VARIABLE INTEREST ENTITIES AND PREFERRED SECURITIES OF SUBSIDIARIES

Variable Interest Entities

In connection with the 2006 sale of approximately 5.6 million acres of forestlands, International Paper received installment notes (the Timber Notes) totaling approximately $4.8 billion. The Timber Notes, which do not require principal payments prior to their August 2016 maturity, are supported by irrevocable letters of credit obtained by the buyers of the forestlands.

During 2006, International Paper contributed the Timber Notes to newly formed entities (the Borrower Entities) in exchange for Class A and Class B interests in these entities. Subsequently, International Paper contributed its $200 million Class A interests in the Borrower Entities, along with approximately $400 million of International Paper promissory notes, to other newly formed entities (the Investor Entities, and together with the Borrower Entities, the Entities) in exchange for Class A and Class B interests in these entities, and simultaneously sold its Class A interest in the Investor Entities to a third party investor. As a result, at December 31, 2006, International Paper held Class B interests in the Borrower Entities and Class B interests in the Investor Entities valued at approximately $5.0 billion. International Paper did not provide any financial support that was not previously contractually required for the nine months ended September 30, 2012 and the year ended December 31, 2011.

Following the 2006 sale of forestlands and creation of the Entities discussed above, the Timber Notes were used as collateral for borrowings from third party lenders, which effectively monetized the Timber Notes. Provisions of certain loan agreements require any bank issuing letters of credit supporting the Timber Notes to maintain a credit rating at or above a specified threshold. In the event the credit rating of a letter of credit bank is downgraded below the specified threshold, the letters of credit must be replaced within 60 days with letters of credit from a qualifying financial institution or for one of the letter of credit banks, collateral must be posted. The Company, retained to provide management services for the third-party entities that hold the Timber Notes, has, as required by the loan agreements, successfully replaced banks that fell below the specified threshold.

Also during 2006, the Entities acquired approximately $4.8 billion of International Paper debt obligations for cash, resulting in a total of approximately $5.2 billion of International Paper debt obligations held by the Entities at December 31, 2006. The various agreements entered into in connection with these transactions provide that International Paper has, and intends to affect, a legal right to offset its obligation under these debt instruments with its investments in the Entities. Accordingly, for financial reporting purposes, International Paper has offset approximately $5.2 billion of Class B interests in the Entities against $5.2 billion of International Paper debt obligations held by these Entities at September 30, 2012 and December 31, 2011. Despite the offset treatment, these remain debt obligations of International Paper. Remaining borrowings of $93 million and $92 million at September 30, 2012 and December 31, 2011, respectively, are included in Long-term debt in the accompanying consolidated balance sheet. Additional debt related to the above transaction of $66 million and $38 million is included in Notes payable and current maturities of long-term debt at September 30, 2012 and December 31, 2011, respectively.

On October 7, 2011, Moody’s Investor Services reduced its credit rating of senior unsecured long-term debt of the Royal Bank of Scotland Group Plc, which issued letters of credit that support $797 million of Timber Notes, below the specified threshold. The Company and the third party managing member instituted a replacement waiver for these letters of credit. On July 25, 2012, these letters of credit were successfully replaced by another qualifying institution. In the event the credit rating of the letter of credit bank is downgraded below a specified threshold, the new bank is required to provide credit support for its obligation. Fees of $5 million were incurred in connection with this replacement.

On June 21, 2012, Moody’s Investor Services reduced its credit rating of senior unsecured long-term debt of BNP Paribas, which issues letters of credit that support $707 million of Timber Notes, below the specified threshold. The relevant parties agreed to extend the deadline for the replacement letters of credit. The Company expects the replacement will be completed in the fourth quarter of 2012.

Activity between the Company and the Entities was as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
In millions	2012		2011		2012		2011
Revenue (a)	$	15	$	14	$	35	$	39
Expense (a)	28		20		68		59
Cash receipts (b)	21		14		36		28
Cash payments (c)	47		39		87		79


(a)	The net expense related to the Company’s interest in the Entities is included in the accompanying consolidated statement of operations, as International Paper has and intends to affect its legal right to offset as discussed above.


(b)	The cash receipts are equity distributions from the Entities to International Paper.


(c)	The semi-annual payments are related to interest on the associated debt obligations discussed above.

Based on an analysis of the Entities discussed above under guidance that considers the potential magnitude of the variability in the structures and which party has a controlling financial interest, International Paper determined that it is not the primary beneficiary of the Entities, and therefore, does not consolidate its investments in these entities. It was also determined that the source of variability in the structures is the value of the Timber Notes, the assets most significantly impacting the structure’s economic performance. The credit quality of the Timber Notes is supported by irrevocable letters of credit obtained by third party buyers which are 100% cash collateralized. International Paper analyzed which party has control over the economic performance of each entity, and concluded International Paper does not have control over significant decisions surrounding the Timber Notes and letters of credit and therefore is not the primary beneficiary. The Company’s maximum exposure to loss equals the value of the Timber Notes; however, an analysis performed by the Company concluded the likelihood of this exposure is remote.

