PURCHASE OPTIONS could become an Achilles heel in some transactions.

The Court of Federal Claims found fault in October with a lease transaction that Anaheim, California used to finance the arena that is home to the Anaheim Ducks, the city’s National Hockey League team. The city leased the arena to Union Bank for 39 years and subleased it back for 19.93 years with an option to extend the sublease through year 31. The transaction is called a LILO. Congress shut down such transactions in 2004, and a series of courts have found fault with them.

The transaction was supposed to let Union Bank deduct the rents it paid under the head lease on an accelerated schedule, while the rental income it received under the sublease accrued in a back-ended pattern.

Union Bank was required to make two rent payments: a payment of $132.3 million at inception in advance rent, and a payment of $975.8 million in deferred rent in 2043 five years after the head lease ends. AIG lent part of the money Union Bank used to make the advance rent payment.

Anaheim had an option at the end of the initial sublease term of 19.93 years to buy out the remaining head lease term for a fixed price. If Anaheim failed to exercise the purchase option, then Union Bank could require it to renew through year 31, sublease the arena to someone else or require Anaheim to return the arena to Union Bank.

The IRS argued that Union Bank did not acquire a genuine interest in the arena. The court agreed.

The central question in the court’s view was whether Anaheim could be expected to exercise the purchase option because, if so, then it would treat Anaheim as if had collapsed the lease arrangement from inception. The court said the standard is whether exercise is “reasonably expected.”

The money needed by Anaheim to exercise the purchase option was set aside from the start in a defeasance account. The financial advisor that conducted annual reviews of Union Bank’s lease transactions observed in a memo involving a similar deal that the “fully defeased” structure “protects equity investments and compels a purchase of the facility.” If Anaheim failed to exercise, then it would lose control over the facility, but still be on the hook for significant financial obligations since the city issued $126.5 million in certificates of participation that were still outstanding to refinance the arena after the original construction.

The court said the transaction had been designed strongly to discourage alternative outcomes to exercising the option and, if nothing else, civic pride would also have compelled it to exercise.

The arena was paid for with public financing. The city charter required annual financial reports by the city’s Department of Finance. The court said they telegraphed Anaheim’s true intentions by repeatedly noting that the option was fully funded and relied on that fact to exclude various potential liabilities from the city’s financial statements. Babcock & Brown said in a message to the city’s financial director that the “buyout option which allows the City to purchase Union Bank’s position . . . is the expected case.” Babcock was the city’s financial adviser.

The court also found fault with the appraisal produced when the deal closed. It called the appraisal “little more than a boilerplate effort.”

The appraisal addressed not only whether the city was likely to exercise the purchase option, but also whether it was economically compelled to do so. However, the court said the appraisal failed to consider the pre-funded nature of the option or to monetize the costs to Anaheim of not exercising. Deloitte, the appraiser, was specifically asked to consider non-economic factors, but it expressly declined to do so.