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A Primer for Secured Lessors on the Use of Bankruptcy Code Section 365(d)(10)

By Jeffrey N. Rich and Robert N. Michaelson
September 10, 2003

A recent decision of the U.S. Bankruptcy Court for the District of Connecticut, In re Circuit-Wise, Inc., 277 B.R. 460 (Bankr. D. Conn.), attempts to clarify the rights of secured equipment lessors under Section 365(d)(10) of the Bankrupt-cy Code and suggests two mechanisms for ensuring that those rights are quickly and fairly addressed. However, the Bankruptcy Court may have unfairly denied the lessor, Wells Fargo Equipment Finance, Inc. ('Wells Fargo'), the prompt relief it deserved. Even if the Bankruptcy Court properly deferred whatever relief Wells Fargo was entitled to, the court's suggested methods for ultimately providing that relief were at least, in part, impractical.

In September 1997, a predecessor to Wells Fargo entered into what was nominally identified as a 'master lease agreement' (the 'Master Lease') pursuant to which Circuit-Wise, Inc. (the 'Debtor') purportedly leased certain equipment. From the facts presented, it cannot be determined whether the Master Lease was a true or bona fide lease or merely a disguised financing, and that is the crux of the controversy.

In March 2001, the debtor filed a Chapter 11 petition and immediately ceased making any payments to Wells Fargo. Eventually, in January 2002, Wells Fargo moved under Section 365(d)(10) for an order compelling the debtor to make the periodic payments provided for under the Master Lease. During the period between the filing of the debtor's petition and January 2002, the debtor apparently continued to hold and make use of the equipment and neither assumed nor rejected the Master Lease. Wells Fargo's reliance on Section 365(d)(10) was premised on a belief that because the Master Lease was labeled a lease, it was presumptively a true lease and therefore entitled to the protections of that section. Section 365(d)(10) provides, in relevant part:

The ' [debtor in possession] shall timely perform all of the obligations of the debtor, except those specified in section 365(b), first arising from and after 60 days after the order for relief in a case under chapter 11 of this title under an unexpired lease of personal property (other than personal property leased to an individual primarily for personal, family, or household purposes), until such lease is assumed or rejected '

The Debtor contended that the Master Lease was not a true lease but rather a disguised financing and, therefore, not entitled to the protection of Section 365(d)(10). Wells Fargo argued that because the Master Lease was at least a putative lease, it automatically fell within the ambit of that section. The Bankruptcy Court sided with the debtor and ruled that until the true character of the Master Lease was finally established (ie a true lease or a secured financing), under standard rules of statutory construction Wells Fargo was not entitled to the benefit of Section 365(d)(10). The Bankruptcy Court held that the plain meaning of that section applied only to true lessors and Wells Fargo did not unambiguously belong in that category. Indeed, the Bankruptcy Court stated that it had no discretion to hold otherwise, at least until the facts were more clearly developed. Simply stated, the Bankruptcy Court told Wells Fargo that it could not enjoy the benefits of Section 365(d)(10) until the true economic character of the Master Lease was determined. That ruling is at odds with In re Elder-Beerman Stores Corp., 201 B.R. 759 (Bankr. S.D.Ohio 1996), which held that an agreement that is denominated a 'lease' is automatically entitled to be treated as such. The reasoning behind that decision is that it protected the lessor against the possibility that a case might be converted to Chapter 7 or become administratively insolvent pending a ruling as to whether the 'lease' was a true lease. While the Bankruptcy Court's ruling did not appear to shift the ultimate burden of proof from the debtor to Wells Fargo (See In re Edison Brothers, Inc., et al., 207 B.R. 801 (Bankr. D.Del. 1997) holding that a debtor resisting a secured lessor's efforts to compel payments under Section 365(d)(10) has the burden of proving that a so-called lease is actually a secured financing), it did delay the ability of Wells Fargo to be promptly paid.

Wells Fargo argued that the Bankruptcy Court's interpretation of Section 365(d)(10) was an open invitation to debtors to argue that leases are disguised financings in order to avoid a duty to make current payments thereby, in essence, obtaining free use of a lessor's property for what might be an extended period while that question is being addressed. The Bankruptcy Court was not indifferent to this argument and gave it thoughtful consideration. In doing so, it took the unusual step of suggesting two methods whereby the strictures of Section 365(d)(10) could be followed while simultaneously addressing the concerns of would-be lessors. Ordinarily, courts tend to limit their rulings to the issues they must resolve and refrain from offering what might be considered gratuitous or unnecessary advice.

