Beating True Lease Challenges: A Lessor's Guide to Structuring and Defending True Leases

For all the complexity of the true lease cases, many of these recent cases turn on whether the lessor maintained meaningful residual value or a reversionary interest in the leased property. As simply stated in In re QDS Components, Inc., 292 B.R. 313, 331 (Bank. S.D. Ohio 2002) (“QDS“), “an essential characteristic of a lease agreement is that the lessor retains an economically meaningful residual interest in the leased property.” To apply the myriad of legal tests advanced by the debtor and lessor in that case, the QDS court traced the lengthy developments of the current Section 1-201(37) and the former Section 1-201(37). The court described the history as “the body of hopelessly irreconcilable decisions construing Section 1-201(37).” Id. at 323. While some of the concepts of the original 1-201(37) no longer apply, the golden thread of beating lessee challenges to a true lease transaction throughout history seems to lie primarily in the lessor maintaining a meaningful residual interest in the leased property.

In general, a lessor has a good chance of prevailing in a true lease contest with its lessee, regardless of the type of leased property, if the lessor demonstrates and can objectively evidence, as of the inception of a lease transaction, that it:

1) Held a meaningful residual value or reversionary interest in the leased property, and

2) Structured its “lease” transaction in such a manner as to avoid creating a security interest under Section 1-201(37) of the UCC.

Fundamental Concepts

Section 2A-103(1)(j) of the UCC defines a “lease” as “a transfer of the right to possession and use of goods for a term in return for consideration, but a sale … or retention or creation of a security interest is not a lease” (a “true lease”). A “security interest” means an interest in personal property or fixtures that secures payment or performance of any obligation.

If a transaction doesn't qualify as a lease, then Revised Article 9 of the UCC applies to the lease transaction as a disguised security interest. If a transaction qualifies as a lease, Article 2A of the Uniform Commercial Code governs the rights and the remedies of the parties. The rights and remedies of the transaction under Revised Article 9 differ significantly from Article 2A. While these general propositions seem simple, the transactions involving the characterization of leases and the attendant rights and remedies have generated extensive litigation, often in bankruptcy proceedings. These cases have yielded inconsistent results and interpretations, making lease structuring more difficult for lessors.

It is well established that state law governs the existence, nature and extent of a security interest in property in bankruptcy court. See Butner v. United States, 440 U.S. 48, 55, 99 S. Ct. 914, 59 L. Ed.2d 136 (1979). In characterizing a lease agreement as other than what it purports to be, the QDS court confirms that the lessee bears the burden of proof. However, in Wells-Fargo Equip. Fin., Inc. v. Circuit-Wise, Inc. (In re Circuit-Wise, Inc.), 277 B.R. 460 (Bankr. D. Conn. 2002), the court questioned this fundamental premise by barring the lessor from using the special protections of 11 U.S.C. Section 365 until the court determined whether the transaction constituted a true lease. In effect, the court switched the burden of proof to the lessor rather than giving it the presumptive benefit of treating the transaction as a true lease until otherwise proven by the lessee. Fortunately for lessors, the Circuit-Wise decision has not been followed by other courts.

Two Test Levels Under Section 1-201(37)

In determining whether a transaction is a security agreement, Section 1-201(37) of the UCC provides two test levels ' the termination test and the residual value test. The first test determines whether the lessee may terminate its payment obligations during the term of the lease, and the second level test evaluates the residual interest of the lessor based on four factors listed in Section 1-201(37).

The Termination Test Under Section 1-201(37)

The first test is not whether the lessee can contractually terminate its lease during the term under an early termination option. Instead, this test determines whether the lessee's right to payment is subject to termination. This subtle, but important, distinction is clear in Section 1-201(37), which provides:

Whether a transaction creates a lease or security interest is determined by the facts of each case; however, a transaction creates a security interest if 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.

