Is Your (Non-True) Lease a Sale?

Just in case the transaction you've just documented using your standard lease forms is not a 'lease,' you've included a granting clause in the form and filed UCC 'notice' filings. So, you've protected the lessor from a re-characterization
risk (i.e., that the transaction is deemed not to create a 'lease' under commercial law) ' right? Well, maybe not.

A recent decision by the Federal District Court for the Western District of Wisconsin reminds us of the need to draft documents that protect against the possibility that a lease may be re-characterized as a 'sale' to which Article 2 of the UCC applies. In Key Equipment Finance, Inc. v. Pioneer Transportation, Ltd., 472 F. Supp. 2d 1131 (W.D. Wis. 2007), the court found that a transaction documented as a lease was instead a sale of goods with a reservation of a security interest and that Article 2 applied to the transaction. Although the court ultimately rejected the lessee's Article 2 defenses, it did consider them.

The Key Equipment Finance decision involved a fairly standard three-party equipment financing arrangement. The equipment to be financed was communication equipment supplied by the vendor. The communication equipment was installed on lessee's trucks. To finance the purchase, lessee entered into a Master Lease Agreement and associated equipment schedules with lessor, which purchased the equipment from the vendor for the purpose of leasing it to the lessee. The agreements were drafted as 'leases.' However, the court characterized the transaction as back-to-back 'sales': '[lessor] acquired the T-Fleet Global Messenger Units from [vendor] and [lessee] acquired said units from [lessor].'

The equipment schedules were entered into in 2003 and 2004. Lessee accepted delivery of each unit without objection and the units initially functioned as represented. According to the opinion, in February 2005 the performance of the units became unreliable and then they stopped receiving messages altogether because the vendor lost access to the sub-carrier frequencies which it relied upon to transfer messages to this equipment. By April 2005, the vendor was not returning lessee's phone calls, and stuck with useless equipment, lessee stopped paying lessor under the lease. Lessor sued for breach of contract, specifically relying on an 'Obligations Absolute' (Hell or High Water) provision that read:

NOTWITHSTANDING ANY CLAIM OR DEFECT OR ANY OTHER REASON WHATSOEVER, ALL RENTALS AND OTHER PAYMENTS UNDER EACH LEASE SHALL BE PAID BY LESSEE TO LESSOR OR ITS ASSIGNEES ABSOLUTELY AND UNCONDITIONALLY, WITHOUT ANY DEFENSE, SETOFF, CLAIM OR COUNTERCLAIM OF ANY NATURE '

Summary Judgment Motion

Lessor moved for summary judgment on the basis of UCC '2A-407 (which makes the lessee's promises under a finance lease irrevocable and independent) and, alternatively, breach of the 'Obligations Absolute' clause. Lessee also moved for summary judgment on the basis that the lease was, in fact, a sale, and that it was entitled to revoke acceptance of the non-conforming goods under UCC '2-608(1).

The court first determined, on the basis of UCC '1-203, that the lease created a security interest and was not a true 'lease' for the following reasons: 1) lessee was not permitted to terminate its monthly payment option; 2) lessee was absolutely obligated to purchase the equipment; and 3) the purchase price was a nominal amount, $1. Because the lease was not a true lease, the lease was also not a 'finance lease' (to qualify as a finance lease, a transaction must first qualify as a lease). This is important because a 'finance lease,' as defined in UCC '2A-103(l), is afforded automatic 'Hell or High Water' treatment pursuant to UCC '2A-407(2). The decision underscores the importance of a 'hell or high water' clause, as lessor was able to fall back on the 'Obligations Absolute' clause and recover despite the court's finding that the lease was not a 'finance lease' (or even a true 'lease').

If a 'lease' creates a security agreement, is it a sale to which Article 2 applies? The court applied Article 2 and answered this question with little discussion: 'when a transaction purports on its face to be a lease, but is in fact a sale with reservation of a security interest in the vendor, it becomes subject to the law of sales.' Id. (citing Centurian Corp. v. A.L. Cripps, 624 P.2d 706 (Utah 1981)).

However, Centurian involved only a two-party transaction, and in Key Equipment Finance, the security interest was not reserved by the vendor, but rather by the financier. Do those differences place the transaction outside the scope of Article 2?

