When Is Equipment Not 'Equipment'? Inventory Leasing or Leasing to Rental Companies

Special Perfection Rules for Purchase Money Security Interest in Inventory

In most circumstances, Lessors file a UCC Financing Statement that describes the leased property as collateral and the Lessee as debtor. This filing is made in case the underlying transaction is, or is at least deemed by a court to be, a 'lease-intended-as-security' or loan instead of a 'true lease.' Making this filing is a fairly simple process with which most Lessors are familiar and the Lessor usually does not need to conduct UCC searches, obtain any subordinations from existing lien holders, or otherwise worry about prior liens. The ease of this process results from the fact that the Lessor can generally obtain a 'purchase money security interest' (also called a 'PMSI') in the leased property by filing a financing statement within 20 days of the date that the Lessee receives possession of the leased property.

Of course, there are some situations where it is not possible to obtain a PMSI in this manner, and UCC searches and subordinations are therefore sometimes necessary. Consider, for example, sale-leasebacks or other circumstances that may result in the Lessee having possession of the leased property for more than 20 days before the Lessor is ready to consummate the transaction and file a UCC financing statement.

It is very important to understand that the purchase money security interest rules in Article 9 of the UCC that apply when the leased goods constitute 'Inventory' under Article 9 are much different than when the leased goods constitute 'Equipment.' Unlike the rule that applies to PMSIs in Equipment and allows a lessor/secured party to file its UCC within 20 days of the date the debtor/lessee receives possession of the leased property, the rule that applies to PMSIs in Inventory imposes additional burdens on lessors/secured parties. See '9-324(a) (PMSI in Equipment) and '9-324(B) (PMSI in Inventory).

Basically, obtaining a PMSI in Inventory requires that: a) Lessor file its UCC financing statement before Lessee receives possession (ie, the 20-day grace period does not apply); and b) Lessor send notices which must be received by holders of conflicting security interests within 5 years before Lessee receives possession of the leased goods. See UCC. '9-324)(b) and Official Comment No. 4. These conditions not only require the Lessor to file its financing statement much earlier than normal, but also require the Lessor to conduct a UCC Search to learn of conflicting security interests and to send official notices to all holders of such interests.

Additional Risks When Leased Goods Are 'Inventory'

The general common law rule is that one cannot convey a better title to goods than he or she had. See Hawkland, Uniform Commercial Code Series, '2-403:1 (discussing the common law concepts of caveat emptor (buyer beware), nemo dat quod non habet (no one can give more than he has), voidable title, void title, and related concepts). However, three distinct provisions in the UCC reverse this common law rule and address the broad rights that a Lessee can grant to a Sublessee with respect to the leased property. Each of these provisions has the potential of cutting off rights that the Lessor would have to recover the leased property from a Sublessee, even if the respective Lessee defaulted under the Lease. In all cases, Lessor would still have all contractual rights against Lessee but would not necessarily have full rights in the leased property as collateral.

It should also be noted that all three of the provisions described below protect 'buyers in ordinary course' although one provision also protects 'lessees in ordinary course.' To the extent a provision only protects a 'buyer in ordinary course,' it would only benefit a Sublessee if a court considers the Sublessee to be a buyer of the leased property. As such, before delving into each of the UCC provisions that may affect the Lessor's rights in the leased property, it is helpful to address the concepts of 'buyers in ordinary course' and the role of the classification of the leased equipment as 'Inventory.'

A 'buyer in ordinary course' is defined to be someone 'that buys goods in good faith, without knowledge that the sale violates the rights of another person in the goods, and in the ordinary course from a person … in the business of selling goods of that kind.' Article 1-201(9). It is a term limited almost exclusively to buyers out of Inventory. See, Barkley Clark, The Law of Secured Transactions Under the Uniform Commercial Code, Vol. 1, '3.04(1).

Another concept in the UCC is that of a 'purchaser.' One may think that buyers and purchasers are the same, but the world of the UCC is not always that simple. Under UCC '1-201(33), the term 'purchaser' is anyone who takes by purchase, and the term 'purchase' is defined to include 'taking by sale, discount, negotiation, mortgage, pledge, lien, security interest, issue, gift or any other voluntary transaction creating an interest in property.' UCC '1-201(32) (emphasis added).

