Bond Airport Financed Leases

Landlord/Tenant. During the pendency of a bankruptcy proceeding, a lessor of nonresidential real property is entitled to timely performance of all obligations arising after the commencement of the case until the lease is assumed or rejected. '365(d)(3). If a debtor/tenant wishes to retain use and occupancy of leased premises, the debtor must assume the lease, cure defaults, compensate the landlord for losses resulting from the default, and provide assurance of its ability to perform under the lease in the future. '365(b). However, if the debtor/tenant elects to reject a nonresidential real property lease, the landlord's claim for rejection damages is subject to the statutory cap. '502(b)(6).

Mortgagor/Mortgagee. In contrast, in order to retain use and possession of mortgaged property during the pendency of the bankruptcy proceeding, there is no requirement that the debtor make payments to the mortgagee unless the mortgagee requests, and the court orders, adequate protection payments. '363(e). The facts and circumstances of the particular case are considered by the court in determining whether to require adequate protection payments as well as the measure of adequate protection. There is no predictable, consistent treatment of a mortgagee's secured claim with respect to nonresidential real property during the pendency of a bankruptcy case. Furthermore, a debtor may retain mortgaged property by providing for payments to the mortgagee of the then current value of the mortgaged property; debt that exceeds the value of the mortgaged property is treated as an unsecured claim. See '506(a) and '1129(b)(2)(A). Likewise, the terms of repayment of a secured claim may be modified under a reorganization plan. '1129(b)(2)(A). However, there is no cap on the amount of the claim of a mortgagee.

The “leases” Judge Wedoff held to be disguised financings involve San Francisco International Airport (SFO), Los Angeles International Airport (LAX) and Kennedy International Airport (JFK). The key facts concerning these leases are as follows:

SFO. United is the lessee under a long-term ground lease of property from the city and county of San Francisco. Twenty-four years after execution of the ground lease, there were a series of interrelated agreements whereby United leased a portion of the ground-leased property to the California Statewide Communities Development Authority (CSCDA), a governmental agency authorized to issue bonds. The term of the lease for the period necessary to retire the bonds. CSCDA agreed to pay $1 rent to United; there were no remedial provisions should CSCDA default. CSCDA issued tax-exempt, limited obligation bonds to pay for the construction of airport improvements on the premises and subleased the premises back to United for rental payments structured to pay the bonded indebtedness. The sublease provided that if United failed to make the lease payments, CSCDA had default remedies, including the right to take possession of and relet the leasehold premises. United guaranteed the payments to the bond trustee.

LAX. Shortly after execution of a lease, the following series of interrelated agreements were executed. In consideration of the agreements between the parties, United assigned to the Regional Airports Improvement Corporation (RAIC), a governmental agency authorized to issue bonds, United's rights and interest in the LAX ground lease. RAIC issued bonds to pay for airport improvements on the premises. RAIC leased the premises back to United until repayment or redemption of the bonds. United agreed to pay rent in the amount necessary to pay the bond indebtedness. Upon default by United, RAIC's remedies included eviction of United and reletting of the premises by RAIC. UAL guaranteed the bonds, not the leaseback.

JFK. Within 2 years of execution of a ground lease between United and the Port Authority of New York and New Jersey, the following series of interrelated agreements were executed. United leased to New York City Industrial Development Authority (NYCIDA), a governmental agency authorized to issue bonds, for a period not to extend longer than the maturity date of the bonds. NYCIDA agreed to pay $10 rent to United, without remedial provisions should NYCIDA default. NYCIDA issued tax-exempt, limited obligation bonds to pay for the construction of airport improvements on the premises and subleased the premises back to United for rent payments structured to pay the bonded indebtedness. The sublease provided that if United failed to make the lease payments, NYCIDA had limited default remedies, including the right to terminate United's tenancy, but not to take possession or relet the premises. United guaranteed the payments to the bond trustee.

