AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
ANNUAL REPORT TO THE PARTNERS, DECEMBER 31, 1998
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
INDEX TO ANNUAL REPORT TO THE PARTNERS
PAGE
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SELECTED FINANCIAL DATA................................................................................... 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS..................... 3-10
FINANCIAL STATEMENTS:
Report of Independent Auditors............................................................................ 11
Statement of Financial Position at December 31, 1998 and 1997............................................. 12
Statement of Operations for the years ended December 31, 1998, 1997 and 1996.............................. 13
Statement of Changes in Partners' Capital for the years ended December 31, 1998, 1997 and 1996............ 14
Statement of Cash Flows for the years ended December 31, 1998, 1997 and 1996.............................. 15
Notes to the Financial Statements......................................................................... 16-28
ADDITIONAL FINANCIAL INFORMATION:
Schedule of Excess (Deficiency) of Total Cash Generated to Cost of Equipment Disposed..................... 29
Statement of Cash and Distributable Cash From Operations, Sales and Refinancings.......................... 30
Schedule of Costs Reimbursed to the General Partner and its Affiliates as Required Section 10.4 of the
Amended and Restated Agreement and Certificate of Limited Partnership................................... 31
SELECTED FINANCIAL DATA
The following data should be read in conjunction with Management's
Discussion and Analysis of Financial Condition and Results of Operations and the
financial statements.
For each of the years in the five year period ended December 31, 1998:
SUMMARY OF OPERATIONS 1998 1997 1996 1995 1994
- ------------------------- ------------- ------------- ------------- -------------------------- -------------
Lease revenue............ $ 3,130,704 $ 3,224,618 $ 4,706,774 $ 6,585,836 $ 9,001,993
Net loss................. $ (1,208,085) $ (1,762,752) $ (3,649,940) $ (5,286,053) $ (1,474,819)
Per Unit:
Net loss............... $ (0.42) $ (0.62) $ (1.28) $ (1.85) $ (0.52)
Cash distributions
declared............. $ -- $ -- $ 2.25 $ 1.75 $ 2.50
FINANCIAL POSITION
- -------------------------
Total assets............. $ 8,076,569 $ 9,765,106 $ 13,163,812 $ 21,432,133 $ 31,553,833
Total long-term
obligations............ $ 1,896,665 $ 2,677,520 $ 3,419,785 $ 1,432,396 $ --
Partners' capital........ $ 5,632,042 $ 6,840,127 $ 8,602,879 $ 18,637,361 $ 28,924,079
2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Year ended December 31, 1998 compared to the year
ended December 31, 1997 and the year ended December 31, 1997
compared to the year ended December 31, 1996
Certain statements in this annual report of AIRFUND II International Limited
Partnership (the "Partnership") that are not historical fact constitute
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995 and are subject to a variety of risks and
uncertainties. There are a number of important factors that could cause actual
results to differ materially from those expressed in any forward-looking
statements made herein. These factors include, but are not limited to, the
outcome of the Class Action Lawsuit described in Note 7 to the accompanying
financial statements, the collection of all rents due under the Partnership's
lease agreements and remarketing of the Partnership's equipment.
YEAR 2000 ISSUE
The Year 2000 Issue generally refers to the capacity of computer programming
logic to correctly identify the calendar year. Many companies utilize computer
programs or hardware with date sensitive software or embedded chips that could
interpret dates ending in "00" as the year 1900 rather than the year 2000. In
certain cases, such errors could result in system failures or miscalculations
that disrupt the operations of the affected businesses. The Partnership uses
information systems provided by EFG and has no information systems of its own.
EFG has adopted a plan to address the Year 2000 Issue that consists of four
phases: assessment, remediation, testing, and implementation and has elected to
utilize principally internal resources to perform all phases. EFG completed
substantially all of its Year 2000 project by December 31, 1998 at an aggregate
cost of less than $50,000 and at a di minimus cost to the Partnership. Remaining
items are expected to be minor and be completed by March 31, 1999. All costs
incurred in connection with EFG's Year 2000 project have been expensed as
incurred.
EFG's primary information software was coded by IBM at the point of original
design to use a four digit field to identify calendar year. All of the
Partnership's lease billings, cash receipts and equipment remarketing processes
are performed using this proprietary software. In addition, EFG has gathered
information about the Year 2000 readiness of significant vendors and third party
servicers and continues to monitor developments in this area. All of EFG's
peripheral computer technologies, such as its network operating system and
third-party software applications, including payroll, depreciation processing,
and electronic banking, have been evaluated for potential programming changes
and have required only minor modifications to function properly with respect to
dates in the year 2000 and thereafter. EFG understands that each of its and the
Partnership's significant vendors and third-party servicers are in the process,
or have completed the process, of making their systems Year 2000 compliant.
Substantially all parties queried have indicated that their systems would be
Year 2000 compliant by the end of 1998.
Presently, EFG is not aware of any outside customer with a Year 2000 Issue
that would have a material effect on the Partnership's results of operations,
liquidity, or financial position. The Partnership's equipment leases were
structured as triple net leases, meaning that the lessees are responsible for,
among other things, (i) maintaining and servicing all equipment during the lease
term, (ii) ensuring that all equipment functions properly and is returned in
good condition, normal wear and tear excepted, and (iii) insuring the assets
against casualty and other events of loss. Non-compliance with lease terms on
the part of a lessee, including failure to address Year 2000 Issues, could
result in lost revenues and impairment of residual values of the Partnership's
equipment assets under a worst-case scenario.
EFG believes that its Year 2000 compliance plan will be effective in
resolving all material Year 2000 risks in a timely manner and that the Year 2000
Issue will not pose significant operational problems with
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respect to its computer systems or result in a system failure or disruption of
its or the Partnership's business operations. However, EFG has no means of
ensuring that all customers, vendors and third-party servicers will conform
ultimately to Year 2000 standards. The effect of this risk to the Partnership is
not determinable.
OVERVIEW
As an equipment leasing partnership, the Partnership was organized to
acquire and lease a portfolio of commercial jet aircraft subject to lease
agreements with third parties. During 1990 and 1991, the Partnership purchased
four commercial jet aircraft and a proportionate interest in two additional
aircraft which were leased by major carriers engaged in passenger
transportation. Initially, each aircraft generated rental revenue pursuant to
primary-term lease agreements. Subsequently, all of the aircraft in the
Partnership's original portfolio have been re-leased, renewed, exchanged for
other aircraft or sold (see below). At December 31, 1998, the Partnership owned
three aircraft and proportionate interests in five additional aircraft. Upon
expiration of the current lease agreements, each aircraft will be re-leased or
sold depending on prevailing market conditions and the assessment of such
conditions by EFG to obtain the most advantageous economic benefit. Presently,
the Partnership is a Nominal Defendant in a Class Action Lawsuit, the outcome of
which could significantly alter the nature of the Partnership's organization and
its future business operations. See Note 7 to the accompanying financial
statements. Pursuant to the Restated Agreement, as amended, the Partnership is
scheduled to be dissolved by December 31, 2005.
RESULTS OF OPERATIONS
For the year ended December 31, 1998, the Partnership recognized lease
revenue of $3,130,704 compared to $3,224,618 and $4,706,774 for the years ended
December 31, 1997 and 1996, respectively. The decrease in the Partnership's
lease revenue from 1997 to 1998 was due primarily to the sale of the
Partnership's interest in a Lockheed L-1011-50 aircraft in April 1998 and a
scheduled reduction in the lease rent payable under the lease agreement related
to the Partnership's Boeing 727-251 Advanced aircraft. Such decrease was
partially offset by an increase in lease revenue recognized related to the
Partnership's Lockheed L-1011-100 aircraft. (See detailed discussion below).
The decrease in lease revenue from 1996 to 1997 was due primarily to the
lease term expiration related to the Partnership's Lockheed L-1011-100 aircraft
which expired in September 1996 and was subsequently re-leased in November 1997
to Classic Airways Limited ("Classic") and the sale of a 727-200 Advanced
aircraft in July 1996 (see discussions below). This decrease was partially
offset by the recognition of a full year's lease revenue related to both the
Partnership's Boeing 727-251 Advanced aircraft which was re-leased to
Transmeridian Airlines, Inc. ("Transmeridian") in September 1996 and its
interest in two McDonnell Douglas MD-82 aircraft which were acquired in March
1996 in connection with a like-kind exchange transaction. As a result of the
exchange, the Partnership replaced its ownership interest in a Boeing 747-SP
aircraft (the "United Aircraft"), having aggregate quarterly lease revenues of
$149,640, with interests in five other aircraft; three Boeing 737 aircraft
leased by Southwest Airlines, Inc. (the "Southwest Aircraft") and two McDonnell
Douglas MD-82 aircraft leased by Finnair OY (the "Finnair Aircraft") having
aggregate quarterly lease revenues of $254,373. The Southwest Aircraft and the
Finnair Aircraft were exchanged into the Partnership in 1995 and in March 1996,
respectively. In aggregate, the Partnership recognized lease revenue related to
the Southwest Aircraft of $377,568, in each of the years ended December 31,
1998, 1997 and 1996. The Partnership recognized lease revenue related to the
Finnair Aircraft of $639,923, $639,752 and $432,973 during the years ended
December 31, 1998, 1997 and 1996, respectively.
The Partnership's Boeing 727-251 Advanced aircraft, formerly on a renewal
rental agreement with Northwest Airlines, Inc. ("Northwest") was returned upon
expiration of its lease term on November 30, 1995. This aircraft underwent heavy
maintenance at a cost of $984,000, all of which was expensed during the year
ended December 31, 1996. During 1996, the Partnership received $468,133 from the
former lessee
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of this aircraft, representing a reimbursement of additional heavy maintenance
costs. In September 1996, the Partnership entered into a new 28-month lease
agreement with Transmeridian. This aircraft generated $876,666 of lease revenue
during the year ended December 31, 1998, compared to $971,500 and $293,333
during the years ended December 31, 1997 and 1996, respectively (see below for
discussion regarding litigation related to this aircraft).
