-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, MGkR0lZFzkQA8GfnLR0KakfGvi/KdeLTLI7AWgDYuMlAAkYI3wKewV1vSrdFJVc5 ogOoEP6KQjGMf2ri/C1ZSg== 0000948524-98-000063.txt : 19980529 0000948524-98-000063.hdr.sgml : 19980529 ACCESSION NUMBER: 0000948524-98-000063 CONFORMED SUBMISSION TYPE: 10-K/A PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980528 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: POLARIS AIRCRAFT INCOME FUND III CENTRAL INDEX KEY: 0000806031 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-EQUIPMENT RENTAL & LEASING, NEC [7359] IRS NUMBER: 943023671 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K/A SEC ACT: SEC FILE NUMBER: 033-10122 FILM NUMBER: 98632938 BUSINESS ADDRESS: STREET 1: 201 HIGH RIDGE ROAD STREET 2: 27TH FL CITY: STAMFORD STATE: CT ZIP: 06927 BUSINESS PHONE: (203) 357- MAIL ADDRESS: STREET 1: 201 HIGH RIDGE ROAD STREET 2: 27TH FL CITY: STAMFORD STATE: CT ZIP: 06927 10-K/A 1 AMENDMENT NO. 1, ITEM 7 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------- FORM 10-K/A Amendment No. 1 --------------- _X_ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 OR ___ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from__to__ Commission File No. 33-10122 POLARIS AIRCRAFT INCOME FUND III, A California Limited Partnership ----------------------------------------------------- (Exact name of registrant as specified in its charter) California 94-3023671 - ------------------------------- ----------------------- (State or other jurisdiction of (IRS Employer I.D. No.) incorporation or organization) 201 High Ridge Road, Stamford, Connecticut 06927 - ------------------------------------------ ---------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (203) 357-3776 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Depository Units Representing Assignments of Limited Partnership Interests Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes _X_ No___ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ___ No formal market exists for the units of limited partnership interest and therefore there exists no aggregate market value at December 31, 1997. Documents incorporated by reference: None This document consists of 10 pages. The undersigned registrant hereby amends Item 7 of its Annual Report on Form 10-K for the year ended December 31, 1997 in its entirety as follows: Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations At December 31, 1997, Polaris Aircraft Income Fund III (the Partnership) owned a portfolio of 10 used McDonnell Douglas DC-9-30 aircraft leased to Trans World Airlines, Inc. (TWA) and certain inventoried aircraft parts out of its original portfolio of 38 aircraft. The Partnership transferred three McDonnell Douglas DC-9-10 aircraft and six Boeing 727-100 aircraft to aircraft inventory in 1992. The inventoried aircraft have been disassembled for sale of their component parts. Of its original aircraft portfolio, the Partnership sold eight DC-9-10 aircraft in 1992 and 1993 and three Boeing 727-200 aircraft in May 1994. In June 1997, the Partnership sold three McDonnell Douglas DC-9-30 aircraft leased to TWA, and five Boeing 727-200 Advanced aircraft leased to Continental Airlines, Inc. (Continental) to Triton Aviation Services III LLC. Remarketing Update General - Polaris Investment Management Corporation (the General Partner or PIMC) evaluates, from time to time, whether the investment objectives of the Partnership are better served by continuing to hold the Partnership's remaining portfolio of Aircraft or marketing such Aircraft for sale. This evaluation takes into account the current and potential earnings of the Aircraft, the conditions in the markets for lease and sale and future outlook for such markets, and the tax consequences of selling rather than continuing to lease the Aircraft. Recently, the General Partner has had discussions with third parties regarding the possibility of selling some or all of these Aircraft. While such discussions may continue, and similar discussions may occur again in the future, there is no assurance that such discussions will result in the Partnership receiving a purchase offer for all or any of the Aircraft which the General Partner would regard as acceptable. Sale of Aircraft - On May 28, 1997, PIMC, on behalf of the Partnership, executed definitive documentation for the purchase of 8 of the Partnership's 18 remaining aircraft (the "Aircraft") and certain of its notes receivables by Triton Aviation Services III LLC, a special purpose company (the "Purchaser"). The closings for the purchase of the 8 Aircraft occurred from June 5, 1997 to June 25, 1997. The Purchaser is managed by Triton Aviation Services, Ltd. ("Triton Aviation" or the "Manager"), a privately held aircraft leasing company which was formed in 1996 by Triton Investments, Ltd., a company which has been in the marine cargo container leasing business for 17 years and is diversifying its portfolio by leasing commercial aircraft. Each Aircraft was sold subject to the existing leases. The General Partner's Decision to Approve the Transaction - In determining whether the transaction was in the best interests of the Partnership and its unitholders, PIMC evaluated, among other things, the risks and significant expenses associated with continuing to own and