Seventh Circuit Rules Again for United Airlines: UAL’s Los Angeles and New York Airport Bonds Also Are Secured Financings
As expected, the United States Court of Appeals for the Seventh Circuit awarded yet another round to United Airlines in the ongoing war between United and the indenture trustees of its airport facility bonds. Hewing closely to its July 26, 2005, decision regarding United’s San Francisco International Airport (SFO) facility bonds, on May 4, 2006, the Seventh Circuit issued a decision finding that the subleases underlying United’s Los Angeles International Airport (LAX) facility bonds also should be characterized as a secured financing and not a true lease. United Air Lines, Inc. v. U.S. Bank National Association, Inc. (In re United Airlines, Inc.), 447 F.3d 504, 2006 WL 1171899 (7th Cir. 2006). A few months earlier, the Seventh Circuit likewise affirmed the lower court’s characterization of the subleases underlying United’s New York John F. Kennedy International Airport (JFK) facility bonds as a secured financing. See United Airlines v. Bank of New York (In re United Airlines, Inc.), 146 Fed. Appx. 836 (7th Cir. August 18, 2005) (unpublished order). In addition, the United States Supreme Court denied certiorari on the indenture trustee’s appeal from the Seventh Circuit’s earlier decision with respect to the San Francisco bonds. As a result, the SFO decision will stand.
The cumulative effect of these decisions is that United will be able to continue using the San Francisco, Los Angeles and New York airport facilities that are the subject of the subleases underlying the bonds without having to assume the subleases pursuant to Section 365 of the Bankruptcy Code or curing any defaults on the bonds. Also, 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 comes due post-petition until such time as the lease is assumed or rejected. Likewise, to retain the benefits of an unexpired lease after confirmation of a plan, a debtor not only must assume all of its obligations thereunder, 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 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 securing such claim 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 the plan 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.
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 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 such, 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. Recharacterization of the subleases as financing arrangements meant that the bondholders would not continue receiving payments post-petition, thereby decreasing 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 that 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 found that state law, rather than the federal “economic realities test,” determined whether the subleases underlying the various United bonds were true leases or secured financings. HSBC Bank USA v. United Air Lines, Inc., 317 B.R. 335 (N.D. Ill. 2004). The district court further found that California law, applicable to the Los Angeles subleases, 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. 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.
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. Id. at 342-43. As such, the district court found that United failed to meet its burden and that the sublease underlying the LAX bonds was a true lease for purposes of Section 365.3
Although the bankruptcy court also erroneously applied the federal economic realities test in determining that the JFK subleases were a secured financing, the district court found this error harmless in the case of the JFK bonds. Contrary to its characterization of California law, the district court found that New York state law, like federal law, looks to the intent of the parties as evidenced by the economic substance of a transaction to determine if a true lease or a secured financing was formed. Viewing the JFK subleases through this prism, the district court agreed that the subleases evidenced an intent to establish a secured financing, not a true lease. In response to the trustee’s argument that recharacterization of the subleases as a secured financing would create a transaction in violation of New York law because the relevant state agency was not permitted to make loans, the district court found that this type of financing is typically used by development agencies and is permissible under New York law.
The SFO Appeal
The Seventh Circuit issued its decision on the SFO appeal in July 2005.4 United Airlines, Inc. v. HSBC Bank USA, N.A., 416 F.3d 609 (7th Cir. 2005). The Seventh Circuit agreed with the district court that, as a matter of federal law, the substance of an agreement, rather than its form, is controlling, and thus only agreements that function as “true leases” qualify for treatment under Section 365. The Seventh Circuit also agreed that state law guides the issue of whether an agreement functions as a true lease. But in a departure from the district court decision, the circuit court further held that state law does not control if it conflicts with federal law in requiring a formalistic approach to this question. In the latter case, federal law would trump state law.
As noted above, the district court construed California law to presume an agreement is a true lease if it meets certain formal criteria and placed upon United the burden of overcoming such presumption by clear and convincing evidence. The Seventh Circuit rejected this formulaic construction of California law. Rather, it found that California law comports with federal law in requiring a functional analysis of the transaction. The Seventh Circuit also took issue with the “clear and convincing” standard of proof applied by the district court, finding 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.
Applying California law, the circuit court found that the sublease’s “hell or high water” clause, which obligated United to pay rent irrespective of whether or not an act of God or another disaster prevented it from actually using the property, meant that 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. Id. at 617. The circuit 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. Id. 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 “would secure the 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.
Finally, the circuit court found that while there are financing devices that also are true leases, this was not such a device. “[I]n 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 Seventh Circuit held that the SFO agreements were not “true leases” for purposes of Section 365. Id. at 618.
The LAX and New York Appeals
The essential structure of the LAX and JFK subleases mirrored that of the SFO subleases. In addition, the LAX subleases also were governed by California law. As such, the Seventh Circuit found that each of the factors that militated in favor of its re-characterization of the SFO subleases as a secured financing supported its determination that the LAX subleases likewise are a secured financing. 447 F.3d 504, 2006 WL 1171899, *3.
Among other things, the circuit court found that the identity between the rent to be paid and the amounts needed to pay the principal and interest due to the bondholders, the requirement of a balloon payment at the end of the term to retire principal, the presence of a “hell or high water” clause in the lease, the fact that pre-payment would terminate the sublease and that the sub-lessor would have no reversionary interest in the property at the conclusion of the sublease indicated that the transaction was a secured financing. Id. at *3 - *5. The mere fact that the proceeds of the bonds were used to finance the construction of improvements that were located on the property that was the subject of the sublease did not, in and of itself, establish that the sublease was a true lease given the presence of these other factors. Id. at *5.
Unlike with the SFO and LAX subleases, the district court had agreed with the bankruptcy court that the JFK subleases were not true leases within the meaning of Section 365. After soliciting the views of the parties, the Seventh Circuit found that no further litigation was required with respect to the JFK leases in light of the opinion on the SFO leases. The same factors that militated in favor of a finding that the SFO leases were a secured financing also applied to the JFK leases, and New York law was in conformity with the law of California for these purposes. Accordingly, the Seventh Circuit simply affirmed the district court opinion without further briefing. See United Airlines, Inc. v. Bank of New York (In re United Airlines, Inc.), 146 Fed. Appx. 836 (7th Cir. August 18, 2005) (unpublished order).
While not unexpected, the Seventh Circuit’s recent decisions with respect to the LAX and JFK leases provide some additional guidance as to that circuit’s approach to the true lease vs. secured financing analysis. Certainly, the circuit court’s analysis has been and will be cited in future cases challenging whether an agreement is a true lease, particularly in cases involving airport facility bonds.
That being said, it remains 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.
The Seventh Circuit’s decision also opens the door to a host of follow-up litigation concerning the value of the collateral securing the subleases, efforts to avoid the liens by United pursuant to Section 544 of the Bankruptcy Code, and potential litigation against non-debtor transaction participants arising out of the recharacterization. Certainly, at a minimum, investors will want to look at the value of any improvements constructed with the proceeds of the bonds, as this will be the collateral supporting future payments in the event of a recharacterization. Investors also will want to make sure that all required financing statements are filed and that the collateral descriptions contained in those financing statements are sufficiently broad to protect the bondholders if litigation ensues.
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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 The parties to each of the adversary proceedings agreed to go forward with the SFO appeal first, in the hope that the decision would inform the remaining litigation.