What is the Future for the Synthetic Leasing of Real Property Under the New Rules Issued by FASB and the SEC?
 
April 1, 2003
 

Synthetic lease financing has been employed to finance warehouses, distribution centers, office buildings, research and development facilities, hotels, assisted living facilities and many other types of property.  Lessees were typically well-thought-of, financially stable companies traded on national stock exchanges.  Default rates were very low and this method of financing before Enron’s collapse, at least for real property, was thought to be a well-worked-out routine method to finance real property capital that did not need fixing.

Recently, the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) promulgated new rules that will affect this financing process.

Synthetic Leases Before Enron

A synthetic lease or tax retention operating lease (TROL for short) is a sophisticated method of real estate financing for the acquisition or development of new properties, which enabled the lessee to derive tax, accounting and rent advantages and provided the lessee with the opportunity to buy the property at a favorable, pre-established termination value at the end of the lease term.

Advantages over conventional leases. The synthetic lease was an excellent tool for a publicly traded company, or a company planning to go public, concerned with the balance sheet ratios on its financial statements and the effect these ratios have on Wall Street. Shareholders and analysts tend to look unfavorably on investments in concrete, steel and glass rather than in core business assets. The real estate assets subject to a synthetic lease do not appear on the lessee’s balance sheet and no depreciation is charged against earnings for SEC reporting purposes. The lease structure still allows the improvements to be depreciated for income tax purposes, thus preserving the tax shelter aspect of owning improved real estate.

The off-balance-sheet synthetic lease also provides other significant advantages over a conventional lease. Occupancy costs are usually lower than with a conventional lease. Synthetic leases do not include rental escalators based on the consumer price index, percentage rent based on sales or similar provisions. For all practical purposes, the company controls the real estate and, in the case of many synthetic lease transactions, can exercise an option to buy the property at a pre-established termination value at any time. This had been a real advance on the traditional sale and leaseback arrangements that typically include purchase options that set the purchase price at the property’s market value at the time the option is exercised. In short, the synthetic lease provided most of the advantages of owning real property and the accounting benefit of treatment as an operating lease.

Funding. The synthetic lease could be funded up to 100 percent by debt or the equivalent, as opposed to a conventional sale and leaseback, which is usually funded by at least 20 percent equity. A lessee with strong credit can expect an effective interest rate of one percent or more below that in a traditional sale and leaseback.

The amount of equity required and limitations on the length of the lease, the pre-established termination value and the maximum amount of rent payable in order to receive the favorable tax and accounting treatment described above were developed by FASB and the SEC. A three-percent equity investment was held to be the minimum amount that would qualify as the “substantial” equity investment necessary for treatment of an entity other than the lessee as the owner. This was in effect a safe harbor. The lease was not to be for a term that was more than 75 percent of the economic life of the property.  For this reason and due to lender preferences for shorter terms, synthetic leases over 10 years were seldom seen. Typical terms were three to seven years.

Lessee’s options to purchase. The lessee’s option to purchase could not be for a “bargain price.. This was avoided by setting the pre-established termination value for each property to equal the unamortized acquisition and development costs of that property or allowing the lessee to sell the properties for their fair market value at the end of the lease term. Finally, the lease income was not to exceed 90 percent of the fair market value of the property. In order to satisfy this condition, the maximum amount that the lessee may have been called upon to pay in the event there is a shortfall in the net sales proceeds from selling all of the properties to third parties at the end of the lease term to cover the remaining obligations to the lenders, referred to as the maximum residual guarantee amount, and rents was usually set so that the present value at lease inception of the rents and the maximum residual guarantee was 89.9 percent. The maximum residual guarantee typically came out to about 85 percent of unamortized cost.

The lessee typically had three options at the end of the lease term: It could buy the property, or all of the properties if there were more than one, at the pre-established termination values; it could roll over the lease with the same lenders or with new lenders by amending the synthetic lease documents; or it could have all of the properties sold to third parties, subject to the lessee’s obligation to make up the amount of any shortfall in the net sales proceeds to reach the pre-established termination values, such makeup amount to be limited to the pre-established maximum residual guarantee amount.

