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Off-Balance-Sheet
Financing And Corporate Governance:
Is It A Lease Or Indedbtedness?
By John C. Murray, Esq.
First
American Title Insurance Company
30 N. La Salle St. Suite 310
Chicago, IL 60602
Introduction
In a recent declaratory
judgment proceeding, the Delaware Chancery Court, in
In re Explorer Pipeline Co., 2001 Del. Ch. LEXIS
97 (July 16, 2001), issued a Memorandum Opinion holding
that Explorer Pipeline Company’s ("Explorer")
decision to finance a pipeline expansion project by
entering into an financeable off-balance-sheet operating
lease was not subject to a "supermajority"
provision in Explorer’s certificate of incorporation,
which required the approval of 75% of the company’s
stockholders before Explorer could "incur, create,
assume or guarantee any indebtedness for borrowed money"
in excess of $15 million.
Background
Explorer, a Delaware
corporation with its headquarters in Tulsa, Oklahoma,
owns and operates a pipeline for the delivery of petroleum
products from the Gulf Coast to the Midwest. Explorer’s
Board of Directors ("Board") consists of affiliates
of seven of the eight major oil companies that comprise
the shareholders of Explorer. (According to the court,
"[t]he shareholders and their representatives on
the Explorer board are sophisticated, knowledgeable,
and experienced in the pipeline industry." Id.
At *5). The Board determined that it was necessary
for Explorer to expand its pipeline capacity, and approved
an expansion project in excess of $100 million. The
Board then reviewed several financing alternatives,
including "short- and long-term debt, capital leasing,
off-balance-sheet operating leasing, retained earnings
and equity financing." Id. at*11.
After deliberation,
the Board believed that "traditional" debt
and off-balance-sheet operating leasing were the best
alternatives. Recognizing that obtaining indebtedness
to finance the expansion would require the supermajority
approval of 75% of the stockholders (which the Board
felt was unattainable), the Board agreed to pursue the
operating-lease alternative. The Board authorized management
to begin negotiations, conditioned upon obtaining appropriate
assurances that the operating lease would be structured
so as to satisfy the applicable accounting and tax criteria
for treatment as off-balance-sheet financing. At a subsequent
meeting, the Board approved a term sheet setting forth
the basic structure of the transaction, which involved
a "Construction Agency Agreement and Operating
Lease."
According to
the court, at least one Board member at the meeting
believed that the operating-lease structure would require
supermajority approval by the shareholders. Therefore,
the Board decided to seek a declaratory judgment to
resolve the issue of whether it could utilize a financeable
operating lease in connection with the expansion project
without having to obtain supermajority approval. Three
of the shareholders, Marathon Oil Company, CITGO Pipeline
Investment Company, and Sun Pipeline Company of Delaware
(collectively, "Objecting Shareholders"),
formally opposed the project and opposed the relief
sought by Explorer in the declaratory judgment action.
Explorer’s certificate
of incorporation stated that "the Board of Directors
is expressly authorized by the affirmative vote of three-fourths
of the whole board to incur, create, assume or guarantee
any indebtedness," including "mortgages and
liens upon the real and personal property of the Corporation,"
provided that "in the event the Board approved
total outstanding indebtedness" in excess of $15
million, "then no further indebtedness or mortgage
lien in connection therewith shall be incurred, created,
assumed or guaranteed by the Corporation unless authorized
by the affirmative vote of the holders of at least seventy-five
per cent of the stock issued and outstanding having
voting power." According to the court, "[t]his
provision requires supermajority approval by the board
and by the shareholders before the board may subject
Explorer to certain indebtedness." Id. at
*7.
The court noted
that several other provisions in Explorer’s certificate
of incorporation expressly authorized the Board to lease
real and personal property. The court further noted
that, in furtherance of Explorer’s decision to pursue
a financeable operating lease to fund expansion of the
pipeline, Explorer was actively involved in structuring
the transaction, including negotiating the interest
rate and other financial terms. As is common in off-balance-sheet
financing utilizing a financeable (or "synthetic")
lease, Explorer would build and operate the contemplated
improvements under a construction agency agreement,
and make the lease payments to the landlord (a business
trust created for the sole purpose of passing through
the lease payments to the debt and equity investors).
The lease payments would be calculated so as to repay
the debt and equity components of the funding required
to complete the pipeline expansion. In addition, the
lease would be "triple net,’ i.e., all operating
and maintenance expenses would be Explorer’s sole responsibility
and the obligation to pay rent would be unconditional.
