OURNAL J OF EQUIPMENT LEASE FINANCING

Articles in the Journal of VOLUME 27 • NUMBER 3 • FALL 2009 Equipment Lease Financing are intended to offer TAKING ANOTHER LOOK AT SYNDICATION RISKS IN THE CHANGED ECONOMY responsible, timely, in-depth By Alan J. Mogol analysis of market segments, Risk management is central to the syndication of a fi nancing transaction. The customs and practices of the past need to be reanalyzed. Originators must be aware of the fi nance sourcing, marketing potential issues so they can respond appropriately when asked to change their standard documents. Here is a summary of what funders may ask originators to do, and why. and sales opportunities, liability management, tax A PRIMER ON LEASING TRANSACTIONS IN THE INTERNATIONAL laws regulatory issues, and MARITIME SECTOR By Basil M. Karatzas current research in the fi eld. The Merchant Marine Act of 1920 (Jones Act) has long governed leasing in the maritime Controversy is not shunned. industry in the United States. However, as this article describes, international markets— “blue-water” shipping—have certain distinct differences regarding asset differentiation If you have something and residual value, sources of capital, legal environment, and taxation. important to say and would like to be published in the EVIDENCE FOR THE LEASING VALUE PROPOSITION By James Schallheim, PhD industry’s most valuable Academic research supports the notion that leasing preserves capital and lines of credit, educational journal, call provides tax advantages, and may offer advantages from the transfer of equipment residual risk to the lessor. Less clear, however, is whether there is any support for off- 202.238.3400. balance sheet fi nancing as a value enhancement to lessee fi rms.

The Equipment Leasing & Finance Foundation 1825 K Street NW Suite 900 Washington, DC 20006 202.238.3400 www.leasefoundation.org Copyright © 2009 by the Equipment Leasing & Finance Foundation • ISSN 0740-008X Taking Another Look at Syndication Risks in the Changed Economy By Alan J. Mogol

here is an old Chinese proverb (blessing or In this article, the author will outline certain com- curse?): “May you live in interesting times.” mon approaches to syndication, identify standard cus- Well, the equipment finance industry is cer- toms and practices, and consider whether the parties tainly living in an interesting time. should reanalyze the risks and rewards associated with TIt is no longer business as usual on those customs and practices. Funders the front end of transactions. Although Funders need to take a need to decide whether they are com- some banks and equipment finance fortable going along with past customs companies say they have liquidity and fresh look at—and apply and practices or whether they should are willing to do business, the reality ask for additional protections from the is that only the most creditworthy cus- a critical eye to—certain originators. For their part, originators tomers, willing to pay heavy spreads, need to be aware of these potential is- are in the running for new financing. issues to be sure they sues in order to formulate responses Many regional banks are restricting when they are asked to change their remain protected, and new business opportunities to com- standard documents. panies in their footprint or companies originators should be As used in this article, the term willing to establish a banking relation- “funder” means assignees, purchasers, ship. prepared to respond to and financiers of lease and loan trans- It should also no longer be busi- actions; the term “originator” means ness as usual with respect to syndica- changed requirements syndicators, assignors, and lessors that tion of equipment finance transactions. originate the lease or loan transactions; Due to the lack of liquidity available in from funders. and the term “obligor” means lessees, the marketplace and the weakened fi- borrowers, and guarantors. This ar- nancial condition of some originators, syndications have ticle uses the terms “lease” and “loan” without regard to also been affected by the current economic situation. As whether the transactions are true leases, financing leases, a result, previously accepted customs and practices— or equipment finance agreements. and allocations of risk—should be reexamined in the current economic marketplace. This is not to say that COMMON STRUCTURES funders will not ultimately remain comfortable dealing In syndicating equipment finance transactions there are with certain originators as they have in the past, but at three common structures: (1) the assignment of the lease the very least funders need to take a fresh look at—and and leased equipment (an “outright assignment”); (2) the apply a critical eye to—certain issues to be sure they re- assignment of the rental stream and certain rights under main protected, and originators should be prepared to the lease (a “discounting transaction”); and (3) the sale respond to changed requirements from funders. of a participation interest in the payments and proceeds TAKING ANOTHER LOOK AT SYNDICATION RISKS JOURNAL OF EQUIPMENT LEASE FINANCING • FALL 2009 • VOL. 27/NO. 3 payable under the transaction documents and from the the originator’s rights under the lease, the rental stream, equipment and any related collateral. and the equipment. Because the originator/borrower remains the owner Outright Assignment of the leased equipment and the lessor under the lease, With respect to the first typical structure, the outright the originator/borrower incurs contractual obligations to assignment of the lease, most parties wait until the lease the funder/lender. The nonrecourse loan is evidenced by and the equipment schedule have been signed, the a promissory note from the originator/borrower to the equipment has been delivered and accepted, and the funder/lender. As with the outright assignment structure, price has been paid for the equipment. When the as- the originator/borrower makes certain basic representa- signee pays the consideration for the assignment, the as- tions with respect to the underlying lease transaction signor conveys legal title to the equipment and assigns and, if those representations prove to be untrue or are all rights under the existing equipment schedule arising breached, there is limited recourse back to the origina- after the lease transaction has been closed. tor/borrower to the extent of any damages resulting from However, there is an alternative approach that in- the breach of those representations. There is, however, volves the assignment of certain rights under the proposal no recourse with respect to the credit of the lessee. This or commitment before the equipment alternative structure is less advanta- is purchased and leased. Using this ap- Because the originator/ geous to the originator, since the origi- proach, the funder acquires the equip- nator incurs certain limited recourse. ment directly from the vendor or the borrower remains the lessee (in a sale-leaseback), and the Participation Interest equipment schedule is executed in the owner of the leased In the third common structure, the par- funder’s name directly. The principal ticipation interest, the originator sells equipment and the lessor advantage of this alternative structure to a participant an undivided propor- is that title to the equipment does not under the lease, the tionate share in either (1) the payments pass through the originator (so there and proceeds to be received pursuant should be no lien issues and no risk of originator/borrower incurs to the transaction documents and from the originator’s subsequent bankrupt- the collateral or (2) the rights under cy), but the disadvantage is that the contractual obligations to the transaction documents, includ- originator may lose some control over ing the payments and proceeds of the the lessee relationship. The alternative the funder/lender. transaction documents and the collat- structure is preferable if the originator eral. Due to tax concerns, this structure has a blanket lien on its assets so that a lien release would is usually used with a loan, a synthetic lease, or a nontax be required, or if the originator is unwilling to confirm lease. It is not typically used with a tax lease because, if that it is conveying clean title. the participation interest includes a proportionate share of the ownership interest of the leased asset, the Inter- Discounting Transaction nal Revenue Service (IRS) may take the position that the In the second common structure, the discounting trans- originator and the participant, now sharing ownership action, the typical approach involves an outright assign- of the leased assets, have formed a partnership for tax ment of the rental stream becoming due under the lease purposes. payable by the lessee, together with the grant of a securi- This position could adversely affect the availability of ty interest in the leased equipment to secure the payment the modified accelerated cost recovery system (MACRS) and performance of the lessee’s obligations to pay the deductions with respect to the leased assets claimed by rent. The originator incurs no independent obligation to the originator and the participant, because the IRS could the funder. The alternative approach involves a nonre- argue that if a partnership has been created, depending course loan made to the originator, which is secured by on the point in time during the calendar year at which a collateral assignment and grant of a security interest in the partnership is deemed to have been created, the

2 TAKING ANOTHER LOOK AT SYNDICATION RISKS JOURNAL OF EQUIPMENT LEASE FINANCING • FALL 2009 • VOL. 27/NO. 3 partnership may have a short first fiscal year, preventing Obligor’s credit. It is generally accepted that the origi- the originator and the participant from claiming the full nator is not responsible for the creditworthiness of the year’s MACRS deductions to which they would other- obligor or the accuracy of any financial information for- wise have been entitled. Also, under this structure, the warded with respect to the obligor. originator and any participants may have to file a part- nership tax return. Validity and enforceability. It is not so cut-and-dried as The choice of the structure depends to a large extent to whether the originator should be responsible for the on the goal of the parties: (1) if the funder is to enjoy validity and enforceability of the underlying transaction the tax benefits and residual value of documents (which would necessar- the assets, the parties would use the Standard customs and ily include responsibility for the due outright assignment; and (2) if the authorization, execution, and deliv- originator is to retain the tax benefits practices have evolved ery of the transaction documents by and residual value, the parties would the obligor). Many originators seek to use the discounting structure (if there in the syndication limit their responsibility in this area by is only one funder) or the sale of a par- including a “knowledge” limitation in ticipation interest (if there are multiple marketplace that address the representation. The parties often funders, but not with respect to a true draw a distinction between (a) due au- lease transaction). the management of the thorization, execution, and delivery of the underlying documents by, and that risks associated with the RISK ANALYSIS the underlying documents constitute Standard customs and practices have underlying transaction the legal, valid, and binding obligation evolved in the syndication marketplace of, the originator itself (which is cus- that address the management of the and allocate those risks to tomarily not qualified to “knowledge”), risks associated with the underlying and (b) the same representation made transaction and allocate those risks to either the originator or with respect to the obligor. either the originator or the funder. The Some originators are willing to customs and practices to be discussed the funder. make this representation with respect in this article fall into three categories: to the obligor if the representation is (1) the use of representations and warranties; (2) com- limited to “knowledge,” while others limit it even fur- pliance with the requirements of the Uniform Commer- ther and state that they are relying solely on closing cer- cial Code (UCC); and (3) the use of agency relationships. tificates or opinions obtained from the obligor in this regard. Some funders are willing to accept these limita- Representations and Warranties tions, while others insist that appropriate due diligence Representations and warranties reflect a negotiated al- be undertaken by the originator as part of its service location of the risk addressed by that representation and originating the transaction, since the originator has the warranty. The representations and warranties to be made “hands on” contact with the obligor, and the originator by the originator will vary depending on the structure makes the representation without qualification. used for the syndication. However, there are certain basic issues to be addressed, regardless of the specific Compliance with law. Similarly, many funders insist that structure, and a customary approach has evolved in the the originator provide a representation as to compliance industry as to the allocation of the risk to be addressed with applicable laws, since the documentation was pro- by the representation. What may have been a reasonable vided by the originator and the transaction was closed by allocation of risk in the past may need to be revisited in the originator. The funder’s argument is that the origina- light of the current economic circumstances, where there tor (a) is in the best position to confirm compliance with are fewer funders actively involved in the marketplace applicable law; (b) in any event, already has that risk with sufficient liquidity to participate in transactions. before the syndication is consummated; and (c) should