Conveyance. A synthetic lease structure was typically created by conveying legal title to the subject properties to a single purpose trust created by the synthetic lease documentation.  Certain financial institutions specialized in serving as the owner trustee of such trusts.  The trust issued notes to the lenders secured by deeds of trust given on the properties and certificates to the equity holders.  The properties were leased to the lessee for rent sufficient to cover debt service.

If the equity required was small, one or more of the lender participants (as holders) often took that position in addition to participating in the loan. The equity was to come from an independent source. It could not come from the lessee or, in most cases, an affiliate. The fact that fee title is typically held in the capacity of owner trustee by a corporate trustee that is unlikely to file bankruptcy added to the appeal of this form of financing to lenders. Although some synthetic lease financings have been recharacterized by bankruptcy courts (in equipment leasing cases) as a secured financing arrangement so that the post filing rents under the lease will not be treated as administrative expenses, but rather as a secured claim, the lenders usually were able to secure title to and possession of the property quicker than they otherwise would have been.

In order to assure that the lenders were still secured in the event of such a recharacterization by any court, the lessee would have given a deed of trust or mortgage on its leasehold estate or whatever higher title it may have been found to have held to the owner trustee, which was then assigned to the lenders.   

Synthetic Leases After Enron

The Enron collapse changed the popular view about synthetic leasing.  The fact that almost every one of the Enron financial vehicles broke one or more of the synthetic leasing rules did not stop members of the accounting profession, financial analysts and securities regulators from taking a hard look at the existing rules with a view toward the development of new rules to achieve greater transparency in financial statements. 

Some commentators were especially hostile to off-balance-sheet financing. As a direct result of an article in Forbes published shortly after Enron’s collapse and criticizing the company’s synthetic lease financing of a new mixing plant and warehouse as a “subterfuge,” Krispy Kreme, then the new darling of Wall Street, felt it necessary to unwind its lease at significant short and long-term costs. This author is unaware of any synthetic lease financing on real property that took place after January 2002, although there probably have been isolated instances involving special situations. On January 22, and January 27, 2003, after more than a year hiatus, the FASB and the SEC  respectively promulgated new guidelines and rules.

The New FASB Rules

Consolidation of Special Purpose Entities and Primary Beneficiaries. FASB Interpretation No. 46, Consolidation of Variable Interest Entities and Interpretation of ARB No. 51 (FIN 46), sets forth the provisions for the consolidation of certain of what have previously been referred to as “special purpose entities” with their “primary beneficiary” for accounting and financial statement purposes.  The entities that are subject to consolidation are referred to as “variable interest entities.”

The primary beneficiary will usually be the entity that will absorb a majority of the variable interest entity’s losses and, if losses occur, will receive the majority of the profits, or receive both.  If one entity will absorb the majority of the losses and another the majority of the profits, the primary beneficiary is the entity that will absorb the majority of the losses.  If two or more entities with variable interests have an agency relationship, the principal is the primary beneficiary. 

If the relationship is not that of principal and agent, the party with activities that are most closely associated with the variable interest entity is the primary beneficiary.

Variable Interest Entity. An entity is a variable interest entity, subject to consolidation if either (1) the total equity investment is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, i.e., the expected losses are equal to or greater than the equity at risk or (2) the holders of the equity at risk lack any one of the following:  the right to make decisions through voting or other rights, the obligation to absorb losses as they occur (it does not have that obligation if such obligation is covered by a guarantee from an involved party), or the right to receive expected residual returns if they occur.

Equity Investment. Generally, an equity investment of less than 10 percent of the entity’s assets will be considered insufficient unless the entity has demonstrated that it can finance its activities without subordinate financial support, comparable entities holding similar assets finance their activities and operate with no more equity, or the equity investment exceeds a reasonable estimate of expected losses.  However, the 10- percent rule is not a safe harbor.  Entities involved in high-risk activities or that cannot finance their activities without subordinate financial support may require an equity investment in excess of 10 percent.

