A New Reality for Lessors in Synthetic Leasing Transactions

Often, the lessor entity in a synthetic lease was a grantor trust, created specifically for the transaction and intended to serve no purpose other than as owner of the leased asset. This trust may have been established by a trust company or financial institution, receiving a fee for its services, but with little or no interest or risk in the underlying transaction. Interaction with this lessor is typically limited to choosing a name for the entity, agreeing to broadly indemnify it for its involvement, reimbursing out-of-pocket costs and paying fees for the specific services provided. This lessor would certainly have no interest in the accounting aspects of the transaction, and the lessee would likewise care to know little more about the lessor than its name and schedule of fees.

Even if the lessor in a synthetic lease transaction was actually a pre-existing, substantive entity with varied operations, the lessee's due diligence, if any, focused on its financial viability, and then solely out of a concern that a bankruptcy of the lessor would put the lessee's control of the leased asset at risk. The lessee did not inquire into specific items in the lessor's portfolio, and any such attempt to obtain details of this nature would certainly have been rebuffed.

In sum, pre-FIN 46, the lessor's role was merely to provide a convenient ownership vehicle for the leased asset. It was necessary to the structure, but rarely given much notice by lessees, who readily accepted whatever choice was proffered by the transaction's arranger.

VIE Lessor Must Be Consolidated

With the release of FIN 46, the formerly overlooked lessor has become a critical piece of the synthetic leasing transaction puzzle. FIN 46 requires that the assets of any lessor that is determined to be a variable interest entity (“VIE”) be consolidated by any other entity with a majority of the variable interests in those assets. Of course, if the lessee is the party who must consolidate the lessor, this results in the leased property appearing on the lessee's balance sheet, thus nullifying the off-balance-sheet treatment of the lease that may have been a goal for the transaction. Therefore, it is imperative that a lessee desirous of keeping the leased asset off its balance sheet either use a lessor that is clearly not a VIE or use a lessor that is a VIE but, even so, is not required to be consolidated. In this second case, the lessor must prove that it has other assets with a fair value greater than the fair value of the assets leased to the lessee and has limited its use of nonrecourse financing to avoid becoming subject to rules regarding “silos.”

Just deciding to use a non-VIE lessor is easier said than done, however. The only entities about which there is clear agreement that they are non-VIEs are perhaps banks themselves. With respect to U.S. banks (and likely foreign banks), this is not particularly helpful, as banking regulations prohibit the ownership of the real estate that is often the subject of a synthetic lease. Even a leasing company affiliated with a bank must be separately scrutinized as a VIE.

The alternative is to use what has been termed a “diffused VIE” — a VIE where no one entity has a variable interest greater than 50%. This is likely a multi-asset leasing company with no single lease representing more than 50% of its assets and a portfolio of lease structures that are not silos. While not defined precisely in the accounting literature, it appears that a silo results only if nonrecourse debt equal to 95% or more of the asset is used to fund the lease.

Lessee Due Diligence

Because consolidation and loss of off-balance-sheet treatment now turn on the nature of the lessor, it is not surprising that lessees and their auditors will now undertake rather extensive due diligence efforts with respect to the lessor. Rather than wait until a deal is on the line, lessors are studying themselves and preparing the information that will be requested in advance. In many cases, lessors have issued letters, which can be provided to the lessee's auditors, that outline key aspects of the lessor's books, including the following:

• amount of equity investment at risk and its form,
• the identity of the equity investor(s),
• the characteristics of the equity investors(s) (their ability to make decisions about the lessor's activities, their obligation to absorb expected losses and their right to receive all residual returns) showing a controlling financial interest,
• whether the lessor is consolidated by another entity and the identity of that entity,
• actual loss history and a statement of expected losses, and
• a description of the business.

Lessors may conclude that they are not a VIE, or they may provide additional information to support a determination that, even if the lessor is a VIE, consolidation is not warranted. This additional information may include a statement that the lessee's transaction does not represent more than 50% of the lessor's assets and is not by itself a silo, with accompanying detail of the lessor's activities, size and mix of its portfolio, equity investment and use of nonrecourse debt.

