When Is a Lease a 'True Lease'?

In the 1990s, United Airlines entered into several transactions to obtain money to improve or build its premises at four airports in four different states. For each airport, a public body issued bonds to take advantage of certain tax advantages and the funds from the bonds were turned over to United. United promised to retire the bonds and reimburse administrative costs. United then entered into a lease agreement with each public body giving them the right to evict if United did not pay its obligations. United's position in bankruptcy was that the “leases” were actually secured financing transactions. If successful, it would be able to continue to operate at the facilities, paying only a portion of the “rent” (the secured claim) and the remaining portion would be treated as unsecured.

The Bankruptcy Court held that the lease of the airport space in Denver was a “true lease” and the other three leases were secured financings. Consequently, to retain the facilities, United had to assume the Denver lease, resume payment of the full rent and cure any defaults. As to the other three transactions, United could reduce its payments to only the secured portion of the rent and the other portion would be treated as an unsecured prepetition claim.

On appeal, the district court held that state law determined whether the lease was a “true lease.” In reviewing each transaction pursuant to the respective state law, the district court held that each transaction was a lease for the purposes of ' 365. This placed the onus on United to assume the leases, pay arrearages and continue paying its obligations under the agreements. United appealed to the Seventh Circuit, which considered only the San Francisco transaction because it was the only one fully briefed.

The San Francisco Lease Transaction

United began leasing 128 acres at the San Francisco airport in 1973. The lease was set to expire in 2013. Rent under the lease was calculated based on an independent party's estimate of the property's market value. In 1997, United and a California state development authority entered into an agreement pursuant to which the authority would issue $155 million in bonds for United's benefit. The transaction involved the following critical elements:

• United subleased 20 of its 128 leased acres to the state authority. The sublease was for a total rent of $1.00 for a term of 36 years, which was tied to the debt-repayment schedule of the bonds as opposed to United's lease with the airport.
• The company then leased the same 20 acres back from the authority. The rent was set at the same amount as the interest on the bonds, plus an administrative fee. In 2033, 20 years after the expiration of United's original lease, a balloon payment was due from United in the amount of $155 million to retire the principal. If United prepaid its obligations, then the sublease and leaseback would be terminated.
• The leaseback also included a “hell or high water clause” where United would have to make the balloon payment even if its lease with the airport ended before 2033, the airport was destroyed by an earthquake or some other event prevented United from using the maintenance facility.
• A trust indenture provided that United's payment of the $155 million to the indenture trustee and would be distributed to the bondholders. The bonds were without recourse to the state authority.
• United also signed a guaranty to repay the bonds.

Substance over Form Determines Whether the San Francisco Lease Is a 'True Lease'

Financial vs. Economic Distress

The Seventh Circuit explained the importance of the finding that a transaction is a lease rather then a secured financing arrangement in light of the structure of the Bankruptcy Code. The court posits that many provisions of the Code, particularly those that deal with secured credit, specifically distinguish between financial and economic distress. Judge Easterbrook explained that financial distress occurs when a firm, albeit with positive cash flow, cannot make its payments as its debts become due. The debtor is financially distressed but not economically distressed and can write down its debt through the reorganization process. By comparison, a company experiencing economic distress has negative cash flow and liquidation may be its best option.

Easterbrook reasoned that the Code distinguishes financial from economic distress by creating a “new firm” on the petition date, unburdened by its prepetition debts. This new firm must cover new expenses, such as leases as the services are provided. The Code allows old debt to be adjusted to enhance a firm's cash flow to deal with financial distress.

To address the issue of whether payment under a “lease” is for old debt or for new value, Easterbrook observed that it is up to the bankruptcy court to separate old debt from current consumption components in a lease.

Legislative History

The Seventh Circuit began its analysis of the lease agreement with the legislative history of ' 365. The court looked to the Senate Report, which reads in pertinent part:

“The distinction between a true lease and a financing transaction is based on the economic substance of the transaction and not for example, upon the locus of title, the form of the transaction or the fact that the transaction is denominated as a 'lease'.” S. Rep. No. 989, 95th Cong., 2d Sess 64 (1978).

