Reforming Characteristics of Maintenance Deposits to Avoid Treatment as Cash Collateral

All of this changes, however, when a lessee files a petition for relief under the U.S. Bankruptcy Code (11 U.S.C. '301, et seq.). From the filing of the petition for relief the escrowed cash reserves are viewed as property of the debtor-lessee, and as such qualify as cash collateral pursuant to the Bankruptcy Code (11 U.S.C. '363 (a)). Accordingly, the cash standing to the credit of the maintenance reserve account or rent payment security account would not be available to the lessor without a new consent of the lessee, or by court order after notice and a hearing (11 U.S.C. '363(d)). The Bankruptcy Court has the power to authorize the use of cash collateral, as property of the debtor's estate, for fuel or wages or other normal operating expenses, notwithstanding the fact that the collateral may have been pledged to an aircraft financier, and notwithstanding that it may be used not necessarily for the improvement or maintenance of the aircraft. And there lies the rub.

Question

Clearly then an important question appears. Is it possible, in this legal context, to disconnect cash otherwise thought of as maintenance reserves from the rules of cash collateral, in Section 363 of the Bankruptcy Code, in order to protect lessors and other financers of equipment vis a vis circumstances where insolvency of the relevant lessee might be likely? Or put another way, how does one uncouple the payment of cash and its application to the maintenance work for which it is intended, in such a way so as to make the cash incapable of being defined as cash collateral?

Rent Versus Reserves

The payment of rent for the use of the equipment is treated differently under the Bankruptcy Code than the payment of maintenance reserves. Among other things, it's not cash collateral. Accordingly, one might reform the payment of maintenance reserves by requiring that they be paid in all circumstances, and not by the hour. If the lessor is obliged to pay a certain proportion of maintenance work expense when the same becomes due, as part of the consideration under the lease, then the risk of the reserves being treated as cash collateral may be obviated. The funds would not need to be held in escrow by the lessor when paid by the lessee, and could be applied as the lessor and its financiers deem appropriate. In other words, gross up the rent and eliminate the concept of maintenance reserves in the lease form. (Of course, if the lessee files a petition for relief and does not assume the lease, the rent could be viewed as use and occupancy and could be subject to adjustment for then current market rates ' up or down.)

Another approach to reforming what is a rent security deposit might be to establish from the outset in the lease a disconnect between the payment of advance rent by the lessee, and its refund (in the form of a success fee) to the lessee upon its satisfactory completion of the lease. This could apply to reform what previously was cash collateral being held by a lessor to secure performance by the lessee of basic rent payment obligations under the lease.

For example, in a conventional leveraged lease transaction, the lessee enters into a lease contract with an equity-investing lessor, who likewise has entered into a loan transaction with a financial institution providing leverage for the equity investment. The financier of the lessor will frequently ask the lessor to assure that the lease provides for maintenance reserves to be paid and applied in such a way that there will always be cash on hand to pay for maintenance items to the extent the airplane has been flown and “used up” some of the useful life of these items. Or perhaps the lessor or its financier wants collateral security for rent. However, there is no requirement for the maintenance reserves concept or the security concept to be perpetuated. There could be, for example, an agreement by the lessee to pay a different kind of rent, say “delivery rent,” to the lessor in consideration for delivering the aircraft in the configuration requested by the lessee, at the commencement of the lease. As between the lessor and the lessee, these funds should be fully earned once paid. The lessor, on the other hand, could take these funds and pledge them as cash collateral or as security to its financiers as part of its underlying financing transaction. By de-linking these items from the concept of the payment of maintenance reserves or security reserves, it may be that the cash collateral rules do not apply. At the time of writing this article, no reported decision was located with a contrary result based on this approach to this fact pattern. Yet, there are some arguments, discussed below, which could be made in an insolvency proceeding of the lessee, to try and recover this cash. As always, the reformation would need to be approached carefully in the drafting by counsel familiar both with the bankruptcy rules, as well as aircraft maintenance and operations.

