June 2010
On June 22, 2010, the US Court of Appeals for the Second Circuit issued a significant opinion resolving conflicting case law and establishing the allowability in bankruptcy of tax indemnity claims arising out of leveraged lease transactions. In its 2005 chapter 11 case, Delta Air Lines, Inc ("Delta") objected to tax indemnity claims for approximately US$85 million held by Arnold & Porter's client ("Insurer"). These claims arose from Delta's rejection of Insurer's three leveraged aircraft leases during the chapter 11 case. Delta also objected to approximately US$1 billion of similar tax indemnity claims, but designated its objection to Insurer's claim as one of a handful of "test cases" that it chose to litigate rather than settle. The Southern District of New York bankruptcy court sustained Delta's objections, and the District Court affirmed, essentially adopting the bankruptcy court's opinion. Rejecting the lower courts' contract interpretation and legal analysis, the Second Circuit vacated the ruling and remanded the matter to the bankruptcy court with instructions to overrule Delta's objections.
The allowability of tax indemnity claims relating to aircraft leveraged leases has been hotly contested since 2003, when United Airlines objected to US$5 billion of similar claims during its chapter 11 case. Delta followed the UAL template for such objections, as did Northwest Airlines in its own chapter 11 case, in which such claims are still pending. Because the leveraged lease documentation for all three airlines' fleets was relatively standardized -- and similar in form and structure to real estate and equipment leveraged leases for the entire leveraged leasing industry -- the objections and the legal issues were essentially identical. The Second Circuit's ruling is framed broadly enough to validate potential tax indemnity claims in all standard leveraged lease transactions.
The basic structure of all of these aircraft leveraged leases follows a standard form. Because Delta, like most airlines, chronically operated at a loss and could not make full use of tax accelerated depreciation deductions for its aircraft fleets, it often chose to acquire aircraft through a leveraged lease transaction in which ownership of the aircraft was held by an owner trust, owned by a profitable "owner participant" company like Insurer that could make use of the accelerated depreciation deductions. The tax benefits were such an important part of leveraged lease transactions that, as part of the overall deal, the owner trusts entered into separate tax indemnity agreements with the airline/lessee to compensate for the potential loss of the tax benefits if the airline defaulted. Paying 20% in equity, the owner trust financed 80% of the purchase price through the issuance of bonds, assigning the lease with the airline to the bond indenture trustee as security for the debt.
The market for used aircraft was so terrible during the early 2000s, when the UAL, Delta, and Northwest Airlines bankruptcy cases were filed, that Delta allowed its surplus aircraft, including two of Insurer's aircraft, to be foreclosed and sold for a loss by the indenture trustees, and rejected many other leases, including our client's third lease, in favor of new lease deals negotiated directly with the indenture trustees that were implemented by foreclosing out the owner trust's interest. When the lease rejections occurred, Insurer and other owner participants filed proofs of claim asserting indemnification rights under the tax indemnity agreement, while the indenture trustees filed claims asserting stipulated loss value ("SLV")-based damages under the terms of the leases.
The objections filed by Delta and the other airline debtors asserted that the tax indemnity claims and the lease claims "overlapped," and that either the tax indemnity claims should be disallowed as duplicative, or the lease claims should be reduced by a corresponding amount as provided in the lease documents. Delta's theory was that the allowance in bankruptcy of lease damages claims based upon calculations by reference to the SLV schedule constituted "payment" of SLV within the meaning of the contracts, even though the lease claims were not being paid in full, but rather by the distribution of Delta stock amounting to payment of pennies on the dollar. Delta argued that the SLV amount was therefore "paid," thereby triggering an exclusion clause that eliminated Delta's liability under the tax indemnification agreements.
The Delta bankruptcy court and district court agreed with Delta's interpretation of the word "pay" and sustained Delta's objection to our client's tax indemnity claims. The bankruptcy court simultaneously overruled Delta's objections seeking reduction of the lease claims of the indenture trustees by the amount that would have corresponded to the tax indemnity claims. The Second Circuit sharply criticized the bankruptcy court's interpretation of the word "payment" as a "strained and improbable reading, which inevitably defeated the intentions of the contracting parties." As the panel observed, "By ruling that partial payment of the Lease claims, in however small an amount, satisfied the exclusion, the bankruptcy court effectively nullified the [tax indemnity agreements] by stripping them of their ability to protect the Owner Participant in the event of Delta's default." Delta failed, however, to preserve its cross-appeal of the order overruling its objection to the lease claims. As the Second Circuit noted in its opinion, to the extent that Delta now faces any "duplicative" payments, it is because of the deals Delta struck with the indenture trustees that effectively gave them the aggregate amounts that were properly due to Insurer and other owner participants under the tax indemnity agreements.
Now that the Second Circuit has established Delta's liability to compensate our client for the tax consequences of Delta's rejection of its three aircraft leases, the amount of the claims must be determined on remand. Once the amount is fixed, Insurer will be entitled to receive its pro rata distributions of Delta stock from a reserve established under Delta's plan of reorganization.
This representation was led by bankruptcy partner Lisa Hill Fenning in the firm's Los Angeles office.
Arnold & Porter has a well-recognized national bankruptcy and corporate restructuring practice that represents a diverse client base, and offers both a national presence and regional accessibility with attorneys in its Washington, DC, New York, Northern Virginia, Los Angeles, and Denver offices. The firm has been involved in other prominent bankruptcy matters, including the highly-publicized Quebecor World (USA) Inc. and Chrysler Dealers cases. The firm advised Quebecor and its 52 affiliated debtors in reorganization and financial restructuring in what was one of the largest Chapter 11 cases filed in the United States. The firm represented the Chrysler National Dealer Council, the entity that represents the collective interests of the more than 3,000 Chrysler dealers throughout the United States, in the Chrysler Chapter 11 case.