POST-ENRON OFF-BALANCE SHEET FINANCING UPDATE Nancy R. Little, Esquire McGuireWoods LLP One James Center 901 East Cary Street Richmond, Virginia 23219 (804) 775-1010 nlittle@mcguirewoods.com AMERICAN COLLEGE OF REAL ESTATE LAWYERS MARCH 20, 2004 TABLE OF CONTENTS Page I. INTRODUCTION............................................................................................................ 1 II. ACCOUNTING RULES ................................................................................................. 1 A. B. III. Basic Off-Balance Sheet Accounting Rules ....................................................... 1 1. SFAS 13 ..................................................................................................... 1 2. SFAS 98 ..................................................................................................... 2 3. Issue No. 90-15 .......................................................................................... 2 4. Issue No. 96-21 .......................................................................................... 3 5. Issue No. 97-1 ............................................................................................ 3 6. Issue No. 97-10 .......................................................................................... 3 7. Consolidation Policy .................................................................................. 4 8. Issue No. 00-13 .......................................................................................... 4 Structure of Lessor; Accounting Issues ............................................................. 4 1. Bankruptcy-Remote Structures .................................................................. 4 2. Accounting Issues ...................................................................................... 5 POST-ENRON ACCOUNTING RULE CHANGES .................................................... 5 A. B. FASB Interpretation No. 46: Consolidation of Variable Interest Entities .................................................................................................................. 5 1. Background ................................................................................................ 5 2. Overview .................................................................................................... 5 3. Application of FIN 46 ................................................................................ 7 4. Implementation for Certain Transactions .................................................. 9 5. Additional FASB Guidance ....................................................................... 9 FASB Interpretation No. 45: Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others ...................................................................................... 10 1. Background .............................................................................................. 10 2. Application ............................................................................................... 10 3. Exceptions ................................................................................................ 11 4. Recognition .............................................................................................. 11 5. Disclosure ................................................................................................ 12 6. Effective Date .......................................................................................... 12 -i- POST-ENRON OFF-BALANCE SHEET FINANCING UPDATE By Nancy R. Little © Copyright 2004. All rights reserved. I. INTRODUCTION. Historically, "off-balance sheet" financings have been a popular way to finance corporate acquisitions and expansion. Synthetic leases, sale-leasebacks and leveraged leases are examples of off-balance sheet financings that have been widely used to finance a variety of assets, including retail, office, manufacturing and distribution facilities and power plants, as well as personal property and equipment such as aircraft. In the wake of Enron’s bankruptcy, off-balance sheet vehicles, such as synthetic leases and other lease financing structures, have been the subject of much debate, even those that are distinguishable from the structures reportedly abused by Enron. This increased attention has resulted in changes in the accounting rules applicable to these transactions and has affected their structure. This outline provides an overview of the primary accounting rules involved in offbalance sheet financings. Included is a summary of certain changes in accounting rules that affect these transactions. II. ACCOUNTING RULES. A. Basic Off-Balance Sheet Accounting Rules. In many off-balance sheet transactions and most lease financings, the parties must comply with certain accounting rules promulgated by the Financial Accounting Standards Board (the "FASB"). A brief summary of some of the principal rules follows. 1. SFAS 13. Statement of Financial Accounting Standards ("SFAS") No. 13 requires that all of the following requirements must be met for the lessee to receive off-balance sheet accounting treatment: (a) There can be no automatic transfer of title to the lessee at the end of the lease term. (b) Any option to purchase the property by the lessee cannot be at a "bargain" purchase price. (c) The term of the lease cannot be seventy-five percent or more of the economic useful life of the leased property. (d) 2. 