3 TAKING ANOTHER LOOK AT SYNDICATION RISKS JOURNAL OF EQUIPMENT LEASE FINANCING • FALL 2009 • VOL. 27/NO. 3 not be able to avoid that risk simply because it syndicates made by both parties, since the funder wants to have a the transaction. claim against the originator as a second, “deep pocket” in addition to having a claim against the obligor. Knowledge limitations. In connection with the syndi- If the parties agree to permit a knowledge qualifier, cation of already funded transactions, many originators another issue has to be addressed as to what the parties try to limit their representations to “knowledge” with re- mean by terms such as “to originator’s knowledge” or spect to the following standard issues: (1) that the equip- “originator has no knowledge.” Some parties include a ment has been delivered and accepted by the obligor, or definition of those terms so as to avoid any ambiguity the collateral is in the possession of the obligor; (2) that as to the parties’ intention. Is the originator required to no casualty has occurred with respect to the equipment undertake an investigation before making the represen- or the collateral; (3) that the purchase tation, or is it sufficient that no respon- price has been paid with respect to the In light of recent fraud sible officer of the originator has actual equipment or the collateral, as well as knowledge that the matter being so any taxes incurred in connection with transactions, some represented or warranted is incorrect the acquisition of the equipment or the or misleading in any material respect? collateral; (4) in the context of a lease funders are now insisting Past practice was to permit the origi- transaction, that all sales or use tax nator to avoid having to undertake the with respect to the rentals has been col- that the originator step due diligence so as to actively seek the lected and remitted to the appropriate knowledge. However, some funders taxing authorities; (5) that no default up to an unqualifi ed are now imposing that obligation on has occurred with respect to the un- the originator since today funders gen- representation as to derlying transaction; and (6) that the erally are viewed as being in a more obligor has no defenses, claims, coun- delivery of the equipment advantageous position and having terclaims, or set-offs. stronger bargaining power. In the past, funders have accepted to and acceptance by the the knowledge limitation since some Title and liens. One of the disad- of these issues are beyond the direct obligor. It is a question of vantages of assigning a funded lease ability of the originator to confirm. transaction is that title to the leased However, in light of recent fraud trans- allocation of the risk. equipment and ownership of the lease actions (such as Le-Nature’s and Allco, documentation pass through the origi- where it was subsequently determined that at least some nator. This gives rise to the possibility that liens might at- of the equipment never existed), some funders are now tach in the hands of the originator. It is customary for the insisting that the originator step up to an unqualified originator to represent that it owns outright the interest representation as to delivery of the equipment to and ac- in the underlying transaction documentation being con- ceptance by the obligor. It is a question of allocation of veyed, free and clear of any liens or encumbrances. As the risk. to the equipment itself, it is less clear as to whether the Some of these issues can be backstopped by includ- appropriate standard is to have the originator represent ing parallel representations to be made by the obligor in that it is conveying good title to the leased equipment, the Notice and Acknowledgment of Assignment unless, free and clear of all liens and encumbrances. of course, the transaction is to be syndicated on a blind In the past, some originators have limited that rep- basis. Where the representations are included in the No- resentation to one where it represents only that it is tice and Acknowledgment of Assignment, the originator’s conveying such title as was received from the vendor, position would be that the funder does not need to have in order to avoid having the originator be a guarantor the same representations made to it both by the obligor of title. Today, some funders are insisting that that risk and by the originator. Now, many funders are taking the be allocated to the originator, justifying their position by position that they do require that the representations be the fact that the originator has that risk before the syndi-

4 TAKING ANOTHER LOOK AT SYNDICATION RISKS JOURNAL OF EQUIPMENT LEASE FINANCING • FALL 2009 • VOL. 27/NO. 3 cation is consummated and should not be able to avoid the stronger hand. In the current economic situation, that risk simply because it syndicates the transaction. there are fewer funders available (whether as a result of the lack of liquidity or increasingly stringent credit stan- Security interest. Similar issues have to be addressed in dards as a condition to agreeing to fund the transaction). the context of the assignment of a rental stream structure Funders may be able to insist more frequently that the or of a secured loan. The funder needs to be assured that allocation of these risks be borne by the originator. the rental stream that it is purchasing or in which it will In light of that situation, some funders are now in- hold a security interest, and the related leased equipment, sisting on inclusion of a “10b-5”-type representation to are owned outright by the originator, free and clear of all the effect that the originator has no knowledge of any liens and encumbrances, so that the interest or security facts impairing the value or validity of the transaction interest acquired by the funder will be good title or a first documents, any rights created thereby, or the syndica- priority perfected security interest, free tion agreement itself. This very broad and clear of all liens and encumbranc- The funder needs to catchall representation is intended es. In the context of a secured loan, the to pick up any negative information funder needs to be assured that the se- be assured that the known to the originator that is not curity interest acquired by the funder covered by the specific representations will be a first priority perfected security rental stream that it is negotiated between the parties. It is in- interest, free and clear of all liens and tentionally broad and ambiguous in or- encumbrances. purchasing or in which der to provide maximum protection to The issues for the originator are the funder. For the same reasons, it is the same in both contexts: (a) should it will hold a security objectionable to the originator since it the originator warrant that the secu- provides an opportunity for the funder rity interest has been perfected; and interest, and the related to recoup any loss that it incurs in the (b) should the originator warrant that future by successfully persuading a leased equipment, are the security interest has first priority, court that the originator was aware of free and clear of all liens and encum- owned outright by the certain negative information but failed brances. Even if an originator is will- to disclose it. ing to give the representation as to the originator, free and Also in light of the unsettled eco- first issue, some originators qualify the nomic times, some funders, being con- representation to the extent that the clear of all liens and cerned about the financial condition of representation addresses only a secu- the originator, are requiring additional rity interest that may be perfected by encumbrances. representations and warranties to the the filing of a UCC financing state- effect that: (a) the originator is not in- ment. Excluded by that limitation is any representation solvent within the meaning of any federal or state laws, as to specialized collateral, such as investment securi- and the consummation of the transaction will not cause ties, or equipment subject to registration statutes, such the originator to become insolvent; and (b) the amount as certificate of title motor vehicles, aircraft, and railroad to be paid by the funder to the originator is fair consider- rolling stock. As to the second issue, if the originator is ation for the interest being acquired, within the meaning willing to give the representation at all, some originators of all federal and state laws. As to the first representation, qualify the representation by reliance solely on a UCC there should no be objection on the part of the origina- filing search report that they obtain and attach to the tor. However, a determination as to whether the price syndication documents. to be paid constitutes “fair consideration” is more prob- lematic. Allocation of risk. As is the case with respect to most of the representation and warranty issues, it boils down Discounting transaction. The specific representations to a question of allocation of risk and which party has and warranties negotiated by the parties are also of great

5 TAKING ANOTHER LOOK AT SYNDICATION RISKS JOURNAL OF EQUIPMENT LEASE FINANCING • FALL 2009 • VOL. 27/NO. 3

concern in the context of a discounting transaction. Al- Under UCC Section 9-102(a)(11), “chattel paper” though customarily thought of as being “nonrecourse” is defined to include a lease of equipment since it con- to the originator, most discounting transactions actually stitutes a record that evidences both a monetary obliga- include limited recourse to the originator, since the orig- tion and a lease of specific goods. Similarly, UCC Section inator is made expressly personally liable for damages 9-102(a)(2) makes it clear that an “account” includes the resulting from the breach of or misrepresentation with rental payment stream as a right to payment of a mone- respect to certain basic representations and warranties. tary obligation for property that has been leased. Accord- This is especially the case with respect to representations ingly, the assignment of a lease involves the sale of chattel and warranties made by the originator with respect to paper and accounts, and the assignment of a loan and the bona fides of the underlying transaction: (1) that related promissory note involves the sale of an instru- the underlying transaction documents ment. In order to perfect the sale, one constitute the legal, valid, and binding Most discounting must file a UCC financing statement obligation of the parties (including the describing the transaction, unless per- obligor), and (2) that the underlying transactions actually fection may be obtained without filing. transaction documents are enforceable UCC Section 9-309 provides for include limited recourse against the obligor in accordance with automatic perfection of the sale of ac- their terms. The funder argues that, to the originator, since counts, a promissory note, or a pay- without having personal recourse to ment intangible without requiring the the originator for a breach of these rep- the originator is made filing of a UCC financing statement, resentations, it has no assurance that and UCC Section 9-313 provides for the asset it is acquiring has any value expressly personally liable perfection of the sale of chattel paper at all. or an instrument by the assignee tak- The further argument is made that for damages resulting ing physical possession of the chattel the originator already bears the risk ad- paper or instrument, rather than by fil- dressed by these representations before from the breach of or ing a UCC financing statement. UCC the syndication is consummated and Section 9-102(a)(61) defines “payment should not be able to avoid that risk misrepresentation with intangible” as a general intangible un- simply because it syndicates the trans- der which the account debtor’s princi- action. The discussion above on the respect to certain basic pal obligation is a monetary obligation. parallel representations with respect “Payment intangibles” took on ad- representations and to a funded lease transaction is equally ditional significance as a result of the applicable in the context of a discount- warranties. court’s decision in Net Bank, FSB v. Kip- ing transaction: are knowledge limita- perman (In re Commercial Money Cen- tions appropriate; who is in a better position to conduct ter, Inc.), 350 B.R. 465 (B.A.P.) 9th Cir. Aug. 25, 2006. due diligence; and who should appropriately bear the The bankruptcy appellate panel found that the transac- risk. tion at issue involved an assignment of payment intangi- bles (the payment stream) that were stripped away from UCC Perfection the underlying equipment leases. It is well recognized that the Uniform Commercial Code This case caused tremors within the equipment fi- is applicable with respect to a sale of accounts, chattel nance industry because of its determination that the paper, payment intangibles, or promissory notes (pur- stream of payments, constituting payment intangibles, suant to Section 9-109(a)(3)). All three of the common could be stripped away from the underlying equipment structures for syndication involve a “sale” within the leases, constituting chattel paper. The issue is whether scope of Section 9-109(a)(3). Even the sale of a partici- UCC Article 9 gives priority to the funder that perfects pation interest is covered. (See, Official Comment 5 to its purchase of a lease by taking possession of the chat- Section 9-109.) tel paper after the sale of the lease payment streams, as