Unfortunately, reforming the payment of cash to assure a fund for maintenance and rent, without figuring out how to move them back to the payor in the first place, might not be satisfactory to lessees, particularly those lessees which are asked to secure ordinary leasehold performance by pledging a calendar quarter's worth of rent, for example, to the lessor, but which expect to receive these monies back or have them applied at some point toward the leasehold obligation. Here the lessor could agree to pay to the lessee a “performance” or “success” bonus based upon satisfactory completion of all payment obligations under the lease by the lessee. Careful attention to drafting can provide that the payment obligation for the performance bonus is subject to the lessor actually being “in funds” and only from the relevant account, in order to pay the bonus, as well as the bonus being incapable of set-off or recoupment. Naturally, if the lessor removes money from this account, there goes the bonus. This could be a satisfactory way to dramatically eliminate the basic concern of cash deposits being viewed as property of the debtor's estate, security reserves or cash collateral, by creating a success payment based on the lessor's experience under the lease.

Issues

Of course there are bankruptcy law concerns about this sort of approach and how it may be viewed. The payment of delivery rent could be viewed as a fraudulent conveyance (See, e.g., Silagy v. Gideon (In Re: Gabor), 280 B.R. 149, 158 (Bankruptcy, North District of Ohio 2002)), the payment of delivery rent combined with a payment of a performance bonus could conceivably create the application of a constructive trust (See, e.g., Tekinsight.com, Inc. v. Stylesite Marketing, Inc. (In Re: Stylesite Marketing, Inc.) 253 B.R 503.), or there could be a view that delivery rent, as a security deposit, could be re-characterized as such, and brought into the bankruptcy estate under that theory (See, e.g., Pine Lake Apartment Co., 17 B.R. 836).

Turning to each of these in turn, whether or not the delivery rent is a fraudulent conveyance will depend on the bankruptcy court's examination of the entire scope of the transaction and not just one individual aspect of it. Thus, the court could look at all of the consideration flowing both ways between the parties and not just the delivery rent in isolation. Now, although there are no cases directly on point (perhaps standing for the proposition that the rule is so obvious) there are other cases which state that a potentially fraudulent transaction requires the court to examine all of the circumstances surrounding the transaction, Silagy v. Gideon (In Re: Gabor) 280 Bankruptcy Reporter 149, 158 (Bankruptcy, Northern District of Ohio 2002), and to determine whether or not reasonably equivalent value was given and received by the debtor.

The test used to determine reasonably equivalent value in the context of a fraudulent conveyance requires the court to determine the value of what was transferred and compare it with what was received. In this case, it might prove challenging to identify the value of satisfactory delivery in a specific configuration. Then again, with the right facts, it might not be.

In the context of a constructive trust, because of the application of the payment of the performance bonus, as a court stated in a comparative case, “no comparable circumstance suggests that a constructive trust's imposition would be likely.” (See, e.g., Tekinsight.com, Inc. v. Stylesite Marketing, Inc. (In Re: Stylesite Marketing, Inc.) 253 B.R. 503, 508 (Bankr. S.D.N.Y. 2000)). A New York bankruptcy court has laid out the basics of a constructive trust and it is unlikely that one could be found in any of the circumstances being discussed here. (See, Tekinsight.com, Inc. v. Stylesite Marketing Inc. (In Re: Stylesite Marketing, Inc.), 253 Bankruptcy Reporter 503, 508 (Bnkry. Ct. S.D.N.Y. 2000) (stating that the elements of a constructive trust are: 1) a confidential or a fiduciary relationship, 2) a promise, 3) a transfer in reliance on the promise, and 4) unjust enrichment.)) The parties in our hypothetical would be deemed to have entered into a lease contract without any escrowed cash deposits for maintenance or rent, and all moneys paid under the lease are made as transfers without residual rights retained by the transferor, the lessee. The lease will be between sophisticated commercial parties and with an arm's length relationship.

