The Synthetic Lease: An Introduction and Practice Guide

The following is intended to provide a basic overview of the synthetic lease and to provide some practice guides on the increasing challenge in structuring such leases both to comply with evolving accounting requirements and, at the same time, to achieve a triple net lease structure under which "no lessee in its right mind" would fail to exercise its end of lease purchase option.

Special Accounting Notice

The Equipment Leasing and Finacing Association (ELFA) and its Financial Accounting Committee met with the Financial Accounting Standards Board (the "FASB") in Norwalk, Connecticut on February 23, 1999. The Board told ELFA representatives that, while reconsideration of SFAS 13 is currently not on the Board's project agenda, there is virtual consensus within the Board's membership and staff that the current lease accounting standard "doesn't work" and needs to be changed.

A G4+1 working group, comprised of the U.S., U.K., Canada, Australia (and New Zealand) and the International Accounting Standards Committee (IASC), is currently developing a paper, which, in all likelihood, will be the starting point for discussions at the IASC on the completion of any change in an international standard. Furthermore, FASB has issued an Exposure Draft also dated February 23, 1999 addressing Consolidated Financial Statements which is likely to have an immediate impact on many synthetic lease structures.

Accountants, not lawyers, will drive this structure, but there is no reason why lawyers need be passive passengers. Creative solutions abound for most problems raised by the interaction of net lease and accounting requirements and creativity remains the service of good counsel.

Overview

Dual Character for Lessee

A synthetic lease is a financing contract drafted from the lessee's perspective so that it is treated as an operating lease for financial accounting purposes and a loan for federal income tax purposes. The result is that lessee does not reflect either the debt or the asset on its balance sheet other than in the footnotes.

For federal income tax purposes, however, lessee has retained such rights and burdens with respect to the asset that lessee is considered the owner of the asset and a borrower with respect to the lease obligation, thereby retaining for lessee the tax benefits of an owner. The key to success in achieving this financial structure begins with SFAS 13 which is outlined together with certain other Accounting Rules below.

Avoiding Consolidation

The structure employed for the synthetic lease must avoid consolidation and therefore must now be drawn not only with an understanding of FASB's Exposure Draft (revised), Proposed Statement of Financial Accounting Standards, Consolidated Financial Statements: Purpose and Policy issued February 23, 1999, particularly the provisions contained in Example 8, paragraphs 141 through and including 153 as they relate to a special purpose entity.

Dual Character for Lessor

Lessor approaches the transaction as a loan and it is underwritten as corporate debt, not an asset based credit. From the perspective of state property laws, however, title to the asset with all attendant burdens and benefits will be in lessor's name except:

• tax benefits of ownership,
• upside residual expectations, and
• any burdens that lessor can place on the lessee under the terms of its intended triple net lease, subject to the growing pressure from accountants to limit or cap such burdens on lessee.

The Tension

Use of the synthetic lease continues to proliferate, with sometimes inconsistent application of the rules by major accounting firms. The FASB, SEC and other international accounting standards setters continue to view lease Accounting Rules as inadequate in many circumstances without a new benefits/burdens analysis. See below for an overview of the Accounting Rules. The Exposure Draft on Consolidation Financial Statements issued February 23, 1999 appears to be the latest effort to advance this analysis, particularly as it addresses the issue of control.

Lessee's Perspective

Off-Balance Sheet Accounting

The lessee intends to achieve the benefits of off-balance sheet accounting treatment for both the asset and the lease obligation incurred to finance the acquisition of the asset. With neither the asset nor the debt reflected on the balance sheet, the debt to equity ratio and other financial ratios based on the balance sheet are improved. Lessor should be responsive to lessee's comments on the draft lease agreement, but avoid making any representation or warranty on the accounting treatment.

Lessee Is Owner For Income Tax Purposes

The lessee intends to achieve the benefits of the owner of the asset for income tax purposes, including both interest and depreciation deductions. The effect is to increase deductions, drive down taxable income, and therefore to increase cash flow. Lessor should be responsive to lessee's comments on the draft lease agreement, but avoid making any representation or warranty on the tax treatment.

Potential Appreciation Retained by Lessee

Lessee's fixed price purchase option operates to preserve for lessee the benefit of any appreciation in the asset value over the lease term. The purchase option price established by the parties on the commencement date of the lease and usually supported by an appraisal is the best estimate of fair market value by the parties as of the lease expiration date.

