Today's Approach to Distressed Situations: A Lessor's Guide

What Kind of Lease?

The position of an equipment lessor in a Chapter 11 is devastatingly simple. The debtor may decline to pay rent for 60 days; provided, however, that thereafter, the debtor is required to commence making payments as a condition to its continued use of such equipment. Specifically, the debtor may either assume the lease, curing all defaults as a precondition to doing so, or reject it, leaving the lessor with its equipment and an unsecured claim for damages. The equipment lessor isn't exposed to preference liability unless he has received more than three monthly rents in the 90 days preceding the filing because a month's possession and use is fair value exchanged for a month's rent and because the payments are surely payments in the ordinary course.

In the presence of this simple legal position, the restructuring executive will be motivated to negotiate only because he knows that the lease is 'above market' or because the leased equipment is 'useful but not essential' and that rejection in a subsequent bankruptcy is likely a worse result than amending lease terms to suit the customer, or more likely, to induce the buyer of the customer's business to assume a modified lease rather than returning the leased equipment.

But, of course, it is rarely so simple. Only a very small percentage of equipment lessors go long on residuals, and most leases pay down to a relatively 'nominal' residual or contain other devices to hedge the equipment lessor's residual bet, e.g., TRAC provisions, fixed price options, lessor friendly return conditions, etc. At the same time, the marketplace has dictated a variety of other lease products and special terms, such as early termination, midstream buyouts, etc.

All of these contrive to give rise to that favorite ploy of the debtor's bar ' to re-characterize the lease as a disguised secured financing with evil consequences for the equipment lessor. Once re-characterized, the leverage of take or leave it imposed by the assumption/rejection decision is gone and a debtor is free once again to try to 'cram down' the equipment lessor's claim to a low number based on liquidation value. Similarly, the equipment lessor is then exposed to receiving less than full rent post-petition based on notions of adequate protection payments being equal only to the provable depreciation of the collateral, as well as to the risk that those last three pre-petition payments will be avoidable as preferential transfers in payment of an undersecured debt, although the 'ordinary course' defense might still be available. Worse yet, if a lease is re-characterized and the lessor hasn't properly perfected its interest, the collateral will be lost in a bankruptcy.

The quantity, if not the quality, of jurisprudence on the re-characterization issue is truly breathtaking, and any leasing executive can order up from his lawyers meticulous 50-page analyses which, at least in the context of an amorphous threat in restructuring negotiations, generally doesn't give the restructuring executive much more guidance than his own application of some simple principles to the terms of the lease he is restructuring and attendant bankruptcy risks.

The equipment lessor will be at risk of having its lease re-characterized with the attendant negative consequences if, as one court put it most succinctly:

A lease in which the consumption component dominates often is called a 'true lease,' while one in which the asset serves as security for an extension of credit is treated as a security agreement governed by the UCC's Article 9. United Airlines, Inc. v. HSBC Bank USA N.A., 416 F.3d 609 (7th Cir. 2005).

To that simple and overriding principle are added laundry lists of nuances and fine legal argument, but 90% of the re-characterization risk can be analyzed by simply taking a look at the level of genuine residual risk the equipment lessor took at the inception of the deal, to put the court's 'consumption component' phrase into words more familiar to the leasing industry.

This simple analysis, on a business/economic level, will lead to one of three conclusions:

1) The lease is a true lease. The pre-bankruptcy restructuring will be negotiated and agreed to for economic reasons to maximize recovery. The only bankruptcy risk is rejection of the lease and return of the equipment.

2) The lease is a disguised secured financing. The pre-bankruptcy economic analysis pro and con restructuring must be overlaid with legal risks:

• of a 'cram down';
• of potential preference risk for recovery of payments;
• of a months-or years-long period of book delinquency if adequate
  protection payments don't equal the stated rentals;
• of a loss of leverage in the negotiations since the equipment lessor no longer has the powerful tool of insisting on assumption or else; or
• of a complete loss of collateral if there is no perfection.

3) The lease is only arguably a disguised secured financing. Some of the risk in point two is reduced. Conversely, the equipment lessor may face significant legal expense which will be recoverable only if it is victorious and the legal expense is reimbursable as part of the required cure of defaults on assumption.

Armed with this information, the restructuring executive is in a solid position to guide his negotiations. Assuming there is some re-characterization risk, the equipment lessor should also be mindful of a second point often overlooked or misunderstood.

What's All This About Cram Down?

Even when the lease might not be a true lease, all is not lost.