FIN 46 also sets forth disclosure requirements with respect to interests in variable interest entities for which the party is not the primary beneficiary.  The new FASB rules appear to require broader disclosures in the body of the financial statement.  However, the new disclosure rules adopted by the SEC, discussed below, appear to be more comprehensive and, thus, controlling.  FIN 46 is immediately effective for all variable interest entities created after January 31, 2003.  Public companies holding variable interest entities must apply FIN 46 beginning with the first interim or annual reporting period beginning on or after June 15, 2003.  Finally, any enterprise that reasonably expects to be consolidating a variable interest entity must report information on such entity and the maximum exposure to loss in all financial statements initially issued after January 31, 2003.  Restatement of earlier statements is encouraged, but not required.

The New SEC Rules

Pursuant to Section 401(a) of the Sarbanes-Oxley Act of 2002, on January 27, 2003, the SEC promulgated rules requiring (1) disclosure of off-balance-sheet arrangements in registration statements, annual reports, and proxy or information statements that are required to include financial statements for fiscal years ending on or after June 15, 2003, and (2) a table of material contractual obligations in such statements and reports for fiscal years ending on or after December 15, 2003.

Disclosure Standard. The rules adopted include a disclosure standard requiring disclosure of information on off-balance-sheet arrangements “reasonably likely to have an effect” on financial condition and other matters material to investors, the current standard for including any information in management’s discussion and analysis section of the financial statement (the MD&A).  The disclosures are to be made in the MD&A under a separate heading.

Which Off-balance-sheet Arrangements Must Be Reported. The off-balance-sheet arrangements to be reported are defined as any contractual arrangement to which an unconsolidated entity is a party under which the reporting party has (1) any obligation to guarantee contracts, (2) a retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to that entity for such assets, (3) any obligation under certain derivative instruments or (4) any obligation under a material variable interest held by the reporting party in an unconsolidated entity that provides financing, liquidity, or market risk support to the reporting party, or engages in leasing, hedging, or research and development services with the reporting party.  For the purposes of this article, we are most interested in arrangements (1) and (4).  The guarantees covered include contingent guarantees to make payments to a party based on changes in an “underlying” obligation that is related to an asset. 

The maximum residual guarantee, as now calculated, could certainly be argued to be such a guarantee and the lessee’s obligations under the documentation used until now could certainly be argued to be obligations arising out of a material variable interest in an unconsolidated entity (assuming consolidation could be avoided) with which it engages in leasing activities.  The SEC expressly adopted the definition for “variable interest” set forth in FIN 46 and set forth above. 

Given the foregoing, it will most likely be necessary to describe any material synthetic lease arrangement in the MD&A if the arrangement is reasonably likely to have a current or future effect on the reporting party’s financial condition, revenues, expenses, results of operations, liquidity, capital expenses, capital resources or other matters that are material to investors.  The discussion must include all of the information necessary to an understanding of the arrangement.  The reporting party must discuss the importance of the off-balance-sheet financing to the reporting party’s financial condition and operations.  Initial disclosures of such arrangements in the MD&A should provide more detailed information on the arrangements.

Contractual Payment Obligations. The new SEC rules also require tabular disclosures of aggregate information on a reporting party’s contractual payment obligations.  The form specified requires the listing of the aggregate of long-term debt, capital lease obligations, operation leases purchase obligations and other long-term liabilities in each such category in a grid showing the aggregate payments due in each category within the year, in one to three years, in three to five years or in more than five years.

Conclusion

The new SEC rules will require much more disclosure and discussion of material synthetic leasing arrangements.  Most of those involved in this area of financing do not believe that synthetic leasing is that much of a secret.  When major synthetic lease facilities were closed, tombstone advertisements were often published by the facilitator of the financing; and the lessees or their attorneys typically released news of the financings to the press.