Total Financing

The transaction generally provides 100% financing for the asset and transaction costs. Reference EITF 97-10 in the Accounting Rules for fees excluded from project costs for the 90% test of SFAS 13.

Lessor's Perspective

Making A Loan

Subject to the qualification set forth below, the lessor wants to view the arrangement as a credit transaction with the lessee retaining any and all construction and operational risks. The lessee's accountants, however, are increasingly trying to quantify all contractual burdens imposed on the lessee, including break cost provisions for early termination and other contractual obligations such as insurance, maintenance and return provisions in order to make allowance for such costs in their analysis to determine compliance with operating lease requirements.

In essence, the lessor wants to make a loan with an expectation of repayment from the rent and the exercise of the purchase option with no real remarketing prospects. The lessor wants a structure with contractual burdens so imposed on the lessee that, in the event of any temptation to make the theoretical decision not to purchase, but instead to return the asset to lessor -- that almost no lessee in its right mind would make such a decision and incur such return obligations and related payments when, for just a slightly larger amount, lessee can purchase the asset.

Legal Title in Lessor

In structuring a synthetic lease for a lessor, either the lessor itself or a special purpose corporation ("SPC") created by the lessor(s) and funded with a 3% equity contribution (dictated by EITF 90-15 to avoid consolidation; see the discussion at Accounting Rules below) would act as lessor with legal title to the asset (including any real estate and improvements) in the name of lessor for state property law purposes only.

With legal title to the asset, which may include real estate, lessor is exposed to third party liability for certain tort claims and for environmental claims, all of which lessor will want covered by broad indemnification from lessee in the lease agreement. This is another reason why synthetic leasing is restricted to the better investment grade credits.

Dual Remedies

Is the synthetic lease agreement fish or fowl; is it a true lease with rights and remedies to the lessor as provided for in UCC Article 2A, or is it a security agreement to be measured by the provisions in UCC Article 9? Counsel has no option but to anticipate both results and draft accordingly. It is not the purpose of this article to outline the different rights, remedies and results that a lessor in bankruptcy will achieve with a true lease as opposed to a lease intended as security. But it is clearly one of the objectives for counsel, especially with real estate in the transaction, to draft the remedies in the first instance as if the lease agreement is a lease and not a loan.

It is certainly preferable that any lease agreement for goods be interpreted under Article 2A. The lessor has greater freedom to provide for remedies in the contract of lease itself. Lessor will have all the rights under UCC 2A-523 and may enforce a liquidated damages clause consistent with UCC 2A-504. One object in structuring a net lease is to achieve the safe harbor status of a finance lease (irrevocable and not subject to modification, repudiation or excuse) under Article 2A-103(g) which means:

• the lessor did not select, manufacture, or supply the goods;
• the lessor acquired the goods only in connection with the lease; and
• if the lessor acquired the goods through a purchase contract directly with the supplier, lessee received a copy or approved same prior to the start of the lease.

These objectives should persist with the synthetic lease. But if the lease is not a true lease to begin with then satisfying the three steps to achieve status as a finance lease under Article 2A-103(g) will provide no comfort. On the other hand, a statement in the lease of the mutual intent of the parties to create a "finance lease" under UCC Article 2A may at least have evidentiary value.

Research has failed to disclose any federal or state case discussing a defaulted synthetic lease, which happy condition no doubt results from the ordinarily excellent credit of the lessee in such transactions. But if it can happen, it will happen, sooner or later. In which event it may be fairly anticipated, in any such bankruptcy that lessee as debtor will take the position that the economic reality of the synthetic lease transaction favors treatment of the lessee as the owner.

The argument will be that lessor bears only the most remote risk that the property may lose substantially all of its value over the relatively short lease term, with contractual return provisions imposed on lessee together with the final or contingent rent payment obligation so burdensome as to approach an effective put of the asset. The lease agreement should, accordingly, grant to lessor a lien on the asset with customary rights and remedies (particularly as may be appropriate under local real estate law).

Gap Issue

If the lessee pays all rent in the amounts and at the times required by the lease but decides (against all expectations and despite every effort to draft an agreement under which "no lessee in its right mind" would return the asset and incur the related costs) to walk away from the asset and not purchase (or renew), then the revenue flow from the lease will not return the full amount of lessor's investment or the full amount of any loan made to lessor or the SPC to acquire such asset for lease.