The Partnership owns a Lockheed L-1011-100 aircraft formerly leased to
Cathay Pacific Airways Limited ("Cathay"). The Partnership's renewal lease
agreements with Cathay expired on February 14, 1996 and were extended until
April 11, 1996. Subsequent to this extension, Cathay again extended the lease
until September 30, 1996. Cathay subsequently returned the aircraft to the
Partnership upon the expiration of these lease extensions and the aircraft
underwent heavy maintenance. The heavy maintenance on the Lockheed L-1011-100
cost the Partnership approximately $947,000; approximately $400,000 of which was
expensed during the year ended December 31, 1996 with the balance expensed
during the year ended December 31, 1997. The Partnership entered into an
agreement with Classic Airways Limited ("Classic") to lease the Partnership's
Lockheed L-1011-100 aircraft for a period of three years with a base rent of
$80,000 per month, effective November 1, 1997. In addition, Classic was granted
an option to purchase the aircraft for $2,500,000 and $2,000,000 after two years
and the entire lease term has elapsed, respectively. Due to certain
refurbishments required to be performed by Classic, the Partnership agreed to
defer rents required under the attendant lease agreement for the three month
period ended March 31, 1998. The lease agreement was therefore extended three
months through January 31, 2001. The Partnership recognized lease revenue in the
amount of approximately $320,000 related to this aircraft during the year ended
December 31, 1998 compared to $145,000 and $1,117,463 during the years ended
December 31, 1997 and 1996, respectively (see additional discussion below).
In September 1998, Classic ceased paying rent to the Partnership with
respect to the Lockheed L-1011-100 aircraft. In October 1998, Classic filed for
receivership in the United Kingdom ("UK") and was placed in liquidation. Prior
to its liquidation, Classic had incurred and failed to pay significant airport
ground fees to BAA plc, Eurocontrol, and CAA (collectively, the "Airport
Authorities"). The failure of Classic to pay such charges resulted in detention
of the aircraft by the Airport Authorities. In addition, the Airport Authorities
have continued to charge incremental ground fees and expenses to the aircraft
and have grounded the aircraft pending collection of such amounts, which are
approximately $284,000 in total. Under UK law, the Airport Authorities have the
right not only to detain the aircraft, but to sell the aircraft at auction in
order to satisfy their outstanding fees. Accordingly, it is anticipated that the
Partnership will be required to pay at least a portion of the airport charges in
order to recover the aircraft. The General Partner has engaged counsel to
represent the Partnership's interests in the UK and; presently, counsel is
negotiating with the Airport Authorities to resolve the issue of the unpaid
charges so that the aircraft can be flown to the United States or otherwise
remarketed. The parties have not executed a final settlement agreement; however,
the Airport Authorities have indicated a willingness to reach a compromise.
Based upon recent discussions, the Partnership accrued and expensed
approximately $167,000 to cover the cost of settling the airport charges, all of
which was recorded in the fourth quarter of 1998. At the date of Classic's
liquidation, the Partnership had accrued $160,000 of rental income which had not
been collected from Classic and all of which was written-off as uncollectible in
the third quarter of 1998. The General Partner does not expect that any funds
are likely to be recovered from Classic in connection with this matter.
Subsequent to the expiration of the last of several lease extensions on June
30, 1996, Cathay returned a Lockheed L-1011-50, in which the Partnership had an
ownership interest. Upon its return, the aircraft underwent heavy maintenance at
a cost to the Partnership of approximately $400,000, the majority of which was
expensed in 1996. The Partnership entered into a new 1-year lease agreement with
Aer Lease Limited ("Aer Lease") with respect to its interest in this aircraft,
at a base rent to the Partnership of $39,550 per month, beginning April 27,1997.
On April 28, 1998, at the expiration of this lease term, the Partnership sold
its interest in this aircraft to Aer Lease for net proceeds of $553,699. The
Partnership's interest in the aircraft had a net book value of $426,434 at the
time of disposal, resulting in a net gain for
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financial statement purposes of $127,265. The Partnership recognized aggregate
lease revenue of approximately $154,600, $320,000 and $302,000 related to this
aircraft during the years ended December 31, 1998, 1997 and 1996, respectively.
The demand for Lockheed L-1011 aircraft is weak, limited principally to air
cargo carriers and operators of passenger charters. Several major airlines have
reduced their commitment to the Lockheed L-1011 aircraft. Such circumstances
have inhibited the remarketing of the Partnership's Lockheed L-1011 aircraft and
required the Partnership to incur costs to meet the needs of Aer Lease and
Classic.
The Partnership's Boeing 727-208 Advanced aircraft is under a two-year
renewal agreement with American Trans Air, Inc. ("ATA"), scheduled to expire in
January 1999 (see discussion below). The Partnership recognized lease revenue of
$762,000 related to this aircraft during the year ended December 31, 1998
compared to $770,467 and $762,000 during the years ended December 31, 1997 and
1996, respectively.
During July 1996, the Partnership sold a Boeing 727-200 Advanced aircraft
with an original cost and net book value of $11,164,679 and $3,074,680,
respectively, to the existing lessee. In connection with this sale, the
Partnership realized sale proceeds of $3,535,649, which resulted in a net gain,
for financial statement purposes, of $460,969. In addition to the sales
proceeds, the Partnership received lease termination rents of $429,351 in
connection with this sale as the aircraft was sold prior to the expiration of
the related lease term. In aggregate, this aircraft generated lease revenue of
$1,421,629, during the year ended December 31, 1996. In the future, the
Partnership's aggregate lease, revenue is expected to decline due to Classic
situation, aircraft sales and the expiration of the lease terms related to the
Partnership's remaining aircraft.
The Partnership holds a proportionate ownership interest in the Southwest
Aircraft and the Finnair Aircraft, discussed above. The remaining interests are
owned by other affiliated partnerships sponsored by EFG. All partnerships
individually report, in proportion to their respective ownership interests,
their respective shares of assets, liabilities, revenues and expenses associated
with the aircraft (see Notes 2 and 3 to the financial statements).
Interest income for the year ended December 31, 1998 was $158,844 compared
to $110,635 and $265,820 for the years ended December 31, 1997 and 1996,
respectively. Generally, interest income is generated from temporary investments
of rental receipts and equipment sale proceeds in short-term instruments.
Interest income in 1996 included $39,346 earned on cash held in a
special-purpose escrow account in connection with the like-kind exchange
transactions and also reflected a temporary increase in the Partnership's cash
available for investment resulting from the receipt of sale proceeds associated
with the Boeing 727-200 Advanced aircraft.
Depreciation was $2,451,737, $3,377,350 and $3,650,745 for the years ended
December 31, 1998, 1997 and 1996, respectively. The Partnership also recorded a
write-down of aircraft carrying values, representing impairments related to the
Partnership's L-1011 aircraft, during the year ended December 31, 1996. The
resulting charge of $2,832,800 ($0.99 per limited partnership unit) was based on
a comparison of estimated net realizable value and corresponding carrying value
of the Partnership's aircraft.
Net realizable values were estimated based on (i) third-party appraisals of
the Partnership's aircraft and (ii) EFG's assessment of prevailing market
conditions for similar aircraft. Market values for certain of the Partnership's
commercial jet aircraft have continued to deteriorate. Consistent price
competition and other pressures within the airline industry have inhibited
sustained profitability for many carriers. Most major airlines have had to
re-evaluate their aircraft fleets and operating strategies. Aircraft condition,
age, passenger capacity, distance capability, fuel efficiency, and other factors
influence market demand and market values for passenger jet aircraft.
Notwithstanding the foregoing, the ultimate realization of residual value
for any aircraft will be dependent upon many factors, including EFG's ability to
sell and re-lease the aircraft. Changes in market
6
conditions, industry trends, technological advances, and other events could
converge to enhance or detract from asset values at any given time. Accordingly,
EFG will attempt to monitor changes in the airline industry in order to identify
opportunities which may be advantageous to the Partnership and which will
maximize total cash returns for each aircraft.
The total economic value realized upon final disposition of each aircraft is
comprised of all primary lease term revenue generated from that aircraft,
together with its residual value. The latter consists of cash proceeds realized
upon the aircraft's sale in addition to all other cash receipts obtained from
renting the aircraft on a re-lease, renewal or month-to-month basis.
Consequently, the amount of gain or loss reported in the financial statements is
not necessarily indicative of the total residual value the Partnership achieved
from leasing the aircraft
Interest expense was $200,679 or 6.4% in 1998, $268,916 or 8.3% of lease
revenue in 1997 and $264,200 or 5.6% of lease revenue in 1996. Interest expense
resulted from financing obtained from third-party lenders in connection with the
Southwest Aircraft and the Finnair Aircraft, described above, which were
financed in December 1995 and March 1996, respectively. Interest expense in
future years will decline as the principal balance of notes payable is reduced
through the application of rent receipts to outstanding debt.
Management fees were 5% of lease revenue during 1998, 1997 and 1996 and will
not change as a percentage of lease revenue in future periods.
Operating expenses were $1,815,947, $1,290,508 and $2,100,419 for the years
ended December 31, 1998, 1997 and 1996, respectively. During the year ended
December 31, 1998, the Partnership incurred or accrued approximately $331,800
for certain legal and administrative expenses related to the Class Action
Lawsuit described in Note 7 to the accompanying financial statements.
Additionally, the increase in operating expenses from 1997 to 1998 was primarily
due to legal costs incurred in connection with the legal proceedings related to
Northwest and Classic and legal and other costs related to Transmeridian (refer
to Note 7 to the financial statements). Operating costs in 1996 and 1997
included significant heavy maintenance expenses incurred to facilitate the
remarketing of certain of the Partnership's aircraft, discussed above. In
addition, in 1996 and 1997 the Partnership incurred legal costs associated with
Transmeridian Airlines legal proceedings (see Note 7 to the financial
statements). Other operating expenses consist principally of administrative
charges, professional service costs, such as audit and other legal fees, as well
as insurance, printing, distribution and other remarketing expenses.
LIQUIDITY AND CAPITAL RESOURCES AND DISCUSSION OF CASH FLOWS
The Partnership by its nature is a limited life entity. As an equipment
leasing program, the Partnership's principal operating activities derive from
aircraft rental transactions. Accordingly, the Partnership's principal source of
cash from operations is generally provided by the collection of periodic rents.