In contrast, the bankruptcy court held the transaction with the city of Denver for the Denver airport to be a true lease within the meaning of '365 of the Bankruptcy Code. The Denver transaction was structured as follows:

DEN. The city of Denver leased to United real property plus facilities that were purchased and constructed with funds received from the issuances of bonds by the city of Denver. United's rental obligations included “ground rentals” and “facilities rentals,” the latter being payments necessary for debt service on the bonds. Failure to pay either category of rentals constituted a default that permitted termination of United's lease and eviction. United also guaranteed the bond payments.

In determining whether the transaction was a true lease or a disguised financing, the key factor relied upon by the bankruptcy court was whether the sublessor-bond issuing agency bore any of the risks or the benefits of the value of the real estate upon termination of the sublease.

Furthermore, the court considered factors set forth in Hotel Syracuse, Inc. v. City of Syracuse Indus. Dev. Agency (In re Hotel Syracuse, Inc.), 155 B.R. 824, 838 (Bankr. N.D.N.Y. 1993):

Relevant factors for purposes of determining whether a particular transaction constitutes a true lease pursuant to 11 U.S.C.S. '365(d)(4) include: (i) whether the “rental” payments were calculated to compensate the lessor for the use of the land, or rather were structured for some other purpose, such as to ensure a particular return on an investment; (ii) whether the purchase price was related to the fair market value of the land, or whether it was calculated as the amount necessary to finance the transaction; (iii) whether the property was purchased by the lessor specifically for the lessee's use; (iv) whether the transaction was structured as a lease to secure certain tax advantages; and (v) whether the lessee assumed many of the obligations normally associated with outright ownership, including the responsibility for paying property taxes and insurance. Also relevant are lease provisions which permit or require the lessee to purchase the premises for a nominal sum at the end of the lease term. [citation omitted] In re Hotel Syracuse, Inc., supra, at 838.

With the exception of the city of Denver lease, the interest of the bond issuing agencies in the leasehold premises terminated when the final bond payments were made. The following factors were deemed critical by the bankruptcy court: 1) the sublessor/bond issuing agency had no surviving ownership interest in the property at the end of the term; 2) the “rental” payments on the leasebacks were designed to retire indebtedness, not to compensate the lessor for the value of usage of the premises; (theoretically the payments on the bond indebtedness were roughly equivalent to the fair rental value, but the court cited other provisions of the agreements supporting the inference that payment of debt, rather than occupancy value, was the central factor), and (iii) the transactions were the economic equivalent of leasehold mortgages. In effect, United “mortgaged” its leasehold as security for the bond indebtedness.

As noted by the court, the key distinction between the Denver transaction and the others was that the city of Denver was both the ground lessor and the bond issuing entity. The court stated:

Unlike the bond-issuing agencies who were the nominal lessors in the leasebacks, the city of Denver unquestionably occupies a traditional lessor's position under the Denver Lease. It owns the leased property, and at the conclusion of the lease term it will receive the return of the property, with a substantial part of its economic life remaining. The city bears a genuine risk of changes in the property value at the end of the lease term. In re UAL Corporation, 307 B.R. 636.

In holding that the United sublease to, and leaseback from, bond issuing agencies was disguised financing, it was necessary to separate the “finance” portion of the transaction from the underlying ground lease, which was a true lease. LAX argued that the sublease/leaseback was an integral part of the underlying ground lease and that the interrelated transactions should be treated as a single agreement. Applying state law, the bankruptcy court rejected this argument. However, applying Colorado law to the city of Denver transaction, the bankruptcy court held the Denver transaction, including the ground lease and the financing components of the transaction, to be one indivisible agreement.

United appealed the adverse decision with respect to Denver. The parties involved with JFK, LAX and SFO also appealed. Given the amounts involved ' $155 million of bonds at SFO, $59 million at LAX, and $34 million at JFK, appeal to the circuit court was inevitable.

On appeal, it is argued that the bankruptcy court improperly focused on the absence of an economic interest of the bond-issuing lessors in the leasehold estate at the end of the sublease term. Instead, it is argued, the focus should be on whether the lessee, United Air Lines, acquired the risks or benefits of the value of the real estate at the end of the term.

