October 31, 2005

Not So Fast: Seventh Circuit Says United Airline’s San Francisco Airport Bonds Are a Secured Financing After All

Holland & Knight Newsletter
Barbra R. Parlin

The latest battle in the more than year-long war between United Airlines (United) and the indenture trustees of United’s airport facility bonds goes to the debtor. On July 26, 2005, the Seventh Circuit Court of Appeals reversed the November 18, 2004, decision of the United States District Court for the Northern District of Illinois, effectively reinstating a March 2004 order by the bankruptcy court overseeing the United chapter 11 cases finding that the subleases underlying United’s San Francisco airport facility bonds actually are secured financings that need not be assumed or rejected under section 365 of the Bankruptcy Code. United Air Lines, Inc. v. HSBC Bank USA, N.A. (In re UAL Corp.), 416 F.3d 609 (7th Cir. 2005). As a result, United will be able to continue using the San Francisco airport facilities that are the subject of the subleases underlying the bonds without having to assume the subleases pursuant to section 365 or curing any defaults on the bonds. Indeed, pursuant to sections 506(a) and 1129 of the Bankruptcy Code, United will be able to write down the secured portion of the bonds in a plan of reorganization to the economic value of the security interest, with the remainder to be treated as unsecured debt.

Treatment of Leases vs. Secured Claims under the Bankruptcy Code

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. ... “ 11 U.S.C. § 365(d)(3). Stated simply, the trustee or 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 assumed or rejected. Likewise, in order to retain the benefits of an unexpired lease after confirmation of a plan, a debtor not only must assume all of its obligations under the lease but also must cure any pre-petition monetary defaults under the lease. 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 a true lease).

By contrast, under section 506(a) of the Bankruptcy Code, a pre-petition claim that is secured by a valid lien on a debtor’s property is secured only to the extent of the value of the collateral, and is unsecured to the extent that the value of the collateral is less than the amount of the debt. See 11 U.S.C. § 506(a). In addition, a debtor can retain the collateral pursuant to a plan, as long as it leaves the lien in place and provides for payment in full of the secured portion of the lien holder’s claim. Those payments, however, can be made over time, as long as the lien holder ultimately receives payments totaling the value of its claim on the petition date, with the remainder, if any, treated as a general unsecured claim. See 11 U.S.C. § 1129.

Procedural Background

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 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 otherwise be required under section 365. Although each airport bond issue was structured somewhat differently, in each instance United’s payments on the lease between it and the bond issuer 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.

The bankruptcy court agreed with United that the leases underlying the SFO, LAX and JFK bonds were not true leases, but found that the DEN leases did qualify as such. Applying federal law (which it deemed controlling of this issue), the bankruptcy court found the most important factor distinguishing a true lease from a financing arrangement was whether the lessor retained “significant risk and benefits as to the value of the putatively leased real estate at the termination of the lease.” 307 B.R. at 631. The bankruptcy court further explained that this factor also is reflected in the Uniform Commercial Code’s per se rule that a true lease “does not exist where upon compliance with the terms of the lease the lessee shall become or has the option to become the owner of the property for no additional consideration or nominal consideration.” Id.

The SFO, LAX and JFK bonds involved lease/leaseback transactions.1 In each case, United had transferred to the bond issuer a leasehold interest in certain airport property that United held pursuant to a separate ground lease. Termination of the leasebacks upon repayment of the bonds would occur with “no property interest reverting to the bond-issuing agencies.” Id. at 632. Under this circumstance, the bankruptcy court found that “the absence of a surviving ownership interest dictates a determination that the leasebacks are not true leases.” Id. at 632-633.2

On appeal, the District Court rejected the bankruptcy court’s application of federal common law, holding that state law (in the case of the SFO leases, the law of California) governs the question of whether the subleases qualify as true leases and thus must be assumed or rejected under section 365. 317 B.R. at 342.

The District Court also disagreed with the bankruptcy court’s finding that the question of whether an agreement is a true lease largely turns on whether the lessor retains a significant economic interest or risk at the end of the lease. According to the District Court, the mere fact that the bond issuer’s interest in its leasehold would terminate at the same time as the sublease to United (presumably upon repayment of the bonds) did not mandate a finding that the subleases were not true leases. Indeed, this test would improperly exclude an entire class of subleases with a term co-equal to the master lease from being deemed true leases notwithstanding the circumstances. The District Court also found that the bankruptcy court’s emphasis on what the landlord retained at the end of the lease term focused too much on the lessor, rather than the lessee. Rather, the District Court found it more telling that United would not and could not own any of the leased property at the conclusion of the lease term. Id. at 343.