These cash inflows are used to satisfy debt service obligations associated with
leveraged leases, and to pay management fees and operating costs. Operating
activities generated net cash inflows of $1,550,424, $496,997 and $3,205,567 in
1998, 1997 and 1996, respectively. The expiration of the Partnership's lease
agreements, and aircraft sales described above, have caused an overall decline
in the Partnership's lease revenue and corresponding sources of operating cash.
This overall decline has been partially offset by rents generated in connection
with the Southwest and Finnair Aircraft and re-lease of the aircraft to
Transmeridian and Aer Lease (see Results of Operations). In addition, the
Partnership has expended substantial funds in 1998 related to the Partnership's
legal proceedings (see Note 7 to the financial statements) and in connection
with its remarketing efforts related to its Lockheed L-1011 and Boeing 727-251
Advanced aircraft during 1997 and 1996. Overall, expenses associated with rental
activities, such as management fees, and net cash flow from operating activities
will decline as the Partnership remarkets its aircraft. Ultimately, the
Partnership will dispose of all aircraft under lease. This will occur
principally through sale transactions
7
whereby each aircraft will be sold to the existing lessee or to a third party.
Generally, this will occur upon expiration of each aircraft's primary or
renewal/re-lease term.
Cash expended for aircraft acquisitions and cash realized form aircraft
disposal transactions are reported under investing activities on the
accompanying Statement of Cash Flows. During the year ended December 31, 1998,
the Partnership sold its interest in a Lockheed L-1011-50 aircraft and realized
net cash proceeds of $553,699. During year ended December 31, 1996, the
Partnership realized $3,535,649 in proceeds from the sale of the Boeing 727-200
Advanced aircraft. In 1996, the Partnership completed the replacement of the
United Aircraft with a 14.85% ownership interest in two Finnair Aircraft at a
total cost to the Partnership of $4,157,280. To acquire the ownership interest
in the Finnair Aircraft, the Partnership paid $1,389,942 in cash and obtained
financing of $2,767,338 from a third-party lender. The Partnership utilized
$1,317,392 (classified as Contractual Right for Equipment at December 31, 1995)
which had been deposited into a special-purpose escrow account through a
third-party exchange agent pending the completion of the aircraft exchange. The
balance of $72,550 was expended from the Partnership's cash reserves. The
remaining ownership interest of 85.15% in the Finnair Aircraft is held by
affiliated equipment leasing programs sponsored by EFG. The like-kind exchange,
involving the United, Southwest and Finnair Aircraft, was undertaken, in part,
to mitigate the Partnership's economic risk resulting from the United Aircraft
being returned to the Partnership upon its lease expiration in April 1996 and
remaining off-lease for an extended period. The exchange enabled the Partnership
to replace a specialized aircraft with other aircraft, which are used more
widely in the industry, and also to significantly extend its rental stream with
two creditworthy lessees. There were no equipment acquisitions during 1997 or
1998 and no equipment sales during 1997. Future inflows of cash from aircraft
disposals will vary in timing and amount and will be influenced by many factors
including, but not limited to, the frequency and timing of lease expirations,
the condition and age of the aircraft, and future market conditions.
At December 31, 1998, the Partnership was due aggregate future minimum lease
payments of $1,444,692 from contractual lease agreements (see Note 2 to the
financial statements), a portion of which will be used to amortize the principal
balance of notes payable of $1,896,665 (see Note 5 to the financial statements).
At the expiration of the individual lease terms underlying the Partnership's
future minimum lease payments, the Partnership will sell the aircraft or enter
re-lease or renewal agreements when considered advantageous by the General
Partner and EFG. Such future remarketing activities will result in the
realization of additional cash inflows in the form of aircraft sale proceeds or
rents from renewals and re-leases, the timing and extent of which cannot be
predicted with certainty. This is because the timing and extent of remarketing
events often is dependent upon the needs and interests of the existing lessees.
Some lessees may choose to renew their lease contracts, while others may elect
to return the aircraft. In the latter instances, the aircraft could be re-leased
to another lessee or sold to a third party. Accordingly, as the terms of the
currently existing contractual lease agreements expire, the cash flows of the
Partnership will become less predictable. In addition, the Partnership will need
cash outflows to satisfy interest on indebtedness and to pay management fees and
operating expenses.
ATA has given the Partnership an irrevocable notice of its intention to
purchase the Partnership's Boeing 727-208 Advanced aircraft for $3.1 million in
April 1999, pursuant to a purchase option contained in the lease agreement.
Following the expiration of the current lease agreement in January 1999, ATA
will continue to lease the aircraft on a month-to-month basis at the existing
base rent until the date of sale. This aircraft was fully depreciated at
December 31, 1998. The Partnership's ability to remarket its Boeing 727-251 ADV
aircraft is being impeded due to Transmeridian's failure and refusal to repair
the substantial damage caused to the airframe of this aircraft as the result of
an on-ground accident at the airport in Caracas, Venezuela in October 1998. See
Note 7 to the accompanying financial statements for details regarding legal
action undertaken by the Partnership related to this situation.
As described in Results of Operations, the Partnership obtained long-term
financing in connection with the like-kind exchange transactions involving the
Southwest Aircraft and the Finnair Aircraft. The corresponding note agreements
are recourse only to the specific equipment financed and to the minimum
8
rental payments contracted to be received during the debt amortization period.
As rental payments are collected, a portion or all of the rental payment will be
used to repay principal and interest. The Partnership also has a balloon payment
obligation at the expiration of the primary lease term related to the Finnair
Aircraft of $1,411,035 (see Note 5 to the financial statements, included
herein).
There are no formal restrictions under the Restated Agreement, as amended,
that materially limit the Partnership's ability to pay cash distributions,
except that the General Partner may suspend or limit cash distributions to
ensure that the Partnership maintains sufficient working capital reserves to
cover, among other things, operating costs and potential expenditures, such as
refurbishment costs to remarket equipment upon lease expiration. Liquidity is
especially important as the Partnership matures and sells equipment, because the
remaining equipment base consists of fewer revenue-producing assets that are
available to cover prospective cash disbursements. Insufficient liquidity could
inhibit the Partnership's ability to sustain its operations or maximize the
realization of proceeds from remarketing its remaining aircraft. The management
and remarketing of aircraft can involve, among other things, significant costs
and lengthy remarketing initiatives.
Although the Partnership's lessees are required to maintain the aircraft
during the period of lease contract, repair, maintenance, and/or refurbishment
costs at lease expiration can be substantial. For example, an aircraft that is
returned to the Partnership meeting minimum airworthiness standards, such as
flight hours or engine cycles, nonetheless may require heavy maintenance in
order to bring its engines, airframe and other hardware up to standards that
will permit its prospective use in commercial air transportation. Individually,
these repairs can cost in excess of $1 million and, collectively, they could
require the disbursement of several million dollars, depending upon the extent
of refurbishment. In addition, the Partnership's equipment portfolio includes
two Stage 2 aircraft as well as proportionate ownership interests in three Stage
2 aircraft. These aircraft are prohibited from operating in the United States
after December 31, 1999 unless they are retro-fitted with hush-kits to meet
Stage 3 noise regulations promulgated by the Federal Aviation Administration.
The cost to hush-kit an aircraft, such as the Partnership's Boeing 727s and
Boeing 737s, can approach $2 million. Although the Partnership is not required
to retro-fit its aircraft with hush-kits, insufficient liquidity could
jeopardize the remarketing of these aircraft and risk their disposal at a
depressed value at a time when a better economic return would be realized from
refurbishing the aircraft and re-leasing them to another user. Collectively, the
aggregation of the Partnership's potential liquidity needs related to aircraft
and other working capital requirements could be significant. Accordingly, the
General Partner has maintained significant cash reserves within the Partnership
in order to minimize the risk of a liquidity shortage.
Finally, the Partnership is a Nominal Defendant in a Class Action Lawsuit
described in Note 7 to the accompanying financial statements. A preliminary
settlement agreement will allow the Partnership to invest in new equipment or
other activities, subject to certain limitations, effective March 22, 1999. To
the extent that the Partnership continues to own aircraft investments that could
require capital reserves, the General Partner does not anticipate that the
Partnership will invest in new assets, regardless of its authority to do so.
Until the Class Action Lawsuit is adjudicated, the General Partner does not
expect to declare any distributions to the Partners. In addition, the proposed
settlement, if effected, will materially change the future organizational
structure and business interests of the Partnership, as well as its cash
distribution policies. See Note 7 to the accompanying financial statements.
Cash distributions paid to the Recognized Owners consist of both a return of
and a return on capital. To the extent that cash distributions consist of Cash
From Sales or Refinancings, substantially all of such cash distributions should
be viewed as a return of capital. Cash distributions do not represent and are
not indicative of yield on investment. Actual yield on investment cannot be
determined with any certainty until conclusion of the Partnership and will be
dependent upon the collection of all future contracted rents, the generation of
renewal and/or re-lease rents, and the residual value realized for each aircraft
at its disposal date. No distributions were declared in either 1997 or 1998.
9
The Partnership's capital account balances for federal income tax and for
financial reporting purposes are different primarily due to differing treatments
of income and expense items for income tax purposes in comparison to financial
reporting purposes (generally referred to as permanent or timing differences;
see Note 6 to the financial statements). For instance, selling commissions and
organization and offering costs pertaining to syndication of the Partnership's
limited partnership units are not deductible for federal income tax purposes,
but are recorded as a reduction of partners' capital for financial reporting
purposes. Therefore, such differences are permanent differences between capital
accounts for financial reporting and federal income tax purposes. Other
differences between the bases of capital accounts for federal income tax and
financial reporting purposes occur due to timing differences. Such items consist
of the cumulative difference between income or loss for tax purposes and
financial statement income or loss and the difference between distributions
(declared vs. paid) for income tax and financial reporting purposes, if any. The
principal component of the cumulative difference between financial statement
income or loss and tax income or loss results from different depreciation
policies for book and tax purposes.