3. The present value of the minimum rental payments cannot be ninety percent or more of the fair market value of the property, determined as of the date of the inception of the lease. SFAS 98. In order to obtain the principal benefits of a synthetic lease, a transaction involving real estate should be structured taking into account SFAS No. 98, which applies to sale-leaseback transactions involving real property. Under SFAS No. 98, a lessee that owns real property, sells it to the lessor and leases it back cannot have any "continuing involvement" after entering into the lease other than in a "normal" leaseback arrangement. SFAS No. 98 cites the following as examples of continuing involvement that would be prohibited: (a) An option or obligation to purchase the property by the lessee. (b) A guarantee by the lessee of the lessor’s investment or return on investment. (c) Sharing of appreciation in the property with the lessor. Issue No. 90-15. The Emerging Issues Task Force ("EITF") of FASB addressed circumstances under which the lessor and the lessee are "consolidated" for financial accounting purposes in Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions, EITF Abstracts (Emerging Issues Task Force of the Financing Accounting Standards Board), at 623 (1990) ("Issue No. 9015"). Issue No. 90-15 established certain tests that must be met for the lessee to receive off-balance sheet accounting. One test in Issue No. 90-15 requires that the lessor’s equity investment must be "at risk" throughout the entire lease term. Issue No. 90-15 also limited the use of letters of credit and guarantees as security for the equity contribution. However, the FASB’s recent accounting rule changes, which are described below, supersede provisions of Issue No. 90-15. For example, Issue No. 90-15 suggested three percent as the minimum equity that qualifies as a "substantive" investment for the purposes of the third test, and current guidance can result in a requirement of an equity investment of ten percent or more. 2 4. Issue No. 96-21. Issue No. 96-21, among other things, limits the use of non-recourse debt by a lessor to fund its minimum equity contribution. It also provides that structuring fees paid by the lessee to the owners of the lessor must be taken into account for the purposes of applying the ninety percent test under SFAS No. 13. 5. Issue No. 97-1. Issue No. 97-1 limits the circumstances in which the lessee can indemnify the lessor for pre-existing environmental conditions. If the risk of loss is not remote, such indemnifications could cause the transaction to be treated as a sale-leaseback under SFAS No. 98. In addition, Issue No. 97-1 describes the circumstances in which the lease arrangement can include defaults that are not related to the lessee’s use of the property, such as defaults based on financial performance. Such defaults, among other things, must be customary in financing arrangements, and there must be no indication at the commencement of the lease that a default will occur. 6. Issue No. 97-10. Issue No. 97-10 provides that a lessee that bears substantially all of the construction period risks will be treated as the owner of the assets during the construction period. Under these circumstances, the provisions of SFAS No. 98 would apply so that the transaction is treated as a saleleaseback upon completion of construction. Issue No. 97-10 applies a test similar to the ninety percent "recovery of investment" test of SFAS No. 13 and includes in the lessee’s "maximum guarantee" any amounts that the lessee is or can be required to make during construction. Such amounts include, for example, construction amounts guaranteed by the lessee, equity investments in or loans to the lessor, any obligation to purchase the project or to fund cost overruns, rent paid during the construction period and indemnities or guarantees to the lessor. Certain of these circumstances may result in the lessee being treated as the owner of the lessee even if the ninety percent test is met. Issue No. 97-10 has had a substantial impact on the structuring of synthetic leases because it limits the lessee’s ability to indemnify the lessor and lender for certain construction period risks. Accordingly, lenders usually request additional protections in construction projects, such as assurance of an adequate contingency in the project budget to cover potential cost overruns. 3 7. Consolidation Policy. Several years ago, FASB proposed changes in its consolidation policies and procedures that could result in the "consolidation" of the lessor with the lessee for financial accounting purposes if the lessor is an entity controlled by the lessee. (See Exposure Draft, Proposed Statement of Financial Accounting Standards No. 154-D, Consolidated Financial Statements: Policy and Procedures, October 16, 1995.) On February 23, 1999, FASB issued a revised exposure draft that proposed a definition of control as "the ability of an entity to direct the policies and management that guide the ongoing activities of another entity so as to increase its benefits and limit its losses from that other entity’s activities" and provides that control "involves decision-making ability that is not shared with others." (See Exposure Draft (Revised), Proposed Statement of Financial Accounting Standards No. 194-B, Consolidated Financial Statements: Purpose and Policy, February 23, 1999, Revision of Exposure Draft issued October 16, 1995.) This consolidation exposure draft was not adopted by the FASB. Following the collapse of Enron, however, the FASB renewed its examination of its consolidation policy, which resulted in FASB Interpretation No. 46 ("FIN 46"), described below. 