potential injury and punitive damages; and

• The variance between the punitive damages and civil penalties in similar cases.

See: Supreme Court Tightens Punitive Damages

*Tip: Although punitive damages may not often arise in a case involving financing, lessors and lenders should benefit from the standards set in this case. It is important to understand that the states, nonetheless, have wide latitude in how to interpret the new ruling. See: Megadamages Against Industry May Be History, The Wall Street Journal (S.W. Ed.), April 9, 2003, Section B:1 (Col. 6). Particularly egregious behavior may still result in more punishing damage awards. As a lender or lessor, you should be cognizant of any behavior that may lead to a test of this new standard. Such a test could arise in alleged cases of lender liability suits or overly zealous enforcement of remedies.

The war in Iraq captivated the American people. During the war, the media and the U.S. government constantly spoke of the risk of terrorism. With the war faded from the front pages, lessors and other investors, still face the potential threat of terrorism.

A myth may exist for some lessors that only high-profile assets face terrorism risks. However, terrorism experts have identified a wide variety of lease assets that may be subject to acts of terrorism such as fire, explosion or biological and chemical attacks. Such assets include power plants, water treatment facilities, aircraft (commercial and business aviation), chemical production plants, public sector assets, technology and communications equipment (including computers), real estate premises of any kind, transportation assets of all kinds (tractors, trailers, tankcars, vessel, railcars, etc.), and water, fuel storage or other tanks. The conclusion for lessors is clear. Leased property of all kinds is at risk. It is not necessarily high-profile assets, such a "trophy real estate" alone that encounters terrorism risk.
What should a lessor do to mitigate new and higher risks? Risk mitigation refers to any sustained action taken to reduce or eliminate long-term risk to human life and property from a hazard or threatening event. In the context of documenting and closing significant lease transactions, lessors should consider taking at least the following four steps to protect their investments:

• Conduct due diligence on security of leased property.
  Lessors should undertake risk mitigation reviews. Such a review probably requires a lessor to hire a security professional to assess a project's risk. Consequently, lessors may: (a) ask for construction/design of new projects with enhanced security, (b) require lessees to develop and implement screening requirements for employees and contractors on site who work at or construct the leased property and (c) evaluate security as an element of design of plants and support facilities to be approved by a lessor or its consultants. The extent of the mitigation efforts depend, of course, on the type of asset. Such efforts may not be appropriate or necessary for highly regulated organizations such as the airlines or certain government-operated facilities. In any case, a risk mitigation program would determine the level of risk analysis and actions to mitigate the perceived risk factors.
  
  

• Structure each transaction to create separation from a lessor's personal assets.
  Lessors should use special purpose entities (such as trusts) as owners of the leased property. As the government continues its war on terrorism, lessors should also watch for (or perhaps initiate efforts to obtain) statutory protection that may provide safe harbors from terrorism risks. Lessors could then structure their lease transaction to fit within such safe harbor (for example, the secured lender's exemption in environmental law). Finally, as is typical in most lease transactions, lessors should avoid having or taking operational control of or influence the operation of the leased property. But lessors can and should monitor lessee's actions to provide security for their leased property and the people nearby. In a default situation, a lessor may have to take possession of a facility or other property. In such cases, lessors should complete a security review first and take adequate precautions to mitigate terrorism risk that would directly affect them as the entity with ownership, possession and control of the leased property. For example, as lessors and lenders take the keys to defaulted power plants, they should, before doing so, engage in an in-depth security/terrorism review and risk mitigation planning process.
  
  

• Draft appropriate documentation with protections for terrorism risks.
  Lessors should require that lessees adhere to the best practice in security for the applicable industry with respect to leased property. For example, National Business Aircraft Association Rules (NBAA) has extensive guidelines for best practices in security of business aircraft. Counsel for lessors should draft comprehensive indemnities that specifically describe terrorism along with other elements of indemnification. For weaker credits, lessors may even consider asking for financial or other credit support to strengthen the terrorism indemnities such as letters of credit to pay insurance premiums or limited terrorism guarantees (protecting defined risks or paying insurance premiums on non-payment by the lessee). Each aspect of documentation should be evaluated with the terrorism risk as a factor in deciding whether to close the transaction.
  
  

• Obtain terrorism and war risk insurance to mitigate risk. 
  Terrorism insurance is a complex topic. However, in evaluating insurance protections, lessors and lessees realistically should consider whether the risk of loss or liability is worth the insurance premium cost. Terrorism insurance covers many lines of insurance including liability and property coverages. Lessors should be aware of potential ambiguities in war risk exclusions that may exclude terrorism coverage. The Terrorism Risk Insurance Act of 2002 has opened the market for more insurance coverage for terrorism, but the insurance markets drive the rates, which can be high relative to other coverages.

