True Lease or Secured Financing?

The obligations of a Chapter 11 debtor under a true lease may be vastly different than those of a Chapter 11 debtor under a secured financing arrangement. This is primarily because, during the pendency of a Chapter 11 case, from and after 60 days from the petition date, a debtor must make lease payments to any lessor of personal property until such time as the debtor either assumes or rejects such lessor's lease. See 11 U.S.C. ' 365(d)(10). If a debtor decides to assume the lease, and the court approves the assumption, then the debtor is required to “cure” any past defaults and to provide “adequate assurance” of future performance. See 11 U.S.C. ' 365(b)(1). Conversely, if the debtor decides to reject the lease, then the debtor must return the leased property to the lessor who may then assert a prepetition claim for rejection damages against the debtor.

Compare the foregoing with the obligations that a debtor has to its secured creditors during the pendency of a Chapter 11 case. While a debtor must provide a secured creditor with “adequate protection” in the form of cash payments, replacement liens, or other relief that results in the indubitable equivalent of the secured creditor's interest in the property, such protection is only required to the extent of the value of the secured creditor's interest in the secured property. The unsecured portion of the secured creditor's claim is not entitled to adequate protection. Thus, a debtor that is a party to a secured financing, as opposed to a true lease, may find that it has comparatively more cash available to reorganize its business and administer its Chapter 11 estate. Additionally, the debtor may be able to retain a creditor's secured property pursuant to a Chapter 11 reorganization plan by cramming-down the secured portion of the secured creditor's claim to the property's fair market value. See 11 U.S.C. ' ' 506(a) and 1129(b)(2)(A).

Form Yields to Substance in Duke v. Pillowtex

In Pillowtex, Duke Energy Royal, LLC (Duke), an energy company, and Pillowtex Corporation (Pillowtex), a manufacturer of linen and bedding products, entered into a master energy services agreement (Agreement) pursuant to which Duke agreed to install certain energy savings equipment to improve the efficiency of Pillowtex's energy consumption and to reduce the operating costs incurred by Pillowtex at its manufacturing plants. 349 F.3d at 713. The parties themselves intended to structure the Agreement as a true lease in large part because Pillowtex was subject to capital expenditure limitations under its senior credit facility and wanted the payments it made under the Agreement to qualify as expenses, not capital expenditures.

To induce Pillowtex to enter into the Agreement, the energy projects were designed to be “cost-neutral” to Pillowtex. Thus, during the term of the Agreement, Pillowtex was only responsible for making payments to Duke under the Agreement in an amount equal to Pillowtex's cost-savings. Duke bore the entire $10.41 million cost of acquiring and installing the energy-savings equipment, which, to Duke's ultimate detriment, consisted of labor costs that exceeded the cost (and value) of the underlying building materials. The parties agreed that the simple payback period under the Agreement would be 5 years. Once the 8-year term of the Agreement expired, Pillowtex would begin to reap the cost-savings benefits of the equipment. Id. at 713.

Approximately 2.5 years after entering into the Agreement, Pillowtex and certain of its subsidiaries filed for relief under Chapter 11 of the Bankruptcy Code. When Pillowtex stopped making payments under the Agreement, Duke filed a motion under section 365(d)(10) of the Bankruptcy Code to compel Pillowtex to make lease payments until such time as Pillowtex assumed or rejected the Agreement. Pillowtex objected to Duke's motion on the grounds that the Agreement was not a true lease but instead a secured financing, and, therefore, Duke was not entitled to receive payments pursuant to Bankruptcy Code section 365(d)(10), which requires that debtors keep current on their unexpired lease obligations. The District Court, sitting in bankruptcy, held in favor of Pillowtex. Duke appealed to the Third Circuit Court of Appeals.