One of the tests commonly used in the context of the sale and leaseback of fee-owned property is whether the lessor “becomes or has the option to become the owner of the leased property for no additional consideration or for nominal consideration [which] indicates that the transaction is a financing lease or lease intended as security.” S. Rep. No. 989, 95th Cong., 22d Sess. 64 (1978), reprinted in 1978 U.S.C.C.A.N. 5850. It is difficult to apply this test to a sublease and leaseback of a leasehold interest as distinguished from an ownership interest because a sublessor, by definition, does not have rights in the property beyond the term of the lease.

While there is pending appellate review of this decision, courts continue to apply these principles to other facts and circumstances. See In re Dena Corp., 312 B.R. 162 (Bankr. N.D.Ill. 2004) where the debtor argued, citing In re UAL Corporation, that a commercial lease executed in connection with the sale by the debtor and leaseback of real property was a disguised financing, not a real lease. Although it acknowledged that “[l]abeling an agreement a 'lease' does not necessarily make it one,” the court concluded that the leaseback was a valid lease, relying upon the following factors: 1) the rental payments were structured to compensate the lessor, 2) the debtor's option to purchase the property for the same price the debtor sold the property at in connection with the leaseback is neither a nominal nor token price suggestive of a disguised financing, 3) a 5-year lease term is relatively short, suggesting the lessor may be purchasing the property for purposes other than the debtor's use, and 4) the debtor's tax returns treated the transaction as a sale and leaseback. Although the debtor bore substantial maintenance, insurance, tax and utility obligations, the lessor's consent was required to make alterations and the lease.

More to come ' at the appellate level and in other courts!

The United Air Lines bankruptcy case has spawned several reported decisions, at the bankruptcy court level, the district court level and the circuit court level.

One key bankruptcy court decision, currently the subject of appeals to the district court for the Northern District of Illinois, is the summary judgment determination that three out of four leases executed in connection with bond-financed airport facilities are “disguised” financing devices and not true leases. In re UAL Corporation, 307 B.R. 618 (Bankr. N.D. Ill. 2004). The decision offers some guidance to practitioners regarding the definition of a “true lease.”

As noted by Bankruptcy Judge Eugene R. Wedoff, there are significant distinctions between the rights of mortgagors and mortgagees, and the rights of lessors and lessees, in the bankruptcy context.

Landlord/Tenant. During the pendency of a bankruptcy proceeding, a lessor of nonresidential real property is entitled to timely performance of all obligations arising after the commencement of the case until the lease is assumed or rejected. '365(d)(3). If a debtor/tenant wishes to retain use and occupancy of leased premises, the debtor must assume the lease, cure defaults, compensate the landlord for losses resulting from the default, and provide assurance of its ability to perform under the lease in the future. '365(b). However, if the debtor/tenant elects to reject a nonresidential real property lease, the landlord's claim for rejection damages is subject to the statutory cap. '502(b)(6).

Mortgagor/Mortgagee. In contrast, in order to retain use and possession of mortgaged property during the pendency of the bankruptcy proceeding, there is no requirement that the debtor make payments to the mortgagee unless the mortgagee requests, and the court orders, adequate protection payments. '363(e). The facts and circumstances of the particular case are considered by the court in determining whether to require adequate protection payments as well as the measure of adequate protection. There is no predictable, consistent treatment of a mortgagee's secured claim with respect to nonresidential real property during the pendency of a bankruptcy case. Furthermore, a debtor may retain mortgaged property by providing for payments to the mortgagee of the then current value of the mortgaged property; debt that exceeds the value of the mortgaged property is treated as an unsecured claim. See '506(a) and '1129(b)(2)(A). Likewise, the terms of repayment of a secured claim may be modified under a reorganization plan. '1129(b)(2)(A). However, there is no cap on the amount of the claim of a mortgagee.