For financial reporting purposes, the General Partner has accumulated a
capital deficit at December 31, 1998. This is the result of aggregate cash
distributions to the General Partner being in excess of its capital contribution
of $1,000 and its allocation of financial statement net income or loss.
Ultimately, the existence of a capital deficit for the General Partner for
financial reporting purposes is not indicative of any further capital
obligations to the Partnership by the General Partner. The Restated Agreement,
as amended, requires that upon the dissolution of the Partnership, the General
Partner will be required to contribute to the Partnership an amount equal to any
negative balance which may exist in the General Partner's tax capital account.
At December 31, 1998, the General Partner had a negative tax capital account
balance of approximately $828,000.
The future liquidity of the Partnership will be influenced by, among other
factors, prospective market conditions, aircraft refurbishment requirements
(discussed above), the ability of EFG to manage and remarket the aircraft, and
many other events and circumstances, that could enhance or detract from
individual aircraft yields and the collective performance of the Partnership's
aircraft portfolio. However, the outcome of the Class Action Lawsuit described
in Note 7 to the accompanying financial statements will be the principal factor
in determining the future of the Partnership's operations.
10
REPORT OF INDEPENDENT AUDITORS
To the Partners of AIRFUND II International Limited Partnership:
We have audited the accompanying statements of financial position of AIRFUND
II International Limited Partnership, as of December 31, 1998 and 1997, and the
related statements of operations, changes in partners' capital, and cash flows
for each of the three years in the period ended December 31, 1998. These
financial statements are the responsibility of the Partnership's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of AIRFUND II International
Limited Partnership at December 31, 1998 and 1997, and the results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1998, in conformity with generally accepted accounting principles.
Our audits were conducted for the purpose of forming an opinion on the basic
financial statements taken as a whole. The Additional Financial Information
identified in the Index to Annual Report to the Partners is presented for
purposes of additional analysis and is not a required part of the basic
financial statements. Such information has been subjected to the auditing
procedures applied in our audits of the basic financial statements and, in our
opinion, is fairly stated in all material respects in relation to the basic
financial statements taken as a whole.
ERNST & YOUNG LLP
Boston, Massachusetts
March 10, 1999
11
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
STATEMENT OF FINANCIAL POSITION
DECEMBER 31, 1998 AND 1997
1998 1997
------------- -------------
ASSETS
Cash and cash equivalents.......................................................... $ 3,425,762 $ 2,102,494
Rents receivable................................................................... 39,933 65,120
Accounts receivable--affiliate..................................................... 71,178 305,359
Other assets....................................................................... 125,734 --
Equipment at cost, net of accumulated depreciation of $40,968,380 and $43,339,081
at December 31, 1998 and 1997, respectively...................................... 4,413,962 7,292,133
------------- -------------
Total assets................................................................... $ 8,076,569 $ 9,765,106
------------- -------------
------------- -------------
LIABILITIES AND PARTNERS' CAPITAL
Notes payable...................................................................... $ 1,896,665 $ 2,677,520
Accrued interest................................................................... 25,126 29,618
Accrued liabilities................................................................ 458,485 8,250
Accrued liabilities--affiliate..................................................... 16,254 42,524
Deferred rental income............................................................. 47,997 167,067
------------- -------------
Total liabilities.............................................................. 2,444,527 2,924,979
------------- -------------
Partners' capital (deficit):
General Partner.................................................................. (2,713,854) (2,653,450)
Limited Partnership Interests (2,714,647 Units; initial purchase price of $25
each).......................................................................... 8,345,896 9,493,577
------------- -------------
Total partners' capital........................................................ 5,632,042 6,840,127
------------- -------------
Total liabilities and partners' capital........................................ $ 8,076,569 $ 9,765,106
------------- -------------
------------- -------------
The accompanying notes are an integral part of
these financial statements.
12
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
STATEMENT OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
1998 1997 1996
------------- ------------- -------------
Income:
Lease revenue...................................................... $ 3,130,704 $ 3,224,618 $ 4,706,774
Interest income.................................................... 158,844 110,635 265,820
Gain on sale of equipment.......................................... 127,265 -- 460,969
------------- ------------- -------------
Total income..................................................... 3,416,813 3,335,253 5,433,563
------------- ------------- -------------
Expenses:
Depreciation....................................................... 2,451,737 3,377,350 3,650,745
Write-down of equipment............................................ -- -- 2,832,800
Interest expense................................................... 200,679 268,916 264,200
Equipment management fees--affiliate............................... 156,535 161,231 235,339
Operating expenses--affiliate...................................... 1,815,947 1,290,508 2,100,419
------------- ------------- -------------
Total expenses................................................... 4,624,898 5,098,005 9,083,503
------------- ------------- -------------
Net loss............................................................. $ (1,208,085) $ (1,762,752) $ (3,649,940)
------------- ------------- -------------
------------- ------------- -------------
Net loss per limited partnership unit................................ $ (0.42) $ (0.62) $ (1.28)
------------- ------------- -------------
------------- ------------- -------------
Cash distributions declared per limited partnership unit............. $ -- $ -- $ 2.25
------------- ------------- -------------
------------- ------------- -------------
The accompanying notes are an integral part of
these financial statements.
13
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
STATEMENT OF CHANGES IN PARTNERS' CAPITAL
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
GENERAL RECOGNIZED OWNERS
PARTNER -------------------------
AMOUNT UNITS AMOUNT TOTAL
------------- ---------- ------------- -------------
Balance at December 31, 1995........................... $ (2,106,228) 2,714,647 $ 20,743,589 $ 18,637,361
Net loss--1996....................................... (182,497) -- (3,467,443) (3,649,940)
Cash distributions declared.......................... (276,587) -- (6,107,955) (6,384,542)
------------- ---------- ------------- -------------
Balance at December 31, 1996........................... (2,565,312) 2,714,647 11,168,191 8,602,879
Net loss--1997....................................... (88,138) -- (1,674,614) (1,762,752)
------------- ---------- ------------- -------------
Balance at December 31, 1997........................... (2,653,450) 2,714,647 9,493,577 6,840,127
Net loss--1998....................................... (60,404) -- (1,147,681) (1,208,085)
------------- ---------- ------------- -------------
Balance at December 31, 1998........................... $ (2,713,854) 2,714,647 $ 8,345,896 $ 5,632,042
------------- ---------- ------------- -------------
------------- ---------- ------------- -------------
The accompanying notes are an integral part of
these financial statements.
14
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
STATEMENT OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
1998 1997 1996
------------- ------------- -------------
Cash flows from (used in) operating activities:
Net loss............................................................. $ (1,208,085) $ (1,762,752) $ (3,649,940)
Adjustments to reconcile net loss to net cash from operating
activities:
Depreciation..................................................... 2,451,737 3,377,350 3,650,745
Write-down of equipment.......................................... -- -- 2,832,800
Gain on sale of equipment........................................ (127,265) -- (460,969)
Changes in assets and liabilities:
Decrease (increase) in:
Rents receivable................................................. 25,187 (65,120) 169,906
Accounts receivable--affiliate................................... 234,181 (158,792) 169,872
Other assets..................................................... (125,734) -- --
Increase (decrease) in:
Accrued interest................................................. (4,492) (6,311) 16,732
Accrued liabilities.............................................. 450,235 (533,284) 448,394
Accrued liabilities--affiliate................................... (26,270) (446,494) 430,866
Deferred rental income........................................... (119,070) 92,400 (402,839)
------------- ------------- -------------
Net cash from operating activities............................. 1,550,424 496,997 3,205,567
------------- ------------- -------------
Cash flow from (used in) investing activities:
Purchase of equipment.............................................. -- -- (72,550)
Proceeds from equipment sales...................................... 553,699 -- 3,535,649
------------- ------------- -------------
Net cash from investing activities............................. 553,699 -- 3,463,099
------------- ------------- -------------
Cash flow used in financing activities:
Principal payments--notes payable.................................. (780,855) (742,265) (779,949)
Distributions paid................................................. -- -- (7,098,923)
------------- ------------- -------------
Net cash used in financing activities.......................... (780,855) (742,265) (7,878,872)
------------- ------------- -------------
Net increase (decrease) in cash and cash equivalents
1,323,268 (245,268) (1,210,206)
Cash and cash equivalents at beginning of year....................... 2,102,494 2,347,762 3,557,968
------------- ------------- -------------
Cash and cash equivalents at end of year............................. $ 3,425,762 $ 2,102,494 $ 2,347,762
------------- ------------- -------------
------------- ------------- -------------
Supplemental disclosure of cash flow information:
Cash paid during the year for interest............................. $ 205,171 $ 275,227 $ 247,468
------------- ------------- -------------
------------- ------------- -------------
Supplemental disclosure of non-cash investing and financing activities:
See Note 3 to the Financial Statements.
The accompanying notes are an integral part of
these financial statements.
15
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
December 31,1998
NOTE 1--ORGANIZATION AND PARTNERSHIP MATTERS
AIRFUND II International Limited Partnership (the "Partnership") was
organized as a limited partnership under the Massachusetts Uniform Limited
Partnership Act (the "Uniform Act") on July 20, 1989 for the purpose of
acquiring and leasing to third parties a specified portfolio of used commercial
aircraft. Partners' capital initially consisted of contributions of $1,000 from
the General Partner (AFG Aircraft Management Corporation, a Massachusetts
corporation) and $100 from the Initial Limited Partner (AFG Assignor
Corporation, a Massachusetts corporation). The Partnership issued 2,714,647
units, representing assignments of limited partnership interests (the "Units"),
to 4,192 investors. Unitholders and Limited Partners (other than the Initial
Limited Partner) are collectively referred to as Recognized Owners. The General
Partner is an affiliate of Equis Financial Group Limited Partnership (formerly
known as American Finance Group), a Massachusetts limited partnership ("EFG").
The common stock of the General Partner is owned by AF/AIP Programs Limited
Partnership. EFG and a wholly owned affiliate are the 99% limited partners and
AFG Programs, Inc., a Massachusetts corporation that is wholly-owned by Geoffrey
A. MacDonald, is the 1% general partner. The General Partner is not required to
make any other capital contributions to the Partnership except as may be
required under the Uniform Act and Section 6.1(b) of the Amended and Restated
Agreement and Certificate of Limited Partnership (the "Restated Agreement, as
amended").