The Third Circuit Applies New York Law

As a preliminary matter, the Third Circuit observed that whether an agreement is a true lease or a secured financing arrangement under the Bankruptcy Code is a matter of state law. Id. at 716. After deciding that New York law applied to the Agreement, the court turned to the New York Uniform Commercial Code (UCC) and the definition of “security interest” under section 1-207(37)(a) of the UCC. The court interpreted this section as establishing a two-part test for determining whether a transaction creates a lease or a security interest. The first part of the analysis is a bright-line test, sometimes referred to as a “per se” rule. The second part, which is performed by a court only if the bright line test does not support the recharacterization of a purported lease, compels a court to look to the particular facts of the case to see whether the economics of the transaction suggest that the transaction is more fairly characterized as a lease or a secured financing arrangement.

The First Level of Analysis

The Bright Line Test Under ' 1-201(37)(a) of the New York UCC

Under the bright-line test, a transaction creates a security interest if 1) the lessee does not have the right to terminate the lease prior to the end of its term, and 2) any one of the following factors is present: a) the original term of the lease is equal to or greater than the remaining economic life of the goods; b) 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; c) the lessee has an option to renew the lease for the remaining economic life of the good for no additional consideration or nominal additional consideration; or d) the lessee has an option to become the owner of the goods for no additional consideration or nominal consideration. These factors are termed as “residual value factors” because they determine whether any meaningful residual value remains for lessors at the end of the term of the lease.

The Second Level of Analysis

The Economic Realities of the Agreement

The second part of the test under Section 1-201(37) of the New York UCC requires a court to analyze the specific facts of the case and determine the economic reality of the transaction. The court enumerated various factors, taken from relevant case law, including: 1) whether the purchase option is nominal; 2) whether the lessee is required to make aggregate rental payments having a present value equaling or exceeding the original cost of the leased property; and 3) whether the lease term covers the total useful life of the equipment. See In re Edison Bros. Stores, Inc., 207 B.R. 801 (Bankr. D. Del. 1997).

The Third Circuit's Decision in Pillowtex

The court first analyzed the terms of the Agreement and held that the Agreement failed to meet the bright-line test. While the court observed that Pillowtex could not terminate the Agreement during the Agreement's term, which satisfied the first part of the test, it held that none of the residual value factors were present because Pillowtex was not contractually bound at the expiration of the term of the Agreement to become the owner of the energy fixtures and did not possess the option to become the owner for nominal additional consideration. It was not enough that Duke expressly reserved the right under the Agreement to grant Pillowtex the option to become the owner at the end of the term of the Agreement or that Duke could extend the term of the Agreement or give Pillowtex the option of purchasing the underlying equipment on terms later agreed to by the parties. Similarly, the fact that Duke would have little or no bargaining power at the end of the term of the Agreement (due to the high cost of removing and replacing the equipment) was not sufficient for the court to find any of the factors met in a de facto sense.

Upon determining that the Agreement did not create a security interest as a matter of law under the bright line test, the court proceeded to analyze the economic realities of the transaction. The court gave great significance to the fact that the present value of the aggregate rental payments made to Duke under the Agreement equaled or exceeded the cost of the energy fixtures. See Pillowtex, 349 F.3d at 719. As a result, Duke effectively received payment in full for the transferal of the lighting fixtures to Pillowtex, which constituted evidence that the transaction was a sale. The court also noted that Pillowtex did not account for its payments under the Agreement as a true lease. Instead, Pillowtex treated its payments to Duke as utility expenses, which was different from the way Pillowtex treated other manufacturing and production equipment obtained from Duke concurrently with the Agreement.

After analyzing each of the relevant factors, the court held that the Agreement was “substantively better characterized as a security agreement than a true lease.” Id. at 719. Distinguishing applicable case law, the court dismissed the fact that the useful life of the energy savings equipment greatly exceeded the 8-year term of the Agreement. While the court acknowledged that this factor may be a relevant fact under certain circumstances, “[s]uch an inference would only be proper … where the evidence showed a plausible intent by the transferor to repossess the goods.” Id. at 720. Here, the economic realities of the transaction belied the existence of such intent because Duke had no economic motivation to repossess the fixtures and to realize upon the equipment's residual value at the end of the Agreement's term; not only was the cost of removal prohibitively expensive but virtually no resale market existed for the used equipment. The court reached its decision even though the Agreement possessed certain characteristics more typical of a true lease: title to the equipment remained with Duke throughout the term of the Agreement and Pillowtex agreed not to claim ownership of the equipment for income tax purposes.