A typical early termination option in a lease may not qualify as a termination of the right to payment because the consideration the lessee must pay in such an early termination provision makes the lessor whole. In other words, the lessor receives consideration that, on a present value basis, equates to what the lessor would have received had the lessee made payments over the entire lease term. Two cases illustrate this point. In the QDS case, the court stated in regard to a lease of lathes: “The Lease Agreement requires the Debtor to pay the Lessors upon termination the present value of precisely what they would receive if QDS made all required monthly installment payments for the full contract term and then exercised the purchase option.” Similarly, in Ford Motor Credit Co. v. Hoskins (In re Hoskins), 266 B.R. 154 (Bank. W.D. Mo. 2001), the court found that, in the lease of a Ford truck, the lessee could not terminate its lease within the meaning of Section 1-201(37), despite the existence of an early termination provision in the lease, because the lessee remained financially liable to the lessor after termination of the lease for payments that become due after the lease termination. Further, the court noted “the lessee could not simply return the vehicle and then walk away from the transaction with no further financial responsibility.” Id. at 160. In many (but not all) lease transactions, lessors cannot or will not allow a lessee simply to walk away from a lease without liability for a termination payment or equivalent sales proceeds. Consequently, lease transactions without a right of termination as contemplated by the statute face a second level residual value test under Section 1-201(37).

Residual Value Test Under Section 1-201(37)

The second level of test evaluates four residual value factors under Section 1-201(37). Section 1-201(37) states that a transaction is a security interest and not a lease, for UCC purposes, if at least one of the following four criteria applies (and the lease payment obligation is not terminable under the first test):

1) The original fixed term equals or exceeds the remaining economic life of the goods (such as 5-year lease of equipment with a 5-year economic life); or

2) The lessee is bound to renew the lease for the remaining economic life of such goods (eg, through year 5) or is bound to become the owner of such goods (for example, through a forced purchase obligation); or

3) The lessee has an option to renew the lease for the remaining economic life of such goods for no or nominal consideration (such as a $1 renewal option through year 5); or

4) The lessee has an option to buy such goods for no or nominal consideration (often a “dollar-out” purchase option).

When structuring transactions, it is critical that lessors and lessees remember that courts will review the facts and circumstances concerning residual value at the time the parties enter into the lease (not later in the term or at the date of a dispute). In this regard, a lack of evidence of meaningful residual value anticipation as of the inception of a lease can prove fatal to residual value arguments of either the lessor or lessee under 1-201(37). For example, in In re Edison Bros. Stores, 207 B.R. 801, 811-12 (Bankr. D. Del. 1997) (“Edison“), the court held that the lessee-debtor failed to meet its burden of proving the lease should be re-characterized as a disguised security agreement because the record before the court provided no credible evidence as to the projected fair market value of the leased property (Atrium point of service cash registers) on the date the debtor would be entitled to exercise the purchase options. In short, the debtor could not meet the burden of proof of demonstrating that the purchase option price was nominal. In reaching its decision, the court in Edison evaluated three factors under New York law:

1) Whether the purchase option price at the end of the lease term is nominal;

2) Whether the lessee is required to make aggregate 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.

If the Edison court had found that the answer to any of these questions was “yes,” the outcome would probably have been different ' a security interest would have existed in the transaction instead of a true lease.

In QDS, the court considered several tests under the original and current version of Section 1-201(37). One test, the “Percentage Test,” has often been used by other courts. The Percentage Test states that a low percentage option relative to the original cost of the leased property automatically creates a security interest. The lessee in QDS argued that the Percentage Test indicated that the option price for the lathes was nominal under Section 1-201(37) because the purchase option equaled only 10% of the original purchase price of the equipment and 8.2% of the total (undiscounted) stream of rents. The QDS court quoted several courts and authorities to disavow the Percentage Test. The percentage does not determine whether a purchase price is nominal under the current Section 1-201(37) and, according to the QDS court, did not survive the amendment of Section 1-201(37) to the current rules. Consequently, lessors and lessees should generally not rely on low percentages of the original cost as the basis for asserting that a lease creates a security interest or true lease, although courts will still likely consider such a percentage as a valid factor. See QDS footnote 16.

