Help Center

Winter Leadership Conference | December 5-7 | Rancho Palos Verdes , CA Register Today View Schedule

7th Circuit Provides Friendlier Skies to United New Decision Has Big Impact on Airport Leases

Journal Issue: 
Column Name: 
Journal Article: 
On July 26, 2005, the U.S. Court of Appeals for the Seventh Circuit in United Airlines Inc. v. HSBC Bank USA1 settled a long-standing controversy in the area of structured finance in bankruptcy and, in overruling the district court, found that United Airlines Inc.'s (United) lease arrangement with a California state agency was a disguised secured financing rather than a "true lease."

In bankruptcy, the distinction between a financing and a true lease is significant because, under §365 of the Bankruptcy Code, United, as a chapter 11 debtor, is required to remain current on its post-petition lease obligations or face eviction. The same is not true for secured financings. In addition, under a lease, United must ultimately either assume the lease and fully perform or surrender the property, whereas under a secured financing, United may retain the property and pay only the value of the security interest, and the balance is treated as unsecured debt.

The Structured Sale/Leaseback Arrangements

In the late 1990s, United entered into complex transactions to obtain funds to build or improve their premises at four airports—San Francisco (SFO), Los Angeles (LAX), Denver and John F. Kennedy in New York (JFK). For each airport, a governmental body issued certain facilities revenue bonds and turned the proceeds over to United in exchange for its promise to repay the bonds with interest and reimburse certain related costs. As security for its repayment obligations, United leased certain property to the governmental body that had issued the applicable bonds, which in turn leased the property back to United, giving the respective governmental body the right to evict United from certain facilities if United defaulted on its obligations. The amount of the lease payments United was obligated to pay under the leases matched the amount of the debt service payments and costs under the bonds.

The Bankruptcy Court and District Court Clash

After its bankruptcy filing in 2002, United filed four lawsuits in the bankruptcy case, seeking a declaratory judgment that each airport transaction was not a "lease" for purposes of §365. United instead sought to treat each arrangement as a secured loan so that it could continue using the airport premises while paying only a fraction of their related obligations. In its decision, the bankruptcy court reasoned that the word "lease" in §365—a term not defined anywhere in the Code—means "true leases" and not transactions that are in substance a secured financing but characterized as a lease under the form of the operative documents. Applying federal law, the bankruptcy court ruled that the Denver transaction was a true lease, but that the arrangements at SFO, LAX and JFK were secured financings.2 This meant that United had to cure the default and resume full payments on its Denver lease, but could reduce its payments on the other transactions (paying only for the current value of its interest in the property) and treat the difference as unsecured debt.

All the parties appealed the bankruptcy court's ruling to the U.S. District Court for the Northern District of Illinois. The district court issued four opinions, one for each airport, holding that all four transactions were "true leases." Relying principally on Supreme Court precedent in Butner v. United States,3 the district court first concluded that state rather than federal law controls the distinction between security interests and leases. Then, applying California, Colorado and New York law, the district court held that each transaction was a "true lease." United appealed the district court rulings in each of the four actions.

The San Francisco Airport Arrangement

The Seventh Circuit's decision focused solely on United's lease arrangements with the California Statewide Communities Development Authority (CSCDA) at SFO. United had been leasing 128 acres of land housing its maintenance base from SFO since 1973. Under the SFO transaction, in 1997 the CSCDA issued $155 million of related facilities revenue bonds for improvements to United's facilities, and United subleased 20 acres of the 128-acre site to the CSCDA for a rental payment of $1. In turn, United leased back the land from the CSCDA with rental payments equaling the bond interest payments and administrative fees. Under the leaseback, a principal balloon payment of $155 million is due in 2033.

The court found the following aspects of the SFO arrangement particularly relevant: (1) United subleased 20 acres of its 128-acre maintenance base to the CSCDA for 36 years, which matches the term of the bonds rather than the term of United's 1973 lease with the airport (which expires in 2013, unless extended); (2) the CSCDA leased the 20 acres back to United for a rent equal to the scheduled payments under the bonds (including a balloon payment) in contrast to the market value of the premises; (3) United is entitled to prepay the lease payments, and if it does, the sublease and leaseback terminate; and (4) the leaseback includes a "hell or high water" clause; in other words, United must pay the promised rent even if its lease from the airport ends before 2033, the property is submerged in an earthquake or some other physical or legal event deprives United of the use or benefit of the premises.

Federal Law Mandates that "Lease" in §365 Must Be "True Lease"

While recognizing that every appellate court that considered the issue has held that substance controlled and that only a "true lease" is a lease under §365, the Seventh Circuit began its legal analysis by declaring that whether the word "lease" in a federal statute has a formal or a substantive connotation is a question of federal law. Thus, it was important to the court to explain why, as a matter of federal law, the word "lease" in §365 means only a true lease and not a financing arrangement in the form of a lease.