remarket the Aircraft (many of which were subject to leases that were nearing expiration). The General Partner determined that such a strategy could require the Partnership to expend a significant portion of its cash reserves for remarketing and that there was a substantial risk that this strategy could result in the Partnership having to reduce or even suspend future cash distributions to limited partners. The General Partner concluded that the opportunity to sell the Aircraft at an attractive price would be beneficial in the present market where demand for Stage II aircraft is relatively strong rather than attempting to sell the aircraft "one-by-one" over the coming years when the demand for such Aircraft might be weaker. GE Capital Aviation Services, Inc. ("GECAS"), which provides aircraft marketing and management services to the General Partner, sought to obtain the best price and terms available for these Stage II aircraft given the aircraft market and the conditions and types of planes owned by the Partnership. Both the General Partner and GECAS approved the sale terms of the Aircraft as 2 being in the best interest of the Partnership and its unit holders because both believe that this transaction will optimize the potential cash distributions to be paid to limited partners. To ensure that no better offer could be obtained, the terms of the transaction negotiated by GECAS included a "market-out" provision that permitted the Partnership to elect to accept an offer for all (but not less than all) of the assets to be sold by it to the Purchaser on terms which it deemed more favorable, with the ability of the Purchaser to match the offer or decline to match the offer and be entitled to be compensated in an amount equal to 1.5% of the Purchaser's proposed purchase price. The Partnership did not receive any other offers and, accordingly, the General Partner believes that a valid market check had occurred confirming that the terms of this transaction were the most beneficial that could have been obtained. The Terms of the Transaction - The total contract purchase price (the "Purchase Price") to the Purchaser was $10,947,000 which was allocated to the Aircraft and a note receivable by the Partnership. The Purchaser paid into an escrow account $1,233,289 of the Purchase Price in cash at the closing of the first aircraft and delivered a promissory note (the "Promissory Note") for the balance of $9,713,711. The Partnership received payment of $1,233,289 from the escrow account on June 26, 1997. On December 30, 1997, the Partnership received prepayment in full of the outstanding note receivable and interest earned by the Partnership to that date. Under the purchase agreement, the Purchaser purchased the Aircraft effective as of April 1, 1997 notwithstanding the actual closing dates. The utilization of an effective date facilitated the determination of rent and other allocations between the parties. The Purchaser had the right to receive all income and proceeds, including rents and receivables, from the Aircraft accruing from and after April 1, 1997, and the Promissory Note commenced bearing interest as of April 1, 1997 subject to the closing of the Aircraft. Each Aircraft was sold subject to the existing leases. Neither PIMC nor GECAS received a sales commission in connection with the transaction. In addition, PIMC was not paid a management fee with respect to the collection of the Promissory Note or on any rents accruing from or after April 1, 1997 with respect to the 8 Aircraft. Neither PIMC nor GECAS or any of its affiliates holds any interest in Triton Aviation or any of Triton Aviation's affiliates. John Flynn, the current President of Triton Aviation, was a Polaris executive until May 1996 and has over 15 years experience in the commercial aviation industry. At the time Mr. Flynn was employed at PIMC, he had no affiliation with Triton Aviation or its affiliates. Polaris Aircraft Income Fund II, Polaris Aircraft Income Fund IV, Polaris Aircraft Income Fund V and Polaris Aircraft Income Fund VI have also sold certain aircraft assets to separate special purpose companies under common management with the Purchaser (collectively, together with the Purchaser, the "SPC's") on terms similar to those set forth above, with the exception of the Polaris Aircraft Income Fund VI aircraft, which were sold on an all cash basis. The Accounting Treatment of the Transaction - In accordance with generally accepted accounting principles (GAAP), the Partnership recognized rental income up until the closing date for each aircraft which occurred from June 5, 1997 to June 25, 1997. However, under the terms of the transaction, the Purchaser was entitled to receive any payments of the rents, interest income and receivables accruing from April 1, 1997. As a result, the Partnership made payments to the Purchaser for the amounts due and received from April 1, 1997 to the closing date. Amounts totaling $1,341,968 during this period are included in rents from operating leases, interest and other income. For financial reporting purposes, the cash down payment portion of the sales proceeds of $1,233,289 has been adjusted by the following; income and proceeds, including rents and receivables from the effective date of April 1, 1997 to the closing