Lease securitization: New challenges for issuers
By Peter Humphreys and Howard Mulligan, partners at McDermott
Will & Emery LLP
In the period beginning with the first quarter of 2002, issuance of securities backed by equipment-lease receivables had dropped off due to a number of factors, including a general downturn in the post — 9/11 economy and, more to the point, a plethora of consolidation among lessors and buy-outs of equipment originators by larger entities that, for various reasons, did not pursue securitization as a financing vehicle.
Yet, lease-backed issuances have gradually escalated over the past three quarters and recently a number of first time issuers have set their sights on entering the market. Consequently, all of the current indicators point to heightened issuance of lease-backed securities during the second half of 2005 and into 2006.
Of all the issues of which new and experienced lessors must be cognizant, securities regulation issues stand out as significant in the current corporate governance and disclosure-minded business environment.
Securities regulation issues
The offering and sale of lease-backed securities must be registered with the Securities & Exchange Commission unless an exemption applies. Common exemptions include the “private placement” exemptions and the commercial paper exemption. Of particular concern for a new issuer are the disclosure requirements, particularly those involving a description of its business and the way in which it underwrites and services leases.
New issuers also must consider the requirements of the securities laws. Many new issuers of lease-backed paper find their way into securitization by selling assets to a conduit or the provider of a warehouse line. This generally involves only talking to the sponsor of the financing and requires disclosure only to that entity.
The next step is usually entering the private placement market, where fairly substantial disclosure must be given, but where the recipients can be limited and carefully targeted. Eventually, however, the originator will think about issuing in the public market. This raises a new range of problems.
Disclosure is publicly available and, through EDGAR and certain other Internet-based outlets, is more generally accessible than ever. The originator is required to widely disseminate not only the way its leases are underwritten and the means of implementing its collection and foreclosure procedures, but also any unusual characteristics of its leases or lease-servicing methods. Moreover it may have to be regularly updated through filings under the securities laws, all of which are publicly available.
Thus, the originator must determine whether it is ready to disclose information on its business regularly to outsiders and competitors. Given the contraction in the number of players in the leasing industry resulting from recent consolidations, disclosure requirements are often a daunting prospect for new issuers.
Last December, the SEC adopted a massive set of new rules — dubbed Regulation AB — relating to the issuance of asset-backed securities under the Securities Act of 1933 and the Securities Exchange Act of 1934, that directly impact public issuances of lease-backed securities. In particular, public issuers must be aware of the ongoing reporting requirements under the Exchange Act.
While there is a fairly lengthy transition period for compliance with the new rules and old deals will be grandfathered in for reporting purposes, the new requirements will apply to new offerings of lease-backed securities and the Exchange Act reporting which is required thereafter. Thus, by the end of 2Q05, frequent issuers should be actively involved in the process of preparation for the new reporting regime.
The general thrust of the new Exchange Act periodic reporting obligations imposed by Regulation AB is the recognition that asset-backed securities and issuers of asset-backed securities differ from corporate securities and operating companies. Many of the existing reporting obligations were designed for corporate issuers and have not operated to elicit relevant information for asset-backed transactions and investors in those transactions. The new rules codify and consolidate many existing staff practices relating to asset-backed securities that had been established through a myriad of SEC no-action letters and also add extensive additional requirements.
Although lease-backed issuers had been required under existing rules to make periodic reports, the new mandates imposed by Regulation AB have expanded the scope of such reporting in a number of ways, including requirements of a filing of a new form 10-D and periodic distribution reports as well as establishing minimum general servicing standards and mandating the filing of reports attesting to compliance with such servicing criteria.
The new rules specifically impact the issuer of lease-backed securities in changes to the treatment of residuals. The new regulations also clarify which entities must file reports and which reports must be filed. Regulation AB generally codifies the June 2003 SEC statement regarding certifications under the Sarbanes-Oxley Act for asset-backed issuers. In particular, with respect to the servicing criteria set forth therein, the party signing the certificate must certify that the reports and related attestation reports have been submitted by all parties participating in the servicing function or disclosing those that have not been submitted, as well as disclosing any material instances of noncompliance.
Treatment of residuals
In general, in securitizations, a distinction is made between an operating lease (or true lease) and a finance lease. The general distinction being that a finance lease is essentially a secured loan or a “lease intended for security.” Operating leases often have a residual value and this may be taken into account in determining the amount of money, which may be raised in a securitization. In the case of operating leases, the servicer should be able to demonstrate that historically it has been successful in recovering an amount equal to the assigned value when it sells the residual. Reliance on residual value may be impacted if weakness on the part of the servicer compromises the servicer's ability to recover value of the residuals. One issue of importance therefore — assuming residual value is to be taken into account — is whether the back-up servicer or trustee has sufficient experience in dealing with the type of asset (i.e., copy machine, computer, etc.) being leased so as to ensure recovery of the assigned residual value.
By application of Regulation AB, the definition of asset-backed security has been expanded to include lease-backed securitizations where a portion of the securitized pool balance is attributable to the residual value of the physical property underlying the leases. However, Regulation AB sets limits on the percentage of the securitized pool balance attributable to residual values. With regard to motor vehicle leases (including trucks and motorcycles, but not leisure craft such as snowmobiles), residual values must not constitute 65% or more, as measured by dollar volume, of the securitized pool balance, as of the measurement date. For all other lease-backed issuances, residual values must not constitute 50% or more of the securitized pool balance as of the measurement date. In order to be eligible for a shelf registration under Form S-3, residual values of lease-backed securitizations, other than those backed by motor-vehicle leases, are further restricted to less than 20%, as measured by dollar volume, of the securitized pool balance as of the measurement date. For purposes of determining residual-value thresholds, residual values need not be included to the extent that a separate party is obligated for the residuals (e.g., through a residual value guaranty or where the lessee is obligated to cover any residual loss). In typical lease-backed issuances, it is rare that the value of the residual component would ever approach these levels.
In addition to satisfying the foregoing tests, lease-backed issuers must provide additional disclosure regarding residuals, such as statistical information on historical realization rates, the manner and process in which residual values will be realized and the entity that will convert the residual values into cash. New requirements to explain the methodology of residual valuation may cause problems for issuers.
Any company contemplating the public issuance of lease-backed securities must be aware of the vexing issue of the application of the term “financial assets,” which are defined for securities law purposes as assets that “convert into cash within a finite time period.” This has an impact on how the securities are to be registered for a public offering and how an exemption may be obtained from registration under the Investment Company Act of 1940.
But it also has wider implications. If the financial asset requires some future performance by an originator or by a third party, payment on the financial asset is subject to that third party's performance and bankruptcy risk. Thus a lease dependent on performance by the lessor raises significant questions. Other assets that have been securitized, such as lease residual interests, may not turn to cash automatically, but may be packaged and used to raise capital or provide credit support, even though they will have to be liquidated. Historical information on the amount of cash realized on equivalent assets is important in this context.
Given the escalating use and increasing sophistication of securitization techniques with regard to leases and lease payments over the past decade, it is safe to say that equipment lease-backed securitization is no longer a novel technique in the capital markets. The past few years of experience have demonstrated that structured financing offers many benefits to both lease originators and investors alike and that the mechanics, enhancements and structural integrity of the transactions have been validated. Lessors considering this form of financing should explore the myriad of options available to the potential new issuer in order to effectively identify, structure and implement the structured finance paradigm that best suits the expectations and vision of their own business models.