8. Issue No. 00-13. SFAS No. 98 applies to "property improvements" and "integral equipment," which SFAS No. 98 refers to as "any physical structure or equipment attached to the real estate, or other parts thereof, that cannot be removed and used separately without incurring significant cost". Therefore, integral equipment that is owned by the lessee before commencement of the lease will result in sale-leaseback treatment. The EITF responded to the need for clarification on whether equipment is integral in Issue No. 00-13, which provides that equipment is "integral equipment" if, as of the commencement of the lease, the removal costs of the equipment plus any decrease in value exceeds ten percent of the fair value of the equipment, as installed. B. Structure of Lessor; Accounting Issues. 1. Bankruptcy-Remote Structures. Historically, the preferred structure for the lessor in off-balance sheet lease financings has been a special purpose entity ("SPE"). Most lessees and lenders prefer that the SPE/lessor be structured as a bankruptcy-remote entity. In addition, the use of SPEs often can facilitate the transfer of interests in the lessor entity and sometimes enables the parties to avoid costly transfer taxes. An SPE can help insulate the lessor's investors from 4 liabilities for risks such as environmental contamination. Limited liability companies, trusts and limited partnerships are examples of SPE structures that frequently have been used as the lessor in off-balance sheet leasing transactions. 2. III. Accounting Issues. The entity acting as the lessor must be carefully structured to comply with current accounting rules. Post-Enron, SPEs have come under intense scrutiny and, under FIN 46, an SPE that is created solely to own an asset and lease it to the lessee can be "consolidated" with the lessee for accounting purposes if the lessee is the "primary beneficiary" of the lease arrangement. Generally, the lessor must be a "voting interest entity", that does not have the characteristics of the SPEs formerly used in off-balance sheet lease transactions or the transaction must otherwise comply with the requirements of FIN 46. See the discussion of FIN 46, below, for further details. POST-ENRON ACCOUNTING RULE CHANGES. A. FASB Interpretation No. 46: Consolidation of Variable Interest Entities. 1. Background. Proposed changes to the FASB’s consolidation policy were discussed by the FASB for most of 2002 following Enron's bankruptcy filing because of Enron's use of SPEs, although media attention focused predominantly on Enron's off-balance sheet partnerships and not on its lease financing transactions. FIN 46 was originally issued on January 17, 2003 as an interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements ("ARB 51"). 2. Overview. (a) Although FIN 46 was not directed specifically at leasing transactions or securitizations, it has affected both. (b) FIN 46 effectively divides entities into two populations: (i) Voting Interest Entities: Entities controlled by voting interests for which consolidation is based on ARB 51 (e.g., consolidation by a corporate parent of its wholly-owned subsidiary which the parent controls by 5 virtue of its ownership of all of the stock of the subsidiary). (ii) Variable Interest Entities ("VIEs"): Entities not controlled through voting interests or whose equity investors do not bear "residual economic risks", which are consolidated by their "primary beneficiaries". (c) Some SPEs will be subject to FIN 46 (i.e., VIEs) and some will not (i.e., voting interest entities subject to consolidation under ARB 51). (d) FIN 46 also provides for the following "scope" exceptions: (i) Not-for-profit entities unless such entities are used to circumvent FIN 46. (ii) Employee benefit plans subject to other FASB statements. (iii) Certain registered investment companies. (iv) QSPEs and transferors to QSPEs subject to SFAS No. 140. (v) Certain entities subject to SEC Regulation S-X Rule 603(c)(1). (vi) Life insurance separate accounts. (e) Additional scope exceptions were added in the December 2003 revision of FIN 46 ("Rev. FIN 46"). These include scope exceptions for: (i) Certain "businesses", as defined in Rev. FIN 46. (ii) Enterprises with an interest in a VIE created before December 31, 2003 if the enterprise cannot obtain the necessary information "after making an exhaustive effort." (iii) Governmental entities except financing entities used like VIEs to circumvent FIN 46. (f) FIN 46 requires disclosure of "variable interests" in a VIE by the VIE’s primary beneficiary and by the holders of variable interests in such VIE even if the holder is not the primary beneficiary. (g) The effective dates for application of FIN 46 are: (i) February 1, 2003 for new VIEs. (ii) The first fiscal or interim period after June 15, 2003 for existing VIEs; however, effective October 9, 2003, the FASB deferred until December 31, 2003 (for a company with a 6 calendar year end) the application of FIN 46 for VIEs created before February 1, 2003. Rev. FIN 46 includes additional deferrals for certain VIEs, depending upon whether the reporting entity is a public company, a "small business issuer" or a non-public company. 