Lease Securitization: New Challenges
The volume of securitization of equipment leases is expected to increase in the second half of 2012 and into 2013 due to its flexibility and usefulness as a corporate financing tool. Leases, once considered a new asset class, have been accepted in the mainstream of asset classes and have now been securitized in many forms. For the past decade and a half, a wide variety of equipment leases have been securitized, including office equipment, computers, medical equipment, dental equipment, exercise equipment, video equipment and data processing leases. Outside of the equipment lease sector, automobile leases, truck leases, motorcycle leases, recreational vehicle leases, cell tower leases and heavy machinery leases have been readily securitized.
Although the financial crisis of 2008, and specifically the issues with the subprime mortgage-backed securitization market, severely stunted the growth of the asset-backed securitization market in 2009 and 2010, it appears as though the securitization market has returned, with a volume of issuances of asset-backed transactions in 2011 to the level of approximately $200 billion. However, the existing structural challenges that face new issuers coupled with the implementation of the Dodd-Frank Act (Dodd-Frank) and Regulation AB II under the securities laws will present serious hurdles for small and thinly capitalized companies to participate in securitization transactions. This article will explore these hurdles and present summaries of the challenges facing issuers.
Benefits of Securitization
For the originator, perhaps the primary motivation for securitization is to reduce the cost of funds by capitalizing on the higher credit rating of a segregated pool of leases rather than the originator’s own credit rating. With proper management, securitization can serve as a useful liquidity tool, providing lease originators with an alternative source of financing to loans from banks and finance companies. As such, securitization can be an especially attractive for highly leveraged companies that originate leases.
If, in the final analysis, it costs more to securitize than to use the more traditional techniques of borrowing through banks or privately placing debt, the value of securitization could be tenuous. However, for a company with a solid portfolio of leases, it is a method of raising capital that should be explored. Even a lease originator for which the savings are marginal may wish to develop a securitization program to expand its available sources of capital and to leave the door open to tap into alternative capital reservoirs in the future.
In addition, covenant restrictions for originators in securitizations tend to be less onerous and restrictive than in traditional financing, allowing greater future flexibility in the development of the originator’s business than with an equivalent amount of bank debt. In any event, developing a securitization program for leases expands the realm of an originator’s options and puts another weapon in the treasury arsenal.
The essence of lease securitization is the isolation of cash flows on the leases from the bankruptcy risk of the originator. Thus, the purchasers of the securities look to the performance of the leases and not to the solvency of the originating company. Confidence in securitization structures has allowed many below investment grade companies to raise capital through the packaging of lease receivables. Since repayment of the securities can be calculated actuarially if comprehensive data on the credit performance of similar lease assets is available, capital costs can be reduced. Lease-backed securities are typically rated AAA and, as a cursory glance at any rating agency chart will reveal, very few leasing companies can raise capital at such a credit rating.
Although the market continues to refine securitization structures, lease-backed securitization transactions follow a general pattern that has been validated by consistent deployment. The originator of the leases transfers them in a “true-sale” to a special purpose entity (SPE), which, in turn, issues securities backed by those leases and lease payments. The SPE may be a corporation, a trust, a limited liability company (LLC), or a partnership, the choice of organizational entity often being decided by tax or accounting considerations.
Essentially, the isolation from bankruptcy risk of the originator is the axis on which the success of the securitization turns. Typically, although not always, the originator acts as servicer of the leases and remits payments on a periodic basis, usually monthly (although some recent issuances have included a limited amount of quarterly or bi-annually paying leases). It is the bankruptcy isolation of the SPE that allows securities of pools of leases to be rated AAA. Along with the AAA rating comes a lower cost of funds for the lease originator. Without bankruptcy isolation, payments on the leases would remain in the bankruptcy estate of the originator if the originator went bankrupt and, accordingly, the rating of the transaction generally would be capped at the originator’s rating level. All sales of lease payments to special purpose vehicles run some risk that they will be recharacterized by a bankruptcy court as financings. For all types of lease securitizations, if a bankruptcy court deems a transaction to be a financing, the automatic stay provisions may apply, thereby trapping the lease payments that, by application of the transaction documents, should be directed to the issuer. Although investors may ultimately get their money as a secured creditor of the seller (assuming the proper back-up procedures and filings were made at the time of the “sale”), by application of the automatic stay, there will be a delay in payment to investors. The structured finance paradigm is intended to prevent this type of uncertainty and create “bankruptcy remoteness” from the originator by structuring the receivables sales as “true-sales” from the originator to the SPE.