Judge Easterbrook relied on the Report to illustrate Congress's understanding of the economic realities of a transaction and the importance of being sensible when addressing financing transactions.

State Law Controls When Determining If a Transaction Is a Lease

In considering which economic features of a transaction should determine whether a transaction is a “true lease,” the court reasoned that leases are state law instruments, and held that it must look to California law. However, if California law placed form over substance in identifying a “true lease,” Easterbrook opined that state law would have to yield to the Bankruptcy Code. This is because such a law would directly conflict with the statutory structure of the Code. [This action was brought pursuant to ' 365(d) of the Bankruptcy Code. When attempting to recharacterize a transaction for the purposes of assumption or rejection under ' 365(a) of the Bankruptcy Code several courts have held that the relevant inquiry is whether it qualifies as a lease under state law. See In re Dunes Hotel Associates Holding Company, 212 B.R. 110 (Bankr. D.S.C. 1997); In re Pittsburgh Sports Associates Holding Company, 239 B.R. 75 (Bankr. W.D. Pa. 1999) (opinion subsequently vacated by request of parties upon settlement).]

Judge Easterbrook pointed to the mistaken approach taken by the district court and the parties in the suit. Each relied on federal court decisions to determine state law. These decisions are from forums that “are not the source of state law or even their oracles.” The Seventh Circuit reviewed California statutes and state court decisions to determine its law.

The court took the position that it would not make sense to have the term “lease” mean one thing for real property and another for personal property. The Court then looked at California law regarding the determination of a lease in the personal and real property contexts in determining its analysis.

The California Uniform Commercial Code takes a functional approach to determine whether a transaction is a “true lease.” It provides that whether a transaction is a lease or a security interest depends on “the facts of each case.” Further, several factors in combination with an agreement where the lessee's payments to the lessor are to continue for the term of the lease even if the lease is terminated are per se secured transactions and not leases. These factors include: 1) the term of the lease is longer than the economic life of the goods; 2) the lessee is bound to become the owner of the goods or must renew the good for their entire economic life; 3) the lease may be renewed by the lessee for the entire economic life of the goods for nominal consideration; or 4) the lessee may become the owner of the goods for nominal to no consideration. Cal. Com. Code ' 1201(36).

The Seventh Circuit found that California courts have looked beyond the form of a real estate lease to determine whether it is a “true lease.” See Burr v. Capital Reserve Corp., 71 Cal.2d 983 (1969), and Beeler v. American Trust Co., 24 Cal.2d 1 (1944). In Beeler, the California Supreme court held that a sale-leaseback of real property transaction was actually a mortgage. The rent was well below market because it was based on the repayment of secured credit and the lessee would become the owner of the property at the end of the term. In Burr, the California Supreme Court held that a sale-leaseback of certain equipment was a usurious loan and not a true lease. The Burr court held that the offering of property for security other than the equipment sold indicated that this transaction was not a true lease.

The Seventh Circuit held the San Francisco Lease was not a “true lease” under California law and emphasized the following factors:

• The “rent” was based on the amount United borrowed and not the market rate of the property.
• The full tenancy interest of the pre-mise reverts back to United at the end of the term in 2033 for no additional charge. The court stated this is the “UCC's per se rule for determining secured credit.”
• The balloon payment of $155 million is a common feature of secured credit, not of a lease.
• In a typical lease transaction, prepayment would result in the right to continue to occupy the property. In the San Francisco transaction, prepayment resulted in the termination of the sublease and lease.
• The destruction of the maintenance base did not affect the obligation to payment. The court found that this indicated the lease was based on the financial obligations owed and not the rent of the property.