6 TAKING ANOTHER LOOK AT SYNDICATION RISKS JOURNAL OF EQUIPMENT LEASE FINANCING • FALL 2009 • VOL. 27/NO. 3 payment intangibles, to a third party that automatically Clearly, the committee’s intention is to indicate that the perfected its purchase of the “stripped” payment stream court’s decision in In re Commercial Money Center was as a payment intangible. In order to avoid this issue, wrong. careful funders are now requiring an additional specific Note that this issue does not relate to perfecting a representation that the originator has not previously sold security interest, but rather the sale itself. It is essential or conveyed an interest in the payment stream becoming that the sale be perfected because otherwise the assets due under the subject equipment lease. could be pulled into the originator’s Relief may be on the way. Whether Careful funders are now bankruptcy estate. (See, In re Commer- payment intangibles can be stripped cial Money Center, infra.) The assets away from the underlying equipment requiring an additional could also be subject to claims of the lease is one of a number of issues to be originator’s general creditors. addressed by the Article 9 Joint Review specifi c representation The filing of a UCC financing Committee, which was authorized in statement to perfect the sale of certain 2007 by the Uniform Law Commission that the originator has assets may be problematic for certain (formerly known as the National Con- originators. Some parties may have a not previously sold or ference of Commissioners on Uniform negative pledge as part of senior credit State Laws) and the American Law In- conveyed an interest agreement provisions that prohibits the stitute. The committee’s charge is to granting of a security interest and, by deal with UCC Article 9 issues that in the payment stream extension, prohibits permitting the fil- have arisen in practice, are the subject ing of a UCC financing statement even of nonuniform amendments, or are of becoming due under the though it does not technically create a sufficient importance that some change security interest in the asset sold. Oth- needs to be made. At its most recent subject equipment lease. er parties have simply taken the posi- meeting in March 2009, the commit- tion as a matter of corporate policy that tee again discussed an appropriate response to the In re they will not permit the filing of UCC financing state- Commercial Money Center decision. The report of that ments against them. meeting states that it is proposed to include an amend- Under the current economic climate, many funders ment to Comment 5d of UCC Section 9-102, which are now reconsidering whether to accept the credit risk would read as follows: of the originators. The old argument that the originator is Note, however, a right to the payment of money is fre- a solid financial institution that presents no bankruptcy quently buttressed by ancillary rights, such as covenants risk is no longer as persuasive as it was as recently as one in a purchase agreement, note, or mortgage requiring in- year ago. Many funders are now seriously reconsidering surance on the collateral or forbidding removal of the col- whether to accept that risk by acceding to the origina- lateral, or covenants to preserve the creditworthiness of the promisor, such as covenants restricting dividends and tor’s requirement that no UCC filing be made to perfect the like. This Article does not treat these ancillary rights the sale. In any event, if a funder is to forgo the filing, it separately from the rights to payment to which they relate. should require that the original chattel paper or instru- For example, attachment and perfection of an assignment ment has been delivered to it. of a right to payment of a monetary obligation, whether In addition to wanting to take possession of the it be an account or payment intangible, also carries these original chattel paper or instrument for purposes of ancillary rights. Among these ancillary rights are the les- sor’s rights with respect to leased goods that arise upon perfecting the sale itself, funders should also insist on the lessee’s default. See Section 2A-253. Accordingly, and possession of the originals because the UCC also affords contrary to the opinion in In re Commercial Money Cen- certain statutory priorities to purchasers of chattel paper ter, Inc., 350 B.R. 465 (B.A.P. 9th Cir. 2006), if the les- or instruments. Under UCC Sections 9-330(a) and (b), if sor’s rights under a lease would constitute chattel paper, the purchaser of chattel paper gives new value and takes an assignment of the lessor’s right to payment under the possession of the chattel paper (or obtains control of the lease also would be chattel paper, even if the assignment chattel paper) in good faith, in the ordinary course of purports to exclude other rights. 7 TAKING ANOTHER LOOK AT SYNDICATION RISKS JOURNAL OF EQUIPMENT LEASE FINANCING • FALL 2009 • VOL. 27/NO. 3 its business, and without knowledge that the purchase Similarly, in the context of the fiscal agency, funders violates the rights of a secured party or that it has been need to reexamine their right to terminate the fiscal assigned to an identified party other than the purchaser, agency. It is customary to include certain trigger events then such purchaser has priority over a security interest that give the funder the right to terminate the fiscal in the chattel paper. agency, including bankruptcy. However, one must be Similarly, under UCC Section 9-330(d), if the pur- careful not to require that pulling the trigger as a re- chaser of an instrument gives value and takes posses- sult of bankruptcy involves the giving of a notice (since sion of the instrument in good faith, that could potentially be made impos- without knowledge that the purchase In light of the current sible by virtue of the automatic stay violates the rights of a secured party under the Bankruptcy Code). In to- (other than a secured party that has economic situation, day’s economic environment, the po- perfected its interest in the instrument tential bankruptcy of the originator by possession), then the purchaser many funders are also must be given more thought and ad- takes priority over the security inter- dressed in the constraints of the agency est in the instrument. Therefore, under reconsidering their relationship. UCC Section 9-330(b), the holder of a security interest by possession of chat- exposure in the context Titling agency. These same issues are tel paper or an instrument has priority presented in connection with a titling over the holder of a security interest in of agency relationships agency used in connection with certifi- such chattel paper or instrument that cate of title motor vehicles, pursuant to created in connection was perfected by the filing of a UCC which the originator is designated as financing statement. with the syndication the agent of the funder for purposes of being designated as the owner of mo- Agency Relationships of equipment fi nance tor vehicles on the certificate of title. In light of the current economic situa- Some parties use this titling agency in tion, many funders are also reconsid- transactions. order to avoid having to retitle motor ering their exposure in the context of vehicles (which entails both an admin- agency relationships created in connection with the syn- istrative burden as well as a possible excise or retitling dication of equipment finance transactions. tax expense). In addition to those same issues as are pre- sented in the context of a fiscal agency, funders must also Fiscal agency. It is common to include a fiscal agency be concerned that the sale of the certificate of title motor relationship in the syndication agreement if the origina- vehicle may be deemed not completed due to a failure tor is experienced in the servicing of similar transactions. to comply with state titling statutes requiring notice of Typically the fiscal agent is required to hold “in trust” for the change of owner or surrender of the certificate of the benefit of the funder any monies it receives in con- title to the state titling agency for issuance of a new cer- nection with the syndicated transaction. However, it has tificate of title designating the actual owner. If the sale not been customary to require the originator to segre- is deemed not completed, it is possible that the motor gate those funds, and the originator has been permitted vehicles could be considered as part of the originator’s to commingle those funds in its general bank account. bankruptcy estate or be subject to claims of the origina- Funders may need to reconsider this structure and re- tor’s general creditors. quire that monies collected by the fiscal agent not be Some parties also use a titling agency in connection commingled and be held in a separate, segregated ac- with designating the originator as the funder’s agent for count in order to protect against the possibility that such purposes of being designated as the lienholder on the monies could be considered as part of the originator’s certificate of title for a motor vehicle. Such an agency bankruptcy estate or be subject to claims of the origina- is intended to avoid the administrative burden of sub- tor’s general creditors. mitting the certificate of title to the state motor vehicle

8 TAKING ANOTHER LOOK AT SYNDICATION RISKS JOURNAL OF EQUIPMENT LEASE FINANCING • FALL 2009 • VOL. 27/NO. 3 agency, together with evidence of the assignment of the interest in the motor vehicle. (See, Fla. Stat. Ann. Section lien, so that the funder’s lien could be noted in lieu of 319.27(6)(d) (2008); Ga. Code Ann. Section 40-3-55(b) the originator’s lien. This agency may not work in all (2008); Mich. Comp. Laws Ann. Section 257.238(b)(2) jurisdictions. For example, Chapter 501 of the Texas (2008); Mo. Ann. Stat. 700.365(2) (2008); and N.Y. Veh. Transportation Code (the Texas Certificate of Title Act) & Traf. Law Section 2120(b) (McKinney 2008).) It is the specifically requires that certain affirmative steps set out author’s understanding that on June 19, 2009, the Texas in that statute must be taken so that governor signed Senate Bill 1592, 81st the identity of the true lienholder is re- As noted, most of the Leg., Reg. Sess. (Tex. 2009), which ad- flected on the certificate of title. Failure dresses the situation presented by the to comply with these statutory require- signifi cant issues in the Texas statute’s requirement. ments resulted in the loss of its per- fected lien status for one funder in the context of the syndication CONCLUSION Bankruptcy Court’s decision in Clark As noted, most of the significant issues Contracting Services, Inc. v. Wells Fargo of a fi nancing transaction in the context of the syndication of a fi- Equipment Finance (In re Clark Con- nancing transaction are a matter of risk are a matter of risk tracting Services, Inc.), 399 B.R. 789 management. What had been stan- (W.D. Tex. Nov. 28, 2008). management. What had dard customs and practices in the past Although it was acknowledged that may need to be reanalyzed in light of the originator had a perfected security been standard customs the changed economic circumstances. interest noted on the certificates of title Funders may ask originators to: with respect to certain vehicles, upon and practices in the past 1. eliminate the “knowledge” limi- assignment of that lien to the funder, tation with respect to many rep- the funder failed to comply with the may need to be resentations (or if a “knowledge” requirements of the Texas Certificate of qualifier is permitted, require the Title Act to cause the assignment of the reanalyzed. originator to investigate the facts lien to the funder to be noted on the and to perform appropriate due certificate of title. As a result, the funder’s lien was held diligence before being allowed to qualify the repre- not effective against the hypothetical judgment creditor sentation); in the bankruptcy. The court acknowledged that the as- 2. make representations (a) addressing some of the signment of a duly perfected security interest does not same factual issues as are addressed by representa- affect the perfection status of that security interest with tions made by the obligor; (b) that the interest in respect to general collateral pursuant to UCC Section the equipment being conveyed is good title, free of 9-310(c). all liens and encumbrances; (c) as to the perfection However, the court distinguished that provision and/or priority of applicable security interests; (d) since the collateral was a motor vehicle and the perfection that the originator has no knowledge of any facts of a security interest in motor vehicles is governed by the impairing the value or validity of the transaction Texas Certificate of Title Act and not the UCC. It should documents, any rights created thereby, or the syn- be noted that the Texas statute’s requirement that the as- dication agreement itself; (e) that the originator is signment of the lien be noted on the certificate of title not insolvent and that consummation of the trans- is not the case in several other jurisdictions (specifically action will not cause the originator to become in- including New York, Michigan, Missouri, Georgia, and solvent; (f) that the consideration being paid to the Florida). In each of those other jurisdictions, it is permis- originator is fair consideration for the interest being sive and not mandatory that the funder cause the assign- acquired, in order to avoid fraudulent conveyance ment of the originator’s lien to be noted on the certificate issues; and (g) that the originator has not previously of title. In those other jurisdictions, the failure to do so sold or conveyed an interest in the payment stream does not affect the continued perfection of the security becoming due under the equipment lease;

