The volume of securitization of equipment leases is expected to increase in 2005 due to its flexibility and usefulness as a corporate financing tool. For the past decade, a wide variety of equipment leases have been securitized, including office equipment, computers, medical equipment, beauty parlor equipment, exercise equipment, video equipment and data processing leases. In the period beginning with the first quarter of 2002, issuances of securities backed by equipment lease receivables had dropped off due to a number of factors, including a general downturn in the post-September 11 economy and, more to the point, a plethora of consolidations among lessors and buy-outs of equipment originators by larger entities that, for various reasons, did not pursue securitization as a financing vehicle. Yet, lease-backed issuances have gradually escalated over the past three quarters and recently a number of first time issuers have set their sights on entering the market. Consequently, all of the current indicators point to heightened issuance of lease-backed securities during the course of 2005.
The purpose of this article is to introduce the basic structures of equipment lease securitizations and to discuss the benefits to, and challenges for, an originator considering the securitization of equipment lease receivables.
Lawyers, accountants, and regulators have cooperated to facilitate the issuance of securities backed by equipment leases. Lawyers have reached accommodations in the ways that transactions may be structured while still providing the bankruptcy opinions that are typically rendered. Evolving accounting standards granting off-balance-sheet treatment for the capital raised through securitization of leases have undergone some much publicized modification. Debt-for-tax structures have been developed to preserve the benefits of tax deductions and postpone income recognition. Issuances of equipment lease transactions have been enhanced and have actuated investor appetites through the innovative use of structured products such as interest rate and credit default swaps.
It is only the occasional aberration, usually based on alleged fraud (and not on any defect inherent in the general structure of asset backed deals or in the transaction documents), that has caused the market to take a censorious view of the complexities of the structures and the way they can be manipulated. Although not directly related to issuances of lease backed securities, the problems presented by the Enron meltdown and, more recently by National Century Financial Enterprises, generated a substantial degree of criticism of the more complicated structures that were innovated and deployed in the structured finance marketplace. The DVI defaults in the lease securitization area have exacerbated this difficulty and the fraud allegations in the Norvergence bankruptcy case will also have an adverse impact. Nonetheless, these specific instances have not halted the growth of securitization as, by most industry yardsticks, 2004 marked a watershed year for the volume of issuances of asset-backed transactions. However, misadventures such as those described above have refocused Wall Street professionals on whether it is appropriate to allow small, thinly capitalized companies to participate in the securitization market. As a consequence, new issuers of securities backed by lease payments, particularly smaller companies, can expect greater scrutiny of their management and procedures and should be prepared to encounter more strenuous structural enhancement requirements in future transactions on the part of underwriters, bond insurers and rating agencies.
Benefits of Securitization
For the originator, perhaps the primary motivation for securitization is to reduce the cost of funds by strategically capitalizing on the higher credit rating of a segregated pool of leases rather than the originator’s own credit rating. With proper management, securitization can serve as a useful liquidity tool, providing lease originators with an alternative source of financing to loans from banks and finance companies. As such, securitization can be an especially attractive for highly leveraged companies that originate leases. Securitization also may enable the originator, in certain circumstances described later in this article, to "borrow off balance sheet," in the sense that, if the transaction is structured as a sale, the assets are removed from the seller’s balance sheet and the securities evidencing interests in the asset pool do not appear as liabilities.
If, in the final analysis, it costs more to securitize than to use the more traditional techniques of borrowing through banks or privately placing debt, the value of the securitization could be tenuous at best. However, for a company with a solid portfolio of leases, it is a method of raising capital that should be explored. Even a lease originator for whom the savings are marginal may wish to develop a securitization program to expand its available sources of capital and to leave the door open to tap into alternative capital reservoirs in the future. In addition, covenant restrictions for originators in securitizations tend to be less onerous than in traditional financing, allowing greater future flexibility in the development of the originator’s business than with an equivalent amount of bank debt. In any event, developing a securitization program for leases expands the realm of originator’s options and puts another weapon in the treasury arsenal.
The essence of lease securitization is the isolation of cash flows on the leases from the bankruptcy risk of the originator. Thus, the purchasers of the securities look to the performance of the leases and not, at least theoretically, to the solvency of the originating company. Since repayment can be calculated actuarially if comprehensive data on the credit performance of the asset is available, capital costs can be reduced. Lease-backed securities are typically rated "AAA," and, as a cursory glance at any rating agency chart will reveal, very few leasing companies can raise capital at such a credit rating.