Finally, the District Court rejected the bankruptcy court’s ultimate conclusion as to the proper characterization of the leases underlying the SFO (and LAX) bonds. Contrary to the bankruptcy court’s examination of the economic realities of the transaction, the District Court found that California law presumed an agreement “to be a lease of real property if it includes a designation of the parties, contains a definite description of the leased property, provides for periodic payment of rent for the term of the lease, and provides a right to occupy the property to the exclusion of the grantor.” Id. at 342.

According to the District Court, to rebut this presumption, United had to come forward with “clear and convincing evidence” that, at the time the documents were executed, the parties intended the subleases to be something other than true leases. Id. The parties’ intent is determined by reviewing all the facts and circumstances of the transaction, including its economic substance. In reviewing this evidence, the District Court found that while the payments due from United to the indenture trustee under the sublease included the amount necessary to pay the bonds and any administrative costs, such payments “also constituted reasonable compensation for the use and occupation” of the leased site, and that United had not presented any contrary evidence. As such, the District Court found that the sublease underlying the SFO bonds was a true lease for purposes of section 365.3

The Seventh Circuit Reverses

On appeal, the Seventh Circuit agreed with both lower courts that the substance of an agreement, rather than its form, is controlling and thus only true leases qualify for treatment under section 365. The Seventh Circuit also agreed with the District Court that state law guides the issue of whether an agreement is a true lease. There the agreement ended, however.4

As noted above, the bankruptcy court analyzed the leases underlying the SFO bonds from a substantive perspective geared towards their economic reality (focusing most acutely on what, if anything, of value will the lessor retain at the end of the lease term and what economic risk is the lessor taking in making the lease). Despite its finding that substance should trump form, the District Court ultimately relied on the form of the subleases in reaching its holding, applying what the court viewed as California’s presumption that an agreement that is denominated a lease and looks like a lease is a lease.

Although it ultimately agreed with the bankruptcy court that the substance, rather than the form of an agreement determines if it is a true lease, and that the agreements at issue were not true leases, the Seventh Circuit applied yet another, more functional method of analysis to determine which substantive features of an agreement matter in making this determination. As an initial matter, the appellate court explained why secured debt is treated differently from new expenses (such as post-petition rent) under the Bankruptcy Code:

Many provisions in the Code, particularly those that deal with the treatment of secured credit, are designed to distinguish financial from economic distress. A firm that cannot meet its debts as they come due, but has a positive cash flow from current operations, is in financial but not economic distress. It is carrying too much debt, which can be written down in a reorganization. A firm with a negative cash flow, by contrast, is in economic distress, and liquidation may be the best option. In order to distinguish financial from economic distress, the Code effectively treats the date on which the bankruptcy begins as the creation of a new firm, unburdened by the debts of its predecessor. … The new firm must cover all new expenses, while debt attributable to former operations is adjusted. Section 365, which deals with leases, classifies payments for retaining airplanes and occupying business premises as new expenses, just like payments for labor and jet fuel. The rules for credit, by contrast, treat debt service as an “old” expense to be adjusted to deal with financial distress.

“[R]ent” that represents the cost of funds for capital assets or past operations rather than ongoing inputs into production has the quality of debt, and to require such obligations to be assumed under § 365 to retain an asset would permit financial distress from past operations to shut down a firm that has a positive cash flow from current operations.

416 F.3d at 612-13 (citation omitted).

Under the foregoing analysis, agreements in which the forward-looking “consumption component” dominate are deemed true leases for purposes of section 365, while an agreement in which “the asset serves as security for an extension of credit” should be deemed a financing not governed by that section. Id. at 613. While state law, best exemplified by the UCC, provides the means of making this functional distinction, the appellate court found that “[a] state law that identified a ‘lease’ in a formal rather than a functional manner would conflict with the [Bankruptcy] Code, because it would disrupt the federal system of separating financial from economic distress ...” Id. at 615.

