Kennedy School of Government CR16-06-1845.0 4 Case Program The Boeing Tanker Lease Deal (A) When Donald Rumsfeld returned to the helm of the Pentagon a quarter-century after his first stint as Defense Secretary, he sought to carry with him many of the business practices he had found successful as a corporate chief executive. To support his initiatives, the Secretary filled many influential Department of Defense (DoD) leadership positions with officials transplanted from senior private sector jobs. In addition to making the department more efficient and increasing the use of competitive sourcing, Rumsfeld was determined to reduce the lag time for acquiring defense systems by relying more on commercially available technology. One Air Force initiative to recapitalize its fleet of in-flight refueling aircraft directed a spotlight on these initiatives and on the difficulties in applying private sector approaches to a governmental entity. The initiative relied upon an unusual lease agreement-traditionally frowned upon by budget officials in both Congress and the White House. Pursuing a “Revolution in Business Affairs” at the Pentagon In the mid-1990s, Congressional, administration, and private analysts pushed for reforms that would increase the efficiency of government agencies and hold them accountable for delivering outcomes to US taxpayers. Many strategies culled from the private sector—such as performance measurement, cus:omer value and core competencies—sat at the heart of these efforts. In the Defense Department, by far the largest government department in terms of its budget allocation, these efforts were referred to as a “revolution in business affairs” (RBA), a parallel to the “revolution in military affairs” (RMA) that defense analysts had argued was arising from the exponential increases in technology in the last decades of the twentieth century. Defense Secretary William Perry made the RBA a centerpiece of his management agenda at the Pentagon by pursuing acquisition reform, urging greater reliance on “off-the-shelf” purchases rather than This case was written by Martin Hrionak under the supervision of Elizabeth K. Keating, Assistant Professor of Public Policy, John F. Kennedy School of Government, Harvard University. (0706) Copyright © 2006 by the President and Fellows of Harvard College. No part of this publication may be reproduced, revised, translated, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means (electronic, mechanical, photocopying, recording, or otherwise) without the written permission of the Case Program. For orders and copyright permission information, please visit our website at www ksgease.harvard.edu or send a written request to Case Program, Jahn F. Kennedy School of Government, Harvard University, 79 John F. Kennedy Street, Cambridge, MA 02138The Boeing Tanker Lease Deal (A)_ CR16-06-1845.0 those designed specifically for military use, and outsourcing DoD operations not integral to the department's warfighting mission. During his 2000 campaign for the presidency, George W. Bush made improving government performance through better management a point of emphasis, often pointing out that he would be the first president to hold a Master in Business Administration. After his election, Bush's decision to call former Defense Secretary Donald Rumsfeld back to the Pentagon from a successful carver as a private sector chief executive signaled that his administration was intent on advancing the improvement in DoD) business processes begun under the Clinton Administration, In introducing Secretary Rumsfeld at his swearing-in ceremony, the President stated that, “as a highly successful businessman, [Rumsfeld] understands that we must modernize and transform the business of defense, getting the value for our taxpayers’ money. He is willing, to challenge the status quo inside the Pentagon.” Rumsfeld emphasized the problems of the department's acquisition system in his prepared testimony at his confirmation hearing before the Senate Armed Services Committee (SASC): The US defense establishment must be transformed to address our new circumstance. The need to swiftly introduce new weapons systems is clear. . The cycle time from program start to initial operational capability for major acquisition programs conducted over the past several decades has, I am told, generally been between eight and nine years. ... Such processes are not capable of harnessing the remarkable genius and productivity of the modern information-based commercial and industrial sectors that have done so much to revolutionize our civilian economy.' The new Secretary began addressing the management challenges at DoD by placing private sector chief executives in key positions involved in the acquisition process. Edward C. Aldridge, chief executive of the Aerospace Corporation, a federally-funded research and development agency, and formerly head of a division of McDonnell Douglas, was selected as Under Secretary for Acquisition, Technology, and Logistics, the Pentagon's chief weapon buyer. In addition, the administration picked Gordon R. England, an executive vice president at the General Dynamics Corporation, as Secretary of the Navy; James G. Roche, a corporate vice president at Northrop Grumman Corporation, as Secretary of the Air Force; and Thomas E. White, the Vice Chairman of Enron Rnergy Services, as Secretary of the Army, Though the service secretaries traditionally had held little authority, Rumsfeld planned to give them greater responsibilities for improving how the department was run. He established a Senior Executive Council, composed of the Deputy Secretary Paul Wolfowitz, the three service secretaries, and Aldridge, to oversee the implementation of “best bu ‘ness practices” in the department's management processes. Donald Rumsfeld, Testimony before the Senate Armed Services Committee, January 11,2001.The Boeing Tanker Lease Deal (A). CR16-06-1845.0 The administration articulated its intentions for Dob’s business processes in the Quadrennial Defense Review, a statement of the administration's defense policy and plans, released in September 2001 A transformed US force must be matched by a support structure that is equally agile, flexible, and innovative, It must be a structure in which each of Dol's dedicated civilian and military members can apply their talents to defend America—where they have the resources, information, tools, training, and freedom lo perforin.’ A Time of Change at the Boeing Company From the introduction of its 707 aircraft as America’s first commercial passenger jet in the 1950s, The Boeing Company has been the symbol of American aerospace. With its merger with commercial air competitor McDonnell Doug! n 1997, Boeing became the lone remaining American manufacturer of commercial jets. At the same time, having assumed the role of a major supplier to the US military during World War II, by 2001, Boeing was the nation’s second-largest defense contractor (in terms of absolute revenue from defense-related contracts) behind Lockheed Martin. The company also has been the top US exporter, bringing in more foreign currency than any other American corporation. In addition, Boeing has provided an important source of employment to the areas that house its plants. Long-time Washington state Senator Henry Jackson’s moniker as the “Senator from Boeing” reflected the influence that came with Boeing's position as one of the top employers in his state. In the late 1990s, however, Boeing was undergoing a transition initiated by its chief executive, Phil Condit. Wary of the company’s dependence on the ups and downs of commercial air travel, Condit sought to diversify Boeing’s revenue base by emphasizing its military and space divisions. Whereas Boeing had relied on commercial aircraft sales for eighty percent of its revenue in 1999, this proportion declined to about sixty percent by 2001. Condit reinforced the company’s shift in focus by moving Boeing headquarters from Seattle, where the company was founded in 1916, to Chicago in May 2001. He explained his strategy in a conference call regarding Boeing’s 2001 second quarter earnings, asserting that Boeing was prepared for the first time to endure a commercial downturn without major impact to its finances. The nature of the commercial aerospace sector had placed Boeing in a difficult financial position that made Condit’s change in direction necessary. Producing airplanes requires large fixed assets, such as Boeing’s plants in Washington state and Kansas, which left the company wilh high operating leverage. It could not easily reduce costs in a downturn without letting go of highly-skilled workers or permanently closing facilities. At the same time, Boeing's pattern of Department of Defense, Quadrennial Defense Review Report, September 30, 2001, p. 49.The Boeing Tanker Lease Deal (A), CRI16-06-1845.0 acquisitions and borrowing, accrued large liabilities that left the firm highly leveraged financially. Without finding additional revenue streams from its defense and space sectors, the company would be ill-positioned to weather a recession, Boeing’s heavier emphasis on the defense and space sectors coincided with stagnation and uncertainty in the firm’s commercial airplane arm. The airframes on which Boeing had relied for decades, particularly its 757 and 767 models, were failing to capture enough new commercial orders to ensure the survivability of the assembly lines that were building them, The firm was undecided on which sort of future airframe to develop, having decided against building a stretched version of ils 747 in favor of a supersonic “cruiser” that existed only on paper. At the same time, Airbus, the world’s second-largest aerospace firm, was mounting an aggressive challenge to Boeing’s dominance of the commercial sector and had announced plans to build the world’s largest passenger aircraft In fall 2001, the Pentagon dealt Boeing a setback in its strategy of greater dependence upon its military unit when the department chose Lockheed Martin to build the Joint Strike Fighter (JSF), a next generation plane that would serve the Air Force, Navy, and Marines. The JSF agreement was the largest defense contract ever, with an initial value of $19 billion and long-term worth of almost $200 billion for developing and manufacturing 3,000 planes over a 40 year timeframe. Because many defense analysts believed the JSF would be the last manned fighter jet the US military ordered, several Congressmen expressed concern that Boeing would be shut out from producing fighter aircraft altogether, leaving just one American manufacturer with the capability to manufacture such plane September 11 Attacks On the morning of September 11, 2001, Al Qaeda terrorists hijacked four airliners to use as missiles against symbols of American power. Two planes brought down the World ‘Trade Center towers in New York City, and a third crashed into the Pentagon. The fourth plane crashed in western Pennsylvania after a rebellion by the passengers against the hijackers flying the aircraft. All told, approximately 3,000 people died in the attacks, and the federal government grounded all commercial planes temporarily. The flight groundings on September 11 caused hundreds of millions of dollars in losses for US airlines. in the weeks after the attacks, fear of further suicide hijackings combined with langer wait times due tu increased airport security measures to drive down the number of passengers traveling by air. An economic downturn that began in 2000 had already cut into revenues of the major airlines. The further fall in ridership—as much as 30 percent on some airlines—and concerns about airlines’ liability for hijackings, created a crisis in the industry. Several major airlines, including Delta, Continental, and US Airways, announced cuts of more than 10,000 employees within weeks of the attacks. Though Congress responded by creating a $10 billion dollar loan‘The Boeing Tanker Lease Deal (A) CR16-06-1845.0 guarantee fund, the airline industry’s future was in doubt as major carriers teetered toward bankruptcy. The effects of the airlines struggles rippled through Boeing. As ridership projections declined, the major carriers cut orders fo: future aircraft, leading Boeing to reduce its forecast for commercial plane deliveries in 2002 by 2C percent and to warn of similar reductions in subsequent years. Boeing responded to its lower workload expectations by announcing that it would eliminate about 30,000 employees through December 2001. The bulk of the layoffs would occur in the Seattle/Puget Sound area, while about 5,000 positions would be cut at Boeing’s Wichita, Kansas facility. Boeing declared on its year-end financial statements that it had taken a $935 million charge tu its balance sheet related tu the attacks. Its commercial arm absorbed the majority of this cost, which included employee severance pay, a decline in firm orders, and lower market value for used raft. America Responds On October 7, the US military began an aerial assault on Afghanistan, the sanctuary of Osama bin Laden and his Al-Qaeda terrorist network, As President Bush declared a “War on Terror,” it was unclear when and how such a war might conclude. It was clear, however, that the administration, Congress, and the American public were willing to fund the largest defense budget increases since the 1980s in order to prevent another such attack. While much of this money would fund the military’s current operations, it would also allow the military services to boost their procurement accounts to moderi bearing the brunt of the workload in Afghanistan. ze or replace weapons systems, including many With the long sorties flown by US aircraft to Afghanistan, the KC-135 tanker was one aging system highlighted prominently in the initial stages of the war. The KC-135 is the Air Force's principal in-flight refueling plane and constitutes about 85 percent of the US tanker fleet. Its mission is to serve as a “gas station in the sky,” refueling the Air Force's fighter and bomber aircraft on long-range missions in which a base in theater is unavailable, The Air Force procured the KC-135s during the 1950s and 1960s, primarily to support the US long-range strategic bomber fleet that constituted one third of the nuclear strategic triad. Because those bombers did not experience the usage that the Air Force's fighter jets did, the tanker fleet’s average flying time remained below half of the KC-135’s expected lifetime air mileage. Thus, though the average KC- 135 lifespan exceeded 40 years in 2001, acquiring replacement tanker aircraft had not made the Air Force's priority procurement list. In fact. during the Clinton Administration, the Air Force had concluded that its fleet of KC-138s could fly for at least another 30 years.The Boeing Tanker Lease Deal (A)_ aeeeeee CRI16-06-1845.0 The aerial operations in Afghanistan were now placing greater demands on the KC-135 