Obviously, some of this information is sensitive in a competitive environment and not available publicly. Where a relationship already exits between the lessor and lessee, a confidentiality arrangement may be in place. Where such an agreement is not in effect, or only anticipates receipt of confidential information from the lessee, the parties may wish to craft a new agreement that also permits sharing of the information with the accountants, so long as they also agree to maintain its confidentiality.

Added Representations and Covenants

Documentation for the ultimate transaction is changing under FIN 46. Lessees and lessors must cooperate on an ongoing basis to remain in compliance with FIN 46's guidance, and this introduces a new tension into the relationship. Even though a lessee will conduct the due diligence described above, it may still look to the lessor (and possibly the transaction's arranger) to warrant the desired accounting treatment. The transaction is unlikely to have been priced to accept such a shifting of responsibility, and the lessor will be equally insistent that the lessee expressly agree that it, and not the lessor, bears responsibility for evaluating the transaction and reporting it in accordance with all applicable accounting guidance.

Rather than an overall warranty, the lessee may more appropriately expect the lessor to provide representations as to those facts that the lessee requires to determine how to properly account for the transaction. Counsel to the lessor must carefully review the requested representations to ensure that its client will represent facts and not accounting conclusions. For example, a lessor may not wish to specifically represent that it is not a VIE, but it is reasonable to request that it represent specific facts that will allow the lessee to determine that consolidation is not required. Therefore, the representation would indicate that the fair market value of the leased property does not exceed half of the fair value of all of the lessor's assets, and no more than 95% of the fair value of the leased asset is financed through nonrecourse debt or targeted equity. Because of the uncertain definition of the term “silo,” any representation should not use that term alone, but limit itself to the readily ascertainable facts necessary to support a conclusion drawn by the lessee.

To address ongoing compliance with FIN 46, the lessee will want to demand covenants, or promises, by the lessor to take or refrain from taking certain actions that bear on the accounting treatment for the transaction. In particular, the lessee will want the right to inspect the books and records of the lessor with its accounting advisers, to restrict lessor transfers of the lease or leased asset, and to force a lessor transfer or restructure if the original lessor cannot continue to provide off-balance- sheet treatment for the transaction. These covenants hit on sensitive areas for a lessor and are likely to be heavily negotiated.

But other, more targeted covenants will be less objectionable. For example, to address the concern of treatment as a silo, the lessor may agree on a going-forward basis not to incur nonrecourse debt or targeted equity in excess of 95% of the fair value of the leased asset. The lessor may further agree to provide information sufficient for the lessee to perform its own analysis under the consolidation rules, such information to be provided upon the request of the lessee, not more frequently than certain agreed-upon intervals. The lessor should avoid broad promises to avoid taking any action that may render it a VIE or result in consolidation by the lessee, and the like.

The Bottom Line

Lessors need to take a more active and proactive role in synthetic lease transactions, starting with involvement in structuring the deal. They will have to make themselves and certain portfolio information available to lessees and their auditors so that accounting requirements are dealt with during the structuring phase. It is quite likely that arrangers will have to prove their commitment to working with the lessee and its auditors to structure a synthetic lease within the bounds of FIN 46 in order to win a mandate from among competing proposals. But while lessees will attempt to place responsibility for obtaining and maintaining the desired accounting treatment on the lessor, lenders and lessors alike must be cautious in agreeing to the inclusion of representations, warranties and covenants in transaction documents that would essentially make them a guarantor of the lessee's accounting treatment. To profitably continue offering a synthetic lease alternative, lessors must invest time and money in educating themselves and their customers, and in providing the type of portfolio and financial information that accountants require.

In a discussion of the Financial Accounting Standards Board (FASB) Interpretation No. 46, Consolidation of Variable Interest Entities, in the November 2003 issue of this newsletter, Jeffrey Ellis wrote that: “accountants will be struggling to implement the guidance in FIN 46 for a while longer.” The multiple FASB staff positions issued, ongoing public comment, and lengthy discussions at FASB meetings concerning changes to existing guidance on consolidation of variable interest entities, continuing almost a full year after issuance of the rules, confirm his conclusion. The effective date for certain applications of FIN 46 was delayed until Dec. 31, 2003, but all of the Big Four firms continued to clamor for guidance. With that new deadline only days away, FASB issued FIN 46-R on Dec. 24.