9 TAKING ANOTHER LOOK AT SYNDICATION RISKS JOURNAL OF EQUIPMENT LEASE FINANCING • FALL 2009 • VOL. 27/NO. 3

3. authorize the funder to file a UCC financing state- Alan J. Mogol ment in order to perfect the sale of accounts, chattel [email protected] paper, payment intangibles, or promissory notes; 4. require the originator, acting as agent, to hold in Alan J. Mogol co-chairs the Fi- a separate segregated account and not commingle nance practice at Ober, Kaler, any monies collected from the obligor; and Grimes & Shriver in Baltimore, 5. permit the termination of any fiscal agency relation- Md. He has over 35 years’ expe- ship automatically without notice upon the bank- rience in the negotiation and documentation of equip- ruptcy of the originator. ment finance transactions, including syndication of transactions and the acquisition and sale of portfolios. Originators should anticipate these requests and formu- He has established motor vehicle and master aircraft ti- late their response in advance as a matter of corporate tling trusts, and he has worked with clients in develop- policy, recognizing that some change to past customs ing structures for the tax leasing of equipment subject to and practices may be necessary in order to successfully industrial revenue bond financings and payment in lieu syndicate the deal in the changed economy. of tax programs. Mr. Mogol is a fellow of the American Bar Association Foundation and the Maryland Bar Foun- dation. Since 2007, he has been listed in the Woodward/ White The Best Lawyers in America in the equipment fi- nance law category. He received his JD from the Univer- sity of Virginia, Charlottesville, in 1971 and a bachelor’s degree with distinction from the university in 1968.

10 A Primer on Leasing Transactions in the International Maritime Sector By Basil M. Karatzas

easing in the maritime industry in the Unit- market includes oceangoing vessels to serve Hawaii, ed States has mostly been focused on Jones Puerto Rico, and other U.S. territories worldwide. Act assets: vessels that are built in the United By comparison, the international maritime indus- States, fly the U.S. flag, and are controlled and try is a significantly larger market. At a time of lionized Lcrewed by U.S. citizens. The Merchant Marine Act of management principles of outsourcing and just-in-time 1920 (Jones Act) grants exclusive cabotage privileges to inventory, international trade has spurred a constant, in- such vessels to trade within the waterways and port sys- cremental demand for maritime transportation. This is tem of the United States and its territories. Such vessels especially true when raw material deposits lie so far from also have the exclusive privilege (with a few exceptions) their major consumer markets (such as iron ore and coal to carry cargoes on behalf of the U.S. government. imports to China and oil imports to the United States). The majority of the Jones Act trade is concentrated The international maritime industry typically is inland, in the river and lake waterways (such as the Mis- referred to as “blue-water” or “deep-water” shipping, sissippi River and Great Lakes), and along the continen- as opposed to “brown-water” shipping for inland and tal and gulf coastal trade (such as in the U.S. Gulf region coastwise trade (Fig. 1). The differences between these and the Atlantic Coast). A smaller part of the Jones Act two markets can be as deep and distinct as the depth

Figure 1. The Maritime Sector From a U.S. Perspective

Maritime Sector (from a U.S.-based point of view)

Level 1. Geography International market Jones Act market

Level 2. Function brown water blue water brown water blue water

Source: Compass Maritime Services

Editor’s note: A related Equipment Leasing and Finance Foundation study, “Marine Equipment Finance Market,” is available at www.store. leasefoundation.org/product/marine. Published in February 2009, the report was written by Global Insight as part of the Foundation’s 2009–2011 Transportation Outlook Series. LEASING TRANSACTIONS IN THE INTERNATIONAL MARITIME SECTOR JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3 and color of the water that distinguishes them. As Fig- Act and international markets in terms of asset differ- ure 2 shows, those differences include the legal envi- entiation and residual value, sources of capital, the legal ronment (international maritime law for foreign vessels environment, and industry practices. In assuming that versus U.S. jurisdiction for Jones Act the reader has passing knowledge of vessels); minimal taxation for most in- From a logistical point leasing practices in the domestic mari- ternational shipping; and lower barri- time industry, the article accordingly ers to enter and exit the markets. On of view, the most focuses on the different practices of the the other hand, both the domestic and international market. international maritime industries share straightforward form of certain common characteristics such as VESSEL EMPLOYMENT an asset’s employment in capital intensity, long commercial lives From a logistical point of view, the of shipping assets, comparable types of leasing is the triple net most straightforward form of an as- employment of shipping assets, expo- set’s employment in leasing is the triple sure, and to a certain extent, the same lease. net lease, where the lessee is respon- macroeconomic factors. sible for all operational, insurance, and This article aims to serve as a primer for leasing maintenance (technical) matters related to the asset. A transactions in the international maritime market. It will vessel’s employment, however, typically is more compli- underline the differences between leasing in the Jones cated than this, especially since the lessee might opt to

Figure 2. The Jones Act and International Maritime Markets

Statutory qualifi cations Jones Act market International market Vessel ownership U.S. nationality Any Vessel registration/fl ag USA Any Shipyard U.S. located Any Vessel crew U.S. citizens Any Market information Jones Act market International market Vessel type Mostly brown water Mostly blue water Vessel variation Mostly inland and offshore assets Great variation Vessel trading privilege Cabotage (exclusive trade within USA) None Trading area Mostly within USA Mostly internationally Freight volatility Low to moderate Moderate to very high Vessel price volatility Low to moderate Moderate to very high Vessel price Usually small (US$5–20 mil.) Can be high (US$40–200 mil.) Vessel economic life Usually long (20–40 years) Shorter (15–30 years) Vessel residual value Less volatile, holds better More volatile, can depreciate fast

Legal jurisdiction U.S. federal courts Country of vessel’s fl ag Vessel classifi cation society Mostly, American Bureau of Shipping (ABS) Any Vessel daily operating expense High, due to crewing costs Medium, comparatively to Jones Act Secondhand market (liquidity) Fairly limited Fairly liquid Secondhand market (strength) Fairly strong Varies widely Taxation U.S. corporate taxation system Mostly offshore jurisdictions, tax-free Barriers to enter/exit market Very high Minimal Competition Statutory protection against foreign players Perfect competition Source: Compass Maritime Services 2 LEASING TRANSACTIONS IN THE INTERNATIONAL MARITIME SECTOR JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3 sublease (charter) the vessel to a third entity. In other situations, a time charter might have two Normally in the brown-water industry, the lessee parts: a financial component payable 100% of the time crews and employs the vessels mostly on the spot mar- (bareboat part) and an operating component to reflect ket, where value can be added due to the lessee’s trade commercial reality and earning revenue. These situations and market expertise. However, there is one instance could occur, for example, due to tax considerations in in the Jones Act products tanker market (tankers suit- certain jurisdictions (such as the KG limited partnership able for the trade of refined petroleum products such as structure in Germany) or when the lessee and the vessel gasoline) where the lessor took ownership of 10 tanker manager are two different entities. vessels. Subsequently, the Overseas Shipholding Group In terms of trading flexibility, the lessee usually has (OSG) undertook a 10-year bareboat charter (“bare- full commercial control of the vessel. The lessee can char- boat” means a boat chartered without a ter the vessel to third parties either on crew). It then provided crew, insurance, In terms of trading the spot market (short term/voyage and certificates for the vessels and then charter) or for a substantial amount time-chartered the vessels to oil com- fl exibility, the lessee of time—up to the same period of the panies and refiners trading petroleum lease. Charterers (lessees) operate the products within the United States. usually has full commercial vessels under different business mod- In strictly maritime terms, vessel els, and their trading preferences de- control of the vessel. employment on a period charter basis is pend on the markets they serve and either by bareboat charter (BBC) or time The lessee can charter their strategic advantage. However, charter (TC). Under the bareboat char- charterers with their own captive car- ter, the lessee is responsible, besides the the vessel to third goes (such as major oil companies) are rent (freight) to the lessor, for under- perceived as stronger performers with taking the administration and manage- parties either on the lower chances of default, while traders ment of the vessel, and paying for the are perceived as less desirable charter- vessel’s crewing, insurance, inspections, spot market (short term/ ers. and maintenance expenses (including As is typical in leasing, the vessel dry-docking). Under the time-charter voyage charter) or for a itself is used as collateral to obtain a employment arrangement, the owner vessel mortgage, and the rent stream substantial amount of of the vessel (or lessor in the case of a is subordinated for additional assur- lease) is responsible for all such admin- time—up to the same ance. In certain cases, the subcharter istrative and operational tasks. of a third, creditworthy party might In general, time-charter employ- period of the lease. be required in order to meet the credit ment is an undesirable option for a fi- requirements of the debt covenants. nancial owner since it requires shipping expertise and Such tripartite transactions can easily escalate to a play in-house operations staff. Another negative feature of for motivated and experienced players. A variation of time-charter employment to a financial owner is that using a third-party subcharter can be the arrangement the charterer (lessee) has the right to take the vessel “off of an artificial charter by selling a freight forward agree- hire” and legitimately stop paying rents under certain ment (FFA) for a period of time to cover the lease period. circumstances (routine maintenance, delays due to in- In reality, the easiest leasing transaction to originate spections by authorities, and so on), whereas bareboat in shipping is the sale-leaseback transaction, whereby employment is always payable 100% of the time. Obvi- the shipowner sells the vessel to the lessor and immedi- ously, bareboat charters are most suitable for long-term ately enters into a long-term employment agreement to (financially priced) transactions where there is financial employ the vessel on a bareboat basis for a certain period ownership (by the lessor), while time charters are more of time. In such a bilateral transaction, where the seller- common as commercial types of employment, where the cum-lessee-cum-charterer is already intimately familiar traditional shipowner provides a ready-to-go vessel. with the asset (both from a technical and commercial