*Tip: Lessors would be well served by creating interdisciplinary teams of finance, structuring, legal and insurance professionals as well as other risk managers to revise lease documentation to properly mitigate the risk of terrorism. No one can determine when or where terrorism may strike. A well-thought out set of lease documents can provide important protections for the lessor against such risk and its attendant liability. For more on such liability potential of lessors, see my article titled: Passive Lessor Liability From Terrorism: A New Era of Higher Risk, LNJ'S Equipment Leasing Newsletter, May 2003.

Leasing companies, banks and other "financial institutions" face potentially extensive and burdensome anti-money laundering and customer identification regulations under the USA Patriot Act of 2001 (Act). Such regulations could drive up the cost of doing business and set a trap for the unwary. The increased costs may produce marginal benefit to accomplish the intent of the Act of identifying actions or circumstances leading to the financing of terrorist activities.

Background

On October 26, 2001, President Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA Patriot Act) Act of 2001 (Public Law 107-56). Title III of the Act, also known as the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001, made a number of amendments to the anti-money laundering provisions of the Bank Secrecy Act ("BSA"). These amendments provide the means to prevent, detect, and prosecute international money laundering and the financing of terrorism.

Section 352(a) of the Act, which became effective on April 24, 2002, amended section 5318(h) of the BSA. As amended, Section 5318(h)(1) requires every financial institution to establish an anti-money laundering program that includes, at a minimum: (i) the development of internal policies, procedures, and controls; (ii) the designation of a compliance officer; (iii) an ongoing employee training program; and (iv) an independent audit function to test programs. The Secretary has delegated the authority to administer the BSA to the Director of FinCEN. "Financial institutions" is a broad term which encompasses, among others, commercial banks and leasing companies. See: 31 U.S.C. 5312(a)(2) and (c)(1)(A).

Lessor Focus Point

Although this law contains far reaching reporting and enforcement provisions, lessors and lenders should focus on Sections 326 and 352 of the Act. One particular concern surrounds the requirement for reports from "vehicle sellers." Vehicles include many of the transportation assets that lessors and lenders lease and/or finance, such as rolling stock, vessels, aircraft and trucks. See: FinCEN Comment Letter on Vehicles.

Temporary Exemption Gives Way to New Regulations of Banks

Lessors have had some illusory relief from enforcement. On April 29, 2002, and again on November 6, 2002, FinCEN temporarily exempted certain financial institutions from the requirement to establish an anti-money laundering program. The purpose of the temporary exemption was to enable Treasury and FinCEN to study the affected industries and to consider the extent to which anti-money laundering program requirements should be applied to them, taking into account the specific characteristics of the various entities defined as "financial institutions" by the BSA. The regulations affecting leasing companies are due soon.

Having worked some of the issues of implementing the Act, the Department of the Treasury and other federal agencies jointly published final regulations regarding the design and identification of customers under Section 362 of the Act. They clarify the reporting and other obligations of banks. For a press release on the regulations with related links, click on: Treasury’s Fact Sheet. The Office of Thrift Supervisions offered staff explanation and final rules at: Section 326 OTS Summary and a detailed description of implementation procedures at: Section 326 OTS Implementation.

*Warning: As "financial institutions," leasing companies have already been caught in the broad net of anti-terrorism regulation as I discussed the Act previously in BLN and in an updated version of the BLN article published in The Monitor (March 2003). These regulations may create the framework for regulations affecting leasing companies. The article and reprint, respectively, are both titled Western Union Pays Big Fine Under USA Patriot Act: Are Lessors and Lenders Next? With regulations still pending for leasing companies (other than banks), lessors and lenders should fully evaluate and comply with the Act to avoid any unwanted fines and adverse publicity. Perhaps the regulations will narrow the scope of compliance from the framework of the Act. Nonetheless, the failure to comply could present serious legal challenges that no lessor or lender needs to confront in our already challenging markets.

Transit authorities in the United States confront budget shortages and, at the same time, increased demands for quality transit services. They need to assign available revenues for system expansion or infrastructure repair. The authorities have little choice but to maintain and sustain the existing system "lifeline" transit services for populations dependent on public transportation. But shortages of cash leave the authorities in a bind. The need for transit assets such as buses and rail service requires a difficult balancing act. How can transit authorities acquire desirable, if not critical, transit assets and still meet their total investment needs? Leveraged leasing has come to the rescue to meet some of these needs.

Two illustrations show the value and utility of leveraged leases.

• On April 18, 2003, the Sacramento Regional Transit District issued requests for proposals (RFPs) for lessee counsel and lease arrangers to assist it in connection with leases of property needed to expand its transit system.
  
  

• In 2002, the second largest transportation system in North American, the Chicago Transit Authority, reportedly completed six leveraged leases valued in excess of $1.7 billion. CTA leased a variety of assets such as rail cars, buses, bus garages, warehouse facilities and a heavy rail maintenance facility.

For transit authorities, using leveraged leasing and other innovative financing makes good business sense. The financings provide additional investment in transit systems, facilitate leveraging of transit assets, avoid the use of purchasing/procurement dollars and attract private investment. In other words, leveraged leasing can contribute a valuable component to the total financing structure of the transit authorities.