The court did not close the door on all lease-financing transactions, opining it did “not doubt that many financing devices are true leases.” In true lease transactions, the lessor finances the acquisition of property or equipment and then leases it. The lessee is saved from raising the funds itself and it can escape the rental obligation by surrendering the asset. Easterbrook found this situation to be quite different from the San Francisco transaction. The maintenance base was already under lease prior to the financing transaction. What actually occurred was United used its leasehold interest to acquire an extension of credit. This, in the Seventh Circuit's view, was clearly a financing transaction.

Conclusion

While not all circuit courts have yet ruled as to whether substance over form governs whether a financing agreement is a true lease, the consensus is that most courts will not allow the form of a transaction to yield over the substance of a transaction. Creditors entering into “lease” transactions must be aware of the risks of such a transaction. For example, a creditor entering into a “lease” of assets subject to great depreciation is not shielded from its “lease” being treated as a loan under the Bankruptcy Code. Also, investors should also be aware of possible risks when buying bonds to be paid through lease payments. For example, the bonds in the United case were without recourse to the state authority and guaranteed by United. Presumably, the bond holders would be reduced to claims against the bankruptcy estate.

Further, while the Seventh Circuit stated that it will look to state law first to determine the factors to be applied in its analysis, the Court did not determine nor did it appear to distinguish whether real property or personal property law applied. Instead, it looked to both to make its decision. This approach gives a court a wide breadth of factors to pick and choose from. This approach illustrates the Seventh Circuit's willingness to emphasize substance over from in its recharacterization analysis.

Financing deals have become increasingly complicated as parties attempt to raise capital and take advantage of accounting and tax incentives. These transactions often face scrutiny when one party files for bankruptcy. During a Chapter 11 reorganization, a debtor must use all tools at its disposal to best restructure its obligations. In contrast, a creditor must work to ensure it receives the best possible return. The term “lease” is not defined in the Bankruptcy Code. Due to this lack of a clear definition, creditors and debtors will often attempt to recharacterize agreements between the parties. In this context, a secured creditor or debtor may argue that a “lease” is actually a disguised secured financing. In the converse, a party could also argue a secured financing is actually a “true lease.” This is due to the Bankruptcy Code's different treatment of secured debt and leases. Depending on the factual scenario, this differing treatment could significantly change the parties' obligations.

This article reviews the Seventh Circuit Court of Appeals' recent decision in United Airlines, Inc. v. HSBC Bank USA, N.A. , 416 F.3d 609 (7th Cir. 2005). In this decision, authored by Judge Easterbrook, the court held that it must look to the substance of a transaction and beyond the label given by the parties to determine whether it is a “true lease.”

United Airlines v. HSBC Bank: The Dispute

In the 1990s, United Airlines entered into several transactions to obtain money to improve or build its premises at four airports in four different states. For each airport, a public body issued bonds to take advantage of certain tax advantages and the funds from the bonds were turned over to United. United promised to retire the bonds and reimburse administrative costs. United then entered into a lease agreement with each public body giving them the right to evict if United did not pay its obligations. United's position in bankruptcy was that the “leases” were actually secured financing transactions. If successful, it would be able to continue to operate at the facilities, paying only a portion of the “rent” (the secured claim) and the remaining portion would be treated as unsecured.

The Bankruptcy Court held that the lease of the airport space in Denver was a “true lease” and the other three leases were secured financings. Consequently, to retain the facilities, United had to assume the Denver lease, resume payment of the full rent and cure any defaults. As to the other three transactions, United could reduce its payments to only the secured portion of the rent and the other portion would be treated as an unsecured prepetition claim.

On appeal, the district court held that state law determined whether the lease was a “true lease.” In reviewing each transaction pursuant to the respective state law, the district court held that each transaction was a lease for the purposes of ' 365. This placed the onus on United to assume the leases, pay arrearages and continue paying its obligations under the agreements. United appealed to the Seventh Circuit, which considered only the San Francisco transaction because it was the only one fully briefed.