Accountants are not the only party struggling with FIN 46 and its implications. The lessor in synthetic lease transactions has seen its role transformed as a result of the application of FIN 46. Lessees are no longer content to accept without question any entity offered by the arranger, but instead are obligated to conduct significant due diligence with respect to the lessor, its organizational and portfolio structures, and its finances. This article discusses the lessor's changed role and how FIN 46 has introduced a new tension and need for cooperation between the lessor and the lessee in synthetic lease transactions.

The Lessor's Role Pre-FIN 46

Often, the lessor entity in a synthetic lease was a grantor trust, created specifically for the transaction and intended to serve no purpose other than as owner of the leased asset. This trust may have been established by a trust company or financial institution, receiving a fee for its services, but with little or no interest or risk in the underlying transaction. Interaction with this lessor is typically limited to choosing a name for the entity, agreeing to broadly indemnify it for its involvement, reimbursing out-of-pocket costs and paying fees for the specific services provided. This lessor would certainly have no interest in the accounting aspects of the transaction, and the lessee would likewise care to know little more about the lessor than its name and schedule of fees.

Even if the lessor in a synthetic lease transaction was actually a pre-existing, substantive entity with varied operations, the lessee's due diligence, if any, focused on its financial viability, and then solely out of a concern that a bankruptcy of the lessor would put the lessee's control of the leased asset at risk. The lessee did not inquire into specific items in the lessor's portfolio, and any such attempt to obtain details of this nature would certainly have been rebuffed.

In sum, pre-FIN 46, the lessor's role was merely to provide a convenient ownership vehicle for the leased asset. It was necessary to the structure, but rarely given much notice by lessees, who readily accepted whatever choice was proffered by the transaction's arranger.

VIE Lessor Must Be Consolidated

With the release of FIN 46, the formerly overlooked lessor has become a critical piece of the synthetic leasing transaction puzzle. FIN 46 requires that the assets of any lessor that is determined to be a variable interest entity (“VIE”) be consolidated by any other entity with a majority of the variable interests in those assets. Of course, if the lessee is the party who must consolidate the lessor, this results in the leased property appearing on the lessee's balance sheet, thus nullifying the off-balance-sheet treatment of the lease that may have been a goal for the transaction. Therefore, it is imperative that a lessee desirous of keeping the leased asset off its balance sheet either use a lessor that is clearly not a VIE or use a lessor that is a VIE but, even so, is not required to be consolidated. In this second case, the lessor must prove that it has other assets with a fair value greater than the fair value of the assets leased to the lessee and has limited its use of nonrecourse financing to avoid becoming subject to rules regarding “silos.”

Just deciding to use a non-VIE lessor is easier said than done, however. The only entities about which there is clear agreement that they are non-VIEs are perhaps banks themselves. With respect to U.S. banks (and likely foreign banks), this is not particularly helpful, as banking regulations prohibit the ownership of the real estate that is often the subject of a synthetic lease. Even a leasing company affiliated with a bank must be separately scrutinized as a VIE.

The alternative is to use what has been termed a “diffused VIE” — a VIE where no one entity has a variable interest greater than 50%. This is likely a multi-asset leasing company with no single lease representing more than 50% of its assets and a portfolio of lease structures that are not silos. While not defined precisely in the accounting literature, it appears that a silo results only if nonrecourse debt equal to 95% or more of the asset is used to fund the lease.

Lessee Due Diligence

Because consolidation and loss of off-balance-sheet treatment now turn on the nature of the lessor, it is not surprising that lessees and their auditors will now undertake rather extensive due diligence efforts with respect to the lessor. Rather than wait until a deal is on the line, lessors are studying themselves and preparing the information that will be requested in advance. In many cases, lessors have issued letters, which can be provided to the lessee's auditors, that outline key aspects of the lessor's books, including the following:

• amount of equity investment at risk and its form,
• the identity of the equity investor(s),
• the characteristics of the equity investors(s) (their ability to make decisions about the lessor's activities, their obligation to absorb expected losses and their right to receive all residual returns) showing a controlling financial interest,
• whether the lessor is consolidated by another entity and the identity of that entity,
• actual loss history and a statement of expected losses, and
• a description of the business.