Had we but a nickel for every time the customer's turnaround professional or insolvency lawyer announces that we had best agree to a big loss right now because it will be bigger still if they 'cram us down.' Sometimes, these threats are supported by truly ugly auction value or OLV appraisals, especially when the equipment lessor has provided not only the manufacturing line but also the installation, the cabling in the wall, and the custom-designed support software. While it is true that a secured claimant is entitled only to the value of collateral in bankruptcy, with any balance of debt over value to become an unsecured claim, debtors most often ignore a simple legal principle: Valuation of collateral must be done in the same context and to the same standard as the transaction before the bankruptcy court. See, e.g., In re: Colfor, Inc., 1996 Bankr. Lexis 1397.

This means that if the debtor is reorganizing as a 'going concern' then the valuation standard is 'going concern, in place/in use' or even 'replacement cost.'

The equipment lessor usually has a significant evidentiary arsenal to do battle under this proper valuation standard. For example:

• Lost production time resulting from the need to recalibrate new machinery gives existing leased machinery greater value;
• The time and cost to assemble replacement equipment is part of the in-place/in-use calculus;
• The very 'soft costs' which detract from auction value very often enhance in-place/in-use value.

The equipment lessor needs to be prepared to hire an appraiser who thinks out of the box and can develop or support in-place/in-use values, a task that frequently requires the skills of an accountant or turnaround specialist rather than a traditional equipment appraiser.

As we noted in the beginning, an ever-higher percentage of Chapter 11 cases are filed to consummate an asset sale. The asset sale, although nominally a public auction, has most often already been agreed to between the debtor, the stalking horse bidder, and the bank. Sometimes these deals dictate that most equipment leases will be assumed (or rejected) without much concern about re-characterization disputes slowing down a fast timetable. Sometimes leases that are susceptible of re-characterization are still treated as contracts capable of being assumed because this is a way for the asset buyer to obtain 100% 'purchase money' financing without even bothering to apply for a loan.

Generally, these kinds of deals lead to relatively happy and easy results for the equipment lessor, who never misses a payment and gets a new customer which is, at least, more financially capable than the original customer. From time-to-time contentment turns to concern when the asset sale deal brings a price higher than liquidation but still far less than the amount required to pay all the revolving, term, mortgage, and lease debt on the assets sold. The greater weight of authority is that the Bankruptcy Court has the power to order a sale free and clear even if all the secured debt isn't paid, and it is almost universally the case that the pre-packaged deal between the debtor, the stalking horse bidder, and the bank allocates great value to the bank's collateral (accounts, inventory, and goodwill) and little value to equipment whether financed or 'leased' under a lease susceptible of re-characterization.

For the reasons addressed earlier, differing valuation standards are not appropriate nor do private asset value allocations have much evidentiary weight. Both in pre-bankruptcy negotiations and in actual courtroom settings, the equipment lessor, in order to get its fair share, needs to be ready to counter the bank's bleak OLV appraisal of the customer's equipment with an equally bleak appraisal of the collectibility of accounts, the worthlessness of WIP and the dubious value of inventory, and its own in-place/in-use appraisal.

Once possessed of his own evidentiary arsenal, the equipment lessor's restructuring executive, though often a latecomer to the asset sale deal, will be able to hold his own with the bank in pre-bankruptcy negotiations to do a private deal, or in bankruptcy court when fighting over proceeds not sufficient to pay all the secured and lessor parties.

Keeping these straightforward points in mind will lead to better results in most negotiations between an equipment lessor and a customer in financial difficulty.

Alexander Terras ([email protected]) is a partner in the Chicago office of Reed Smith LLP, where he practices in the firm's Bankruptcy and Restructuring Group. He focuses his practice on insolvency, corporate finance, and general business transactions. Jason N. Kaplan ([email protected]) is also a partner in Reed Smith's Chicago office and practices in the firm's Financial Services Group. He regularly represents financial institutions in all aspects of their portfolio administration matters including purchases and sales of portfolios; loan and lease transactions involving all types of equipment, aircraft, and other collateral; and debt restructuring and workout matters.

Back in 1985, one of us contributed to an industry publication an article titled Strategies for Recovery in Lessee Bankruptcy. Twenty-two years later, the landscape of bankruptcy law and the leasing industry have changed dramatically, and issues and problems faced by the equipment lessor today have much different priorities. As the equipment leasing community contemplates the landscape today, some new approaches and decision drivers face the leasing executive when his lessee files Chapter 11, or threatens to do so.

Whether bankruptcy professionals blame it on a continuously robust company, too much liquidity in the credit markets, or some other cause, the financial community recognizes that corporate Chapter 11 filings are way down. While these stated reasons are doubtless valid and contributory, the bankruptcy bar and turnaround professionals sometimes fail to recognize and admit that they have been, to some extent, agents of their own distress. Chapter 11 has simply fallen out of favor as a cost-effective and expeditious remedy for debtors and creditors, in part, because every lender and lessor has cultivated an in-house restructuring group ' non-lawyers who can see business solutions in distressed situations and then reach consensus with the customer and other creditors to achieve an end result without the trauma of an intervening bankruptcy case. This private process, however, is more often than not conducted in the looming shadow of the Chapter 11 filing, which will follow if the private restructuring does not come together. To understand and effectively negotiate his position, the equipment lessor's restructuring executive has to grasp the downsides and upsides of a failed negotiation and an ensuing Chapter 11 filing. Here, we briefly point out the important points that have become so much more central to pre-bankruptcy workouts and many of the Chapter 11 cases filed today.

