Big Bear Power is a public utility with a strong financial position for the past several years. As a result of having a positive cash flow, Big Bear is in compliance with all of its debt covenants. Big Bear has entered a 10 year noncancelable lease with Goliath Company for a combustion turbine. The lease is signed on
December 15, 2010 and the right to use the turbine begins on January 1, 2011.
Relevant Issues and Case Facts
The case focuses on whether certain costs and provisions associated with the lease would be included in “minimum lease payments” under ASC 840 under leases. There are three specific provisions under question: legal fees paid in negotiating the lease contract, a possible penalty paid by Big Bear to Goliath in the event that Big Bear a “material adverse change” that leads to a default on its debt covenants, and increasing level rents equal to the increase in consumer price index.
In negotiating the lease, Big Bear has paid $500,000 to it outside legal counsel.
Big Bear is also required to pay $1 million in legal fees incurred by Goliath.
A provision in the lease states that Big Bear must pay a penalty to Goliath if Big
Bear’s bank declares a default under its primary credit arrangement. The provision is dependent upon whether or not there is a “material adverse change” in Big Bear’s financial condition. Big Bear believes that the likelihood of default is remote. Goliath and Big Bear’s bank have no relationship.
The lease arrangement stipulates that Big Bear make lease payments of $1
million per year, increased (but not decreased) by the same rate as the consumer price index. These increasing level rents are payable ratably over 12 months, at the beginning of each month. At the inception of the lease, the CPI was four percent. Issues to Resolve
The issue to resolve is whether the costs associated with each provision should be included in “minimum lease payments” as defined in ASC 840 under Leases.
Provision 1: Big Bear’s payment of $500,000 to its own legal counsel would not be included in a minimum lease payment. ASC 84010256(e) states that Fees that are paid by the lessee to the owners of the specialpurpose entity for structuring the lease transaction. Such fees shall be included as part of minimum lease payments. The $500,000 paid to its own legal counsel is not an obligatory payment made directly for the lease of the turbine by Big Bear. However, the $1 million in legal fees incurred by Goliath and paid by Big Bear would be included under minimum lease payments under ASC 84010255:
For a lessee, minimum lease payments comprise the payments that the lessee is obligated to make or can be required to make in connection with the leased property, excluding both of the following:
a. Contingent rentals
b. Any guarantee by the lessee of the lessor's debt and the lessee's obligation to pay (apart from the rental payments) executory costs…in connection with the leased property.
ASC 84010256(e) as stated above is also a supporting authority as to including
Goliath’s legal fees in the minimum lease payments.
Provision 2: In order to determine whether a default payment penalty would fall under a minimum lease payment we can look at ASC 840102514. The ASC states that:
Default covenants related to nonperformance do not affect lease classification if
all of the following conditions exist:
a. The default covenant provision is customary in financing arrangement
b. The occurrence of the event of default is objectively determinable (for example, subjective acceleration clauses would not satisfy this condition).
c. Predefined criteria, related solely to the lessee…