Explorer would also have the option to purchase the
property under certain conditions (as is required under
applicable accounting rules and regulations to qualify
for off-balance-sheet treatment) and "to assume
the Trust’s debt to the lenders." Id. at
14. [This feature is not common in most synthetic leases,
which usually require payment in full of the indebtedness
if the purchase option is exercised]. The lease would
have a base term of 30 years. [This also is not a common
feature of a synthetic lease, which, in order to comply
with applicable accounting rules, usually has a term
of 3-7 years].
In its motion
for summary judgment, Explorer sought a determination
that, as a matter of law, a "true operating lease"
did not require supermajority approval of the Board
or the shareholders. The Objecting Shareholders argued
that the supermajority provision was ambiguous and that
extrinsic evidence should be introduced to interpret
the provision. Alternatively, they argued that the supermajority
provision was not ambiguous and that it prohibited the
proposed operating-lease transaction. They asserted
that, based on the economic substance of the financeable
operating lease, it constituted exactly the type of
transaction contemplated by the supermajority provision.
The Objecting Shareholders also raised several equitable
claims with respect to the manner in which Explorer
reached its decision to pursue the operating-lease format.
(However, the court declined to address these additional
equitable allegations in its opinion).
The Court’s Decision
As a threshold
issue, the court addressed the Objecting Shareholders’
argument that it should not issue an "advisory
opinion" on a "hypothetical" transaction,
because the transactional documents were not in final
form. The court rejected this argument, finding that
the Board had already adopted a resolution authorizing
the operating-lease transaction and noting that the
term sheet submitted to the Board set forth the basic
structure of the transaction. (According to the court,
"[s]ince the filing of this action, Explorer has
moved forward and, apparently, is now close to being
able to consummate the transaction although ‘final’
documents are not yet available." Id. at
*12). The court reasoned that because subsequent and
more complex drafts of the proposed documents were currently
available, the proposed transaction could be evaluated
in a more substantial context. The court found that
the validity of the Board’s action had been questioned
by the Objecting Shareholders, and that there existed
a significant question of corporate governance. Id
at *18.
The court then
discussed the principles of construction applicable
to Delaware corporate-governance issues. The court noted
that it was obligated to construe the provisions of
Explorer’s certificate of incorporation within the context
of the entire document, and that generally a majority
vote controls when shareholder approval is required.
According to the court, Delaware law requires that a
supermajority provision must be "clear and unambiguous",
and is to be strictly construed. Id. at *22 (citing
Centaur Partners, IV v. Nat’l Intergroup, Inc.,
Del. Supr., 582 A.2d 923, 927 (1990)). The court also
recited several provisions in the lease that granted
the Board authority, absent the supermajority provision,
to enter into and implement an operating lease.
The court next
turned to the operative language in the supermajority
provision, which referred to an arrangement that would
cause Explorer to "incur, create, assume or guarantee
any indebtedness for borrowed money." The court
held that the supermajority provision did not apply
because the operating-lease structure, as approved by
the Board, would not cause Explorer to borrow any money,
i.e., only the lessor-trust would be liable for repayment
of the indebtedness, and Explorer would be liable solely
for the lease payments to the lessor-trust.
The Objecting
Shareholders argued that "economic reality"
required that the proposed operating lease be treated
as debt. They noted that the lease was "triple
net", with Explorer bearing all the risks and burdens
associated with the operation of the property. The Objecting
Shareholders’ expert witness testified that the proposed
lease was "debt in disguise", and stated that
credit-rating agencies commonly treat such transactions
as indebtedness when evaluating the credit strength
of publicly traded companies. The court did not dispute
this conclusion and noted that Explorer’s general counsel
had conceded that the operating-lease structure approved
by the Board was equivalent to indebtedness.
However, the
court held that even though the operating-lease obligations
should be treated as indebtedness, this indebtedness
did not trigger the supermajority provision. This was
so, the court reasoned, because Explorer did not incur,
create, assume or guarantee any indebtedness for "borrowed
money", as required by the supermajority provision.
According to the court, the obligation to repay the
borrowed money was solely that of the lessor-trust,
with Explorer being responsible only for the lease payments
to the trust-lessor and assuming neither primary nor
contingent liability for repayment of the debt.
The court acknowledged
that it had some difficulty with its finding that Explorer
has not "created" the indebtedness, in light
of Explorer’s significant involvement in structuring,
negotiating, and implementing the operating lease. However,
the court ruled that it was the actions of the trust
and the lender, and not Explorer, that brought into
existence the indebtedness for the borrowed money. The
court found that the mere fact that Explorer played
a role in arranging financing from a third party --
as is common in may commercial transactions -- did not
cause Explorer to "create" the indebtedness.