Even as cost and time factors today result in far fewer operating Chapter 11 cases ending in true reorganization, Chapter 11 remains a very popular vehicle to complete going concern sales of the debtor's business, whether on an expedited basis by employment of '363 of the Bankruptcy Code or confirmation of a plan, pre-packaged or not. Within these contexts, the equipment lessor must, as a first order of business, drill down and spread its legal position even as it does the same with the customer's historical and projected financial data. While every case might be different, the restructuring executive is going to be an effective negotiator if he knows his equipment values, the functionality of the equipment in the customer's business, his customer's financials and has a solid grasp of the legal drivers in almost every lease restructure.

What Kind of Lease?

The position of an equipment lessor in a Chapter 11 is devastatingly simple. The debtor may decline to pay rent for 60 days; provided, however, that thereafter, the debtor is required to commence making payments as a condition to its continued use of such equipment. Specifically, the debtor may either assume the lease, curing all defaults as a precondition to doing so, or reject it, leaving the lessor with its equipment and an unsecured claim for damages. The equipment lessor isn't exposed to preference liability unless he has received more than three monthly rents in the 90 days preceding the filing because a month's possession and use is fair value exchanged for a month's rent and because the payments are surely payments in the ordinary course.

In the presence of this simple legal position, the restructuring executive will be motivated to negotiate only because he knows that the lease is 'above market' or because the leased equipment is 'useful but not essential' and that rejection in a subsequent bankruptcy is likely a worse result than amending lease terms to suit the customer, or more likely, to induce the buyer of the customer's business to assume a modified lease rather than returning the leased equipment.

But, of course, it is rarely so simple. Only a very small percentage of equipment lessors go long on residuals, and most leases pay down to a relatively 'nominal' residual or contain other devices to hedge the equipment lessor's residual bet, e.g., TRAC provisions, fixed price options, lessor friendly return conditions, etc. At the same time, the marketplace has dictated a variety of other lease products and special terms, such as early termination, midstream buyouts, etc.

All of these contrive to give rise to that favorite ploy of the debtor's bar ' to re-characterize the lease as a disguised secured financing with evil consequences for the equipment lessor. Once re-characterized, the leverage of take or leave it imposed by the assumption/rejection decision is gone and a debtor is free once again to try to 'cram down' the equipment lessor's claim to a low number based on liquidation value. Similarly, the equipment lessor is then exposed to receiving less than full rent post-petition based on notions of adequate protection payments being equal only to the provable depreciation of the collateral, as well as to the risk that those last three pre-petition payments will be avoidable as preferential transfers in payment of an undersecured debt, although the 'ordinary course' defense might still be available. Worse yet, if a lease is re-characterized and the lessor hasn't properly perfected its interest, the collateral will be lost in a bankruptcy.

The quantity, if not the quality, of jurisprudence on the re-characterization issue is truly breathtaking, and any leasing executive can order up from his lawyers meticulous 50-page analyses which, at least in the context of an amorphous threat in restructuring negotiations, generally doesn't give the restructuring executive much more guidance than his own application of some simple principles to the terms of the lease he is restructuring and attendant bankruptcy risks.

The equipment lessor will be at risk of having its lease re-characterized with the attendant negative consequences if, as one court put it most succinctly:

A lease in which the consumption component dominates often is called a 'true lease,' while one in which the asset serves as security for an extension of credit is treated as a security agreement governed by the UCC's Article 9. United Airlines, Inc. v. HSBC Bank USA N.A., 416 F.3d 609 (7th Cir. 2005).

To that simple and overriding principle are added laundry lists of nuances and fine legal argument, but 90% of the re-characterization risk can be analyzed by simply taking a look at the level of genuine residual risk the equipment lessor took at the inception of the deal, to put the court's 'consumption component' phrase into words more familiar to the leasing industry.

This simple analysis, on a business/economic level, will lead to one of three conclusions:

1) The lease is a true lease. The pre-bankruptcy restructuring will be negotiated and agreed to for economic reasons to maximize recovery. The only bankruptcy risk is rejection of the lease and return of the equipment.

2) The lease is a disguised secured financing. The pre-bankruptcy economic analysis pro and con restructuring must be overlaid with legal risks:

• of a 'cram down';
• of potential preference risk for recovery of payments;
• of a months-or years-long period of book delinquency if adequate
  protection payments don't equal the stated rentals;
• of a loss of leverage in the negotiations since the equipment lessor no longer has the powerful tool of insisting on assumption or else; or
• of a complete loss of collateral if there is no perfection.