force, however. Additionally, the prospect of open-ended military engagements. decision by DoD leadership to develop the capability to project power aver long distances—raised and a strategic questions in the Air Force and among some defense analysts on the wisdom of relying on 40-year old planes for such a crucial function At the end of September, representative Norm Dicks (D-Wash) announced his support for replacing a portion of the KC-135 fleet with new tanker aircraft that would be derived from Boeing’s 767 commercial airframes. Dicks announced that he would try to insert a provision appropriating $100 million in the FY2002 defense appropriations bill to provide momentum for the tanker acqu ition, which was estimated to cost $20 billion over 10 years. Because the Air Force was struggling to fund its priority acquisition programs, and government budget regulations would require each tanker purchased to be funded in the fiscal year the plane was ordered, Dicks advocated that the military lease, rather than buy, the planes. Acquiring the planes through a lease agreement would enable the Air Force to operate the planes without paying, the full purchase cost up front. Instead, the service would acquire the right to possess and operate the planes for a fixed period of time, while paying periodic installments each amounting to some portion of the purchase cost. This would allow the bulk of the program costs to be shifted into the future and, under an operating lease, to be funded from operations and maintenance rather than procurement dollars. While the Afghanistan operation gave impetus to the tanker recapitalization program, Boeing had set the groundwork for the dual well before the September 11 attacks. It first offered its 767 airframe as a military tanker aircraft to the United Kingdom in 1999, as part of CEO Phil Condit’s effort to streamline production by reducing the need for separate military and commercial airframes. ‘I'he company began pitching the 767 to the Air Force as a replacement for the KC-135 in March 2001, and established a business unit in St. Louis to manage its military tanker program. Boeing succeeded in selling its first military version of the 767 in August 2001, when the Italian armed forces selected Boeing’s offering over that of rival Airbus. The eftects of the commercial aerospace downturn combined with the increased demand for tanker aircraft to lead Boeing and its supporters to push to accelerate this timetable. Deliveries of the 767 airframe had dropped from 44 in 2000 to 40 in 2001; Boeing would have only 77 firm orders for the model at the end of 2001, which guaranteed only 20 months of work at the 767 lines. At the same time, Congressional officials saw the idea as a chance to offset some of the firings that Roeing hac announced in the aftermath of the September attacks. Boeing documents given to the Kansan delegation in Congress estimated that a 100-plane lease would add 1,350 jobs at the company sight in Wichita and create another 3,000 at local suppliers— almost offsetting the 5,000 area layoffs the company had announced.The Boeing Tanker Lease Deal (A), CR16-06-1845.0 Government Aversion to Leasing Major Systems Congressman Dicks’ proposal challenged a long-standing government aversion to leasing major systems. Federal budget rules require services to budget the entire cost of a weapons system in the year the department commits to buying the system. This requirement exists to enforce fiscal discipline upon the services by preventing them from beginning multiple programs with low initial costs in current fiscal years—the time period upon which budget analysts are focused —only to create large “bow waves” of procurement costs in the out-years. Also, appropriators try to avoid tying future Congresses’ hands by planting seed money for programs that must continue to be funded in future years on pain of large penalties for termination, In fact, leasing could undermine the purpose of the budgeting process by permitting DoD to buy more than the department has funds for. A Congressional Budget Office analysis of leases in government acquisition concluded A growing number of public/private ventures and leases are being structured to avoid the requirement for recognizing the costs of government investments up front. That trend could reduce the budget's ability to encourage cost-effective investment decisions and to make agencies’ commitments visible to the Congress and the public.” For these reasons, OMB traditionally has made leasing difficult. OMB Circular A-11 specifies the conditions under which a government agency may lease rather than purchase an asset, The A-11 guidelines state that the government may only lease “general purpose assets” that are available commercially and are not configured specifically for government use. Additionally, a private sector market must exist for such assets. The total costs of the lease also cannot exceed ninety percent of the asset's fair market retail price. Further, the rules prevent the government from taking ownership of the asset during the period covered by the lease or shortly after its expiration. A lease agreement that fails to meet these provisions is considered for budget purposes a “lease-purchase” arrangement, which is accounted for identically to an outright purchase. A principal objective of the Circular A-I1 provisions is to prevent government agencies from obscuring the cost of equipment purchases by portraying capital lease agreements as operating leases. Capital leases usually allow the lessee to rent an item for most of its useful life and then often assume ownership of the item at the conclusion of the agreement. Such a lease enables the lessee to spread the cost of acquisition over a number of years, while paying financing costs to compensate the lessor for the time value of money. By contrast, under an operating lease, the lessee normally controls the item being leased for a time period well short of the item’s useful life, and ownership of the item remains with the lessor at the end of the lease. Operating leases are advantageous for entities planning to use an item for a limited duration, for which paying the full purchase price does not make sense. Congressional Budget Office, “I'he Budgetary Treatment of Leases and Public/Private Ventures,” February 2003.The Boeing Tanker Lease Deal (A), CR16-06-1845.0 While both types of leaves allow the lessee to defer into the future payments that would be required to purchase the item, accounting rules treat them differently. A company acquiring a piece of equipment through an operating lease never assumes ownership of the item. For accounting purposes, therefore, the company records the lease as an operating expense on the income statement, rather than recognizing it as an asset and liability on the balance sheet. Because a capital lease essentially provides the lessee with a degree of ownership of the item being leased, the lessee must record the item as an asset and the lease obligation as a liability on its balance sheet. Often, companies prefer to delay recognition of expenses as long as possible; for this purpose, an operating lease is preferable to a capital lease. Consequently, entities often attempt to disguise capital leases as operating arrangements to gain the more favorable accounting treatment. Rationale for Leasing Rather than Buying An operating lease was attractive to the Air Force because it would allow the service to