EFG is a Massachusetts partnership formerly known as American Finance Group
("AFG"). AFG was established in 1988 as a Massachusetts general partnership and
succeeded American Finance Group, Inc., a Massachusetts corporation organized in
1980. EFG and its subsidiaries (collectively, the "Company") are engaged in
various aspects of the equipment leasing business, including EFG's role as
Equipment Manager or Advisor to the Partnership and several other
direct-participation equipment leasing programs sponsored or co-sponsored by EFG
(the "Other Investment Programs"). The Company arranges to broker or originate
equipment leases, acts as remarketing agent and asset manager, and provides
leasing support services, such as billing, collecting, and asset tracking.
The general partner of EFG, with a 1% controlling interest, is Equis
Corporation, a Massachusetts corporation owned and controlled entirely by Gary
D. Engle, its President, Chief Executive Officer and sole Director. Equis
Corporation also owns a controlling 1% general partner interest in EFG's 99%
limited partner, GDE Acquisition Limited Partnership ("GDE LP"). Equis
Corporation and GDE LP were established in December 1994 by Mr. Engle for the
sole purpose of acquiring the business of AFG.
In January 1996, the Company sold certain assets of AFG relating primarily
to the business of originating new leases, and the name "American Finance
Group," and its acronym, to a third party. AFG changed its name to Equis
Financial Group Limited Partnership after the sale was concluded. Pursuant to
terms of the sale agreements, EFG specifically reserved the rights to continue
using the name American Finance Group and its acronym in connection with the
Partnership and the Other Investment Programs and to continue managing all
assets owned by the Partnership and the Other Investment Programs.
In 1990, EFG assigned its Equipment Management Agreement with the
Partnership to AF/AIP Programs Limited Partnership, and AF/AIP Programs Limited
Partnership entered into an identical management agreement with EFG.
On June 28, 1991, the Offering of Units of the Partnership was concluded.
The Partnership issued an aggregate of 2,714,647 Units in six Interim Closings
during the period May 17, 1990 through June 28, 1991. The initial purchase of
the aircraft and the associated lease commitments occurred on May 18, 1990.
16
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
Additional purchases of aircraft (or proportionate interests in aircraft)
occurred subsequent to each Closing. The six Interim Closings which occurred in
1990 and 1991 and the associated Units issued, purchase price and number of
investors who became Recognized Owners of the Partnership are summarized below.
RECOGNIZED
CLOSING DATE UNITS ISSUED PURCHASE PRICE OWNERS
- ------------------------------------------------------------------------ ------------ -------------- -------------
May 17, 1990............................................................ 1,725,100 $ 43,127,500 2,600
August 2, 1990.......................................................... 317,986 7,949,650 494
October 1, 1990......................................................... 159,510 3,987,750 251
December 27, 1990....................................................... 246,845 6,171,125 398
February 15, 1991....................................................... 112,796 2,819,900 173
June 28, 1991........................................................... 152,410 3,810,250 276
------------ -------------- -----
Totals.................................................................. 2,714,647 $ 67,866,175 4,192
------------ -------------- -----
------------ -------------- -----
Pursuant to the Restated Agreement, as amended, distributions of
Distributable Cash From Operations and Distributable Cash From Sales or
Refinancings of the Partnership shall be made as follows: Prior to Payout, (i)
Distributable Cash From Operations will be distributed 95% to the Recognized
Owners and 5% to the General Partner and (ii) Distributable Cash From Sales or
Refinancings shall be distributed 99% to the Recognized Owners and 1% to the
General Partner. After Payout, (i) all Distributions will be distributed 99% to
the General Partner and 1% to the Recognized Owners until the General Partner
has received an amount equal to 5% of all Distributions made by the Partnership
and (ii) thereafter, all Distributions will be made 90% to the Recognized Owners
and 10% to the General Partner.
Under the terms of a Management Agreement between the Partnership and EFG,
management services are provided by EFG to the Partnership at fees which the
General Partner believes to be competitive for similar services (see Note 4).
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
STATEMENT OF CASH FLOWS
The Partnership considers liquid investment instruments purchased with a
maturity of three months or less to be cash equivalents. From time to time, the
Partnership invests excess cash with large institutional banks in federal agency
discount notes and in reverse repurchase agreements with overnight maturities.
Under the terms of the agreements, title to the underlying securities passes to
the Partnership. The securities underlying the agreements are book entry
securities. At December 31, 1998, the Partnership had $3,316,450 invested in
federal agency discount notes and in reverse repurchase agreements secured by
U.S. Treasury Bills or interests in U.S. Government securities.
REVENUE RECOGNITION
Rents are payable to the Partnership monthly or quarterly and no significant
amounts are calculated on factors other than the passage of time. The leases are
accounted for as operating leases and are
17
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
noncancellable. Rents received prior to their due dates are deferred. Future
minimum rents are $1,444,692 are due as follows:
For the year ending December 31, 1999 ............................................. $1,015,910
2000 ............................................. 349,318
2001 ............................................. 79,464
----------
Total ............................................. $1,444,692
----------
----------
In December 1998, the Partnership and the other affiliated leasing programs
owning interests in two McDonnell Douglas MD-82 aircraft entered into lease
extension agreements with Finnair OY. The lease extensions, effective upon the
expiration of the existing primary lease terms on April 28, 1999, extended the
leases for nine months and two years, respectively. In aggregate, these lease
extensions will provide additional lease revenue of approximately $876,000 to
the Partnership.
During the third quarter of 1998, Classic Airways Limited ("Classic"), a
lessee of the Partnership, ceased paying rents related to the Partnership's
Lockheed L-1011-100 aircraft. In October 1998, Classic was placed in
liquidation. The Partnership's future minimum rents exclude $2,000,000 scheduled
to be received from Classic under the existing lease agreement at December 31,
1998. The General Partner does not expect to collect any additional rents from
Classic (see Note 7 for additional information).
Revenue from major individual lessees which accounted for 10% or more of
lease revenue during the years ended December 31, 1998, 1997 and 1996 is as
follows:
1998 1997 1996
---------- ---------- ------------
Transmeridian Airlines, Inc................................................ $ 876,667 $ 971,500 $ --
(One Boeing 727-251ADV)
American Trans Air, Inc.................................................... $ 762,000 $ 770,467 $ 762,000
(One Boeing 727-208 ADV)
Finnair OY................................................................. $ 639,923 $ 639,752 $ --
(Two MD-82)
Southwest Airlines, Inc.................................................... $ 377,568 $ 377,568 $ --
(Three Boeing 737-2H4)
Classic Airways Limited.................................................... $ 319,960 $ -- $ --
(One Lockhead L-1011-100)
Northwest Airlines, Inc.................................................... $ -- $ -- $ 1,421,629
(One Boeing 727-200 ADV)
Cathay Pacific Airways Limited............................................. $ -- $ -- $ 1,419,024
(Two Lockheed L-1011)
USE OF ESTIMATES
The preparation of the financial statements in conformity with generally
accepted accounting principles requires the use of estimates and assumptions
that affect the amounts reported in the financial statements and accompanying
notes. Actual results could differ from those estimates.
EQUIPMENT ON LEASE
All aircraft were acquired from EFG or one of its Affiliates. Equipment Cost
means the actual cost paid by the Partnership to acquire the aircraft, including
acquisition fees. Equipment cost reflects the
18
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
actual price paid for the aircraft by EFG or the Affiliate plus all actual costs
incurred by EFG or the Affiliate while carrying the aircraft less, (a) for all
aircraft other than the Boeing 727-208 ADV aircraft, the amount of all rents
received by EFG or the Affiliate prior to selling the aircraft or, (b) with
respect to the Boeing 727-208 ADV aircraft, rents received from the date of the
commencement of the lease of the aircraft until the date of the sale to the
Partnership.
DEPRECIATION
The Partnership's depreciation policy is intended to allocate the cost of
aircraft over the period during which they produce economic benefit. The
principal period of economic benefit is considered to correspond to each
aircraft's primary lease term, which term generally represents the period of
greatest revenue potential for each aircraft. Accordingly, to the extent that an
aircraft is held on primary lease term, the Partnership depreciates the
difference between (i) the cost of the aircraft and (ii) the estimated residual
value of the aircraft on a straight-line basis over such term. For purposes of
this policy, estimated residual values represent estimates of aircraft values at
the date of primary lease expiration. To the extent that an aircraft is held
beyond its primary lease term, the Partnership continues to depreciate the
remaining net book value of the aircraft on a straight-line basis over the
aircraft's remaining economic life. Periodically, the General Partner evaluates
the net carrying value of equipment to determine whether it exceeds estimated
net realizable value. Adjustments to reduce the net carrying value of equipment
are recorded in those instances where estimated net realizable value is
considered to be less than net carrying value. Such adjustments are reflected
separately on the accompanying Statement of Operations as Write-Down of
Equipment.
The ultimate realization of residual value for any type of aircraft is
dependent upon many factors, including EFG's ability to sell and re-lease
aircraft. Changing market conditions, industry trends, technological advances,
and many other events can converge to enhance or detract from asset values at
any given time.
ACCRUED LIABILITIES--AFFILIATE
Unpaid operating expenses paid by EFG on behalf of the Partnership and
accrued but unpaid administrative charges and management fees are reported as
Accrued Liabilities--Affiliate (see Note 4).
ALLOCATION OF PROFITS AND LOSSES
For financial statement purposes, net income or loss is allocated to each
Partner according to their respective ownership percentages (95% to the
Recognized Owners and 5% to the General Partner). See Note 6 concerning
allocation of income or loss for income tax purposes.
19
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(CONTINUED)
NET LOSS AND CASH DISTRIBUTIONS PER UNIT
Net loss and cash distributions per Unit are based on 2,714,647 Units
outstanding during each of the three years in the period ended December 31, 1998
and computed after allocation of the General Partner's 5% share of net loss and
applicable share of cash distributions (see Note 1 for additional information).