Conclusion

The payment of funds in the form of maintenance or rent reserves paid to the lessor in a complicated equipment financing, where maintenance reserves are necessary to maintain the value of the equipment for the lessor and prospective users, or other reserves are necessary for credit matters, probably would be deemed property of the debtor-lessee, and as such subject to the cash collateral rules found in the Bankruptcy Code. Such a result could be seriously troubling to the lessor's financial expectations. Accordingly, disconnecting the receipt of funds otherwise equal in amount to maintenance reserves or cash security from the application of funds equal to maintenance or security deposits may prove to be an effective approach, when lessees understand clearly the lessor's expectations with respect to these funds. In other words, de-linking the payment obligation of the reserves from the return or application obligation by separating them into unrelated, distinct and justifiable obligations (like delivery rent and a performance bonus), may prove effective in establishing to a U.S. bankruptcy court that the payments are sufficiently independent of one another, so as to defeat the assertion that the cash is property of the estate of the lessee. This is an approach that awaits court treatment and use history. If this theory is sustained in practice, then this would indeed be a careful and imaginative way in which to eliminate one of the customary concerns of domestic leveraged or single investor leasing.

One of the common issues facing businessmen and lawyers in the lease financing of complicated equipment such as aircraft, is how to impose an obligation upon the lessee to pay and segregate funds sufficient to assure aircraft maintenance expenses, while preventing these funds from being treated as property of a debtor and cash collateral within the meaning of Bankruptcy Code Section 363 (11 U.S.C. '363). If a lessee is asked in a written lease agreement to deposit, from time to time, contemplated amounts of cash by which to assure the lessor that certain long-term maintenance obligations will be funded and completed, or that rent will be paid, then there is a risk that these deposits might be treated as cash collateral and property of the estate. This subjects the lessor to the risk that the bargained-for cash set-aside funds, might, in a bankruptcy case context, not be available for the purposes for which they were originally intended. This article addresses a risk avoidance approach to that problem.

Example

In a typical equipment lease for modern, transport category, intercontinental jet aircraft, investors and lessors are keen to assure themselves that funds will be on hand for regularly scheduled maintenance when due, regardless of the identity of the lessee. This is because it is not only intrinsic to the value of the leased equipment, but it is necessary to ensure that these monies are available in order to encourage a new lessee to take on the equipment, and the attendant maintenance expenses, by establishing the availability of funds to pay for that portion of the maintenance cost attributable to prior use by other, earlier lessees, who may nonetheless have used the aircraft, its engines and landing gear. Engines, landing gear, and auxiliary power units are the frequent focal points for maintenance reserves in aircraft leases. Generally speaking, the lessor will look at the regularly accruing interval between maintenance events measured in hours, and will divide the maintenance expense by the hours for a maintenance reserve amount collectable from the lessee per hour of use for each of the engines, the landing gear, the auxiliary power unit, and other major pieces of equipment (eg, if the aircraft has a supplemental structural inspection program, this too might be included in the maintenance reserves). Each month, the lessee is required to account for the use of the equipment and pay the corresponding reserves for these items. The money is deposited into a segregated account that may be pledged to the lessor and/or a financier that has financed the acquisition of the aircraft by the lessor investor. As and when maintenance events occur, funds from the reserve account are withdrawn and made available to the lessee in order to pay some or all of the cost of the relevant item of maintenance. As the aircraft moves from lessee to lessee, so usually does the availability of these funds. Well, this is the theory, anyway.

All of this changes, however, when a lessee files a petition for relief under the U.S. Bankruptcy Code (11 U.S.C. '301, et seq.). From the filing of the petition for relief the escrowed cash reserves are viewed as property of the debtor-lessee, and as such qualify as cash collateral pursuant to the Bankruptcy Code (11 U.S.C. '363 (a)). Accordingly, the cash standing to the credit of the maintenance reserve account or rent payment security account would not be available to the lessor without a new consent of the lessee, or by court order after notice and a hearing (11 U.S.C. '363(d)). The Bankruptcy Court has the power to authorize the use of cash collateral, as property of the debtor's estate, for fuel or wages or other normal operating expenses, notwithstanding the fact that the collateral may have been pledged to an aircraft financier, and notwithstanding that it may be used not necessarily for the improvement or maintenance of the aircraft. And there lies the rub.