receive the new tanker aircraft in the near term without having to sacrifice other programs. Though the $1.5 billion to $3 billion the Air Force would need to allocate toward tanker acquisition in Fiscal Year 2002 under an outright purchase constituted a small portion of the $345 billion defense budget, the service's fiscal flexibility was constrained. Defense-wide, about 62 percent of the budget funded personnel and operations and maintenance (O&M) costs—military and civilian pay and benefits and the costs of operating the force. These costs were on an upward trajectory due to the increased pace of military activity and could not be reduced to provide boosts to other areas of the budget. Most of the remainder of the budget was divided among the three services for procurement, research and development, and infrastructure construction, The Air Force’s procurement budget for FY02 totaled approximately $22.6 billion, Of this amount, about $12.1 billion went toward ordnance, vehicle equipment, base maintenance, replacement parts, and equipment and facilities support. None of these costs could feasibly be reduced in a time of war. These realities left only two real options for offsets that would enable a direct tanker purchase: the F-22 fighter (around $3 billion in FY02) and the C-17 airlifter (§3.7 billion). The Air Force had long viewed the F-22 as the key to its operational future and would never agrec to give it up, nor would members of Congre: whose states or districts housed the Lockheed Martin plants constructing the plane. Additionally, with the prospects of rapid military deployments growing, the C-17 appeared more valuable than ever as a lool to deliver assets far from the US As another Boeing product, the C-17 had its supporters in Congress, as well. And the Air Force would need to carve out a similar amount each of the next three or four fiscal years after 2002. Leasing the planes eased this budgeting challenge in two ways, First, a lease removed the full funding requirements and would permit the service to spread the cost of each plane over a number of years. In any single year, then, the Air Force would need to carve out a much smaller pool of money under a lease, Second, an operating lease would allow the Air Force to use O&M money, rather than procurement dollars to fund the lease. With an increasing pace of operationsThe Boeing Tanker Tease Deal (A) CR16-06-1845.0 due to the war, the Air Force would likely have an easier time gamering additional funds for O&M, while insulating the service’s other key programs in the procurement account. Yet, it was unclear whether the 767 proposal met OMB’s requirements for an operating lease, particularly the requirement that the tankers be general purpose assets. The Congressional Budget Office’s Director would write in a letter to Senator McCain that while ‘Leases have a greater potential to be cost-effective if the government does not have a long-term requirement for the asset. ... Cost-effective leases also require the existence of a substantial market (by scoring rules, a private market) into which to sell assets at the end of the lease. While there is no private market for tankers, even the public, government market is not likely to absorb more than a few of the 100 tankers. However, leasing the planes would fit well with the business process transformation that Rumsfeld’s team had pledged to institute at the Pentagon. A lease would allow the department to deliver improved aerial refueling capabilities to the warfighter more quickly than through a traditional purchase, given the Air Force's inability to fit the full purchase price of the tankers within its budget limits. The arrangement also met the goal of utilizing commercially available technology —in this case, the 767 airframe—rather than building an entire platform from scratch to meet specific military requirements. To Air Force Secretary James Roche, the lease was an opportunity for the department to benefit from the downturn in the economy and air travel to shave support costs associated with the KC-135s. “We have a unique opportunity to get the best pricing possible to address our critical need” for a new tanker aircraft, he said. This is not a bailout, but taking advantage of a buyer's market ... .This can be a win-win. Boeing needs business, and we need airplanes.” Though leasing ‘was an unusual mechanism for government procurement, using such an arrangement in order to acquire a key capability at lower cost represented the adaptive and flexible business practices that Rumsfeld sought to instill in DoD. Proposal Draws Fire Congress included the $100 million jumpstart to the tanker lease in the final version of the FY02 Appropriations bill. However, senior government officials raised criticism that the proposal failed to deliver best value to American taxpayers. Senator John McCain (R-AZ), a member of the SASC famous for excoriating government “pork,” claimed the lease amounted to a subsidy to Dan L. Crippen, “Letter to Senator MeCain Regarding Costs of Alternatives for Modernizing the Ait Force Tanker Fleet,” May 7, 2002 Vago Muradian, “Roche Seeks Speedy 767 Deal with Bocing to Renew Support Fleet at Low Cost." Defense Daily International, October 12, 2001The Boeing Tanker Lease Deal (A) ___ CR16-06-1845.0 Boeing that was “the envy of corporate lobbyists from one end of K Street to the other.” Additionally, the Bush Administration’s budget director, Mitch Daniels, publicly opposed the lease because he argued it would cost more than an outright purchase, That the tanker lease program did not develop through the normal Defense Department requirements process also raised objections. Typically, a military service identifies a requirement for a new military system by assessing its current systems against the demands the national military strategy. Service proposals to develop new systems or purchase additional units are then validated by a body within the Joint Chiefs of Staff and subsequently submitted to DoD’s civilian leadership for approval. The services then build programs into their budgets to address these requirements within the top-line budget limits set by the department's leadership. Because the top- line never permits the services to buy everything they want, they devote funds to those programs they consider priorities, Prior to the fall of 2001, the Air Force had not included funding for tanker replacements in its budget submission to Congress. The Air Force also did not mention the tankers on an “unfunded priorities” list supplied to Congress in spring 2001 that detailed programs the service claimed it needed but could not afford under its present budget limits. Further, the Air Force had not conducted analysis demonstrating that the tankers needed replacement and, if so, that leasing 767 aircraft was the best option. In fact, Air Force studies of its tanker fleet had found the fleet could remain operational for another 40 years, due to the low mileage on the planes in spite of their average 40-year age. The service had not conducted an Analysis of Alternatives (AoA), which would assess the leasing option against a range of other potential solutions for recapitalizing the tanker flect. DoD acquisition guidelines normally require such a study before proceeding to develop a major program to ensure that the proposed program is the best combination of capability and cost for the military. The Air Force also had neglected to open its tanker program