The result is that the term 'buyer' is generally held to include a much smaller group of purchasers. See e.g. Quinn's Uniform Commercial Code Commentary and Law Digest (2nd ed.), '1-201[A][3] (Noting that the definition of a buyer in ordinary course 'applies not to any and all purchasers, but only to a person who 'buys.'). Official Comment No. 3 to UCC '2A-304 indicates, without detailed discussion, that a lessee from a merchant who deals in goods of that kind does not qualify as a buyer in ordinary course. As such, there is some possibility that a Sublessee who does not buy the leased property from a Lessee may not be able to successfully claim the benefits of some of the provisions outlined below. However, the law does not currently address this issue in a clear manner, and there is no guaranty as to how a given court would address this issue.

Part Two of this article will address: buyer in ordinary course of business under revised Article '9-320(A); power to transfer and entrusting under '2-403; and rights of buyers and Sublessee in ordinary course under '2A-305.

Ken Weinberg and Barry S. Marks are the founding partners of Marks & Weinberg, P.C. They have significant experience dealing with virtually every type of equipment and facility lease financing, and have participated in leasing financings for more than a billion dollars of equipment. In addition to being active members of three national leasing associations, the authors have published three books on equipment leasing and chapters in two equipment leasing treatises.

It is not unusual for a finance lessor to discover that its Lessee intends to enter into a contract with a third party whereby the Lessee delivers possession of the leased equipment to that third party. Although many finance lessors may be aware of the practical risks associated with having its leased property/collateral in the hands of a third party, many are unaware of the increased legal risks that result from such a situation. This article addresses some of the key issues. For the sake of clarity, the third party receiving possession and control of the leased equipment will be referred to as a 'Sublessee,' and the agreement between the Lessee and the Sublessee will be referred to as a 'Sublease.' It should be noted that a contract of service pursuant to which the Sublessee receives possession also constitutes a 'Sublease' for purposes of this article.

The key legal distinction between this type of transaction and the standard finance lease is that the leased property is treated under the Uniform Commercial Code ('UCC') as 'Inventory' in the hands of the Lessee. It would have been ordinarily considered 'Equipment' were it not for the Sublease. This classification results from the fact that under '9-102(a)(48) of the UCC as Revised in 2001, goods constitute 'Inventory' if they 'are leased by a person as lessor [or] held by a person for sale or lease or to be furnished under a contract of service [or] are furnished under a contract of service.'

As will be discussed in more detail, the classification of the leased property as 'Inventory' raises perfection issues and also allows a Lessee, in certain circumstances, to provide a Sublessee with greater rights with respect to the equipment than the Lessor originally provided to the Lessee.

Special Perfection Rules for Purchase Money Security Interest in Inventory

In most circumstances, Lessors file a UCC Financing Statement that describes the leased property as collateral and the Lessee as debtor. This filing is made in case the underlying transaction is, or is at least deemed by a court to be, a 'lease-intended-as-security' or loan instead of a 'true lease.' Making this filing is a fairly simple process with which most Lessors are familiar and the Lessor usually does not need to conduct UCC searches, obtain any subordinations from existing lien holders, or otherwise worry about prior liens. The ease of this process results from the fact that the Lessor can generally obtain a 'purchase money security interest' (also called a 'PMSI') in the leased property by filing a financing statement within 20 days of the date that the Lessee receives possession of the leased property.

Of course, there are some situations where it is not possible to obtain a PMSI in this manner, and UCC searches and subordinations are therefore sometimes necessary. Consider, for example, sale-leasebacks or other circumstances that may result in the Lessee having possession of the leased property for more than 20 days before the Lessor is ready to consummate the transaction and file a UCC financing statement.

It is very important to understand that the purchase money security interest rules in Article 9 of the UCC that apply when the leased goods constitute 'Inventory' under Article 9 are much different than when the leased goods constitute 'Equipment.' Unlike the rule that applies to PMSIs in Equipment and allows a lessor/secured party to file its UCC within 20 days of the date the debtor/lessee receives possession of the leased property, the rule that applies to PMSIs in Inventory imposes additional burdens on lessors/secured parties. See '9-324(a) (PMSI in Equipment) and '9-324(B) (PMSI in Inventory).