Article 2 'applies to transactions in goods; it does not apply to any transaction which although in the form of an unconditional contract to sell or present sale is intended to operate only as a security transaction.' UCC '2-102. The application of UCC '2-102 might be worth noting. In General Electric Credit Corp. of Tennessee v. Ger-Beck Machine Co., Inc., 806 F.2d 1207 (3rd Cir. 1986), the court found that '2-102 prevented the application of UCC-2 to a lease in a similar three-party transaction because the lease was intended only to operate as a security transaction. However, the dissent argued that the transaction had elements of both a sale and a secured loan, and that Article 2 should apply. Because Article 2 could be found to apply to transactions documented as leases, but re-characterized as sales, lessors must be sure that the lease documents fully protect them from risks associated with the application of Article 2 to the transaction.

Two UCC-2 Defenses

The Key court's decision to treat the lease as a sale to which Article 2 applied instead of a lease led it to consider two UCC-2 defenses raised by the lessee: 1) the goods were non-conforming and lessee had a right to revoke its acceptance under UCC '2-608 and then cancel the contract under UCC '2-711; and 2) that the 'Obligations Absolute' clause left it with no remedy in violation of UCC '2-719.

The court's discussion of these defenses is a bit confused. For example, the court disposed of the first defense on the ground that the equipment was not 'non-conforming,' because the equipment worked but the service of transmitting the signals was defective. Because the equipment was 'conforming,' the lessee could not revoke acceptance under UCC '2-608(1). Arguably, this analysis was misdirected. Under UCC '2-106(2), goods are conforming 'when they are in accordance with the obligations under the contract.' Under the lease, which was the only contract between lessor and lessee, the goods were leased 'AS IS.' A reasonable argument seems to be that if the equipment which, by the express terms of the lease documents, is leased 'AS IS,' it can't be 'non-conforming.'

Lessee's second defense was that because of the 'Obligations Absolute' clause, it had no remedy to address its receipt of defective equipment, and that UCC '2-719 requires that some remedy be available to a buyer. The official comment to UCC '2-719 provides, 'it is of the very essence of a sales contract that at least minimum adequate remedies be available ' there [must] be at least a fair quantum of remedy for breach of the obligations or duties outlined in the contract.' Although the court considered this defense, it should have been irrelevant, unless the court determined that the lessor delivered non-conforming goods to the lessee. As mentioned above, 'non-conformity' of the goods was deemed not to be an issue.

Nonetheless, the court found that an assignment from lessor to lessee of breach of warranty claims against the vendor under the lease was a sufficient remedy for the lessee. Interestingly, language intended to protect the lessee/buyer in a back-to-back sale transaction (by ensuring that lessee can maintain breach of warranty claims against the vendor) actually aided the lessor by convincing the court that lessee did have an adequate remedy.

Right Result

In the end, the court reached the right result and awarded damages to lessor under the 'Obligations Absolute' clause. The practical application of this case for equipment lessors is to draft leases so as to protect their interests in the event that the lease is found to be something other than a lease. Many well-drafted lease documents already include provisions that cover the possibility that the lease will be subject to UCC-2 as well as UCC-9.

The Key Equipment Finance case is an excellent reminder of the stakes of failing to protect against an Article 2 re-characterization risk. The equipment's collateral value depended on the continuing reliability of the vendor and its communications services. In this case, the vendor was apparently insolvent, and the risk of this insolvency could have been re-allocated to the lessor. Specifically, the lessee was arguing that the transaction was really the second in a series of back-to-back 'sales.' So, if it was permitted to reject (per UCC-2) the delivery by the lessor of the equipment, the lessor would have to resort to the vendor (also per UCC-2) for some remedy; but without a credit-worthy vendor, the lessor would have been left with worthless collateral and worthless warranty claims.

To protect themselves, lessors should ensure that their lease documents disclaim all Article 2 Seller's warranties contained in '2-312 through '2-316 of the UCC, including the warranties of merchantability and warranty of fitness for a particular purpose.