date, interest due from the Purchaser on the cash portion of the purchase price, interest on the Promissory Note from the effective date of April 1, 1997 to the closing date and estimated selling costs. As a result of these GAAP adjustments, the net adjusted sales price recorded by the Partnership, including the Promissory Note, was $9,827,305. The Aircraft sold pursuant to the definitive documentation executed on May 28, 1997 had been classified as aircraft held for sale from that date until the 3 actual closing date. Under GAAP, aircraft held for sale are carried at their fair market value less estimated costs to sell. The adjustment to the sales proceeds described above and revisions to estimated costs to sell the Aircraft required the Partnership to record an adjustment to the net carrying value of the aircraft held for sale of $1,092,046 during 1997. This adjustment to the net carrying value of the aircraft held for sale is included in depreciation and amortization expense on the statement of operations. Partnership Operations The Partnership reported net income of $4,989,096, or $9.88 per limited partnership unit for the year ended December 31, 1997, compared to a net loss of $6,803,529, or $17.25 per limited partnership unit for the year ended December 31, 1996, and net income of $7,897,946, or $13.39 per limited partnership unit, for the year ended December 31, 1995. The decrease in rental revenues, depreciation expense and management fees during 1997, is attributable to the sale of 8 aircraft to Triton during 1997. This decrease in rental revenues and depreciation expense was offset in part by increased depreciation expense attributable to the acquisition in November 1996 of noise-suppression devices, commonly known as "hushkits", for the 10 aircraft currently leased to TWA. The hushkits are being financed over 50 months at an interest rate of 10% per annum. The leases for these 10 aircraft were extended for a period of eight years until November 2004. The rent payable by TWA under the leases has been increased by an amount sufficient to cover the monthly debt service payments on the hushkits and fully repay, during the term of the TWA leases, the amount borrowed. The Partnership recorded $1,205,566 and $122,197 in interest expense on the amount borrowed to finance the hushkits during 1997 and 1996, respectively. The Partnership recorded an increase in other income during 1997. This increase in other income was the result of the receipt of $743,476 related to amounts due under the TWA maintenance credit and rent deferral agreement. Rental revenues, net of related management fees, declined in 1996 as compared to 1995 due to the extension of the Continental leases at a current market rate that was lower than the prior lease rate. Additionally, TWA rental revenues were higher in 1995 due to the receipt, during 1995, of certain deferred rental amounts from 1994 as discussed below under TWA Restructuring. In consideration for the rent deferral discussed later under TWA Restructuring, the Partnership received $157,568 in January 1995 as its share of such payment by TWA. This amount was recognized as other revenue in 1995. In addition, TWA agreed to issue warrants to the Partnership for TWA Common Stock. The Partnership received warrants to purchase 159,919 shares of TWA Common Stock from TWA in November 1995 and recognized the net warrant value as of the date of receipt of $1,247,768 as revenue in 1995. The Partnership exercised the warrants on December 29, 1995 for the strike price of $0.01 per share and has recognized a gain on the value of the warrants of $409,792 in 1995. In 1996, the Partnership sold its TWA Common Stock. In January 1995, the United States Bankruptcy Court approved an agreement between the Partnership and Continental which specified payment to the Partnership by Continental of approximately $1.3 million as final settlement for the return of six Boeing 727-100 aircraft. The Partnership received an initial payment of $311,111 in February 1995 and received the balance of the settlement in equal monthly installments of $72,222 through February 1996. The Partnership received all payments due from Continental for the settlement, which were recorded as revenue when received. The Partnership recorded payments of $1,105,556 and $144,444 as other revenue during 1995 and 1996, respectively. The Partnership recognized substantially higher depreciation expense in 1996, as compared to the prior year. As discussed in the Industry Update section, if the projected net cash flow for each aircraft (projected rental revenue, net of management fees, less projected maintenance costs, if any, plus the estimated residual value) is less than the carrying value of the aircraft, the Partnership 4 recognizes the deficiency currently as increased depreciation expense. The Partnership recognized impairment losses on aircraft to be held and used by the Partnership of approximately $12.5 million and $1.8 million in 1996 and 1995 as increased depreciation expense. In 1996, the impairment loss was the result of several significant factors. As a result of industry and market changes, a more extensive review of the Partnership's aircraft was completed in the fourth quarter of 1996 which resulted in revised assumptions of future