to bidding from other contractors, particularly Airbus, which publicly expressed interest in offering a modified tanker version o* its A330 airframe. By the spring of 2002, it was uncertain whether the criticism would derail the 767 acquisition. Sen. McCain was furions at the lack of oversight the deal had seen to this point. "You're talking about a dea! that may be worth $26 billion, and we've never held a hearing, This has nothing to do with national defense and everything to do with taking care of Boeing.” * He requested investigations from Congress’ accounting body and the DoD Inspector General, writing that the lease “could put the Air Force at risk of being urable to procure higher priority items that have been discussed at length with Congress and raised in formal testimony at hearings.” At the same time, senior Dol) officials appeared split on the program's fuluze. Joint Chiefs Chairman Richard Meyers stated thal the military would be able to meet its operational demands with the current tanker fleet. However, Air Force Secretary James Roche pledged that the service would Anne Marie Squeo and J. Lyna Lunsford, “Air Fore Journal, May 3, 2002. fanker Plan Faces Political Fight for Life,” The Wall Street 10The Boeing Tanker Lease Deal (A) CR16-06-1845.0 proceed with the lease if it found the costs were less than those required to maintain the current In fact, the lease’s supporters did not try to conceal that they had motivations in addition to meeting the Air Force’s mission requirements. Dicks stated that Congressional and Pentagon officials understooc: that Boeing is going through a bad period ... Boeing is our leading exporter in the country; it’s a very major defense contractor, and they’re in some difficulty. This has an industrial-base dimension to it—keeping Boving going, Similatly, Dicks aide George Behan said that given “the announcement of [the 30,000] potential layoffs, we are making every attempt to avoid the downtum ... by filling some of the work with the military contracts.” “ Washington state Senator Maria Cantwell declared that “this could be a big win for our local economy, as well as giving our military a much needed upgrade.” The lease proposal absorbed a series of blows in May 2002, as multiple analyses reiterated criticism of the deal’s likely costs. In a letter responding to a request for data from Senator McCain, Daniels wrote that OMB analysis determined that leasing 100 aircraft over ten years would cost $26 billion in straight dollar term times more than upgrading the oldest 126 KC: $8 billion more than buying the planes outright and almost ten 35s. These data were based on an assumption that each tanker would cost $150 million—-$90 million for the commercial 767 airframe and $60 million for conversion to military specifications. Additionally, because the fuel capacity of the 126 KC-135s exceeded that of the 100 Boeing 767s by about 2 million pounds, Daniels stated that the replacement plan “would not solve, and could exacerbate, the shortfalls identified” in a recent Air Force study. Days later, a similar letter from the CBO Director stated that “under a variety of assumptions, a long-term lease of tanker aircraft would be significantly more expensive than a direct purchase of such aircraft.” At the same time, a GAO briefing to the Senate Armed Services Committee questioned the Air Force’s need to rapidly replace the tanker fleet, citing the service's own statement that the oldest KC-135s would not reach their lifetime flying hour limits until 2040. §20 Billion Plan From Air Force Calls on Boeing Planes to Replace Old Tankers,” The Seattle Times, September 28, 2001. Katherine Pfleger, “Lawmakers Consider Air Force as Boeing Commercial-plane Customer,” Associated Press, September 30, 2001 ilThe Boeing Tanker Lease Deal (A) CR16-06-1845.0 Lease Backers Return Fire The lea could not be determined without a contract being signed. A Boeing spokesman stated that the did not back down, however, pointing out that the planes’ cos Ys: supporter studies used “some totally erroneous assumptions.” The company, another spokesperson said, was focused on developing “a cost-effective solution that will help [the Air Force] replace old, less capable aircraft with modern, dependable platforms for our military forces.” A spokesman for Senator Patty Murray criticized the studies as a stalling tactic, saying that once a lease was signed, “we can end the politically motivated speculation and assess the cost of getting this critical asset into the hands of our servicemen and women.” The SASC kept the lease proposal alive in passing its version of the FY03 defense authorization bill, rejecting a provision that would have prohibited the Air Force from leasing tanker replacements. McCain claimed some measure of viclory in a stipulation that the Air Force would need to return to the committee for approval of any deal it negotiated with Boeing. "I'm just trying to get the process under control so that there's not a $26 billion rip-off of the taxpayers,” McCain remarked, Lease backers disputed that McCain had accomplished anything but win himself abundant television airtime. “Despite the theatrics of Senator McCain, this action changes little,” Kansas Senator Pat Roberts said, adding that the Air Force would have come before Congress with a final lease agreement regardless of the language in the authorization act. Murray declared that “the only question that is left is not whether [the lease] will be approved, but when.” In a letter to McCain at the beginning of August, Daniels argued that while spreading funding out over several years “would seem appealing ... the excess cost {of lease financing] would inevitably crowd out funding for essential warfighting needs.” However, legislators sought to turn the spotlight on what they described as insufficient modernization funding from the Pentagon and Bush’s budget office. Dicks responded that “the Administration’s unrealistically low defense procurement budgets” had forced Congress and the Air Force to operate outside of the normal acquisition proce I believe the best approach is lo immediately increase defense procurement budgets to the $100 billion level to make room for recapitalizing our forces. In the near term, however, it would be irresponsible to ignore what we and the Air Force believe is an urgent requirement to procure new tankers through any creative strategy— including leasing —until the procurement accounts can catch up.” Negotiations dragged on through the summer and fall of 2002, despite regular statements from legislators, Boeing representatives, and Air Force officials that a deal was imminent. No real oa loney Woes Force ‘Creative’ Approach to Replace KC-135Es,” Aerospace Daily, August 9, 02 sirThe Boeing Tanker Lease Deal (A). CR16-06-1845.0 movement occurred until the passage of the FY03 defense appropriations bill in October, which provided more solid legal justification for the tanker lease. Congress clarified legal concerns that had been raised about the Air Torce’s authority to enter a lease agreement, including explicitly permitting the service to fund the lease from its operations and maintenance, rather than procurement accounts. In addition, the law provided $3 million for the Air Force to establish an administrative office to oversee the tanker program. While the sum constituted but a piddling of the $355 billion allotted in the appropriations bill, it provided important momentum to the