By Howard L. Siegel, Brown Rudnick LLP
U.S. coal-fired power plants subject to long term sale-leaseback financing, such as EME Homer City, AES Eastern and Midwest Generation, face distinct debt restructuring challenges in the current merchant power market. The coal power sector as a whole is confronted with weaker than projected energy and capacity prices at the same time as escalating mandates for environmental compliance require consideration of significant new capex investments in many cases. The persistence of low cost natural gas generation makes this restructuring/investment calculus difficult in any case; however, the added complexity of the multi-party sale-leaseback structure causes the analysis to be especially daunting. This article will briefly map out the multi-dimensional battleground for those sale-leaseback debt investors seeking to navigate the territory for opportunities.
The chart below sets out the basic power plant sale-leaseback structure.
This chart is simplified insofar as most transactions involve multiple owner trusts, each of which owns and leases an undivided fractional interest in the subject power plant(s) and is also party to an underlying land lease and sublease for a corresponding fractional interest.
The owner trust is typically a single purpose pass-through entity which owns title to the physical power plant components and leases the power plant to the lessee/operator under a long term facility lease. The lessee/operator, also usually a single purpose entity, owns the underlying land on which the power plant is located, leases that land to the owner trust, and the owner trust concurrently subleases the land back to the lessor/operator. The lessee/operator has responsibility for operating and conducting the power plant business, and current business assets such as coal inventory and accounts receivable as well as various operating contract rights are typically held by the lessee/operator outside of the sale-leaseback structure. Often, the lessee/operator will enter into working capital financing arrangements by which its current assets are pledged as collateral, and the lessee/operator will also incur ordinary course unsecured creditor obligations in connection with ongoing business operations.
Owner trusts finance the power plant acquisition through a combination of equity and debt. The beneficiaries of the owner trust typically provide equity funding with an expectation for both a cash return as well as certain tax benefits through their ownership of the depreciable power plant components. Debt financing is placed by means of a pass-through trust structure whereby each owner trust issues secured lessor notes to a pass-through trustee, and debt financing is then raised through the issuance of pass-through trust certificates (PTCs) to the ultimate debt investors. The secured lessor notes carry a first lien position on the power plant asset itself, the power plant facility lease, the underlying land lease, and certain key contract rights related to the conduct of the business. The secured lessor notes are typically nonrecourse as to the owner trusts.
Generally, the sole assets of the pass-through trust are the secured lessor notes, and the rights of the pass-through trustee for the benefit of the holders of PTCs are dependent on the secured lessor notes and the related collateral for such notes.
Unlike other debt structures where overall deal terms are likely to be contained in one or two key transaction documents, the sale-leaseback structure requires a debt investor to refer to a series of documents. Usually, the key documents include a participation agreement, facility lease, land lease and sublease, indenture, secured lessor notes, pass-through trust agreement, and a deposit and disbursement agreement.
The participation agreement describes the overall transaction structure and is usually the only document to which all transaction parties are signatories. It contains various representations, warranties and covenants and often includes a detailed appendix setting out comprehensive definitions that are cross-referenced in many other transaction documents.
The facility lease between the owner trust, as lessor, and the lessee/operator, as lessee, sets out the initial lease term and extension options during which the lessee/operator will operate the power plant. It specifies rental obligations, maintenance and/or improvement obligations, default remedies, and other customary terms.
The underlying land lease and concurrent sublease relate back to the real property owned by the lessee/operator on which the power plant is located and from which it operates and set out initial terms and renewal options, as well as rental amounts and other customary provisions.
The indenture between an indenture trustee and the owner trust evidences and governs the issuance of the secured lessor notes by the owner trust in favor of the indenture trustee and contains payment, distribution and default terms as well administrative provisions and customary indenture terms. The secured lessor notes are accompanied by related security agreements or other lien documents.
The pass-through trust agreement or separate indenture is the vehicle by which all secured lessor notes from different owner trusts are aggregated and pass-through trust certificates or other debt instruments are issued to ultimate sale-leaseback debt investors and contain customary administrative, distribution and default provisions.
