DECEMBER 2005
ISSUE NO. 48

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1. Technology Spending Is Prescription for Growth of Healthcare Industry

Technology assets will play a central role in the efficiency and effectiveness of the healthcare industry over the next several years, according to a September 2005 report of the Equipment Leasing & Finance Foundation, titled Long-Term Trends in Healthcare and Their Implications for Leasing Industry (Healthcare Study). The expected capital spending will provide enormous, though risky, opportunities for lenders and lessors in healthcare businesses. Managing these risks will be essential, whether a transaction involves a single information technology (IT) asset or a secured loan facility. The potential growth in this area has already compelled many lenders and lessors to expand health care financing in technology and other healthcare assets. Other are sure to follow.

Trends and Opportunities

Healthcare has been growing rapidly and massively in the United States. Healthcare expenditures increased 7.2 percent in 2004, representing 15.4 percent of the U.S. gross domestic product (GDP), or approximately $1.8 trillion.

*Trend Point: The upward trend in healthcare spending should continue unabated. An aging U.S. population, growing labor shortages, new medical treatments and technology needs and innovations will place a huge burden on the healthcare system in the United States. Expansive and expanding governmental policy requirements will demand more compliance efforts by healthcare providers.

The Healthcare Study indicates that healthcare spending is projected to grow 2.5 percent per year faster than the GDP between the years 2001 and 2011, such that it will constitute 17 percent of the GDP by 2011. By 2014, spending will grow to 18.7 percent of the GDP, which amounts to about $3.6 trillion. Medicare and Medicaid spending will drive national healthcare spending to 22.9 percent of the GDP in 2030 and 32.4 percent in 2050.

Although the healthcare industry currently spends only about 2.5 percent of its revenues on information technology, the shortage of labor will require the industry to rely more heavily on technology to meet the needs of the aging population in the United States. Industry organizations have published findings that healthcare providers must dramatically increase their capital spending during the next several years. For example, the Healthcare Financial Management Association (HFMA) stated, in a March 2, 2004 press release, that nearly three-fourths of chief financial officers expected to increase capital spending 14 percent per year at their hospitals through 2009.

CFOs overwhelmingly cited IT spending as a primary contributor to their increasing capital spending. Among the three main areas where CFOs will focus their technology spending are digital radiology systems (72 percent), computerized physician order entry systems (64 percent), and major information technology systems (61 percent). Rick Wolfert, then at GE Healthcare Financial Services, estimated that IT spending would grow by nearly 9 percent per year to reach $30.5 billion in 2006, in a bid by the industry "to leverage technology to improve patient safety, deliver the highest quality clinical care and enhance operational productivity."

*Opportunity Point: The Healthcare Study suggests that leasing should prosper during the growth of the healthcare industry. Of the $360 billion of technology expenditures expected by 2014, the Healthcare Study states:

If 30% of this new investment utilized leasing financing (consistent with overall historic penetration of lease financing), it would represent a market of $120 billion in annual leasing volume in 2014. That $120 billion in annual leasing volume is an amount 15 times the size of the estimated overall leasing volume in the Healthcare industry projected for 2005.

To illustrate, IBM and Sun Microsystems, Inc., in separate efforts, aim to jump-start digital record keeping in the emerging healthcare market. Though lower than the Healthcare Study estimate, Sun estimated that $160 billion in new IT spending is expected to occur over the next five years. See IBM, Sun Setting Out To Heal Health Care With Latest Systems, by Ken Spencer Brown, Investor’s Business Daily (Dec. 2, 2005).

This trend has already become evident. Equipment leasing increased from $3.7 billion in new leases in 1997 to $5.8 billion in 2002. The Healthcare Study suggests that, in the coming years, the leasing industry will experience even faster growth of healthcare financings. Leasing presents one type of financing opportunity, but lenders may have an even greater opportunity to provide funding to healthcare businesses for new technology and other healthcare assets, facilities, and hospital projects, as well as to physicians and clinical services, dental services, nursing homes, and home healthcare.

