Recharacterization Risks: Beware!

One risk is well known, but the other is not. While both risks are discussed herein, this article also highlights the less apparent risk for the finance lessor to consider in these post-Enron days when numerous off-balance sheet transactions and the accounting rules that facilitate them are being attacked and reconsidered.

The Known Risk

The substance over form rule dictates that just because a transaction is documented as a 'lease' does not mean that a reviewing court will treat it as such. Instead, courts are required by the rule, codified in the definition of 'security interest' found in UCC '1-201(37), to look at the economic substance of a transaction to determine whether the lease is in reality an operating lease, or if it should be treated as a disguised security device. For purposes of this article, the term 'operating lease' is used to mean an operating lease under GAAP, as well as a true lease for tax, bankruptcy and UCC purposes.

One of the main features of UCC ' 1-201(37) is to ascertain which party in a lease transaction bears the real benefits and burdens of asset ownership. If a transaction that is documented as a lease squarely places the benefits and burdens of asset ownership on the lessee, then UCC '1-201(37) requires a reviewing court to characterize the transaction as a loan by the purported lessor to the lessee, secured by the leased equipment, irrespective of the form chosen by the parties. Financial transactions that are documented as leases and characterized as loans under UCC '1-201(37) are often referred to as 'disguised security devices.'

There are four bright-line tests contained in UCC ' 1-201(37) that can be isolated to determine whether a lease will be considered a disguised security device. If a lease transaction that is not terminable by a lessee, it will be recharacterized as a secured loan if:

• 
  
• The original term of the lease is equal to or greater than the remaining economic life of the equipment;
  
• The lessee is bound to renew the lease for the remaining economic life of the equipment or is bound to become the owner of the equipment;
  
• The lessee has an option to renew the lease for the remaining economic life of the equipment for no or nominal consideration; or
  
• The lessee has an option to become the owner of the equipment for no or nominal consideration.
  

The focus of these four tests is to determine whether the lessee will enjoy the possession and use of the equipment for its entire economic life. Conversely stated, if any one of the four tests is met, then the finance lessor really has no significant residual interest in the equipment. Accordingly, a properly advised finance lessor will always file a financing statement against its lessee when the lease transaction is structured in away to be treated as a disguised security device so as to protect its superior rights to the equipment and lease payments as against the lessee's other creditors and/or trustee in bankruptcy.

Many operating lessors will file 'protective' financing statements against their operating lessees as a prophylactic measure, given the recharacterization risk when lessees default.

Part two, appearing next month, discusses the Hidden Risk.

John P. Amato is a partner in the New York office of Hahn & Hessen LLP. He handles commercial and bankruptcy litigations, including many equipment leasing disputes. A member of the firm's Lease Practice Group, Amato can be reached at [email protected].

This is the first of a two-part article

To the unwary, Revised Article 9 of the Uniform Commercial Code may pose significant risks. The Article is intended to cover all transactions, regardless of form, that in economic substance create a security interest. Using this broad policy mandate, courts have frequently disregarded many different transaction forms that, on their face, were documented to appear to be outside the scope of Revised Article 9. When this occurs the party that is deemed a secured lender in the recharacterized transaction will face losing substantial rights ' unless that party complied with Article 9's perfection rules, which typically require the filing of a financing statement.

This article (Parts one and two) discusses two separate and distinct recharacterization risks inherent in certain commonly structured tripartite lease transactions. This type of tripartite lease transaction consists of two elements and three parties: the first element involves the transfer of equipment that is transferred from a supplier (the first party) to a finance lessor (the second party) and the second element consists of the lease of such equipment from the finance lessor to the lessee (the third party), with a supplier support guarantee. (For purposes of this article, a supplier support guarantee means a written agreement in which the supplier guarantees the finance lessor either the credit of the lessee or provides residual support for the equipment at the end of the lease term.)

One risk is well known, but the other is not. While both risks are discussed herein, this article also highlights the less apparent risk for the finance lessor to consider in these post-Enron days when numerous off-balance sheet transactions and the accounting rules that facilitate them are being attacked and reconsidered.

The Known Risk

The substance over form rule dictates that just because a transaction is documented as a 'lease' does not mean that a reviewing court will treat it as such. Instead, courts are required by the rule, codified in the definition of 'security interest' found in UCC '1-201(37), to look at the economic substance of a transaction to determine whether the lease is in reality an operating lease, or if it should be treated as a disguised security device. For purposes of this article, the term 'operating lease' is used to mean an operating lease under GAAP, as well as a true lease for tax, bankruptcy and UCC purposes.

One of the main features of UCC ' 1-201(37) is to ascertain which party in a lease transaction bears the real benefits and burdens of asset ownership. If a transaction that is documented as a lease squarely places the benefits and burdens of asset ownership on the lessee, then UCC '1-201(37) requires a reviewing court to characterize the transaction as a loan by the purported lessor to the lessee, secured by the leased equipment, irrespective of the form chosen by the parties. Financial transactions that are documented as leases and characterized as loans under UCC '1-201(37) are often referred to as 'disguised security devices.'

There are four bright-line tests contained in UCC ' 1-201(37) that can be isolated to determine whether a lease will be considered a disguised security device. If a lease transaction that is not terminable by a lessee, it will be recharacterized as a secured loan if:

• 
  
• The original term of the lease is equal to or greater than the remaining economic life of the equipment;
  
• The lessee is bound to renew the lease for the remaining economic life of the equipment or is bound to become the owner of the equipment;
  
• The lessee has an option to renew the lease for the remaining economic life of the equipment for no or nominal consideration; or
  
• The lessee has an option to become the owner of the equipment for no or nominal consideration.
  

The focus of these four tests is to determine whether the lessee will enjoy the possession and use of the equipment for its entire economic life. Conversely stated, if any one of the four tests is met, then the finance lessor really has no significant residual interest in the equipment. Accordingly, a properly advised finance lessor will always file a financing statement against its lessee when the lease transaction is structured in away to be treated as a disguised security device so as to protect its superior rights to the equipment and lease payments as against the lessee's other creditors and/or trustee in bankruptcy.

Many operating lessors will file 'protective' financing statements against their operating lessees as a prophylactic measure, given the recharacterization risk when lessees default.

Part two, appearing next month, discusses the Hidden Risk.

John P. Amato is a partner in the New York office of Hahn & Hessen LLP. He handles commercial and bankruptcy litigations, including many equipment leasing disputes. A member of the firm's Lease Practice Group, Amato can be reached at [email protected].