cash flows including reassessment of projected re-lease terms and potential future maintenance costs. As discussed in Note 4, the Partnership accepted an offer to purchase eight of the Partnership's remaining aircraft subject to each aircraft's existing lease. This offer constituted an event that required the Partnership to review the aircraft carrying value pursuant to SFAS 121. In determining this additional impairment loss, the Partnership estimated the fair value of the aircraft based on the purchase price reflected in the offer, less the estimated costs and expenses of the proposed sale. The partnership is deemed to have an impairment loss to the extent that the carrying value exceeded the fair value. Management believes the assumptions related to fair value of impaired assets represents the best estimates based on reasonable and supportable assumptions and projections. The increased depreciation expense reduces the aircraft's carrying value and reduces the amount of future depreciation expense that the Partnership will recognize over the projected remaining economic life of the aircraft. The Partnership also made downward adjustments to the estimated residual value of certain of its on-lease aircraft as of December 31, 1995. For any downward adjustment to the estimated residual values, future depreciation expense over the projected remaining economic life of the aircraft is increased. The Partnership's earnings are impacted by the net effect of the adjustments to the aircraft carrying values recorded in 1996 and 1995, and the downward adjustments to the estimated residual values recorded in 1995 as discussed later in the Industry Update section. Liquidity and Cash Distributions Liquidity - The Partnership received prepayment in full of all amounts due from Triton and all lease payments from lessees, except for the December 27, 1997 payment due from TWA. On January 2, 1998, the Partnership received its $850,000 rental payment from TWA that was due on December 27, 1997. This amount was included in rent and other receivables on the balance sheet at December 31, 1997. In addition, proceeds totaling $590,981 have been received for the sale of parts from the nine disassembled aircraft during 1997, as compared to proceeds of and $902,733 and $1,915,820 during 1996 and 1995, respectively. The net book value of the Partnership's aircraft inventory was recovered in full during 1996. As a result, the payments received during 1997 have been recorded as gain on sale of aircraft inventory. PIMC has determined that the Partnership maintain cash reserves as a prudent measure to ensure that the Partnership has available funds in the event that the aircraft presently on lease to TWA require remarketing, and for other contingencies including expenses of the Partnership. The Partnership's cash reserves will be monitored and may be revised from time to time as further information becomes available in the future. As discussed above and in Note 6 to the financial statements (Item 8), the Partnership agreed to share the cost of meeting certain Airworthiness Directives (ADs) with TWA. In accordance with the cost-sharing agreement, TWA may offset up to an additional $1.0 million against rental payments, subject to annual limitations, over the remaining lease terms. Cash Distributions - Cash distributions to limited partners were $11,100,000, $18,875,000 and $11,250,000 in 1997, 1996 and 1995, respectively. Cash distributions per limited partnership unit totaled $22.20, $37.75 and $22.50 in 1997, 1996 and 1995, respectively. The timing and amount of future cash distributions are not yet known and will depend on the Partnership's future cash requirements (including expenses of the Partnership) and need to retain cash reserves as previously discussed in the Liquidity section; the receipt of rental payments from TWA; and payments generated from the aircraft disassembly process. 5 TWA Restructuring In October 1994, TWA notified its creditors, including the Partnership, of another proposed restructuring of its debt. Subsequently, GECAS negotiated a standstill arrangement, as set forth in a letter agreement dated December 16, 1994 (the Deferral Agreement), with TWA for the 46 aircraft that are managed by GECAS, 13 of which are owned by the Partnership. As required by its terms, the Deferral Agreement (which has since been amended as discussed below) was approved by PIMC on behalf of the Partnership with respect to the Partnership's aircraft. The Deferral Agreement provided for (i) a moratorium on all the rent due to the Partnership in November 1994 and on 75% of the rents due to the Partnership from December 1994 through March 1995, and (ii) all of the deferred rents, together with interest thereon, to be repaid in monthly installments beginning in May 1995 and ending in December 1995. The repayment schedule was subsequently accelerated upon confirmation of TWA's bankruptcy plan. The Partnership recorded a note receivable and an allowance for credit losses equal to the total of the deferred rents, the net of which was reflected in the Partnership's 1994 balance sheet (Item 8). The Partnership did not recognize either the $1,137,500 rental amount deferred in 1994 or the $1,462,500 rental amount deferred during the first quarter of 1995 as rental