Risky Business

Although the opportunity for increased business looms large for lenders and lessors, it does not come without significant risk. For technology lenders and lessors, risk has been and will continue to play a crucial role in decisions to fund transactions. Because of the shortage of qualified labor, technology assets may provide one of the better and safer types of assets to finance, as technology will increasingly substitute for and supplement skilled labor.

*Tip: Lenders and lessors should require the borrower or lessee to demonstrate that the assets will improve the quality, effectiveness, and efficiency of the healthcare services, including diagnosis, treatment, and productivity. The optimal asset type should increase revenue and/or reduce costs while alleviating demand for skilled labor. These points respond to current weaknesses in many healthcare organizations and treatments today, which evidence significant inefficiency and excessive treatment costs, according to the Healthcare Study. Captive leasing companies should exercise caution not to overlook these issues in their drive to complete sales of products of vendors or manufacturing parent companies.

Lessors and lenders face three major risks in healthcare financing:

• Technology Obsolescence. Rapid evolution of healthcare equipment undermines residual and collateral values, diminishes asset value recoveries after a lessee or borrower default, and reduces residual value upside on lease expirations or earlier termination.

• Credit Risk. Healthcare lessees have plagued the leasing industry with a 26 percent failure rate arising out of poor credit quality. Table One in the Healthcare Study shows an analysis of healthcare lease failures with discernible patterns. The smaller the lessee organization and the smaller the lease contract amount, the higher the failure rate, with the greatest problems arising in professional practices.

• Governmental Policy. The U.S. government has not only promulgated heavy regulation of the healthcare industry such as the Health Insurance Portability and Accountability Act (HIPAA), but also faces a budget-crushing demand for healthcare payments in the coming years.

As with any segment of the finance business, higher risk provides the opportunity to charge higher rates on leases or loans. However, the higher rates alone will not protect lenders and lessors against inherent business risks such as inadequate labor, global competition, and unmet demands for rapidly evolving medical treatments.

Risk Mitigation

Lenders and lessors can mitigate risk in financing health care facilities and assets. In any transaction, lessors and lenders should usually require experienced management, acceptable credit risk, a defensible business plan, and supportable residual/collateral values of financed assets as a basis for approving a healthcare financing. However, a few more specific actions may also help produce a successful financing:

• Manage transaction size. The Healthcare Study noted that smaller transactions tend to result in higher lease failures. Lessors may therefore wish to exercise caution in accepting concentrations of smaller lease transactions with physician practices and small medical facilities. Larger secured lending transactions to healthcare facilities and hospitals may mitigate risk by taking priority interests in all assets and potentially benefiting in the enterprise value of the healthcare provider.

• Finance mission-critical assets. Technology assets should facilitate growth, cut labor needs and costs, and promote service quality and efficiency. Consequently, lessors and lenders should evaluate carefully the types of assets, including software and equipment, that will promote the success of the lessee or borrower medical business, and consider including a significant or exclusive group of such assets in any financing. To mitigate loss of collateral or residual value, financers should use lease terms or loan maturities that are as short as possible on technology assets, ranging from 24 and 36 months. Obsolescence risks make longer terms more risky on asset valuation and realization.

• Support credit exposure. Lessors and lenders should consider ways to shore up the credit risk of their borrowers or lessees and protect collateral and residual values. For example, they could structure transactions with guarantees, additional collateral, intercreditor arrangements, and subordination agreements to optimize recoveries after a default occurs. See lntercreditor Agreements: How Lenders Share and Negotiate Rights in Collateral, by Scott Wallace and David G. Mayer, Business Leasing News (Jan. 2005). They can also require proper asset and risk management, detailed borrowing certificates (for lenders), and financial reporting to set default triggers and enable the prompt exercise of remedies. See Red Flags For Lenders...Monitoring the Borrowing Certificate, by Marcie B. Trump, AbfJournal at 45 (Sept. 2005).

