June 29, 2005

Split Decisions on United Airline’s Site Subleases at JFK and LAX

Holland & Knight Newsletter
Barbra R. Parlin
On November 18, 2004, the United States District Court for the Northern District of Illinois overruled a prior decision by the bankruptcy court overseeing the United Airlines, Inc. (United) chapter 11 cases and held that the subleases underlying United’s San Francisco airport facility bonds are true leases within the meaning of section 365 of the Bankruptcy Code.1 See HSBC Bank USA v. United Air Lines, Inc., 317 B.R. 335 (N.D. Ill. 2004). In its original decision, the bankruptcy court had held that the subleases underlying the San Francisco airport facility bonds, as well as the subleases underlying the bonds issued in connection with United’s facilities at New York’s John F. Kennedy International Airport (JFK) and Los Angeles International Airport (LAX), were disguised financing arrangements. Since then, on January 24 and February 16, 2005, respectively, the District Court issued follow up decisions in the appeals of those portions of the bankruptcy court’s order related to the LAX and JFK bonds, finding that the subleases underlying the LAX bonds also are true leases but that the subleases underlying the JFK bonds are disguised financing arrangements.

 

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 the agreement was disguised as a financing arrangement and not a true lease).

The bankruptcy court’s original ruling, 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), LAX, 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 claimed 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 the bondholders’ right 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.

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.2

As previously noted, 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.

The District Court’s reversal of the bankruptcy court’s characterization of the SFO subleases alleviated some of the market’s uncertainty about airline-backed municipal bonds. In particular, market participants predicted that the District Court would rule similarly with respect to the LAX subleases, as the structure of those subleases and bonds was deemed sufficiently similar to the SFO subleases as to warrant a similar result. However, the debate continued with respect to the JFK subleases and bonds.

As expected, in its January 24, 2005, decision the District Court reversed the bankruptcy court’s characterization of the LAX sublease, finding that it, like the SFO sublease, is a true lease and, thus, subject to the protections of section 365.3 In particular, the District Court found that the LAX sublease bore all the indicia of a “triple net” lease commonly used for ground leases. The District Court also determined that the payments under the LAX sublease were designed to reasonably compensate the lessor for the use of the facility, that United had an absolute obligation to pay rent for the entire term, that United could not reduce its rental obligation through termination or pre-payment, that the lessor retained an economically significant interest in the property and that United would retain no interest in the leased property upon termination of the sublease. U.S. Bank N.A., et al. v. United Air Lines, Inc., 2005 WL 563214 (N.D. Ill. January 24, 2005). In the District Court’s view, each of these factors indicated that the subleases were “true leases.” Id. at *6. 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 further found that a “lease-leaseback” arrangement as a method of construction financing is not inconsistent with the existence of a true lease.

By contrast, in its February 16, 2005, decision, the District Court affirmed the bankruptcy court’s characterization of the JFK subleases as a disguised financing arrangement. The Bank of New York v. United Air Lines, Inc., 2005 WL 670528 (N.D. Ill. February 16, 2005). In particular, the District Court found that the New York economic development agency (the NYEDA), the entity to which payments under the subleases at issue had to be made, did not have an economically significant interest in the property during the term of the sublease or after. In fact, NYEDA would not retain an interest in the property if United defaulted under the sublease, and did not have the right to re-let the property to another tenant. The District Court further found that the nominal purchase price paid by the NYEDA for the property was unrelated to the fair market value of the land, and that United’s payments under the sublease were not keyed to such value either. Rather, the payments under the sublease simply were keyed to the bond indenture, while United also was required to pay the New York Port Authority rent for the facilities under a separate lease.

Finally, the trustee for the JFK bonds argued that the characterization of the bonds as disguised financing arrangements would create a transaction that violates New York law and, thus, could not be proper. The District Court disagreed, however, and found that typical financing by a development agency was often made through instruments similar to those at issue in the case, and that the practice is permitted under New York law. As such, the District Court found there was no impediment to characterizing the JFK bonds as disguised financing arrangements.

Taken together, the District Court’s rulings on the DEN, JFK, SFO and LAX bonds have relieved much of the uncertainty in the market for airport special facilities bonds that was created when the bankruptcy court first issued its rulings in March 2004. Even the decision with respect to the JFK bonds provides holders of airport special facilities bonds with at least some guidance as to whether their bonds contain the types of provisions that make it more or less likely that a court will find that such bonds should be afforded the protections of section 365 in the event that the underlying airline subsequently is in bankruptcy. The District Court’s decisions also firmly side with those that apply state law, rather than federal common law, in determining whether an agreement constitutes a true lease or a disguised financing arrangement. Nevertheless, some uncertainty will continue while all of the decisions are appealed to the Seventh Circuit. Stay tuned.

1 Barbra R. Parlin, United Airlines Site Subleases Are “True Leases” After All,” Holland & Knight News and Analysis/Bankruptcy and Creditors’ Rights (December 2004, Vol. 5, Issue 4).

2 The bankruptcy court’s decision with respect to the DEN leases was upheld by the district court in a separate opinion dated January 24, 2005.

3 Also, as in its prior decisions, the District Court reversed the bankruptcy court’s application of federal common law in both of its recent rulings, and found that state law governed the determination as to whether the various subleases constituted “true leases.”

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