PROVISION FOR INCOME TAXES
No provision or benefit from income taxes is included in the accompanying
financial statements. The Partners are responsible for reporting their
proportionate shares of the Partnership's taxable income or loss and other tax
attributes on their tax returns.
NOTE 3--EQUIPMENT
The following is a summary of equipment owned by the Partnership at December
31, 1998. Remaining Lease Term (Months), as used below, represents the number of
months remaining from December 31, 1998 under contracted lease terms. In the
opinion of EFG, the acquisition cost of the equipment did not exceed its fair
market value.
REMAINING
LEASE TERM EQUIPMENT
EQUIPMENT TYPE (MONTHS) AT COST LOCATION
- -------------------------------------------- ------------- ------------- ---------------------------------------
One Lockheed L-1011-100 (Classic)........... 0 $ 16,644,138 Foreign
One Boeing 727-208 ADV (ATA)................ 1 12,928,710 IN
One Boeing 727-251 ADV (Transmeridian)...... 0 9,732,714 MN
Two McDonnell-Douglas MD-82 (Finnair)....... 13-28 4,157,280 Foreign
Three Boeing 737-2H4 (Southwest)............ 12 1,919,500 TX
-------------
Total equipment cost........................ 45,382,342
Accumulated depreciation (40,968,380)
-------------
Equipment, net of accumulated depreciation $ 4,413,962
-------------
-------------
The costs of the two McDonnell-Douglas MD-82 aircraft and the three Boeing
737-2H4 aircraft represent proportionate ownership interests. The remaining
interests are owned by other affiliated partnerships sponsored by EFG. All
partnerships individually report, in proportion to their respective ownership
interests, their respective shares of assets, liabilities, revenues, and
expenses associated with the aircraft.
In 1996, the Partnership completed the replacement of a Boeing 747 SP
aircraft with a 14.85% ownership interest in two Finnair Aircraft at a total
cost to the Partnership of $4,157,280. To acquire the ownership interest in the
Finnair Aircraft, the Partnership paid $1,389,942 in cash and obtained financing
of $2,767,338 from a third-party lender. The Partnership utilized $1,317,392
(classified as Contractual Right for Equipment at December 31, 1995) which had
been deposited into a special-purpose escrow account through a third-party
exchange agent pending the completion of the aircraft exchange. The balance of
$72,550 was expended from the Partnership's cash reserves. The remaining
ownership interest of 85.15% in the Finnair Aircraft is held by affiliated
equipment leasing programs sponsored by EFG.
20
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(CONTINUED)
Certain of the equipment and related lease payment streams were used to
secure term loans with third-party lenders. The preceding summary of equipment
includes leveraged equipment having an original cost of approximately $6,077,000
and a net book value of approximately $4,308,000 at December 31, 1998. (See Note
5.)
Generally, the costs associated with maintaining, insuring and operating the
Partnership's aircraft are incurred by the respective lessees pursuant to terms
specified in their individual lease agreements with the Partnership. However,
the Partnership has purchased supplemental insurance coverage to reduce the
economic risk arising from certain losses. Specifically, the Partnership is
insured under supplemental policies for "Aircraft Hull Total Loss Only" and
"Aircraft Hull Total Loss Only War and Other Perils."
As aircraft are sold to third parties, or otherwise disposed of, the
Partnership will recognize a gain or loss equal to the difference between the
net book value of the aircraft at the time of sale or disposition and the
proceeds realized upon sale or disposition. The ultimate realization of
estimated residual value in the aircraft is dependent upon, among other things,
EFG's ability to maximize proceeds from selling or re-leasing the aircraft upon
the expiration of the primary lease terms.
The Partnership recorded a write-down of aircraft carrying values,
representing impairments related to the Partnership's L-1011 aircraft, during
the year ended December 31, 1996. The resulting charge of $2,832,800 ($0.99 per
limited partnership unit) was based on a comparison of estimated net realizable
values and corresponding carrying values of the Partnership's aircraft.
At December 31, 1998, the Partnership's Lockheed L-1011-100, Boeing 727-208
ADV and its Boeing 727-251 ADV were held for sale. The Boeing 727-251 ADV is
fully depreciated and the Lockhead L-1011-100 had a book value of $106,275 at
December 31, 1998. See Note 7 for additional discussion regarding these two
aircraft. American Trans Air, Inc. ("ATA") has given the partnership irrevocable
notice of its intention to purchase the Partnership's Boeing 727-208 Advanced
aircraft for $3.1 million in April 1999, pursuant to a purchase option contained
in the lease agreement. Following the expiration of the current lease agreement
in January 1999, ATA will continue to lease the aircraft on a month-to-month
basis at the existing base rent until the date of sale. This aircraft was fully
depreciated at December 31, 1998.
NOTE 4--RELATED PARTY TRANSACTIONS
All operating expenses incurred by the Partnership are paid by EFG on behalf
of the Partnership and EFG is reimbursed at its actual cost for such
expenditures. Fees and other costs incurred during each of the three years in
the period ended December 31, 1998, which were paid or accrued by the
Partnership to EFG or its Affiliates, are as follows:
1998 1997 1996
------------ ------------ ------------
Equipment management fees............................................... $ 156,535 $ 161,231 $ 235,339
Administrative charges.................................................. 53,676 50,304 28,694
Reimbursable operating expenses due to third parties.................... 1,762,271 1,240,204 2,071,725
------------ ------------ ------------
Total............................................................. $ 1,972,482 $ 1,451,739 $ 2,335,758
------------ ------------ ------------
------------ ------------ ------------
As provided under the terms of the Management Agreement, EFG is compensated
for its services to the Partnership. Such services include acquisition and
management of equipment. For acquisition services, EFG was compensated by an
amount equal to 3.07% of Equipment Base Price paid by the Partnership. For
21
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(CONTINUED)
management services, EFG is compensated by an amount equal to 5% of gross
operating lease rental revenue and 2% of gross full payout lease rental revenue
received by the Partnership. Both acquisition and management fees are subject to
certain limitations defined in the Management Agreement.
Administrative charges represent amounts owed to EFG, pursuant to Section
10.4(c) of the Restated Agreement, as amended, for persons employed by EFG who
are engaged in providing administrative services to the Partnership.
Reimbursable operating expenses due to third parties represent costs paid by EFG
on behalf of the Partnership which are reimbursed to EFG at actual cost.
All equipment was purchased from EFG or one of its Affiliates. The
Partnership's Purchase Price was determined by the method described in Note 2,
Equipment on Lease.
All rents and proceeds from the sale of equipment are paid directly to EFG.
EFG temporarily deposits collected funds in a separate interest-bearing escrow
account prior to remittance to the Partnership. At December 31, 1998, the
Partnership was owed $71,178 by EFG for such funds and the interest thereon.
These funds were remitted to the Partnership in January 1999.
Certain affiliates of the General Partner own Units in the Partnership as
follows:
NUMBER OF PERCENT OF TOTAL
AFFILIATE UNITS OWNED OUTSTANDING UNITS
- ------------------------------------------------------------- ------------- -------------------
Old North Capital Limited Partnership........................ 40,000 1.47%
Old North Capital Limited Partnership ("ONC") is a Massachusetts limited
partnerships formed in 1995 and an affiliate of EFG. The general partner of ONC
is controlled by Gary D. Engle. In addition, the limited partnership interests
of ONC are owned by Semele Group, Inc. ("Semele"). Gary D. Engle is Chairman and
CEO of Semele.
NOTE 5--NOTES PAYABLE
Notes payable at December 31, 1998 consisted of installment notes payable to
banks of $1,896,665. The installment notes are non-recourse, with interest rates
ranging between 8.65% and 8.89% and are collateralized by the equipment and
assignment of the related lease payments. All of the notes were originated in
connection with the Southwest Aircraft and the Finnair Aircraft. The installment
notes related to the Southwest Aircraft will be fully amortized by
noncancellable rents. The Partnership, has a balloon payment obligation at the
expiration of the primary lease term related to the Finnair Aircraft of
$1,411,035. The carrying amount of notes payable approximates fair value at
December 31, 1998.
All of the Partnership's installment notes payable mature during the year
ending December 31, 1999.
NOTE 6--INCOME TAXES
The Partnership is not a taxable entity for federal income tax purposes.
Accordingly, no provision for income taxes has been recorded in the accounts of
the Partnership.
For financial statement purposes, the Partnership allocates net income or
loss to each class of partner according to their respective ownership
percentages (95% to the Recognized Owners and 5% to the General Partner). This
convention differs from the income or loss allocation requirements for income
tax and Dissolution Event purposes as delineated in the Restated Agreement, as
amended. For income tax reporting purposes, the Partnership allocates net income
or loss in accordance with such agreement. The Restated Agreement, as amended,
requires that upon dissolution of the Partnership, the General Partner
22
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(CONTINUED)
will be required to contribute to the Partnership an amount equal to any
negative balance which may exist in the General Partner's tax capital account.
At December 31, 1998, the General Partner had a negative tax capital account
balance of approximately $828,000.
The following is a reconciliation between net loss reported for financial
statement and federal income tax reporting purposes for the years ended December
31, 1998, 1997 and 1996:
1998 1997 1996
------------- ------------- -------------
Net loss............................................................. $ (1,208,085) $ (1,762,752) $ (3,649,940)
Tax depreciation in excess of financial statement depreciation....... (713,082) (2,136,596) (3,015,164)
Write-down of equipment.............................................. -- -- 2,832,800
Deferred rental income............................................... (119,070) 92,400 (402,839)
Other................................................................ 362,435 (998,111) 1,501,218
------------- ------------- -------------
$ (1,677,802) $ (4,805,059) $ (2,733,925)
------------- ------------- -------------
------------- ------------- -------------
The principal component of "Other" consists of the difference between the
tax gain or loss on aircraft disposals and the financial statement gain or loss
on aircraft disposals. It also includes reversal of certain maintenance
reserves.
