True Lease v. Disguised Security Interest: A New Dilemma

2) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods,

3) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement, or

4) the lessee has an option to become the owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement.

UCC '1-201(37). (This test is referred to as the “Bright-Line Test”.) Since most equipment leases are not subject to termination during their original term, the focus of this analysis is usually on the second part of the test; whether any one of the residual value factors is satisfied.

If the Bright-Line Test has not been satisfied, then the court must examine all of the facts and circumstances of the case to determine whether the agreement in question is a true lease or disguised security agreement. Although different states have different factors that they weigh in making this determination, most courts have determined that the essential issue in this analysis is whether the lessor retains a meaningful residual interest at the end of the lease term and, therefore, focus mostly on residual value issues in determining if a transaction is a true lease or a disguised security interest. (Hereinafter, these tests are referred to as “Multiple Factor Tests.”) Thus, whether the determination is made by using the Bright-Line Test or a Multiple Factor Test, the most important component of the analysis is whether the residual value of the equipment remaining after the original term of the lease is nominal.

Many, if not most, courts used to hold that a residual value of 8% to 10% was not nominal and therefore was sufficient to create a “true lease.” However, recently many courts are requiring higher residual values in order to determine that the residual value is not nominal. In fact, many states have precedent holding that a residual value of less than 25% is nominal (Ohio, Virginia, Florida, Indiana, Oklahoma, and Nebraska (cite favorably cases imposing the 25% rule)). In addition there are other states that arguably require at least a 20% residual value (for example, Illinois). Lastly, there are some states that have not indicated what percentage of the original value is required, but have precedent requiring more than 10% (for example, Massachusetts and New York).

Requiring a residual value of 20% to 25% of the original value of the equipment can in many instances serve to change the transaction from one that was originally intended by both parties to be a true lease, to a disguised security interest. This is detrimental to the leasing industry, as lessors who rely on the economics of a leasing deal may later be forced to deal with unforeseen losses upon the conversion of the characterization of the transaction. In certain industries, such as computer equipment and other high-tech equipment, a lessor will almost never have a residual value of 20% to 25% given how quickly the value of such goods declines and the ordinary lease term for such goods. While it is possible for lessors to shorten the term of such leases in order to raise the residual value, in most cases it isn't economically feasible to shorten the term of the transaction materially. Do the courts that are requiring these high residual values really mean to, in essence, legislate that lease transactions cannot be accomplished for certain types of equipment in their jurisdiction? I doubt it, but this is the practical effect.

In addition, courts that are requiring such high residual values are changing the bargain of the parties to a lease. Thus, they are going against a fundamental principle of contract law that the bargain of contracting parties should be enforced, not overridden. The Official Comment to the UCC even states that whereas the prior version of the UCC looked to the parties' intent when determining if a lease was a true lease or a disguised security interest, the amended UCC does not look to the intent of the parties, but rather to the economic reality of the transaction. Official Comment, UCC '1-201(37). Thus, the UCC states (and many courts have confirmed) that the intent of the parties is not dispositive. This comment seems to encourage lessees who can benefit from converting a lease to a disguised security agreement, to challenge the characterization despite their original intent to enter a true lease.

While the precedent discussed above does not bode well for certain segments of the leasing industry, and the trend across the country seems to be to increase the residual value required, there is some precedent going against requiring such high values. Tennessee has precedent providing that 10% residual value is not nominal and South Carolina, Kansas and Texas have precedent disavowing percentage texts.

Further, amended UCC '1-201(37) provides two tests for determining whether an option price is nominal: 1) the option price is not nominal when the agreement states that it is the fair market value of the property, and 2) the option price is nominal if it is less than the lessee's reasonably predictable cost of performing under the lease agreement if the option is not exercised. UCC '1-201(37). The second of these tests is instructive. Lessors should make sure that the cost of performing under the lease if the option is not exercised is less than the option price. Further, where a true lease is intended, the lease should provide language that confirms this.

Argument along the lines of the first test listed above is not as easy as it seems. Most courts require that even if the option price is equal to the fair market value at the time the option is exercised, the actual fair market value must not be nominal. Thus, a fair market value option price is not the end of the analysis. However, this provision of the UCC gives the leasing industry a place to start in attempting to undo the damage done by the precedent discussed here. Counsel for lessors must forcefully argue that fair market value should be dispositive or, if not, that the analysis of whether the fair market value is nominal should take into consideration the type of equipment involved and the rate at which the equipment declines in value. We must make it clear to the courts that face this issue, the practical, real-world effect of requiring residual values that are too high. We must vigorously argue that effectively prohibiting leasing for certain industries is certainly not what was intended by the UCC or their state's legislature, is exclusionary, and will have a detrimental economic impact.

Over the past several years, courts faced with the issue of whether a lease is a “true lease” or a “disguised security interest” have been making it more and more difficult for lessors to have their leases confirmed as true leases. Through a process of focusing on economic reality instead of the intent of the parties and increasing the amount of residual value required at the end of a lease term, courts are creating a dilemma for the leasing industry. Certain segments of the equipment leasing industry are more severely effected by these changes than others.