Question

Clearly then an important question appears. Is it possible, in this legal context, to disconnect cash otherwise thought of as maintenance reserves from the rules of cash collateral, in Section 363 of the Bankruptcy Code, in order to protect lessors and other financers of equipment vis a vis circumstances where insolvency of the relevant lessee might be likely? Or put another way, how does one uncouple the payment of cash and its application to the maintenance work for which it is intended, in such a way so as to make the cash incapable of being defined as cash collateral?

Rent Versus Reserves

The payment of rent for the use of the equipment is treated differently under the Bankruptcy Code than the payment of maintenance reserves. Among other things, it's not cash collateral. Accordingly, one might reform the payment of maintenance reserves by requiring that they be paid in all circumstances, and not by the hour. If the lessor is obliged to pay a certain proportion of maintenance work expense when the same becomes due, as part of the consideration under the lease, then the risk of the reserves being treated as cash collateral may be obviated. The funds would not need to be held in escrow by the lessor when paid by the lessee, and could be applied as the lessor and its financiers deem appropriate. In other words, gross up the rent and eliminate the concept of maintenance reserves in the lease form. (Of course, if the lessee files a petition for relief and does not assume the lease, the rent could be viewed as use and occupancy and could be subject to adjustment for then current market rates ' up or down.)

Another approach to reforming what is a rent security deposit might be to establish from the outset in the lease a disconnect between the payment of advance rent by the lessee, and its refund (in the form of a success fee) to the lessee upon its satisfactory completion of the lease. This could apply to reform what previously was cash collateral being held by a lessor to secure performance by the lessee of basic rent payment obligations under the lease.

For example, in a conventional leveraged lease transaction, the lessee enters into a lease contract with an equity-investing lessor, who likewise has entered into a loan transaction with a financial institution providing leverage for the equity investment. The financier of the lessor will frequently ask the lessor to assure that the lease provides for maintenance reserves to be paid and applied in such a way that there will always be cash on hand to pay for maintenance items to the extent the airplane has been flown and “used up” some of the useful life of these items. Or perhaps the lessor or its financier wants collateral security for rent. However, there is no requirement for the maintenance reserves concept or the security concept to be perpetuated. There could be, for example, an agreement by the lessee to pay a different kind of rent, say “delivery rent,” to the lessor in consideration for delivering the aircraft in the configuration requested by the lessee, at the commencement of the lease. As between the lessor and the lessee, these funds should be fully earned once paid. The lessor, on the other hand, could take these funds and pledge them as cash collateral or as security to its financiers as part of its underlying financing transaction. By de-linking these items from the concept of the payment of maintenance reserves or security reserves, it may be that the cash collateral rules do not apply. At the time of writing this article, no reported decision was located with a contrary result based on this approach to this fact pattern. Yet, there are some arguments, discussed below, which could be made in an insolvency proceeding of the lessee, to try and recover this cash. As always, the reformation would need to be approached carefully in the drafting by counsel familiar both with the bankruptcy rules, as well as aircraft maintenance and operations.

Unfortunately, reforming the payment of cash to assure a fund for maintenance and rent, without figuring out how to move them back to the payor in the first place, might not be satisfactory to lessees, particularly those lessees which are asked to secure ordinary leasehold performance by pledging a calendar quarter's worth of rent, for example, to the lessor, but which expect to receive these monies back or have them applied at some point toward the leasehold obligation. Here the lessor could agree to pay to the lessee a “performance” or “success” bonus based upon satisfactory completion of all payment obligations under the lease by the lessee. Careful attention to drafting can provide that the payment obligation for the performance bonus is subject to the lessor actually being “in funds” and only from the relevant account, in order to pay the bonus, as well as the bonus being incapable of set-off or recoupment. Naturally, if the lessor removes money from this account, there goes the bonus. This could be a satisfactory way to dramatically eliminate the basic concern of cash deposits being viewed as property of the debtor's estate, security reserves or cash collateral, by creating a success payment based on the lessor's experience under the lease.