The following is a reconciliation between partners' capital reported for
financial statement and federal income tax reporting purposes for the years
ended December 31, 1998 and 1997:
1998 1997
------------- -------------
Partners' capital.................................................................. $ 5,632,042 $ 6,840,127
Add back selling commissions and organization and offering costs................. 7,085,240 7,085,240
Cumulative difference between federal income tax and financial statement income
(loss)......................................................................... (1,678,373) (1,208,656)
------------- -------------
Partners' capital for federal income tax reporting purposes........................ $ 11,038,909 $ 12,716,711
------------- -------------
------------- -------------
The cumulative difference between federal income tax and financial statement
income (loss) represents a timing difference.
NOTE 7--LEGAL PROCEEDINGS
In January 1998, certain plaintiffs (the "Plaintiffs") filed a class and
derivative action, captioned LEONARD ROSENBLUM, ET AL. V. EQUIS FINANCIAL GROUP
LIMITED PARTNERSHIP, ET AL., in the United States District Court for the
Southern District of Florida (the "Court") on behalf of a proposed class of
investors in 28 equipment leasing programs sponsored by EFG, including the
Partnership (collectively, the "Nominal Defendants"), against EFG and a number
of its affiliates, including the General Partner, as defendants (collectively,
the "Defendants"). Certain of the Plaintiffs, on or about June 24, 1997, had
filed an earlier derivative action, captioned LEONARD ROSENBLUM, ET AL. V. EQUIS
FINANCIAL GROUP LIMITED PARTNERSHIP, ET AL., in the Superior Court of the
Commonwealth of Massachusetts on behalf of the Nominal Defendants against the
Defendants. Both actions are referred to herein collectively as the "Class
Action Lawsuit".
The Plaintiffs have asserted, among other things, claims against the
Defendants on behalf of the Nominal Defendants for violations of the Securities
Exchange Act of 1934, common law fraud, breach of contract, breach of fiduciary
duty, and violations of the partnership or trust agreements that govern each of
23
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(CONTINUED)
the Nominal Defendants. The Defendants have denied, and continue to deny, that
any of them have committed or threatened to commit any violations of law or
breached any fiduciary duties to the Plaintiffs or the Nominal Defendants.
On July 16, 1998, counsel for the Defendants and the Plaintiffs executed a
Stipulation of Settlement setting forth terms pursuant to which a settlement of
the Class Action Lawsuit is intended to be achieved and which, among other
things, is expected to reduce the burdens and expenses attendant to continuing
litigation. The Stipulation of Settlement was based upon and superseded a
Memorandum of Understanding between the parties dated March 9, 1998 which
outlined the terms of a possible settlement. The Stipulation of Settlement was
filed with the Court on July 23, 1998 and was preliminarily approved by the
Court on August 20, 1998 when the Court issued its "Order Preliminarily
Approving Settlement, Conditionally Certifying Settlement Class and Providing
for Notice of, and Hearing on, the Proposed Settlement" (the "August 20 Order").
Prior to issuing a final order, the Court will hold a fairness hearing that will
be open to all interested parties and permit any party to object to the
settlement. The investors of the Partnership and all other plaintiff class
members in the Class Action Lawsuit will receive a Notice of Settlement and
other information pertinent to the settlement of their claims that will be
mailed to them in advance of the fairness hearing. Since first executing the
Stipulation of Settlement, the Court has scheduled two fairness hearings, the
first on December 11, 1998 and the second on March 19, 1999, each of which was
postponed because of delays in finalizing certain information materials that are
subject to regulatory review prior to being distributed to investors.
On March 15, 1999, counsel for the Plaintiffs and the Defendants entered
into an amended stipulation of settlement (the "Amended Stipulation") which was
filed with the Court on March 15, 1999. The Amended Stipulation was
preliminarily approved by the Court by its "Modified Order Preliminarily
Approving Settlement, Conditionally Certifying Settlement Class and Providing
For Notice of, and Hearing On, the Proposed Settlement" dated March 22, 1999
(the "March 22 Order"). The Amended Stipulation, among other things, divides the
Class Action Lawsuit into two separate sub-classes that can be settled
individually. This revision is expected to expedite the settlement of one
sub-class by the middle of 1999. However, the second sub-class, involving the
Partnership and 10 affiliated partnerships (collectively referred to as the
"Exchange Partnerships"), is expected to remain pending for a longer period due,
in part, to the complexity of the proposed settlement pertaining to this class.
Specifically, the settlement of the second sub-class is premised on the
consolidation of the Exchange Partnerships' net assets (the "Consolidation"),
subject to certain conditions, into a single successor company ("Newco"). Under
the proposed Consolidation, the partners of the Exchange Partnerships would
receive both common stock in Newco and a cash distribution; and thereupon the
Exchange Partnerships would be dissolved. In addition, EFG would contribute
certain management contracts, operations personnel, and business opportunities
to Newco and cancel its current management contracts with all of the Exchange
Partnerships. Newco would operate as a finance company specializing in the
acquisition, financing and servicing of equipment leases for its own account and
for the account of others on a contract basis. Newco also would use its best
efforts to list its shares on the Nasdaq National Market or another national
exchange or market as soon after the Consolidation as Newco deems that market
conditions and its business operations are suitable for listing its shares and
Newco has satisfied all necessary regulatory and listing requirements. The
potential benefits and risks of the Consolidation will be presented in a
Solicitation Statement that will be mailed to all of the partners of the
Exchange Partnerships as soon as the associated regulatory review process is
completed and at least 60 days prior to the fairness hearing. A preliminary
Solicitation Statement was filed with the Securities and Exchange Commission on
August 24,
24
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(CONTINUED)
1998 and remains pending. Class members will be notified of the actual fairness
hearing date when it is confirmed.
One of the principal objectives of the Consolidation is to create a company
that would have the potential to generate more value for the benefit of existing
limited partners than other alternatives, including continuing the Partnership's
customary business operations until all of its assets are disposed in the
ordinary course of business. To facilitate the realization of this objective,
the Amended Stipulation provides, among other things, that commencing March 22,
1999, the Exchange Partnerships may collectively invest up to 40% of the total
aggregate net asset values of all of the Exchange Partnerships in any
investment, including additional equipment and other business activities that
the general partners of the Exchange Partnerships and EFG reasonably believe to
be consistent with the anticipated business interests and objectives of Newco,
subject to certain limitations, including that the Exchange Partnerships retain
sufficient cash balances to pay their respective shares of the cash distribution
referenced above in connection with the proposed Consolidation.
In the absence of the Court's authorization to enter into such activities,
the Partnership's Restated Agreement, as amended, would not permit new
investment activities without the approval of limited partners owning a majority
of the Partnership's outstanding Units. Accordingly, to the extent that the
Partnership invests in new equipment, the Manager (being EFG) will (i) defer,
until the earlier of the effective date of the Consolidation or December 31,
1999, any acquisition fees resulting therefrom and (ii) limit its management
fees on all such assets to 2% of rental income. In the event that the
Consolidation is consummated, all such acquisition and management fees will be
paid to Newco. To the extent that the Partnership invests in other business
activities not consisting of equipment acquisitions, the Manager will forego any
acquisition fees and management fees related to such investments. In the event
that the Partnership has acquired new investments, but the Partnership does not
participate in the Consolidation, Newco will acquire such new investments for an
amount equal to the Partnership's net equity investment plus an annualized
return thereon of 7.5%. Finally, in the event that the Partnership has acquired
new investments and the Consolidation is not effected, the General Partner will
use its best efforts to divest all such new investments in an orderly and timely
fashion and the Manager will cancel or return to the Partnership any acquisition
or management fees resulting from such new investments.
The Amended Stipulation and previous Stipulation of Settlement prescribe
certain conditions necessary to effecting final settlements, including providing
the partners of the Exchange Partnerships with the opportunity to object to the
participation of their partnership in the Consolidation. Assuming the proposed
settlement is effected according to present terms, the Partnership's share of
legal fees and expenses related to the Class Action Lawsuit is estimated to be
approximately $76,200 all of which was accrued and expensed by the Partnership
in 1998. In addition, the Partnership's share of fees and expenses related to
the proposed Consolidation is estimated to be approximately $255,600, all of
which was accrued and expensed by the Partnership in 1998.
While the Court's August 20 Order enjoined certain class members, including
all of the partners of the Partnership, from transferring, selling, assigning,
giving, pledging, hypothecating, or otherwise disposing of any Units pending the
Court's final determination of whether the settlement should be approved, the
March 22 Order permits the partners to transfer Units to family members or as a
result of the divorce, disability or death of the partner. No other transfers
are permitted pending the Court's final determination of whether the settlement
should be approved. The provision of the August 20 Order which enjoined the
General Partners of the Exchange Partnerships from, among other things,
recording any transfers not in accordance with the Court's order remains
effective.
25
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(CONTINUED)
There can be no assurance that settlement of either sub-class of the Class
Action Lawsuit will receive final Court approval and be effected. There also can
be no assurance that all or any of the Exchange Partnerships will participate in
the Consolidation because if limited partners owning more than one-third of the
outstanding Units of a partnership object to the Consolidation, then that
partnership will be excluded from the Consolidation. The General Partner and its
affiliates, in consultation with counsel, concur that there is a reasonable
basis to believe that final settlements of each sub-class will be achieved.
However, in the absence of final settlements approved by the Court, the
Defendants intend to defend vigorously against the claims asserted in the Class
Action Lawsuit. Neither the General Partner nor its affiliates can predict with
any degree of certainty the cost of continuing litigation to the Partnership or
the ultimate outcome.
