Terminal Valuation: Will the Seventh Circuit Decision on Valuation of United Airlines Bond Collateral Bring Closure to Recharacterization Litigation?

Terminal Valuation: Will the Seventh Circuit Decision on Valuation of United Airlines Bond Collateral Bring Closure to Recharacterization Litigation?

The Seventh Circuit's decision to reverse a ruling on valuation made by the Northern District of Illinois District Court regarding collateral for United Airlines bonds is an interesting one in its own right, for its approach to valuing collateral in bankruptcy. It is also an important development in nearly a decade of municipal conduit finance recharacterization litigation in the United Airlines, Delta, and Northwest bankruptcy cases.
In its recent United Airlines decision, the Seventh Circuit held that the District Court had undervalued the collateral for bonds issued by the Los Angeles airport authority to finance improvements at facilities leased by United Airlines in Los Angeles International Airport (LAX) terminals. The Seventh Circuit increased the collateral value for the $60 million in bond claims from $35 million to over $60 million, dramatically increasing the recovery on the bonds. The Seventh Circuit found that the District Court had improperly tied its valuation methodology to the value of unimproved airport terminal space under constrained market conditions, rather than improved space like that comprising the bond collateral on an open market. In addition, the Seventh Circuit criticized the District Court's selection of a discount rate for the collateral value—the District Court had averaged the discount rates proposed by United Airlines and the representatives for the bonds, rather than choosing the legally correct discount rate.

Background Financing

The United Airlines litigation is grounded in the structure of the bond financing at issue. The bonds were issued not by United Airlines, as would be the case for ordinary corporate bonds, but rather by the Regional Airports Improvement Corporation (RAIC), a governmental entity created for the purpose of issuing such bonds and using the proceeds to finance airport improvements. However, United Airlines was the sole source of payment on the bonds, through payments made by United Airlines to RAIC under a lease for the LAX terminals, between United Airlines as lessee and the City of Los Angeles as lessor (who assigned its right to payment as lessor to RAIC). The reason for this "conduit finance" structure was to qualify the interest on the bonds for tax exemption as municipal bond interest.

Recharacterization Litigation

When United Airlines (and other airlines) filed bankruptcy cases, they challenged the status of the terminal leases providing the revenue stream for the bonds. The airlines argued that the leases were not "true leases" for the terminal space, subject to assumption or rejection in bankruptcy, but rather components of a financing transaction for terminal improvements. As a corollary, the airlines took the position that the terminal improvements were owned by the airlines, rather than owned by the airport authorities and leased to the airlines. The airlines argued—successfully in the case of United Airlines at LAX—that the bond claims were not lease claims but rather should be "recharacterized" as loan claims. If the United Airlines bond claims were loan claims, RAIC would not own the lease improvements but would, at best, be able to argue that the loan claims should be secured loan claims and that the court should impose a retroactive lien to make the lease improvements collateral for the bond claims. [footnote omitted]
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