This gap is essential to the synthetic lease structure and represents the minimum risk of at least 10.1% that must be retained by lessor. Lessor usually addresses the gap risk with the rational that the benefits and burdens of the purchase option to lessee are such "almost that no lessee in its right mind" would fail to exercise the purchase option.

This may be otherwise stated: "almost no lessee may prudently abandon" its purchase option. On the other hand, lessee's accountants are increasingly pushing to quantify the cost of all contractual obligations imposed on the lessee so that the final payment by lessee in the event of the decision not to purchase is moving well down from 89.9% to allow space for the quantified costs of these contractual burdens imposed by lessor. Note the basic structure:

1. If lessee purchases the asset at the end of the lease term, then lessor recovers its full investment (i.e., the loan) and its required yield.
2. If the lessee does not purchase and the asset moves to the remarketing stage, then the "gap" discussed above becomes more real. Even if the asset has held its value, the proceeds of remarketing may not be available on the last day of the term of the lease.

Lessor as Debt Issuer

Lessor may leverage or back leverage its investment. Lenders to a lessor, including an SPC, in a synthetic lease structure typically view synthetic leases as credit transactions, with the asset providing security for the loan arrangement. Often the lenders are one or more financial institutions that are parties to the lessee's other revolving credit facilities or loan arrangements. It is essential to understand the debt structure and whether it entails any residual risk.

The debt obligations issued by a lessor (including an SPC) would likely be in three distinct traunches:

Class A Debt

• This would be fully amortized by mandatory lease payments including the final mandatory payment in the event lessee determines to walk away from the asset and not to purchase same at the end of the lease. There is no residual risk for the holders of such debt.

Class B Debt

• This is higher risk with a higher rate payable solely out of the proceeds of the residual realized from a purchase or lease renewal by lessee or any third party. If lessee exercises its purchase option, then Class B Debt would be paid in full. If lessee does not exercise its purchase option, but negotiates a lease renewal, then the balance of the Class B Debt must be reset accordingly.
• There will likely be a contract provision in the Class B Debt which obligates the holder to follow the lessee with the balance of its debt automatically reset to match the rent installments during the renewal term (possibly with a rate floor). If the lessee walks way and remarketing to third parties now unknown is required, the final payment on the Class B Debt may not be paid at a date certain. Under these circumstances, the lessor or SPC should not be in default of any debt, Class B or C.
• The debt is effectively paid out of the asset and its remarketing proceeds. The asset must be remarketed by lessee but the scope of this remarketing obligation is under increasing scrutiny by lessee's accountants. The final or contingent rent payment from lessee, in the event of a decision not to exercise its purchase option may be due on the last day of the term and may be sufficient to discharge Class B Debt, but the transaction terms must be ascertained on this point to understand the residual risk.
• It would not be uncommon to have the final rent payment due only in connection with the ultimate sale of the asset (which could occur at some time well after the last day of the lease term) and, indeed, structures have been accepted in which the final rent payment is due only if a sale to a third party occurs within a fixed number of days after the last day of the term. There appears to be nothing in the relevant Accounting Rules which would necessarily require this result but lessee may not guaranty lessor's full return and, accordingly, sensitivity on this issue may not be misplaced.

Class C Debt

• This usually is the equity contribution to the SPC -- at least 3% of lessor's cost. If lessee exercises its purchase option then this debt is paid in full. If lessee declines to purchase, and the asset is remarketed, this debt is subordinated to Class B. Obviously, this is higher risk with a higher rate payable solely out of the proceeds of remarketing and is subordinated to Class B Debt.

Lessor Participation

It would not be uncommon for the transaction, as participated, to come to a prospective participant with counsel already selected so that a participating lessor seeking an independent review may be forced to stay inside with its choice of counsel or likely pay the tariff for outside counsel from its own pocket. Under these circumstances, the need for precision review and comment is most acute. The following points should be noted:

1. Is there residual risk to the participant's position?
2. Have any of the otherwise standard obligations of lessee set forth in the net lease been capped or qualified by dollar limitations, such as maintenance and return obligations, break costs, insurance or capital adequacy clauses?
3. Is any indemnification which might otherwise be expected in a net lease to survive termination of the lease limited by a dollar amount or by a final time or cut-off provision? Lessee may be especially attracted to such a provision in a real estate lease with the associated environmental risk.
4. Is the lease devoid of representations by lessor regarding the tax and accounting expectations of lessee?
5. Is there any provision in the lease under which the rent can be adjusted down to compensate lessee for loss of any tax benefits?
6. What voice does a participating lessor have in any remarketing in the event that the lessee, contrary to expectations, declines to purchase. Does the participating lessor have a veto in a loss situation?