3. Application of FIN 46. (a) FIN 46 applies where control of an entity is by other than its voting interests (i.e., an entity is a VIE), such as where: (i) The entity’s equity investors do not have a "controlling financial interest" in the entity, or (ii) The entity does not have "sufficient equity at risk … to finance its activities without additional subordinated financial support … ." (b) FIN 46 includes the following definitions: (i) Variable Interest Entity: An entity subject to consolidation under FIN 46. (ii) Variable Interests: The "contractual, ownership, or other pecuniary interests in an entity that change with changes in the entity’s net asset value." (iii) Primary beneficiary: The entity required to consolidate a VIE under FIN 46. (c) FIN 46 refers to FASB Concepts Statement No. 7 for determination of "expected losses" and "expected residual returns". Accountants and financial advisors structuring off-balance sheet transactions have developed models to calculate expected losses. (d) An entity is subject to consolidation under FIN 46 if, "by design", either: (i) The equity at risk is not sufficient to finance the entity’s activities "without additional unsubordinated financial support", i.e., the equity is not greater than the entity’s expected losses, or 7 (ii) The equity investors, as a group, lack any of the following "characteristics of a controlling financial interest": x. The direct or indirect decision-making ability as to the entity's activities, determined through voting or similar rights. y. The obligation to absorb the entity’s expected losses. z. The right to receive the expected the residual returns. (e) Determination; Re-evaluation. (i) The initial determination under FIN 46 is to be made on the date an entity first becomes involved with a VIE by ownership, contract or other variable interests. (ii) Consolidation under FIN 46 is to be re-evaluated "whenever the design of the entity or ownership of interests in the entity changes", such as if: x. The governing documents or contractual arrangements change significantly. y. The equity is returned and other interests are exposed to the expected losses. z. The entity’s additional activities or assets increase its expected losses. (f) Required equity. (i) For VIEs, the amount of equity is presumed to be insufficient if it is less than 10%, but this presumption is rebuttable. (ii) An equity investment exceeding ten percent may be required under certain circumstances. (g) Silos. If a VIE "walls off", or creates a "silo" for, a group of assets because such assets are the only source of payment for certain of the entity’s liabilities, the silo is treated as a separate VIE that is to be consolidated by its primary beneficiary. Note: Silos can only exist in VIEs. (h) Consolidation. (i) Under FIN 46: "An enterprise shall consolidate a variable interest entity if that enterprise has a variable interest (or combination of variable interests) that will absorb a majority of the entity’s expected losses if they occur, receive a majority of the entity’s expected residual returns if they occur, or both." 8 (Note: Emphasis is on expected losses more than on expected returns.) (ii) "The enterprise that consolidates a variable interest entity is … the primary beneficiary." (Note: In determining who is the primary beneficiary, consideration is to be given to variable interests held by related parties.) (i) Disclosure. (i) Disclosure is required on all financial statements if consolidation or disclosure is reasonably possible, including: x. The nature, purpose, size and activities of the VIE. y. The maximum exposure to loss form involvement with the VIE. (ii) The primary beneficiary is to disclose: x. The nature, purpose, size and activities of the VIE. y. The carrying amount and classification of assets that are collateral for the VIE’s obligations. z. The lack of recourse if creditors do not have recourse to the VIE’s general credit. (iii) The following disclosure is required by any non-primary beneficiary: x. The nature of the involvement with the VIE and the date such involvement began. y. The nature, purpose, size and activities of the VIE. z. The maximum exposure to loss from involvement with the VIE. (j) 4. 5. Recognition of existing VIEs (if consolidation occurs) is based on the carrying amounts, with adjustments made for the cumulative effects of differences between previous the carrying amount and the amount newly recognized. Implementation for Certain Transactions. (a) For a synthetic lease, the lessee may be required to consolidate the SPE/Lessor (b) True leases and credit tenant loans (leases) are less likely to be affected. Additional FASB Guidance. 9 (a) On October 31, 2003, the FASB issued an Exposure Draft with proposed changes to clarify the implementation of FIN 46. (b) As noted above, FIN 46 was issued in December, 2003. Rev. FIN 46 adds more scope exceptions, defers the implementation of FIN 46 in certain circumstances, addresses the impact of troubled debt restructurings on reconsideration of VIEs and revises Appendix B of FIN 46. The impact of Rev. FIN 46 will likely take some time to fully evaluate. B. FASB Interpretation No. 45: Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others. 