Is It a True Lease or a Loan?

By Ken Weinberg
June 01, 2004

Part Two of a Two-Part Series

The first part of this article, published in last month's issue, addressed the importance of the distinction between true leases and loans and began a detailed analysis of the rules that courts use for state law and bankruptcy purposes to determine the category in which a given transaction belongs.

As outlined in part one of this article, courts utilize the Two-Part Test provided in '1-201(37) of the Uniform Commercial Code, and any transaction that satisfies that Two-Part Test creates a security interest as a matter of law. The first prong of the test is satisfied if the lessee does not have the option of terminating the lease early or if any such early termination option requires the lessee to pay the lessor a significant sum. The second prong, which addresses the issues that are most often litigated, is discussed below.

The Second Prong of the Two-Part Test: Purchase, Renewal and Economic Life

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. Courts interpreting both of the old and current definitions of “security interest” have consistently held that the principal characteristic of a lease, which distinguishes it from a secured transaction, is that it allows the lessee the right to use the leased property with an attendant opportunity to return the property to the lessor while it still has “substantial useful economic life.” See e.g., In re Zaleha, 159 B.R. at 585 (explaining that “the drafters of Article 2A have attempted to re-establish the significance of residual value as an economic rationale for a lease transaction”); and Kimco Leasing, Inc. v. State Bd. of Tax Comm'rs, 656 N.E.2d 1208, 1218 (Ind. Tax 1995) (stating that “[i]f the lessor retains a meaningful residual interest in the leased property at the end of the lease term, the lease is a true lease. If, however, the lessor cannot reasonably expect to receive back anything of value at the end of the lease, then the lease creates a security interest”).

The old definition of security interest provided only two factors for making this determination. The first was if the lessee was bound to become the owner of the leased property. The second was if the lessee had the option to become the owner of the leased property for no additional consideration or for only nominal consideration. Old UCC '1-201(37)(b). In either event, the lease was considered a disguised security interest. The current definition retains these two factors and provides substantially more guidance than did the old definition. It asks the three questions outlined below. If the answer to any of the questions is “yes,” the lease is almost certain to be treated as a disguised security interest.

1) Is the lessee required to purchase the goods?

If the lessee is required to purchase the goods, the lease is not a true lease because there is no chance that the leased equipment will be returned to the lessor. UCC '1-201(37)(b)(2).

2) Is the lessee required to lease the goods for their full economic life?

If the lessee is required to lease the goods for their full economic life, nothing of value will be returned to the lessor and the lease is not a true lease. UCC '1-201(37)(b)(1). The result is the same even if the initial lease term is for less than the economic life of the goods if the lessee is required to renew the lease for the remaining economic life of the goods. UCC '1-201(37)(b)(2).

3) Does the lease contain a nominal renewal or nominal purchase option?

Any reasonable lessee would be certain to exercise an option: 1) that allows it to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal consideration; or 2) that allows it to become the owner of the goods for no additional consideration or for nominal consideration. As a result, no lessor under any lease that contains either of these options can expect to receive something of value from the lessee at the end of the lease term and such leases are deemed to be disguised security interests rather than true leases. UCC '1-201(37)(b)(3) and (4).

In order to answer the foregoing questions, it is necessary to understand what is meant by the terms “remaining economic life” and “nominal consideration.” The old definition of security interest does not set forth any guidelines with respect to these terms and the case law analyzing the old definition therefore varies considerably. In fact, the “considerable confusion” evidenced by various court decisions is one of the reasons the old definition was revised. See Official Comments to New UCC '1-201(37). The current definition of security interest provides better guidelines, although more is said about the term “nominal” consideration than is said regarding the “economic life” of the leased property. With respect to the latter, it is to be determined based on the “facts and circumstances at the time the transaction [was] entered into.” UCC '1-201(37)(y).

With respect to the term “nominal consideration,” the UCC defines the two end points of the spectrum, noting that: 1) consideration is nominal if it is for less than the lessee's reasonably predictable cost of performing were the option not to be exercised; and 2) consideration is not nominal when the option to renew or purchase is stated in the agreement to be the fair market value of the property. UCC '1-201(37)(x).

Less than the Reasonably Predictable Cost of Continued Performance Equals Nominal

This test has been described as a codification of a common law test alternatively known as the “economic realities” test, the “no sensible alternative” test, or the “no lessee in its right mind” test. See In re Taylor, 209 B.R. 482, 486 (Bankr. S.D. Ill. 1997). Although there is a dearth in case law discussing application of this part of the test under the current definition, prior case law under the old definition is helpful. For example, in In re Howell, the court noted that “consideration paid to exercise a purchase option is to be considered nominal if at the end of the lease, the only economically sensible course of action for the lessee is to exercise the option.” 161 B.R. 285, 289 & n.3 (Bankr. N.D. Fla 1993). In In re Berge, the court stated that “if the fair market value of the property contemplated at the end of the lease term was less than the cost of reassembly and transport of the equipment … the exercise of the option would be virtually 'compelled' or the 'only sensible course,' and the consideration ipso facto nominal.” 32 B.R. 370, 372-73 (Bankr. W.D. Wis. 1983).

