Developments, Risks and Advanced Structures in the Lease Syndication Market

Lease syndications are generally distinguishable from brokered transactions and from many vendor-originated transactions by, among other things, the larger size of the financings, the increased burden of due diligence and credit analysis placed on the assignee/funder, and the financial strength and experience of the syndicator. As a general rule, the syndicator is in a stronger financial and negotiating position than a broker, vendor, or other originator and therefore takes minimal recourse risks. This article focuses on the most common types of syndications, but individual transactions may be closer to the broker or vendor model in terms of recourse exposure to the originator and other legal and practical effects.

Overview of Common Structures

There are three common structures typically used in connection with the syndication of equipment finance transactions: 1) the assignment of the lease and leased equipment (sometimes called an “outright assignment”); 2) the assignment of the rental stream and certain rights under the lease (sometimes called a
“discounting transaction”); and 3) the sale of a participation interest in the payments and proceeds payable under the transaction documents and from the equipment and any related collateral.

Outright Assignments

There are two timing approaches to the outright assignment of lease structure:

1. The traditional, most common approach is where the lease and the equipment schedule have been signed, the equipment has been delivered and accepted, and the price has been paid for the equipment. Upon payment of the consideration for the assignment, there is a conveyance of legal title to the equipment and an assignment of all rights under the existing equipment schedule arising after the lease transaction has been closed.
2. The less traditional approach is an assignment of some or all of the rights under the proposal or commitment before the equipment is purchased and leased. Under this approach, the funder acquires the equipment directly from the vendor or the lessee (in a sale-leaseback), and the equipment schedule is executed in the funder's name directly. The principal advantage of this alternative structure is that title to the equipment does not pass through the originator (so there should be no lien issues and no risk of the originator's subsequent bankruptcy), but the disadvantage is that the originator may lose some control over the lessee relationship.

The timing approach used for the assignment requires consideration of different representations and warranties offered by the originator and required by the funder, and different notification to the lessee. These differences are discussed later in this article.

One important feature of an outright assignment is that it should result in a “true sale” in which all rights in the lease and equipment pass to the funder. The intricacies of true sale analysis are beyond the scope of this article, but remarketing, buyback and residual sharing arrangements all give rise to questions on the part of auditors and may lead to unanticipated exposure in the event of an originator bankruptcy. Clear documentation, utilizing sale language is advisable.

Assignment of Rental Stream

Here, too, there are two approaches to the discounting transaction structure:

1. There is an outright assignment of the rental stream becoming due under the lease payable by the lessee, together with the grant of a security interest in the leased equipment to secure the payment and performance of the lessee's obligations to pay the rent. The originator incurs no independent obligation to the funder.
2. The alternative approach is back-leveraging, where a non-recourse loan is made to the originator, secured by a collateral assignment and grant of a security interest in the originator's rights under the lease, the rental stream, and the equipment. Under this approach, because the originator/borrower remains as the owner of the leased equipment and the lessor under the lease, the originator/borrower incurs contractual obligations to the funder/lender. The loan is customarily documented as a non-recourse loan, which is evidenced by a promissory note from the originator/borrower to the funder/lender. As with the outright assignment structure, the originator/borrower will make certain basic representations with respect to the underlying lease transaction and, if those representations prove to be untrue or are breached, there is a limited recourse back to the originator/borrower to the extent of damages resulting from the breach of those representations. There is, however, no recourse with respect to the credit of the lessee.

Participation Interests

In this structure, the originator sells to a participant an undivided proportionate share in either: 1) just the payments and proceeds received pursuant to the transaction documents and from the collateral, or 2) the rights under the transaction documents, including the payments and proceeds of the transaction documents and the collateral. This structure is usually used with a loan, a synthetic lease, or a non-tax lease. It is not typically used with a tax lease because certain tax issues are presented by this structure. If the participation interest includes a proportionate share of the ownership interest of the leased asset as it would in a tax lease structure, the Internal Revenue Service may take the position that the originator and the participant, now both holding ownership interests in the leased asset, have formed a partnership for tax purposes. This position could cause an adverse effect on the ability of the originator and the participant to claim the MACRS deductions with respect to the leased assets, because the Service could argue that if a partnership has been created, depending upon the point in time during the calendar year at which the partnership is deemed to have been created, the partnership may have a short first fiscal year, leading to the result that the originator and the participant would not be able to claim the full year's MACRS deductions to which they would otherwise have been entitled. Under such a structure, the originator and any participants may have to file a partnership tax return.

With these general observations in mind, we turn, in no particular order, to the authors' list of the most frequently encountered and troubling issues in negotiating syndications. Some are common to more than one structure or approach, others relate to a single type of transaction.

Reserved/Shared Rights and Obligations in an Assignment

Regardless of the specific structure, a well-drafted assignment agreement will expressly address in detail those rights and obligations under the transaction documents that: are to be shared; are to be reserved to the originator; or are to be assigned entirely to the funder.

Shared rights typically include the ability to call upon the lessee: 1) for the payment of personal indemnities; 2) for the payment of tax indemnities; and 3) to seek recovery under the lessee's liability insurance coverage, regardless of whether the claim giving rise to the indemnification obligation or the liability insurance claim is made before or after the assignment became effective.

With respect to non-shared rights, there is usually a chronological split such that payments, liabilities, and duties that are due or relate to the period before the effective date of the assignment are reserved for the benefit or burden of the originator, and those that become due on or after the effective date of the assignment are for the benefit or burden of the funder.

One of the issues to be addressed in this context is whether the originator has the right to pursue the lessee under the transaction documents to enforce its reserved or shared rights. Should the enforcement of those rights include the ability to sue the lessee and/or the guarantor? How about to declare a default under the lease if the lessee fails to perform its obligations with respect to those rights? Most funders will not surrender control of the deal to the extent of permitting a declaration of default, but the originator must have some remedy to pursue the obligors or else the lessee or guarantor could simply ignore its demands.