3 LEASING TRANSACTIONS IN THE INTERNATIONAL MARITIME SECTOR JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3 point of view), both transaction costs and risks are mini- action worldwide in case of default and possibly the lack mized. Usually such transactions are the most competi- of viable options in taking action against a vessel’s owner tive from an economical point of view. in unfriendly jurisdictions. The traditional international shipping finance cen- DEBT FINANCING ters have been located in London, Oslo, and Hamburg, A cardinal element of leveraged leases is the availability with major satellite offices in Singapore, Hong Kong, of debt financing both in sufficient amounts and com- New York, Dubai, and Athens; this is where the banks’ petitive terms. However, lending in the traditional shipowners/clients were maritime sector is as unique a propo- With several shipowning based, who historically financed acqui- sition as the industry itself, and this sitions of new vessels with 35% equity is primarily because of the collateral’s companies publicly listed, and first preferred mortgage with five- ability to move between jurisdictions to to eight-year amortization at about growth of their fl eets can potentially avoid arrest. For Jones Act 8% interest per annum. However, in assets, such considerations are rather only be achieved with the age of modern finance with sev- limited: to be legally registered in a eral shipowning companies publicly foreign jurisdiction, the owner of the massive vessel acquisitions listed, growth of their fleets can only asset must get special permission from be achieved with massive vessel acqui- the U.S. Coast Guard and the Depart- and signifi cant leverage, sitions and significant leverage, and ment of Transportation’s Maritime Ad- therefore loan syndication and bond ministration (MarAd). In addition, the and therefore loan issuing have proven the optimal ways jurisdiction of the U.S. court system is to access the debt markets. well known and established; therefore, syndication and bond for lenders in the Jones Act market the ASSET IDENTIFICATION issuing have proven the biggest hurdle becomes their familiar- Broadly speaking, mainstream ship- ization with the collateral asset in the optimal ways to access the ping assets comprise three types of shipping sector and the quality of the vessels: (1) tankers (tanker vessels for borrowers in the Jones Act maritime debt markets. crude oil, refined petroleum products, industry. or industrial chemicals), (2) dry-bulk For lending in the international maritime industry, vessels, and (3) containership vessels. Figure 3 shows one has to look for traditional shipping centers and for the biggest vessels in each sector. Naturally, within each institutions that have knowledge and exposure to the category the vessel sizes vary, with smaller vessels serv- shipping markets. A thorough understanding of the ing local markets and players and bigger vessels serv- shipping cycles, shipping assets, market drivers, and ing multinational companies or countries. (Think of oil quality of the borrowers is mandatory. In addition, a companies transporting oil on supertankers at incre- lender has to be well aware of the limitations of taking ments of two million barrels at a time.) Complement-

Figure 3. A Comparison of Vessels by Deadweight and Length

Vessel type Deadweight (DWT) Length (feet) MT Jahre Viking (biggest vessel ever built) 560,000 DWT (in tons) 1,470 Containership (Maersk Line, biggest containership ever) Apx. 14,000 TEU (20-foot equivalent units) 1,250 Very large crude carrier (VLCC; supertanker) 300,000 DWT 1,100 Capesize dry-bulk 170,000 DWT 925 Jones Act tanker 142,000 DWT 870 Source: Compass Maritime Services Note: By comparison, the Empire State Building is 1,453 feet high.

4 LEASING TRANSACTIONS IN THE INTERNATIONAL MARITIME SECTOR JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3 ing these three primary markets are maritime assets that istry for the vessel and ensure acceptance by charterers, serve niche markets related to (1) geography (such as insurers, bankers, and port authorities worldwide and Great Lake vessels and ice-class tankers, (2) type of cargo can guide change of vessel ownership and jurisdiction (such as heavy lift vessels, car carriers, and livestock ves- venue in case of litigation. Jones Act vessels by defini- sels), (3) industry (such as offshore, inland, and dredg- tion list a port of registry within the United States, while ers), and (4) business model (cruise ships, ferries, and so foreign vessels typically fly “open registry” flags, such as on, based on the retail model). the Bahamas or Panama, to minimize registration costs Identifying an asset class as a leasing candidate is and taxation. crucial from several points of view: The significance of the flag is that it controls the • purchase price (both in absolute and in historical jurisdiction of the mortgage, management, and crew- terms), ing matters of the vessel as well as certain trade mat- • tonnage dynamics (in terms of size ters and boycotts. (As an example, of the whole sector and the subsec- Jones Act vessels by Israeli-flagged vessels may be pro- tor under consideration, such as hibited from entering ports of Arab worldwide fleet in existence, new defi nition list a port of countries.) More importantly, based building contracts and orderbook, on accident records, authorities may registry within the United demolitions), deem that certain flags are associated • trade dynamics (present and pro- States, while foreign with lax standards, so those vessels jected demand to charter such ves- with “blacklisted” flags might be sub- sels), vessels typically fl y “open ject to additional inspections, delays, • regulatory regime (tankers are typ- and possible loss of hire. ically more closely regulated than registry” fl ags, such as the The second difference between any other maritime sector due to brown-water and blue-water shipping the potential for environmental Bahamas or Panama, to assets concerns the determination of pollution), seaworthiness. Vessels require cer- minimize registration costs • breadth and depth of the second- tificates by a classification society, an hand market (ease to exit the trans- and taxation. independent body that ascertains the action with low transaction costs seaworthiness of the vessel. Jones Act and an orderly liquidation value as close as possible vessels receive their class certificates from the American to fair market value, and Bureau of Shipping (ABS), whereas international vessels • asset price volatility and expectations of residual may choose among a number of societies. Not all clas- value. (As a rule of thumb, bigger vessels experience sification societies are created equal, but as long as they higher price volatility than smaller ones.) are accredited members of the International Association Each of these factors acts as a double-edged sword. As an of Classification Societies (IACS), their classed vessels example, although higher regulation in the tanker sector usually are treated uniformally by regulatory bodies (in leads to additional red tape and higher operating expens- terms of inspections) and by protection and indemnity es than other shipping segments, the heavy regulatory (P&I) clubs for coverage (in terms of insurability and hand can act as additional safeguards for proper main- premiums). tenance and adherence to good industry practices. This in turn ensures a better-holding residual value, all else TRANSACTION DRIVERS being equal, and thus provides the lessor with a safety Asset Price net in protecting its interests in the asset. Two noteworthy differences underline brown-water Comparatively, high asset prices in the maritime industry and blue-water shipping assets. First, blue-water assets make for larger transactions than found in most of the depend heavily on statutory certificates such as the reg- equipment leasing and finance sectors. In the brown- istry (“flag”). Those certificates indicate the port of reg- water class there are assets (such as barges) that may cost 5 LEASING TRANSACTIONS IN THE INTERNATIONAL MARITIME SECTOR JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3 less than US$1 million. However, for the international es are still applicable in the maritime industry, estimating maritime industry in general, the entry fee might be as the residual value of a vessel can be more esoteric than low as a few million dollars for older (but marketable) in other industries, due to a number of variables that can assets. At the high end of the spectrum, there were cases affect the asset price. One parameter of note is the state in 2008 when brand-new containerships were leased at of the freight market and the vessel’s perceived earnings US$160 million (by Danaos Corp.). potential in the freight environment Even higher, in the offshore drillship Estimating residual value at redelivery. Therefore, estimating re- market, there was an example of a sale- sidual value in the international mari- leaseback transaction in 2008 for two in the international time industry is always contingent ultradeep drillships at US$1.7 billion on one’s opinion on the trend of the for a 15-year period (by Seadrill). maritime industry is freight markets. International freight rates are highly volatile, as evidenced always contingent on Residual Value by the asset prices of foreign-flagged Assessing the expected residual value one’s opinion on the trend vessels. (See Fig. 4 for an assessment of an asset at redelivery is usually the of asset prices and freight rates for five- secret to correctly pricing the revenue of the freight markets. and 10-year-old very large crude car- streams. Besides the standard account- rier tankers.) Since Jones Act vessels ing and historical guidelines, such as the vessel’s original are protected against foreign competition, their freight construction cost and total economic life, the lessor must rates are smoother. Jones Act prices vary less, and thus consider supply and demand, and breadth and depth of residual values are more predictable, which is one of the the secondhand market. Seemingly lesser details, such as great differentiating factors between Jones Act vessels the maintenance level and the condition of the asset at and oceangoing vessels. redelivery, can end up being of paramount importance. As a corollary, the asset class itself can exhibit a dif- Although such accounting and historical approach- ferent behavior in projecting future asset prices (residual

Figure 4. Asset Values and Freight Rates for VLCC Tankers January 2004 – July 2009 $180 $100,000

◆ $90,000 rate (US$) 1-year time charter $160 ◆ ◆ ◆ ◆ $80,000 ◆ $140 ◆ ●●●● ◆ ● ◆ ◆ ●●◆ $70,000 ◆ ◆ ◆ ◆ ◆ ● $120 ◆ ◆ ◆ ◆ ● ●● ◆ ● ● ● ● ◆ ◆ ◆ ◆ ◆ ◆ ● ◆ ◆ ◆ ◆ $60,000 ◆ ◆◆◆◆ ◆◆◆ ◆ ◆ ◆ ● ◆ ● ◆ $100 ●●●● ◆ ◆ ●●●●●◆ ●●● ◆ ◆ ●●●● ●●● ◆ ◆ ◆◆ ● ◆● ◆ ◆ ● ● ● ●●●● ◆◆● ◆ $50,000 ● ● ● ● ● $80 ◆ ● ◆ ◆ ◆ ◆ ● ● ● ● $40,000 ● ● ●●◆ ◆ ◆◆ ●● ●●● $60 ● ● $30,000

Asset values (US$ mil.) AVG 10YR (LHS) VLCC D/H 300K DWT 5YR Price (LHS) $40 $20,000 AVG 5YR (LHS) ◆ 1-yr TC RATE (RHS) $20 $10,000 ● VLCC D/H 300K DWT 10YR Price (LHS) 0 0 2004-01 2004-07 2005-01 2005-07 2006-01 2006-07 2007-01 2007-07 2008-01 2008-07 2009-01 2009-07

