E Pluribus Unum or Ex Uno Plures? Attempted ABS Master Lease Rejection in the Hertz Bankruptcy
Since filing for Chapter 11 in May 2020, Hertz and its major stakeholders have been in negotiations and, at times, disputes over how best to reduce Hertz’s nearly half-a-million vehicle fleet. These negotiations and disputes have caught the eye of investors in asset-backed securities (“ABS”) and market watchers alike, as the outcome of the case could have rippling effects across the ABS industry and capital markets, generally.
Like many other car-rental companies, Hertz’s operations are financed, in large part, through ABS facilities, in which a non-debtor special-purpose financing subsidiary and lessor (here, Hertz Vehicle Financing LLC or “HVF”) purchases vehicles using proceeds from notes issued by an affiliated entity (here, Hertz Vehicle Financing II LP) and leases the purchased vehicles to certain debtor operating subsidiaries, pursuant to the terms of a master lease agreement (the “Master Lease Agreement”), with the leased vehicles serving as collateral to secure the lease payments owed from the debtors to the lessor. These complex ABS financing structures typically allow businesses to raise capital at much lower rates than if they had issued corporate debt. Indeed, Hertz’s Master Lease Agreement supports a complex financing structure that allowed Hertz to raise $11 billion at a lower cost than it could have through traditional secured financing. These ABS arrangements include a master lease structure for a variety of reasons, but one is that lenders and bondholders to the special-purpose entity want to argue that, if the lessee becomes a chapter 11 debtor, it must choose to assume or reject the entire master lease tied to the debt—if the debtor assumes the master lease, it has to continue making payments on all of the vehicles; if the debtor rejects the master lease, the bondholders would have all rights and remedies under the transaction documents, including potentially recourse to foreclose upon and sell the entire fleet. If upheld in bankruptcy, the ABS master lease structure would provide significant leverage to lenders and bondholders because, assuming that the debtor intends to remain in business, the debtor would need to retain at least some vehicles and, so, presumably would not seek to reject the master lease in its entirety.
On June 11, 2020, the Hertz debtors filed a motion1 seeking to reject the Master Lease Agreement with respect to only a portion of the leased vehicles (approximately 30%), asserting that the individual agreements relating to the roughly 494,000 vehicles were not part of an integrated master lease but were instead distinct contracts that could be individually assumed or rejected under section 365 of the US Bankruptcy Code. The ABS noteholders objected,2 arguing that the Master Lease Agreement had to be assumed or rejected as a single, integrated contract and could not be severed on an individual vehicle-by-vehicle basis, as the debtors sought to do. As noted by both parties’ motions, determining whether a debtor may assume or reject a single, integrated contract under section 365 of the Bankruptcy Code and relevant state law (here, New York) “depends on the contracting parties’ intent, as evidenced by the language of the contract itself viewed in light of the circumstances at the time of contract formation . . . [including] whether the pieces of a contract sought to be severed are ‘economically interrelated.’”3 The ABS noteholders claimed that the intent here was clearly to treat the Master Lease Agreement as one integrated agreement, not as 494,000 individual leases; the Hertz debtors argued the opposite.
On July 24, the Bankruptcy Court approved a stipulation between the parties, which postponed any litigation on this aspect of the Master Lease Agreement through the end of 2020.4 Specifically, the parties agreed to adjourn the debtors’ motion seeking to reject the Master Lease Agreement with respect to individual vehicles until at least January 15, 2021. In the interim period, the parties agreed that the debtors would pay $650 million in cash to the ABS noteholders for base-rent payments due under the Master Lease Agreement, resulting in a roughly 50% discount for the six months of base-rent payments at issue.
Regardless of whether the dispute in Hertz becomes live again, it remains to be seen if and how the ABS market will respond to Hertz’s attempted rejection approach. The Structured Finance Association (the “SFA”), for example, a leading securitization industry group, has opined that any ruling in favor of the debtors would not only impact the ABS noteholders in Hertz, but the securitization industry and capital markets, more broadly—namely, it could affect (a) the risk profile of all current rental-car ABS transactions, which include billions of dollars in currently outstanding debt (predominantly in the bank market); (b) credit ratings assigned to rental-car ABS transactions; (c) investor appetite for future similar transactions in both the rental-car and other leased-asset industries, such as farm equipment and construction machinery, among others; and (d) capital-funding costs for borrowers and, ultimately, end-consumers. Indeed, according to the SFA’s June 26, 2020 proposed amicus brief,5 allowing rejection of vehicle leases in “piece-meal” fashion will only make the underlying ABS bonds riskier by upending the long-standing assumption underlying the leased-asset ABS market—specifically, that the leases tied to all of the vehicles securing the bonds would be assumed or rejected in toto in the event of bankruptcy. In other words, because ABS master lease structures and the risk profiles thereof are each dependent upon the inclusion of all vehicles in the fleet as collateral to secure the lease payments owed under the respective master lease agreement, permitting debtors to selectively reject certain leases will, in effect, leave bondholders with a different collateral package than bargained for at the time of purchase—thereby running afoul of the “contractual parties’ intent.” Whether the litigation will become live again, and its ultimate impact on comparable ABS-financing arrangements, will remain of keen interest to bankruptcy practitioners and market observers alike.
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1 See Master Lease Rejection Motion [ECF No. 390].
2 See ABS Noteholders Objection [ECF No. 567].
3 Master Lease Rejection Motion, ¶¶ 28-33.
4 See Order Temporarily Resolving Certain Matters Related to the Master Lease Agreement [ECF No. 802].