The San Francisco Lease Transaction

United began leasing 128 acres at the San Francisco airport in 1973. The lease was set to expire in 2013. Rent under the lease was calculated based on an independent party's estimate of the property's market value. In 1997, United and a California state development authority entered into an agreement pursuant to which the authority would issue $155 million in bonds for United's benefit. The transaction involved the following critical elements:

• United subleased 20 of its 128 leased acres to the state authority. The sublease was for a total rent of $1.00 for a term of 36 years, which was tied to the debt-repayment schedule of the bonds as opposed to United's lease with the airport.
• The company then leased the same 20 acres back from the authority. The rent was set at the same amount as the interest on the bonds, plus an administrative fee. In 2033, 20 years after the expiration of United's original lease, a balloon payment was due from United in the amount of $155 million to retire the principal. If United prepaid its obligations, then the sublease and leaseback would be terminated.
• The leaseback also included a “hell or high water clause” where United would have to make the balloon payment even if its lease with the airport ended before 2033, the airport was destroyed by an earthquake or some other event prevented United from using the maintenance facility.
• A trust indenture provided that United's payment of the $155 million to the indenture trustee and would be distributed to the bondholders. The bonds were without recourse to the state authority.
• United also signed a guaranty to repay the bonds.

Substance over Form Determines Whether the San Francisco Lease Is a 'True Lease'

Financial vs. Economic Distress

The Seventh Circuit explained the importance of the finding that a transaction is a lease rather then a secured financing arrangement in light of the structure of the Bankruptcy Code. The court posits that many provisions of the Code, particularly those that deal with secured credit, specifically distinguish between financial and economic distress. Judge Easterbrook explained that financial distress occurs when a firm, albeit with positive cash flow, cannot make its payments as its debts become due. The debtor is financially distressed but not economically distressed and can write down its debt through the reorganization process. By comparison, a company experiencing economic distress has negative cash flow and liquidation may be its best option.

Easterbrook reasoned that the Code distinguishes financial from economic distress by creating a “new firm” on the petition date, unburdened by its prepetition debts. This new firm must cover new expenses, such as leases as the services are provided. The Code allows old debt to be adjusted to enhance a firm's cash flow to deal with financial distress.

To address the issue of whether payment under a “lease” is for old debt or for new value, Easterbrook observed that it is up to the bankruptcy court to separate old debt from current consumption components in a lease.

Legislative History

The Seventh Circuit began its analysis of the lease agreement with the legislative history of ' 365. The court looked to the Senate Report, which reads in pertinent part:

“The distinction between a true lease and a financing transaction is based on the economic substance of the transaction and not for example, upon the locus of title, the form of the transaction or the fact that the transaction is denominated as a 'lease'.” S. Rep. No. 989, 95th Cong., 2d Sess 64 (1978).

Judge Easterbrook relied on the Report to illustrate Congress's understanding of the economic realities of a transaction and the importance of being sensible when addressing financing transactions.

State Law Controls When Determining If a Transaction Is a Lease

In considering which economic features of a transaction should determine whether a transaction is a “true lease,” the court reasoned that leases are state law instruments, and held that it must look to California law. However, if California law placed form over substance in identifying a “true lease,” Easterbrook opined that state law would have to yield to the Bankruptcy Code. This is because such a law would directly conflict with the statutory structure of the Code. [This action was brought pursuant to ' 365(d) of the Bankruptcy Code. When attempting to recharacterize a transaction for the purposes of assumption or rejection under ' 365(a) of the Bankruptcy Code several courts have held that the relevant inquiry is whether it qualifies as a lease under state law. See In re Dunes Hotel Associates Holding Company, 212 B.R. 110 (Bankr. D.S.C. 1997); In re Pittsburgh Sports Associates Holding Company, 239 B.R. 75 (Bankr. W.D. Pa. 1999) (opinion subsequently vacated by request of parties upon settlement).]

