Is It a True Lease or a Loan?

This article focuses on tests used by courts to determine whether a “lease” is a true lease or a loan to the extent that the distinction impacts a lessor's rights under state laws and federal bankruptcy generally. The test used under state law and bankruptcy is essentially the same test since bankruptcy rules dictate that the issue of whether a transaction that is labeled as a “lease” constitutes a true lease or a disguised security interest is governed by state law. See 11 U.S.C. '101, Historical and Statutory Notes (“Whether a … lease constitutes a security interest under the bankruptcy code will depend on whether it constitutes a security interest under applicable State or local law”) and Butner v. United States, 440 U.S. 48, 54-55 (1979). It is important to note that, although there is some overlap, courts use a different test when determining if a transaction is a true lease for federal tax purposes from the one used for accounting purposes and that both of those tests are different from the one discussed in this article (ie, the test used for state law and federal bankruptcy purposes).

Why is the Distinction Important?

The failure of a lessor to correctly file a UCC-1 Financing Statement in the appropriate jurisdiction (a “Financing Statement”) is a common reason for the litigation of whether a given transaction is a true lease or a disguised security interest. In the event that the transaction is a disguised security interest, a lessor must “perfect” its security interest in the property being leased by filing a Financing Statement. Failure to do so may subordinate the lessor's rights in the leased equipment to those of another creditor. If the lessor fails to file a Financing Statement, or improperly files one, and the lessee goes into bankruptcy, the lessor will lose its rights to the equipment as collateral for the lessee's obligations under the lease.

Even if the lessor properly files a Financing Statement, a lessor under a true lease receives better treatment in bankruptcy than does a lessor who holds a disguised security interest. A detailed analysis of this issue is beyond the scope of this article. However, to address the point briefly, true leases are treated as “executory contracts” under the Bankruptcy Code and the lessee usually must begin making payments at the contract rate on the 60th day of the debtor's bankruptcy case. In addition, lessees under true leases can retain possession and use of the leased property only by curing defaults in payments, assuring future payments and compensating the lessor for pecuniary loss. On the contrary, if the transaction constitutes a disguised security interest, the lessee may “value” the leased property and take other steps that may result in reduction of the amount of rent required under the lease.

There are also implications outside of the bankruptcy context. For example, if the transaction creates a disguised security interest, the lessor must comply with Article 9 of the Uniform Commercial Code when repossessing and disposing of the property being leased. The provisions of Article 9 are designed, among other things, to protect the lessee's “equity” in the leased assets and generally result in more obstacles than a lessor would encounter under a true lease. For example: 1) a holder of a disguised security interest has to send out “Notices of Disposition” to certain parties (including any guarantors and other lien holders revealed by a UCC search conducted prior to disposing of the equipment); 2) the sale of the repossessed equipment has to be commercially reasonable; and 3) lessee receives any surplus left after the lessor and any other junior lien holders are made whole.

Other examples of implications outside of the bankruptcy context include: 1) the fact that usury laws, which can operate to reduce the amount of interest the lessor may charge the lessee, generally apply to disguised security interests but not to true leases; and 2) lessors under true leases generally fair better against landlords and mortgagees than do lessors under disguised security agreements.

Outline of the Applicable Test

In order to determine whether a transaction is a true lease under state law, and by implication under the laws of bankruptcy, the logical starting place is to look to the definition of “lease” under the Uniform Commercial Code. That definition, which is found in Article 2A relating to true leases, defines a lease as “a transfer of the right to possession and use of goods for a term in return for consideration. … ” UCC '2A-103(j). That section further adds that the “ creation of a security interest is not a lease.” The definition of “security interest” which is currently found in '1-201(37) of the Uniform Commercial Code, provides significantly more detail and therefore becomes the key provision to use when determining whether a transaction creates a true lease or a disguised security interest (ie, a loan).

Until the late 1980s, the definition of security interest under this section was very short and provided little guidance. However, when Article 2A of the UCC (which applies to true leases) was first codified in 1987, it modified '1-201(37) to provide significantly more guidance. The definition created by the Article 2A modifications is sometimes referred to throughout the remainder of this discussion as the “current definition.” The definition of security interest under the old version of '1-201(37) is sometimes referred to throughout the remainder of this article as the “old definition” and, although the remainder of this article focuses on the current definition, the case law analyzing the old definition still has some relevance and is therefore addressed where appropriate.

The current definition of security interest provides a two-part test (the “Two-Part Test”). See UCC '1-201(37)(a) through (d). Any transaction that satisfies the Two-Part Test creates a security interest and is therefore a loan as matter of law ' ie, no additional factors need to be considered. The elements of the Two-Part Test generally focus on whether the alleged lessor retains some interest in the goods (known as its residual interest). If there is a realistic chance that the lessee will return something of value to the lessor, the lease will likely be deemed to be a true lease. The first prong of the Two-Part Test is discussed below and the second prong of the Two-Part test will be discussed in next month's issue.