The Seventh Circuit also disagreed with the District Court’s view of California law. Contrary to the District Court, the appellate court found that California state courts likewise apply a functional analysis, rather than a presumption based on form, to determine if an agreement is really a lease.5 Applying that law to the subleases underlying the SFO bonds, the Circuit Court found that the rent was not tied to the market value of the 20 acres that were the subject of the lease, but rather to the amount United had borrowed through the bonds. To support this finding, the Circuit Court cited to the sublease’s “hell or high water” clause, which obligated United to pay rent whether or not an act of God or another disaster prevented it from actually using the 20 acres. The appellate court also found that the bond issuer/lessor would have no interest in the property at the conclusion of the lease while United’s full tenancy under the ground lease would revert to it without any additional payment, thus satisfying the UCC’s per se rule for identifying secured credit. In addition, the Seventh Circuit found that the provisions for a balloon payment at the conclusion of the lease and the termination of the lease upon prepayment were not typical of true leases. In the latter case, prepayment under a true lease typically “secures a tenant’s right to occupy the property for an additional period” and does not act as a means of terminating such right of occupation. Id. at 617.

Finally, the Circuit Court found that while there are financing devices that also are true leases, this was not such a device. “In such a transaction the lessee acquires an asset; from the lessee’s perspective, it is engaged in securing assets with current value, and it can escape the rental obligation by surrendering the asset.” Id. By contrast, in this case, United took an asset that it already had – its leasehold interest in the 20 acres of airport property – and used it to secure an extension of credit from the bondholders. Accordingly, the Circuit Court held that the agreements were not true leases for purposes of section 365.


Although the Seventh Circuit’s opinion directly concerns only the SFO bonds, the analysis applied predicts the eventual outcomes of the other appeals, i.e., the court will reverse the District Court’s determination that the subleases underlying the LAX bonds are true leases, and will affirm the District Court’s findings with respect to the JFK (disguised financing) and DEN (true leases) bonds.

The Seventh Circuit’s approach in this case likely will be cited in future cases challenging whether an agreement is a true lease. That being said, it is unclear what impact, if any, the decision will have on the form of future municipal bond issues. In this case, the holders of United’s airport bonds argued strenuously for treatment under section 365 as such treatment would provide them with an uninterrupted stream of post-petition payments and because it was unlikely, given the importance of the underlying airport facilities to its business operations, that United would reject the leases in a plan of reorganization. However, in many cases, bondholders seek the opposite result – characterization as secured creditors – in order to prevent the debtor from simply rejecting its obligations to such bondholders pursuant to section 365. The latter scenario occurs most often when the bonds at issue financed the construction of a facility that the debtor’s business no longer requires or which the debtor no longer can afford to operate.

Certainly, the Seventh Circuit’s decision has affected the relative market values of the United bonds at issue, and likely will cause holders of other airport municipal bonds to once again examine the documents underlying their respective bonds, in an effort to divine whether the relevant agreements most resemble the DEN or the SFO/LAX/JFK bonds.

For more information, e-mail Barbra R. Parlin at barbra.parlin@hklaw.com or call toll free, 1.888.688.8500.

1 By contrast, the DEN bonds involved a lease directly from the owner of the airport property, the City of Denver, which also was the issuer of the bonds. Under this scenario, the bankruptcy court found that the DEN bonds were true leases subject to section 365.

2 In addition, the bankruptcy court found that other factors relied on by courts in determining whether an agreement is a true lease for purposes of section 365, including: (i) whether the rent is calculated to compensate for use of the land or for some other purpose, such as “to ensure a particular return on investment”; (ii) whether the lessor’s purchase price is related to the price of the property or if it was “calculated as the amount necessary to finance the transaction”; (iii) if the lessor purchased the property specifically for the lessee’s use; (iv) if the transaction was structured as a lease to secure tax advantages; and (v) if, pursuant to the transaction, the lessee assumed the obligations of ownership such as paying property taxes and insurance, all weighed against a finding that the subleases underlying the SFO, LAX and JFK bonds were true leases for purposes of section 365. Id. at 631-632.

3 In separate but related opinions, the District Court affirmed the bankruptcy court’s holding that the agreements underlying the DEN bonds were true leases, reversed with respect to the LAX bonds (the structure of which mirrored the SFO bonds and also were governed by California law), and affirmed the bankruptcy court’s determination that the agreements underlying the JFK bonds were disguised financing arrangements.

4 By agreement of the parties, United’s appeal to the appellate court from the District Court’s decision as to the SFO bonds was briefed and argued first, with the parties’ appeals from the LAX, JFK and DEN decisions held in abeyance pending the outcome of the SFO bonds appeal. Although their respective appeals have not yet proceeded, the indenture trustees for the LAX, JFK and DEN bonds participated in the SFO bonds appeal by filing amicus curiae briefs.

5 The Seventh Circuit also took issue with the “clear and convincing” standard of proof applied by the District Court, holding that bankruptcy uses a “preponderance” standard and that, in any event, “burdens of persuasion are irrelevant to characterization of documentary transactions.” 416 F.3d at 615.

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