Fixed-price purchase options

Fixed-price purchase options

February 05, 2013

FIXED-PRICE PURCHASE OPTIONS could spell trouble in some equipment leases.

A US appeals court in Washington suggested in January that it is a problem to give a lessee an option to purchase equipment at the end of the lease term if exercise of the option is “reasonably
expected.” The court said the lessee will be considered the tax owner of the equipment from inception.

This is a different standard than the market has been using. 

Nearly all tax counsel have viewed purchase options as a problem only if exercise by the lessee is “reasonably certain”: for example, because the exercise price is expected to be below the equipment value at the time or because other facts will compel the lessee to exercise.

The decision may spell trouble for leases with fixed-price purchase options in transactions that would be reviewed by the US appeals court for the federal circuit. The United States is divided
into 11 geographic circuits, one District of Columbia circuit and one federal circuit. Cases heard first in the US claims court are appealed to the federal circuit.

The case involved Consolidated Edison in New York. The company entered into a complicated cross-border lease transaction called a LILO in 1997 with Dutch electric utility EZH. The utility
leased a 47.47% undivided interest in a gas-fired combined-cycle power plant to Con Ed for 43.2 years and then subleased it back for 20.1 years. Con Ed paid $120 million in rent under the head
lease at inception. It agreed to pay another $831.5 million in rent on the last day of the term if EZH had not exercised an option before then to buy out the Con Ed leasehold interest.

EZH had an option to purchase the leasehold interest at the end of the 20.1-year sublease for $215 million.

Con Ed had an appraisal from Deloitte that concluded there was no economic compulsion on EZH to exercise because the leasehold interest was expected to be worth less at the end of the sublease than the option price. However, the court was not persuaded because EZH was expected to have slightly more than the $215 million option price available to it by then in two defeasance accounts into which the initial rent payment was deposited, “rendering the option effectively costless to EZH.” The court said the appraiser also failed to address the consequences to EZH of not exercising the option. The court said the question is whether exercise is “highly probable” — whether someone in Con Ed’s position would have “reasonably expected that outcome.”

It pointed to statements by Con Ed to its accountants, Price Waterhouse, when the transaction closed that exercise was “reasonably assured” and by the outside financial advisers in a transaction structure memo when the deal was being put together that “it is reasonable to assume . . . that [EZH] will exercise the purchase option.”

The case is an example of how bad facts make bad law. Nevertheless, it may make some tax equity investors more wary of fixed-price purchase options.

It is a reminder to insist on careful analyses in appraisals. 

It should not affect transactions with options to purchase at fair market value determined when the option is exercised. It may affect the choice of venue when litigating tax cases in tax equity transactions.