It is well known that in the financial community that both banks and airlines are keen to move assets off of their balance sheets. Banks are keen to move their loans and other principal investments; and to reduce leverage and capital charges, while airlines are keen to move their aircraft to reduce debt and maintain operational flexibility.  From the structuring and legal perspective, they will utilize tools such as securitization, operating leases, sale and leasebacks, repurchase transactions and partnership structures. Regulators and investors perceive these practices as “loopholes” and are keen to shut them down, for example, with effect 1 January 2019, all operating leases will be recognized on the balance sheet, with a right to use asset and financial liability that recognize more expense in profit or loss during the earlier life of an operating lease. Previously, accounting treatment made a distinction between on-balance sheet finance leases and off-balance sheet operating leases (under IAS17). This article looks behind these practices and examines some of the features that are still relevant when assessing the relevant risks in these related products. 

Why is off-balance sheet financing attractive?

Managing the cost of financing is an essential part of a successful business. There are two obvious problems with high levels of debt: (i) cost of debt capital tends to increase with increased debt level (financier will have to accept a higher level of risk and demand a higher interest rate in return); and (ii) leverage ratios may be violated, causing breaches of financing arrangements. Off-balance sheet financing creates liquidity that is unlinked to its credit rating, enabling it to raise funds from sources that would not normally consider funding such a company. The most common way of doing this is securitization. 

How does it work?

Off-balance sheet financing inevitably involves a “sale”. Where the financing is structured as a sale, the parties will want the monies advanced by the financier to be characterized as a purchase price; and the assignment of the receivables (or even by selling assets into a bankruptcy remote special purpose vehicle) by the seller to be characterized as a sale. Unfortunately, there is no one legal test by which it is possible to determine conclusively whether a transaction amounts to a true sale of receivables, rather than a secured loan. In the case of Re George Inglefield Ltd [1933] Ch. 1, the Court of Appeal identified the following essential differences between a “sale” and a secured loan:

  1. In a sale transaction, the vendor is not entitled to get back the subject-matter of the sale by returning to the purchaser the money that has passed between them. In the case of a mortgage or charge however, the mortgagor is entitled to get back the subject-matter by returning the money that has passed between them.
  2. If the mortgagee realizes the subject-matter of the mortgage for a sum more than sufficient to repay him (with interest and costs), he is obliged to account to the mortgagor for the surplus money. Whereas if the purchaser sells the subject-matter of the purchase, and realizes a profit, he is not obliged to account to the vendor for the profit.
  3. If the mortgagee realizes the mortgage property for a sum that is insufficient to repay him the money that he has paid to the mortgagor (together with interest and costs), then the mortgagee is entitled to recover from the mortgagor the balance of the money. If the purchaser were to resell the purchased property at a price that was insufficient to recoup him the money that he paid to the vendor, he would not be entitled to recover the balance from the vendor.

However in Welsh Development Agency v Export Finance Co Limited, Dillon LJ implicitly rejected the application of the three criteria set out above as the sole test, but rather considered it to be necessary to look at the provisions of the relevant document as a whole, in order to be able to decide whether it amounts to an agreement for the sale of the assets or only a mortgage or charge.

How do we account for off-balance sheet financing in financial statements?

“True Sale” is more than a legal construction. Whether or not a transaction can be classified as off-balance sheet financing must be judged in accordance with the applicable accounting rules. The accounting implication would inevitably invite two questions: (i) whether the special purpose entities involved have to be consolidated; and (ii) for accounting purposes, have the transferred assets been sold. Indeed the interpretation of these rules are complex. Some of the questions that needs to be addressed include:

  1. Does the securitization meet the sale criteria under the relevant accounting standards?
  2. Has the transferor surrendered control and eligible for derecognition?
  3. How do you determine gain or loss on sale?
  4. How did the investor account for the sale?

So, does it really matter?

Where a purported off-balance sheet financing fails the “true sale” test, there is a risk that the payment of the purchase price will be re-characterized by the courts on the insolvency of the seller as a loan and the purported sale will be re-characterized as a security assignment. If the seller is incorporated in a jurisdiction where security assignments must be registered, that re-characterization may lead to the security being void against the seller’s liquidator as a security for want of registration. The financier would then be left as an unsecured creditor of the seller. This is more than just accounting and legal play.

Investors need to beware of how off-balance sheet components can impact their investments. While the recent changes accounting rules have its role to safeguard the true and fair presentation of the financial statements, there are many cases where it is difficult for an investor to assess and quantify the risk involved in these components. We have, in a recent M&A transaction involving a large aircraft lessor, suggested that we due diligence a securitization structure (even when the investor holds a nominal amount of equity notes of the structure) as a secured loan, to account for the (perhaps unlikely, one may think) risk of re-characterization.