However, it is important to note that the Two-Part Test is not definitive and that the current definition of security interest also provides courts with flexibility by noting that “[w]hether a transaction creates a lease or security interest is determined by the facts of each case.” As such, even if the Two-Part Test does not result in the transaction being characterized as a loan as a matter of law, some courts may still find the transaction to be a loan based on an analysis of the facts and circumstances of the particular case and the underlying economics of the transaction. See In re Taylor, 209 B.R. at 487.

The First Prong of the Two-Part Test: Does the Lessee have the Option of Terminating the Lease Early?

A transaction will flunk the Two-Part Test, and therefore will not automatically become a loan, unless the “consideration the lessee is to pay 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.” Put another way, if the lessee has the right to terminate the lease at any time without a significant penalty, the transaction cannot pass the Two-Part Test and is likely to be a true lease.

This component of the Two-Part Test was added in order to correct the results of decisions made under the old definition by some courts. See, e.g., Aoki v. Shepherd Mach. Co., Inc., 665 F.2d 941, 946-47 (9th Cir. 1982) (noting that “[t]he cases construing the [old] section have uniformly held that if the lessee, upon compliance with the lease, has the option to purchase the property for no additional consideration, or for a nominal consideration, the lease is a security interest as a matter of law … without reference to other facts from which the opposite inference might be drawn”); In re Lykes Bros. S.S. Co., 196 B.R. 574, 581 (Bankr. M.D. Fla. 1996) (stating that “if the so-called lessee has an option to become an owner for no additional consideration or for nominal consideration upon completing the lease terms, the so-called lease is conclusively deemed to be a financing transaction. If that has been established, the court's inquiry ends”).

It is important to note that a termination right that requires the lessee to pay the lessor a significant sum will not necessarily result in true lease status since courts generally view such termination payments as penalties which force reasonable lessees to continue performing under the lease documents. See e.g. In re Taylor, 209 B.R. at 485.

The second component of the Two-Part Test focuses on the purchase and renewal options in the lease as well as the economic life of the leased equipment. This prong, which is the most often litigated aspect of the Two-Part Test, is discussed in the next publication.

Part One of a Two-Part Series

Anyone who has been in the leasing business for much time at all understands that a transaction that the parties describe as a “lease” can be either a “true lease” where the lessor owns the leased equipment or a “loan” which results in the lessee being the owner and the lessor having merely a security interest. The latter is commonly referred to as “disguised security interests” or “leases intended as security” or “financing leases.” Many people also have a general understanding of the distinction between the two, and most of those reading this article have heard one person or another proclaim the bright-line rule that a lease with a dollar purchase option is a loan and a lease with a fair market value purchase option is a true lease.

Unfortunately, the rule is not anywhere near that straightforward, and many people analyzing this issue are incorrect with respect to some of the fine-tuned details. Given that the distinction between a true lease and a loan is still one of the most often litigated issues in the leasing profession and that case law continues to develop in this area, even people who know this issue well can benefit from the overview and refresher offered in the remainder of this article.

This article focuses on tests used by courts to determine whether a “lease” is a true lease or a loan to the extent that the distinction impacts a lessor's rights under state laws and federal bankruptcy generally. The test used under state law and bankruptcy is essentially the same test since bankruptcy rules dictate that the issue of whether a transaction that is labeled as a “lease” constitutes a true lease or a disguised security interest is governed by state law. See 11 U.S.C. '101, Historical and Statutory Notes (“Whether a … lease constitutes a security interest under the bankruptcy code will depend on whether it constitutes a security interest under applicable State or local law”) and Butner v. United States , 440 U.S. 48, 54-55 (1979). It is important to note that, although there is some overlap, courts use a different test when determining if a transaction is a true lease for federal tax purposes from the one used for accounting purposes and that both of those tests are different from the one discussed in this article (ie, the test used for state law and federal bankruptcy purposes).

Why is the Distinction Important?

The failure of a lessor to correctly file a UCC-1 Financing Statement in the appropriate jurisdiction (a “Financing Statement”) is a common reason for the litigation of whether a given transaction is a true lease or a disguised security interest. In the event that the transaction is a disguised security interest, a lessor must “perfect” its security interest in the property being leased by filing a Financing Statement. Failure to do so may subordinate the lessor's rights in the leased equipment to those of another creditor. If the lessor fails to file a Financing Statement, or improperly files one, and the lessee goes into bankruptcy, the lessor will lose its rights to the equipment as collateral for the lessee's obligations under the lease.

Even if the lessor properly files a Financing Statement, a lessor under a true lease receives better treatment in bankruptcy than does a lessor who holds a disguised security interest. A detailed analysis of this issue is beyond the scope of this article. However, to address the point briefly, true leases are treated as “executory contracts” under the Bankruptcy Code and the lessee usually must begin making payments at the contract rate on the 60th day of the debtor's bankruptcy case. In addition, lessees under true leases can retain possession and use of the leased property only by curing defaults in payments, assuring future payments and compensating the lessor for pecuniary loss. On the contrary, if the transaction constitutes a disguised security interest, the lessee may “value” the leased property and take other steps that may result in reduction of the amount of rent required under the lease.