Judge Easterbrook pointed to the mistaken approach taken by the district court and the parties in the suit. Each relied on federal court decisions to determine state law. These decisions are from forums that “are not the source of state law or even their oracles.” The Seventh Circuit reviewed California statutes and state court decisions to determine its law.

The court took the position that it would not make sense to have the term “lease” mean one thing for real property and another for personal property. The Court then looked at California law regarding the determination of a lease in the personal and real property contexts in determining its analysis.

The California Uniform Commercial Code takes a functional approach to determine whether a transaction is a “true lease.” It provides that whether a transaction is a lease or a security interest depends on “the facts of each case.” Further, several factors in combination with an agreement where the lessee's payments to the lessor are to continue for the term of the lease even if the lease is terminated are per se secured transactions and not leases. These factors include: 1) the term of the lease is longer than the economic life of the goods; 2) the lessee is bound to become the owner of the goods or must renew the good for their entire economic life; 3) the lease may be renewed by the lessee for the entire economic life of the goods for nominal consideration; or 4) the lessee may become the owner of the goods for nominal to no consideration. Cal. Com. Code ' 1201(36).

The Seventh Circuit found that California courts have looked beyond the form of a real estate lease to determine whether it is a “true lease.” See Burr v. Capital Reserve Corp. , 71 Cal.2d 983 (1969), and Beeler v. American Trust Co. , 24 Cal.2d 1 (1944). In Beeler, the California Supreme court held that a sale-leaseback of real property transaction was actually a mortgage. The rent was well below market because it was based on the repayment of secured credit and the lessee would become the owner of the property at the end of the term. In Burr, the California Supreme Court held that a sale-leaseback of certain equipment was a usurious loan and not a true lease. The Burr court held that the offering of property for security other than the equipment sold indicated that this transaction was not a true lease.

The Seventh Circuit held the San Francisco Lease was not a “true lease” under California law and emphasized the following factors:

• The “rent” was based on the amount United borrowed and not the market rate of the property.
• The full tenancy interest of the pre-mise reverts back to United at the end of the term in 2033 for no additional charge. The court stated this is the “UCC's per se rule for determining secured credit.”
• The balloon payment of $155 million is a common feature of secured credit, not of a lease.
• In a typical lease transaction, prepayment would result in the right to continue to occupy the property. In the San Francisco transaction, prepayment resulted in the termination of the sublease and lease.
• The destruction of the maintenance base did not affect the obligation to payment. The court found that this indicated the lease was based on the financial obligations owed and not the rent of the property.

The court did not close the door on all lease-financing transactions, opining it did “not doubt that many financing devices are true leases.” In true lease transactions, the lessor finances the acquisition of property or equipment and then leases it. The lessee is saved from raising the funds itself and it can escape the rental obligation by surrendering the asset. Easterbrook found this situation to be quite different from the San Francisco transaction. The maintenance base was already under lease prior to the financing transaction. What actually occurred was United used its leasehold interest to acquire an extension of credit. This, in the Seventh Circuit's view, was clearly a financing transaction.

Conclusion

While not all circuit courts have yet ruled as to whether substance over form governs whether a financing agreement is a true lease, the consensus is that most courts will not allow the form of a transaction to yield over the substance of a transaction. Creditors entering into “lease” transactions must be aware of the risks of such a transaction. For example, a creditor entering into a “lease” of assets subject to great depreciation is not shielded from its “lease” being treated as a loan under the Bankruptcy Code. Also, investors should also be aware of possible risks when buying bonds to be paid through lease payments. For example, the bonds in the United case were without recourse to the state authority and guaranteed by United. Presumably, the bond holders would be reduced to claims against the bankruptcy estate.

Further, while the Seventh Circuit stated that it will look to state law first to determine the factors to be applied in its analysis, the Court did not determine nor did it appear to distinguish whether real property or personal property law applied. Instead, it looked to both to make its decision. This approach gives a court a wide breadth of factors to pick and choose from. This approach illustrates the Seventh Circuit's willingness to emphasize substance over from in its recharacterization analysis.