Air Force and other lease backers. At the same time, some financial parameters of the lease began to leak to the media. Foremost, the Air Force and Boeing were now discussing six-year, rather than decade-long, terms for the lease, at the conclusion of which the service could purchase the planes at a guaranteed price reported to be $4 billion. The planes would be delivered on a staggered schedule beginning in 2006 and with final deliveries occurring in 2011, Interest on the lease payments would fall between 4 and 5 percent, with total costs for the lease (without the purchase option) approximating $17 billion. The total cost of $21 billion for a lease-purchase arrangement, while reflecting lesser financing costs due to the reduction in the lifespan of the lease, fell far below the estimates of the analyses on which the deal’s opponents were relying to attack it. More Ups and Downs Any sense of victory the appropriations bill gave lease advocates soon dissipated. The Defense Department announced that it was delaying a decision on the deal until March 2003. Media reports cited a senior Pentagon official saying that the administration’s FY04 budget request—to be presented to Congress at the beginning of February—would include no funds for leasing the tanker aircraft. Additionally, influential conservative commentator Robert Novak reported in his syndicated column that two senior defense officials, DoD Comptroller Dov Zakheim and acquisition chief Pete Aldridge, had “killed a generous helping of corporate pork” by veloing the lease, a charge the Pentagon denied. The lease’s congressional supporters and Boeing, insisted that the Air Force's plans to acquire the tanker remained on track despite the delayed decision timetable. However, Kansas Representative Todd Tiahrt, a pro-lease member of the House Appropriations Committee, summed up the feelings of many by describing himself as “beyond frustration.” The year concluded with further upheaval for the Boeing Company. On December 20, the firm announced that it had abandoned its plans to build the Sonic Cruiser, which would have been Boeing's first new commercial airframe since the 777’s f September 2001 downturn in commercial air travel had undermined the premise that building a jet that could travel at nearly the speed of sound would attract business travelers willing to pay a t flight almost a decade earlier. The post- premium to get places more quickly. At the same time, Boeing's confirmed orders for its 767 aoeThe Boeing Janker Lease eal (A), CR16-06-1845.0 variants declined to thirty-six, and Boeing moved to slow its production rate on the 767 line from four planes per month to one plane every six weeks. With the developments in the commercial market, Boeing projected that 2003 would mark the first year that its defense revenues exceeded inflows from its commercial aerospace division. In the new year, lease supporters renewed their push for Secretary Rumsfeld’s approval. In a move to create momentum for the deal, the Air Force announced that it would retire 68 of its oldest KC-135Es by the coming October. The lease’s congressional supporters began emphasizing the maintenance costs associated with keeping the current fleet in the air in an effort to portray the lease proposal as a cost saver. for the military. In February, Washington senators Cantwell and Murray wrote in a letter to OMB Director Mitch Daniels that One-third of our tanker fleet is unfit to fly at any given time due to mechanical failure. .., Without the lease program, we will unnecessarily spend billions of dollars to maintain these aircraft, which have limited capacity to meet the growing demand for tanker aircraft and in-air refueling, Other lease backers declared that maintaining and upgrading the KC-135 fleet could not meet Air Force mission requirements. Addressing a proposal to install new engines in the existing tankers rather than lease new ones, Roche argued that The real issue is these other things are rotting out, and they're corroding in the fuselage section. So, re-engining a 45- to 50-year-old airplane isn't the solution. ... Why people think you can take these old buggers and keep them going for a long time is a little bonkers.” Senate Appropriations Committee Chairman Ted Stevens (R-Alaska) was more blunt: Let’s take the people from OMB who are holding this up and let them see those planes. I think we ought to put some of the people that's [sic] holding this up and put them in those tankers and let them fly a little bit, and see them and listen to them creak.” Another Innovative Business Import or “Enron-style Accounting Practices”? As the debate over the proposal continued, Boeing and the Air Force announced that an approved lease would utilize a common private sector mechanism—a special purpose entity Charles Pope, “Aging Military Tankers to Be Retired,” Seattle Post-Intelligencer, January 22, 2003. “767 Lease Would Cost the Same as Purchase, Provide Other Savings,” Inside the Air Force, February 28, 2003. Stephen Trimble, “Debate on Price Stalls Decision on Tanker Lease Deal, Rumsfeld Says” Aerospace Daily, May 15, 2003. 14The Boeing Tanker Lease Deal (A). CR16-06-1845.0 (SPE)—rarely used in government acquisition. Boeing proposed to establish an independent “trust,” managed by a finance committee comprising officials from Boeing and the Air Force that would borrow from commercial banks in order to finance construction of the tanker aircraft through progress payments to the company. As the planes were completed, the trust would issue bonds to repay the commercial bank loans, purchase the aircraft from Boeing, and lease the planes to the Air Force. The trust would nse the lease payments from the service to meet its obligations to the hondholders. At the conclusion of the lease term, the Air Force either would purchase the planes for a fixed price or return them to the trust. The SPE held several advantages from the perspectives of Boeing and the Air Force. Boeing would receive payment in full for the planes much earlier than it would if it leased the aircraft directly to the Air Force. As a Boeing statement explained, “in this way, no customer is burdened by the large up-front development costs that have been associated with typical military aircraft procurements in the past.” The SPE would also enable both Boeing and the Air Force to prevent the debt associated with the lease from appearing on their balance sheets. Additionally, the Air Force, planning that investors would view the investment as a government security, saw the trust as a way to secure low interest rate financing. To the deal’s critics, the addition of an SPE to the already unusual procurement arrangement reinforced their view that Boeing and the military were deceiving Congress and the taxpayers. SPEs had garnered an association with corruption due to their role in the spectacular collapse of Enron, a major American energy-trading firm, in the fall of 2001, Enron's managers had created numerous SPEs to hide debt from transactions that would otherwise have appeared on the company’s financial statements. These maneuvers enabled the company to portray itself to investors as significantly more profitable and less leveraged than was really the case, while allowing the company’s senior management to enrich themselves. When the company’s true financial situation emerged in the summer and fall of 2001, its stock price plunged, the firm fell into bankruptcy, and many people lost large portions (or the entirety) of their savings. In the process, SPEs and Enron became synonymous with corporate corruption. The mechanics of the tanker lease SPE also raised questions. Because the trust would hold ownership of the planes during the lease, it was unclear what would happen to the aircraft if the Air Force decided not to exercise its purchase option at the expiration of the six-year term. Additionally, repaying the finance costs to the trust’s bondholders appeared to be predicated on revenue from the eventual purchase of the airplanes. Therefore, it was also unclear how the SPE would pay its creditors in the absence of a purchase, and whether Boeing or the Air Force would hold any liability if the bonds went into default. These uncertainties seemed to underscore the contention of the lease’s critics that the deal was a disguised lease-purchase, in which case the entire cost of the planes should be accounted up front. 