In addition to the foregoing, the Partnership is a party to other lawsuits
that have arisen out of the conduct of its business, principally involving
disputes or disagreements with lessees over lease terms and conditions. The
following actions had not been finally adjudicated at December 31, 1998:
ACTION INVOLVING CLASSIC AIRWAYS LIMITED
In September 1998, a lessee of the Partnership, Classic Airways Limited
("Classic"), ceased paying rent to the Partnership with respect to an L-1011-100
aircraft. In October 1998, Classic filed for receivership in the United Kingdom
("UK") and was placed in liquidation. Prior to its liquidation, Classic had
incurred and failed to pay significant airport ground fees to BAA plc,
Eurocontrol, and CAA (collectively, the "Airport Authorities"). The failure of
Classic to pay such charges resulted in detention of the aircraft by the Airport
Authorities. In addition, the Airport Authorities have continued to charge
incremental ground fees and expenses to the aircraft and have grounded the
aircraft pending collection of such amounts, which are approximately $284,000 in
total. Under UK law, the Airport Authorities have the right not only to detain
the aircraft, but to sell the aircraft at auction in order to satisfy their
outstanding fees. Accordingly, it is anticipated that the Partnership will be
required to pay at least a portion of the airport charges in order to recover
the aircraft. The General Partner has engaged counsel to represent the
Partnership's interests in the UK and; presently, counsel is negotiating with
the Airport Authorities to resolve the issue of the unpaid charges so that the
aircraft can be flown to the United States or otherwise remarketed. The parties
have not executed a final settlement agreement; however, the Airport Authorities
have indicated a willingness to reach a compromise. Based upon recent
discussions, the Partnership accrued and expensed approximately $167,000 to
cover the cost of settling the airport charges, all of which was recorded in the
fourth quarter of 1998. At the date of Classic's liquidation, the Partnership
had accrued $160,000 of rental income which had not been collected from Classic
and all of which was written-off as uncollectible in the third quarter of 1998.
The General Partner does not expect that any funds are likely to be recovered
from Classic in connection with this matter.
ACTION INVOLVING NORTHWEST AIRLINES, INC.
On September 22, 1995, Investors Asset Holding Corp. and First Security
Bank, N.A., trustees of the Partnership and certain affiliated investment
programs (collectively, the "Plaintiffs"), filed an action in United States
District Court for the District of Massachusetts against a lessee of the
Partnership, Northwest Airlines, Inc. ("Northwest"). The Complaint alleges that
Northwest did not fulfill its maintenance obligations under its Lease Agreements
with the Plaintiffs and seeks declaratory judgment concerning Northwest's
obligations and monetary damages. Northwest filed an Answer to the Plaintiffs'
Complaint and a motion to transfer the venue of this proceeding to Minnesota.
The Court denied Northwest's motion. On June 29, 1998, a United States
Magistrate Judge recommended entry of partial summary judgment in
26
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(CONTINUED)
favor of the Plaintiffs. Northwest appealed this decision and a hearing was
scheduled for January 1999 by the District Judge to consider arguments and
review the Magistrate's recommendation. A ruling by the District Judge remains
pending. The General Partner believes that the Plaintiff's claims ultimately
will prevail and that the Partnership's financial position will not be adversely
affected by the outcome of this action.
FIRST ACTION INVOLVING TRANSMERIDIAN AIRLINES
On October 11, 1996, Prime Air Inc. d/b/a Transmeridian Airlines (the
"Plaintiff") filed an action in the 61st Judicial District Court of Harris
County, Texas (the "Court") entitled PRIME AIR, INC. D/B/A TRANSMERIDIAN
AIRLINES V. INVESTORS ASSET HOLDING CORP., AS TRUSTEE FOR AIRFUND II
INTERNATIONAL LIMITED PARTNERSHIP, PLM INTERNATIONAL, AND NAVCOM AVIATION, INC.
(collectively, the "Defendants"). In that action, the Plaintiff claimed damages
of more than $3 million for alleged breach of contract, fraud, civil conspiracy,
tortious interference of business relations, negligent misrepresentation,
negligence and gross negligence, and punitive damages against the Defendants in
connection with Transmeridian's lease of a Boeing 727-251 ADV jet aircraft from
the Partnership. On November 7, 1996, PLM removed the action to United States
District Court for the Southern District of Texas. On February 14, 1997, the
Defendants answered the Plaintiff's Complaint denying the allegations made
therein and asserting various defenses. Extensive discovery has been taken and
is continuing. The Court has placed this action on the trial calendar for
July/August, 1999.
On July 31, 1998, the Court granted IAHC's motion to strike Plaintiff's
fraud and negligent misrepresentation claims due to failure to plead with
particularity; however, the Court dismissed IAHC's motion for summary judgment.
The Plaintiff has provided a revised expert report claiming actual damages of
approximately $8.5 million and is seeking punitive damages and both pre-judgment
and post-judgment interest. The General Partner believes that the Plaintiff's
claims are without merit and intends to defend such action vigorously. While
there is no certainty as to the outcome of this litigation, the General Partner,
in consultation with counsel, does not believe that the Plaintiff ultimately
will obtain a successful judgment against IAHC or PLM. Therefore, the General
Partner does not believe that the outcome of this litigation will adversely
affect the Partnership's financial position. See Note 8, Subsequent Event.
SECOND ACTION INVOLVING TRANSMERIDIAN AIRLINES
On November 9, 1998, Investors Asset Holding Corp., as Trustee for the
Partnership (the "Plaintiff"), filed an action in Superior Court of the
Commonwealth of Massachusetts in Suffolk County against Prime Air, Inc. d/b/a
Transmeridian Airlines ("Transmeridian"), Atkinson & Mullen Travel, Inc., and
Apple Vacations, West, Inc., both d/b/a Apple Vacations, asserting various
causes of action for declaratory judgment and breach of contract. The action
subsequently was removed to United States District Court for the District of
Massachusetts. The Plaintiff has filed an Amended Complaint asserting claims for
breaches of contract and covenant of good faith and fair dealing against
Transmeridian and breach of guaranty against Apple Vacations.
In October 1998, an aircraft leased by Transmeridian (being the same
aircraft in the above-referenced "First action involving Transmeridian
Airlines") was damaged in an on-ground accident at the Caracas, Venezuela
airport. The aircraft currently is undergoing repairs at a repair facility in
Louisiana; however, it is anticipated that the repairs will not be completed for
several months and are likely to extend into late summer 1999. The cost to
repair the aircraft is estimated to be at least $350,000. The Plaintiff alleges
that Transmeridian, among other things, has impeded the Partnership's ability to
terminate two engine lease
27
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
NOTES TO THE FINANCIAL STATEMENTS
(CONTINUED)
contracts between the Partnership and a third party. The Plaintiff intends to
pursue insurance coverage and also to enforce written guarantees issued by Apple
Vacations that absolutely and unconditionally guarantee Transmeridian's
performance under the lease and is seeking recovery of all costs, lost revenue
and monetary damages in connection with this matter. Discovery has not yet
commenced, and although the General Partner plans to vigorously pursue this
action, it is too early to predict the Plaintiff's likelihood of success. The
aircraft was fully depreciated at December 31, 1998 for financial reporting
purposes.
NOTE 8--SUBSEQUENT EVENT
On March 19, 1999, the Court referenced in connection with the "First action
involving Transmeridian Airlines" described in Note 7 herein, issued its
preliminary order dismissing all of the Plaintiff's claims against Investors
Asset Holding Corporation and PLM International, Inc.
28
ADDITIONAL FINANCIAL INFORMATION
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
SCHEDULE OF EXCESS (DEFICIENCY) OF TOTAL CASH GENERATED TO COST
OF EQUIPMENT DISPOSED
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
The Partnership classifies all rents from leasing aircraft as lease revenue.
Upon expiration of the primary lease terms, aircraft may be sold, rented on a
month-to-month basis or re-leased for a defined period under a new or extended
lease agreement. The proceeds generated from selling or re-leasing the aircraft,
in addition to any month-to-month revenue, represent the total residual value
realized for each aircraft. Therefore, the financial statement gain or loss,
which reflects the difference between the net book value of the aircraft at the
time of sale or disposition and the proceeds realized upon sale or disposition
may not reflect the aggregate residual proceeds realized by the Partnership for
such aircraft.
The following is a summary of cash excess (deficiency) associated with the
aircraft disposition which occurred in the years ended December 31, 1998 and
1996. No aircraft were disposed of during the year ended December 31, 1997.
1998 1996
------------ ------------
Rents earned prior to disposal of aircraft............................................ $ 4,150,170 $ 11,072,532
Sale proceeds realized upon disposition of aircraft................................... 553,699 3,535,649
------------ ------------
Total cash generated from rents and aircraft sale proceeds............................ 4,703,869 14,608,181
Original acquisition cost of aircraft disposed........................................ 5,248,872 11,164,679
------------ ------------
Excess (deficiency) of total cash generated to cost of aircraft disposed.............. $ (545,003) $ 3,443,502
------------ ------------
------------ ------------
29
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
STATEMENT OF CASH AND DISTRIBUTABLE CASH FROM OPERATIONS,
SALES AND REFINANCINGS
FOR THE YEAR ENDED DECEMBER 31, 1998
SALES AND
OPERATIONS REFINANCINGS TOTAL
------------- ------------- -------------
Net income (loss).................................................... $ (1,335,350) $ 127,265 $ (1,208,085)
Add:
Depreciation....................................................... 2,451,737 -- 2,451,737
Management fees.................................................... 156,535 -- 156,535
Book value of disposed equipment................................... -- 426,434 426,434
Less:
Principal repayment of notes payable............................... (780,855) -- (780,855)
------------- ------------- -------------
Cash from operations, sales and refinancings....................... 492,067 553,699 1,045,766
Less:
Management fees.................................................... (156,535) -- (156,535)
------------- ------------- -------------
Distributable cash from operations, sales and refinancings......... 335,532 553,699 889,231
Other sources and uses of cash:
Cash at beginning of year.......................................... -- 2,102,494 2,102,494
Net change in receivables and accruals............................. 434,037 -- 434,037
------------- ------------- -------------
Cash at end of year.................................................. $ 769,569 $ 2,656,193 $ 3,425,762
------------- ------------- -------------
------------- ------------- -------------
30
AIRFUND II INTERNATIONAL LIMITED PARTNERSHIP
SCHEDULE OF COSTS REIMBURSED TO THE
GENERAL PARTNER AND ITS AFFILIATES AS REQUIRED
BY SECTION 10.4 OF THE AMENDED AND RESTATED
AGREEMENT AND CERTIFICATE OF LIMITED PARTNERSHIP
DECEMBER 31, 1998
For the year ended December 31, 1998, the Partnership reimbursed the General
Partner and its Affiliates for the following costs:
Operating expenses................... $1,381,437
31