Lease-backed securitization transactions follow a general pattern that has been validated by consistent deployment. The originator of the leases transfers them to a special purpose entity (SPE), which, in turn, issues securities backed by those leases and lease payments. The SPE may be a corporation, a trust, a limited liability company (LLC), or a partnership, the choice often being decided by tax or accounting considerations. Essentially, the isolation from bankruptcy risk of the originator is the axis on which the success of the securitization turns. Typically, although not always, the originator acts as servicer of the leases and remits payments on a periodic basis, usually monthly (although some recent issuances have included a limited amount of quarterly or biannually paying leases). It is precisely this bankruptcy isolation of the SPE that allows securities of pools of leases to be rated "AAA." Along with the "AAA" rating comes a lower cost of funds for the lease originator. Without bankruptcy isolation, lessee payments are subject to the automatic stay under Section 362 of the Bankruptcy Code in a bankruptcy case of the originator and the rating of the transaction generally will be capped at the originator’s rating level. All sales of lease payments to special purpose vehicles run some risk that they will be recharacterized by a bankruptcy court as financings. For all types of lease securitizations, if a bankruptcy court deems a transaction to be a financing, the automatic stay provisions may apply, thereby trapping the lease payments that, by application of the transaction documents, should be directed to the issuer. Although investors may ultimately get their money as a secured creditor of the seller (assuming the proper backup procedures and filings were made at the time of the "sale"), by application of the automatic stay, there will be a delay in payment to investors. The structured finance paradigm is intended to prevent this type of uncertainty.
Typical Lease-Backed Securitization Structure
Factors affecting characterization as a "sale" include: recourse against the seller, treatment of assets as sold (this is particularly important if the seller continues to service the assets, in which case the sold assets should be easily identifiable), repurchase rights for the seller (does the "up side" belong to the seller?); accounting treatment, and tax treatment (operating lease securitizations may be characterized as debt of the seller for tax purposes) and title to the underlying equipment.
Accordingly, two primary legal opinions related to bankruptcy matters must be rendered for the deal to be rated: the true sale opinion and the non-consolidation opinion. The former states that, in the event of a bankruptcy of the originator, the transaction will not be recharacterized as a financing by the originator and in effect, there has been a "true sale" of the leases to the SPE that conducts the financing. The latter states that, in the event of a bankruptcy of the originator, the SPE and the originator will not be treated as the same entity, i.e. consolidated, for bankruptcy purposes. Obviously, to the extent the two entities are consolidated, the structure has failed for the assets have not been isolated from the originator. As a matter of practice, in a typical deal, transaction counsel will also be asked to render a third opinion so that if the bankruptcy court were to recharacterize the transaction to be a financing secured by the leases, the trustee on behalf of the holders of the lease-backed securities would have a first priority security interest in the leases and lease payments. In practice, this opinion can act as a back stop measure and serves as a disincentive to a bankruptcy trustee, a debtor-in-possession or a creditors’ committee from challenging the integrity of the sale.
SPE’s are structured in a manner to render them bankruptcy-remote. This does not mean that SPE’s are exempt from bankruptcy proceedings or are somehow legally or contractually precluded from filing a bankruptcy petition. Rather, because SPE’s have limited purposes (i.e., the purchase of assets and the issuance of securities), and they are passive in nature, the risk of a bankruptcy in a properly structured transaction is negligible. Because the SPE usually remains an affiliate of the originator and under its control, to prevent the originator from overriding the structure by causing a voluntary bankruptcy filing by the SPE, the SPE is required to have one or two independent directors, in the case of a corporate SPE, or member/managers, in the case of an LLC, who will have veto rights over such action.
The separateness of the SPE underlies the success of securitization structures. Investors rely on an essentially passive entity that acts as a legal receptacle of lease payments on the assets and, pursuant to the transaction documents, funnels them to payments on the securities. Except in a limited manner (typically limited to less than 10% recourse) the originator does not step in to guarantee payments on the assets or the securities. Similarly, the originator must not ignore the separate legal integrity of the SPE in its dealings with obligors on the assets or its future treatment of collections.