Note that the Key Equipment Finance lease contained the following disclaimer:

LESSEE LEASES THE EQUIPMENT ON AN 'AS-IS,' 'WHERE IS' BASIS. LESSOR MAKES NO REPRESENTATION OR WARRANTY OF ANY KIND WHATSOEVER, EXPRESS OR IMPLIED, REGARDING ANY EQUIPMENT, INCLUDING, WITHOUT LIMITATION, ANY IMPLIED WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE.

This language should have eliminated the need for the court's analysis of whether the equipment was 'non-conforming' and whether lessee had a sufficient remedy. It does appear that it at least prevented lessee from making a breach of warranty claim against lessor.

Leases should limit lessee's (as buyer) remedies for defects or other breaches of warranty regarding the equipment, and should specifically exclude lessee's (as buyer) right to reject or revoke acceptance of non-conforming goods. However, a lessee should be given some recourse in that circumstance, but still maintain the 'hell or high water' nature of the lease obligations. Under the Key Equipment Finance lease, lessee agreed 'to look only to Supplier or the manufacturer for any defect or breach of warranty regarding the equipment.' Although the court's overall analysis was misplaced, the court found this to be an enforceable limitation of remedy.

Lessors should also consider the possible tax, regulatory, and other consequences of a lease being re-characterized as a sale, and make sure that their documents contain proper protective provisions.

Obviously lessors should continue to ensure that their lease documents contain appropriate Article 9 protections in the event the lease is re-characterized as creating a security interest, as in Key Equipment Finance. As most equipment finance parties know, this re-characterization will impact the remedies which can be pursued by lessor and raises priority issues. So, lessors should continue to file precautionary financing statements under '9-505 to perfect the potential security interest. Among other things, lease forms should also continue to contain granting clauses, lien searches as closing conditions, lien removal provisions, usury and other loan-related regulatory protections, and other rights and remedies on which lessor may have to rely if its rights are to be governed by UCC-9 and not UCC-2A to create the security interest.

Edward Gross, a shareholder, and Philip Livingston, a senior associate, are members of the Equipment Finance Group in the Washington, DC, office of Vedder, Price, Kaufman & Kammholz, P.C. This article does not constitute legal advice or a statement of substantive law.

Just in case the transaction you've just documented using your standard lease forms is not a 'lease,' you've included a granting clause in the form and filed UCC 'notice' filings. So, you've protected the lessor from a re-characterization
risk (i.e., that the transaction is deemed not to create a 'lease' under commercial law) ' right? Well, maybe not.

A recent decision by the Federal District Court for the Western District of Wisconsin reminds us of the need to draft documents that protect against the possibility that a lease may be re-characterized as a 'sale' to which Article 2 of the UCC applies. In Key Equipment Finance, Inc. v. Pioneer Transportation, Ltd. , 472 F. Supp. 2d 1131 (W.D. Wis. 2007), the court found that a transaction documented as a lease was instead a sale of goods with a reservation of a security interest and that Article 2 applied to the transaction. Although the court ultimately rejected the lessee's Article 2 defenses, it did consider them.

The Key Equipment Finance decision involved a fairly standard three-party equipment financing arrangement. The equipment to be financed was communication equipment supplied by the vendor. The communication equipment was installed on lessee's trucks. To finance the purchase, lessee entered into a Master Lease Agreement and associated equipment schedules with lessor, which purchased the equipment from the vendor for the purpose of leasing it to the lessee. The agreements were drafted as 'leases.' However, the court characterized the transaction as back-to-back 'sales': '[lessor] acquired the T-Fleet Global Messenger Units from [vendor] and [lessee] acquired said units from [lessor].'

The equipment schedules were entered into in 2003 and 2004. Lessee accepted delivery of each unit without objection and the units initially functioned as represented. According to the opinion, in February 2005 the performance of the units became unreliable and then they stopped receiving messages altogether because the vendor lost access to the sub-carrier frequencies which it relied upon to transfer messages to this equipment. By April 2005, the vendor was not returning lessee's phone calls, and stuck with useless equipment, lessee stopped paying lessor under the lease. Lessor sued for breach of contract, specifically relying on an 'Obligations Absolute' (Hell or High Water) provision that read:

NOTWITHSTANDING ANY CLAIM OR DEFECT OR ANY OTHER REASON WHATSOEVER, ALL RENTALS AND OTHER PAYMENTS UNDER EACH LEASE SHALL BE PAID BY LESSEE TO LESSOR OR ITS ASSIGNEES ABSOLUTELY AND UNCONDITIONALLY, WITHOUT ANY DEFENSE, SETOFF, CLAIM OR COUNTERCLAIM OF ANY NATURE '

Summary Judgment Motion

Lessor moved for summary judgment on the basis of UCC '2A-407 (which makes the lessee's promises under a finance lease irrevocable and independent) and, alternatively, breach of the 'Obligations Absolute' clause. Lessee also moved for summary judgment on the basis that the lease was, in fact, a sale, and that it was entitled to revoke acceptance of the non-conforming goods under UCC '2-608(1).

The court first determined, on the basis of UCC '1-203, that the lease created a security interest and was not a true 'lease' for the following reasons: 1) lessee was not permitted to terminate its monthly payment option; 2) lessee was absolutely obligated to purchase the equipment; and 3) the purchase price was a nominal amount, $1. Because the lease was not a true lease, the lease was also not a 'finance lease' (to qualify as a finance lease, a transaction must first qualify as a lease). This is important because a 'finance lease,' as defined in UCC '2A-103(l), is afforded automatic 'Hell or High Water' treatment pursuant to UCC '2A-407(2). The decision underscores the importance of a 'hell or high water' clause, as lessor was able to fall back on the 'Obligations Absolute' clause and recover despite the court's finding that the lease was not a 'finance lease' (or even a true 'lease').

If a 'lease' creates a security agreement, is it a sale to which Article 2 applies? The court applied Article 2 and answered this question with little discussion: 'when a transaction purports on its face to be a lease, but is in fact a sale with reservation of a security interest in the vendor, it becomes subject to the law of sales.' Id . ( citing Centurian Corp. v. A.L. Cripps , 624 P.2d 706 (Utah 1981)).

However, Centurian involved only a two-party transaction, and in Key Equipment Finance, the security interest was not reserved by the vendor, but rather by the financier. Do those differences place the transaction outside the scope of Article 2?

Article 2 'applies to transactions in goods; it does not apply to any transaction which although in the form of an unconditional contract to sell or present sale is intended to operate only as a security transaction.' UCC '2-102. The application of UCC '2-102 might be worth noting. In General Electric Credit Corp. of Tennessee v. Ger-Beck Machine Co., Inc. , 806 F.2d 1207 (3rd Cir. 1986), the court found that '2-102 prevented the application of UCC-2 to a lease in a similar three-party transaction because the lease was intended only to operate as a security transaction. However, the dissent argued that the transaction had elements of both a sale and a secured loan, and that Article 2 should apply. Because Article 2 could be found to apply to transactions documented as leases, but re-characterized as sales, lessors must be sure that the lease documents fully protect them from risks associated with the application of Article 2 to the transaction.

Two UCC-2 Defenses

The Key court's decision to treat the lease as a sale to which Article 2 applied instead of a lease led it to consider two UCC-2 defenses raised by the lessee: 1) the goods were non-conforming and lessee had a right to revoke its acceptance under UCC '2-608 and then cancel the contract under UCC '2-711; and 2) that the 'Obligations Absolute' clause left it with no remedy in violation of UCC '2-719.

The court's discussion of these defenses is a bit confused. For example, the court disposed of the first defense on the ground that the equipment was not 'non-conforming,' because the equipment worked but the service of transmitting the signals was defective. Because the equipment was 'conforming,' the lessee could not revoke acceptance under UCC '2-608(1). Arguably, this analysis was misdirected. Under UCC '2-106(2), goods are conforming 'when they are in accordance with the obligations under the contract.' Under the lease, which was the only contract between lessor and lessee, the goods were leased 'AS IS.' A reasonable argument seems to be that if the equipment which, by the express terms of the lease documents, is leased 'AS IS,' it can't be 'non-conforming.'