In most cases, all revenues from power plant operations are required to be deposited by the lessee/operator with a collateral trustee and made subject to a deposit and disbursement agreement which sets up a series of subaccounts for designated purposes and provides specified waterfalls for depositing into and disbursing from those subaccounts.
The document analysis is further complicated insofar as most sale-leaseback transactions involve multiple owner trusts, each of which will have entered into a similar series of the foregoing types of documents for its applicable undivided fractional interest.
The essence of the sale-leaseback structure is to shuffle and then separately deal out the various components of the otherwise integrated power plant business. Specifically, the depreciable power plant components are dealt out to the owner trust equity investors. While ownership of the underlying land is held by the lessee/operator, the shuffling of the land into a lease/sublease structure permits the land to track along with power plant operations. The lessee/operator is dealt operating control of the power plant through, and for the term of, the facility lease for the purpose of conducting day-to-day business operations. Rent and other sale-leaseback economics are set based on the long-term projection of revenues from power plant operations being sufficient to service the secured lessor notes, provide an equity return to the owner trusts, and provide an operating profit to the lessee/operator.
If during the term of the facility lease, the power plant business is no longer able to generate revenues sufficient to meet rent and other facility lease obligations on a sustained basis, it may become necessary to unshuffle the deck of business and asset components in the course of a restructuring. In the event of a sustained revenue shortfall, a facility lease default and termination can be avoided only if all necessary transaction parties agree to modify the terms of the facility lease or, if one or more parties are motivated by some factor outside of simple rent economics, to inject additional capital to cover the shortfall.
If the lessee/operator does default under the facility lease, the owner trust will have the right in the first instance to exercise default remedies, including termination of the facility lease and the underlying land sublease, and thereby begin to unshuffle the separate sale-leaseback components by obtaining operating control of the power plant business. Under that default scenario, the power plant and underlying land lease will remain subject to the liens securing the secured lessor notes for the benefit of the PTC holders. During a facility lease default, the owner trust can elect to continue to pay the secured lessor notes while it maintains control of the power plant business and seeks a longer term debt resolution. If the owner trust defaults under the secured lessor notes, however, the trustee for the benefit of the PTC holders will be entitled to seek a disposition of the power plant and underlying land lease through foreclosure and thereby divest the owner trust of title and control.
Under pending Environmental Protection Agency regulations, many coal-fired power plants face mandates to install significant pollution control equipment. In a number of cases such environmental capex expenditures could be necessary to avoid plant shutdowns; however, such expenditures, if made, may not serve to materially increase revenues in various regional power pools. Since coal plant revenues are already strained, this environmental capex requirement comes at a difficult time, and the issue is especially complicated in the sale-leaseback context.
In most cases, sale-leaseback transaction documents require the lessee/operator to make those power plant improvements during the term of the facility lease if they are "required by law," but impose no such obligation with respect to so-called "optional improvements." Depending on how that definitional issue is resolved, the sale-leaseback transaction documents address the following matters, each of which requires careful attention:
(1) Whether the lessee/operator or the owner trust will hold title to the environmental improvements;
(2) Whether the lessee/operator has the ability to finance the environmental improvements and, if so, on a secured or unsecured basis;
(3) Whether there is a carve out permitting the issuance of additional secured lessor notes to finance such improvements, and, if so, in what amount and at what priority in relation to existing secured lessor notes; and
(4) Whether there is an ability to adjust the rental amount under the facility lease or adjust the distribution waterfall under the deposit and disbursement agreement in the event that all or any portion of the cost of improvements is financed by equity from either the lessee/operator or the owner trust.
Any mismatch under the governing transaction documents in the requirements for installation, title, and/or the ability to finance environmental improvements merits particular attention in order to assess the prospects for default and debt investment opportunities.
As indicated above, one important aspect of the sale-leaseback structure is the tax benefit provided to owner trust beneficiaries through their ownership of the depreciable power plant components. The flip side of that benefit is the potential under Internal Revenue Service regulations that in the event of either a foreclosure of the power plant or a substantial debt restructuring, the owner trust beneficiaries could suffer significant adverse tax consequences. Such adverse consequences are more likely in sale-leaseback transactions that have been in place and performing for a number of years prior to the time of default.