For new issuers of lease-backed securities, this archetypical separateness is somewhat counterintuitive. Usually accustomed to dealing with payors of receivables in a sensible businesslike manner, the originator now must grapple with the realization that it has to go through the admittedly artificial process of opening bank accounts for the SPE and sending money to them. Cash collections on the leases which the originator was accustomed to spending for general corporate purposes now must be scrupulously accounted for and may not be "borrowed" for the originator’s own purposes. Thus, the new issuer has given up control over what it perceives to be "its money." Nevertheless, respecting the structure and rigidly adhering to SPE orthodoxy is essential if the transaction is later to withstand the scrutiny inherent in a bankruptcy case.
Issuers need to determine what they are trying to achieve in a securitization from an accounting and tax perspective. Lease-backed structures are flexible enough that issuers have a broad range of options from which to choose such that a myriad of combined accounting and tax results can be achieved.
In a lease-backed securitization, securities are issued which rely on the cash flow underlying the leases for repayment. In order to determine the amount of securities that may be issued, the stream of payments on the leases is discounted at a projected yield (usually equivalent to the coupon on the securities plus the servicing fee rate). This creates an imputed current "principal balance" on the leases and securities in like amount (less the amount of credit support) can be issued. This "principal balance" of the lease amortizes over the life of the lease and can be calculated at any time by a rediscounting of unpaid monthly payments at the projected yield. The remaining part of the payment on the lease, not attributable to amortization of principal, is notionally "interest." Repayment of the principal on the securities takes place as this "principal" on the leases is reduced. Lease securitizations have commonly utilized the following structures:
- Pass-Through Securities. With pass-through securities, the seller sells assets to a grantor trust that meets federal tax rules for an investment trust. The trust issues securities evidencing undivided interests in the underlying assets while the trust itself is disregarded for federal income tax purposes. Payments on the leases are passed-through to holders of the securities as they are received.
- Collateralized Bonds. The seller sells the leases to an SPE or an owner trust which issues debt collateralized by the lease receivables and the lease residuals.
- Commercial Paper Structures. Typically, the leases in these types of transactions have been assigned to a third-party commercial paper conduit. Overcollateralization and/or reserve levels are set which are maintained as the leases pay down. Since the life of the lease is typically much longer than the tenor of the commercial paper, a liquidity facility is required, usually provided by a highly rated bank.
Throughout the mid to late 1990s, off-balance-sheet accounting treatment commonly was the goal. Smaller entities took advantage of the "gain-on-sale" accounting and significantly boosted earnings as a result. Needless to say, this procedure generated appreciable rewards in the market place. However, recently such accounting treatment has been viewed with a jaundiced eye by investors, regulators and rating agencies. As a result, a much greater frequency of "on-balance-sheet" securitizations are currently taking place. Structurally, these two types of accounting transactions are similar to those described above. The difference is in the way in which the SPE is structured. Financial Accounting Standard No. 140 (FAS 140) requires that the SPE for off-balance-sheet treatment must be a qualified special purpose entity (QSPE), which is essentially passive in outlook. Failing to meet the detailed characteristics set forth in FAS 140 will cause the QSPE to be consolidated on the books of its originator parent, thus bringing the securitization on-balance-sheet. However, this is not always as easy as it seems and sometimes accountants take a vigorous stand for off-balance-sheet treatment when the issuer wants to consolidate. Consolidation on the balance sheet does not by itself result in a bankruptcy consolidation. According to most prevailing views, lawyers seem generally comfortable that, while accounting consolidation is one of the factors to be examined, it is not dispositive provided, that title to the leases and lease payments have been transferred successfully from the originator to the SPE.
The tax treatment of a lease backed transaction also poses a question for the originator and, in practice, is often the overriding concern. Frequently, even though accounting considerations require sale treatment of the transfer of the securitized assets, issuers desire to preserve the tax benefits they currently enjoy as the owner of the leased assets, such as depreciation and interest deductions. Issuers do not want to trigger any immediate adverse federal or state income tax treatment, such as tax gain or recapture, by a sale. To accommodate these apparently conflicting goals, the transaction can be structured so that the consolidated tax group of the seller retains a sufficient interest in the pool of leases such that no sale is recognized for income tax purposes. Over the past several quarters, most lease-backed transactions have used debt-for-tax structures that have enabled the originator to treat the securities as debt of its consolidated tax group, even while it is viewed as a sale of leases and lease payments for corporate and bankruptcy purposes. However, some originators may still prefer gain-on-sale treatment and, although currently less common, such a preference may still be accommodated in the current market place, particularly when the gains may be used to offset current year losses.