The “leases” Judge Wedoff held to be disguised financings involve San Francisco International Airport (SFO), Los Angeles International Airport (LAX) and Kennedy International Airport (JFK). The key facts concerning these leases are as follows:

SFO. United is the lessee under a long-term ground lease of property from the city and county of San Francisco. Twenty-four years after execution of the ground lease, there were a series of interrelated agreements whereby United leased a portion of the ground-leased property to the California Statewide Communities Development Authority (CSCDA), a governmental agency authorized to issue bonds. The term of the lease for the period necessary to retire the bonds. CSCDA agreed to pay $1 rent to United; there were no remedial provisions should CSCDA default. CSCDA issued tax-exempt, limited obligation bonds to pay for the construction of airport improvements on the premises and subleased the premises back to United for rental payments structured to pay the bonded indebtedness. The sublease provided that if United failed to make the lease payments, CSCDA had default remedies, including the right to take possession of and relet the leasehold premises. United guaranteed the payments to the bond trustee.

LAX. Shortly after execution of a lease, the following series of interrelated agreements were executed. In consideration of the agreements between the parties, United assigned to the Regional Airports Improvement Corporation (RAIC), a governmental agency authorized to issue bonds, United's rights and interest in the LAX ground lease. RAIC issued bonds to pay for airport improvements on the premises. RAIC leased the premises back to United until repayment or redemption of the bonds. United agreed to pay rent in the amount necessary to pay the bond indebtedness. Upon default by United, RAIC's remedies included eviction of United and reletting of the premises by RAIC. UAL guaranteed the bonds, not the leaseback.

JFK. Within 2 years of execution of a ground lease between United and the Port Authority of New York and New Jersey, the following series of interrelated agreements were executed. United leased to New York City Industrial Development Authority (NYCIDA), a governmental agency authorized to issue bonds, for a period not to extend longer than the maturity date of the bonds. NYCIDA agreed to pay $10 rent to United, without remedial provisions should NYCIDA default. NYCIDA issued tax-exempt, limited obligation bonds to pay for the construction of airport improvements on the premises and subleased the premises back to United for rent payments structured to pay the bonded indebtedness. The sublease provided that if United failed to make the lease payments, NYCIDA had limited default remedies, including the right to terminate United's tenancy, but not to take possession or relet the premises. United guaranteed the payments to the bond trustee.

In contrast, the bankruptcy court held the transaction with the city of Denver for the Denver airport to be a true lease within the meaning of '365 of the Bankruptcy Code. The Denver transaction was structured as follows:

DEN. The city of Denver leased to United real property plus facilities that were purchased and constructed with funds received from the issuances of bonds by the city of Denver. United's rental obligations included “ground rentals” and “facilities rentals,” the latter being payments necessary for debt service on the bonds. Failure to pay either category of rentals constituted a default that permitted termination of United's lease and eviction. United also guaranteed the bond payments.

In determining whether the transaction was a true lease or a disguised financing, the key factor relied upon by the bankruptcy court was whether the sublessor-bond issuing agency bore any of the risks or the benefits of the value of the real estate upon termination of the sublease.

Furthermore, the court considered factors set forth in Hotel Syracuse, Inc. v. City of Syracuse Indus. Dev. Agency (In re Hotel Syracuse, Inc.), 155 B.R. 824, 838 (Bankr. N.D.N.Y. 1993):

Relevant factors for purposes of determining whether a particular transaction constitutes a true lease pursuant to 11 U.S.C.S. '365(d)(4) include: (i) whether the “rental” payments were calculated to compensate the lessor for the use of the land, or rather were structured for some other purpose, such as to ensure a particular return on an investment; (ii) whether the purchase price was related to the fair market value of the land, or whether it was calculated as the amount necessary to finance the transaction; (iii) whether the property was purchased by the lessor specifically for the lessee's use; (iv) whether the transaction was structured as a lease to secure certain tax advantages; and (v) whether the lessee assumed many of the obligations normally associated with outright ownership, including the responsibility for paying property taxes and insurance. Also relevant are lease provisions which permit or require the lessee to purchase the premises for a nominal sum at the end of the lease term. [citation omitted] In re Hotel Syracuse, Inc., supra, at 838.

