Overview

Author: | Published: 10 Oct 2001
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Once a stepchild of the lease securitization marketplace, transport equipment has finally arrived under the guise of operating assets. During the past year, pools of containers, chassis, vehicles and aircraft, together with short-term leases of the equipment, have led to several billion dollars worth of asset-backed securities (ABSs) being issued in Rule 144A transactions. This article will summarize some of the more interesting developments in this segment of the ABS market.

EXPANSION OF ASSET CLASSES

Five years ago, containers were essentially the sole source of operating asset securitizations. In these transactions, each item of equipment is not subject to a long-term lease; instead, the lessor can extract a greater profit by leasing the asset for relatively short periods of time, usually to different users over the life of the asset. The asset-backed securities are issued with a legal maturity date that is less than the useful life of the assets in the pool, and are sized to be payable from the present value of asset cash flow.

Cash flow comes from the repeated leasing of the asset during the life of the deal, and the sale of the asset if needed to pay off the ABS at maturity. Expected revenues from leasing or sale will be based upon appraisals or depreciated book values of the pool assets calculated at the time of issuing the ABS and at periodic intervals thereafter. If any of those periodic appraisals or calculations disclose asset values that are lower than originally projected, a mandatory partial prepayment of the ABS will be necessary to reduce the outstanding ABS principal amount to the agreed percentage of the asset pool value. Declining asset values may also trigger a diversion of cash otherwise payable to the issuer, either to a collateral account or to prepayment of the ABS.

Some of the early transactions involved large fleets of containers where the law of large numbers provided much of the same comfort that a portfolio of a large number of contracts provides in a typical ABS receivables deal. More recent deals have involved aircraft and other kinds of equipment, thereby demonstrating the viability of ABS concepts to a wide variety of operating assets.

REVISED UCC ARTICLE 9

New York law typically governs the security documents in many ABS financings of cross-border transport assets. The basic law of secured transactions in the US has been revised, effective July 1 2001, in New York and in all but four other states (where revised Article 9 will be effective not later than January 1 2002). One of the modifications assists cross-border transactions by authorizing secured parties to perfect their security interest in the equipment, wherever located, by filing a UCC financing statement in Washington, DC, if the debtor is organized under the laws of a foreign jurisdiction that does not require "information concerning the existence of a nonpossessory security interest to be made generally available in a filing, recording, or registration system". Perfecting the security interest enables the ABS holders' lien to withstand US bankruptcy law challenge should the issuer become insolvent.

Taking advantage of this new UCC provision may not be as easy as it appears. This is because the general rule is that a "debtor that is an organization" is located at its sole place of business or, if it has more than one place of business, at its chief executive office (another brand-new rule, deeming a debtor located at its state of registered organization, does not apply to non-US entities). The general rule, though, applies only if the debtor's office is located in a jurisdiction "whose law generally requires information concerning the existence of a nonpossessory security interest to be made generally available in a filing, recording, or registration system as a condition or result of the security interest's obtaining priority over the rights of a lien creditor with respect to the collateral." Unless it is clear that the law of the non-US jurisdiction does or does not comply with this condition, the secured party would be wise to file in both the District of Columbia and the overseas jurisdiction.

For example, the authors' firm has obtained an opinion letter from reputable Bermuda counsel that Bermuda maintains a records system under which a properly filed charge will obtain priority over a competing claim, so that security interests in the assets of issuers located there can be perfected by filing in Bermuda. However, in the Cayman Islands, counsel has advised that the filing system does not provide for central public records, but merely recordation on the books and records of the issuer, and consequently that filing in the District of Columbia is advisable. And whatever the jurisdiction, it will be necessary for the financing parties to establish to their satisfaction that the issuer really is located in a jurisdiction of convenience such as Bermuda, rather than elsewhere, such as where its parent company is headquartered.

AIRCRAFT

Because of the high concentration of values in individual items of equipment and the related leases, aircraft present special issues. In prior years, enhanced equipment trust certificates, leveraged lease loans, and full-payout finance leases were the basis for securitized aircraft financings. More recently, pools of aircraft or aircraft engines, along with related operating leases, have been securitized. Although the methodology of appraised equipment values is similar to that used for other operating assets, there are some special issues that aircraft present.

A well-structured deal will contain limitations on the principal types of aircraft. For example, McDonnell-Douglas airliners are, in the words of one rating agency commentator, "approaching the sunset of their liquidity value". More specifically, the portfolio will need to limit the proportion of particular aircraft, such as Boeing 747, 737 and 777 model aircraft or comparable Airbus models. For each aircraft and related lease, there should be specific maintenance reserves and default reserves that cannot be invaded if shortfalls arise with respect to any other aircraft or lessee in the portfolio. On a pool-wide basis, there should be a liquidity reserve to cover the risk that any one or more planes may be off-lease for extended periods. Because of the importance of remarketing the aircraft after each relatively short-term lease expires, the ABS deal likely will require a recognized aircraft remarketing agent as the back-up servicer, unless the servicer is the manufacturer or an experienced aircraft lessor. Rating agencies and investors will also consider factors, such as the ratio of appraised value of the aircraft in the pool to the original principal amount of the ABS, which may result in a linkage between the credit rating of the servicer and that of the ABS.