In certain jurisdictions, applicable state tax laws may preclude an originator from consolidating for tax purposes. To solve this dilemma, the LLC structure may be used. A single member LLC is usually disregarded for federal and state tax purposes and no tax "sale" is deemed to take place. Thus, despite the inability to consolidate, no state or federal tax is payable since no sale has occurred. The LLC structure may also be used to prevent the payment of sales tax upon the transfer of equipment to the SPE where residual values thereof are to be used in the securitization.
Methods of Credit Support
There are several ways of providing credit support for the securities issued in a lease-backed securitization. In overcollateralization structures (senior/subordinate), two types of securities are issued with the "senior" securities effectively over collateralized by the amount of the subordinate securities. In a conduit issuing commercial paper, the seller into the conduit often retains an interest in the pool of leases (retention of excess receivables) but subordinates that interest to pay the commercial paper. Alternatively, a letter of credit may be obtained from a third party bank which accepts the first loss position. Reimbursement usually comes only from the cash flow on the leases. Commercial paper programs are sometimes supported by a revolving credit agreement that evidences a commitment to lend both for credit and liquidity support. Another form of credit support is a guarantee or surety bond from a highly rated monoline insurance company or surety. Again, the insurer or surety usually looks to the pool of leases for recourse. Finally, credit enhancement may be provided by the credit provider standing ready to purchase defaulted assets from the special purpose vehicle (whether it be a grantor trust or an SPE). Where the credit provider is the originator/seller, as discussed elsewhere in this article, this raises significant questions as to whether a true sale of leases from the seller has taken place.
One of the most pressing concerns for a new entrant into securitization is the servicing of the leases and the effect of servicing requirements on existing business. Obviously, the proposed servicer must be able to demonstrate that it has the capability to monitor the leases and collect payments from lessees in a timely manner; some upgrade in systems capabilities may be required. Because the rating agencies and underwriters commonly require that servicing charges be applied, it is often important to know what is the standard in the market for servicing fees among servicing companies in the equipment lease industry. In general, the servicing methods that have been successfully applied by the lessor in its own business are probably the starting point for the servicer’s contractual obligations in a securitization because employees are familiar with such procedures, and they will minimize the effect of doing a transaction on the business as a whole.
Often in collecting data, the originator will discover efficiencies that can be used to improve its business. For example, an analysis of categories of credit defaults may lead to loan underwriting improvements. Other costs, however, may be incurred that relate solely to the securitization. Computer systems that are adequate for current purposes may not be good enough to prepare the detailed reports required for securitization. In our time of dynamic evolution of data systems, upgrades (and continual future upgrades) are often required. Nonetheless, it is always wise to question the necessity of such reports before undertaking the expenses and logistical burdens of a major technology upgrade.
As discussed in connection with concerns related to residuals, in the event the seller becomes insolvent one significant question is who will assume responsibility for servicing the assets. Although most deals name a successor servicer (often the trustee for the transaction) it may be extremely difficult as a practical matter for a successor servicer to access records, computer systems and documentation in a timely fashion. Moreover, it is never desirable from a deal performance perspective to have a reluctant trustee acting as a "conscripted servicer" who is responsible for making collections on the leases. In many transactions, particularly in transactions in which the servicer may be inexperienced or have a relatively low credit rating, a highly motivated backup servicer should be provided with a great deal of current data over the course of the deal. The purpose of this "hot backup servicing" feature (that is becoming more common in the market) is to ease the burdens of servicing transitions and to reduce the costs related to such transitions as well as enhance collections generally. However, sharing proprietary information with another entity may cause an issuer some major concerns.
Servicing is one of the most difficult aspects of lease securitization. There is a tendency, particularly for a first time issuer, to follow "market standards." Our advice to an issuer is to carefully consider the necessity of disrupting the current flow of business.