• Evaluate the customer's reliance on labor and technology. Labor shortages in medical facilities, including nurses and doctors, are expected to continue, as will their escalating cost. The Healthcare Study states (on page 2) that "[t]he critical element in improving productivity of the healthcare industry and reducing its cost growth is capital investment in productivity improving technology that will substitute for labor." Therefore, lessors and lenders should focus on whether the prospective lessee or borrower properly balances its reliance on labor and technology during the lease or loan term to enable it to achieve required productivity and projected profitability.

Technology acquisitions and financing will be essential to support massive growth in the healthcare industry. Lessors and lenders should experience robust growth in financing healthcare assets and businesses over the next decade. However, they must strike a balance between risk management and new financings as healthcare investment entails significant risk. Even with the attendant risk, future leasing and lending should produce healthy transaction volume and returns.

2. Will Captive Finance Companies Use Five Winning Strategies in 2006?

Captive finance companies can facilitate and increase sales and profits of their parent companies. They can promote the parent's products and services and create the opportunity for recurring income in global operations in addition to product sales revenue. Captive finance companies, like any other leasing or financing company, encounter challenges that require sound management. For some captive finance companies, positive earnings follow naturally from their independence from, their smooth interaction with, and accountability to, their parent companies. Yet, many existing or new captive finance companies may wish to consider a few strategies that could improve their development or results in 2006.

*Term to Know: A captive finance company is a subsidiary or division (Captive) of a specific dealer, vendor, or manufacturer. The purpose of the Captive is to provide financing or leasing to customers acquiring the products or services of the parent company, including the parent's software rights and hardware.

Mixed Results of Captive and Customer Financing

According to the 2005 State of the Industry Report, released in October by the Equipment Leasing & Finance Foundation, Captives provide a substantial amount of leasing support to their parent companies and produce significant transaction volume as a percentage of the entire annual leasing market in the United States. The State of the Industry Report indicates that Captives have experienced an 11.3 percent growth rate in 2005. Investment banking analysts have noted the importance and controversial nature of customer financing through Captives. See What Goes Around - Customer financing seemed like a smart move when times were good. Now, it's wreaking havoc on corporate balance sheets, by Ronald Fink, CFO Magazine (March 1, 2003). The technology industry incurred huge losses from financing its customers when the Internet bubble exploded in 2000. Yet, when manufacturing and other sales businesses profit, Captives can also prosper and vice versa.

Five Winning Strategies

To optimize their value and success in 2006, Captives and their parent companies may wish to implement or improve upon these five basic strategies:

1.   1.  Manage balance sheet assets and debt. Captives can lease or finance their parent's products and services "on book" (that is, using the parent's funds and balance sheets) or by using third-party vendor financing relationships (such as disclosed or private label vendor programs with banks). Captives should use an appropriate mix of the two resources to avoid placing too large a drag on earnings of the consolidated group due to slow recognition of revenue and debt costs. Captives should consider using both operating leases and sale-type leases to develop the optimal earnings pattern. Operating leases produce back-end earnings as the cost to carry the asset and depreciation decline over the lease term. However, rental income is straight-line. A sales-type lease will create gross profit on the sale plus finance income at a constant rate. See Optimizing Captive Finance Activities...To Finance Sales or Not to Finance Sales That is the Question, by Bill Bosco, Principal of Leasing 101, Monitor at 37 (Oct. 2005).

2.  Set and hold to target returns for transactions. Because the dominant purpose of most Captives is to facilitate sales of products and services of the parent company, the management may, to close a transaction, accept sub-market returns or yields with inadequate spreads based on the Captive's cost of capital. Captives should resist such tendencies except for compelling reasons, such as landing a new, significant customer or breaking up the dominance of another manufacturer or lessor over a particular customer's account. Low returns make deals difficult to syndicate or market, and provide the Captive (and its parent) little or no cushion for troubled credits.

3.  Develop a comprehensive back office process. To handle the complexities of operations, Captives should manage tax, accounting, and other reporting responsibilities with a full appreciation for how their operations differ from that of their parent companies. Parents may understandably require their Captives to rely on the parents’ existing personnel to handle the financing or other Captive functions. However, parent companies and Captives should exercise caution in using existing resources from the parent’s business unless the personnel have direct experience and/or proper training to handle the Captive's functions. For example, income tax, property tax, sales or use tax, and related indemnity issues (as well as the lease accounting, tax, state lender's licensing, and reporting issues) will likely require additional knowledge from the parent’s operations. Captives should find, hire, and/or retain knowledgeable personnel to make their back office operations useful, efficient, and effective.