Source: Compass Maritime Services

TC: Time charter DWT: Deadweight (in tons); the weight of the vessel when it is fully laden VLCC: Very large crude carrier (supertanker) with cargo, crew, provisions, fuel, and water D/H: Double-hulled (tanker); after the EXXON Valdez accident, tankers have LHS: Left-hand scale to have two hulls to prevent pollution in case of collision RHS: Right-hand scale 6 LEASING TRANSACTIONS IN THE INTERNATIONAL MARITIME SECTOR JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3 values). Usually, in the case of bigger-sized vessels such it is clearly important to choose to affiliate with a clas- as supertankers and capesize vessels that can only carry sification society with a good reputation. large amounts of cargo economically over long distances, In addition to the condition of the vessel, the con- freight rates are most volatile and thus asset prices can tractual terms of the delivery, such as the location of the fluctuate widely. Smaller-size vessels can find employ- physical redelivery of the vessel, will affect the value of ment through smaller operators and can carry different the asset. (For example, if the vessel is redelivered in a types of cargoes to smaller ports; thus their earnings are remote location, a buyer will discount for the fuel ex- more stable and accordingly their valuations are as well. pense to reposition the vessel.) Experience has taught Residual values are more volatile that at redelivery, the lessee/charterer for dry-bulk vessels, for which the The unique and volatile of the vessel, no longer having a vested barriers to entry and exit are relatively interest, on occasion may not be fully lower than any other segment of the nature of the shipping cooperative in assisting the beneficial international shipping market. Asset owners (lessors) in remarketing the prices seem to be the least volatile for industry is refl ected in vessel. containership vessels, which usually are employed long term by few op- leasing transactions CASE STUDIES erators with logistical infrastructure. The unique and volatile nature of the Again, in general, bigger container- that were terminated in shipping industry is reflected in leasing ships vary most in residual value in transactions that were terminated in the last couple of years, this sector. the last couple of years, a period of ex- During the total economic life a period of extreme treme variation in the shipping market. of approximately 25 to 30 years for For transactions that originated during oceangoing vessels, residual values variation in the shipping the super-cycle years of 2004–2008, it are not behaving uniformly: modern is still too early to calculate returns. vessels not only are the most capital market. In 1999, at a time of anemic ship- intense but they also have the most ping markets, Tsakos Energy Naviga- to lose in the event of a market correction. However, a tion (TNP) acquired a brand-new, 107,000 deadweight modern tanker is definitely more desirable for charter ton (DWT) Aframax tanker at US$38 million and entered by oil companies and thus can better hold its residual into a sale-leaseback transaction for eight years with Dr. value, while in general, charterers of dry-bulk vessels are Peters, a tax-oriented limited partnership in ship leasing indifferent regarding the age of the vessel—all else being in Germany. At the end of the lease in summer 2007, equal—thus, older dry-bulk vessels may provide a better TNP exercised its option to acquire the asset at US$31.1 value proposition. million and immediately sold the vessel in the open market to a third party at approximately US$61 million. Redelivery Terms—Physical and Contractual Although the lessors satisfied their investment require- Aside from the state of the market, the residual value ments on this transaction, it is abundantly clear that the of the vessel positively depends on its maintenance and ‘‘lottery” potential of the residual value could be signifi- physical condition. Since it is difficult to objectively de- cantly different from the asset’s book value. In a volatile fine the quality standards under which the vessel must industry such as shipping, on occasion vessels may be be maintained and delivered back to the lessor, the strat- valued more at the termination than at the origination of egy by consensus has been to adhere to the technical the lease; thus purchase options, as “out of the money” standards of the classification society of a seaworthy ves- as they may seem, might end up having significant value. sel. The standard stipulation calls for vessels at redelivery AP Moller, with its U.S.-based subsidiary, Maersk to have all class certificates valid and free of any class rec- Line, is the biggest operator of containerships in the ommendations for mandatory repairs and maintenance. world, with many of them under the beneficial ownership Since the standards are those of the classification society, of leasing companies. In summer 2007, upon termina-

7 LEASING TRANSACTIONS IN THE INTERNATIONAL MARITIME SECTOR JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3 tion of a charter for five vintage 2,800 20-foot equivalent additional aspects of the maritime industry. For example, (TEU) containership vessels, the lessors were able to sell in the leasing deal, besides the shipping asset itself, the the vessels to third-party entities at a profit of 20% above third-party charter can be subordinated. Another exam- the residual value of the vessels (about ple is a leasing deal where the residual US$1 million per vessel). Fast forward Lack of fi nancing is a exposure or the market exposure can to the abysmal freight market of 2009, be the focus. when the lessor of two vintage 4,600- more pressing issue for Since the financial turmoil, few TEU containership vessels to Maersk leasing transactions have taken place sold the vessels for scrapping, expe- shipowners than most in the international maritime sector, riencing a 50% loss over the value of mostly because of the lack of debt fi- the investment. (That is approximately leasing companies, so nancing at competitive terms in the US$10 million per vessel, in nominal present market environment. Howev- leasing may become terms.) In both cases, the lease ended er, lack of financing is a more pressing well because of the timing of the rede- an appealing fi nance issue for shipowners than most leasing livery of comparable vessels, the state companies, so leasing may become an of the freight markets, and likely the alternative in the appealing finance alternative in the different assessment of the vessels’ re- shipping sector. Because shipping as- sidual values by the lessors. shipping sector. sets are presently valued close to their historical average prices (by a 40% to CONCLUSION 70% decline in most mainstream asset classes in the last The international maritime industry is an indispens- year), this might be a good entry point for lessors inter- able conduit for international trade but subject to a high ested in dipping their toes in blue waters. number of variables. Not surprisingly, though, many players in the market have been successful and profitable throughout market cycles, peaks, troughs, tidal waves, Basil M. Karatzas and all. If one were to hazard a guess at the reason of [email protected] their success, it may be because they have built a busi- [email protected] ness strategy to get exposure only to the variables that Basil M. Karatzas is managing di- they understand and can control optimally. For instance, rector for projects and finance for certain shipping companies have opted to be active in Compass Maritime Services in Fort the Jones Act market, where volatility is low and barriers Lee, N.J. He is a competitive bro- to entry are higher than in the international maritime ker for the purchase and sale of commercial vessels both market. As a result, a shipping finance market, including in the Jones Act and international markets, mainly on equipment leasing, has developed to service this particu- behalf of financial clients. In the area of corporate and lar part of the shipping market. financial advisory services, he works on project financ- The breadth of the international shipping markets ing, financial modeling and simulations, asset valuation, provides numerous opportunities for those who are keen risk management, and trading and hedging strategies to analyze variables (risks), identify the variables that (freight forward agreements). Mr. Karatzas’s prior experi- they are best equipped to undertake, and quantify the ence includes operations in the tanker sector (lightering amount of risk they can handle. Much like owners in the and port operations), chartering, project development in market that have carved out a market where they can the oil and shipping sectors, business plan development, compete successfully, there are finance and leasing com- and financial analysis and trading. He holds degrees in panies that have discovered their competence sphere, chemistry and biology from Houston Baptist University with the Jones Act being the most prominent. In the in- and an MBA in finance and international business from ternational markets, there are lessors that specialize in Rice University in Houston. certain market sectors or that structure deals involving

8 Evidence for the Leasing Value Proposition

By James Schallheim, PhD

hen leasing professionals offer the additional academic research is needed and could sup- leasing option to their clients, they port potential value propositions for leasing. attempt to sell the value of leasing. A list of the prominent value enhance- CONSERVATION OF CAPITAL AND LINES OF CREDIT mentsW in leasing includes the conservation of working capital, preservation of lines of credit, Until recently, 100% debt financing, net tax advantages, transfer of risk of Academic research conservation of capital, preservation equipment obsolescence, off-balance of credit lines, and free working capi- sheet accounting treatment, debt cov- supports the notion tal were deemed by many academics enant compliance, and unique struc- as dubious reasons for leasing. How- turing such as service contract and that leasing preserves ever, recent research by Eisfeldt and bundling arrangements.1 The purpose Rampini (2009) offers a compelling capital and lines of credit, of this article is to summarize the pub- reason why this value proposition for leasing is valid. Leasing is valuable to lished “scientific” or academic evidence provides tax advantages that examines these leasing attributes lessee firms that have a difficult time with empirical data. The article will and may offer advantages obtaining financing elsewhere. point out the value propositions that Eisfeldt and Rampini develop a are supported by the evidence, but also from the transfer of leasing model that trades off a bank- will identify others where the evidence ruptcy cost (repossession) advantage is lacking or where additional research equipment residual risk to lessors against an agency cost disad- is needed. vantage. The bankruptcy cost advan- In summary, the academic evi- to the lessor. Less clear, tage comes about because true leases dence supports the value proposition can have higher priority in bankruptcy that leasing preserves capital and lines however, is whether there than even secured debt. Furthermore, of credit, provides tax advantages, and the ownership position of the lessor may offer advantages from the transfer is any support for off- may offer a repossession advantage of equipment residual risk. In pub- even outside bankruptcy. balance sheet fi nancing as lished studies to date, the ubiquitous There is also an advantage to the lessor in the finance lease as contained off-balance sheet advantage to leasing a value enhancement to has not been shown to enhance firm in Article 2A of the Uniform Commer- value. Further research is needed in this lessee fi rms. cial Code. One of the provisions of the area. Other areas are pointed out where UCC for the finance lease is the so- EVIDENCE FOR THE LEASING VALUE PROPOSITION JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3 called hell-or-high-water clause, which provides strong metry (meaning that they are at an information disad- protection to the lessor as provider of funding even if the vantage) are much more likely to employ lease financing. equipment fails to perform for any reason. The agency Several academic studies find very strong support for cost disadvantage to leasing refers to the notion that the this size effect in leasing; these include Schallheim, John- lessee may be less motivated to care for and maintain son, Lease, and McConnell (1987), Sharpe and Nguy- equipment than if the lessee owned en (1995), Graham, Lemmon, and the equipment outright. Of course, If size does serve as a Schallheim (1998), and Danielson and this disadvantage (to the lessor) can be Scott (2006).4 If size does serve as a valid proxy for mitigated by contract provisions. valid proxy for information, then small The arguments discussed above information, then small firms are gaining benefits from leasing are favorable to the lessor by offering even with the stronger provisions that the lessor increased protections. How fi rms are gaining benefi ts leasing offers to the lessors. Thus the do lessees benefit? Lessees benefit in reasons for leasing as advertised are two ways. First, many lessees, par- from leasing even with supported by this evidence. That is, ticularly small lessee firms, have very the Eisfeldt and Rampini model and limited access to capital markets or the stronger provisions empirical tests provide strong support lenders. Leasing may be one of the few for 100% debt financing, conservation viable options available to these firms. that leasing offers to the of capital, preservation of credit lines, Lessors are willing to lease to these and the freeing-up of working capital higher-risk lessees due to the protec- lessors. Thus the reasons as valid value enhancements for leas- tions mentioned. Eisfeldt and Rampini ing. for leasing as advertised suggest that leasing has the advantage TAX BENEFITS of increasing the debt capacity for are supported by this firms. Second, even if the lessee firms Much of the academic literature cover- have access to the lending market, the evidence. ing leasing has concentrated on the tax cost of borrowing may be very high or savings reason for leasing. A few years the covenants of the loans may be very restrictive. Leas- ago, many academics would have suggested tax asym- ing may be the cheaper or less restrictive alternative to metries as the only economic reason for leasing. This at- borrowing. Moreover, the leasing advantage offers les- titude may be changing, but Andrew and Gilstad (2005) sees the possibility of higher leverage (100% financing) discuss possible academic “bias” against leasing. or the possibility of maintaining higher cash balances or lines of credit (preservation of working capital). Figure 1. Eisfeldt and Rampini use the economic idea of in- Leasing and Firm Size formation asymmetry or information cost to incorporate Ratio of Equipment Rental Payments the bankruptcy cost advantage to leasing. Firms with to Cost of Capital Services less information (financial economists use the term “in- 25 formation asymmetry” to describe unequal information 20 distribution) are likely to have greater credit and bank- ruptcy risk. Size of the lessee firm is the variable used to 15 proxy for information.2 Figure 1 shows the important re- 10 sult that Eisfeldt and Rampini find using a database from Percentage 5 the 1992 Census of Manufacturers with over 37,000 ob- 3 0 servations. 1 2 3 4 5 6 7 8 9 10 Clearly, Figure 1 demonstrates that leasing inten- Size deciles (total assets) sity and firm size are directly related by the downward Source: Author’s fi gures based on numbers from Eisfeldt and Rampini sloping plot. Smaller firms with more information asym- (2009).

