This article could be a book but what we shall attempt to do here is talk briefly about how one can: 1.) mitigate risk at the corporate level and 2.) mitigate risk so as to access the capital markets in an efficient manner.

The equipment finance and leasing industry has undergone a consolidation, which has given birth to a whole new set of companies that fill the void for small to middle-market finance. Its ability to manage growth, protect the corporate entity, its officers and directors and access the capital market to sustain growth is a challenge to these companies.

Corporate Coverage
At the corporate level, the risk lies primarily in the entities exposure to shareholder suits, product liability and employment practices liability.

Directors & Officers (D&O) coverage is paramount in protecting the directors and officers and, to a limited degree, the corporate entity. This coverage should be considered as supportive of the corporate indemnification agreement(s) as written in the corporate by-laws. The indemnification provisions contained in a company’s charter, however broad, have certain important limitations that expose the company’s directors and officers to personal liability. However, even the best indemnification provisions are meaningless if the company is financially unable to meet its indemnification obligations. Charter provisions may have shortcomings regarding the advancement of defense costs or the burden of proof related to the availability of indemnification that can impose financial burdens on the personal assets of directors and officers.

The SEC takes the position that it is against public policy for a company to indemnify its directors and officers with respect to their liabilities under the federal securities laws. Other areas that should be considered are pollution coverage and punitive damages; these are typically not covered under a D&O contract.

It is therefore impossible for a company to shield its directors and officers from exposures to personal liability solely by virtue of the indem-nification provisions contained in the charter. It should be noted, however, that all D&O policies contain fraud and dishonesty exclusions, as well as other exclusions based on personal conduct. Therefore even a well-negotiated D&O policy will not provide protection under all circumstances.

D&O insurance may be critical to the financial health of the company. Especially in a small to medium size company, the loss of several million dollars from working capital by a judgment or settlement can threaten a company’s ability to meet its business goals. D&O insurance, together with sound loss prevention measures on the part of lessors and lenders can, therefore, be an important part of good risk management.

D&O coverage is split into two distinct portions: One portion covering the directors and officers, and the other covering the corpora-tion or entity.

The portion specific only to D&O is utilized solely when the suit alleges an act that is either not indemnifiable and not excluded, or the corporation is unable to respond due to its inability, such as bankruptcy. Considering this, it is very important for the directors and officers to know exactly what coverage they have to protect them.

Most lawsuits against directors and officers also name the affected company as a defendant. Traditionally, however, D&O insurance policies have not considered the corporate entity an insured party under the policy unless specifically covered, so the costs of defense and of any settlement or judgment attributable to the company may not be covered by the policy. Normally, the only direct financial benefit that a company received from D&O insurance is the payment of amounts otherwise payable as indemnification to its own directors and officers pursuant to its charter, by-laws or contractual arrangements.

Another form of coverage that should be considered in this day and age is Employment Practices Liability Insurance (EPLI). This coverage is often incorporated in the D&O policy; however, buyers may not realize that this coverage has the potential to erode away the limit purchased for D&O. EPLI is written to protect employees, directors, officers and the corporation from suits brought against them for wrongful termination, sexual harassment and violation of The Americans with Disabilities Act. This is clearly a coverage that all companies should have, but be sure it is done on a stand-alone basis or at least as an additional sub-limit to the firm’s D&O coverage.

Transactional Coverage
In our practice we are being asked to provide lease enhancements for an ever-increasing amount of portfolio and stand-alone transaction purchases and sales. These enhancements include 1.) excess casualty coverage and 2.) residual value coverage.

The issue of creating liquidity is key in today’s financing world and it is the main aim of our clients when they request our assistance in structuring coverage for either a new transaction or in the sale of an existing portfolio.

Excess Casualty Coverage
Excess casualty insurance may be used to stabilize the economics of the lease for the new owner/lessor in a purchase of an existing lease of real estate and chattel assets, and to protect against an uninsured gap in a new real estate lease.

Purchase of an Existing Lease
Frequently a lessor will sell a lease to a new lessor, and by doing so, balance its portfolio and recognize a profit on the sale. In such cases, the new lessor may have a casualty value schedule in the lease whose values are not large enough to achieve its rate of return if the equipment suffers a casualty event. In such cases, there are companies that provide an insurance policy that gives coverage for the gap amount that exists between the casualty values required by the new lessor and those values set forth in the lease that was purchased.

New Real Estate Lease Transactions
In many real estate and facilities transactions we are asked to upgrade a “non-hell and high water” lease into a triple net “hell and high water lease,” or to insure the new lessor’s excess stipulated loss value termination schedule over the schedule imbedded in the original lease document. One of the principal reasons for a triple net lease not qualifying as a bondable “hell and high water” lease is due to lease provisions, which permit the tenant to terminate the lease or abate rent due to a total or partial taking of the improvements, parking and/or lack of access to the subject property. These conditions occur when there is a condemnation under local, state or federal government’s eminent domain statutes.

In addition, these leases may contain a provision that if there is damage to improvements within a specified period of the lease or during the full term of the lease, the tenant may either abate rent during reconstruction or terminate the lease if the damage is in excess of the standard established within the lease for casualty and the termination occurs within the time period specified in the lease.