Participations: Intercreditor Issues

One of the most heavily negotiated issues in the context of the sale of a participation interest is how to address the intercreditor issues. Specifically, who will “call the shots” with respect to important issues that come up over the course of the transaction? This is to be considered in a different context than ordinary servicing obligations, such as billing and collecting, where the fiscal agent must have certain flexibility in order to properly do its job.

What we are talking about here are significant decisions such as agreeing to: 1) changes in the deal terms; 2) changes in the payment terms; 3) requests to release, subordinate or substitute collateral or equipment; and 4) requests to release or substitute obligors. Also of tremendous concern are decisions as to: 1) whether to waive the occurrence of a default; 2) whether to declare the default; and 3) determining which remedies are to be exercised.

It is customary to use a “majority in interest” concept for most of these significant decision-making situations. For this purpose, should the “majority” be 51% or 66 and two-thirds percent? Perhaps there are certain issues that would require different percentages or even unanimity. For example, in our view, even a majority should not be able to force on an unwilling participant a change in the payment terms of the transaction. Similarly, the specific underlying obligors or the specific equipment or specific deal terms may have been critical to the underwriting process for a particular participant. Should a majority be able to force a release, subordination, or substitution of equipment or obligors on that unwilling participant?

Participations: Avoiding Deadlock

However one addresses decision-making, the bottom line is that one must avoid deadlock. One way to avoid deadlock, and a right many originators find valuable for several other reasons, is an originator repurchase right. This provision gives the originator the right to repurchase the participation under certain circumstances. For example, the originator may want to protect its investment by reserving the right to repurchase in the event of a refusal by the participant to vote to enforce remedies or in the event of a default under the lease. Conversely, an originator may want to protect its relationship with its customer by retaining the right to repurchase if the participant refuses to grant the lessee a waiver or consent.

The terms of any repurchase require careful consideration and negotiation to protect the participant's anticipated return while according the originator a meaningful right.

Participations: Restrictions on Rights to Assign or Delegate

Originators and participants should also consider restrictions on the sale of additional participations by the originator and transfers of the participation interest by the participant.

In many transactions, the originator's expertise and experience are key selling points. A participant may well rely on the originator's interest in protecting its own investment in agreeing to take a passive role under the participation agreement. These assumptions may change if the originator reduces or eliminates its financial risk in the lease. An originator without “skin in the game” may be a markedly less aggressive administrator. Worse, if the originator has other transactions with the lessee, it may face a strong disincentive to insist on strict performance, to exercise remedies, and otherwise to act to protect the participant's interests. Therefore, it is important to expressly address the originator's duties and obligations in the participation agreement.

Originators usually reserve the right to sell from the originator's retained interest additional participation interests in a participated transaction. While originators normally will not agree to restrict their ability to further sell participation interests to other participants, a participant should understand the potential consequences of this right. In a participation, the parties may rely on the good judgment or cooperation of the other parties. Other participants may have different priorities, agendas, underwriting standards, levels of sophistication, and tolerances for loss, which could affect the way such participants may vote on issues posed to them and expose the participant to unwanted risk. Many participants may face public scrutiny making them sensitive regarding the identity of those with whom they transact business, and most participants would object to being placed in a venture alongside a party with which they are involved in litigation.

Concerns regarding the identity of the participants are shared by originators, who will traditionally want to limit each participant's right to sell its participation interest in whole or in part. One reason given by originators for such a restriction is that, as the named originator on the transaction documents and the agent, the originator is relying on the cooperation, responsiveness, and financial wherewithal of its participants. In addition, originators may face additional administrative burdens due to partial transfers or transfers to foreign or regulated entities. Originators also face concerns regarding possible securities law issues, and the creation of a market in participation interests may impact future transactions between the originator and its lessee and the originator's ability to sell other participations in the affected lease or in other leases.

These concerns may be addressed by: 1) giving both parties a right of first refusal or requiring the originator or participant to offer any future sale first to the other; 2) participants may require originators to maintain a minimum level of investment at all times or forfeit management rights; and 3) originators may simply require their consent to transfers by the participant (although these limitations may require exceptions for lessee defaults, regulatory requirements, or other changed circumstances).

Assignments: Receivable Purchase or Loan?

Where the originator desires to retain a residual or other ownership interest but is willing to part with the entire rent stream, a transaction may be structured as a sale of the rent stream or a non-recourse loan and assignment. These common “discounting” transactions are attractive to the parties for many reasons.

Funders may obtain financial rewards without taking residual risk and may avoid ownership of dangerous or otherwise undesirable assets. Originators retain a measure of control in the lessor-lessee relationship and can realize additional profit from their residual position. Depreciation benefits are generally available to the originator, as equipment owner in a discounting transaction, but belong to the funder in an outright sale.

Different tax and accounting treatments may result from a sale of the rent stream. There is a possible, but uncertain, benefit in a sale of a “payment intangible” under the UCC. See NetBank, FSB v. Kipperman (In Re Commercial Money Center, Inc.) 350 B.R. 465 (BAP, 11 Cir. 2006). Taking possession of the sole original counterpart of the lease and (if agreeable to the originator) filing a UCC financing statement against the originator furnish similar benefits in either structure.

A loan-type transaction may also be more familiar to banks and other traditional lenders. In these structures, the originator “borrows” the discounted present value of the rent stream, usually on a non-recourse basis, and assigns the lease as security. Rent under the lease amortizes the loan and, when the loan is repaid in full, the loan and the grant of security interest is terminated and the lease continues to remain in place with the originator. The originator at all times owns the equipment, granting a security interest to the funder.