The court further determined that the supermajority
provision (which the court found was not ambiguous)
was intended to apply to situations in which Explorer
itself would become liable for indebtedness for borrowed
money, and not to a third party’s borrowing of money.
The court stated that it "cannot overlook the truism
that Explorer, in the proposed transaction, will not
be liable for borrowed money." Id at *33.
The court then
addressed the Objecting Shareholders’ argument that
the supermajority provision’s limitation on indebtedness
in excess of $15 million applied to the proposed transaction.
The Objecting Shareholders argued that because the language
requiring supermajority approval with respect to indebtedness
exceeding $15 literally applied to "indebtedness"
and not "indebtedness for borrowed money,"
such approval was required for the Board’s action approving
the operating lease. The court rejected this assertion,
ruling that this specific language was subject to the
preceding language in the provision referring to "borrowed
money" and that "[i]f indebtedness for borrowed
money is not involved then this provision simply does
not apply." Id at *37.
The court then
reviewed the extrinsic evidence that had been presented
by the parties. The court found that in this case "the
extrinsic evidence is less than conclusive." Id
at *39. The court acknowledged that the Objecting Shareholders’
"most persuasive argument is that an operating
lease and traditional bank financing have substantially
the same economic impact on the company." Id.
The court also stated that "[a]s a matter of
consistent corporate governance policy, the Opposition
Respondents’ argument makes sense." Id at
*40. However, the court found that "to achieve
the result they advance, the certificate of incorporation
would not require mere interpretation, it would require
reformation." Id.
The court next
considered, as additional extrinsic evidence, the fact
that the supermajority provision had been amended in
1990. According to the court, "before the 1990
amendment the limiting factor was not the amount of
indebtedness, but the term or duration of the debt."
Id at *41-42. The court found that the testimony
of the drafters of the 1990 amendment, as well as the
corporate minutes, indicated that the drafters were
"addressing an issue raised by questions about
a commercial paper policy in the context of approval
of expenditures for major capital improvements."
Id at *48.
The court concluded
that, based on its review of the corporate minutes approving
the 1990 amendment, "the purpose of the amendment
to the supermajority provision was to address borrowing
in a traditional sense through the use of commercial
paper." Id at *44. Furthermore, the court
noted, the affidavits of two of the participants in
the 1990 amendment process -- while not entirely consistent
-- concurred that the use of operating leases as a means
of financing future projects was never considered. Therefore,
the court reasoned, "(b)ecause a supermajority
provision restricts the general right of the majority
to govern corporate activities, that operating leases
were not even considered may tend to support the conclusions
that the supermajority provision was not intended to
address or to restrict the use of operating leases."
Id at *46-47. The court stated that the drafters
of the 1990 amendment "chose to leave the phrase
‘for borrowed money’ as they found it." Id
at *49. Furthermore, the court noted that although operating
leases had not theretofore been used to finance pipeline
expansion, they "had been around (as of 1990) for
many years as a means of financing capital improvements."
Id at *48. In sum, the court found that the extrinsic
existence, although inconclusive, tended to support
Explorer’s argument "that the supermajority provision
should not be construed to restrict the use of operating
leases as now contemplated by Explorer." Id.
Discussion
1. Although the court referred
to the financing transaction approved by Explorer’s
Board as an "operating lease format" or
"operating lease concept" throughout its
opinion, it is more commonly known as a "synthetic
lease." In the past several years, many United
States and foreign banks, as well as other capital
sources, have become increasingly active in offering
off-balance-sheet financing for corporate real estate
acquisition, construction and expansion. This method
of structured financing is attractive to the corporate
user of real estate because, if properly structured
as a true "synthetic" leasing transaction,
the lessee-corporate user will be able to expense
the rental payments it makes to the lessor under the
lease, and its balance sheet will not be "tainted"
by a real property asset (and ownership) or by the
existence of mortgage debt. However, the lessee-corporate
user will retain all the tax benefits and burdens
of ownership, including the ability to depreciate
the improvements located on the real property and
obtain any appreciation upon a subsequent purchase
of real property and improvements from the lessor
(pursuant to an option to purchase contained in the
lease) or upon resale to a third party.
