Substance over Form in the Bankruptcy Courts

Under the Bankruptcy Code, whether a lease is a true lease or a disguised security agreement also has serious consequences. If a lease is a true lease, and the debtor in possession has need of the equipment or other leased property, the lessor is entitled to receive all the payments due under the contract. If a lease is not a true lease but is a disguised security agreement, the lender is only entitled to the lesser of what is owed and the property's value, which could be significantly less than the totality of the lease payments. The balance will be treated as a general unsecured claim. Further, the creditor will only be entitled to the value of the collateral if it perfected its lien. If it did not perfect, its entire claim will be treated as a general secured claim (which is why informational filings of UCC-1 forms are recommended in lease transactions). Even if it did perfect, payment could be delayed until a plan is confirmed and even then stretched out over the length of the plan as opposed to the terms required by the original contract. For these reasons, usually the debtor will argue that the lease is a disguised security agreement, and the creditor will argue that the lease is a true lease.

The Uniform Commercial Code, adopted in all 50 states, contains a recharacterization test for personal property leases. That test looks not so much to the parties' intent, but more to their expectations. Although the UCC specifically states that the determination will be made on the facts of each case, usually if the lessor expects to retain a meaningful residual interest in the goods at the end of the lease, or receive a payment equal to the fair value of the goods at that time, then the transaction will be deemed a true lease. On the other hand, if the lessee cannot terminate the lease and:

• the term of the lease (or any required renewals) is as long as or longer than the economic life of the goods,
• the lessee is required to become the owner of the goods,
• any renewal is for no or nominal additional consideration, or
• the lessee can become the owner of the goods for no or nominal additional consideration,

then the lease will be considered a security agreement and the lessor's interest that of a secured creditor. Under those circumstances, the economic reality is that at the end of the lease, the lessor would not have expected to have anything of value or have any meaningful residual interest. The lease is the equivalent of a sale.

Even if the transaction does not fit squarely within the UCC test, because perhaps the lessee has retained the right to terminate the lease, the courts will shift to equitable considerations and look to some of the factors to try to determine whether the lessor expected to have something of value at the end of the lease. For example, if the purchase option price at the end of the lease is nominal or even simply below market value, then the lessor never really expected to recover the property or its fair value and the lease will be deemed a disguised security agreement. On the other hand, if the option is voluntary and at the same monthly payment, the court should declare it a true lease.

Finally, the courts sometimes also look for indicia of ownership such as who bears the risk of loss, who has the obligation to pay taxes, insurance and maintenance, and whether there is a lack of a requirement of return in good condition. This is unsound analysis. Many net leases are true leases and not security interests and indicia of ownership alone should never be an adequate basis for recharacterization.

True Sales and Loans

Whether an asset transfer is truly a sale or is actually a loan dressed up to look like a sale has enormous implications in a bankruptcy case. If the debtor never parted with ownership, the asset comes into the bankruptcy estate and can be used or sold by the estate. If the sale was of accounts receivable or other current assets, the proceeds will be the cash collateral that the debtor in possession may spend in its operations or to pay other creditors, subject only to the Bankruptcy Code's restrictions. After recharacterization, the “buyer” would be entitled to all of its rights as a secured creditor if it took the steps to perfect but, at a minimum, those rights would be delayed by the bankruptcy process. On the other hand, if the court determines that the transfer was a true sale, the buyer retains all of the legal and equitable interests in the property and need not be hindered nor otherwise affected by the bankruptcy case. The debtor must reorganize without those assets.

True sale challenges in factoring arrangements are not new. Creditors frequently try to undo the label the parties used and find a sale of accounts receivable to be really a secured lending arrangement. In these contests, the risk of loss and whether there is recourse to the seller if a factored account does not collect, are the primary questions. If the seller/debtor is liable for the shortfall, it likely will be considered a loan. If the factor has the entire risk, it likely will be considered a true sale and not disturbed.

More recently, unpaid creditors and debtors are raising the same true sale challenges to asset-backed securitizations. This is true even though a huge industry has developed around creating and using special purpose, supposedly “bankruptcy remote” entities (“SPEs”) to take title to the assets from their originators and make the transfer impervious to attack. Although no court decision has conclusively undone a securitization, these challenges put billions of dollars of transactions (and the insurance policies of those giving true sale opinions) at risk.

The case that caused an enormous stir in the industry arose from the bankruptcy of LTV Steel Company. In re LTV Steel Co., 274 B.R. 278 (Bankr. N.D. Ohio). Pre-bankruptcy, LTV transferred its inventory and accounts into SPEs in exchange for cash that the SPEs had received from bank groups, which in exchange took a lien on the inventory and accounts purchased by the SPEs. Upon filing a Chapter 11 petition, LTV argued that the transactions were not true sales, but financings designed to deprive creditors of “the lenders' enormous equity cushion, and to enable the lenders to exercise remedies without any accountability to this court or any other parties in interest.” While avoiding directly deciding the issue, the bankruptcy court did authorize LTV to use the cash proceeds of the transferred accounts and inventory on an interim basis, finding that the use of cash collateral was necessary to enable LTV to keep its doors open, meet its obligations to its employees, retirees, customers and creditors, and avoid a negative economic impact on the geographic areas where LTV did business. In other words, the bankruptcy court considered only the equitable considerations tied to the bankruptcy policy favoring reorganizations. It will never be known whether that decision was the correct one. Rather than face the upheaval an affirmance on appeal would cause, the bank groups and LTV promptly settled.