As with participations, consideration of specific rights to be retained or granted is essential to a successful discounting. One important issue is who services the lease, collects rent, and interfaces with the lessee. In some cases, the originator will want to maintain its relationship with the lessee. In others, the funder will require that payments are made to it directly, or to a lockbox under its control. These devices protect the funder from misapplication or breaches by the originator and provide a measure of legal and practical protection from an originator bankruptcy.

Another key issue is whether the originator can protect its residual in the event of a lessee default. As a borrower, or under the terms of most sales of rent streams, the originator faces loss of its ownership interest in the equipment on a lessee default. Some originators require cure rights or other protections for their position.

Although the classic sale of rents or loan is non-recourse as to the originator, many variations exist. Full recourse transactions are not uncommon, as are ultimate net loss (“UNL”) provisions. Under a UNL structure, the originator is responsible for a portion of the funder's loss, either “first dollar” as to each transaction, by a percentage of each transaction, or under limitations calculated as to the total amount funded. The originator's obligation may be secured by a holdback of partial funding, a cash deposit, or by other collateral.

Finally, with the leveraging approach one must also consider the standard debt/equity issues encountered in any leveraging of an equipment lease transaction. The originator/borrower must take appropriate steps to minimize the possibility that it will be “squeezed” out of the transaction by the lender upon the occurrence of a lease default. It is customary to build in cure rights in favor of the originator/borrower, as well as a maximum standstill period so that the lender is forced to exercise remedies under the defaulted lease after some specified period. There should also be a requirement that the funder/lender exercise its remedies under the defaulted lease depriving the lessee of possession of the equipment.

UCC Issues

Any analysis of the UCC issues with respect to the syndication of an equipment finance transaction requires that one investigate the chain of title with regard to the syndication assets (lease, rental stream, equipment) to determine the previous owners of the assets in order to be certain of who may have rights or interests in those assets. With one notable exception, appropriate due diligence requires that the funder/lender/participant should do a UCC, tax, and judgment lien search on the originator to confirm that there are no liens on the assets that are the subject of the syndication. The notable exception is the special assignment of lease structure in which the originator assigns to the funder the right to acquire the equipment directly from the vendor and to enter into the lease documentation directly with the lessee. Under that structure, neither the lease rights nor the ownership of the equipment pass through the hands of the originator, so no originator lien could attach. As discussed more fully below, it is customary to include representations by the originator that it owns the interest being conveyed, free and clear of all liens and encumbrances, and that there has been no prior sale of that interest.

Under UCC '9-102(a)(11), “chattel paper” is defined to include a lease of equipment since it constitutes a record that evidences both a monetary obligation and a lease of specific goods. Similarly, UCC '9-102(a)(2) makes it clear that an “account” includes the rental payment stream as a right to payment of a monetary obligation for property that has been leased. Accordingly, the assignment of a lease involves the sale of chattel paper and accounts, and the assignment of a loan and related promissory note involves the sale of an instrument, and UCC '9-109(a)(3) makes it clear that Article 9 applies to a sale of chattel paper, accounts, and promissory notes. Accordingly, in order to perfect the sale one must file a UCC financing statement describing the transaction, unless perfection may be obtained without filing. UCC '9-309 provides for automatic perfection of the sale of accounts, a promissory note, or a payment intangible without requiring the filing of a UCC financing statement, and UCC '9-313 provides for perfection of the sale of chattel paper or an instrument by the assignee taking physical possession of the chattel paper or instrument, rather than by filing a UCC financing statement. Note that this does not perfect a security interest, but rather the sale itself.

The filing of a UCC financing statement to perfect the sale of certain assets may be problematic for certain originators. Some parties may have a negative pledge as part of senior credit agreement provisions that prohibits the granting of a security interest and, by extension, prohibits permitting the filing of a UCC financing statement even though it does not technically create a security interest in the asset sold. Other parties have simply taken the position as a matter of corporate policy that they will not permit the filing of UCC financing statements against them. Depending upon the creditworthiness of the originator, some funders will proceed with the transaction without requiring the filing to be made. However, if a funder is to forego the filing it should confirm that the original chattel paper or instrument has been delivered to it.

The UCC also affords certain statutory priorities to purchasers of chattel paper or instruments. Under UCC '9-330(a) and (b), if the purchaser of the chattel paper gives new value and takes possession of the chattel paper (or obtains control of the chattel paper) in good faith, in the ordinary course of its business, and without knowledge that the purchase violates the rights of a secured party or that it has been assigned to an identified funder other than the purchaser, then such purchaser has priority over a security interest in the chattel paper. Similarly, under UCC '9-330(d), if the purchaser of an instrument gives value and takes possession of the instrument in good faith, without knowledge that the purchase violates the rights of a secured party (other than a secured party which has perfected its interest in the instrument by possession), then the purchaser takes priority over the security interest in the instrument. Therefore, under UCC '9-330(b), the holder of a security interest by possession of chattel paper or an instrument has priority over the holder of a security interest in such chattel paper or instrument which was perfected by the filing of a UCC financing statement.

Syndication of Motor Vehicle Leases

Syndication of lease transactions involving titled vehicles after the initial titling has been done may be impeded by: 1) the significant administrative burden and expense of re-titling or changing the lienholder notation on the titles, depending upon the number of titles to be handled and the filing fees charged by the state; and 2) the fact that many states also impose an excise, sales, or re-titling tax in connection with the transfer of ownership, which could have a significant impact on the economic benefit of the syndication. There are certain syndication structures that may be utilized to overcome these challenges.

Motor Vehicle Titling Trust

It is possible to avoid or minimize the burden and expense by using a titling trust. The originator creates a trust for the purpose of holding legal title or being designated as the lienholder with respect to motor vehicles.