The 'Economic Realities' Test

Once a transaction overcomes the tests under Section 1-201(37), indicating that a security interest does not exist (and a lease does exist), the trend requires yet another level of analysis ' the “economic realities” test.

One of the key precedents in demonstrating the recent trend is Duke Energy Royal, LLC v. Pillowtex Corp. (In re Pillowtex, Inc.), 349 F.3d 711 (3d Cir. 2003) (“Pillowtex”). Decided under New York law, the transaction reviewed by the court did not involve a transaction called a “lease.” Rather, the parties entered into a master energy services agreement (“MESA”) for 20-year energy-savings equipment and property such as light fixtures and a wastewater heat recovery system. The MESA provided for an 8-year contract under which Duke agreed to acquire, hold title to, and install at its cost approximately $10.41 million of the energy-savings equipment in nine Pillowtex facilities. At the end of 5 years of the 8-year term, Duke expected to recover a “simple payback” of its investment. Duke (and not Pillowtex) retained various end-of-term options ' the right to remove the equipment at its cost, abandon the equipment, extend the MESA term or give Pillowtex the option to purchase the equipment at a mutually agreeable price. The cost to remove the equipment was prohibitive for Duke when weighed against the nominal residual value of the leased property as removed at the end of the MESA term. The net effect for Duke is that it had little or no anticipation of residual value at the end of the term even though the leased property had about 12 years of useful life remaining at the end of the 8-year term.

Relying in large part on Edison, the court first analyzed the per se tests under 1-201(37). It did not find that a security interest existed under those tests. For that moment, the lease survived. Then it considered that Duke (the lessor) had a large expense to remove the leased property but a very low residual value. The court considered the transaction as a whole. It evaluated the “economic realities” of the transaction, as did the court in Edison, but unlike Edison, the Pillowtex court then found that the transaction did not constitute a lease. Edison not only influenced the Pillowtex court, but also other courts in many other recent cases.

Pillowtex will likely provide a persuasive approach to analyze true lease cases in bankruptcy courts for the foreseeable future. Frequently, the contest over whether a true lease exists arises in connection with motions under Section 365(d)(10) of the Bankruptcy Code. The bankruptcy courts provide fertile ground to test whether a lease exists and, if so, whether a lessor is entitled to the payment and performance by a lessee of its obligations to the lessor starting 60 days after the filing of a bankruptcy petition by the lessee. In that context, lessees typically assert that a lease does not constitute a true lease, but rather a disguised security interest. As discussed above, the loss of true lease treatment may destroy the lessor's economics and rights as an owner of the “leased” property.

True leasing has been around in its modern forms for several decades. The trend seems to show an increasing willingness of lessees to challenge even the most typical lease as a disguised security agreement. As a result, structuring leases has become more complex, even for transactions that, in the past, would be considered relatively straightforward. Although this complexity exists, it is manageable. However, lessors will need to manage risks of these transactions in the future with a view toward the economic realities of true leases and maintaining meaningful residual value or reversionary interests in the leased property. With careful attention to the trends of the courts and the requirements of applicable law, lessors will be able to structure, use and defend true leases as a viable method of making capital investment in various properties well into the future.

Lessees increasingly challenge leases in bankruptcy proceedings or disputes with lessors. They assert and litigate the issue of whether a lease constitutes a disguised security arrangement instead of a true lease. This issue arises with respect to leases of equipment as well as software. The consequence of losing true lease status under state law can dramatically affect a lessor's legal rights and remedies and impair a lessor's economics. Despite this increased uncertainty, lessors can effectively structure and defend their lease transactions as true leases when armed with working knowledge of current judicial trends and applicable rules under the Uniform Commercial Code (UCC).