Under the amended Uniform Commercial Code (UCC) '1-201(37), which most states have adopted, courts first determine if the lease is considered to be a disguised security interest as a matter of law. A transaction creates a security interest as a matter of law if the consideration that the lessee is to pay to the lessor for the right to possession and use of the goods is an obligation for the term of the lease not subject to termination by the lessee, and:

1) the original term of the lease is equal to or greater than the remaining economic life of the goods,

2) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods,

3) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement, or

4) the lessee has an option to become the owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement.

UCC '1-201(37). (This test is referred to as the “Bright-Line Test”.) Since most equipment leases are not subject to termination during their original term, the focus of this analysis is usually on the second part of the test; whether any one of the residual value factors is satisfied.

If the Bright-Line Test has not been satisfied, then the court must examine all of the facts and circumstances of the case to determine whether the agreement in question is a true lease or disguised security agreement. Although different states have different factors that they weigh in making this determination, most courts have determined that the essential issue in this analysis is whether the lessor retains a meaningful residual interest at the end of the lease term and, therefore, focus mostly on residual value issues in determining if a transaction is a true lease or a disguised security interest. (Hereinafter, these tests are referred to as “Multiple Factor Tests.”) Thus, whether the determination is made by using the Bright-Line Test or a Multiple Factor Test, the most important component of the analysis is whether the residual value of the equipment remaining after the original term of the lease is nominal.

Many, if not most, courts used to hold that a residual value of 8% to 10% was not nominal and therefore was sufficient to create a “true lease.” However, recently many courts are requiring higher residual values in order to determine that the residual value is not nominal. In fact, many states have precedent holding that a residual value of less than 25% is nominal (Ohio, Virginia, Florida, Indiana, Oklahoma, and Nebraska (cite favorably cases imposing the 25% rule)). In addition there are other states that arguably require at least a 20% residual value (for example, Illinois). Lastly, there are some states that have not indicated what percentage of the original value is required, but have precedent requiring more than 10% (for example, Massachusetts and New York).

Requiring a residual value of 20% to 25% of the original value of the equipment can in many instances serve to change the transaction from one that was originally intended by both parties to be a true lease, to a disguised security interest. This is detrimental to the leasing industry, as lessors who rely on the economics of a leasing deal may later be forced to deal with unforeseen losses upon the conversion of the characterization of the transaction. In certain industries, such as computer equipment and other high-tech equipment, a lessor will almost never have a residual value of 20% to 25% given how quickly the value of such goods declines and the ordinary lease term for such goods. While it is possible for lessors to shorten the term of such leases in order to raise the residual value, in most cases it isn't economically feasible to shorten the term of the transaction materially. Do the courts that are requiring these high residual values really mean to, in essence, legislate that lease transactions cannot be accomplished for certain types of equipment in their jurisdiction? I doubt it, but this is the practical effect.

In addition, courts that are requiring such high residual values are changing the bargain of the parties to a lease. Thus, they are going against a fundamental principle of contract law that the bargain of contracting parties should be enforced, not overridden. The Official Comment to the UCC even states that whereas the prior version of the UCC looked to the parties' intent when determining if a lease was a true lease or a disguised security interest, the amended UCC does not look to the intent of the parties, but rather to the economic reality of the transaction. Official Comment, UCC '1-201(37). Thus, the UCC states (and many courts have confirmed) that the intent of the parties is not dispositive. This comment seems to encourage lessees who can benefit from converting a lease to a disguised security agreement, to challenge the characterization despite their original intent to enter a true lease.

While the precedent discussed above does not bode well for certain segments of the leasing industry, and the trend across the country seems to be to increase the residual value required, there is some precedent going against requiring such high values. Tennessee has precedent providing that 10% residual value is not nominal and South Carolina, Kansas and Texas have precedent disavowing percentage texts.

Further, amended UCC '1-201(37) provides two tests for determining whether an option price is nominal: 1) the option price is not nominal when the agreement states that it is the fair market value of the property, and 2) the option price is nominal if it is less than the lessee's reasonably predictable cost of performing under the lease agreement if the option is not exercised. UCC '1-201(37). The second of these tests is instructive. Lessors should make sure that the cost of performing under the lease if the option is not exercised is less than the option price. Further, where a true lease is intended, the lease should provide language that confirms this.

Argument along the lines of the first test listed above is not as easy as it seems. Most courts require that even if the option price is equal to the fair market value at the time the option is exercised, the actual fair market value must not be nominal. Thus, a fair market value option price is not the end of the analysis. However, this provision of the UCC gives the leasing industry a place to start in attempting to undo the damage done by the precedent discussed here. Counsel for lessors must forcefully argue that fair market value should be dispositive or, if not, that the analysis of whether the fair market value is nominal should take into consideration the type of equipment involved and the rate at which the equipment declines in value. We must make it clear to the courts that face this issue, the practical, real-world effect of requiring residual values that are too high. We must vigorously argue that effectively prohibiting leasing for certain industries is certainly not what was intended by the UCC or their state's legislature, is exclusionary, and will have a detrimental economic impact.