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.
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.
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.
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.
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.
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.
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.
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.
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.
©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.
To view additional stories from Bloomberg Law® request a demo now