There are two types of trusts that are available for use with this program: a common law trust and a statutory trust. A number of states have adopted statutory trust provisions, but Delaware is on the leading edge and has the longest history of successfully using the statutory trust model. One of the principal advantages of the Delaware statutory trust is that one or more sub-trusts may be created within the umbrella of the master trust, and assets may be allocated into those sub-trusts. Assets allocated to a sub-trust are insulated from exposure to liability of creditors of other sub-trusts or of the general trust. The sub-trust concept is not available under the common law trust structure. All of the assets held in a common law trust are exposed to liability of creditors of the trust.

There are two alternative approaches that could be taken with respect to the use of the statutory trust to facilitate the syndication of motor vehicles: 1) the trust would be the lessor under the lease, and all motor vehicles would be titled in the name of the trust; or 2) the trust would only be designated on the certificate of title and would not serve as the lessor with respect to the lease (the lease would be retained by the originator and, upon syndication, assigned to the funder together with the beneficial ownership interest in the sub-trust).

Under the first approach, with the trust as lessor and registered owner, the rights and obligations of the originator, as well as ownership of the leased assets, would be held by the trust. The downside of this approach is that the trust is a separate legal entity that must qualify to transact business in each jurisdiction in which any other leasing company would be required to qualify by reason of the laws of the individual state and the scope and extent of the leasing company's activities in that state. There is an administrative burden and expense associated with qualification to transact business: the burden and expense of the initial qualification process, and the burden and expense of having to prepare and file annual tax reports and returns for each state in which the trust is qualified.

The second approach, bifurcating the lessor's interest from the designation of owner on the certificate of title, may avoid the necessity of qualifying the trust to transact business in foreign jurisdictions, since the trust would not itself be serving as the lessor and would not be transacting business in foreign jurisdictions. This approach is only effective if state law does not characterize ownership of motor vehicles as “doing business” and does not require more than bare ownership in order to be designated as registered owner on certificates of title.

The downside of the second approach is that state taxing authorities may be confused by the bifurcation: If the trust is designated on the titles as the registered owner, the originator would file sales/use/rental tax reports and returns, and pay those taxes, while the personal property tax reports and returns, and the personal property taxes, would be filed and paid on behalf of the trust since legal title ownership of the assets is shown in the trust. This issue would not be presented if the trust is not designated on the titles as the registered owner but only as the lienholder, since the originator would file the personal property taxes and reports, as well as the sales/use/rental taxes and reports.

Titling Agency

Some parties have utilized titling agencies as a method to avoid re-titling vehicles upon an assignment of a lease and the leased vehicles. Under a titling agency approach, the originator's name is left on the titles as owner, and the originator continues to act in such capacity as the funder's agent. In our view, this is a potentially problematic approach from both a sales tax standpoint as well as a titling statute standpoint. First, the sale of the vehicles may be subject to sales tax and the use of a titling agency may not be a permissible method of avoiding payment of a sales tax in those states that would otherwise impose a sales tax on the sale of the vehicle. Second, each state has its own titling statute that governs how ownership is transferred and whose name should be listed on the titles as owner. It is our understanding that most (if not all) states require that the actual owner of the vehicle be listed on the titles and that any transfer of ownership must be reflected on the titles. These strict statutory requirements may not permit originators to continue to be named as owners on the titles after the assignment, and failure to comply with the titling statutes often results in penalties and potential criminal liability.

One-Hundred Percent Participation

Another syndication structure that has been used to syndicate titled vehicle leases has been the 100% participation. While traditionally used in loan and non-true lease syndications, some parties have utilized this structure in connection with true leases. As long as there is only one participant, then the parties stand a good chance that the 100% participant (and not the originator) would be deemed the tax owner and there would be no tax partnership since the originator does not have any economic benefit in the transaction. It is also important that the Participation Agreement be structured in a way to avoid a transfer of the vehicles that could be subject to any transfer requirements of the titling laws or sales tax. Therefore, it is imperative that the parties make it clear that the participant is only receiving an interest in the payments and proceeds payable under the transaction and not directly in the lease or the vehicles. We recommend that the parties consult their tax and legal advisers to make sure the appropriate state law analyses are completed and that the intent of the parties is properly reflected in the Participation Agreement.

Referral or Broker-Only Deal

For those titled vehicle leases where the funder will fund the initial purchase, the parties can avoid re-titling requirements, taxes, and expenses by putting the titles and the related lease documents directly in the name of the funder. This avoids having to title the vehicles first in the name of the originator and then having to transfer the vehicles to the funder, which transfer could be subject to sales tax, re-titling fees, and the other requirements of the titling laws. However, this structure only works where the parties are identified early enough in the process and with specificity so as initially to title the leased vehicles in the correct name of the funder.

Next month's installment will address types of recourse to the seller; allocation of taxes, costs, and expenses; servicing; remarketing and residual support; and securities laws issues.

Mark D. Kohler is General Counsel Syndications at GE Capital, Americas. He may be reached at [email protected]. Barry S. Marks, a member of this newsletter's Board of Editors, is a founding shareholder of Marks & Weinberg, P.C. Marks may be reached at [email protected] or through the firm's Web site www.leaselawyer.com. Alan J. Mogol, a member of this newsletter's Board of Editors, is a principal of Ober, Kaler, Grimes & Shriver in Baltimore. He may be reached at [email protected].

Part One of a Two-Part Article

Lease syndications have enjoyed a significant rise in popularity in recent years. This rise in popularity has brought about an evolution in the commonly used structures, leading to additional complexity and confusion in practice. In this article, we provide a framework for analyzing syndications and addressing the practical needs of originators and funders.