2 EVIDENCE FOR THE LEASING VALUE PROPOSITION JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3

Even taxes as a reason for leasing are limited to situ- lations use a set of forecasted future earnings to estimate ations where a tax-rate differential exists between lessee the tax rate, and Graham then repeated this exercise and lessor (asymmetric tax rates). If both lessee and les- many times with different sets of future earnings drawn sor face the same marginal tax rate, it is commonly ar- randomly (for example, 1,000 times). The average of gued that leasing does not provide any advantage from all of these tax rates is Graham’s estimate of the firm’s taxes (in the language of finance, leasing remains a zero marginal tax rate. An article previously published in the net present value transaction). If lessee and lessor face Journal of Equipment Lease Financing explains this “new different tax rates, then there is a potential tax savings measure of the marginal tax rate: Schallheim (2000). to the lessor resulting from the lease transaction. In a Graham, Lemmon, and Schallheim (1998) use the general sense, the lease is a mechanism to transfer tax marginal tax rate calculation of Graham to test if firms shields from the lessee to the lessor. Instead of the lessee that use more leasing are in higher or lower tax brackets taking depreciation and interest tax shields (and any oth- than firms that use less leasing. In many previous stud- er tax credits connected to the asset), ies, the amounts of leasing and tax rates the lessor can use these “tax transfers,” Lower tax rate fi rms were not significantly related. In some typically for true leases. Both the lessee studies, in fact, leasing was shown to and lessor can save at the expense of have a greater incentive be positively related to the average tax governmental tax revenues as the fol- rate, which is contrary to much of the lowing (rather extreme) example illus- to lease fi nance and, in theory and practice of lease financing. trates. The marginal tax rate used by Gra- The example is the quick and easy fact, do lease more. This ham, Lemmon, and Schallheim is neg- transfer of tax shields allowed under atively related to the relative amount of is particularly true for the brief existence of the so-called safe- leasing. In other words, lower tax rate harbor leases in 1981. Stickney, Weil, the number of operating firms have a greater incentive to lease and Wolfson (1983) examine the suc- finance and, in fact, do lease more. cessful transfer of tax shields (both de- leases, which are more This is particularly true for the num- preciation and investment tax credits ber of operating leases, which are more at the time) from low-tax-paying les- likely to be true tax leases. likely to be true tax leases. Graham, sees to the highly profitable GE Corp. Lemmon, and Schallheim provided the through its GE Credit subsidiary. Stickney, Weil, and first unambiguous evidence in the academic literature Wolfson estimate that GE paid approximately 70 cents supporting the hypothesis that low-tax-rate firms lease for every dollar of tax shield transferred. This was also a more than high-tax-rate firms. good deal for the lessee firms that were unable to use tax shields for some time into the future (due to net operat- TRANSFER OF THE RISK OF EQUIPMENT ing loss carryforwards, such as the case of Chrysler Corp. OBSOLESCENCE in 1981). These safe-harbor lease transactions were espe- Schallheim, Johnson, Lease, and McConnell (1987) pro- cially advantageous to lessees that had losses that were vide evidence that the residual value risk of the asset close to expiration. The tax benefit transferred helped is “priced” in the lease contract. Using a version of the the lessors save these tax benefits that were on the brink popular risk measure known as beta,5 the study demon- of being lost altogether. strates that the asset beta is significantly and positively A study by Graham (1996) describes a method of related to the yield on the lease. In the study, asset beta is calculating the marginal tax rate unlike any previous at- an estimated measure of the risk of the leased asset’s sec- tempt. Graham’s methodology uses the prevailing tax ondary market price. However, the fact that the residual code and an estimate of the future earnings of the firm to value risk is priced in the lease does not necessarily give derive the marginal tax rate on another dollar of income. rise to a value proposition. If the residual value risk were Because future earnings are uncertain, Graham uses a perfectly priced in the lease contract, the transfer of risk process known as “Monte Carlo simulation.” The simu- would simply be a fair bargain without increasing value.

3 EVIDENCE FOR THE LEASING VALUE PROPOSITION JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3

Residual value risk transfer could add value if the large tenants (as measure by square footage of the lease lessor has an advantage in the secondary market for the property) are likely to have reduced rent relative to oth- asset and is willing to share some of that advantage with ers (for example, an anchor tenant in a mall). It appears the lessee. Unfortunately, there is no direct evidence for that size is again a leading factor, in the real estate leasing this portion of the value proposition from the academic marketplace in this case. literature. Giaccotto, Goldberg, and Hegde (2007) examine a There is evidence concerning the difference between sample of consumer automotive leases. First, they con- booked residual values and realized residual value for clude that early cancellation options contained in some lessors. Over the years, the Survey of of the leases have little or no value. Industry Activity produced by the Residual value risk transfer This is attributed to the fact that early Equipment Leasing and Finance Asso- cancellation requires a premium pay- ciation generally shows that realized re- could add value if the ment or penalty for the auto leases siduals exceed booked residuals across they examine. Giaccotto, Goldberg, lessor has an advantage a broad category of leased equipment. and Hegde estimate a model of end- An academic study by Lease, McCon- in the secondary market of-lease purchase options where the nell, and Schallheim (1990) also finds future used vehicle value is estimated larger realized residuals over booked for the asset and is willing from depreciated rates based on pub- residuals and shows that this result lished used car prices. The end-of- is statistically significant. Lease, Mc- to share some of that lease purchase options were found to Connell, and Schallheim suggest the have significant value at approximately difference could be the result of tax ad- advantage with the lessee. 16% on average of the future used ve- vantages (it is better to take larger de- hicle values. However, the authors do preciation deductions in the early years) or unexpected not conclude who benefits from the purchase option be- greater inflation in secondary equipment values. They cause they do not know if the lessor fully or partly prices conclude that the evidence is consistent with unexpected the option in the lease payments. price inflation. However, this evidence does not indicate whether lessees benefit from these residual value gains OFF-BALANCE SHEET FINANCING by the lessor. Abdel-Khalik (1981) found that the capitalization of One other component of transfer of residual value leases has no significant impact on the stock or bond risk is the use of options in leasing contracts. Lease con- prices of lessee firms. El-Gazzar, Lilien, and Pastena tracts may contain options for the lessee to purchase the (1986) examine management’s choices in accounting asset, extend the lease, or cancel the lease before the end for leases prior to the implementation of FASB No. 13. of the lease term. The value of these options will be tied Their evidence indicates that high debt-equity ratios lead to the value of the underlying asset, which in turn will be to the choice of operating leases. They also find that a tied to equipment obsolescence and economic deprecia- variable representing the existence of managerial bonus tion. There do not appear to be any direct tests of com- plans tends to increase the use of operating leases. Fi- mercial equipment leasing contracts and lease options, nally, El-Gazzar, Lilien, and Pastena consider a “political but there are some closely related tests in the area of real cost” hypothesis that suggests that large firms with high estate leasing and automotive leasing. income are likely to attract regulators and others who Stanton and Wallace (2008) examine a sample of may desire to reallocate resources away from these large real estate leases and find prices that are not consis- firms. But they find that tax considerations appear to tent with their option-based model of leases, indicating motivate the choice between capital and operating leases “mispricing” in the real estate leasing market. Although as opposed to a political cost hypothesis. Stanton and Wallace conclude mispricing occurs relative A study by Ely (1995) examines the issue of operat- to their no-arbitrage model, they also observe the mis- ing and capital leases from the “property rights” point of pricing is random, on average. But they do observe that view. She examines the impact on stock return risk from