revenue until the deferred rents were received. The Partnership received all scheduled rent payments beginning in April 1995, and all scheduled deferred rental payments beginning in May 1995, including interest at a rate of 12% per annum, from TWA and has recognized the $2.6 million deferred rents as rental revenue during 1995. The deferred rents were paid in full by October 1995. In consideration for the partial rent moratorium described above, TWA agreed to make a lump sum payment of $1,000,000 to GECAS for the TWA lessors for whom GECAS provides management services and who agreed to the Deferral Agreement. The Partnership received $157,568 in January 1995 as its share of such payment by TWA. This amount was recognized as other revenue in the accompanying 1995 statement of operations. In addition, TWA agreed to issue warrants to the Partnership for TWA Common Stock. In order to resolve certain issues that arose after the execution of the Deferral Agreement, TWA and GECAS entered into a letter agreement dated June 27, 1995, pursuant to which they agreed to amend certain provisions of the Deferral Agreement (as so amended, the Amended Deferral Agreement). The effect of the Amended Deferral Agreement, which was approved by PIMC with respect to the Partnership's aircraft, is that TWA, in addition to agreeing to repay the deferred rents to the Partnership, agreed (i) to a fixed payment amount (payable in warrants, the number of which was determined by formula) in consideration for the aircraft owners' agreement to defer rent under the Deferral Agreement, and, (ii) to the extent the market value of the warrants is less than the payment amount, to supply maintenance services to the aircraft owners having a value equal to such deficiency. The payment amount was determined by subtracting certain maintenance reimbursements owed to TWA by certain aircraft owners, including the Partnership, from the aggregate amount of deferred rents. On June 30, 1995, TWA filed its prepackaged Chapter 11 bankruptcy in the United States Bankruptcy Court for the Eastern District of Missouri. On August 4, 1995, the Bankruptcy Court confirmed TWA's plan of reorganization, which became effective on August 23, 1995. Pursuant to the Amended Deferral Agreement, on the confirmation date of the plan, August 4, 1995, the Partnership received a payment of $881,480 from TWA which represented fifty percent (50%) of the deferred rent outstanding plus interest as of such date. The remaining balance of deferred rent plus interest was paid in full to the Partnership on October 2, 1995. TWA has been current with its obligation to the Partnership since August 1995. While TWA has committed to an uninterrupted flow of lease payments, there can be no assurance that TWA will continue to honor its obligations in the future. The Partnership received warrants to purchase 159,919 shares of TWA Common Stock from TWA in November 1995 and has recognized the net warrant value as of the date of receipt of $1,247,768 as revenue in the 1995 statement of operations. The Partnership exercised the warrants on December 29, 1995 for the strike price 6 of $0.01 per share and recognized a gain on the value of the warrants of $409,792 in the 1995 statement of operations. The TWA Common Stock was classified as trading securities in 1995 because the Partnership intended to sell the stock in the near term. The fair market value of the TWA stock at December 31, 1995 of $1,659,160 is reflected in the Partnership's December 31, 1995 balance sheet (Item 8). The Partnership sold the TWA Common Stock in the first quarter of 1996, net of broker commissions, for $1,698,057. Industry Update Maintenance of Aging Aircraft - The process of aircraft maintenance begins at the aircraft design stage. For aircraft operating under Federal Aviation Administration (FAA) regulations, a review board consisting of representatives of the manufacturer, FAA representatives and operating airline representatives is responsible for specifying the aircraft's initial maintenance program. The general partner understands that this program is constantly reviewed and modified throughout the aircraft's operational life. Since 1988, the FAA, working with the aircraft manufacturers and operators, has issued a series of ADs which mandate that operators conduct more intensive inspections, primarily of the aircraft fuselages. The results of these mandatory inspections may uncover the need for repairs or structural modifications that may not have been required under pre-existing maintenance programs. In addition, an AD adopted in 1990, applicable to McDonnell Douglas aircraft, requires replacement or modification of certain structural items on a specific timetable. These structural items were formerly subject to periodic inspection, with replacement when necessary. The AD requires specific work to be performed at various cycle thresholds between 40,000 and 100,000 cycles, and on specific date or age thresholds. The estimated cost of compliance with all of the components of this AD is approximately $850,000 per aircraft. The extent of modifications required to an aircraft varies according to the level of incorporation of design improvements at manufacture. In January 1993, the FAA adopted another AD intended to mitigate corrosion