For simplicity, we will use the terms “funder” to include assignees, purchasers, and financiers of leasing and lending transactions and “originator” to include syndicators, assignors, and lessors who originate the lease or loan transactions. We will also use the terms “lease” and “loan” interchangeably without regard to whether the transactions are true leases, financing leases, equipment finance agreements, or other structures except as specifically stated.

Lease syndications are generally distinguishable from brokered transactions and from many vendor-originated transactions by, among other things, the larger size of the financings, the increased burden of due diligence and credit analysis placed on the assignee/funder, and the financial strength and experience of the syndicator. As a general rule, the syndicator is in a stronger financial and negotiating position than a broker, vendor, or other originator and therefore takes minimal recourse risks. This article focuses on the most common types of syndications, but individual transactions may be closer to the broker or vendor model in terms of recourse exposure to the originator and other legal and practical effects.

Overview of Common Structures

There are three common structures typically used in connection with the syndication of equipment finance transactions: 1) the assignment of the lease and leased equipment (sometimes called an “outright assignment”); 2) the assignment of the rental stream and certain rights under the lease (sometimes called a
“discounting transaction”); and 3) the sale of a participation interest in the payments and proceeds payable under the transaction documents and from the equipment and any related collateral.

Outright Assignments

There are two timing approaches to the outright assignment of lease structure:

1. The traditional, most common approach is where the lease and the equipment schedule have been signed, the equipment has been delivered and accepted, and the price has been paid for the equipment. Upon payment of the consideration for the assignment, there is a conveyance of legal title to the equipment and an assignment of all rights under the existing equipment schedule arising after the lease transaction has been closed.
2. The less traditional approach is an assignment of some or all of the rights under the proposal or commitment before the equipment is purchased and leased. Under this approach, the funder acquires the equipment directly from the vendor or the lessee (in a sale-leaseback), and the equipment schedule is executed in the funder's name directly. The principal advantage of this alternative structure is that title to the equipment does not pass through the originator (so there should be no lien issues and no risk of the originator's subsequent bankruptcy), but the disadvantage is that the originator may lose some control over the lessee relationship.

The timing approach used for the assignment requires consideration of different representations and warranties offered by the originator and required by the funder, and different notification to the lessee. These differences are discussed later in this article.

One important feature of an outright assignment is that it should result in a “true sale” in which all rights in the lease and equipment pass to the funder. The intricacies of true sale analysis are beyond the scope of this article, but remarketing, buyback and residual sharing arrangements all give rise to questions on the part of auditors and may lead to unanticipated exposure in the event of an originator bankruptcy. Clear documentation, utilizing sale language is advisable.

Assignment of Rental Stream

Here, too, there are two approaches to the discounting transaction structure:

1. There is an outright assignment of the rental stream becoming due under the lease payable by the lessee, together with the grant of a security interest in the leased equipment to secure the payment and performance of the lessee's obligations to pay the rent. The originator incurs no independent obligation to the funder.
2. The alternative approach is back-leveraging, where a non-recourse loan is made to the originator, secured by a collateral assignment and grant of a security interest in the originator's rights under the lease, the rental stream, and the equipment. Under this approach, because the originator/borrower remains as the owner of the leased equipment and the lessor under the lease, the originator/borrower incurs contractual obligations to the funder/lender. The loan is customarily documented as a non-recourse loan, which is evidenced by a promissory note from the originator/borrower to the funder/lender. As with the outright assignment structure, the originator/borrower will make certain basic representations with respect to the underlying lease transaction and, if those representations prove to be untrue or are breached, there is a limited recourse back to the originator/borrower to the extent of damages resulting from the breach of those representations. There is, however, no recourse with respect to the credit of the lessee.

Participation Interests

In this structure, the originator sells to a participant an undivided proportionate share in either: 1) just the payments and proceeds received pursuant to the transaction documents and from the collateral, or 2) the rights under the transaction documents, including the payments and proceeds of the transaction documents and the collateral. This structure is usually used with a loan, a synthetic lease, or a non-tax lease. It is not typically used with a tax lease because certain tax issues are presented by this structure. If the participation interest includes a proportionate share of the ownership interest of the leased asset as it would in a tax lease structure, the Internal Revenue Service may take the position that the originator and the participant, now both holding ownership interests in the leased asset, have formed a partnership for tax purposes. This position could cause an adverse effect on the ability of the originator and the participant to claim the MACRS deductions with respect to the leased assets, because the Service could argue that if a partnership has been created, depending upon the point in time during the calendar year at which the partnership is deemed to have been created, the partnership may have a short first fiscal year, leading to the result that the originator and the participant would not be able to claim the full year's MACRS deductions to which they would otherwise have been entitled. Under such a structure, the originator and any participants may have to file a partnership tax return.

With these general observations in mind, we turn, in no particular order, to the authors' list of the most frequently encountered and troubling issues in negotiating syndications. Some are common to more than one structure or approach, others relate to a single type of transaction.

Reserved/Shared Rights and Obligations in an Assignment

Regardless of the specific structure, a well-drafted assignment agreement will expressly address in detail those rights and obligations under the transaction documents that: are to be shared; are to be reserved to the originator; or are to be assigned entirely to the funder.

Shared rights typically include the ability to call upon the lessee: 1) for the payment of personal indemnities; 2) for the payment of tax indemnities; and 3) to seek recovery under the lessee's liability insurance coverage, regardless of whether the claim giving rise to the indemnification obligation or the liability insurance claim is made before or after the assignment became effective.

With respect to non-shared rights, there is usually a chronological split such that payments, liabilities, and duties that are due or relate to the period before the effective date of the assignment are reserved for the benefit or burden of the originator, and those that become due on or after the effective date of the assignment are for the benefit or burden of the funder.