The industry has reacted to the LTV decision by urging the state legislatures to adopt non-uniform provisions of the UCC to facilitate and safeguard asset-backed securitizations. Adopted now in Alabama, Ohio and Texas, the new provisions state that absent fraud or intentional misrepresentation, the parties' characterization of a transaction as a sale of assets is conclusive. Hence, a securitization will be deemed a sale and not a secured transaction regardless of whether the secured party has any recourse to the debtor, whether the debtor is entitled to any surplus, or any other term of the parties' agreement. Often referred to slightly derisively as “facade statutes,” they are clear legislative statements that courts should not engage in recharacterization.

Unfortunately for the supporters of the provisions, as often seen in recharacterizations, when state law contradicts the policy objectives of the Bankruptcy Code, courts can turn to equitable principles. This is what happened in Reaves Brokerage Co. v. Sunbelt Fruit & Vegetable Co., 336 F.3d 410 (5th Cir. 2003), which arose in a challenge to a factoring arrangement involving a seller of fruits and vegetables. The courts of appeal ignored the facade statute, focused on substance over form, and found that the account purchase was a secured lending arrangement because of risk retention. In spite of the best efforts of the Texas Legislature, the duck test triumphed.

Until the law on recharacterization is better developed, parties will continue to be faced with uncertainty of whether their transactions' facial nature will change with all that entails under bankruptcy law. In other words, despite any label you may give your transaction, if it walks and talks like a duck, you may find yourself the proud owner of a duck.

Pamela Kohlman Webster is a shareholder in the Los Angeles office of Buchalter, Nemer, Fields & Younger LLP and is a member of the firm's Insolvency Group. Her practice includes corporate reorganizations, insolvency, bankruptcy, workouts and liquidations. She may be reached at 213-891-5069 or [email protected].

Part Two of a Two-Part Series

Last month's installment discussed recharacterization and the factors that bankruptcy courts have considered in determining whether what is labeled debt is really equity or what is labeled equity is really debt.

Personal Property Leases and Security Agreements

Under the Bankruptcy Code, whether a lease is a true lease or a disguised security agreement also has serious consequences. If a lease is a true lease, and the debtor in possession has need of the equipment or other leased property, the lessor is entitled to receive all the payments due under the contract. If a lease is not a true lease but is a disguised security agreement, the lender is only entitled to the lesser of what is owed and the property's value, which could be significantly less than the totality of the lease payments. The balance will be treated as a general unsecured claim. Further, the creditor will only be entitled to the value of the collateral if it perfected its lien. If it did not perfect, its entire claim will be treated as a general secured claim (which is why informational filings of UCC-1 forms are recommended in lease transactions). Even if it did perfect, payment could be delayed until a plan is confirmed and even then stretched out over the length of the plan as opposed to the terms required by the original contract. For these reasons, usually the debtor will argue that the lease is a disguised security agreement, and the creditor will argue that the lease is a true lease.

The Uniform Commercial Code, adopted in all 50 states, contains a recharacterization test for personal property leases. That test looks not so much to the parties' intent, but more to their expectations. Although the UCC specifically states that the determination will be made on the facts of each case, usually if the lessor expects to retain a meaningful residual interest in the goods at the end of the lease, or receive a payment equal to the fair value of the goods at that time, then the transaction will be deemed a true lease. On the other hand, if the lessee cannot terminate the lease and:

• the term of the lease (or any required renewals) is as long as or longer than the economic life of the goods,
• the lessee is required to become the owner of the goods,
• any renewal is for no or nominal additional consideration, or
• the lessee can become the owner of the goods for no or nominal additional consideration,

then the lease will be considered a security agreement and the lessor's interest that of a secured creditor. Under those circumstances, the economic reality is that at the end of the lease, the lessor would not have expected to have anything of value or have any meaningful residual interest. The lease is the equivalent of a sale.

Even if the transaction does not fit squarely within the UCC test, because perhaps the lessee has retained the right to terminate the lease, the courts will shift to equitable considerations and look to some of the factors to try to determine whether the lessor expected to have something of value at the end of the lease. For example, if the purchase option price at the end of the lease is nominal or even simply below market value, then the lessor never really expected to recover the property or its fair value and the lease will be deemed a disguised security agreement. On the other hand, if the option is voluntary and at the same monthly payment, the court should declare it a true lease.