Fair Market Value Purchase Option Generally is not Nominal Consideration

The current definition of security interest further provides that consideration is not nominal when the option to renew or purchase is stated in the agreement to be the fair market value of the property. Application of this test generally results in the court comparing the option price to the anticipated fair market value of the property.

A minority of courts has taken the approach that a fair market value option is not nominal per se, holding that a lease that provides for a fair market value purchase option is a true lease as a matter of law. See e.g., In re Paz, 179 B.R. 743, 748 (Bankr. S.D. Ga. 1995); and Agristor Leasing v. Meuli, 634 F. Supp. 1208, 1214-15 (D. Kan. 1986) (stating that “[t]his court is convinced that an option to purchase for 'fair market value' is not nominal”). Other decisions have found that a fair market value option in a lease constitutes only a presumption that the option was not for nominal consideration, which can be rebutted by facts and circumstances particular to the transaction. See e.g., Jahn v. M.W. Kellogg Co., 822 F.2d 16, 18 (6th Cir. 1987) (stating that “[g]enerally, an option for the lessee to purchase the property at the end of the lease term for the then existing fair market value of the property creates an inference that the consideration to be paid by the lessee is not nominal”).

One instance where a fair market value purchase option has been found to be nominal is where the value of the property is shown to be negligible, the idea being that if the fair market value is so small as to be “nominal” under any common sense of the term, then the lease is a disguised security interest. See e.g., In re Owen, 221 B.R. at 61 (setting forth the exception of negligible fair market value as potentially “nominal”). Perhaps a better way to resolve this line of cases is to hold that the fair market value purchase option is not nominal, but that other factors result in the characterization of the transaction as a disguised security interest ' such as the fact that the equipment was leased for its useful economic life (as evidenced by the low fair market value at the end of the lease).

A second such instance occurs when the fair market option is shown to be illusory because no market for the property exists. This generally occurs when the property is custom-made or modified for the express use of the lessee, or when the property is of the type that will become obsolete and useless due to anticipated technological advances. See e.g., In re The Answer – The Elegant Large Size Discounter, Inc., 115 B.R. 465 at 469 (concluding that lease constituted secured transaction, in part because no market existed for either custom-built fixtures installed in retail stores or for computer equipment which was found to be obsolete in face of new technology); and In re Beker Industries Corp., 69 B.R. 937, 941 (Bankr. S.D.N.Y. 1987) (noting that fair market option was not determinative of transaction for security where used and antiquated telephone equipment lacked readily ascertainable fair market value because no market existed for such equipment).

A third instance where even substantial fair market value options may be found to be nominal arises when options are shown to be illusory because the lessee's cost of removal and redelivery, in the absence of the option's exercise, is so high that it approaches or exceeds the anticipated fair market value. Under such circumstances, the so-called fair market value option price is effectively nominal in that the lessee's only reasonable economic choice is to exercise the option. For example, in In re Triplex Marine Maintenance, Inc, the court determined that a lease with a purchase option equal to the greater of 10% or the fair market value of the equipment was a loan under the “sensible person test” solely because the lease covered all of the lessee's assets and the court felt that the lessee's only sensible choice was therefore to exercise its purchase option. 45 UCC Rep. Serv.2d 977 (Bankruptcy Ct., Texas, 2000).

Although the current definition of security interest provides significantly more guidance than did the old definition, there is still a gray area. In particular, small purchase options may still be deemed to be nominal without discussion of the aforementioned tests, and courts unfortunately continue to use older common law tests to determine whether an option is “nominal” under the common sense use of the term.

One test used under both the current definition and the old definition is a comparison of the option price to the original purchase or list price of the property. Unfortunately, cases applying this analysis are very inconsistent. Pursuant to this test, it is not unusual for courts to describe the magical percentage at which a purchase option results in a true lease as being equal to or greater than 25% of the original cost. See In re Architectural Millwork of Virginia, Inc., 226 B.R. 551, 554-56 (Bankr. W.D. Va. 1998) (purchase option of approximately 25% of agreement's capitalized cost was not nominal); and In re Spears, 20 UCC. Rep. Serv.2d 260 (BC CD Ill, 1992) (option price over 25% resulted in a true lease).

On the other end of the spectrum, there are ample cases holding that a 10% purchase option is nominal. See e.g., Equilease Corp. v. AAA Mach. Co., 30 B.R. 323, 325 (Bankr. S.D. Fla. 1983); and In re Haddox, No. 2-82-02133, 1983 Bankr. LEXIS 5667 (Bankr. S.D. Ohio August 5, 1983).