1. Background. (a) The FASB’s guarantee project ("FIN 45") was originally part of the consolidation project that produced FIN 46 because guarantees are common in SPE transactions. However, the guarantee project was spun off as a separate project early in 2002. (b) The stated goal of the FASB was to "improve the transparency of a guarantor’s financial reporting about the obligations and risks arising from issuing guarantees" in two respects: (i) To improve disclosure on the nature and the amount of guarantees, and (ii) To clarify the initial recognition of guarantee liabilities and thereby improve reporting of guarantees issued with and without a "separately identified premium." 2. (c) Under prior accounting guidance (SFAS No. 5), recognition of a guarantee occurred when payment under the guaranty was "probable" and "reasonably estimable". (d) Under FIN 45, the "remoteness" of payment under the guarantee does not eliminate the need for disclosure and/or recognition. Application. (a) Under FIN 45, a "guarantee" is an agreement to make payments based on "changes in an underlying" or because another entity fails to pay. It also includes an indirect guarantee of the obligations of another entity. (b) FIN 45 applies whether the guarantee is embedded in another transaction or is paid for separately. 10 3. (c) FIN 45 also applies to direct and indirect, as well as contingent, guarantees. (d) Indemnification agreements (e.g., indemnities in business transactions for adverse judgments and lawsuits) are also included within its scope. Exceptions. (a) FIN 45 includes exceptions for commercial letters of credit and loan commitments, which are not considered "financial guarantees" because they do not provide a guarantee of payment of an obligation. Certain subordination agreements in securitization transactions are also not financial guarantees. (b) Total "scope-outs" from FIN 45 include: (i) Residual value guarantees in capital leases. (ii) Contingent rent. (iii) Certain insurance/re-insurance contracts. (c) Certain guarantees are scoped out of the recognition requirements but not the disclosure requirements, including: (i) Performance guarantees of non-financial assets. (ii) Guarantees between a parent and its subsidiaries or corporations under common control. (d) 4. See FIN 45 for other exceptions. Recognition. (a) Recognition under FIN 45 occurs at the inception of the entity's liability for the guarantee (i.e., the obligation to stand ready to pay) even if payment is not probable. (i) Recognition is required for the premium received or receivable by the guarantor for its guarantee. (ii) In estimating the guarantee’s fair value a transaction "with multiple elements" (e.g., a sale of assets or an operating lease), an inquiry is to be made as to what premium would be required for the same guarantee in a "standalone arm’s-length transaction with an unrelated party." (iii) Recognition is at the greater of (x) fair value or (y) the amount required under SFAS 5. Reference is made to Concepts Statement No. 7 for a present value measurement to determine "fair value." 11 (b) There are several options that have been suggested to account for residual value guarantees under leases, one being a credit for the guarantee obligation and an off-setting entry (debit) for prepaid rent. (c) FIN 45 applies to lease finance and other financial transactions as well as to sales, etc. where there are guarantees and indemnities. These can include, for example: (i) Residual value guarantees. (ii) Tax and other indemnities. 5. Disclosure. FIN 45 also requires disclosure of the nature of the guarantee, e.g., how it arose and the events that would result in performance by the guarantor, the maximum amount of future payments, the current "carrying amount" of the liability, and any recourse the guarantor has to third parties for recovery of guaranteed amounts and collateral from which the guarantor could seek recovery. 6. Effective Date. (a) FIN 45 requires recognition for guarantees issued or modified after December 31, 2002. (b) It is not entirely clear, however, which modifications to a guarantee would trigger recognition. 12 Nancy R. Little is a partner in the law firm of McGuireWoods LLP. Her lease finance practice includes synthetic leases, sale-leasebacks, and credit tenant loans of real estate and equipment, including structured transactions utilizing commercial paper conduits and other securitized loans. Ms. Little received her B.S. from Virginia Polytechnic Institute and State University and her J.D. from the University of Virginia School of Law. She is a member of the Virginia State Bar, the Virginia Bar Association, the National Association of Bond Lawyers, the National Health Lawyers Association, the International Association of Attorneys and Executives in Corporate Real Estate, the American College of Real Estate Lawyers, the American College of Mortgage Attorneys and the American Bar Association’s Continuing Legal Education Committee in the Section of Real Property, Probate and Trust Law. Ms. Little has lectured and written extensively on lease financing transactions. \\RIC4\7714\1010\Seminars\2004\ACREL - Mar 2004\Post-Enron Off-Balance Sheet.doc