From a legal perspective, fewer documents are obtained for each aircraft than are generally required for one-off aircraft lease financings. A typical lessee consent to assignment of the lease is essential, but, for aircraft ABS transactions, a mortgage on the aircraft is not always necessary if the equipment is owned by a bankruptcy-remote, special purpose entity. For example, each plane could be owned by an owner trust, with the beneficiary pledging its interest in the trust to the ABS holders. Increasingly, lessors are forming a Delaware business trust (DBT) to acquire aircraft, and to be the lessor under each lease of that equipment. Ownership by the DBT enables the beneficial owner of the trust to take advantage of the tax benefits and residual value of the trust assets, and to collateralize the ABS by having either the DBT pledge its ownership of the assets, or the beneficiary pledge its beneficial interest in the trust.

One advantage for the financing parties is the DBT statute, which incorporates many bankruptcy-remote features:

  • the DBT is a legal entity that is separate and apart from its trustee and beneficial owners;
  • the trustees and beneficial owners have no personal liability for debts of the DBT;
  • the trust assets are not deemed property of the beneficial owners; and
  • no creditor of a beneficial owner has any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the trust assets.

Because investors have become increasingly comfortable with a pledge of the beneficial interest in the trust assets, there should be no need to file mortgage documents with any governmental authorities to perfect the investors' security interest in the trust assets. Instead, the secured party can simply take possession of the issuer's certificate of beneficial interest in the trust, to perfect its security interest in the collateral for the ABS. This provides the issuer of the ABS with the ability to refinance the assets from time to time without the need for filing new security documents.

Other advantages of the DBT in aircraft finance are the ability of the parties to determine the scope of the powers and duties of the DBT's trustees and beneficial owners, and the lack of need to file annual reports or pay income taxes in most states (since many states do not require DBTs to be licensed to do business, or subject DBTs to income tax). Under ordinary circumstances, the failure to pay taxes in a particular state could give rise to tax liens which would be superior to the investors' lien; or the failure to qualify to do business in a particular jurisdiction could hamper the leasing company's or the investors' ability to seek a legal or equitable remedy against the lessee or the equipment in that jurisdiction.

CREDIT DEFAULT SWAPS

Of course, the latest buzz is over credit default swaps (CDSs) such as those used in the BCI "Leonardo" aircraft transaction. Much has been said, justifiably, over the coverage by CDSs of lessee default and residual value shortfalls. What lessors should realize is that a credit default swap does not:

  • remove the assets from the lessor's balance sheet;
  • shift tax ownership of the equipment; or
  • permit lessors the same prepayment or substitution rights which they customarily have in traditional ABS note deals.

Additionally, CDSs are usually written, like an insurance policy, with both an initial and periodic issuer "premium" payments, and a "deductible" level below which the CDS will not cover losses. It may be that CDSs are most useful where a large portion of the rentals have already been leveraged, or where the residual value and tax benefits have been conveyed to one or more investors, and the latter then use a CDS to hedge their risk, leaving them with the upside potential of the asset appreciation.

There is another area where CDSs have proven valuable. Earlier this year, the authors' firm handled a credit default swap for a $2 billion transport equipment lease portfolio held by a bank-affiliated lessor. The counterparty under the swap agreed to cover losses (above an agreed-upon level) resulting from non-payment of rent by the lessees. Because of this swap coverage, the bank was able to free up almost $120 million of capital that it previously had been required to maintain for regulatory purposes. However, the bank had no need for, and did not get, off-balance sheet treatment for tax or accounting purposes. Even with those pared-down objectives, the complete transaction required six months. Those who use CDSs should expect a time frame at least as long as for a traditional ABS deal.

FUTURE ISSUES

Obviously, there have been significant developments recently in the securitization of operating assets. More can be expected, such as the Unidroit Convention on international security interests in mobile goods, and amendment of Uniform Commercial Code Article 2A. The latter is a statute that applies to all leases governed by the law of a state of the US, unless the parties take appropriate steps to restrict the effect of this uniform law. Some of the Article 2A amendments as drafted in May 2001 would have an adverse impact on lessors, such as proposed section 2A-211 (expanding the lessor's warranties regarding infringement or interference with the lessee's ability to use the equipment). Both the Unidroit Convention and revision of UCC 2A will require further approvals, and it is presently unclear what the final product in either case will look like. What is clear is that securitization of transport assets will continue to evolve as both financiers and lawyers take advantage of this important ABS class.


Thacher Proffitt & Wood
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