The Japanese Operating Lease
Before looking at the Japanese operating lease (JOL) market, we should pay respects to the demise of the Japanese leveraged lease (JLL) in light of its long contribution to international big-ticket leasing. The JLL will remain relevant to Japanese domestic transactions and will possibly drain equity funds from the JOL market.
March 31 1999 marked an end to the cross-border JLL that had existed as a primary tool of international aircraft finance since 1986. With the rules that came into effect on April 1 1998, only cross-border JLL transactions for which binding commitments had been entered into by September 30 1998 could be completed, and even these had to be completed before March 31 1999. After April 1 1999, the old form, full payout JLL structure could only be used domestically for equipment operated by Japanese airlines and other companies in their Japanese domestic businesses.
These tax law changes did not directly prohibit JLL transactions but went to the heart of JLL economics and require that in any cross-border transaction the JLL lessor takes depreciation on the aircraft on a straight-line basis over the lease term (120% of the Japanese statutory useful life of the asset). This is compared to the double-declining balance depreciation method over the statutory useful life (eight years for narrow body aircraft and 10 years for wide body aircraft) under the old JLL rules. In the current low interest rate environment, these changes assure that any JLL formulated on this basis will produce negative benefits to all parties, but that if a higher interest rate market develops in the future there may still be some life in the old structures.
The beginnings of an active post-JLL market are continuing Japanese participation in international aircraft finance by adopting broad-based JOL structures. There has been a low volume, but steady stream of JOL transactions since the late 1980s. Although this structure has been discussed in the past, previously the structures have only been implemented on a limited basis, in respect to used aircraft, for relatively short lease terms (three to seven years) and primarily in planning for Japanese inheritance tax purposes. Between 1990 and 1999, in cases where JOL transactions were offered to investors at the same time as JLL transactions, the JLL was almost always chosen due to the investors' primary consideration of avoiding direct aircraft risk.
Since April 1999 the ability of Japanese investors to avoid such direct aircraft risk has only been possible through the limited number of domestic JLLs in the market. As the order books for Japanese airlines have shrunk dramatically in recent years, they are no longer considered the excellent credits they once were. For any Japanese investor seeking an effective and reliable tax-deferral investment structure, especially to further defer the recapture from their past JLL transactions, as of February 2000 the JOL is the only readily available alternative to the domestic JLL.
From April 2000, and in particular for the fiscal year ending March 2001, there will be a large amount of original JLL transaction income recapture for Japanese investors. As these Japanese investors have had success with JLL aircraft investments in the past, the education process introducing them to the JOL product is relatively easy as (i) they are faced with substantial immediate tax recapture and (ii) there are no readily available alternatives. In fiscal 1999 (up to March 31 2000), an encouraging number of JOL transactions have been closed. This trend is expected to continue even if it is not as active as the old JLL market.
Many advisors in the international aircraft finance markets see it as a coincidence that globally all of the previously popular tax-based leasing finance products seem to have been curtailed by their local tax authorities within the space of 12 months in 1998 to 1999. The US, French and Japanese markets, and most recently the German market, were almost completely shut down for cross-border transactions as of April 1999. This drastic change in the financing for the world's airlines will inevitably mean that even though the JOL product is much less advantageous to the lessee airline than its JLL predecessor, they will have to consider this JOL structure because there will simply not be many competitive alternatives for global aircraft finance.
One interesting competitive development in 1999 in this respect was the successful European Enhanced Equipment Trust Certificate (EETC) securitization transaction by Iberia. If that transaction can be duplicated for other European or Asian carriers, despite the continuing concerns presented to the rating agencies by the local bankruptcy regimes of the airlines around the world, then we may see this EETC structure proliferate, which could lead to a less competitive position for the JOL.
There are six primary factors in the JOL market.
From an investor standpoint the Japanese market has been very conservative in the past, but with intermittent (and unpredictable) periods of excess competition among JLL arrangers to obtain mandates. In the future the primary beneficiaries of this new market will probably be first and upper-second tier airlines and reputable operating lessors. This may allow Japanese trading companies a significant role as operating lessors who can be lessees under JOLs to finance aircraft acquisitions for themselves (and their airline customers) on an off-balance sheet basis, and take the credits and country risks of lesser-rated airlines.