4.  Approve transactions selectively. Captives encounter pressure to finance products or services for every customer of the parent to increase sales. The pressure is understandable given the charter of the Captive. However, Captives should resist the temptation or pressure from the parent to finance unacceptable credits and consider a rule of thumb that they should not finance any transaction that the Captive cannot sell at a profit in a syndication, securitization, one-off sale, or leveraging of rents or debt service. A captive should act like standalone finance or leasing company with a mission of contributing profits to the parent.

5.  Create a separate legal entity or operation. Whenever feasible, the Captive should have operational and/or legal separation from the parent company and maintain updated legal documents in its name at all times. By using a separate legal entity, the parent company promotes management accountability, clarifies bottom line metrics, and establishes useful legal protections at the Captive. A notable legal protection arises under Article 2A of the Uniform Commercial Code when leases by the Captive receive "finance lease" treatment (that is, get the "hell or high water" lease benefit), whereas the division or manufacturer cannot. See BLN Case & Comment: Affiliate to Vendor Gets Finance Lease Protection in Sony Financial Case, by David G. Mayer, Business Leasing News (July 2005). The separate entity requires the management structure of the Captive to perform transparently and separately. It must satisfy targeted metrics just like any other similar finance or leasing company in today's markets.

Captives can provide benefits to the parent companies on a worldwide basis. While their use may be controversial and involve complex issues, when they operate in an optimal manner, their profits can contribute substantial value to the parent company. History has shown that to be true. In 2006, the prospects look bright for Captives to continue to grow and facilitate the parent company's goals of increasing sales and profits, as well as to offer significant value as a separate but related enterprise. The five winning strategies should help Captives realize this success.

3. Texas Voters Defeat Constitutional Amendment to Ease Its Usury Laws

The State of Texas cannot decide whether it is a business-friendly state. Despite having no organized opposition, favorable editorials, and supportive endorsements from every major Texas newspaper, Texas voters still rejected "Proposition 5" last month to ease usury laws for certain commercial lending transactions in Texas. But all is not lost by this vote.

Preceding the vote, the 79^th Texas Legislature passed omnibus legislation that affected nearly every aspect of state-regulated financial practices. Amending no less than 27 chapters of the Texas Finance Code, House Bill 955 ("HB 955") made several significant changes to rules governing consumer and commercial lending, including usury rates. See Texas Legislature Takes Step Toward Business-Friendly Usury Law, by Rafael Anchia, Business Leasing News (Sept. 2005).

While most of HB 955's provisions became effective as of September 1, 2005, the commercial lending rules involving usury required amendments to the Texas Constitution. Proposition 5 had been placed on the November 8, 2005 statewide ballot to allow the Legislature to exempt certain commercial transactions from state usury caps. Because Proposition 5 failed, the commercial loan usury reforms in HB 955 are rendered null and void.

Even though Proposition 5 failed, certain usury reforms in HB 955 do remain in effect. HB 955 will:

• Limit the application of usury rules regarding closing and amendment costs. It states that creditors are authorized to charge "all reasonable expenses and fees incurred in connection with making, closing, disbursing, extending, readjusting or renewing a loan not secured by real property, whether or not those expenses or fees are paid to third parties." Section 2.03 of H.B. 955, adding a new Section 303.017 to the Finance Code.

• Clarify that prepayment premiums, make-whole premiums or other similar charges are not "interest" for usury calculations. Section 2.12 of H.B. 955, amending Section 306.005 to the Finance Code.

• Declare that a commercial obligor's assumption, payment, or guaranty of another person's obligations does not constitute "interest" to the obligor. This provision was a response to the Texas Supreme Court's opinion in Alamo Lumber Co. v. Gold, 661 S.W. 2d 926, 928 (Tex. 1983), where the court held that a bank can be liable for usury when, as a condition of making a loan, assumption of third party debt is required because the third party debt must be treated as interest. Section 2.14 of H.B. 955, adding a new Section 306.007 to the Finance Code.