Finally, the courts sometimes also look for indicia of ownership such as who bears the risk of loss, who has the obligation to pay taxes, insurance and maintenance, and whether there is a lack of a requirement of return in good condition. This is unsound analysis. Many net leases are true leases and not security interests and indicia of ownership alone should never be an adequate basis for recharacterization.

True Sales and Loans

Whether an asset transfer is truly a sale or is actually a loan dressed up to look like a sale has enormous implications in a bankruptcy case. If the debtor never parted with ownership, the asset comes into the bankruptcy estate and can be used or sold by the estate. If the sale was of accounts receivable or other current assets, the proceeds will be the cash collateral that the debtor in possession may spend in its operations or to pay other creditors, subject only to the Bankruptcy Code's restrictions. After recharacterization, the “buyer” would be entitled to all of its rights as a secured creditor if it took the steps to perfect but, at a minimum, those rights would be delayed by the bankruptcy process. On the other hand, if the court determines that the transfer was a true sale, the buyer retains all of the legal and equitable interests in the property and need not be hindered nor otherwise affected by the bankruptcy case. The debtor must reorganize without those assets.

True sale challenges in factoring arrangements are not new. Creditors frequently try to undo the label the parties used and find a sale of accounts receivable to be really a secured lending arrangement. In these contests, the risk of loss and whether there is recourse to the seller if a factored account does not collect, are the primary questions. If the seller/debtor is liable for the shortfall, it likely will be considered a loan. If the factor has the entire risk, it likely will be considered a true sale and not disturbed.

More recently, unpaid creditors and debtors are raising the same true sale challenges to asset-backed securitizations. This is true even though a huge industry has developed around creating and using special purpose, supposedly “bankruptcy remote” entities (“SPEs”) to take title to the assets from their originators and make the transfer impervious to attack. Although no court decision has conclusively undone a securitization, these challenges put billions of dollars of transactions (and the insurance policies of those giving true sale opinions) at risk.

The case that caused an enormous stir in the industry arose from the bankruptcy of LTV Steel Company. In re LTV Steel Co., 274 B.R. 278 (Bankr. N.D. Ohio). Pre-bankruptcy, LTV transferred its inventory and accounts into SPEs in exchange for cash that the SPEs had received from bank groups, which in exchange took a lien on the inventory and accounts purchased by the SPEs. Upon filing a Chapter 11 petition, LTV argued that the transactions were not true sales, but financings designed to deprive creditors of “the lenders' enormous equity cushion, and to enable the lenders to exercise remedies without any accountability to this court or any other parties in interest.” While avoiding directly deciding the issue, the bankruptcy court did authorize LTV to use the cash proceeds of the transferred accounts and inventory on an interim basis, finding that the use of cash collateral was necessary to enable LTV to keep its doors open, meet its obligations to its employees, retirees, customers and creditors, and avoid a negative economic impact on the geographic areas where LTV did business. In other words, the bankruptcy court considered only the equitable considerations tied to the bankruptcy policy favoring reorganizations. It will never be known whether that decision was the correct one. Rather than face the upheaval an affirmance on appeal would cause, the bank groups and LTV promptly settled.

The industry has reacted to the LTV decision by urging the state legislatures to adopt non-uniform provisions of the UCC to facilitate and safeguard asset-backed securitizations. Adopted now in Alabama, Ohio and Texas, the new provisions state that absent fraud or intentional misrepresentation, the parties' characterization of a transaction as a sale of assets is conclusive. Hence, a securitization will be deemed a sale and not a secured transaction regardless of whether the secured party has any recourse to the debtor, whether the debtor is entitled to any surplus, or any other term of the parties' agreement. Often referred to slightly derisively as “facade statutes,” they are clear legislative statements that courts should not engage in recharacterization.

Unfortunately for the supporters of the provisions, as often seen in recharacterizations, when state law contradicts the policy objectives of the Bankruptcy Code, courts can turn to equitable principles. This is what happened in Reaves Brokerage Co. v. Sunbelt Fruit & Vegetable Co., 336 F.3d 410 (5th Cir. 2003), which arose in a challenge to a factoring arrangement involving a seller of fruits and vegetables. The courts of appeal ignored the facade statute, focused on substance over form, and found that the account purchase was a secured lending arrangement because of risk retention. In spite of the best efforts of the Texas Legislature, the duck test triumphed.

Until the law on recharacterization is better developed, parties will continue to be faced with uncertainty of whether their transactions' facial nature will change with all that entails under bankruptcy law. In other words, despite any label you may give your transaction, if it walks and talks like a duck, you may find yourself the proud owner of a duck.

Pamela Kohlman Webster is a shareholder in the Los Angeles office of Buchalter, Nemer, Fields & Younger LLP and is a member of the firm's Insolvency Group. Her practice includes corporate reorganizations, insolvency, bankruptcy, workouts and liquidations. She may be reached at 213-891-5069 or [email protected].