One of the issues to be addressed in this context is whether the originator has the right to pursue the lessee under the transaction documents to enforce its reserved or shared rights. Should the enforcement of those rights include the ability to sue the lessee and/or the guarantor? How about to declare a default under the lease if the lessee fails to perform its obligations with respect to those rights? Most funders will not surrender control of the deal to the extent of permitting a declaration of default, but the originator must have some remedy to pursue the obligors or else the lessee or guarantor could simply ignore its demands.

Participations: Intercreditor Issues

One of the most heavily negotiated issues in the context of the sale of a participation interest is how to address the intercreditor issues. Specifically, who will “call the shots” with respect to important issues that come up over the course of the transaction? This is to be considered in a different context than ordinary servicing obligations, such as billing and collecting, where the fiscal agent must have certain flexibility in order to properly do its job.

What we are talking about here are significant decisions such as agreeing to: 1) changes in the deal terms; 2) changes in the payment terms; 3) requests to release, subordinate or substitute collateral or equipment; and 4) requests to release or substitute obligors. Also of tremendous concern are decisions as to: 1) whether to waive the occurrence of a default; 2) whether to declare the default; and 3) determining which remedies are to be exercised.

It is customary to use a “majority in interest” concept for most of these significant decision-making situations. For this purpose, should the “majority” be 51% or 66 and two-thirds percent? Perhaps there are certain issues that would require different percentages or even unanimity. For example, in our view, even a majority should not be able to force on an unwilling participant a change in the payment terms of the transaction. Similarly, the specific underlying obligors or the specific equipment or specific deal terms may have been critical to the underwriting process for a particular participant. Should a majority be able to force a release, subordination, or substitution of equipment or obligors on that unwilling participant?

Participations: Avoiding Deadlock

However one addresses decision-making, the bottom line is that one must avoid deadlock. One way to avoid deadlock, and a right many originators find valuable for several other reasons, is an originator repurchase right. This provision gives the originator the right to repurchase the participation under certain circumstances. For example, the originator may want to protect its investment by reserving the right to repurchase in the event of a refusal by the participant to vote to enforce remedies or in the event of a default under the lease. Conversely, an originator may want to protect its relationship with its customer by retaining the right to repurchase if the participant refuses to grant the lessee a waiver or consent.

The terms of any repurchase require careful consideration and negotiation to protect the participant's anticipated return while according the originator a meaningful right.

Participations: Restrictions on Rights to Assign or Delegate

Originators and participants should also consider restrictions on the sale of additional participations by the originator and transfers of the participation interest by the participant.

In many transactions, the originator's expertise and experience are key selling points. A participant may well rely on the originator's interest in protecting its own investment in agreeing to take a passive role under the participation agreement. These assumptions may change if the originator reduces or eliminates its financial risk in the lease. An originator without “skin in the game” may be a markedly less aggressive administrator. Worse, if the originator has other transactions with the lessee, it may face a strong disincentive to insist on strict performance, to exercise remedies, and otherwise to act to protect the participant's interests. Therefore, it is important to expressly address the originator's duties and obligations in the participation agreement.

Originators usually reserve the right to sell from the originator's retained interest additional participation interests in a participated transaction. While originators normally will not agree to restrict their ability to further sell participation interests to other participants, a participant should understand the potential consequences of this right. In a participation, the parties may rely on the good judgment or cooperation of the other parties. Other participants may have different priorities, agendas, underwriting standards, levels of sophistication, and tolerances for loss, which could affect the way such participants may vote on issues posed to them and expose the participant to unwanted risk. Many participants may face public scrutiny making them sensitive regarding the identity of those with whom they transact business, and most participants would object to being placed in a venture alongside a party with which they are involved in litigation.

Concerns regarding the identity of the participants are shared by originators, who will traditionally want to limit each participant's right to sell its participation interest in whole or in part. One reason given by originators for such a restriction is that, as the named originator on the transaction documents and the agent, the originator is relying on the cooperation, responsiveness, and financial wherewithal of its participants. In addition, originators may face additional administrative burdens due to partial transfers or transfers to foreign or regulated entities. Originators also face concerns regarding possible securities law issues, and the creation of a market in participation interests may impact future transactions between the originator and its lessee and the originator's ability to sell other participations in the affected lease or in other leases.

These concerns may be addressed by: 1) giving both parties a right of first refusal or requiring the originator or participant to offer any future sale first to the other; 2) participants may require originators to maintain a minimum level of investment at all times or forfeit management rights; and 3) originators may simply require their consent to transfers by the participant (although these limitations may require exceptions for lessee defaults, regulatory requirements, or other changed circumstances).

Assignments: Receivable Purchase or Loan?

Where the originator desires to retain a residual or other ownership interest but is willing to part with the entire rent stream, a transaction may be structured as a sale of the rent stream or a non-recourse loan and assignment. These common “discounting” transactions are attractive to the parties for many reasons.

Funders may obtain financial rewards without taking residual risk and may avoid ownership of dangerous or otherwise undesirable assets. Originators retain a measure of control in the lessor-lessee relationship and can realize additional profit from their residual position. Depreciation benefits are generally available to the originator, as equipment owner in a discounting transaction, but belong to the funder in an outright sale.

Different tax and accounting treatments may result from a sale of the rent stream. There is a possible, but uncertain, benefit in a sale of a “payment intangible” under the UCC. See NetBank, FSB v. Kipperman (In Re Commercial Money Center, Inc.) 350 B.R. 465 (BAP, 11 Cir. 2006). Taking possession of the sole original counterpart of the lease and (if agreeable to the originator) filing a UCC financing statement against the originator furnish similar benefits in either structure.