Leveraged leasing transactions also present challenges for the authorities. While the transit agencies understand more traditional financing, the Sacramento illustration shows that the agencies will necessarily seek help in evaluating financing structures and proposals. Their concerns also include the following:

• Securing the lowest net present value of the rents to fit their budgets

• Maintaining control and use of the assets for the desired lease term

• Understanding the tax attributes and limitations for investors

• Managing transaction costs effectively

• Meeting the test of public scrutiny

As the budget crunch continues and demand for public services expand, leasing could become an even more useful and vital tool for transit authorities. State and other local government authorities may not be far behind in using lease products. Lessors can play a vital role and should find many deals attractive based on the reasonable credit strength of the lessees, mission critical assets for lease and acceptable transaction risk and structures.

*Deal Opportunity: Law firms and lease arrangers, along with lessors, who want to increase their volume of leasing transactions should tune into the public finance sector. Be aware that you will need to demonstrate proven skills and experience in leasing and public finance as well as public policy. With these skills watch for RFPs from state and local government authorities as a way to lift your leasing volume and participate in interesting, demanding and potentially rewarding transactions.

Vicarious liability is a well-established legal doctrine that imposes liability on an owner of an asset for the negligence of the user or operator of the asset. Often seen in the context of automobile leasing, vicarious liability rests on a public policy that third parties should be protected by an owner for the wrongful acts of a user of an asset who can't pay for the harm he or she causes. See: Vicarious Liability and Automobile Leasing Companies.

This old concept has been applied to modern auto leasing to the detriment of the automobile, insurance and leasing companies. For example, as a result of being held liable for negligent drivers over whom the leasing company has no control, J.P. Morgan Chase & Co. said that it will no longer provide auto leases in New York and Connecticut. Ford Motor Credit intends to stop leasing cars in New York for the same reasons, starting in July. Much controversy surrounds this multi-billion dollar industry, both for and against state statutes that create vicarious liability.

Terrorism Risk Insurance Regulations Open for Comment. The Department of the Treasury has published an interim final rule on how insurers make terrorism insurance available under the Terrorism Risk Insurance Act of 2002 and how the pricing works (generally as a percentage of the related insurance premium such as property insurance). You can submit comments through May 19, 2003. See: Terrorism Insurance Regulations.

Wind Energy Projects Attract Financing in a Stormy Power Market. Driven largely by tax benefits, the pricing of wind energy continues to draw interest from developers and financing sources. A key ingredient to the future success of wind power projects is whether the wind energy tax credits remain available under current legislative proposals for a sufficient length of time to entice investors. See: Wind Power Draws Increasing Interest from U.S. Project Developers, Financers, Global Power Report, March 27, 2003 at page 15. Wind energy may provide one bright spot in the independent power market that has encountered distressed asset sales and burdensome debt loads.

Bankruptcies Continue at Near Record Pace. PriceWaterhouseCoopers suggests in a recent report, titled The Phoenix Forecast: Industries Under Financial Stress and the 2003 Bankruptcy Forecast, that bankruptcies will decline somewhat from last year, but continue at a torrid pace in 2003 in excess of average historical levels. For an analysis of the financing perspective, see: No Tail-Off Seen in U.S. Failures.

To help improve your business operation, deal management and risk management, 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. 

There's Life After the Economic Doldrums

Let's face it. The flow of new business for leasing companies stinks. Small companies and large ones alike seem to take a dim view of our economic growth in the near future. Attendees at the recent Large Ticket Conference of The Equipment Leasing Association offered various stories that business flow could not be much worse. In general, March 2003 numbers indicate that 73 percent of small businesses planned no capital investment over the next three to six months. Business jet manufacturers have reported a 43 percent drop in deliveries in the first quarter compared to the same period in 2002. Even the chief executive officers in The Business Roundtable have said that 27 percent of them expect to decrease their capital expenditures over the next six months. Only 18 percent of these executives expect their corporate expenditures to increase over the same period.

Despite all of this gloom and doom, I am starting to feel more optimistic about prospects for equipment leasing this year. Some of my clients have indicated that their pipeline of deals is starting to fill up. Others say that activity is coming from every quarter, ranging from middle to large ticket deals. In business aviation, some players have told me that the low values of used aircraft make the current market a good time for lessees and buyers to acquire business aircraft again. A recent quick poll of The Equipment Leasing Association suggests that significant, pent-up demand exists for capital equipment.

If you have not seen these signs yet, take heart. Chairman Greenspan recently said: "Fundamentally, the long-run growth potential of the economy remains solid." Although the business investment will likely remain sluggish for a while, your continued, diligent efforts could promise a handsome payoff later this year. So hang in there and have a good month.

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.

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, Julie Rivard and Steve Reagan. The technical team of George Barber, Winston Jackson and Adrian Nicole McCoy 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. I appreciate their guidance and assistance.

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