The existing bias against defeasance under the JLL structure continues into the JOL structures. The December 1998 National Tax Administration of Japan (NTA) circular expressly states that any lessee finance will result in the disallowance of operating lease treatment. Inclusion of elaborate economic defeasance mechanisms into transaction structures will probably be attacked by the NTA more than any other feature. In this respect the types of defeasance approaches utilized in US Foreign Sales Corporation or LILO (lease-in, lease-out) transactions are not appropriate to JOL transactions. There were press reports in late 1999 that two European JOL transactions had been completed in Austria and Ireland earlier in 1999. Those reports were promptly retracted but there remains much speculation in the market. Certainly in Tokyo everyone vehemently denies that these transactions were defeased. Lessee advisors will probably try to break this resistance by disguising lessee economic defeasances as lessee credit support but with the typical JLL representations and warranties requiring that the lessee has not paid any funds to any third party which directly or indirectly finance the loan for the transaction.
JOL investors will necessarily be required to take some asset risk. The amount of asset risk must, under the strictest interpretations of existing Japanese tax circulars, exceed 10% of the lessor's total acquisition and finance cost during the lease term. From a more conservative perspective, a 20% asset residual value risk level should be relatively safe for the investors. In fact, in many of the early JOL transactions since April 1999, the equity ratio has been nearer 30%, providing a very good cushion for non-recourse lenders. The equity investors will hedge that risk effectively by utilizing non-recourse debt and, where feasible, residual value insurance. The December 1998 NTA circular recognizes the existence of such non-recourse debt in the world aircraft finance markets. Given the past inexperience of Japanese banks in providing non-recourse financing, as well as their well-documented credit rating and Japan premium problems in the past several years, the debt into such JOL transactions can be expected to come primarily from more experienced non-Japanese financial institutions. Where the Japanese owner places residual value insurance for his/her own account directly with a third-party guarantor or insurer who has no link or back-finance arrangement with the lessee, the NTA should respect that hedging arrangement by the lessor. However, lessors are very conservative in this respect and the use of forward sale agreements or put options which are not true options, could result in treatment by the NTA up front as a current disposition of the subject aircraft in the future and therefore result in treatment as a financing rather than an operating lease.
In the past there has been minimal use of residual value insurance in Japan. The JOL presents significant new business opportunities for operating lessors, Japanese trading companies and other industry players who can provide reliable aircraft remarketing, technical and management services to the JOL lessors. These JOL transactions will also bring with them foreign currency exchange exposure which may be very difficult to hedge. Since the Japanese investors in JLLs have always been focused primarily on tax deferral and protection of equity principally in yen terms, they may be amenable to relinquishing substantial portions of upside benefits in dollars in exchange for limitation of downside risk in yen. For innovative arrangers this formula presents many potential variations with yen-dollar swaps, straight dollar or yen residual value supports and remarketing arrangements.
There will be great flexibility in determining the length of lease terms for JOL transactions. For new aircraft there is no particular reason why JOL lease terms cannot extend even beyond the previous 10 to 12 year JLL standards to a more commercial 15 to 20 years based on the real economic useful life of the assets. Where real ownership risk is being taken and the lessee's credit risk supports this lease term, this approach should withstand scrutiny from the NTA based on the historical real economic useful lives of aircraft. However, Japanese investors have always had a preference for shorter lease terms where possible because of the greater predictability of tax deferral needs over three to seven-year terms. Of course in a true operating lease environment, the relatively short three to seven-year periods would produce substantially smaller benefits to all parties and increase the risks on the lenders and the lessor owners as a result of the relatively high unrecouped residual investment at the end of such a short investment period. The economic balance achieved in this respect will be a critical aspect of how the JOL market develops.
A primary issue for the arrangement of JOLs will be the types of purchase option rights available to the airlines. Lessees will want to have certainty in this respect. In the past the NTA has not been amenable to consideration of allowing for current estimates of future fair market values (FMV) as a basis for setting future fixed price estimated FMV purchase options, as used in US leveraged leasing practice. During summer 1997, in the heat of negotiations between the NTA and the Japan Leasing Association on the final rules for abolishing the JLL, the NTA raised the possibility of requiring such future estimated fair market value appraisals for its own purposes in limiting depreciation deductions. The drafts of the December 1998 NTA circular also contained some elements of this concept. So although this limiting feature was later dropped by the NTA, use of such appraisals of estimated future fair market values for setting fixed price purchase options could now be more acceptable in Japanese practice.
