Gains and losses: Court of Federal Claims upholds LILO transaction.

• Author: Beavers, James A.
• Position: Lease-in/lease-out

The Court of Federal Claims held that a lease-in, lease-out (LILO) transaction involving a Dutch power plant undertaken by a New York utility company was a valid business transaction that had economic substance.

Background

In the mid-1990s, the Consolidated Edison Company of New York (Con Ed), a New York electricity and natural gas utility company, was ordered by its state regulator, the New York Public Service Commission (PSC), to restructure its electricity generation operations as part of the deregulation of the electric industry in New York. Under the deregulation order, the PSC and Con Ed agreed that Con Ed would restructure as a holding company composed of unregulated subsidiaries and that it would sell off 50% of its electricity-generating plants in New York. Con Ed could invest up to 5% of its consolidated capital in unregulated subsidiaries, including subsidiaries that made investments in foreign power-generating plants and projects.

Con Ed expected to have losses due to deregulation and the resulting divestiture of assets. It also expected to have short-term losses on some of the new projects it was investing in due to their substantial upfront costs. Therefore, according to Con Ed's former controller, the company began looking for LILO investments to offset some of these losses. A LILO transaction is a leveraged lease arrangement designed to frontload the transaction's financial profits into its early years without changing the overall profit expected.

Con Ed carefully evaluated many prospective investments before entering into a LILO transaction with the Dutch utility company Electriciteitsbedrijf Zuid-Holland, N.V. (EZH), involving the RoCa3 power-generating facility. In that transaction, EZH leased a 47.3% interest in the RoCa3 facility to Con Ed through one of its unregulated subsidiaries for a term of 43.2 years, and Con Ed subleased the interest back to EZH for a term of 20.1 years. Under the terms of the sublease, EZH was responsible for the operation, maintenance, repair, and upkeep of the facility. At the end of the sublease term, EZH could exercise an option to purchase Con Ed's remaining leasehold interest, or Con Ed could exercise an option to either renew the sublease or have EZH return Con Ed's interest in the facility. The parties also entered into a number of financing and other agreements that supported the primary lease/sublease.

For the year 1997, Con Ed reported rental income from the RoCa3 transaction of...