Issues

Of course there are bankruptcy law concerns about this sort of approach and how it may be viewed. The payment of delivery rent could be viewed as a fraudulent conveyance (See, e.g., Silagy v. Gideon (In Re: Gabor), 280 B.R. 149, 158 (Bankruptcy, North District of Ohio 2002)), the payment of delivery rent combined with a payment of a performance bonus could conceivably create the application of a constructive trust (See, e.g., Tekinsight.com, Inc. v. Stylesite Marketing, Inc. (In Re: Stylesite Marketing, Inc.) 253 B.R 503.), or there could be a view that delivery rent, as a security deposit, could be re-characterized as such, and brought into the bankruptcy estate under that theory (See, e.g., Pine Lake Apartment Co., 17 B.R. 836).

Turning to each of these in turn, whether or not the delivery rent is a fraudulent conveyance will depend on the bankruptcy court's examination of the entire scope of the transaction and not just one individual aspect of it. Thus, the court could look at all of the consideration flowing both ways between the parties and not just the delivery rent in isolation. Now, although there are no cases directly on point (perhaps standing for the proposition that the rule is so obvious) there are other cases which state that a potentially fraudulent transaction requires the court to examine all of the circumstances surrounding the transaction, Silagy v. Gideon (In Re: Gabor) 280 Bankruptcy Reporter 149, 158 (Bankruptcy, Northern District of Ohio 2002), and to determine whether or not reasonably equivalent value was given and received by the debtor.

The test used to determine reasonably equivalent value in the context of a fraudulent conveyance requires the court to determine the value of what was transferred and compare it with what was received. In this case, it might prove challenging to identify the value of satisfactory delivery in a specific configuration. Then again, with the right facts, it might not be.

In the context of a constructive trust, because of the application of the payment of the performance bonus, as a court stated in a comparative case, “no comparable circumstance suggests that a constructive trust's imposition would be likely.” (See, e.g., Tekinsight.com, Inc. v. Stylesite Marketing, Inc. (In Re: Stylesite Marketing, Inc.) 253 B.R. 503, 508 (Bankr. S.D.N.Y. 2000)). A New York bankruptcy court has laid out the basics of a constructive trust and it is unlikely that one could be found in any of the circumstances being discussed here. (See, Tekinsight.com, Inc. v. Stylesite Marketing Inc. (In Re: Stylesite Marketing, Inc.), 253 Bankruptcy Reporter 503, 508 (Bnkry. Ct. S.D.N.Y. 2000) (stating that the elements of a constructive trust are: 1) a confidential or a fiduciary relationship, 2) a promise, 3) a transfer in reliance on the promise, and 4) unjust enrichment.)) The parties in our hypothetical would be deemed to have entered into a lease contract without any escrowed cash deposits for maintenance or rent, and all moneys paid under the lease are made as transfers without residual rights retained by the transferor, the lessee. The lease will be between sophisticated commercial parties and with an arm's length relationship.

Conclusion

The payment of funds in the form of maintenance or rent reserves paid to the lessor in a complicated equipment financing, where maintenance reserves are necessary to maintain the value of the equipment for the lessor and prospective users, or other reserves are necessary for credit matters, probably would be deemed property of the debtor-lessee, and as such subject to the cash collateral rules found in the Bankruptcy Code. Such a result could be seriously troubling to the lessor's financial expectations. Accordingly, disconnecting the receipt of funds otherwise equal in amount to maintenance reserves or cash security from the application of funds equal to maintenance or security deposits may prove to be an effective approach, when lessees understand clearly the lessor's expectations with respect to these funds. In other words, de-linking the payment obligation of the reserves from the return or application obligation by separating them into unrelated, distinct and justifiable obligations (like delivery rent and a performance bonus), may prove effective in establishing to a U.S. bankruptcy court that the payments are sufficiently independent of one another, so as to defeat the assertion that the cash is property of the estate of the lessee. This is an approach that awaits court treatment and use history. If this theory is sustained in practice, then this would indeed be a careful and imaginative way in which to eliminate one of the customary concerns of domestic leveraged or single investor leasing.