15The Boeing Tanker Lease Deal (A). CR16-06-1845.0 For Roche, the SPE was another example of how the Defense Department should change the way it does b . He again pointed to the slow economy as a window of opportunity for the military to gain cut-rate financing on the bonds issued by the trust, saying that “investors have no really good investments now ... You can get a very good investment buying the bonds and being part of the group that leases to the government.” Roche acknowledged, however, that sines different perspectives separated the private and public sectors: ‘It's hard for a businessman to look at this and wonder what their problem is, but, from the point of view of a government person, paying for a lease is bad. Why don't we buy these things? Except no one is giving us $16 billion to buy them up front.” Lease Terms Emerge Negotiations between Boeing and the Air Force accelerated in the spring of 2003, and concrete details of the mechanics behind the agreement began to emerge. Spurred by a DoD- sponsored study showing the price of the planes to be too high, Boeing slashed the offered price from $150 million to $131 million per aircraft. Under the proposed transaction, the Air Force would agree to a multiyear contract to lease 100 tankers, each for a six-year term, from the SPE. Boeing would build the aircraft and sell them to the SPE at an average price of $131 million. The SPE would tap about $105 million in commercial financing to make progress payments to Boeing during the construction process. As the aircraft near completion, the SPE would issue bonds to raise money to repay the principal and interest on the construction financing loans (estimated at about $7 million per plane) and to make a final payment to Boeing to complete the sale. The SPE would need to borrow about $138 million per aircraft to cover the purchase price of the plane plus interest." Boeing would then shift ownership of the aircraft to the SPE and deliver the planes to the Air Force. The service would receive the planes on a staggered schedule covering six years—four planes in 2006, 16 aircraft in 2007, and 20 planes in each of 2008, 2009, 2010, and 2011. For each plane, the Air Force would pay the SPE approximately $126 million over the six year lease. At the condlusion of the six-year term on each plane, the Air Force would have the option of purchasing the aircraft for $35 million or returning it to the SPE, However, the intent of the agreement would clearly be for the Air Force to exe payment, the SPE would be unable to return the principal to its bondholders, let alone additional ise the purchase option. Without the additional purchase financing costs." “767 Lease Would Cost the Same,” Inside the Air Force, February 28, 2003, Congressional Budget Office, “Assessment of the Air Force’s Plan to Acquire 100 Bocing ‘Tanker Aircraft,” August 2003 Ibid. 8 16The Boeing Tanker Lease Deal (A) CR16-06-1845.0 Decision Time for Secretary Rumsfeld While Boeing's price reduction made the lease option more competitive with an outright purchase, the arrangement’s detractors did not relent on their charge that it was a bad deal for taxpayer Moreover, the unusual—for the public sector, at least—financing arrangement amplified the unease of many observers. Nevertheless, after nearly two years, Defense Secretary Donald Rumsfeld was finally prepared to make a decision whether to go forward with the tanker lease, 7The Boeing Tanker Lease Deal (A) CR16-06-1845.0 Appendix A Overview of Department of Defense Organization The Department of Defense (DoD) comprises both civilian and military elements, with a civilian leader—the Secretary of Defense— maintaining the American tradition of civilian oversight of the military. The principal components of the department are the Office of the Secretary of Defense; the Joint Chiefs of Staff; the military departments; the military services; defense agencies; and the Unified Combatant Commands. A brief description of each of these elements follows. The Secretary of Defense DoD is led by a civilian Secretary of Defense and Deputy Secretary of Defense. The Secretary serves as the principal advisor to the President on defense matters and is responsible for managing the defense enterprise. In carrying out these duties, the Secretary issues guidance to direct the military departments in their programming and budgeting activities and, with the President's approval, provides guidance for developing contingency plans to the Chairman of the Joint Chiefs of Staff. Office of the Secretary of Defense (OSD) The Secretary oversees a civilian staff known as the Office of the Secretary of Defense (OSD). OSD staff assists the Secretary in formulating policy, conducting long-range planning, allocating resources, and monitoring DoD’s enterprise and operational performance. Organizationally, OSD is divided into five functional areas: Policy; Intelligence; Acquisition, Technology, and Logistics; Personnel and Readiness; and Comptroller. An Under Secretary leads each of these branches and reporis directly to the Secretary or the Deputy Secretary. Defense Agencies Defense agencies are established by the Secretary of Defense as needed to provide support to a department activity that cuts across multiple military services. Similar to the military departments, defense agencies develop programs and budgets to support their activities. Military Departments The three military departments of the Army, Navy, and Air Force provide civilian oversight and direction to the nation’s armed services. Each department is led by a civilian Secretary, usually referred to as a service Secretary, who reports directly to the Secretary of Defense. The service Seeretary is legally responsible for meeting the military department's requirements to organize, train, equip, and maintain the forces of the service or services it oversees. The service Secretary must both ensure that the military department carries out the policies and priorities of the Secretary of Defense and represent the views of the military department to the Defense Secretary. The department Secretary approves the military department’s program and budget and makes the final decision on what systems the military department will propose that it acquire. The military department's budget is then reviewed and adjudicated by OSD before being submitted to Congress as part of the President's budget. Military Services 18‘The Boeing ‘Tanker Lease Deal (A) CR16-06-1845.0 ‘The department's military personnel are organized into four