• Provide creditors a 60-day cure period after actually discovering a usury violation. This cure includes correcting the violation by taking any necessary action and making any necessary adjustment, including the payment of interest on a refund. For example, if a debtor counterclaims alleging usury by the creditor, the lawsuit may be stayed or abated for 60 days while the creditor cures the alleged usury violation. A violation is "actually discovered" at the time of the discovery of the violation in fact and not at the time when an ordinarily prudent person, through reasonable diligence, could or should have discovered or known of the violation. Tex. Fin. Code Ann. §305.103(b) (Supp. 2005).

*Warning: The Texas usury laws retain much of their complexity. Consult Texas counsel about how the laws apply to your transactions. True leases should not be subject to the law, but you should continue to analyze any financing lease or other loan carefully for compliance with usury limits. Proper drafting of provisions can help protect your business arrangements. Obviously usurious interest may be incurable.

Putting a positive spin on the changes to the Texas usury law, business parties did gain some certainty about the meaning of "interest" and rights to cure mistakes under Texas usury laws. However, a popular vote approving an unregulated regime on business loans, an approach consistent with almost every other state in the Union, will have to wait until another day in Texas.

Thanks to Rafael Anchia for contributing this article. Rafael serves as the Texas State Representative for District 103. He is a member of the Corporate Finance, Public Finance, and Public Policy and Lobbying practice groups at Patton Boggs LLP in the firm's Dallas office.

4. Leasing 101: What Is a "Representation" in a Lease or Other Agreement?

5. Case & Comment: Term Sheet Alone Binds Lessee in Fairbrook Leasing, Inc. v. Mesaba Aviation, Inc.

Term sheets may mean more than you think. The parties in Fairbrook Leasing, Inc. v. Mesaba Aviation, Inc., 408 F. 3d 460 (8th Cir. 2005), found out how enforceable a deal could be even before they entered into definitive lease documents.

BACKGROUND: Fairbrook Leasing, Inc. (FLI), Lambert Leasing, Inc., and Swedish Aircraft Holdings AR (collectively, the Lessors) brought a declaratory judgment action against Mesaba Aviation, Inc. (Mesaba). Mesaba is a regional airline, which then operated as a Northwest Airlink affiliate under code-sharing agreements with Northwest Airlines, Inc. ("Northwest"). FLI proposed to sublease twenty (20) 340A Saab Aircraft to Mesaba, and described the transaction in a March 7, 1996 Term Sheet Proposal (Term Sheet).

The Lessors sought a court declaration that the Term Sheet constituted a binding contract that required Mesaba to execute long-term aircraft leases of 72 to 96 months in duration. Before the leases were negotiated, Saab stopped manufacturing the 340A aircraft covered by the Term Sheet, making the aircraft less desirable and valuable. The Term Sheet contained provisions relating to advance rent payments, lease term, delivery schedule, conditions precedent (including board and Northwest approvals), and rights of Mesaba to assign certain rights to Northwest in the event the code-sharing agreement was not renewed before March 31, 1997. Mesaba and FLI continued negotiations for the long-term leases, but Mesaba accepted delivery of the aircraft under two to three-month leases. After continually renewing the short-term leases over five years, Mesaba sought to return the aircraft.

FLI argued and won a judgment that the Term Sheet constituted a binding contract under New York law, and, accordingly, Mesaba should be forced to lease the aircraft for the long lease terms of 72 to 96 months. Mesaba appealed this judgment on several issues including the one discussed here.

ISSUE: Was the Term Sheet binding on the lessee, Mesaba, requiring it to enter into the 72 to 96 month leases?

OUTCOME/DECISION: Yes. The Appellate Court affirmed the lower court judgment in favor of the Lessors. The negotiations surrounding the Term Sheet and the parties' conduct, which evidenced their intent, indicated that the parties meant to comply with the Term Sheet under New York law, including the provisions to lease the aircraft for 72 to 96 months.