The first method the Bankruptcy Court suggested is for the aggrieved lessor to seek an expedited determination of the issue. Of course, this requires the cooperation of the court and even then does not assure a rapid outcome. For example, it is possible that the facts may be so complicated that it is impossible to reach a prompt determination without offending basic principles of due process. Further, even after a ruling is made, there remains the possibility of one and possibly multiple appeals that could linger for months and even years.

The second suggested method is the use of Rule 9011 of the Federal Rules of Bankruptcy Procedure to punish debtors who raise a disguised financing defense without good cause. Rule 9011, and its analog, Rule 11 of the Federal Rules of Civil Procedure, permit the imposition of sanctions upon a party that makes an argument that it knows or should know is not valid. Though noble in its intent, this suggestion is not practical. Experienced practitioners know that Rule 9011 sanctions are often threatened but rarely employed. To effectively employ Rule 9011 as a deterrent it would need to be shown that a debtor knew or should have known that a lease was a true lease and therefore acted improperly by claiming otherwise. Experienced practitioners also know that there is not always a bright-line distinction between a true lease and a disguised financing. Many so-called 'leases' share characteristics of secured financings, but that does not necessarily mean that they are not true leases. Each situation must be judged on its particular facts and, more often than not, skilled advocates will be able make colorable arguments supporting both sides of the issue. In sum, Rule 9011 is not an effective or reliable vehicle for avoiding the dilatory tactics Wells Fargo feared.

Wells Fargo's concerns (and the concerns of similarly situated lessors) are better served by taking prompter action at the outset of a case. Wells Fargo simply waited too long (approximately 9 months after the commencement of the case) to enforce its rights. In addition to acting sooner, Wells Fargo should have moved for alternate relief in the form of relief from the automatic stay and/or adequate protection payments in the event it was determined that the Master Lease was actually a disguised financing. By not seeking this alternate relief, Wells Fargo lost the opportunity to receive adequate protection payments from an earlier date since such payments are only available from the date they are first requested. In fairness to Wells Fargo, it may have made that argument ' but it is not clear from the record.

Of course, none of the Bankruptcy Court's suggestions would have been necessary if it had simply found that Wells Fargo was entitled to immediate payments pending a final ruling as to whether the Master Lease was a true lease or a secured financing.

In sum, the lessons that come from this case are to know the law of the court and circuit where the matter is to be litigated and that lessors must act quickly and decisively at the start of a case to protect their interests.


Jeffrey N. Rich is a partner and Robert N. Michaelson is of counsel in the Corporate Reorganization and Creditors' Rights Group in the New York office of Kirkpatrick & Lockhart LLP

A recent decision of the U.S. Bankruptcy Court for the District of Connecticut, In re Circuit-Wise, Inc., 277 B.R. 460 (Bankr. D. Conn.), attempts to clarify the rights of secured equipment lessors under Section 365(d)(10) of the Bankrupt-cy Code and suggests two mechanisms for ensuring that those rights are quickly and fairly addressed. However, the Bankruptcy Court may have unfairly denied the lessor, Wells Fargo Equipment Finance, Inc. ('Wells Fargo'), the prompt relief it deserved. Even if the Bankruptcy Court properly deferred whatever relief Wells Fargo was entitled to, the court's suggested methods for ultimately providing that relief were at least, in part, impractical.

In September 1997, a predecessor to Wells Fargo entered into what was nominally identified as a 'master lease agreement' (the 'Master Lease') pursuant to which Circuit-Wise, Inc. (the 'Debtor') purportedly leased certain equipment. From the facts presented, it cannot be determined whether the Master Lease was a true or bona fide lease or merely a disguised financing, and that is the crux of the controversy.

In March 2001, the debtor filed a Chapter 11 petition and immediately ceased making any payments to Wells Fargo. Eventually, in January 2002, Wells Fargo moved under Section 365(d)(10) for an order compelling the debtor to make the periodic payments provided for under the Master Lease. During the period between the filing of the debtor's petition and January 2002, the debtor apparently continued to hold and make use of the equipment and neither assumed nor rejected the Master Lease. Wells Fargo's reliance on Section 365(d)(10) was premised on a belief that because the Master Lease was labeled a lease, it was presumptively a true lease and therefore entitled to the protections of that section. Section 365(d)(10) provides, in relevant part:

The ' [debtor in possession] shall timely perform all of the obligations of the debtor, except those specified in section 365(b), first arising from and after 60 days after the order for relief in a case under chapter 11 of this title under an unexpired lease of personal property (other than personal property leased to an individual primarily for personal, family, or household purposes), until such lease is assumed or rejected '