military services—the Army, Navy, Marine Corps, and Air Force—which are overseen by a military department. The Department of the Navy provides civilian oversight and direction for both the Navy and the Marine Corps. Each service is led by a senior military officer, who also serves as a member of the Joint Chiefs of Staff. These officers are known as the Chief of Staff of the Army; the Chief of Naval Operations; the Chief of Staff of the Air Force; and the Commandant of the Marine Corps. These senior officers, supported by an analytical staff, are responsible for developing plans and recommendations to meet the military department's missions to organize, train, equip, and maintain the forces. After approval from the department Secretary, the four service heads are responsible for executing those plans so that the military forces are available and ready to mect the nation's military requirements when directed. joints Chiefs of Staff The Joint Chiefs of Staff (JCS) is composed of a Chairman and a Vice Chairman who may be from any military service; the Chief of Staff of the Army; the Chief of Naval Operations; the Chief of Staff of the Air Force; and the Commandant of the Marine Corps. The Chairman of the JCS is the principal military advisor to the President and the Secretary of Defense. The Chairman is responsible for assisting the Secretary of Defense in providing direction to the armed services, strategic and contingency planning, and advising the Secretary on requirements, programs, and budgets. In addition to their duties as leaders of their individual services, the four service chiefs serve as military advisors to the President and Secretary of Defense. They provide input to the Chairman and may supply advice to the President and Secretary supplementing or differing with that of the Chairman. Unified Combatant Commands Unified Combatant Commands are joint military organizations responsible for carrying out military missions assigned by the President and Secretary of Defense. The leaders of the commands are known as Combatant Commanders, who report directly to the Secretary of Defense. (The operational chain-of-command runs from the President to the Secretary of Defense to the Combatant Commanders.) The Combatant Commands are assigned forces to perform their missions by the military departments 19‘The Boeing Tanker Lease Deal (A) Assets Cash and cash equivalents Short-term investments Accounts receivable Current portion of customer and commercial financing Deterred incnme taxes Inventories, net of advances, progress billings and reserves Total current assets Customer and commercial financing, net Property, plant and equipment, net Goodwill Other acquired intangibles, net Prepaid pension expense Deferred income taxes Other assets Total assets Liabilities and Shareholders’ Equity Accounts payable and other liabilities Advances in excess of related costs Income taxes payable Short-term debt and current portion of long-term debt Total current liabilities Deferred income taxes, Accrued retiree health care Accrued pension plan liability Deferred lease income Long-term debt Total liabilities Shareholders’ Equity Common shares, par value $5.00 Additional paid-in capital Treasury shares, at cost Retained earnings Accumulated other comprehensive income Uneamed compensation ShareValue Trust shares, Total shareholders’ equity Total liabilities and equity Appendix B Boeing Balance Sheets: 1999 through 2002 2002 2,333 5,007 1,289 2,042 6,184 16,855 10,922 8,765 2,760 1,128 6671 2,272 2,969 52,342 13,739 3,123 1,134 1814 19,810 7,696 52,342 2001 5,156 1,053 2444 7,559 16,845 9,345 8,459 5,127 1,320 5,838 2,044 48,978 14,237 4,021 909 1,399 20,566 477 5,367 555 622 10,866 38,153 5,059 1,975 CR16-06-1845.0 2000 1999 1,010 3,354 100 5,519 3,453 995 799, 2,137 1,467 6,852 6,539 16,513 15,712 5,964 5,205 8814 8,245, 5214 2,233 4845 3,845 60 1,267 907 92,677 36,147 12,312 11,269 3,517 1,215 1,866 420 1,232 752 18,927 13,656 172 5,163 4877 7,567 5,980 31,657 24,685 20The Boeing Tanker Lease Deal (A) Total revenues Total costs and expenses Total revenues minus expenses Income/(loss) from operating, investments, net General and administrative expense Research and development expense Gain on dispositions, net Share-based plans expense Impact of September 11, 2001, recoveries Earnings from continuing operations Other income, net Interest and debt expense Earnings before income taxes Income tax (expense)/benefit Net carnings from continuing operations Income from discontinued operations, net of taxes Cumulative effect of accounting change, net of taxes Net earnings Appendix C Boeing Income Statements: 1999 through 2002 3,426 ae: e20) 2,296 23 492 2,827 2,128 Ce 160e- 10400. 1999 57,993 S1320) 6,673 4 (2,044) (1341) 87 (209) 3,170 585 (431) 3,324 (1.013) 2,309 2,309é : 7 2 . ’ : a 1 7 3 : 7 ae : aThe Boeing Tanker Lease Deal (A) : : CR16-06-1845.0 Appendix D Costs Per Aircraft Under the Tanker Financing Plan" 2, Permanent Finuacing = S1S84M Principal & tnterest = S1L4M co 1. Construction Loans =$103M_ LO 9. Peace 8 Interest = $16)M x - 6. Lease Payruents » S126M Purchase at Lease End'= $35M. 4, Airorafi Sale to ‘Trust = 31M 7 3. Tuakers 1. As Boeing, builds the tankers, the Trust will borrow money from commercial banks to make progress payments to Boeing. CBO estimates that, on average, the Trust will borrow approximately $105 million per plane for progress payments. 2. Shortly before the planes are delivered, the Trust will issue bonds to raise $138.4 million per plane in permanent financing. 3. The Trust will use the bond proceeds to pay principal and interest on the construction financing loans, which CBO estimates will average $112.4 million per plane. 4, The Trust will use the rest of the bond proceeds to pay Boeing the remainder it is owed on the aircraft. Total payments to Boeing will equal $131 million per plane. 5. Boeing will transfer title to the planes to the Trust and deliver the aircraft to the Air Force. 6. The Air Force will make lease payments totaling $126 million per plane and a final payment of $35 million should it choose to purchase the planes at the end of the lease. 7. The Trust will use the Air Force's lease and purchase payments to remit $161 million in principal and interest to the bondholders. Source: “Assessment of the Air Force's Plan to Acquire 100 Boeing Tanker Aircraft", Congressional Budget Office, August 2003, page 4. 23The Boeing Tanker Lease Deal (A). (CR16-06-1845.0 Appendix E May 2002 Office of Management and Budget Cost Estimates Aircraft Orders and Deliveries Fyo2 | Fvo3 | FYo4 | FYos | FYos | Fyo7 | Fyos | FYo9 | Fy10 | FY11 Ordered 6| 14] 20] 20] 20[ 20 Delivere | 4 eae 20 20 20 20 5 Relevant Assumptions © Cost of 767 airframe is $90 million * Cost of conversion of 767 airframe to military specifications is $60 million * Each plane is leased for 10 years Leasing Cost Estimate FY02 FY03 FY02 - FYO7 Total Program Commercial 767 Lease Costs 0 oO 1603.8 17860.6. Tanker Modification 365.8 | __ 866.9 6453.8 6453.8 | Military Construction 0 194 1004.5 1086.9 | Other Government Costs 2 55.4 515.7 610.3 Total 367.8 1116 9577.8 26011.6 Direct Purchasing Cost Estimate Fyo2_| FYo3 | Fyo4 | Fyos5 | Fyo6 | FYo7 | Total Ordered 6 14, 20. 20 20 20 100 Gost goo| 2100] 3000] 3000] 3000| 3000] 15000 + Military Construction* — ~3000 Total ~18000 * Military Construction costs for direct purchase exceed those for leasing option because of need for permanent facshives. 24