The court then proceeded to describe Congress's intent in distinguishing between the treatment in bankruptcy of lease obligations that the court called "current consumption" or "new inputs" and the treatment of debt obligations. The Seventh Circuit reasoned that current consumption, analogous to an airplane lease or the purchase of jet fuel, adds current value to the reorganization effort, and therefore, Congress wanted those costs to be paid by the debtor on a current basis. In contrast, debt obligations were "old expenses" and were to be adjusted or written down to alleviate the financial distress to enable the debtor to begin operating its business with a fresh start. Consequently, Congress intended the debtor to remain current on "true leases," but not financings disguised as leases.

In addition, the court noted that stripping away the form to get at the substance of lease transactions has long been routine in tax law matters and was explicitly codified in commercial law in the Uniform Commercial Code (UCC) since 1958. The court noted that the UCC declared a "per se" rule that if the lessee has an option to acquire ownership at the end of the term for no or a nominal payment, then the transaction must be treated as secured credit, notwithstanding its form.4 Finally, the court observed that the legislative history of the Code unambiguously demonstrates that the term "lease" in the statute means only a "bona fide" lease or a true lease and that the economic substance of a transaction must be scrutinized to determine whether it is a true lease or a financing. Thus, the court concluded that as a matter of federal law, substance prevails over form in the definition of the word lease under §365.

SFO Arrangement Is Secured Financing Under California Law

Because nothing in the Code reveals which economic features of a transaction have consequences for the question of true lease vs. financing, the Seventh Circuit turned to California state law. Disagreeing with the district court that under California law form must prevail unless clear and convincing evidence supports a different conclusion, the court cited two California State Supreme Court decisions5 that illustrate that California takes a functional rather than mechanical approach to distinguish leases from financings. Each of the cases involved a sale leaseback arrangement, with the rental payments equal to the debt amortization rather than the market value of the property, and at the end of the lease term the premises or property reverted back to the lessee for no additional cost—i.e., the UCC's per se rule. Both California cases held that form must be pierced to get at the substance of a lease transaction and ruled that the transaction at issue was a financing rather than a lease.

Analogizing to these and other California state court precedents,6 the Seventh Circuit ruled that the SFO arrangement was not a "true lease" under California law. In reaching its decision, the court reviewed the factors described above and concluded that (1) the "rent" is measured not by the market value of the 20 acres leased but by the amount United borrowed, and that the "hell or high water" clause highlights the lack of connection between the rental value of the "leased" property and United's obligation to the CSCDA; (2) at the end of the lease term, the CSCDA has no remaining interest and United's tenancy interest reverts to it for no additional charge; the reversion without additional payment is the UCC's per se rule for identifying secured credit; (3) the balloon payment has no parallel in a true lease, though it is a common feature of secured credit; and (4) if United prepays, the lease and sublease terminate immediately; in a true lease, by contrast, prepayment would allow the tenant to occupy the property for the remaining lease term without further payment. Consequently, the court ruled that for purposes of §365, the SFO arrangement was a secured financing and not a "true lease."

Conclusion

The Seventh Circuit's opinion is significant on several fronts. First, it sets the legal precedent in the Seventh Circuit as to how a "true lease" is to be distinguished from a loan or financing arrangement in bankruptcy proceedings. Second, it provides a framework for how the court may eventually rule on another $350 million of United's bonds for projects at the three other airports.7 Finally, from a bondholder's perspective, it provides guidance for how future special facilities revenue bonds should be structured in order to prevent a recharacterization in a chapter 11 proceeding.


Footnotes

1 __ F.3d, __, 2005 WL 1743787 (7th Cir. 2005). Return to article

2 United Airlines Inc. v. HSBC Bank USA (In re UAL Corp.), 307 B.R. 618 (Bankr. N.D. Ill. 2004). Return to article

3 440 U.S. 48 (1979). Return to article

4 2005 WL 1743787 at *3. Return to article

5 Burr v. Capital Reserve Corp., 71 Cal.2d 983 (1969); Beeler v. Am. Trust Co., 24 Cal.2d 1 (1944). Return to article

6 See, e.g., Lovelady v. Bryson Escrow Inc., 27 Cal.App. 4th 25 (1994). Return to article

7 The appeals related to the three other airports remain pending before the Seventh Circuit. Return to article

Bankruptcy Code: 
Bankruptcy Rule: 
Journal Date: 
Thursday, September 1, 2005

Reprint Request