Basic Structural Concerns

Lease Terms

Subject to certain limitations arising from the accounting requirements discussed in the section on Accounting Rules below, the lease agreement will be a triple net lease and place upon lessee all risks associated with the ownership and operation of the property, including casualty and condemnation. The lessee will be required to pay all taxes, insurance, utility and other charges normally paid by a property owner and will contain a "hell or high water" clause requiring the lessee to pay rent regardless of the occurrence of damage to or destruction or taking of the property. The lease and its conditions precedent should be drafted to evidence compliance with the conditions necessary to become a "finance lease" under UCC Article 2A.

Sale and Leasebacks

The lessee may enter into a contract to acquire the asset, but the lessor should actually acquire title to the asset direct from the third party to comply with the Accounting Rules described below particularly where real estate or a non-mobile fixture is involved. Avoid the sale and leaseback structure. Lessee may execute the purchase agreement, but the purchase agreement should be assigned to lessor so title does not vest in lessee.

Construction Period

Where the asset is real estate or includes real estate, it would not be uncommon for the structure to include a construction period and construction risk. Care must be taken to structure and allocate construction risk consistent with EITF 95-10 discussed with the Accounting Rules below. Lessor must have more than 10% of the construction risk (an extension of the Gap issue discussed above).

Options at Expiration

At the end of the lease term, the lessee will have several options under the lease agreement:

1. The lease agreement will surely include a purchase option under which the lessee, with a typical notice period of 180 days prior to the end of the lease, may elect to purchase the property for a purchase price agreed upon by the parties at the inception of the lease (and supported by appraisal) to represent their best estimate of fair market value as of the last day of the original term of the lease. The purchase option price will be equal to the amount of any and all outstanding debt and will suffice to return to the single investor its investment (loan amount) and required yield;
2. Some, but not all, synthetic lease structures also provide that the lease may be renewed. With a non-amortizing loan still fully outstanding, lessors may want to condition any renewal term on a new credit approval; or
3. The lessee may terminate the lease, commence to perform the obligations associated with the return of the asset and assume certain remarketing obligations. If the lessee terminates the lease, lessee will also be obligated to pay the lessor a substantial final or "contingent" rent amount reflecting both the minimal debt service to the date of such final payment and the portion of the residual risk lessee has assumed consistent with the limitations of SFAS 13. The final payment may approach but not equal 90% of the cost of the asset when aggregated with all other amounts paid by lessee during the term.
4. The remarketing obligation is not a guarantee by lessee of lessor's residual exposure. On the other hand, without any sale by a certain date, lessor will want to assume "zero" as the net remarketing proceeds and trigger the final or contingent rent payment in full. Lessee's accountants may want to resist this assumption and ask lessor to assume the risk of no sale. The relevant provision in the lease agreement will certainly operate so that if the best price obtained by lessee's remarketing efforts exposes lessor to a loss, then lessor can refuse to sell.

Accounting Rules

SFAS 13

Statement of Financial Accounting Standards ("SFAS") No. 13 requires that all of the following requirements must be met in order for the lessee to receive off-balance sheet accounting treatment:

1. There can be no automatic transfer of title to the lessee at the end of the lease.
2. Any option to purchase the property by the lessee cannot be at a "bargain" purchase price.
3. The term of the lease cannot be seventy-five percent or more of the economic useful life of the leased property.
4. The present value of the minimum rental payments cannot be ninety percent or more of the fair market value of the property, determined as of the date of the inception of the lease.