International Paper also held variable interests in two financing entities that were used to monetize long-term notes received from the sale of forestlands in 2001 and 2002. International Paper transferred notes (the Monetized Notes, with an original maturity of 10 years from inception) and cash having a value of approximately $1.0 billion to these entities in exchange for preferred interests, and accounted for the transfers as a sale of the notes with no associated gain or loss. In the same period, the entities acquired approximately $1.0 billion of International Paper debt obligations for cash. International Paper has no obligation to make any further capital contributions to these entities and did not provide any financial support that was not previously contractually required during the nine months ended September 30, 2012 and the year ended December 31, 2011.

Activity between the Company and the 2001 financing entities was as follows:



In millions	Nine Months Ended September 30, 2011
Revenue (a)	$	1
Expense (a)	3
Cash receipts (b)	—
Cash payments (c)	3


(a)	The net expense related to the Company’s interest in the 2001 financing entities is included in Interest expense, net in the accompanying consolidated statement of operations, as International Paper has and intends to affect its legal right to offset as discussed above.


(b)	The cash receipts are equity distributions from the 2001 financing entities to International Paper.


(c)	The cash payments are related to interest on the associated debt obligations discussed above.

The 2001 Monetized Notes of $499 million matured on March 16, 2011. Following their maturity, International Paper purchased the Class A preferred interest in the 2001 financing entities from an external third party for $21 million. As a result of the purchase, effective March 16, 2011, International Paper owned 100% of the 2001 financing entities. Based on an analysis performed by the Company after the purchase, under guidance that considers the potential magnitude of the variability in the structure and which party has a controlling financial interest, International Paper determined that it was the primary beneficiary of the 2001 financing entities and thus consolidated the entities effective March 16, 2011. Effective April 30, 2011, International Paper liquidated its interest in the 2001 financing entities.

Activity between the Company and the 2002 financing entities was as follows:



	Three Months Ended September 30,				Nine Months Ended September 30,
In millions	2012		2011		2012		2011
Revenue (a)	$	—	$	—	$	—	$	2
Expense (b)	—		—		—		3
Cash receipts (c)	—		15		252		16
Cash payments (d)	—		15		159		68


(a)	The revenue is included in Equity earnings (losses) in the accompanying consolidated statement of operations.


(b)	The expense is included in Interest expense, net in the accompanying consolidated statement of operations.


(c)	The cash receipts are principal and interest from the maturity of a portion of the 2002 Monetized Notes.


(d)	The cash payments include both interest and principal on the associated debt obligations.

On May 31, 2011, the third party equity holder of the 2002 financing entities retired its Class A interest in the entities for $51 million. As a result of the retirement, effective May 31, 2011, International Paper owns 100% of the 2002 financing entities. Based on an analysis performed by the Company after the retirement, under guidance that considers the potential magnitude of the variability in the structure and which party has a controlling financial interest, International Paper determined that it is the primary beneficiary of the 2002 financing entities and thus consolidated the entities effective May 31, 2011.

During 2011, approximately $191 million of the 2002 Monetized Notes matured. Outstanding debt related to the 2002 financing entities of $158 million is included in Notes payable and current maturities of long-term debt in the accompanying consolidated balance sheet at December 31, 2011. As of May 31, 2012, this debt has been repaid.

During the three months ended March 31, 2012, approximately $111 million of the 2002 Monetized Notes matured. In May 2012, the remaining $141 million of 2002 Monetized Notes matured. As a result of these maturities, Accounts and notes receivable, net decreased $252 million and Notes payable and current maturities of long-term debt decreased $158 million. Deferred tax liabilities associated with the 2002 forestlands sales decreased $67 million. Effective June 1, 2012, International Paper liquidated its interest in the 2002 financing entities.

The use of the above entities facilitated the monetization of the credit enhanced Timber and Monetized Notes in a cost effective manner by increasing the borrowing capacity and lowering the interest rate while continuing to preserve the tax deferral that resulted from the forestlands installment sales and the offset accounting treatment described above.

In connection with the acquisition of Temple-Inland in February 2012, two special purpose entities became wholly-owned, indirect subsidiaries of International Paper.