4 EVIDENCE FOR THE LEASING VALUE PROPOSITION JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3 operating lease leaseholds and obligations. She finds a The author asked one of his graduate students to significant relation between equity risk and the adjust- perform an analysis of several companies that appeared ment to the debt-equity ratio for operating leases. This to be caught with off-balance sheet leases in the wake of result implies that investors do take into account operat- the Enron scandal.6 (This is a departure from the premise ing lease obligations when assessing the of this article to examine only pub- equity risk of the firm. Ely concludes The fact is that some fi rms lished studies.) An analysis of these that these results imply that investors transactions revealed some very large do adjust for operating leases by treating appear to be willing to stock market losses adjusted for gen- them as an asset and liability. (In other eral market movement (we call these undergo the additional words, investors are capitalizing the op- market-adjusted or abnormal re- erating leases in their evaluation of the cost of a synthetic lease in turns). Looking at the period of Janu- firm’s risk and return profile.) ary through March 2002, when the One more example from the ac- order to meet accounting Enron fallout was prominent, Krispy counting literature regards synthetic Kreme suffered abnormal returns of leases. Synthetic leases are designed to classifi cation regulations. -25%, GE was -13%, and PG&E was give a lessee firm capital lease treatment -65%. However, a larger sample of 20 for tax reporting at the same time they A number of synthetic firms mentioned in the media as hav- allow for operating lease treatment for ing off-balance sheet leases resulted leases were undertaken financial reporting. The fact is that some in an overall abnormal or market-ad- firms appear to be willing to undergo by utilities that may have justed return of -5%, which was not the additional cost of a synthetic lease in statistically significant. This result, order to meet accounting classification had rate-based reasons unfortunately, shows neither a bene- regulations. A number of synthetic leas- fit nor loss in value due to off-balance es were undertaken by utilities that may for undertaking the sheet leases. (Nobel Prize-winning have had rate-based reasons for under- economist Merton Miller called simi- taking the additional cost of structuring additional cost of lar types of financial securities “neu- the synthetic lease. A working paper by tral mutations.”) Therefore, “What is structuring the synthetic Altamuro (2006) examines the economic the value of off-balance sheet financ- costs and benefits for a sample of syn- lease. ing?” remains very much an open thetic leases. Altamuro suggests the costs question. are associated with corporate governance issues while the benefits come in the form of lower bank lending rates SERVICE AND BUNDLING CONTRACTS in subsequent periods. To date, there are no direct empirical studies of service One possibility to infer (“backdoor”) the value of and bundling contracts in equipment leasing. However, off-balance sheet leases is to look at the experience of the related topic of contracting costs has been examined some firms that were penalized by the stock market for by Sharpe and Nguyen (1995), who empirically test the off-balance sheet leases when these became unfavorable. influence of information on the propensity of firms to The year was 2001 when the Enron collapse hit the mar- lease. They measure both operating and capital leases. ket. Enron was cited for an excess of off-balance sheet The proxy variables they use for information costs in- transactions and inappropriate exploitation of special clude no-dividends, ratio of operating income to sales, purpose entities. Even though the Enron scandal did and Standard & Poor’s debt rating. “No-dividends” refers not involve off-balance sheet leases, the fallout led to the to firms that pay no dividend. Information costs for these stock market taking a dim view of all off-balance sheet firms will be high because they tend to be young, fast- transactions. In particular, several firms with numerous growing, and innovation-intensive firms. off-balance sheet leases were caught in this fallout such Alternatively, they may be firms facing financial as Krispy Kreme, General Electric, and PG&E Corp. distress. Sharpe and Nguyen find that firms with more

5 EVIDENCE FOR THE LEASING VALUE PROPOSITION JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3 leasing are more likely to pay no dividends, have lower References operating income, and have lower debt ratings. In addi- Abdel-Khalik, Rashad. “Economic Effects on Lessees of FASB tion, this result holds for the breakdown by operating Statement No. 13,” Accounting for Leases, FASB, 1981. leases, capital leases, and both combined. Sharpe and Altamuro, Jennifer. “The Determinants of Synthetic Lease Nguyen state, “In summary, we find strong evidence that Financing and the Impact on the Cost of Future Debt,” a corporation’s propensity to lease is substantially influ- Working Paper, available at Social Science Research enced by the financial contracting costs associated with Network: http://ssrn.com/abstract=951514, 2006. information problems.” This reference to information Andrew, Gary and Dennis Gilstad. “A Generation of Bias costs or information asymmetries is very similar to the against Leasing,” Journal of Equipment Lease Financing, 23, arguments by Eisfeldt and Rampini as presented more no. 2 (2005): 1–14. fully in the section above, titled Conservation of Capital Danielson, Morris and Jonathan Scott. “The Benefi ts of and Lines of Credit. Leasing: The Small Firm Perspective,” Journal of Equipment Lease Financing, 24, no. 2 (2006): 1–10. SUMMARY Eisfeldt, Andrea and Adriano Rampini. “Leasing, Ability to Table 1 summarizes the academic evidence in relation to Repossess, and Debt Capacity,” The Review of Financial Studies, 22 no. 4 (2009): 1621–1657. the value propositions of leasing. The first two reasons for leasing in Table 1 are sup- El-Gazzar, Samir, Steve Lilien, and Victor Pastena. “Accounting for Leases by Lessees,” Journal of Accounting ported by academic research. It is clearly true and sup- and Economics, 8 (1986): 217–237. ported by research that leasing can transfer of equipment Ely, Kirsten. “Operating Lease Accounting and the Market’s risk to the lessor. Less clear, however, is whether this Assessment of Equity Risk,” Journal of Accounting Research, offers value to the lessee because the equipment residual 33, no.2 (1995): 397–415. value risk or an end-of-lease option is priced in the con- Giaccotto, Carmelo, Gerson Goldberg, and Shantaram Hegde. tract. More research is needed in this area, but the data “The Value of Embedded Real Options: Evidence from are difficult to obtain. The off-balance sheet advantage Consumer Automobile Lease Contracts,” The Journal of to leasing has not received much support from academic Finance, 62, no. 1, (2007): 411–445. research. Finally, two other areas of value proposition for Graham, John. “Debt and the Marginal Tax Rate,” Journal of leasing shown in the Table 1 as (5) and (6) would be Financial Economics, 41 (1996): 41–73. fruitful areas for further academic research. Graham, John, Michael Lemmon, and James Schallheim. “Debt, Leases, and the Endogeneity of Corporate Tax Status,” The Journal of Finance, 53, no.1 (1998): 131–162.

Table 1 Lease, Ronald, John J. McConnell, and James Schallheim. “Realized Returns and the Default and Prepayment Summary of Academic Research on Value Experience of Financial Leasing Contracts,” Financial Proposition for Leasing Management, 19 (1990): 11–20. Schallheim, James. “Leases, Debt and Taxes: A New Measure,” Support from the Value proposition: academic research? Journal of Equipment Lease Financing, 18, no. 2 (2000): Reason to lease 16–23. Yes No Maybe 1 Conserve working capital Schallheim, James S., Ramon E. Johnson, Ronald C. Lease Preserve lines of credit ✔ and John J. McConnell. “The Determinants Of Yields On 100% fi nancing Financial Leasing Contracts,” Journal of Financial Economics, 2 Tax advantages ✔ 19, no. 1 (1987): 45 68. 3 Transfer of equipment risk ✔ Sharpe, Steven and H. Nguyen. “Capital Market Imperfections 4 Off-balance sheet fi nancing ✔✔ and the Incentive to Lease,” Journal of Financial Economics, 39 (1995): 271–294. 5 Debt covenant compliance Academic research is needed 6 Service contracts and bundling Academic research is needed Stanton, Richard and Nancy Wallace. “An Empirical Test of a arrangements Contingent Claims Lease Valuation Model,” Journal of Real Estate Research, 31 (2008): 1–26.

6 EVIDENCE FOR THE LEASING VALUE PROPOSITION JOURNAL OF EQUIPMENT LEASE FINANCING • Fall 2009 • VOL. 27/NO. 3

Stickney, Clyde, Roman Weil, and Mark Wolfson. “Income 5. Based on the economic model known as the capital as- Taxes and Tax-Transfer Leases: General Electric’s set pricing model, only systematic or market risk should Accounting for a Molotov Cocktail,” The Accounting Review, be priced in the capital market because all other risk can 58, no. 2 (1983): 439–459. be diversifi ed away. Beta is the widely accepted measure of systematic risk. Endnotes 6. Kolay, Madhuparna. “The Market Value of Off-Balance 1. The author thanks David S. Wiener for providing elements Sheet Leases,” Term Paper, University of Utah, 2008. for this list.

2. Size has been used as a proxy variable for information avail- ability by a plethora of academic studies in fi nancial econom- James Schallheim ics. The idea is simply that large (often public) corporations jim.schallheim@business have a lot of publicly available information and also access to .utah.edu many securities offered in both the public and private capital markets. Small fi rms often have little public information avail- James Schallheim has taught cor- able about them and limited access to capital markets. There- fore, small fi rms are more likely to be fi nancially constrained. porate finance at the University of Utah, Salt Lake City, since 1980 af- 3. The ratio of rental payments to cost of capital services is explained in detail the Eisfeldt and Rampini (2009) paper. ter receiving his PhD in finance from Purdue University, Briefl y, it is the amount of rental payments divided by the sum West Lafayette, Ind. His research and teaching interests of rental payments plus an estimate of the interest rate times are corporate finance, leasing, and stock markets in the the capital employed plus depreciation. Eisfeldt and Rampini United States and Japan. He is an internationally known also use (1) the ratio of rental payments to the sum of rental scholar in equipment leasing and author of Lease or Buy: payments plus capital expenditures, (2) the ratio of rental payments to number of employees, and (3) the ratio of rental Principles for Sound Corporate Decision Making (Harvard payments to the total value of shipments. All of these ratios Business School Press, 1994). Dr. Schallheim has pub- lead to similar results to those presented in Figure 1. lished extensively in the leading academic journals in fi- 4. Clearly size is not the only proxy for fi nancial constrained nance. He serves on this journal’s editorial review board fi rms, but size is the easiest and most available proxy. The as well as on the board of directors for the Equipment literature cited in this section also has measured other proxies Leasing and Finance Foundation. He also serves on the for fi nancial constraints such as probability of bankruptcy, board of directors of LCA Bank, in Park City, Utah. He credit score, coverage ratios, earnings, and debt ratios. Almost received his MBA from Wright State University, Dayton, of all of these other measures show that lessee fi rms tend to be fi nancial constrained. Ohio, and BA from the University of California at Santa Barbara.

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