SFAS 98

A sale and leaseback structure with real estate is to be avoided. In order to obtain the principal benefits of a synthetic lease, a transaction involving real estate should be structured with full appreciation for SFAS No. 98, which applies to sale-leaseback transactions. Under SFAS No. 98, a lessee that owns the property and sells it to the lessor cannot have any "continuing involvement" after entering into the lease other than in a "normal" leaseback arrangement. SFAS No. 98 cites the following as examples of continuing involvement that would be prohibited:

1. An option or obligation to purchase the property by the lessee (thus destroying lessee's ability to control the property (and its upside potential) pursuant to contract at the end of the lease).
2. A guarantee by the lessee of the lessor's investment or return on investment.
3. Sharing of appreciation in the property with the lessor.

EITF 90-15

The Emerging Issues Task Force ("EITF") of FASB has addressed circumstances under which the lessor and the lessee are "consolidated" for financial accounting purposes. Under EITF 90-15, the lessee will not receive off-balance sheet accounting treatment if all of the following tests are met:

Substantially all of the activities of the lessor involve assets that are leased to the lessee. The lessee bears substantially all of the residual risks and enjoys substantially all of the residual benefits of the leased assets.

The lessor has not made any substantive investment that is at risk during the term of the lease.

The first test of EITF 90-15 is met in a synthetic lease if the transaction is structured using an SPC as the lessor. In addition, the triple-net lease meets the second test. With respect to the third test, however, EITF 90-15 proposes three percent as the minimum equity that qualifies as a "substantive" investment with the result that the typical synthetic lease SPC is structured with a three percent equity contribution.

When using a special purpose entity, lessee will also be concerned that the transaction is structured to comply with the February 23, 1999 FASB Exposure Draft on Consolidated Financial Statements which suggests very clearly that a three percent equity contribution may no longer be sufficient by itself to avoid consolidation. See the Special Accounting Notice at the outset.

EITF 97-10

At issue is the question of when a lessee is so involved with the construction of a real estate project that it is contractually obligated to lease upon completion that the lessee will be considered to be the owner of the property during construction. If the lessee is determined to be an "owner" during construction, then the transaction would fall within the scope of SFAS 98, and be considered a sale/leaseback upon completion. In that event, the seller/lessee may not be permitted to remove the asset from its balance sheet or recognize the sale of the asset.

The EITF 97-10 consensus (proposed by SFAS in 1998 but treated as currently effective) proposes considering the lessee as the owner during construction if the lessee has substantially all of the construction period risks.

The determination of "all" should follow a precise calculation of the present value of minimum lease payments under the 90 percent test and this means that lessor must assume more than 10% of the construction risk. The proposal recommends that minimum lease payments for the lessee (used to calculate the 90% test for capital lease treatment) include the following:

1. Any guarantee made by the lessee or a related party to the lessee;
2. The maximum amount of any indemnification in favor of the lessor against third party claims related to construction performance;
3. Total costs to be paid to third parties including transaction costs;
4. Land carrying costs such as ground rentals paid by the lessee during construction;
5. Lessee guarantees of cost overruns;
6. Lessee assumption of costs for change orders and tenant improvements;
7. Any lease payments required to be made during construction;
8. Contingent obligations, including the obligations resulting from failure to complete the project (i.e., lessor must have more than 10% of construction risk); and
9. Any equity investment that the lessee has in the SPC (which investment should be zero).

Each of the following should be considered forbidden because the EITF consensus states that the lessee should be considered to be the owner if any of the following conditions exist:

1. The lessee provides financing during construction;
2. The lessee, in its capacity as construction agent/manager, can be required to pay costs that are not regularly reimbursed;
3. The lessee can be required to pay any nonreimbursable costs except rent or normal tenant improvements;
4. The lessee indemnifies the owner-lessor for environmental risks and the risk of loss is more than remote;
5. The lessee takes title to the real estate at any time during construction or transfers ownership of any tangible assets that it previously owned prior to entering the contract with the lessor; or
6. The lessee provides indemnification for contingencies over which it has no control. Some major accounting firms have concluded that the following contingent obligations can be assumed by the lessee and excluded from the maximum guaranty test (which must be less than 90% of project cost --- similar to FASB 13 for operating lease treatment):

• environmental indemnities but only when supported by an up-front phase I evaluation showing such risk to be remote,
• third party claims based on lessee's action or failure to act, or
• claims related to fraud, misapplication of funds or illegal acts on the part of lessee as construction agent. EITF 97-10 has raised numerous interpretive questions so that lessee's accountants should be consulted at every turn.

Article courtesy of Anthony F. Walsh, a senior partner in Saul Ewing's Business Department.