The December 1998 NTA circular also recognizes that in international aircraft transactions it is common to grant purchase options in favour of lessees, so it is likely that the NTA, which usually looks to international rules and practice for guidance in these types of issues, especially in the United States, will recognize and respect the use of such estimated future fair market value fixed price purchase options. It may still be necessary, however, for these options to be tested against the market at the time to confirm that the original estimates are not wildly different. These options must be true options with no economic compulsion. Where the lessee decides not to exercise the purchase option the downside risk cannot be shared. The lessees will appreciate being protected against such downside risk, but where the downside risk is not shared owners may be reluctant to discuss any sharing with lessees of the upside benefits either.
For the foreseeable future, Japanese investors will probably be particularly conservative and sensitive to these lessee purchase option arrangements granted to lessees in any form other than a simple fair market value purchase option which is not fixed upfront. In the JOL transactions completed to date, there have been some with fixed price future estimated fair market value options based upon current appraisals, as well as deals with no purchase options at all in relation to aircraft which the lessee was planning out of its fleet. These elements of the structure will obviously have a significant impact on the debt financing which can be packaged into each respective transaction, and must be carefully negotiated among lessee, lessor and lenders in each case.
Significant questions have arisen between the lessor, lender and lessee concerning the lessee's indemnity liability in the new JOL structure. In a typical straight operating lease with a major operating lease company, the lessee has no direct responsibility for, or relation to, the debt. In those cases the lenders may have a mortgage and be loss payee on the insurances, as well as an indemnity under the operating indemnities, but they may otherwise not have any indemnity protections from the lessee in respect to increased cost or withholding-tax risks affecting the debt or cash flows from the lessor to the lender. In the JLL structure those risks were borne by the lessees, not the lessors, since the debt was essentially considered lessee credit risk only. The JOL seems to be somewhere in the middle of this spectrum. The JOL lessor is a special purpose entity, just as in JLLs. The JOL investors are seeking typical lower Japanese market equity yield returns, as compared with the major international operating lessors. As a result of these primary economic factors, lessees may receive better comparative benefits through lower lease rentals, and lenders will require a reliable level of debt support based on the lessee's credit amortization. And indemnity coverage of these critical increased costs and withholding tax change-in-law risks. In fact, this aspect of lessee indemnity support has been one of the most difficult issues in the transactions closed to date.
The JOL is proving to be an interesting hybrid financing product with substantial flexibility and potential benefits, where lessees may agree to cover such risks in order to gain the economic benefits of lower current rental obligations without residual risk.
The JOL market is a more commercial and very different product from the JLL. It raises difficult true debt-equity and lessor-lessee issues and the return conditions are real commercial operating lease terms. In other words, the JOL is not likely to emerge as a commodity product even after establishing itself in the fiscal year from 1999 to March 2000. Costs and rewards for arrangers are higher and there is closing risk to a degree not seen with the JLL. As a result, there will be fewer completed transactions, higher success fees, higher lessor benefits, continuing management, residual value and remarketing fees through the lease terms, and higher transaction costs for financial advisors, appraisers, technical advisors and lawyers. These incentives, combined with the absence of any viable big-ticket tax-deferral investment structures in the Japanese and global markets, generally should assure that the JOL market will continue at a reliable level into 2001.
The JOL is not a product that the world's airlines would generally prefer to the JLL if they had a free choice. And some airlines will question whether the JOL is of any interest to them at all. However, in a world with very few remaining viable tax-based finance options and decreasing availability of finance generally, many airlines will conclude that a JOL financing offer is a good opportunity and will come to welcome this vehicle as a means of gaining greater fleet planning flexibility and mid-term financing.
For further information on this topic please contact Robert Grondine at White & Case LLP by telephone (+81 3 3259 0200), by fax (+81 3 3259 0150) or by e-mail ([email protected]).
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