Securities Law Issues
The offering and sale of lease-backed securities must be registered with the Securities and Exchange Commission (SEC) unless an exemption applies. Common exemptions include those for "private placement" and commercial paper.. Of particular concern for a new issuer are disclosure requirements, particularly those involving a description of its business and the way in which it underwrites and services leases.
New issuers also must consider the requirements of the securities laws. Many new issuers of lease-backed paper find their way into securitization by selling assets to a conduit or the provider of a warehouse line. This generally involves only talking to the sponsor of the financing and requires disclosure only to that entity. Usually the next step is to enter the private placement market; fairly substantial disclosure must be given but recipients can be limited and carefully targeted. Eventually, however, the originator will think about issuing in the public market. This raises a new range of problems. Disclosure is publicly available and is more generally accessible than ever through EDGAR and certain other internet based outlets. The originator is required to widely disseminate not only the way its leases are underwritten and the means of implementing their collection and foreclosure procedures but also any unusual characteristics of its leases or servicing methods. Moreover, it may have to be regularly updated through filings under the securities laws, all of which are publicly available. Thus, the originator must determine whether it is ready to regularly disclose information on its business to outsiders and competitors. Given the contraction in the number of players in the leasing industry resulting from recent consolidations, disclosure requirements are often a daunting prospect for new issuers.
In December 2004, the SEC adopted a massive set of new rules (Regulation AB) relating to the issuance of asset-backed securities under the Securities Act of 1933 and the Securities Exchange Act of 1934 that directly impact public issuances of lease-backed securities. In particular, public issuers must be aware of the ongoing reporting requirements under the Exchange Act. Although lease-backed issuers had been required under existing rules to make periodic reports, the new mandates imposed by Regulation AB have expanded the scope of such reporting in a number of ways, including filing the new form 10-D and periodic distribution reports,, establishing minimum general servicing standards and mandating the filing of reports that attest to compliance with such servicing criteria. While old deals will be grandfathered for reporting purposes, the new requirements will apply to new offerings of lease-backed securities and the Exchange Act reporting which is required thereafter.
- Treatment of Residuals. In general, a distinction is made between an operating lease (or true lease) and a finance lease in securitization deals. The general distinction is that a finance lease is essentially a secured loan or a "lease intended for security." Operating leases often have a residual value and this may be taken into account in determining the amount of money which may be raised in a securitization. In the case of operating leases, the servicer must demonstrate that it can successfully recover an amount equal to the assigned value when it sells the residual. Reliance on residual value may be impacted if weakness on the part of the servicer compromises the servicer’s ability to recover the value of the residuals. One issue of importance therefore, if residual value is to be taken into account, is whether the trustee or back-up servicer has sufficient experience in dealing with the type of asset (i.e., copy machine, computer, etc) which is being leased so as to ensure recovery of the assigned residual value.
- Financial Assets. Any company contemplating the public issuance of lease-backed securities must be aware of the vexing issue of the application of the term "financial assets," which is defined for securities law purposes as assets that "convert into cash within a finite time period." This impacts how the securities are to be registered for a public offering and how an exemption may be obtained from registration under the Investment Company Act of 1940, but it also has wider implications. If the financial asset requires some future performance by an originator or third party, then payment on the financial asset is subject to that third party’s performance and bankruptcy risk. Thus, a lease dependent on performance by the lessor raises significant questions. Other assets that have been securitized, such as lease residual interests, may not turn to cash automatically but may be packaged and used to raise capital (or provide credit support) even though they will have to be liquidated. Historical information on the amount of cash realized on equivalent assets is important in this context.