of structural components, which would require repeated inspections from 5 years of age throughout the life of an aircraft, with replacement of corroded components as needed. Integration of the new inspections into each aircraft operator's maintenance program was required by January 31, 1994. The Partnership's existing leases require the lessees to maintain the Partnership's aircraft in accordance with an FAA-approved maintenance program during the lease term. At the end of the leases, each lessee is generally required to return the aircraft in airworthy condition, including compliance with all ADs for which action is mandated by the FAA during the lease term. The Partnership agreed to bear a portion of certain maintenance and/or AD compliance costs, as discussed in Item 1, with respect to the aircraft leased to Continental and TWA. An aircraft returned to the Partnership as a result of a lease default would most likely not be returned to the Partnership in compliance with all return conditions required by the lease. In negotiating subsequent leases, market conditions currently generally require that the Partnership bear some or all of the costs of compliance with future ADs or ADs that have been issued, but which did not require action during the previous lease term. The ultimate effect on the Partnership of compliance with the FAA maintenance standards is not determinable at this time and will depend on a variety of factors, including the state of the commercial aircraft industry, the timing of the issuance of ADs, and the status of compliance therewith at the expiration of the current leases. Aircraft Noise - Another issue which has affected the airline industry is that of aircraft noise levels. The FAA has categorized aircraft according to their noise levels. Stage 1 aircraft, which have the highest noise level, are no longer allowed to operate from civil airports in the United States. Stage 2 aircraft meet current FAA requirements, subject to the phase-out rules discussed below. Stage 3 aircraft are the most quiet and Stage 3 is the standard for all new aircraft. 7 On September 24, 1991, the FAA issued final rules on the phase-out of Stage 2 aircraft by the end of this decade. The key features of the rule include: - Compliance can be accomplished through a gradual process of phase-in or phase-out (see below) on each of three interim compliance dates: December 31, 1994, 1996 and 1998. All Stage 2 aircraft must be phased out of operations in the contiguous United States by December 31, 1999, with waivers available in certain specific cases to December 31, 2003. - All operators have the option of achieving compliance through a gradual phase-out of Stage 2 aircraft (i.e., eliminate 25% of its Stage 2 fleet on each of the compliance dates noted above), or a gradual phase-in of Stage 3 aircraft (i.e., 55%, 65% and 75% of an operator's fleet must consist of Stage 3 aircraft by the respective interim compliance dates noted above). The federal rule does not prohibit local airports from issuing more stringent phase-out rules. In fact, several local airports have adopted more stringent noise requirements which restrict the operation of Stage 2 and certain Stage 3 aircraft. Other countries have also adopted noise policies. The European Union (EU) adopted a non-addition rule in 1989, which directed each member country to pass the necessary legislation to prohibit airlines from adding Stage 2 aircraft to their fleets after November 1, 1990, with all Stage 2 aircraft phased-out by the year 2002. The International Civil Aviation Organization has also endorsed the phase-out of Stage 2 aircraft on a world-wide basis by the year 2002. Hushkit modifications, which allow Stage 2 aircraft to meet Stage 3 requirements, are currently available for the Partnership's aircraft. Hushkits were added to 10 of the Partnership's Stage 2 aircraft in 1996. Demand for Aircraft - Industry-wide, approximately 330 commercial jet aircraft were available for sale or lease at December 31, 1997, approximately 50 more than a year ago. At under 3% of the total available jet aircraft fleet, this is still a relatively low level of availability by industry historic standards. From 1991 to 1994, depressed demand for travel limited airline expansion plans, with new aircraft orders and scheduled deliveries being canceled or substantially deferred. As profitability declined, many airlines took action to downsize or liquidate assets and some airlines were forced to file for bankruptcy protection. Following four years of strong traffic growth accompanied by rising yields, this trend reversed with many airlines reporting substantial profits since 1995. As a result of this improving trend, just over 1200 new jet aircraft were ordered in 1996 and a further 1300 were ordered in 1997, making this the second highest ever order year in the history of the industry. To date, this strong recovery has mainly benefited Stage 3 narrow-bodies and younger Stage 2 narrow-bodies, many of which are now being upgraded with hushkits, whereas older Stage 2 narrow-bodies and early wide-bodies have shown only marginal signs of recovery since the depressed 1991 to 1994 period. Economic turmoil in Asia in the second half of 1997 has brought about a significant reduction in traffic growth in much of that region which is resulting in a number of new aircraft order deferrals and cancellations, mainly in the wide-body sector of the market with as yet no impact evident in other world markets. The general partner believes that, in addition to the factors cited above, the deteriorated market for the Partnership's aircraft reflects the airline industry's reaction to the significant expenditures potentially necessary to bring these aircraft into compliance with certain ADs issued by the FAA relating to aging aircraft, corrosion prevention and control and structural inspection and modification as previously discussed. 