The Intent of the Parties Does Not Control the Issue

The court rejected Duke's argument that the District Court erred by failing to analyze the intent of the parties. Under the revised UCC, courts no longer consider this factor in determining whether a transaction is a lease or a security agreement. Instead, the “court must subordinate the parties' intent to the economic reality that Duke would not have plausibly reclaimed the fixtures at the end of the [Agreement's] term.” Id. at 723. Similarly, the court dismissed Duke's admonition that the “[e]quipment leasing between sophisticated commercial entities dealing at arms length for their mutual benefit is an important commercial activity and one that should not be lightly recharacterized.” Id. at 722. The Third Circuit observed that it was “particularly appropriate” to refuse to defer to the intent of the contracting parties in the context of a bankruptcy proceeding because the cost of doing so would be imposed on third-party creditors. Id.

Conclusion

In structuring leasing transactions, parties to a “true” lease must be mindful of the nature of the asset leased and the cost of recovering and repossessing the leased asset at the end of the lease term. In determining whether a transaction is more appropriately characterized as a true lease or a secured financing, bankruptcy courts will look beyond the form of the transaction to its substance. The Pillowtex decision makes clear that a lessor who fails to account for the impact of recovery costs on the residual value of the leased property is at risk of having the transaction recharacterized as a secured financing arrangement in a Chapter 11 proceeding.

In the Chapter 11 context, it is common for interested parties to challenge the characterization of a Chapter 11 debtor's obligations under an agreement styled as a lease. See In re APB Online, Inc., 259 B.R. 812, 815 (Bankr. S.D.N.Y. 2001). A Bankruptcy Court's determination as to whether a transaction is a “true” lease or a secured financing can have far-reaching consequences on the administration of a debtor's Chapter 11 case and the respective rights of each party to the agreement. As the recent decision by the Third Circuit Court of Appeals in Duke Energy Royal, LLC v. Pillowtex Corp. (In re Pillowtex, Inc.), 349 F.3d 711 (3d Cir. 2003) illustrates, when faced with the question of whether a transaction constitutes a “true” lease or a secured financing, bankruptcy courts will look beyond the form to the substance of the parties' agreement.

In Pillowtex, the Third Circuit recharacterized as a secured financing transaction a transaction intended by both parties to be an equipment lease. The decision highlights the risk to equipment lessors in the Chapter 11 context if they do not 1) retain (as a matter of form) an economically meaningful “residual value” in the leased property, and 2) expect (as a matter of substance) to be economically motivated at the end of the lease term to take possession of the property in order to recover the residual value of such leased property.

Why Is Recharacterization Important Under Chapter 11?

The obligations of a Chapter 11 debtor under a true lease may be vastly different than those of a Chapter 11 debtor under a secured financing arrangement. This is primarily because, during the pendency of a Chapter 11 case, from and after 60 days from the petition date, a debtor must make lease payments to any lessor of personal property until such time as the debtor either assumes or rejects such lessor's lease. See 11 U.S.C. ' 365(d)(10). If a debtor decides to assume the lease, and the court approves the assumption, then the debtor is required to “cure” any past defaults and to provide “adequate assurance” of future performance. See 11 U.S.C. ' 365(b)(1). Conversely, if the debtor decides to reject the lease, then the debtor must return the leased property to the lessor who may then assert a prepetition claim for rejection damages against the debtor.

Compare the foregoing with the obligations that a debtor has to its secured creditors during the pendency of a Chapter 11 case. While a debtor must provide a secured creditor with “adequate protection” in the form of cash payments, replacement liens, or other relief that results in the indubitable equivalent of the secured creditor's interest in the property, such protection is only required to the extent of the value of the secured creditor's interest in the secured property. The unsecured portion of the secured creditor's claim is not entitled to adequate protection. Thus, a debtor that is a party to a secured financing, as opposed to a true lease, may find that it has comparatively more cash available to reorganize its business and administer its Chapter 11 estate. Additionally, the debtor may be able to retain a creditor's secured property pursuant to a Chapter 11 reorganization plan by cramming-down the secured portion of the secured creditor's claim to the property's fair market value. See 11 U.S.C. ' ' 506(a) and 1129(b)(2)(A).