A loan-type transaction may also be more familiar to banks and other traditional lenders. In these structures, the originator “borrows” the discounted present value of the rent stream, usually on a non-recourse basis, and assigns the lease as security. Rent under the lease amortizes the loan and, when the loan is repaid in full, the loan and the grant of security interest is terminated and the lease continues to remain in place with the originator. The originator at all times owns the equipment, granting a security interest to the funder.

As with participations, consideration of specific rights to be retained or granted is essential to a successful discounting. One important issue is who services the lease, collects rent, and interfaces with the lessee. In some cases, the originator will want to maintain its relationship with the lessee. In others, the funder will require that payments are made to it directly, or to a lockbox under its control. These devices protect the funder from misapplication or breaches by the originator and provide a measure of legal and practical protection from an originator bankruptcy.

Another key issue is whether the originator can protect its residual in the event of a lessee default. As a borrower, or under the terms of most sales of rent streams, the originator faces loss of its ownership interest in the equipment on a lessee default. Some originators require cure rights or other protections for their position.

Although the classic sale of rents or loan is non-recourse as to the originator, many variations exist. Full recourse transactions are not uncommon, as are ultimate net loss (“UNL”) provisions. Under a UNL structure, the originator is responsible for a portion of the funder's loss, either “first dollar” as to each transaction, by a percentage of each transaction, or under limitations calculated as to the total amount funded. The originator's obligation may be secured by a holdback of partial funding, a cash deposit, or by other collateral.

Finally, with the leveraging approach one must also consider the standard debt/equity issues encountered in any leveraging of an equipment lease transaction. The originator/borrower must take appropriate steps to minimize the possibility that it will be “squeezed” out of the transaction by the lender upon the occurrence of a lease default. It is customary to build in cure rights in favor of the originator/borrower, as well as a maximum standstill period so that the lender is forced to exercise remedies under the defaulted lease after some specified period. There should also be a requirement that the funder/lender exercise its remedies under the defaulted lease depriving the lessee of possession of the equipment.

UCC Issues

Any analysis of the UCC issues with respect to the syndication of an equipment finance transaction requires that one investigate the chain of title with regard to the syndication assets (lease, rental stream, equipment) to determine the previous owners of the assets in order to be certain of who may have rights or interests in those assets. With one notable exception, appropriate due diligence requires that the funder/lender/participant should do a UCC, tax, and judgment lien search on the originator to confirm that there are no liens on the assets that are the subject of the syndication. The notable exception is the special assignment of lease structure in which the originator assigns to the funder the right to acquire the equipment directly from the vendor and to enter into the lease documentation directly with the lessee. Under that structure, neither the lease rights nor the ownership of the equipment pass through the hands of the originator, so no originator lien could attach. As discussed more fully below, it is customary to include representations by the originator that it owns the interest being conveyed, free and clear of all liens and encumbrances, and that there has been no prior sale of that interest.

Under UCC '9-102(a)(11), “chattel paper” is defined to include a lease of equipment since it constitutes a record that evidences both a monetary obligation and a lease of specific goods. Similarly, UCC '9-102(a)(2) makes it clear that an “account” includes the rental payment stream as a right to payment of a monetary obligation for property that has been leased. Accordingly, the assignment of a lease involves the sale of chattel paper and accounts, and the assignment of a loan and related promissory note involves the sale of an instrument, and UCC '9-109(a)(3) makes it clear that Article 9 applies to a sale of chattel paper, accounts, and promissory notes. Accordingly, in order to perfect the sale one must file a UCC financing statement describing the transaction, unless perfection may be obtained without filing. UCC '9-309 provides for automatic perfection of the sale of accounts, a promissory note, or a payment intangible without requiring the filing of a UCC financing statement, and UCC '9-313 provides for perfection of the sale of chattel paper or an instrument by the assignee taking physical possession of the chattel paper or instrument, rather than by filing a UCC financing statement. Note that this does not perfect a security interest, but rather the sale itself.

The filing of a UCC financing statement to perfect the sale of certain assets may be problematic for certain originators. Some parties may have a negative pledge as part of senior credit agreement provisions that prohibits the granting of a security interest and, by extension, prohibits permitting the filing of a UCC financing statement even though it does not technically create a security interest in the asset sold. Other parties have simply taken the position as a matter of corporate policy that they will not permit the filing of UCC financing statements against them. Depending upon the creditworthiness of the originator, some funders will proceed with the transaction without requiring the filing to be made. However, if a funder is to forego the filing it should confirm that the original chattel paper or instrument has been delivered to it.

The UCC also affords certain statutory priorities to purchasers of chattel paper or instruments. Under UCC '9-330(a) and (b), if the purchaser of the chattel paper gives new value and takes possession of the chattel paper (or obtains control of the chattel paper) in good faith, in the ordinary course of its business, and without knowledge that the purchase violates the rights of a secured party or that it has been assigned to an identified funder other than the purchaser, then such purchaser has priority over a security interest in the chattel paper. Similarly, under UCC '9-330(d), if the purchaser of an instrument gives value and takes possession of the instrument in good faith, without knowledge that the purchase violates the rights of a secured party (other than a secured party which has perfected its interest in the instrument by possession), then the purchaser takes priority over the security interest in the instrument. Therefore, under UCC '9-330(b), the holder of a security interest by possession of chattel paper or an instrument has priority over the holder of a security interest in such chattel paper or instrument which was perfected by the filing of a UCC financing statement.

Syndication of Motor Vehicle Leases

Syndication of lease transactions involving titled vehicles after the initial titling has been done may be impeded by: 1) the significant administrative burden and expense of re-titling or changing the lienholder notation on the titles, depending upon the number of titles to be handled and the filing fees charged by the state; and 2) the fact that many states also impose an excise, sales, or re-titling tax in connection with the transfer of ownership, which could have a significant impact on the economic benefit of the syndication. There are certain syndication structures that may be utilized to overcome these challenges.

