United Airline's Site Subleases are "True Leases" After All
In a decision sure to be cheered by Wall Street bond analysts and investors alike, on November 18, 2004, the United States District Court for the Northern District of Illinois overruled a March 2004 order by the bankruptcy court overseeing the United Airlines (United) chapter 11 cases to find that the subleases underlying United’s San Francisco airport facility bonds are true leases within the meaning of section 365 of the Bankruptcy Code. See HSBC Bank USA v. United Air Lines, Inc., No. 04 C 2836, 2004 WL 2609196 (N.D. Ill. November 18, 2004). As a result of this decision, United will be required to continue making payments on the San Francisco airport subleases as a condition to using the facilities, thereby ensuring continued payments to the bondholders.
Section 365 of the Bankruptcy Code applies to “executory contracts and unexpired leases,” and requires a debtor to “timely perform all the [debtor’s post-petition] obligations ... under any unexpired lease of nonresidential real property, until such lease is assumed or rejected... “ Stated simply, the trustee or a debtor in possession, such as United, is required to pay its rent and perform its other obligations under a commercial lease that come due post-petition until such time as the lease is rejected. Although the Bankruptcy Code does not define the term “lease,” courts consistently have held that the provisions and protections of section 365 only apply to true leases, irrespective of whether the underlying documents are denominated as such. See, e.g., Liona Corp. N.V. v. PCH Associates (In re PCH Associates), 804 F.2d 193, 199-200 (2d Cir. 1986) (finding section 365 inapplicable as agreement was disguised financing arrangement and not true lease).
The bankruptcy court’s original ruling in the United bankruptcy case, reported at 307 B.R. 618 (Bankr. N.D. Ill. 2004), arose out of four related adversary proceedings commenced by United after it filed chapter 11. In the adversary proceedings, United sought declaratory judgments that the site subleases underlying the bonds by which United financed certain improvements at San Francisco International Airport (SFO), Los Angeles International Airport (LAX), John F. Kennedy International Airport (JFK) and Denver International Airport (DEN) were not true leases within the meaning of section 365, but rather were disguised financing arrangements. As a result, United argued that it was not required to make post-petition payments on such leases as a condition to using the facilities as would be required by section 365. Although each airport bond issue was structured somewhat differently, in each instance United’s payments on the subleases were used to finance the payments due to the bondholders. Accordingly, if successful, United’s attempt to recharacterize the subleases as financing arrangements would have a direct impact on both the bondholders’ ability to continue receiving payments post-petition and, more generally, on the market value of the particular bonds at issue and, potentially, other bonds with similar structures.
After reviewing the underlying documents, the bankruptcy court agreed with United’s characterization of the leases for its facilities at SFO, LAX and JFK as disguised financing arrangements, but found that the DEN lease was a true lease. As a result of the bankruptcy court decision, United was not required to continue making payments on the SFO, LAX and JFK subleases as a condition to using the respective facilities, but did have to make the payments related to DEN. The bankruptcy court’s decision had an immediate impact upon the market for airline-backed municipal bonds, “as participants began scrutinizing security provisions across the entire sector” to see whether the provisions of the documents underlying their bonds were structured more like those of the DEN subleases than those of the other airports. See, e.g., Jacob Fine and Yvette Shields, United Case Has Investors Poring Over Their Airline Debt, The Bond Buyer, April 1, 2004, vol. 348, no. 31854 at 48, 2004 WL 55821796.
On appeal to the District Court, the trustees for the bonds related to the SFO, LAX and JFK airports argued that the subleases contained in their documents were “true leases” within the meaning of section 365. In a ruling with respect to the SFO trustee’s appeal only, the District Court agreed. As an initial matter, the District Court rejected the bankruptcy court’s application of federal common law, and found that state law governed the determination as to whether the various subleases constituted “true leases.”
Applying the state law of California applicable to the sublease, the District Court found that United had not presented clear and convincing evidence to overcome the presumption that the SFO sublease was a true lease. Among other things, the District Court found that the SFO sublease bore all the indicia of a true “triple net” lease, insofar as the payments under the sublease were designed to reasonably compensate the lessor for the use of the facility, United had an absolute obligation to pay rent for the entire term, United could not reduce its rental obligation through termination or pre-payment, the lessor retained an economically significant interest in the property and United would retain no interest in the leased property upon termination of the sublease. Indeed, United admitted that it could not own the leased property and had no option to purchase the leased property upon the conclusion of the lease term, while the lessor had the option to relet the property in the event that United defaulted, factors that the District Court found indicative of a true lease, not a financing arrangement.
The District Court’s ruling provided a “dramatic boost” to the value of the SFO bonds. Yvette Shields, U.S. Judge Overturns United Ruling: Airline May Have to Pay Off Munis, The Bond Buyer, Nov. 19, 2004, vol. 350, no. 32014, 2004 WL 97039744. Given that the documents underlying the LAX bonds also are governed by California law and apparently contain similar provisions, it appears likely that the District Court would rule similarly with respect to those bonds, although decisions with respect to the LAX and JFK bonds have not yet been issued. In any case, the District Court’s ruling has removed some of the uncertainty in the market for airport special facilities revenue bonds caused by the bankruptcy court’s original ruling recharacterizing the SFO, JFK and LAX subleases.