Courts have exhaustively analyzed the true lease issues over the past 20 years and have created a confusing and complex array of inconsistent decisions. The analysis of true lease challenges often starts with Section 1-201(37) of the UCC. In general, Section 1-201(37) establishes a “per se” or “bright-line” test of whether a transaction should be treated as a true lease or disguised security agreement. Current case law also includes an additional “economic realities” test that evaluates the facts of each transaction to determine objectively whether the transaction is a lease or disguised security interest.

The Golden Thread: Residual Value or Reversionary Interests

For all the complexity of the true lease cases, many of these recent cases turn on whether the lessor maintained meaningful residual value or a reversionary interest in the leased property. As simply stated in In re QDS Components, Inc., 292 B.R. 313, 331 (Bank. S.D. Ohio 2002) (“QDS“), “an essential characteristic of a lease agreement is that the lessor retains an economically meaningful residual interest in the leased property.” To apply the myriad of legal tests advanced by the debtor and lessor in that case, the QDS court traced the lengthy developments of the current Section 1-201(37) and the former Section 1-201(37). The court described the history as “the body of hopelessly irreconcilable decisions construing Section 1-201(37).” Id. at 323. While some of the concepts of the original 1-201(37) no longer apply, the golden thread of beating lessee challenges to a true lease transaction throughout history seems to lie primarily in the lessor maintaining a meaningful residual interest in the leased property.

In general, a lessor has a good chance of prevailing in a true lease contest with its lessee, regardless of the type of leased property, if the lessor demonstrates and can objectively evidence, as of the inception of a lease transaction, that it:

1) Held a meaningful residual value or reversionary interest in the leased property, and

2) Structured its “lease” transaction in such a manner as to avoid creating a security interest under Section 1-201(37) of the UCC.

Fundamental Concepts

Section 2A-103(1)(j) of the UCC defines a “lease” as “a transfer of the right to possession and use of goods for a term in return for consideration, but a sale … or retention or creation of a security interest is not a lease” (a “true lease”). A “security interest” means an interest in personal property or fixtures that secures payment or performance of any obligation.

If a transaction doesn't qualify as a lease, then Revised Article 9 of the UCC applies to the lease transaction as a disguised security interest. If a transaction qualifies as a lease, Article 2A of the Uniform Commercial Code governs the rights and the remedies of the parties. The rights and remedies of the transaction under Revised Article 9 differ significantly from Article 2A. While these general propositions seem simple, the transactions involving the characterization of leases and the attendant rights and remedies have generated extensive litigation, often in bankruptcy proceedings. These cases have yielded inconsistent results and interpretations, making lease structuring more difficult for lessors.

It is well established that state law governs the existence, nature and extent of a security interest in property in bankruptcy court. See Butner v. United States , 440 U.S. 48, 55, 99 S. Ct. 914, 59 L. Ed.2d 136 (1979). In characterizing a lease agreement as other than what it purports to be, the QDS court confirms that the lessee bears the burden of proof. However, in Wells-Fargo Equip. Fin., Inc. v. Circuit-Wise, Inc. (In re Circuit-Wise, Inc.), 277 B.R. 460 (Bankr. D. Conn. 2002), the court questioned this fundamental premise by barring the lessor from using the special protections of 11 U.S.C. Section 365 until the court determined whether the transaction constituted a true lease. In effect, the court switched the burden of proof to the lessor rather than giving it the presumptive benefit of treating the transaction as a true lease until otherwise proven by the lessee. Fortunately for lessors, the Circuit-Wise decision has not been followed by other courts.

Two Test Levels Under Section 1-201(37)

In determining whether a transaction is a security agreement, Section 1-201(37) of the UCC provides two test levels ' the termination test and the residual value test. The first test determines whether the lessee may terminate its payment obligations during the term of the lease, and the second level test evaluates the residual interest of the lessor based on four factors listed in Section 1-201(37).