Lessors may conclude that they are not a VIE, or they may provide additional information to support a determination that, even if the lessor is a VIE, consolidation is not warranted. This additional information may include a statement that the lessee's transaction does not represent more than 50% of the lessor's assets and is not by itself a silo, with accompanying detail of the lessor's activities, size and mix of its portfolio, equity investment and use of nonrecourse debt.

Obviously, some of this information is sensitive in a competitive environment and not available publicly. Where a relationship already exits between the lessor and lessee, a confidentiality arrangement may be in place. Where such an agreement is not in effect, or only anticipates receipt of confidential information from the lessee, the parties may wish to craft a new agreement that also permits sharing of the information with the accountants, so long as they also agree to maintain its confidentiality.

Added Representations and Covenants

Documentation for the ultimate transaction is changing under FIN 46. Lessees and lessors must cooperate on an ongoing basis to remain in compliance with FIN 46's guidance, and this introduces a new tension into the relationship. Even though a lessee will conduct the due diligence described above, it may still look to the lessor (and possibly the transaction's arranger) to warrant the desired accounting treatment. The transaction is unlikely to have been priced to accept such a shifting of responsibility, and the lessor will be equally insistent that the lessee expressly agree that it, and not the lessor, bears responsibility for evaluating the transaction and reporting it in accordance with all applicable accounting guidance.

Rather than an overall warranty, the lessee may more appropriately expect the lessor to provide representations as to those facts that the lessee requires to determine how to properly account for the transaction. Counsel to the lessor must carefully review the requested representations to ensure that its client will represent facts and not accounting conclusions. For example, a lessor may not wish to specifically represent that it is not a VIE, but it is reasonable to request that it represent specific facts that will allow the lessee to determine that consolidation is not required. Therefore, the representation would indicate that the fair market value of the leased property does not exceed half of the fair value of all of the lessor's assets, and no more than 95% of the fair value of the leased asset is financed through nonrecourse debt or targeted equity. Because of the uncertain definition of the term “silo,” any representation should not use that term alone, but limit itself to the readily ascertainable facts necessary to support a conclusion drawn by the lessee.

To address ongoing compliance with FIN 46, the lessee will want to demand covenants, or promises, by the lessor to take or refrain from taking certain actions that bear on the accounting treatment for the transaction. In particular, the lessee will want the right to inspect the books and records of the lessor with its accounting advisers, to restrict lessor transfers of the lease or leased asset, and to force a lessor transfer or restructure if the original lessor cannot continue to provide off-balance- sheet treatment for the transaction. These covenants hit on sensitive areas for a lessor and are likely to be heavily negotiated.

But other, more targeted covenants will be less objectionable. For example, to address the concern of treatment as a silo, the lessor may agree on a going-forward basis not to incur nonrecourse debt or targeted equity in excess of 95% of the fair value of the leased asset. The lessor may further agree to provide information sufficient for the lessee to perform its own analysis under the consolidation rules, such information to be provided upon the request of the lessee, not more frequently than certain agreed-upon intervals. The lessor should avoid broad promises to avoid taking any action that may render it a VIE or result in consolidation by the lessee, and the like.

The Bottom Line

Lessors need to take a more active and proactive role in synthetic lease transactions, starting with involvement in structuring the deal. They will have to make themselves and certain portfolio information available to lessees and their auditors so that accounting requirements are dealt with during the structuring phase. It is quite likely that arrangers will have to prove their commitment to working with the lessee and its auditors to structure a synthetic lease within the bounds of FIN 46 in order to win a mandate from among competing proposals. But while lessees will attempt to place responsibility for obtaining and maintaining the desired accounting treatment on the lessor, lenders and lessors alike must be cautious in agreeing to the inclusion of representations, warranties and covenants in transaction documents that would essentially make them a guarantor of the lessee's accounting treatment. To profitably continue offering a synthetic lease alternative, lessors must invest time and money in educating themselves and their customers, and in providing the type of portfolio and financial information that accountants require.