Although cases with specific holdings regarding security interests between 10% and 25% are much less common, some do hold that purchase options of 15% and 20% are not nominal. See e.g., Keeling v. Ford Motor Credit Corp., 9 UCC. Rep. Serv.2d 227 (Maryland 1988) (residual value of at least 15% of original selling price results in a true lease); and Western Enterprises, Inc. v. Arctic Office Machines, Inc., 36 UCC. Rep. Serv. 1331 (Alaska 1983) (purchase option price of 20% of original costs found not to be nominal).

Unfortunately, these cases do not allow for any clear rule. For example, the line of cases holding that a purchase price greater than 25% is a true lease have resulted in a line of cases holding that purchase options less than 25% are loans. See e.g., In re Royal Food Mkts., Inc., 121 B.R. 913, 915 (Bankr. S.D. Fla. 1990) (finding consideration to be nominal where option price is less than 25% of original purchase or list price).

Factors That Do Not Prevent the Transaction From Being a Lease

Under the old definition of security interest, courts developed myriad additional factors that they have found to constitute “incidents of ownership” by the lessee and, thus, evidence of a disguised security interest. Some of the factors that have been erroneously applied include whether the lessor is granted a security interest and whether a Financing Statement is filed by lessor and whether the lessor has any facilities to store or retake the leased property. Of course, many factors erroneously applied are characteristic of the type of leasing engaged in by banks, captive financing companies and other financial institutions and would result in many true leases constituting disguised security interests. The drafters of the current definition of security interest sought to rectify the erroneous use of such factors by setting forth certain factors that cannot be viewed as solely determinative of whether a transaction is a true lease or a disguised security interest. The current definition of security interest therefore explicitly notes that a transaction designated as a “lease” does not create a security interest merely because: 1) the lease is a “full payout lease” (where the lessee is obligated to pay an amount equal to or greater than the cost of the goods); 2) the lease is a “net lease” (where the lessee assumes the risk of loss, and the costs of taxes, insurance, filing, service and maintenance); 3) the lease contains an option to purchase or renew (unless the option is binding or for no additional or only nominal consideration); or 4) there is an option to renew or buy at a fixed price equal to or greater than the reasonably predictable fair market value. In addition, in the Official Comments to the current definition, the drafters specify several additional factors and further provide that, in fact, most of the “incidents of ownership” factors developed by the case law (but not specified in the statute or official comment) should similarly be considered as not determinative of a transaction for security.

Conclusion

Although the current definition of a security interest provides substantially more guidance, there is no “definitive formula” to guarantee true lease treatment. Nonetheless it is helpful to bear in mind the following: 1) it is safer if the lease term, including any renewal periods required pursuant to the terms of the lease, does not exceed 80% of the equipment's useful life; 2) if the lessee doesn't have a reasonable business decision with respect to whether or not to return the equipment at the end of the lease term, some courts will treat that transaction as a loan no matter how carefully the numbers are structured ' for example, very expensive return requirements may prevent a transaction from being a “true lease”; 3) the Uniform Commercial Code clearly provides that it is not fatal to true lease treatment for a lease to obligate the lessee to pay an amount that equals or exceeds the cost of the goods, but some courts may be confused by this issue and could incorrectly find full payout leases to be loans; and 4) although there is a wide variation of case law on this point, as a rule of thumb: (a) a fair market value purchase option of greater than 25% is very safe; and (b) a fair market value purchase option of 10% or less is quite risky.

Ken Weinberg [email protected]

Part Two of a Two-Part Series

The first part of this article, published in last month's issue, addressed the importance of the distinction between true leases and loans and began a detailed analysis of the rules that courts use for state law and bankruptcy purposes to determine the category in which a given transaction belongs.

As outlined in part one of this article, courts utilize the Two-Part Test provided in '1-201(37) of the Uniform Commercial Code, and any transaction that satisfies that Two-Part Test creates a security interest as a matter of law. The first prong of the test is satisfied if the lessee does not have the option of terminating the lease early or if any such early termination option requires the lessee to pay the lessor a significant sum. The second prong, which addresses the issues that are most often litigated, is discussed below.

The Second Prong of the Two-Part Test: Purchase, Renewal and Economic Life

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. Courts interpreting both of the old and current definitions of “security interest” have consistently held that the principal characteristic of a lease, which distinguishes it from a secured transaction, is that it allows the lessee the right to use the leased property with an attendant opportunity to return the property to the lessor while it still has “substantial useful economic life.” See e.g., In re Zaleha, 159 B.R. at 585 (explaining that “the drafters of Article 2A have attempted to re-establish the significance of residual value as an economic rationale for a lease transaction”); and Kimco Leasing, Inc. v. State Bd. of Tax Comm'rs , 656 N.E.2d 1208, 1218 (Ind. Tax 1995) (stating that “[i]f the lessor retains a meaningful residual interest in the leased property at the end of the lease term, the lease is a true lease. If, however, the lessor cannot reasonably expect to receive back anything of value at the end of the lease, then the lease creates a security interest”).