With the exception of the city of Denver lease, the interest of the bond issuing agencies in the leasehold premises terminated when the final bond payments were made. The following factors were deemed critical by the bankruptcy court: 1) the sublessor/bond issuing agency had no surviving ownership interest in the property at the end of the term; 2) the “rental” payments on the leasebacks were designed to retire indebtedness, not to compensate the lessor for the value of usage of the premises; (theoretically the payments on the bond indebtedness were roughly equivalent to the fair rental value, but the court cited other provisions of the agreements supporting the inference that payment of debt, rather than occupancy value, was the central factor), and (iii) the transactions were the economic equivalent of leasehold mortgages. In effect, United “mortgaged” its leasehold as security for the bond indebtedness.

As noted by the court, the key distinction between the Denver transaction and the others was that the city of Denver was both the ground lessor and the bond issuing entity. The court stated:

Unlike the bond-issuing agencies who were the nominal lessors in the leasebacks, the city of Denver unquestionably occupies a traditional lessor's position under the Denver Lease. It owns the leased property, and at the conclusion of the lease term it will receive the return of the property, with a substantial part of its economic life remaining. The city bears a genuine risk of changes in the property value at the end of the lease term. In re UAL Corporation, 307 B.R. 636.

In holding that the United sublease to, and leaseback from, bond issuing agencies was disguised financing, it was necessary to separate the “finance” portion of the transaction from the underlying ground lease, which was a true lease. LAX argued that the sublease/leaseback was an integral part of the underlying ground lease and that the interrelated transactions should be treated as a single agreement. Applying state law, the bankruptcy court rejected this argument. However, applying Colorado law to the city of Denver transaction, the bankruptcy court held the Denver transaction, including the ground lease and the financing components of the transaction, to be one indivisible agreement.

United appealed the adverse decision with respect to Denver. The parties involved with JFK, LAX and SFO also appealed. Given the amounts involved ' $155 million of bonds at SFO, $59 million at LAX, and $34 million at JFK, appeal to the circuit court was inevitable.

On appeal, it is argued that the bankruptcy court improperly focused on the absence of an economic interest of the bond-issuing lessors in the leasehold estate at the end of the sublease term. Instead, it is argued, the focus should be on whether the lessee, United Air Lines, acquired the risks or benefits of the value of the real estate at the end of the term.

One of the tests commonly used in the context of the sale and leaseback of fee-owned property is whether the lessor “becomes or has the option to become the owner of the leased property for no additional consideration or for nominal consideration [which] indicates that the transaction is a financing lease or lease intended as security.” S. Rep. No. 989, 95th Cong., 22d Sess. 64 (1978), reprinted in 1978 U.S.C.C.A.N. 5850. It is difficult to apply this test to a sublease and leaseback of a leasehold interest as distinguished from an ownership interest because a sublessor, by definition, does not have rights in the property beyond the term of the lease.

While there is pending appellate review of this decision, courts continue to apply these principles to other facts and circumstances. See In re Dena Corp., 312 B.R. 162 (Bankr. N.D.Ill. 2004) where the debtor argued, citing In re UAL Corporation, that a commercial lease executed in connection with the sale by the debtor and leaseback of real property was a disguised financing, not a real lease. Although it acknowledged that “[l]abeling an agreement a 'lease' does not necessarily make it one,” the court concluded that the leaseback was a valid lease, relying upon the following factors: 1) the rental payments were structured to compensate the lessor, 2) the debtor's option to purchase the property for the same price the debtor sold the property at in connection with the leaseback is neither a nominal nor token price suggestive of a disguised financing, 3) a 5-year lease term is relatively short, suggesting the lessor may be purchasing the property for purposes other than the debtor's use, and 4) the debtor's tax returns treated the transaction as a sale and leaseback. Although the debtor bore substantial maintenance, insurance, tax and utility obligations, the lessor's consent was required to make alterations and the lease.

More to come ' at the appellate level and in other courts!