Lessee's second defense was that because of the 'Obligations Absolute' clause, it had no remedy to address its receipt of defective equipment, and that UCC '2-719 requires that some remedy be available to a buyer. The official comment to UCC '2-719 provides, 'it is of the very essence of a sales contract that at least minimum adequate remedies be available ' there [must] be at least a fair quantum of remedy for breach of the obligations or duties outlined in the contract.' Although the court considered this defense, it should have been irrelevant, unless the court determined that the lessor delivered non-conforming goods to the lessee. As mentioned above, 'non-conformity' of the goods was deemed not to be an issue.

Nonetheless, the court found that an assignment from lessor to lessee of breach of warranty claims against the vendor under the lease was a sufficient remedy for the lessee. Interestingly, language intended to protect the lessee/buyer in a back-to-back sale transaction (by ensuring that lessee can maintain breach of warranty claims against the vendor) actually aided the lessor by convincing the court that lessee did have an adequate remedy.

Right Result

In the end, the court reached the right result and awarded damages to lessor under the 'Obligations Absolute' clause. The practical application of this case for equipment lessors is to draft leases so as to protect their interests in the event that the lease is found to be something other than a lease. Many well-drafted lease documents already include provisions that cover the possibility that the lease will be subject to UCC-2 as well as UCC-9.

The Key Equipment Finance case is an excellent reminder of the stakes of failing to protect against an Article 2 re-characterization risk. The equipment's collateral value depended on the continuing reliability of the vendor and its communications services. In this case, the vendor was apparently insolvent, and the risk of this insolvency could have been re-allocated to the lessor. Specifically, the lessee was arguing that the transaction was really the second in a series of back-to-back 'sales.' So, if it was permitted to reject (per UCC-2) the delivery by the lessor of the equipment, the lessor would have to resort to the vendor (also per UCC-2) for some remedy; but without a credit-worthy vendor, the lessor would have been left with worthless collateral and worthless warranty claims.

To protect themselves, lessors should ensure that their lease documents disclaim all Article 2 Seller's warranties contained in '2-312 through '2-316 of the UCC, including the warranties of merchantability and warranty of fitness for a particular purpose.

Note that the Key Equipment Finance lease contained the following disclaimer:

LESSEE LEASES THE EQUIPMENT ON AN 'AS-IS,' 'WHERE IS' BASIS. LESSOR MAKES NO REPRESENTATION OR WARRANTY OF ANY KIND WHATSOEVER, EXPRESS OR IMPLIED, REGARDING ANY EQUIPMENT, INCLUDING, WITHOUT LIMITATION, ANY IMPLIED WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE.

This language should have eliminated the need for the court's analysis of whether the equipment was 'non-conforming' and whether lessee had a sufficient remedy. It does appear that it at least prevented lessee from making a breach of warranty claim against lessor.

Leases should limit lessee's (as buyer) remedies for defects or other breaches of warranty regarding the equipment, and should specifically exclude lessee's (as buyer) right to reject or revoke acceptance of non-conforming goods. However, a lessee should be given some recourse in that circumstance, but still maintain the 'hell or high water' nature of the lease obligations. Under the Key Equipment Finance lease, lessee agreed 'to look only to Supplier or the manufacturer for any defect or breach of warranty regarding the equipment.' Although the court's overall analysis was misplaced, the court found this to be an enforceable limitation of remedy.

Lessors should also consider the possible tax, regulatory, and other consequences of a lease being re-characterized as a sale, and make sure that their documents contain proper protective provisions.

Obviously lessors should continue to ensure that their lease documents contain appropriate Article 9 protections in the event the lease is re-characterized as creating a security interest, as in Key Equipment Finance. As most equipment finance parties know, this re-characterization will impact the remedies which can be pursued by lessor and raises priority issues. So, lessors should continue to file precautionary financing statements under '9-505 to perfect the potential security interest. Among other things, lease forms should also continue to contain granting clauses, lien searches as closing conditions, lien removal provisions, usury and other loan-related regulatory protections, and other rights and remedies on which lessor may have to rely if its rights are to be governed by UCC-9 and not UCC-2A to create the security interest.

Edward Gross, a shareholder, and Philip Livingston, a senior associate, are members of the Equipment Finance Group in the Washington, DC, office of Vedder, Price, Kaufman & Kammholz, P.C. This article does not constitute legal advice or a statement of substantive law.