3) The lease is only arguably a disguised secured financing. Some of the risk in point two is reduced. Conversely, the equipment lessor may face significant legal expense which will be recoverable only if it is victorious and the legal expense is reimbursable as part of the required cure of defaults on assumption.

Armed with this information, the restructuring executive is in a solid position to guide his negotiations. Assuming there is some re-characterization risk, the equipment lessor should also be mindful of a second point often overlooked or misunderstood.

What's All This About Cram Down?

Even when the lease might not be a true lease, all is not lost.

Had we but a nickel for every time the customer's turnaround professional or insolvency lawyer announces that we had best agree to a big loss right now because it will be bigger still if they 'cram us down.' Sometimes, these threats are supported by truly ugly auction value or OLV appraisals, especially when the equipment lessor has provided not only the manufacturing line but also the installation, the cabling in the wall, and the custom-designed support software. While it is true that a secured claimant is entitled only to the value of collateral in bankruptcy, with any balance of debt over value to become an unsecured claim, debtors most often ignore a simple legal principle: Valuation of collateral must be done in the same context and to the same standard as the transaction before the bankruptcy court. See, e.g., In re: Colfor, Inc., 1996 Bankr. Lexis 1397.

This means that if the debtor is reorganizing as a 'going concern' then the valuation standard is 'going concern, in place/in use' or even 'replacement cost.'

The equipment lessor usually has a significant evidentiary arsenal to do battle under this proper valuation standard. For example:

• Lost production time resulting from the need to recalibrate new machinery gives existing leased machinery greater value;
• The time and cost to assemble replacement equipment is part of the in-place/in-use calculus;
• The very 'soft costs' which detract from auction value very often enhance in-place/in-use value.

The equipment lessor needs to be prepared to hire an appraiser who thinks out of the box and can develop or support in-place/in-use values, a task that frequently requires the skills of an accountant or turnaround specialist rather than a traditional equipment appraiser.

As we noted in the beginning, an ever-higher percentage of Chapter 11 cases are filed to consummate an asset sale. The asset sale, although nominally a public auction, has most often already been agreed to between the debtor, the stalking horse bidder, and the bank. Sometimes these deals dictate that most equipment leases will be assumed (or rejected) without much concern about re-characterization disputes slowing down a fast timetable. Sometimes leases that are susceptible of re-characterization are still treated as contracts capable of being assumed because this is a way for the asset buyer to obtain 100% 'purchase money' financing without even bothering to apply for a loan.

Generally, these kinds of deals lead to relatively happy and easy results for the equipment lessor, who never misses a payment and gets a new customer which is, at least, more financially capable than the original customer. From time-to-time contentment turns to concern when the asset sale deal brings a price higher than liquidation but still far less than the amount required to pay all the revolving, term, mortgage, and lease debt on the assets sold. The greater weight of authority is that the Bankruptcy Court has the power to order a sale free and clear even if all the secured debt isn't paid, and it is almost universally the case that the pre-packaged deal between the debtor, the stalking horse bidder, and the bank allocates great value to the bank's collateral (accounts, inventory, and goodwill) and little value to equipment whether financed or 'leased' under a lease susceptible of re-characterization.

For the reasons addressed earlier, differing valuation standards are not appropriate nor do private asset value allocations have much evidentiary weight. Both in pre-bankruptcy negotiations and in actual courtroom settings, the equipment lessor, in order to get its fair share, needs to be ready to counter the bank's bleak OLV appraisal of the customer's equipment with an equally bleak appraisal of the collectibility of accounts, the worthlessness of WIP and the dubious value of inventory, and its own in-place/in-use appraisal.

Once possessed of his own evidentiary arsenal, the equipment lessor's restructuring executive, though often a latecomer to the asset sale deal, will be able to hold his own with the bank in pre-bankruptcy negotiations to do a private deal, or in bankruptcy court when fighting over proceeds not sufficient to pay all the secured and lessor parties.

Keeping these straightforward points in mind will lead to better results in most negotiations between an equipment lessor and a customer in financial difficulty.

Alexander Terras ([email protected]) is a partner in the Chicago office of Reed Smith LLP, where he practices in the firm's Bankruptcy and Restructuring Group. He focuses his practice on insolvency, corporate finance, and general business transactions. Jason N. Kaplan ([email protected]) is also a partner in Reed Smith's Chicago office and practices in the firm's Financial Services Group. He regularly represents financial institutions in all aspects of their portfolio administration matters including purchases and sales of portfolios; loan and lease transactions involving all types of equipment, aircraft, and other collateral; and debt restructuring and workout matters.