The above tax issues may cause the owner trust beneficiaries to consider some form of financial contribution to a restructuring package to avoid the adverse consequences of default. Debt investors should therefore carefully review the prospects for, and level of potential contribution from, owner trust beneficiaries in such circumstances in assessing sale-leaseback debt investment opportunities. It is also important in this context to determine whether a tax indemnity agreement has been executed as part of the sale-leaseback transaction, and, if so, to identify the parties to that agreement. Oftentimes the lessee/operator is a party to a tax indemnity agreement by which it indemnifies the owner trust beneficiaries from all or part of the described adverse tax consequences. To the extent the single purpose lessee/operator is likely to have limited assets, such an indemnity may provide little comfort to the owner trust beneficiaries. However, in some cases a solvent parent company or other affiliate of the lessee/operator may also be a party to the tax indemnity agreement, in which event the parent/affiliate may also be looked to as a potential source of consideration in restructuring negotiations.
In moving down the restructuring path, sale-leaseback debt holders face the prospect of dueling or serial bankruptcies by both the lessee/operator, on one hand, and the owner trust, on the other.
If the lessee/operator desires to remain in control of the power plant and related business operations following a default under the facility lease it may initiate Chapter 11 proceedings prior to the time the facility lease has been terminated. In that circumstance, the parties will be faced with issues of lease assumption or rejection and a potential damage cap in the event of lease rejection. Under bankruptcy law, such issues may turn, in part, upon whether the facility lease is characterized as a lease of real property or personal property and whether it is a true lease or a financing lease. To the extent the owner trust (or the indenture trustee for the benefit of the PTC holders) holds an unsecured damage claim against the lessee/operator, recovery of that claim will also be subject to the Chapter 11 process.
Resolution of bankruptcy or other default issues in regard to the lessee/operator may not end the bankruptcy story for PTC holders. In the event the facility lease is terminated, the owner trust will hold title to the power plant free of the facility lease but subject to a secured claim in favor of the PTC holders through the secured notes. In that event, the owner trust may be motivated to file its own Chapter 11 case to defend against the foreclosure of the power plant, particularly where adverse tax consequences would result from that foreclosure. Any Chapter 11 filing is likely to be complicated by the fact that multiple owner trusts each hold different fractional undivided interests in the subject power plant(s).
The potential for such dueling or serial bankruptcy filings and the assessment of alternative outcomes and strategies in regard to each should be part of any sale-leaseback debt investment analysis.
In many power plant sale-leaseback transactions, there is a history of successful operations whereby the lessee/operator has made substantial distributions to its parent or other affiliated entities over the years. It is also common for the lessee/operator to enter into various operating agreements and other contracts with affiliated companies in relation to power plant operations whereby substantial payments have been made to those affiliates over the years. In the event of a lessee/operator bankruptcy filing, the potential for clawback of some of the foregoing distributions or payments may exist whereby the pool of assets available to satisfy facility lease damage claims can be increased. Such clawback liability would be sought under either fraudulent transfer or preference theories and require a showing of insolvency or unreasonably small capital at the time the various distributions or payments were made. Clawback actions are quite fact-specific and likely to be further complicated in the sale-leaseback structure where payments have been made under a contractual waterfall. However, where substantial distributions have been made in relatively close time proximity to default, sale-leaseback debt investors should assess the prospect for such clawback recoveries as part of the investment decision.
Coal-fired power plants, which provide about half of the U.S. electric power supply, currently face multiple competing economic and political challenges. For those seeking to invest or trade in coal power plant debt, there are significant risks and rewards to be had in assessing how complex and inter-related regulatory, commodity, energy, and environmental factors will impact plant value. The complexity of that exercise, and the concomitant risks and rewards, are likely to be even greater for debt investors in the sale-leaseback milieu.
Howard L. Siegel is a partner at Brown Rudnick LLP where he is a member of the firm’s Bankruptcy and Corporate Restructuring Group and its Energy and Utilities Practice Group. Mr. Siegel regularly represents official and ad-hoc committees of creditors and equity security holders and other parties in interest in bankruptcy and restructuring matters. He also represents clients in merchant power M&A and financing transactions, project development and valuation litigation. For more information, Mr. Siegel can be reached at +1.860.509.6519 or firstname.lastname@example.org.
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