In October 2007, Temple-Inland sold 1.55 million acres of timberland for $2.38 billion. The total consideration consisted almost entirely of notes due in 2027 issued by the buyer of the timberland, which Temple-Inland contributed to two wholly-owned, bankruptcy-remote special purpose entities. The notes are shown in Financial assets of special purpose entities in the accompanying consolidated balance sheet and are supported by $2.38 billion of irrevocable letters of credit issued by three banks, which are required to maintain minimum credit ratings on their long-term debt. In the third quarter of 2012, International Paper completed its preliminary analysis of the acquisition date fair value of the notes and determined it to be$2.09 billion. As a result of this analysis, Financial assets of special purpose entities decreased by $292 million and Goodwill increased by the same amount. As of September 30, 2012, the fair value of the notes was $2.16 billion.

In December 2007, Temple-Inland’s two wholly-owned special purpose entities borrowed $2.14 billion shown in Nonrecourse financial liabilities of special purpose entities. The loans are repayable in 2027 and are secured only by the $2.38 billion of notes and the irrevocable letters of credit securing the notes and are nonrecourse to us. The loan agreements provide that if a credit rating of any of the banks issuing the letters of credit is downgraded below the specified threshold, the letters of credit issued by that bank must be replaced within 30 days with letters of credit from another qualifying financial institution. In the third quarter of 2012, International Paper completed its preliminary analysis of the acquisition date fair value of the borrowings and determined it to be $2.03 billion. As a result of this analysis, Nonrecourse financial liabilities of special purpose entities decreased by $110 million and Goodwill decreased by the same amount. As of September 30, 2012, the fair value of this debt was $2.08 billion.

The buyer of the Temple-Inland timberland issued the $2.38 billion in notes from its wholly-owned, bankruptcy-remote special purpose entities. The buyer’s special purpose entities held the timberland from the transaction date until November 2008, at which time the timberland was transferred out of the buyer’s special purpose entities. Due to the transfer of the timberland, Temple-Inland evaluated the buyer’s special purpose entities and determined that they were variable interest entities and that Temple-Inland was the primary beneficiary. As a result, in 2008 Temple-Inland began consolidating the buyer’s special purpose entities.

On June 21, 2012, Moody’s Investor Services reduced its credit rating of senior unsecured long-term debt of Barclays Bank PLC, which issued letters of credit that support approximately $500 million of the 2007 Monetized Notes, below the specified threshold. The relevant parties agreed to extend the deadline for the replacement letters of credit and then, on August 16, 2012, these letters of credit were successfully replaced by another qualifying institution. Fees of $6 million were incurred in connection with this replacement.

Activity between the Company and the 2007 financing entities was as follows:



In millions	Three Months Ended September 30, 2012		Nine Months Ended September 30, 2012
Revenue (a)	$	15	$	21
Expense (b)	11		20
Cash receipts (c)	3		10
Cash payments (d)	6		16


(a)	The revenue is included in Interest expense, net in the accompanying consolidated statement of operations and includes $12 million of accretion income for the amortization of the purchase accounting adjustment on the Financial assets of special purpose entities.


(b)	The expense is included in Interest expense, net in the accompanying consolidated statement of operations and includes $5 million of accretion expense for the amortization of the purchase accounting adjustment on the Nonrecourse financial liabilities of special purpose entities.


(c)	The cash receipts are interest received on the Financial assets of special purpose entities.


(d)	The cash payments are interest paid on Nonrecourse financial liabilities of special purpose entities.

Based on an analysis performed by the Company after the purchase of Temple-Inland and completed in the third quarter of 2012, under guidance that considers the potential magnitude of the variability in the structure and which party has a controlling financial interest, International Paper determined that it was not the primary beneficiary of the buyer's special purpose entities that purchased the timberlands from Temple-Inland and therefore, should not consolidate the buyer's special purpose entities financial results as was historically shown by Temple-Inland. As a result of this determination, as of September 30, 2012, Financial assets of special purpose entities and Noncontrolling interests were both reduced by approximately $92 million in the accompanying consolidated balance sheet since the second quarter of 2012.

Preferred Securities of Subsidiaries

In March 2003, Southeast Timber, Inc. (Southeast Timber), a consolidated subsidiary of International Paper, issued $150 million of preferred securities to a private investor with future dividend payments based on LIBOR. Southeast Timber, which through a subsidiary initially held approximately 1.5 million acres of forestlands in the southern United States, was International Paper’s primary vehicle for sales of southern forestlands. As of September 30, 2012, substantially all of these forestlands have been sold. These preferred securities may be put back to International Paper by the private investor upon the occurrence of certain events, and have a liquidation preference that approximates their face amount. The $150 million preferred third-party interest is included in Noncontrolling interests in the accompanying consolidated balance sheet. Distributions paid to the third-party investor were $4 million for each of the nine months ended September 30, 2012 and 2011. The expense related to these preferred securities is shown in Net earnings (loss) attributable to noncontrolling interests in the accompanying consolidated statement of operations.