The Termination Test Under Section 1-201(37)

The first test is not whether the lessee can contractually terminate its lease during the term under an early termination option. Instead, this test determines whether the lessee's right to payment is subject to termination. This subtle, but important, distinction is clear in Section 1-201(37), which provides:

Whether a transaction creates a lease or security interest is determined by the facts of each case; however, a transaction creates a security interest if 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.

A typical early termination option in a lease may not qualify as a termination of the right to payment because the consideration the lessee must pay in such an early termination provision makes the lessor whole. In other words, the lessor receives consideration that, on a present value basis, equates to what the lessor would have received had the lessee made payments over the entire lease term. Two cases illustrate this point. In the QDS case, the court stated in regard to a lease of lathes: “The Lease Agreement requires the Debtor to pay the Lessors upon termination the present value of precisely what they would receive if QDS made all required monthly installment payments for the full contract term and then exercised the purchase option.” Similarly, in Ford Motor Credit Co. v. Hoskins (In re Hoskins), 266 B.R. 154 (Bank. W.D. Mo. 2001), the court found that, in the lease of a Ford truck, the lessee could not terminate its lease within the meaning of Section 1-201(37), despite the existence of an early termination provision in the lease, because the lessee remained financially liable to the lessor after termination of the lease for payments that become due after the lease termination. Further, the court noted “the lessee could not simply return the vehicle and then walk away from the transaction with no further financial responsibility.” Id. at 160. In many (but not all) lease transactions, lessors cannot or will not allow a lessee simply to walk away from a lease without liability for a termination payment or equivalent sales proceeds. Consequently, lease transactions without a right of termination as contemplated by the statute face a second level residual value test under Section 1-201(37).

Residual Value Test Under Section 1-201(37)

The second level of test evaluates four residual value factors under Section 1-201(37). Section 1-201(37) states that a transaction is a security interest and not a lease, for UCC purposes, if at least one of the following four criteria applies (and the lease payment obligation is not terminable under the first test):

1) The original fixed term equals or exceeds the remaining economic life of the goods (such as 5-year lease of equipment with a 5-year economic life); or

2) The lessee is bound to renew the lease for the remaining economic life of such goods (eg, through year 5) or is bound to become the owner of such goods (for example, through a forced purchase obligation); or

3) The lessee has an option to renew the lease for the remaining economic life of such goods for no or nominal consideration (such as a $1 renewal option through year 5); or

4) The lessee has an option to buy such goods for no or nominal consideration (often a “dollar-out” purchase option).

When structuring transactions, it is critical that lessors and lessees remember that courts will review the facts and circumstances concerning residual value at the time the parties enter into the lease (not later in the term or at the date of a dispute). In this regard, a lack of evidence of meaningful residual value anticipation as of the inception of a lease can prove fatal to residual value arguments of either the lessor or lessee under 1-201(37). For example, in In re Edison Bros. Stores, 207 B.R. 801, 811-12 (Bankr. D. Del. 1997) (“Edison“), the court held that the lessee-debtor failed to meet its burden of proving the lease should be re-characterized as a disguised security agreement because the record before the court provided no credible evidence as to the projected fair market value of the leased property (Atrium point of service cash registers) on the date the debtor would be entitled to exercise the purchase options. In short, the debtor could not meet the burden of proof of demonstrating that the purchase option price was nominal. In reaching its decision, the court in Edison evaluated three factors under New York law:

1) Whether the purchase option price at the end of the lease term is nominal;

2) Whether the lessee is required to make aggregate 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.

If the Edison court had found that the answer to any of these questions was “yes,” the outcome would probably have been different ' a security interest would have existed in the transaction instead of a true lease.