- New Rules for Publicly Issued Lease-Backed Securities. By application of Regulation AB, the definition of asset-backed security has been expanded to include lease-backed securitizations where a portion of the securitized pool balance is attributable to the residual value of the physical property underlying the leases. However, Regulation AB sets limits on the percentage of the securitized pool balance attributable to residual values. With regard to motor vehicle leases (which includes all types of automobiles, trucks and motorcycles but not "leisure craft" such as snowmobiles), residual values must not constitute 65% or more, measured by dollar volume, of the securitized pool balance as of the measurement date. For all other lease-backed issuances, residual values must not constitute 50% or more of the securitized pool balance as of the measurement date. In order to be eligible for a "shelf registration" under Form S-3 (which is far more common than a Form S-1 issuance), residual values of lease-backed securitizations other than those backed by motor vehicle leases are further restricted to less than 20%, measured by dollar volume, of the securitized pool balance as of the measurement date. For purposes of determining residual value thresholds, residual values need not be included to the extent that a separate party is obligated for the residuals (e.g. through a residual value guarantee or when the lessee is obligated to cover any residual loss). In typical lease-backed issuances, it is rare for the value of the residual component to approach these levels. In addition to satisfying the foregoing tests, lease-backed issuers must provide additional disclosure regarding residuals, such as statistical information on historical realization rates, the manner and process in which residual values will be realized and the entity that will convert the residual values into cash. New requirements to explain the methodology of residual valuation may cause problems for issuers.
Other Common Lease Issues
- Master Leases. Frequently, the inclusion of leases coupled with a master lease (i.e. when the master lease sets out the basic terms of each lease and one or more schedules are attached to define the specific assets subject to the lease as well as any special terms relating to those assets) in a securitized pool will give rise to certain concerns relating to disentangling the rights of the securitized assets from those those that are not securitized (particularly with regard to the enforcement of remedies). In certain instances, it may be necessary to require lessees to execute amendments to ensure that the SPE will have the right to separately enforce the rights under the master lease with respect to securitized leases. A similar issue is the manner in which master lease payments are invoiced. The use of a single invoice for all equipment subject to the master lease is not only a "bad fact" for establishing a true sale, but it also may be a factor considered by a bankruptcy court to determine is the difficulty of discerning the individual assets and liabilities of the originator with those of the SPE. Both commingling and the difficulty of discerning assets are factors that favor substantive consolidation of the SPE with the originator in the event of the originator’s bankruptcy.
- Incentive Programs. For captive finance subsidiaries of equipment manufacturers, lease financing often is a means to help the manufacturer sell more goods. It is not unusual for the manufacturer to design a program to provide incentives to potential lessees which may help facilitate the sale of equipment. Typically, the manufacturer will agree to compensate the finance company for any losses the finance company sustains based on the difference between the present value of the actual residual and the present value of the increased residual. Depending on how incentive programs are handled in a securitization, they can potentially expose the transaction to the credit risk of manufacturer or the finance company providing the incentives and, depending on the level of recourse, may present true sale issues in the event the seller of the receivables provides the incentive. In structuring the transaction, the number and volume of leases impacted by such an incentive program must be limited. In most cases, incentive programs create an issue in the transaction because the lease contract and the equipment together represent a package that is "below market."
- Credit Profile of the Assets. Most new originators have few if any losses. Unseasoned portfolios (or at least those that get securitized) rarely do. Thus, in order to appreciate the credit risk, it will be important to look at comparable assets by comparable issuers. One of the biggest obstacles for a new issuer is its lack of data. Without detail on the performance of an asset, it is hard to understand credit risk and thus difficult to achieve ratings goals.
- Contractual Impediments to Securitization. Many new issuers find they already have restricted their ability to securitize by agreeing to covenants in bank loan documents or other financings that restrict their ability to sell assets. Others already have pledged assets under blanket liens that pick up all their receivables. These are fairly typical types of covenants, particularly for smaller companies, and counsel may not have objected to them in prior deals. Amendments of these provisions may be difficult to obtain but, as securitization has become more prevalent, secured creditors have recently been more willing to grant accommodations in this regard than in the past. Another contractual issue that frequently arises is when certain maintenance contracts between the originator/servicer and the lessee give rise to offset rights on the part of lessees which may undercut the unconditional character of leases to be sold in a securitization transaction. Thus, any new issuer will need to review its prior contractual arrangements and debt documents to determine if any of these landmines exist. This should be done as soon as possible so waivers can be obtained in adequate time.
It is safe to say that equipment lease-backed securitization is no longer a novel technique in the capital markets given the escalating use and increasing sophistication of securitization techniques with regard to leases and lease payments over the past decade,. The past few years of experience have demonstrated that structured financing offers many benefits to both lease originators and investors alike and that the mechanics, enhancements and structural integrity of the transactions are valid. Lessors considering this form of financing should explore the many variations in the above structures to find the structured finance paradigm that best suits the expectations and vision of their own business models.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.