Motor Vehicle Titling Trust

It is possible to avoid or minimize the burden and expense by using a titling trust. The originator creates a trust for the purpose of holding legal title or being designated as the lienholder with respect to motor vehicles.

There are two types of trusts that are available for use with this program: a common law trust and a statutory trust. A number of states have adopted statutory trust provisions, but Delaware is on the leading edge and has the longest history of successfully using the statutory trust model. One of the principal advantages of the Delaware statutory trust is that one or more sub-trusts may be created within the umbrella of the master trust, and assets may be allocated into those sub-trusts. Assets allocated to a sub-trust are insulated from exposure to liability of creditors of other sub-trusts or of the general trust. The sub-trust concept is not available under the common law trust structure. All of the assets held in a common law trust are exposed to liability of creditors of the trust.

There are two alternative approaches that could be taken with respect to the use of the statutory trust to facilitate the syndication of motor vehicles: 1) the trust would be the lessor under the lease, and all motor vehicles would be titled in the name of the trust; or 2) the trust would only be designated on the certificate of title and would not serve as the lessor with respect to the lease (the lease would be retained by the originator and, upon syndication, assigned to the funder together with the beneficial ownership interest in the sub-trust).

Under the first approach, with the trust as lessor and registered owner, the rights and obligations of the originator, as well as ownership of the leased assets, would be held by the trust. The downside of this approach is that the trust is a separate legal entity that must qualify to transact business in each jurisdiction in which any other leasing company would be required to qualify by reason of the laws of the individual state and the scope and extent of the leasing company's activities in that state. There is an administrative burden and expense associated with qualification to transact business: the burden and expense of the initial qualification process, and the burden and expense of having to prepare and file annual tax reports and returns for each state in which the trust is qualified.

The second approach, bifurcating the lessor's interest from the designation of owner on the certificate of title, may avoid the necessity of qualifying the trust to transact business in foreign jurisdictions, since the trust would not itself be serving as the lessor and would not be transacting business in foreign jurisdictions. This approach is only effective if state law does not characterize ownership of motor vehicles as “doing business” and does not require more than bare ownership in order to be designated as registered owner on certificates of title.

The downside of the second approach is that state taxing authorities may be confused by the bifurcation: If the trust is designated on the titles as the registered owner, the originator would file sales/use/rental tax reports and returns, and pay those taxes, while the personal property tax reports and returns, and the personal property taxes, would be filed and paid on behalf of the trust since legal title ownership of the assets is shown in the trust. This issue would not be presented if the trust is not designated on the titles as the registered owner but only as the lienholder, since the originator would file the personal property taxes and reports, as well as the sales/use/rental taxes and reports.

Titling Agency

Some parties have utilized titling agencies as a method to avoid re-titling vehicles upon an assignment of a lease and the leased vehicles. Under a titling agency approach, the originator's name is left on the titles as owner, and the originator continues to act in such capacity as the funder's agent. In our view, this is a potentially problematic approach from both a sales tax standpoint as well as a titling statute standpoint. First, the sale of the vehicles may be subject to sales tax and the use of a titling agency may not be a permissible method of avoiding payment of a sales tax in those states that would otherwise impose a sales tax on the sale of the vehicle. Second, each state has its own titling statute that governs how ownership is transferred and whose name should be listed on the titles as owner. It is our understanding that most (if not all) states require that the actual owner of the vehicle be listed on the titles and that any transfer of ownership must be reflected on the titles. These strict statutory requirements may not permit originators to continue to be named as owners on the titles after the assignment, and failure to comply with the titling statutes often results in penalties and potential criminal liability.

One-Hundred Percent Participation

Another syndication structure that has been used to syndicate titled vehicle leases has been the 100% participation. While traditionally used in loan and non-true lease syndications, some parties have utilized this structure in connection with true leases. As long as there is only one participant, then the parties stand a good chance that the 100% participant (and not the originator) would be deemed the tax owner and there would be no tax partnership since the originator does not have any economic benefit in the transaction. It is also important that the Participation Agreement be structured in a way to avoid a transfer of the vehicles that could be subject to any transfer requirements of the titling laws or sales tax. Therefore, it is imperative that the parties make it clear that the participant is only receiving an interest in the payments and proceeds payable under the transaction and not directly in the lease or the vehicles. We recommend that the parties consult their tax and legal advisers to make sure the appropriate state law analyses are completed and that the intent of the parties is properly reflected in the Participation Agreement.

Referral or Broker-Only Deal

For those titled vehicle leases where the funder will fund the initial purchase, the parties can avoid re-titling requirements, taxes, and expenses by putting the titles and the related lease documents directly in the name of the funder. This avoids having to title the vehicles first in the name of the originator and then having to transfer the vehicles to the funder, which transfer could be subject to sales tax, re-titling fees, and the other requirements of the titling laws. However, this structure only works where the parties are identified early enough in the process and with specificity so as initially to title the leased vehicles in the correct name of the funder.

Next month's installment will address types of recourse to the seller; allocation of taxes, costs, and expenses; servicing; remarketing and residual support; and securities laws issues.

Mark D. Kohler is General Counsel Syndications at GE Capital, Americas. He may be reached at [email protected]. Barry S. Marks, a member of this newsletter's Board of Editors, is a founding shareholder of Marks & Weinberg, P.C. Marks may be reached at [email protected] or through the firm's Web site www.leaselawyer.com. Alan J. Mogol, a member of this newsletter's Board of Editors, is a principal of Ober, Kaler, Grimes & Shriver in Baltimore. He may be reached at [email protected].