*Tip: The issue raised by this case is not limited to leases. The parties to any transaction evidenced by a term sheet, proposal, or commitment can encounter this issue and outcome if counsel and business people do not craft those documents carefully and the parties do not act consistently with the terms of the deal. Term sheets should include appropriate language regarding the provisions intended to have no binding effect and other provisions the parties intend to be binding, such as sharing expenses. The parties should avoid performing any part of the terms before the completion of definitive documents.

LAW OF CASE: The Appellate Court quoted the lower court statement of New York law:

New York law recognizes two types of binding preliminary agreements. The first, ("Type I"), arises when the parties agree on "all the points that require negotiation" and is preliminary only as to form. The parties have the right to demand performance of the transaction. The second, ("Type II"), establishes a framework for agreement, and binds the parties to negotiate in good faith within that framework. The parties are free to walk away once they have made a good faith effort to close the deal and have not insisted on conditions that do not conform to the preliminary writing.

The intent of the parties determines whether they are bound and to what extent. The Appellate Court considered the intent of the parties in this transaction to be bound. It considered a Type I agreement under New York law, set out in items (1) through (4) below, and a Type II agreement, which includes all five items set out below, as follows:

(1)  Language of Term Sheet. The length, detail, formality, and completeness defined the parties' obligations and did not constitute a mere invitation for them to continue to negotiate. The parties also signed the last page of a form of lease attached to the Term Sheet as well as each of the ten pages of the Term Sheet.

(2)  Existence of open terms. The absence of terms on maintenance and refurbishment obligations, insurance, manner and location of use, stipulated loss values, and return conditions did not preclude the formation of a binding agreement. Despite continuing negotiations for the long-term lease, the Appellate Court found that the essential terms, including rent and commitment to obtain the aircraft, sufficed to create a binding arrangement.

(3)  Partial performance. For nearly six years, the parties complied with the Term Sheet, indicating their intent to perform its detailed terms.

(4)  Written agreement typical. The size of the transaction, the nature of the assets being leased, and the length of the contemplated leases warranted a writing to evidence a formal contract. The Term Sheet outlined the terms, but did not suffice as a definitive agreement. This point favored Mesaba's argument against the formation of long-term obligations.

(5)  Context of the negotiations. Despite the lack of definitive agreements under point (4) above, the Term Sheet recorded agreement on the major terms of the lease: the identity of the lessor and lessee, the number of planes, the rent for each, the configuration of each plane, the delivery schedule, and the lease term. The parties performed the major terms of their agreement as they continued to negotiate the minor terms.

In reaching conclusions on the issue, the Appellate Court may have decided that the lessee, Mesaba, was not acting in good faith to close the long term leases. Rather, it was attempting to end-run its obligations under a substantially completed arrangement. The Appellate Court found that the Term Sheet "represented a binding preliminary commitment and obligated both sides to seek to conclude a final [agreement] upon the agreed terms by negotiating in good faith to resolve such additional terms as are customary in such agreements." In its brief requesting oral argument, Mesaba argued vigorously, but unsuccessfully, against any completed agreement.

*Comment: It is disturbing that a term sheet alone bound parties when a final lease had not been negotiated. The Appellate Court treated important terms such as return condition of the equipment as immaterial, apparently to prevent the lessee from manipulating the lease terms in bad faith to suit its equipment needs and avoid what the court perceived to be the intended transaction. Mesaba arguably acted in bad faith by trying to avoid a long-term lease of what it considered to be an undesirable aircraft. The court apparently saw this behavior and decided that the lessee's actions spoke far louder than the words and stuck the lessee with the real deal. In other words, it would not let the lessee renew short-term, two–to-three-month leases and return the aircraft after five years instead of performing the intended long-term, 72 to 96 month leases. Acting in bad faith is a lousy idea in any deal, and bad faith may have produced bad law on the facts in this case.

6. About Patton Boggs LLP and Our Law Practice; Publications

7. A Message from the Founder, David G. Mayer

All the best,

David

David G. Mayer
Founder
Business Leasing News
Patton Boggs LLP
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