In QDS, the court considered several tests under the original and current version of Section 1-201(37). One test, the “Percentage Test,” has often been used by other courts. The Percentage Test states that a low percentage option relative to the original cost of the leased property automatically creates a security interest. The lessee in QDS argued that the Percentage Test indicated that the option price for the lathes was nominal under Section 1-201(37) because the purchase option equaled only 10% of the original purchase price of the equipment and 8.2% of the total (undiscounted) stream of rents. The QDS court quoted several courts and authorities to disavow the Percentage Test. The percentage does not determine whether a purchase price is nominal under the current Section 1-201(37) and, according to the QDS court, did not survive the amendment of Section 1-201(37) to the current rules. Consequently, lessors and lessees should generally not rely on low percentages of the original cost as the basis for asserting that a lease creates a security interest or true lease, although courts will still likely consider such a percentage as a valid factor. See QDS footnote 16.

The 'Economic Realities' Test

Once a transaction overcomes the tests under Section 1-201(37), indicating that a security interest does not exist (and a lease does exist), the trend requires yet another level of analysis ' the “economic realities” test.

One of the key precedents in demonstrating the recent trend is Duke Energy Royal, LLC v. Pillowtex Corp. (In re Pillowtex, Inc.), 349 F.3d 711 (3d Cir. 2003) (“Pillowtex”). Decided under New York law, the transaction reviewed by the court did not involve a transaction called a “lease.” Rather, the parties entered into a master energy services agreement (“MESA”) for 20-year energy-savings equipment and property such as light fixtures and a wastewater heat recovery system. The MESA provided for an 8-year contract under which Duke agreed to acquire, hold title to, and install at its cost approximately $10.41 million of the energy-savings equipment in nine Pillowtex facilities. At the end of 5 years of the 8-year term, Duke expected to recover a “simple payback” of its investment. Duke (and not Pillowtex) retained various end-of-term options ' the right to remove the equipment at its cost, abandon the equipment, extend the MESA term or give Pillowtex the option to purchase the equipment at a mutually agreeable price. The cost to remove the equipment was prohibitive for Duke when weighed against the nominal residual value of the leased property as removed at the end of the MESA term. The net effect for Duke is that it had little or no anticipation of residual value at the end of the term even though the leased property had about 12 years of useful life remaining at the end of the 8-year term.

Relying in large part on Edison, the court first analyzed the per se tests under 1-201(37). It did not find that a security interest existed under those tests. For that moment, the lease survived. Then it considered that Duke (the lessor) had a large expense to remove the leased property but a very low residual value. The court considered the transaction as a whole. It evaluated the “economic realities” of the transaction, as did the court in Edison, but unlike Edison, the Pillowtex court then found that the transaction did not constitute a lease. Edison not only influenced the Pillowtex court, but also other courts in many other recent cases.

Pillowtex will likely provide a persuasive approach to analyze true lease cases in bankruptcy courts for the foreseeable future. Frequently, the contest over whether a true lease exists arises in connection with motions under Section 365(d)(10) of the Bankruptcy Code. The bankruptcy courts provide fertile ground to test whether a lease exists and, if so, whether a lessor is entitled to the payment and performance by a lessee of its obligations to the lessor starting 60 days after the filing of a bankruptcy petition by the lessee. In that context, lessees typically assert that a lease does not constitute a true lease, but rather a disguised security interest. As discussed above, the loss of true lease treatment may destroy the lessor's economics and rights as an owner of the “leased” property.

True leasing has been around in its modern forms for several decades. The trend seems to show an increasing willingness of lessees to challenge even the most typical lease as a disguised security agreement. As a result, structuring leases has become more complex, even for transactions that, in the past, would be considered relatively straightforward. Although this complexity exists, it is manageable. However, lessors will need to manage risks of these transactions in the future with a view toward the economic realities of true leases and maintaining meaningful residual value or reversionary interests in the leased property. With careful attention to the trends of the courts and the requirements of applicable law, lessors will be able to structure, use and defend true leases as a viable method of making capital investment in various properties well into the future.