Equipment Trust Certificate: What it is, How it Works

What Is an Equipment Trust Certificate?

An equipment trust certificate (ETC) refers to a debt instrument that allows a company to take possession of and enjoy the use of an asset while paying for it over time. The debt issue is secured by the equipment or physical asset. During this time, the title for the equipment is held in trust for the holders of the issue.

ETCs were originally put in place to finance the purchase of railway cars, but are now used in the sale and purchase of aircraft and shipping containers.

Understanding Equipment Trust Certificates

Equipment trust certificates are medium- to long-term debt instruments that allow a company to use an asset while they pay for it over time. A trust is set up which creates the certificate. Investors can then purchase and hold these certificates. The capital raised from investors allows the trust to purchase the asset, which is then leased to a company. The trust receives payments from the lessee and distributes them among investors or certificate holders. The terms of the agreement are set out at the beginning of the lease relationship including payment dates, interest payments, etc., until such time that the debt is paid off. In other words, an equipment trust certificate is a lot like a mortgage or car loan in that it is a debt vehicle secured by an asset.

There are two possible outcomes that may arise from an ETC, both of which depend on the borrower's ability to pay. If the borrower maintains payments and pays off the debt, the asset's title is transferred from the holder to the borrower. But, on the other hand, if the borrower defaults, the lender or seller has the right to repossess or foreclose on the asset.

These certificates were originally used to finance railway box-cars and rolling stock, with the box-cars used as collateral. Nowadays, equipment trust certificates are used to finance aircraft purchases and containers used for shipping and offshore businesses.

ETCs are a popular way of financing equipment because of the tax advantages associated with them. Since the borrower doesn't hold title to the asset during the financing period, it isn't considered the owner. This means it won't have to pay taxes on it, at least until the debt is paid off in full.

Enhanced Equipment Trust Certificates

An enhanced equipment trust certificate (EETC) is one form of ETC that is issued and managed through special purpose vehicles known as pass-through trusts. These special purpose vehicles (SPEs) allow borrowers to aggregate multiple equipment purchases into one debt security. While the borrower leases the assets from the trust, the trust issues the debt, acts as a repository for it, while handling debt service and payments to investors who hold the certificate.

Airlines commonly use EETCs very often, raising billions in financing for their aircraft purchases because of their high capital spending requirements. In fact, Northwest Airlines pioneered the use of EETCs for aircraft finance in 1994. In return for greater liquidity and a broader investor base for these financial instruments, airlines enjoy cost savings and greater flexibility by avoiding the need to structure multiple ETCs for individual aircraft purchases. EETCs were further enhanced when tranches—or different slices of debt with different levels of seniority, security, risks, coupons, and credit ratings—were introduced.

EETCS have come under scrutiny from the Securities and Exchange Commission (SEC) and Financial Accounting Standard Board (FASB), which questioned their treatment as separate economic entities for accounting purposes. By using SPEs, borrowers are able to keep their debt obligations as items off their balance sheets, with the result that their financial statements often do not present a complete picture of their borrowings. FASB issued Financial Interpretation Notice (FIN) 46 to outline when companies should consolidate or show off-balance sheet assets and liabilities on their financial statements for these vehicles.

Benefits of ETCs

As mentioned above, there are tax benefits for lessees that use ETCs as a way to attain the assets they need to run their operations. Because they don't own the asset, lessees aren't required to pay any property taxes. That may change, though, once the title is transferred from the trust to the lessee.

ETCs also provide some form of protection to the trust and investors. If a company goes bankrupt or insolvent, it may default on its financial obligation. But in the case of an ETC, the trust has the right to reclaim the asset. In other words, if an airline company goes belly up and still has payments to make, the trust can take back the planes it leased to the company.