8 Effects on the Partnership's Aircraft - The Partnership periodically reviews the estimated realizability of the residual values at the projected end of each aircraft's economic life based on estimated residual values obtained from independent parties which provide current and future estimated aircraft values by aircraft type. The Partnership made downward adjustments to the estimated residual value of certain of its on-lease aircraft as of December 31, 1995. For any downward adjustment in estimated residual value or decrease in the projected remaining economic life, the depreciation expense over the projected remaining economic life of the aircraft is increased. As a result of the 1995 adjustments to the estimated residual values, the Partnership is recognizing increased depreciation expense of approximately $194,000 per year beginning in 1996 through the end of the estimated economic lives of the aircraft. If the projected net cash flow for each aircraft (projected rental revenue, net of management fees, less projected maintenance costs, if any, plus the estimated residual value) is less than the carrying value of the aircraft, the Partnership recognizes the deficiency currently as increased depreciation expense. The Partnership recognized approximately $12.5 million and $1.8 million, or $24.95 and $3.54 per limited Partnership unit, of this deficiency as increased depreciation expense in 1996 and 1995. In 1996, the impairment loss was the result of several significant factors. As a result of industry and market changes, a more extensive review of the Partnership's aircraft was completed in the fourth quarter of 1996 which resulted in revised assumptions of future cash flows including reassessment of projected re-lease terms and potential future maintenance costs. As discussed in Note 4, the Partnership accepted an offer to purchase eight of the Partnership's remaining aircraft subject to each aircraft's existing lease. This offer constituted an event that required the Partnership to review the aircraft carrying value pursuant to SFAS 121. In determining this additional impairment loss, the Partnership estimated the fair value of the aircraft based on the proposed purchase price reflected in the offer, and then deducted this amount from the carrying value of the aircraft. The partnership recorded an impairment loss to the extent that the carrying value exceeded the fair value. Management believes the assumptions related to fair value of impaired assets represents the best estimates based on reasonable and supportable assumptions and projections. The deficiency in 1995 was generally the result of declining estimates in the residual values of the aircraft. The increased depreciation expense reduces the aircraft's carrying value and reduces the amount of future depreciation expense that the Partnership will recognize over the projected remaining economic life of the aircraft. The Partnership's future earnings are impacted by the net effect of the adjustments to the carrying value of the aircraft recorded in 1995 (which has the effect of decreasing future depreciation expense), and the downward adjustments to the estimated residual values recorded in 1995 (which has the effect of increasing future depreciation expense). The net effect of the 1995 adjustments to the estimated residual values and the adjustments to the carrying value of the aircraft recorded in 1995 is to cause the Partnership to recognize increased depreciation expense of approximately $194,000 in 1996. The Partnership periodically reviews its aircraft for impairment in accordance with SFAS No. 121. The Partnership uses information obtained from third party valuation services in arriving at its estimate of fair value for purposes of determining residual values. The Partnership will use similar information, plus available information and estimates related to the Partnership's aircraft, to determine an estimate of fair value to measure impairment as required by the statement. The estimates of fair value can vary dramatically depending on the condition of the specific aircraft and the actual marketplace conditions at the time of the actual disposition of the asset. If assets are deemed impaired, there could be substantial write-downs in the future. 9 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. POLARIS AIRCRAFT INCOME FUND III, A California Limited Partnership (REGISTRANT) By: Polaris Investment Management Corporation General Partner May 27, 1998 By: /S/ Marc A. Meiches - --------------------------- ---------------------------------------- Date Marc A. Meiches, Chief Financial Officer 10 -----END PRIVACY-ENHANCED MESSAGE-----