Our lease enhancement policy will provide continuation of payment of the base rent, which permits continued payments of the interest and principal on the loan without any disruption. This coverage is not primary insurance, and requires that there be all risk insurance on the improvements as well as one year or more of rents insurance should abatement of rent be permitted in the case of a casualty.

Another area of increasing concern is environmental liability. These liabilities are talked about in today’s market mainly in two areas: 1.) the “sick” building syndrome and 2.) contamination to ground water from a lender or lessors site.

A fundamental shift is underway in the field of commercial real estate lending. For the past 20 years, this industry has traditionally relied solely on Phase I site assessments to deal with environmental risk. However, lenders have learned the hard way that information afforded by Phase I assessments is not enough to address their environmental liabilities.

Financial institutions can now take advantage of a new risk transfer tool to help them manage environmental risk that may be associated with their commercial real estate loans.

A Collateral Impairment and Environmental Site Liability policy specifically to address multiple environmental liability concerns of lenders, should include:

As an added benefit — many lenders choose to pass through the cost of this insurance protection to their borrowers as a component of the loan closing.

The introduction of mold/fungus/microbial exclusions in virtually all personal and commercial lines insurance policies over the past two years leaves unprecedented numbers of borrowers in non-compliance with the insurance requirements in commercial loan covenants. There are affordable insurance solutions available today to insure the mold loss exposures in commercial property. If lenders encourage their borrowers to meet the insurance requirements of their loan covenants, their borrowers will automatically have access to the state-of-the-art water intrusion and mold loss control protocols that have recently been developed by specialized environmental insurance underwriters. By utilizing these innovative insurance products property owners no longer need to be uninsured nor their lenders unsecured for mold-related damages.

Affordable environmental insurance products for commercial properties more than 50,000 square feet have been introduced that can effectively fulfill the insurance coverage requirements in loan covenants on a cost effective basis. The most comprehensive of these insurance products — Real Estate Environmental Liability/Highly Protected Risk with Mold, (REEL/HPR/Mold) — provides building science-based loss control services in addition to filling the mold and other environmental contaminants coverage gaps in the borrowers property and liability insurance on the property.

Residual Value Insurance
Residual value insurance is a tool to achieve one or all of the following objectives: 1.) to arbitrage accounting standards; 2.) to utilize asset knowledge in achieving a level of asset risk pricing and protection for a lender or lessor; 3.) to create liquidity in one’s portfolio or 4.) to reduce the amount of capital required to support an uncovered risk.

The specific goals and applications of residual value insurance are 1.) to assist either a lender or lessor to achieve capital lease accounting treatment for the lessor’s income recognition or 2.) to transfer a portion of the residual risk to an insurance company and thereby to turn some portion of the balloon payments or booked residual values into financial receivables, which in turn, results in some level of a guaranteed rate of return and reduces the level of capital charges placed against the transaction.

A residual value insurance policy indemnifies a lessor or lender against a loss, which occurs if the fair market value of an asset (assuming proper maintenance) is less than the insured residual value on the termination date of the lease. From a lessor’s or lender’s perspective, a residual value or balloon payment on a loan or lease financing transaction — whether or not guaranteed — is the unamortized principal portion of an asset’s original cost existing at the end of a lease or a loan. Unamortized residual value in a lease is established when a lease financing transaction is consummated and is created primarily in response to a lessee’s demand for a lease transaction that qualifies for operating lease accounting. An unamortized balloon payment in a loan is established when a loan financing transaction is structured and is created primarily in response to a borrower’s structuring requirements that a loan contain a particular amortization schedule or that the loan be structured to meet “off balance sheet” accounting treatment. Lessors and lenders providing operating leases and structured loans are generally either asset-oriented or credit-oriented. Lessors and lenders that are asset-oriented are comfortable assuming unamortized residual value or balloon risk, but may obtain limited levels of residual value insurance to achieve finance lease accounting and accelerate income recognition. Lessors and lenders that are credit-oriented are generally not comfortable assuming any unamortized residual value or balloon risk and therefore seek full coverage levels of residual value insurance. In either case, residual value insurance can be used to meet the lessors’ and lenders’ needs and to structure leasing and financing transactions, which satisfy market demands from lessees and borrowers.

The financial community has long been aware that residual value insurance could conceivably supply a most useful additional structuring tool, in the form of a guarantee of asset residual value, which would enable transaction structures to monetize the value of the assets being financed, without recourse to either the asset user or the financier. Briefly, this would be accomplished by the insurer guaranteeing a value of the financed asset at transaction’s end.

The insurer’s recourse in the event of a claim would be solely to the market value of the asset, as realized through reemployment or liquidation. This would not necessarily require the insurer to provide coverage at imprudent levels. The substance of the guarantee however, would have to be a transparent statement of the nature of the insurer’s liability in the event of a claim; the perception that the insurer would in fact be willing to pay a justified claim; and the issuance of a policy by a substantial, investment grade insurer.

Thomas A. Orofino is a managing partner of Quintessence Financial, LLC. Orofino is a graduate of Villanova University. He can be reached at 203.227.7080 or [email protected].

The author would like to thank Alexander Fisher of International Amalgamated, Ltd., in the preparation of the excess casualty and condemnation insurance, and Jeremy Alderman of International Insurance Corporation in the preparation of the D&O coverage.