There are also implications outside of the bankruptcy context. For example, if the transaction creates a disguised security interest, the lessor must comply with Article 9 of the Uniform Commercial Code when repossessing and disposing of the property being leased. The provisions of Article 9 are designed, among other things, to protect the lessee's “equity” in the leased assets and generally result in more obstacles than a lessor would encounter under a true lease. For example: 1) a holder of a disguised security interest has to send out “Notices of Disposition” to certain parties (including any guarantors and other lien holders revealed by a UCC search conducted prior to disposing of the equipment); 2) the sale of the repossessed equipment has to be commercially reasonable; and 3) lessee receives any surplus left after the lessor and any other junior lien holders are made whole.

Other examples of implications outside of the bankruptcy context include: 1) the fact that usury laws, which can operate to reduce the amount of interest the lessor may charge the lessee, generally apply to disguised security interests but not to true leases; and 2) lessors under true leases generally fair better against landlords and mortgagees than do lessors under disguised security agreements.

Outline of the Applicable Test

In order to determine whether a transaction is a true lease under state law, and by implication under the laws of bankruptcy, the logical starting place is to look to the definition of “lease” under the Uniform Commercial Code. That definition, which is found in Article 2A relating to true leases, defines a lease as “a transfer of the right to possession and use of goods for a term in return for consideration. … ” UCC '2A-103(j). That section further adds that the “ creation of a security interest is not a lease.” The definition of “security interest” which is currently found in '1-201(37) of the Uniform Commercial Code, provides significantly more detail and therefore becomes the key provision to use when determining whether a transaction creates a true lease or a disguised security interest (ie, a loan).

Until the late 1980s, the definition of security interest under this section was very short and provided little guidance. However, when Article 2A of the UCC (which applies to true leases) was first codified in 1987, it modified '1-201(37) to provide significantly more guidance. The definition created by the Article 2A modifications is sometimes referred to throughout the remainder of this discussion as the “current definition.” The definition of security interest under the old version of '1-201(37) is sometimes referred to throughout the remainder of this article as the “old definition” and, although the remainder of this article focuses on the current definition, the case law analyzing the old definition still has some relevance and is therefore addressed where appropriate.

The current definition of security interest provides a two-part test (the “Two-Part Test”). See UCC '1-201(37)(a) through (d). Any transaction that satisfies the Two-Part Test creates a security interest and is therefore a loan as matter of law ' ie, no additional factors need to be considered. The elements of the Two-Part Test generally focus on whether the alleged lessor retains some interest in the goods (known as its residual interest). If there is a realistic chance that the lessee will return something of value to the lessor, the lease will likely be deemed to be a true lease. The first prong of the Two-Part Test is discussed below and the second prong of the Two-Part test will be discussed in next month's issue.

However, it is important to note that the Two-Part Test is not definitive and that the current definition of security interest also provides courts with flexibility by noting that “[w]hether a transaction creates a lease or security interest is determined by the facts of each case.” As such, even if the Two-Part Test does not result in the transaction being characterized as a loan as a matter of law, some courts may still find the transaction to be a loan based on an analysis of the facts and circumstances of the particular case and the underlying economics of the transaction. See In re Taylor, 209 B.R. at 487.

The First Prong of the Two-Part Test: Does the Lessee have the Option of Terminating the Lease Early?

A transaction will flunk the Two-Part Test, and therefore will not automatically become a loan, unless the “consideration the lessee is to pay 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.” Put another way, if the lessee has the right to terminate the lease at any time without a significant penalty, the transaction cannot pass the Two-Part Test and is likely to be a true lease.

This component of the Two-Part Test was added in order to correct the results of decisions made under the old definition by some courts. See, e.g., Aoki v. Shepherd Mach. Co., Inc., 665 F.2d 941, 946-47 (9th Cir. 1982) (noting that “[t]he cases construing the [old] section have uniformly held that if the lessee, upon compliance with the lease, has the option to purchase the property for no additional consideration, or for a nominal consideration, the lease is a security interest as a matter of law … without reference to other facts from which the opposite inference might be drawn”); In re Lykes Bros. S.S. Co., 196 B.R. 574, 581 (Bankr. M.D. Fla. 1996) (stating that “if the so-called lessee has an option to become an owner for no additional consideration or for nominal consideration upon completing the lease terms, the so-called lease is conclusively deemed to be a financing transaction. If that has been established, the court's inquiry ends”).

It is important to note that a termination right that requires the lessee to pay the lessor a significant sum will not necessarily result in true lease status since courts generally view such termination payments as penalties which force reasonable lessees to continue performing under the lease documents. See e.g. In re Taylor, 209 B.R. at 485.

The second component of the Two-Part Test focuses on the purchase and renewal options in the lease as well as the economic life of the leased equipment. This prong, which is the most often litigated aspect of the Two-Part Test, is discussed in the next publication.