The Debtor contended that the Master Lease was not a true lease but rather a disguised financing and, therefore, not entitled to the protection of Section 365(d)(10). Wells Fargo argued that because the Master Lease was at least a putative lease, it automatically fell within the ambit of that section. The Bankruptcy Court sided with the debtor and ruled that until the true character of the Master Lease was finally established (ie a true lease or a secured financing), under standard rules of statutory construction Wells Fargo was not entitled to the benefit of Section 365(d)(10). The Bankruptcy Court held that the plain meaning of that section applied only to true lessors and Wells Fargo did not unambiguously belong in that category. Indeed, the Bankruptcy Court stated that it had no discretion to hold otherwise, at least until the facts were more clearly developed. Simply stated, the Bankruptcy Court told Wells Fargo that it could not enjoy the benefits of Section 365(d)(10) until the true economic character of the Master Lease was determined. That ruling is at odds with In re Elder-Beerman Stores Corp., 201 B.R. 759 (Bankr. S.D.Ohio 1996), which held that an agreement that is denominated a 'lease' is automatically entitled to be treated as such. The reasoning behind that decision is that it protected the lessor against the possibility that a case might be converted to Chapter 7 or become administratively insolvent pending a ruling as to whether the 'lease' was a true lease. While the Bankruptcy Court's ruling did not appear to shift the ultimate burden of proof from the debtor to Wells Fargo (See In re Edison Brothers, Inc., et al., 207 B.R. 801 (Bankr. D.Del. 1997) holding that a debtor resisting a secured lessor's efforts to compel payments under Section 365(d)(10) has the burden of proving that a so-called lease is actually a secured financing), it did delay the ability of Wells Fargo to be promptly paid.

Wells Fargo argued that the Bankruptcy Court's interpretation of Section 365(d)(10) was an open invitation to debtors to argue that leases are disguised financings in order to avoid a duty to make current payments thereby, in essence, obtaining free use of a lessor's property for what might be an extended period while that question is being addressed. The Bankruptcy Court was not indifferent to this argument and gave it thoughtful consideration. In doing so, it took the unusual step of suggesting two methods whereby the strictures of Section 365(d)(10) could be followed while simultaneously addressing the concerns of would-be lessors. Ordinarily, courts tend to limit their rulings to the issues they must resolve and refrain from offering what might be considered gratuitous or unnecessary advice.

The first method the Bankruptcy Court suggested is for the aggrieved lessor to seek an expedited determination of the issue. Of course, this requires the cooperation of the court and even then does not assure a rapid outcome. For example, it is possible that the facts may be so complicated that it is impossible to reach a prompt determination without offending basic principles of due process. Further, even after a ruling is made, there remains the possibility of one and possibly multiple appeals that could linger for months and even years.

The second suggested method is the use of Rule 9011 of the Federal Rules of Bankruptcy Procedure to punish debtors who raise a disguised financing defense without good cause. Rule 9011, and its analog, Rule 11 of the Federal Rules of Civil Procedure, permit the imposition of sanctions upon a party that makes an argument that it knows or should know is not valid. Though noble in its intent, this suggestion is not practical. Experienced practitioners know that Rule 9011 sanctions are often threatened but rarely employed. To effectively employ Rule 9011 as a deterrent it would need to be shown that a debtor knew or should have known that a lease was a true lease and therefore acted improperly by claiming otherwise. Experienced practitioners also know that there is not always a bright-line distinction between a true lease and a disguised financing. Many so-called 'leases' share characteristics of secured financings, but that does not necessarily mean that they are not true leases. Each situation must be judged on its particular facts and, more often than not, skilled advocates will be able make colorable arguments supporting both sides of the issue. In sum, Rule 9011 is not an effective or reliable vehicle for avoiding the dilatory tactics Wells Fargo feared.

Wells Fargo's concerns (and the concerns of similarly situated lessors) are better served by taking prompter action at the outset of a case. Wells Fargo simply waited too long (approximately 9 months after the commencement of the case) to enforce its rights. In addition to acting sooner, Wells Fargo should have moved for alternate relief in the form of relief from the automatic stay and/or adequate protection payments in the event it was determined that the Master Lease was actually a disguised financing. By not seeking this alternate relief, Wells Fargo lost the opportunity to receive adequate protection payments from an earlier date since such payments are only available from the date they are first requested. In fairness to Wells Fargo, it may have made that argument ' but it is not clear from the record.

Of course, none of the Bankruptcy Court's suggestions would have been necessary if it had simply found that Wells Fargo was entitled to immediate payments pending a final ruling as to whether the Master Lease was a true lease or a secured financing.

In sum, the lessons that come from this case are to know the law of the court and circuit where the matter is to be litigated and that lessors must act quickly and decisively at the start of a case to protect their interests.


Jeffrey N. Rich is a partner and Robert N. Michaelson is of counsel in the Corporate Reorganization and Creditors' Rights Group in the New York office of Kirkpatrick & Lockhart LLP

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