Court Blocks SILO Termination Payment

WASHINGTON - A federal court in Indiana has blocked a company from obtaining a $120 million termination payment from the Hoosier Energy Rural Electric Cooperative Inc. in connection with a 2002 sell-in/lease-out, or SILO, transaction, which technically defaulted after the rating of guarantor Ambac Assurance Corp. was downgraded in June.

Bond lawyers are closely watching the case to see if the court ultimately finds the contract invalid, which would have implications for derivatives and other contracts in the financial markets.

The outcome of the case also could hold precedent for state and local governments, some of them bond issuers, involved in other SILO and lease-in/lease-out, or LILO, transactions whose guarantors' ratings have been downgraded, throwing the deals into technical default with the risk that investors could force the governments to make huge termination payments.

The U.S. Court of Appeals for the Seventh Circuit in Chicago is scheduled to hear oral arguments in the case on Jan. 5.

In the $300 million leveraged lease deal between Hoosier and Boston-based John Hancock Life Insurance Co. and other investors, the company bought a power station from the cooperative and leased it back to them for a 30-year term. The lease's guarantor was Ambac, which was downgraded in June to Aa3 by Moody's Investors Service, putting the guarantor below the lease contract's stipulated credit rating.

Ambac's downgrade triggered a technical default in the lease deal, similar to the situation facing transit agencies in major metropolitan areas that were recently hit with the defaults from downgraded insurers, resulting in potentially billions of dollars of payments to investors and sending at least one transit agency to court.

That agency, the Washington Metropolitan Area Transit Authority, settled a lawsuit with KBC Bank NV of Belgium for an undisclosed amount after the guarantor, American International Group Inc., lost its rating and the bank sought a $43 million termination payment.

Under SILOs and LILOs, private investors from the 1980s through part of his decade were able to take advantage of tax deductions for depreciation on equipment and facilities belonging to nonprofit transit, governmental, and utility entities. The private investor would give an up-front payment to a tax-exempt public entity and then lease the equipment or facility back to them.

In the transaction involving Hoosier, John Hancock made an up-front payment of $300 million to the cooperative. Hoosier kept about $21 million and gave the remaining $279 million to Ambac to make lease payments to John Hancock on Hoosier's behalf.

The contract terms also required Hoosier to obtain a credit default swap from Ambac to give John Hancock further assurance that it would receive the lease payments, according to court documents. The parties agreed that if Hoosier defaulted on its obligations, John Hancock could demand a termination payment from Ambac, and Ambac would in turn demand payment from Hoosier.

After Ambac's downgrade, John Hancock demanded payment of $120 million in lost tax benefits.

Hoosier responded asking the Monroe County Circuit Court in Indiana to grant it a restraining order on Oct. 30. The court issued the order and extended it to Nov. 18. The cooperative then filed a motion for a preliminary injunction on Nov. 17, saying it was "defending itself against John Hancock's attempt to obtain an enormous windfall" and that the company was "improperly taking advantage of the 'once in a century credit tsunami' that is paralyzing the nation."

But John Hancock, OP Merom Generation I LLC, and Merom Generation I LLC , which are collectively called John Hancock in the case, opposed the motion. In its response, John Hancock said Hoosier was skirting its obligation to the contractual commitment, asking to "renegotiate retroactively a $300 million transaction that was prepared at Hoosier's behest."

The investors got the case moved to federal court. David F. Hamilton, chief judge of the U.S. District Court in the Southern District of Indiana granted the temporary injunction against them on Nov. 25, preventing John Hancock from demanding payment or asserting that a default had occurred.

In his decision, Hamilton wrote: "This case provides a case study of some of the worst aspects of modern finance ... Hoosier Energy has shown a reasonable likelihood of success on the merits on two independent theories for relief: the essential illegality of the [SILO] transaction, and temporary commercial impracticability."

Hamilton called the deal "a sham, without economic substance" and "rotten to the core." He said assuming Hoosier prevails on the theory of illegality, the transaction will likely be unwound, possibly forcing Hoosier to give up the $21 million it received from Hancock at the front end of the transaction.

A spokesman for John Hancock declined to comment.

Reed Oslan, attorney for Hoosier, which has issued tax-exempt bonds in the past and plans to in the future, said the nonprofit would be pushed to its financial brink unless the injunction stands.

"Any uniform support for the position that Hancock has taken would cause many hundreds of millions of dollars, if not more, of windfall to entities that were attempting to purchase tax deductions like Hancock did," Oslan said, adding that an unwinding of the deal is one option the cooperative is seeking.

The IRS designated LILOs as "listed transactions" or abusive tax shelters in 2000, and added SILOs in 2005, after the Hancock-Hoosier transaction.

The government has since pursued lawsuits challenging the deals, claiming their only purpose was to provide tax benefits to private parties.

In August, the IRS offered to settle with corporate taxpayers and other investors who participated in the LILO and SILO transactions, requiring them to relinquish 80% of the tax savings they realized under leaseback transactions.

The IRS had not yet challenged the Hancock-Hoosier SILO deal or the associated tax deductions, according to court documents.

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