Basically, obtaining a PMSI in Inventory requires that: a) Lessor file its UCC financing statement before Lessee receives possession (ie, the 20-day grace period does not apply); and b) Lessor send notices which must be received by holders of conflicting security interests within 5 years before Lessee receives possession of the leased goods. See UCC. '9-324)(b) and Official Comment No. 4. These conditions not only require the Lessor to file its financing statement much earlier than normal, but also require the Lessor to conduct a UCC Search to learn of conflicting security interests and to send official notices to all holders of such interests.

Additional Risks When Leased Goods Are 'Inventory'

The general common law rule is that one cannot convey a better title to goods than he or she had. See Hawkland, Uniform Commercial Code Series, '2-403:1 (discussing the common law concepts of caveat emptor (buyer beware), nemo dat quod non habet (no one can give more than he has), voidable title, void title, and related concepts). However, three distinct provisions in the UCC reverse this common law rule and address the broad rights that a Lessee can grant to a Sublessee with respect to the leased property. Each of these provisions has the potential of cutting off rights that the Lessor would have to recover the leased property from a Sublessee, even if the respective Lessee defaulted under the Lease. In all cases, Lessor would still have all contractual rights against Lessee but would not necessarily have full rights in the leased property as collateral.

It should also be noted that all three of the provisions described below protect 'buyers in ordinary course' although one provision also protects 'lessees in ordinary course.' To the extent a provision only protects a 'buyer in ordinary course,' it would only benefit a Sublessee if a court considers the Sublessee to be a buyer of the leased property. As such, before delving into each of the UCC provisions that may affect the Lessor's rights in the leased property, it is helpful to address the concepts of 'buyers in ordinary course' and the role of the classification of the leased equipment as 'Inventory.'

A 'buyer in ordinary course' is defined to be someone 'that buys goods in good faith, without knowledge that the sale violates the rights of another person in the goods, and in the ordinary course from a person … in the business of selling goods of that kind.' Article 1-201(9). It is a term limited almost exclusively to buyers out of Inventory. See, Barkley Clark, The Law of Secured Transactions Under the Uniform Commercial Code, Vol. 1, '3.04(1).

Another concept in the UCC is that of a 'purchaser.' One may think that buyers and purchasers are the same, but the world of the UCC is not always that simple. Under UCC '1-201(33), the term 'purchaser' is anyone who takes by purchase, and the term 'purchase' is defined to include 'taking by sale, discount, negotiation, mortgage, pledge, lien, security interest, issue, gift or any other voluntary transaction creating an interest in property.' UCC '1-201(32) (emphasis added).

The result is that the term 'buyer' is generally held to include a much smaller group of purchasers. See e.g. Quinn's Uniform Commercial Code Commentary and Law Digest (2nd ed.), '1-201[A][3] (Noting that the definition of a buyer in ordinary course 'applies not to any and all purchasers, but only to a person who 'buys.'). Official Comment No. 3 to UCC '2A-304 indicates, without detailed discussion, that a lessee from a merchant who deals in goods of that kind does not qualify as a buyer in ordinary course. As such, there is some possibility that a Sublessee who does not buy the leased property from a Lessee may not be able to successfully claim the benefits of some of the provisions outlined below. However, the law does not currently address this issue in a clear manner, and there is no guaranty as to how a given court would address this issue.

Part Two of this article will address: buyer in ordinary course of business under revised Article '9-320(A); power to transfer and entrusting under '2-403; and rights of buyers and Sublessee in ordinary course under '2A-305.

Ken Weinberg and Barry S. Marks are the founding partners of Marks & Weinberg, P.C. They have significant experience dealing with virtually every type of equipment and facility lease financing, and have participated in leasing financings for more than a billion dollars of equipment. In addition to being active members of three national leasing associations, the authors have published three books on equipment leasing and chapters in two equipment leasing treatises.