Form Yields to Substance in Duke v. Pillowtex

In Pillowtex, Duke Energy Royal, LLC (Duke), an energy company, and Pillowtex Corporation (Pillowtex), a manufacturer of linen and bedding products, entered into a master energy services agreement (Agreement) pursuant to which Duke agreed to install certain energy savings equipment to improve the efficiency of Pillowtex's energy consumption and to reduce the operating costs incurred by Pillowtex at its manufacturing plants. 349 F.3d at 713. The parties themselves intended to structure the Agreement as a true lease in large part because Pillowtex was subject to capital expenditure limitations under its senior credit facility and wanted the payments it made under the Agreement to qualify as expenses, not capital expenditures.

To induce Pillowtex to enter into the Agreement, the energy projects were designed to be “cost-neutral” to Pillowtex. Thus, during the term of the Agreement, Pillowtex was only responsible for making payments to Duke under the Agreement in an amount equal to Pillowtex's cost-savings. Duke bore the entire $10.41 million cost of acquiring and installing the energy-savings equipment, which, to Duke's ultimate detriment, consisted of labor costs that exceeded the cost (and value) of the underlying building materials. The parties agreed that the simple payback period under the Agreement would be 5 years. Once the 8-year term of the Agreement expired, Pillowtex would begin to reap the cost-savings benefits of the equipment. Id. at 713.

Approximately 2.5 years after entering into the Agreement, Pillowtex and certain of its subsidiaries filed for relief under Chapter 11 of the Bankruptcy Code. When Pillowtex stopped making payments under the Agreement, Duke filed a motion under section 365(d)(10) of the Bankruptcy Code to compel Pillowtex to make lease payments until such time as Pillowtex assumed or rejected the Agreement. Pillowtex objected to Duke's motion on the grounds that the Agreement was not a true lease but instead a secured financing, and, therefore, Duke was not entitled to receive payments pursuant to Bankruptcy Code section 365(d)(10), which requires that debtors keep current on their unexpired lease obligations. The District Court, sitting in bankruptcy, held in favor of Pillowtex. Duke appealed to the Third Circuit Court of Appeals.

The Third Circuit Applies New York Law

As a preliminary matter, the Third Circuit observed that whether an agreement is a true lease or a secured financing arrangement under the Bankruptcy Code is a matter of state law. Id. at 716. After deciding that New York law applied to the Agreement, the court turned to the New York Uniform Commercial Code (UCC) and the definition of “security interest” under section 1-207(37)(a) of the UCC. The court interpreted this section as establishing a two-part test for determining whether a transaction creates a lease or a security interest. The first part of the analysis is a bright-line test, sometimes referred to as a “per se” rule. The second part, which is performed by a court only if the bright line test does not support the recharacterization of a purported lease, compels a court to look to the particular facts of the case to see whether the economics of the transaction suggest that the transaction is more fairly characterized as a lease or a secured financing arrangement.

The First Level of Analysis

The Bright Line Test Under ' 1-201(37)(a) of the New York UCC

Under the bright-line test, a transaction creates a security interest if 1) the lessee does not have the right to terminate the lease prior to the end of its term, and 2) any one of the following factors is present: a) the original term of the lease is equal to or greater than the remaining economic life of the goods; b) 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; c) the lessee has an option to renew the lease for the remaining economic life of the good for no additional consideration or nominal additional consideration; or d) the lessee has an option to become the owner of the goods for no additional consideration or nominal consideration. These factors are termed as “residual value factors” because they determine whether any meaningful residual value remains for lessors at the end of the term of the lease.

The Second Level of Analysis

The Economic Realities of the Agreement

The second part of the test under Section 1-201(37) of the New York UCC requires a court to analyze the specific facts of the case and determine the economic reality of the transaction. The court enumerated various factors, taken from relevant case law, including: 1) whether the purchase option is nominal; 2) whether the lessee is required to make aggregate rental payments having a present value equaling or exceeding the original cost of the leased property; and 3) whether the lease term covers the total useful life of the equipment. See In re Edison Bros. Stores, Inc., 207 B.R. 801 (Bankr. D. Del. 1997).

