BONDS SECURED BY LEASES 1. Leases as collateral.—A lease is a contract by which one party, known as the lessor, temporarily transfers the possession of property to another party, known as the lessee, in return for a certain charge, known as a rental.
As a rule, leases serve as collateral for bonds only in the purchase of railway equipment, and especially when a closed first mortgage or the after-acquired property clause interferes with making a new direct loan against the equipment to finance its purchase. These obligations are known as car or equipment trust bonds, or car-trust certificates.
The lease may be used as security in three different ways. The first is for a syndicate, usually headed by some prominent banker, to purchase the equipment and lease it to a railway company for a certain amount down and certain deferred rental payments, following the complete payment of which the equip ment is transferred to the railway for one dollar and becomes its own property. The deferred payments are evidenced by equipment notes, which are interest bearing obligations of the railway, usually in de nominations of one thousand dollars each and matur ing in series or instalments upon the dates on which the deferred rental payments fall due.
The syndicate, having now purchased the equip ment and leased it to the railway, assigns the lease to a trustee, usually a trust company, under a trust agreement which pledges the lease as security for the equipment notes. These notes are known as car trust certificates. They are issued and certified thru the trustee much in the same manner as bonds, and the trustee is authorized, in case the rentals and other re quirements of the lease are not maintained by the rail way company, to take back the equipment and sell it for the benefit of the holders of the trust certificates.
A second method of utilizing a lease as security for bonds issued to purchase equipment is for a subsidiary company, whose stock is held by the railway, to sell its equipment bonds. The subsidiary company, hav ing been formed solely for this purpose, buys the equipment, leases it to the railway, and sells its own bonds in order to secure funds to pay for the cars. Its bonds are usually guaranteed by the railway com pany and are secured by the deposit of the lease with a trustee, as security for the bondholders.
A third use of the lease as security is found only in the case of long-term leases, which cover rights-of way and other permanent property, and are not con fined to equipment. If the lessee company earns a substantial profit on such lease over and above the rental charges, the leasehold may become very valu able, and in such case may itself become good security for bonds. A good example of this form is found in the bonds of the Interborough Company of New York City, which are secured mainly by a 999 year lease, covering street, elevated and subway lines in New York. It should be noted in this case that the lessee is the borrower, the bonds being secured by the surplus earnings of the leased property, and not by the equipment or property itself.
2. Security of equipment trust ment trust bonds such as the car-trust certificates above mentioned, are very secure and enjoy an in creasingly broad market. This is because the equip ment covered by the lease is practically indispensable to the railway, and can be taken from it instantly in the event of default.
Unlike many other forms of property, railway properties are of such a specialized nature that their value ceases almost entirely when the road ceases to operate. A station or a mile of track may be worth fifty thousand dollars to the railroad as an operating concern, but may not be worth five thousand dollars to any one else for another purpose. Railways, there fore, must continue to operate regardless of their financial condition, and of course this requires equip ment, without which operation would be impossible. Since the leased equipment is not the property of the railway, a receiver of the road cannot control it, ex cept under the terms of the lease. Car-trust certifi cates and the interest thereon, therefore, will be paid, even before receivers' certificates, in order that the equipment of the road may be retained in use pending reorganization. If not paid, the trustees may imme diately withdraw the equipment under the lease and sell it to other roads. Defaults upon equipment trust bonds are practically unknown.