Accounting (FAS 166 and FAS 167)
Prior to the adoption of Financial Accounting Standard No. 166 (FAS 166) and Financial Accounting Standard No. 167 (FAS 167), in order to gain off-balance-sheet treatment for receivables sold in securitizations under the accounting standards set forth in Financial Accounting Standard No. 140 (FAS 140), the SPE purchasing the leases receivables and issuing the lease-backed securities was required to be a qualified special purpose entity (QSPE), essentially passive in outlook. Failing to meet the detailed characteristics set forth in FAS 140 caused the QSPE to be consolidated on the books of its originator parent, thus bringing the securitization on-balance sheet.
However, these off-balance sheet rules were substantially changed in July 2009 with the adoption of FAS 166 and FAS 167 making it much more challenging for securitizations to receive off-balance sheet treatment. These new rules also changed the accounting standards that determine whether a transfer of a receivable in a securitization should be treated as an accounting sale or a financing and eliminated the QSPE component. FAS 167 changed the accounting standards used to determine whether reporting entities should consolidate SPEs on their balance sheets.
It is important to note that consolidation on the balance sheet does not by itself result in a bankruptcy consolidation for securitization transactions. According to most prevailing views, lawyers seem generally comfortable that, while accounting consolidation is one of the factors to be examined, it is not dispositive, provided, of course, that title to the leases and lease payments has been legally transferred successfully from the originator to the SPE.
The tax treatment of a lease-backed transaction also plays an important part for the originator when determining the viability of a securitization structure. Typically, issuers desire to preserve the tax benefits they currently enjoy, such as depreciation and interest deductions, as the owner of the leased assets and not trigger any immediate adverse federal or state income tax treatment, such as tax gain or recapture, by a sale. To accommodate these goals, the transaction can be structured so that the consolidated tax group of the seller retains a sufficient interest in the pool of leases such that no sale is recognized for income tax purposes.
Over the past several years, most lease-backed transactions have used debt-for-tax structures that have enabled the originator to treat the securities as debt of its consolidated tax group, even while it is viewed as a sale of leases and lease payments for corporate and bankruptcy purposes. However, some originators may still prefer gain-on-sale treatment and, although currently less common, such a preference may still be accommodated in the current market place, particularly when the gains may be used to offset current-year losses.
In certain jurisdictions, applicable state tax laws may preclude an originator from consolidating for tax purposes, opening up the possibility that sales tax may be payable on transfers of the leases and related equipment. To solve this dilemma, the LLC structure may be used. A single member LLC is usually disregarded for federal and state tax purposes and no tax “sale” is deemed to take place. Thus, despite the inability to consolidate, no state tax is payable since for state tax purposes (and federal for that matter) no sale is deemed to have occurred.
Methods of Credit Support
There are several ways of providing credit support for the securities issued in a lease-backed securitization. In overcollateralization structures (senior/subordinate), two types of securities are issued, with the “senior” securities effectively being overcollateralized by the amount of the subordinate securities. If the transaction is with a conduit issuing commercial paper, the seller into the conduit often retains an interest in the pool of leases (retention of excess receivables), but subordinates that interest to payment of funds used to pay the commercial paper. Alternatively, a cash reserve account — funded to an agreed upon level set by the sponsor, the underwriters, investors and the rating agencies, as applicable — is made available to pay certain shortfalls on the securities issued in the lease-backed securitization.
Finally, credit enhancement may be provided by the credit provider standing ready to purchase defaulted assets from the special purpose vehicle (whether it be a grantor trust or an SPE). Where the credit provider is the originator/seller, as discussed elsewhere in this article, this raises significant questions as to whether a true sale of leases from the seller has taken place. In the past, another form of credit support was a guarantee or surety bond from a highly-rated monoline insurance company or surety. This type of credit support is rarely used today, a victim of the changes in the securitization market since 2008.
Underwriting and Servicing Issues
One of the most pressing concerns for a new entrant into securitization is the servicing of the leases and how the requirements imposed on it as a servicer will disrupt its existing business. Obviously, the proposed servicer must be able to demonstrate that it has the capability to monitor the leases and collect payments from lessees in a timely manner and some upgrade in systems capabilities may be required. Because the rating agencies and underwriters commonly require that servicing charges be applied, it is important to know what is the standard in the market for servicing fees among servicing companies in the equipment lease industry. In general, the servicing methods that have been successfully applied by the lessor in its own business are probably the starting point for the servicer’s contractual obligations in a securitization in that employees are familiar with such procedures and they will minimize the effect of doing a transaction on the business as a whole.
The prospect of securitizing lease receivables imposes a rigorous examination of the underwriting and servicing procedures utilized by the potential new issuer. A typical array of issues that commonly arise for the new issuer include:
- Does the issuer have written credit policies?