The Third Circuit's Decision in Pillowtex

The court first analyzed the terms of the Agreement and held that the Agreement failed to meet the bright-line test. While the court observed that Pillowtex could not terminate the Agreement during the Agreement's term, which satisfied the first part of the test, it held that none of the residual value factors were present because Pillowtex was not contractually bound at the expiration of the term of the Agreement to become the owner of the energy fixtures and did not possess the option to become the owner for nominal additional consideration. It was not enough that Duke expressly reserved the right under the Agreement to grant Pillowtex the option to become the owner at the end of the term of the Agreement or that Duke could extend the term of the Agreement or give Pillowtex the option of purchasing the underlying equipment on terms later agreed to by the parties. Similarly, the fact that Duke would have little or no bargaining power at the end of the term of the Agreement (due to the high cost of removing and replacing the equipment) was not sufficient for the court to find any of the factors met in a de facto sense.

Upon determining that the Agreement did not create a security interest as a matter of law under the bright line test, the court proceeded to analyze the economic realities of the transaction. The court gave great significance to the fact that the present value of the aggregate rental payments made to Duke under the Agreement equaled or exceeded the cost of the energy fixtures. See Pillowtex, 349 F.3d at 719. As a result, Duke effectively received payment in full for the transferal of the lighting fixtures to Pillowtex, which constituted evidence that the transaction was a sale. The court also noted that Pillowtex did not account for its payments under the Agreement as a true lease. Instead, Pillowtex treated its payments to Duke as utility expenses, which was different from the way Pillowtex treated other manufacturing and production equipment obtained from Duke concurrently with the Agreement.

After analyzing each of the relevant factors, the court held that the Agreement was “substantively better characterized as a security agreement than a true lease.” Id. at 719. Distinguishing applicable case law, the court dismissed the fact that the useful life of the energy savings equipment greatly exceeded the 8-year term of the Agreement. While the court acknowledged that this factor may be a relevant fact under certain circumstances, “[s]uch an inference would only be proper … where the evidence showed a plausible intent by the transferor to repossess the goods.” Id. at 720. Here, the economic realities of the transaction belied the existence of such intent because Duke had no economic motivation to repossess the fixtures and to realize upon the equipment's residual value at the end of the Agreement's term; not only was the cost of removal prohibitively expensive but virtually no resale market existed for the used equipment. The court reached its decision even though the Agreement possessed certain characteristics more typical of a true lease: title to the equipment remained with Duke throughout the term of the Agreement and Pillowtex agreed not to claim ownership of the equipment for income tax purposes.

The Intent of the Parties Does Not Control the Issue

The court rejected Duke's argument that the District Court erred by failing to analyze the intent of the parties. Under the revised UCC, courts no longer consider this factor in determining whether a transaction is a lease or a security agreement. Instead, the “court must subordinate the parties' intent to the economic reality that Duke would not have plausibly reclaimed the fixtures at the end of the [Agreement's] term.” Id. at 723. Similarly, the court dismissed Duke's admonition that the “[e]quipment leasing between sophisticated commercial entities dealing at arms length for their mutual benefit is an important commercial activity and one that should not be lightly recharacterized.” Id. at 722. The Third Circuit observed that it was “particularly appropriate” to refuse to defer to the intent of the contracting parties in the context of a bankruptcy proceeding because the cost of doing so would be imposed on third-party creditors. Id.

Conclusion

In structuring leasing transactions, parties to a “true” lease must be mindful of the nature of the asset leased and the cost of recovering and repossessing the leased asset at the end of the lease term. In determining whether a transaction is more appropriately characterized as a true lease or a secured financing, bankruptcy courts will look beyond the form of the transaction to its substance. The Pillowtex decision makes clear that a lessor who fails to account for the impact of recovery costs on the residual value of the leased property is at risk of having the transaction recharacterized as a secured financing arrangement in a Chapter 11 proceeding.