The greater difficulty is going to be avoiding consolidation under FIN 46.  That analysis is made more difficult because FASB, like the SEC, has adopted standards based on general principles rather than objective rules. In the previous era, if you determined that there was a minimum of three-percent cash equity that did not derive directly or indirectly from the lessee, calculated the maximum residual guarantee to the fourth significant digit, and complied with all of the other objectively stated rules, you knew you were good to go.

Even the new equity standard is hedged.  Ten percent may not be enough in some circumstances, but more than enough in others.  In the case of the types of real properties that are typically the subject of synthetic lease financing, ten percent equity should be enough.  Ten percent initially would probably be the rule for real property assets unless other substantial structural changes were made.  That is not to say that over time the standard for acceptable equity levels might not be reduced.  The consensus appears to be that the best chance to avoid consolidation would be to make the lessor a real company with some substance and, better yet, with some actual employees and assets other than the leased assets.  The further consensus is that the lessor should be consolidated with some other company.  The days of lightly capitalized paper trusts that do not show up on any company’s balance sheet are over.  The likely candidate for such consolidation is the facilitator of the financing or an affiliate.

One banker actively involved in developing a synthetic lease structure that fits the new rules has suggested that the lease transactions be carried out by a Regulation Y holding company subsidiary of a bank that, as such, would be consolidated with the bank for accounting and financial statement purposes.  Presumably one such holding company would engage in numerous lease transactions.  It would borrow from the same group of lenders that have historically lent on synthetic leases. If a large number of leases were outstanding, the magnitude of the effect on the total portfolio of a default on one transaction would be relatively small, perhaps justifying an equity investment of significantly less than ten percent. 

Some issues would still remain.  Although it would help that the lessor is a substantial company that is consolidated, a particular lease transaction might still be analyzed as involving a separate variable interest entity to which the activities of the lessee are more closely related than those of the lessor, a factor identified in paragraph 17 of FIN 46.  Synthetic lease lenders have become accustomed to receiving an 85-percent, plus or minus one percent, residual guarantee and may be reluctant to give it up or substantially reduce it.  A guarantee of that magnitude may undercut the argument that having a lessor of substance that is consolidated with another substantial entity is enough. 

The guarantee fails to pass both of FASB’s tests, to be applied alternatively, regarding whether an entity is subject to consolidation.  The guarantee indicates the entity does not have sufficient equity to permit its financing activities without subordinated financial accommodations from the lessee and, by reason of the of the guarantee, is left without an obligation to absorb expected losses.  Also, paragraph B10 of Appendix B to FIN 46 states that long-term leases are not considered in determining whether the lessee is a primary beneficiary if they are at market rate and there is no feature such as a residual guarantee, implying that if there is a residual guarantee, consolidation with the lessee may be required.  However, it may still be argued that in the case of real property assets, the expected losses and expected residual returns of the lessee are equal to each other and are no greater than the expected losses and expected residual returns of the lenders, which is the underlying consideration cited in FIN 46.  This depends on a belief in the relatively stable value of real property assets.  The history of synthetic leasing of real estate has largely been the rollover into a new lease at the end of each term.

At this juncture, the future of synthetic leasing will depend on the ability of facilitators of synthetic leasing to develop new structures designed to respond to the new rules and find lessees that are interested in working with the facilitator and the lessee’s accountants and attorneys on a particular transaction. 

Time will tell whether lease structures that are competitive with other financing alternatives will appear in the market.  Accounting firms will play a central role in determining what will be accepted and will probably take a conservative approach early on. 

It would help if some follow-up interpretation was available from the FASB on particular structures that are likely to be tried.  The most reasonable available alternative for a company that has a strong interest in keeping its real property off its balance sheet and not much time to work with would appear to be a true sale and leaseback. There are equity investors out there seeking the relatively certain returns from leases to major public companies; and rates on mid-to long-term real estate loans are currently very low.

For more information, contact Vernon Watters, toll free, at 1-888-688-8500.