2. The operating-lease
transaction approved by the Board, as described in
the court’s opinion, differs in a few respects from
a typical synthetic-leasing transaction. Most synthetic
leases have terms of 3-7 years, in order comply with
Statement of Financial Accounting Standards No. 13
(Accounting for Leases), issued by the Financial Account
Standards Board ("FASB") in 1976. This accounting
standard ("FASB 13") states that a synthetic-leasing
transaction will not qualify as an operating lease
for financial accounting purposes if (among other
things) the non-cancelable lease term in equal to,
or greater than seventy-five percent of the estimated
economic life of the property. However, the court
states that Explorer’s operating lease will have a
base term of 30 years. FASB 13 also provides that,
to qualify as an operating lease, it cannot automatically
transfer ownership to the lessee at the end of the
lease or contain a "bargain price" option
to purchase. To avoid an automatic transfer of ownership
to the lessee, the synthetic lease is structured to
provide the lessee with an option to either purchase
the property at the end of the lease term or cause
it to be sold to a third party. To ensure that the
lease does not contain a bargain-price option to purchase,
the option provision provides that the lessee is obligated
to purchase the property at the expiration of the
lease for a fixed amount set at the inception of the
lease, equal to the unamortized acquisition cost plus
additional costs advanced by the lessor in connection
with the acquisition and development of the property,
including debt financing. Although the court stated
that Explorer had the option to purchase the lessor-trust’s
interest in the project, it also stated that Explorer
had the right at such time "to assume the Trust’s
debt to the lessee." Id at *14. Perhaps
as the result of these deviations from standard accounting
requirements in connection with a synthetic-leasing
transaction, the court was careful to note that its
holding was limited in scope and did not constitute
a determination that the "operating lease format"
approved by the Board complied "with applicable
tax, accounting, and UCC for operating leases,"
or "contain[ed] specific provisions that would
convert the proposed operating lease transaction into
one that would require supermajority approval,"
which would cause the operating lease to qualify as
off-balance-sheet financing.
3. The court
attempted to distinguish between "indebtedness"
and "borrowed money" in the supermajority
provision. While construing "indebtedness"
as including Explorer’s operating lease rental payments,
the court stated that "it cannot rewrite the
provision to read, in substance, ‘to incur create,
assume, or guarantee any indebtedness for borrowed
money, operating lease payments or otherwise.’ Perhaps
a provision that restricts not only ‘borrowed money’
but also operating lease payments would be appropriate."
Id at *49-50. The court also found that, because
operating leases were not contemplated at the time
that the supermajority provision (or the 1990 amendment)
was entered into, and because a supermajority provision
"restricts the general right of the majority
to govern corporate activities," these facts
"may tend to support the conclusion that the
supermajority provision was not intended to address
or to restrict the use of operating leases."
Id. at *46-47.
4. One of the commonly stated
benefits of a synthetic lease is that it may not trigger
financial covenants in bank loan documents that otherwise
limit the ability of the lessee-corporate user to
incur further debt obligations. Based on the court’s
decision in Explorer, a lessee-corporate user
may also be able to utilize a synthetic lease as a
means of avoiding restrictive corporate-governance
provisions that limit the corporation’s ability to
incur indebtedness. This decision may cause counsel
for corporate clients to "tighten up" the
language in supermajority provisions in articles of
incorporation or other corporate-governance documents,
if the intention of the drafters is to restrict this
type of corporate financing. Because there are several
forms of off-balance-sheet financing in addition to
(or that are variations of) synthetic leasing, the
definition of "indebtedness" could be expanded
to include, e.g., limits on the board of directors’
(or management’s) ability to "incur, create,
assume, or guarantee any indebtedness for borrowed
money, operating lease and "synthetic lease"
payments, and payments under other forms of off-balance-sheet
transactions (including without limitation, lease-leasebacks,
"black box" transactions, sale-leasebacks,
and credit-tenant leases), or otherwise.
5. One of the distinguishing
features of a synthetic lease is specific language
in the lease (and any recorded memorandum of lease)
stating the parties’ intention regarding the nature
of the transaction, similar to the following:
"It
is the parties’ intention that for all purposes
other than financial accounting purposes, including
state, real estate, commercial law, bankruptcy and
federal, state and local income tax purposes, the
transaction contemplated in this document is a financing
arrangement and preserves ownership of the property
in the lessee."
This standard
language (which is designed to preserve the off-balance-sheet
status of the transaction) appears to contradict the
court’s assertion that an operating-lease financing
arrangement is not indebtedness incurred or created
by the lessee-corporate user. It is, in fact, the
clearly stated intention of both the lessor and the
lessee that the transaction is to be treated for all
purposes -- except only with respect to reporting
for financial accounting purposes -- as a financing
arrangement for the lessee’s benefit.
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