- Were the lease receivables originated in compliance with state laws, particularly consumer laws such as truth in lending applicable to consumer lessees?
- Where are lease payments sent, a central location or multiple lockboxes?
- How will lease payments be segregated from other corporate funds?
- What, if any, are the issuer’s collection policies for overdue accounts?
Often in collecting data, the originator will discover efficiencies that can be used to improve its business. For example, an analysis of categories of credit defaults may lead to lease-underwriting improvements. Other costs, however, may be incurred that relate solely to the securitization. Computer systems that are adequate for current purposes may not be good enough to prepare the detailed reports required for securitization, and in a time of dynamic evolution of data systems, upgrades (and continual future upgrades) are often required. Nonetheless, it is always wise to question the necessity of such reports before undertaking the expenses and logistical burdens of a major technology upgrade.
Another difficult challenge for a new issuer is its lack of servicing history and experience. While the issuer may be accustomed to servicing a portfolio with few losses and commonly waiving terms for important customers, it may now be required to enforce those covenants in its new role of “servicer.” The customer relationship may be seriously jeopardized by such action. Customers used to a relaxed collection policy may be genuinely shocked by the change. Moreover, sometimes the servicing requirements imposed on originators because of “the demands of investors” or because “the rating agencies require it” may not work well for new lease derived assets. Consequently, careful assessment must be made of how the particular asset needs to be serviced.
Before entering into contractual servicing commitments, the new issuer should ask itself whether the resulting loss of control and limited flexibility works for the asset class and for its customers. If not, it is time to push back and try to reassess the servicing “requirements.” This is particularly important with new asset classes. The typical servicing requirements and expectations typically imposed by rating agencies were initially developed for the mortgage market and may need to undergo further evolution to operate with maximum effectiveness in the arena of lease receivables or other types of new lease derived assets.
In the event the seller becomes insolvent, one significant question is who will assume responsibility for servicing the assets. Although most deals name a successor servicer (often the trustee for the transaction) it may be extremely difficult as a practical matter for a successor servicer to access records, computer systems and documentation in a timely fashion. Moreover, it is never desirable from a deal performance perspective to have a reluctant trustee acting as a “conscripted servicer” being responsible for making collections on the leases.
In many transactions, particularly in transactions in which the servicer may be inexperienced or have a relatively low credit rating, a back-up servicer that is provided with a great deal of real-time current data and access to records over the course of the deal will be required. The purpose of this “hot back-up servicing” feature is to ease the burdens of servicing transition and to reduce the costs related to such transition as well as enhancing collections generally. While this seems harmless enough at first glance, the sharing of proprietary information with another entity may cause an issuer some major concerns particularly for new issuers with unique assets.
For instance, the only person capable of servicing a portfolio of atypical receivables is often a major competitor of the entity conducting the securitization. The question for the originator, therefore, is how much information, particularly underwriting standards, credit histories and customer lists, does it wish to turn over to one of its principal rivals.
Servicing is one of the most difficult aspects of lease securitization. There is a tendency, particularly for a first-time issuer, to follow “market standards.” Our advice to an issuer is to look very carefully at the necessity where they will disrupt the way the company currently does business.
The conclusion of this article will appear in the Monitor’s 2012 July/August edition and will discuss issuer challenges such as securities law concerns, Dodd-Frank and the Securities and Exchange Commission’s Regulation AB II.
Peter Humphreys is a partner in the New York office of Hogan Lovells. He focuses his practice on a wide range of securitizations including financings of equipment and operating leases, credit card receivables, auto loans, franchise loans, small business loans, energy receivables, intellectual property, trade receivables, healthcare receivables, bank loans and mortgages. Humphreys also works on structured capital transactions providing reserve and capital relief for insurance companies and banks. In addition, he has experience in other public and private capital markets transactions and the development of new financial products for U.S. and offshore transactions in both the public and private markets. Humphreys was named one of the top 25 structured finance lawyers in the United States in Legal Media Group’s Expert Guides to the Leading Lawyers — Best of the Best USA 2008. He is also recognized by The Legal 500 United States for being one of the leading lawyers in his field. He may be reached at 212-918-8250 or firstname.lastname@example.org.
Evan Kelson is an associate in the New York office of Hogan Lovells. He focuses his practice on a wide range of term and conduit securitizations including financings of credit card receivables, consumer loans, trade receivables, small business loans, energy receivables, and equipment loans and operating leases. The transaction structures that Kelson has worked on include, among others, SPV asset-based lending, direct asset purchases, master trusts and master note trusts. Kelson also has experience in the development of new financial products for U.S. and offshore transactions in both the public and private markets. He may be reached at 212-918-3290 or email@example.com.