UCC ' 1-203: A Few Lesser (and Not Always Lessor) Known Pitfalls

Can a lease with a 10% purchase option ever not be a true lease? Most lessors know the answer is “yes.” A simple three-year forklift lease is a good example. Surely both the lessee and lessor would predict, at the time the lease is written, that the equipment will be worth far more than 10% after three years. The transaction therefore would fail to pass the nominality test under ' 1-203 of the Uniform Commercial Code (“UCC”) and would be deemed a security agreement. Simple enough.

So can a lease with a fair market value (“FMV”) purchase option ever not be a true lease? Some lessors would say “yes,” but probably many more would say “no,” or at least would hedge and say “I don't think so.” The correct answer, though, is “absolutely yes.”

But now, can a lease with no purchase option ' a lease with an end-of-term provision specifically denying the lessee an option to purchase and requiring the lessee to return the equipment ' ever not be a true lease? On this question, many lessors would say “absolutely no.” And again, they would be absolutely wrong.

Section 1-203 contains five sections, 12 subsections, and many more than 12 twists and turns. There are also more than a few pitfalls into which a lawyer or lease asset manager can stumble and get badly hurt if she does not study the statutory test carefully and understand the different kinds of transactions that, while they might superficially look like leases, cannot pass the test. The unexpected (and, for a lessor, sometimes unfortunate) consequences that can result by not understanding all the nuances of ' 1-203 are many and varied.

For example, if a transaction in the form of a lease does not pass the true-lease test under ' 1-203, then it could be subject to state loan-licensing requirements, retail-installment statutes, usury restrictions, and other state laws that do not apply to true leases. (Some of these state laws would apply to loans but not conditional sales, and vice-versa.) To take another example, if the transaction is not a true lease, then ' 365 of the Bankruptcy Code (“Unexpired Leases and Executory Contracts”) will not apply; and if the lessee files for bankruptcy and the lessor failed to file a UCC financing statement, then the lessor, who will not be deemed the owner of the equipment, could lose it to another creditor who filed a blanket lien on the lessee's assets.

There are many more examples, but suffice it say that understanding the more obscure components of ' 1-203 is important in managing risk. This article explores two of the lesser-known pitfalls embedded in the statute, both of which arise (or maybe a better word is “descend”) from subsection (d).

The Lessee's Cost to Return the Equipment

Every lessor knows that a non-cancelable lease containing a “nominal” purchase option is not a true lease. The statutory language, which is found in UCC ' 1-203(b)(4), seems simple enough at first glance:

A transaction in the form of a lease creates a security interest if the consideration that the lessee is to pay the lessor ' is an obligation for the term of the lease and not subject to termination by the lessee; and ' the lessee has an option to become the owner of the goods for no additional consideration or for nominal consideration upon compliance with the lease agreement.

The difficulty comes in understanding the many facets of the concept of nominality and being able to imagine the myriad transaction structures that will not meet the statutory test. One of the more elusive statutory provisions is found in the first sentence of subsection (d), which provides: “Additional consideration is nominal if it is less than the lessee's reasonably predictable cost of performing under the lease agreement if the option is not exercised.” (And pursuant to ' 1-203(e), this means “reasonably predictable” at the time the lease commenced.)

A lessee's cost to comply with an equipment-return provision in a lease is an example of what is contemplated in subsection (d). Although there are not many reported decisions on this subject, clearly it is a factor that could determine the outcome of a case. See generally, In re Gateway Ethanol, L.L.C., 415 B.R. 486 (2009) (a lease having a $3.6 million equipment cost and a $600,000 purchase option was held to be a true lease, but only after the court rejected testimony that the cost to return was in excess of the purchase option amount).

A typical equipment-return provision states, in essence, that unless the lessee purchases the equipment or renews the lease at the end of the term, she must return the equipment, at her own expense, to a location determined by the lessor, and the equipment must be in good condition and ready for immediate resale. One could imagine any number of examples of equipment types and contractual return requirements in which the lessee's reasonably predictable cost to ship the equipment (and recondition it, if necessary to make it presentable for resale) exceeds the reasonably predictable end-of-term fair market value.

Compare, for example, a hypothetical $25,000 five-year tractor-trailer lease having an FMV purchase option to a hypothetical $25,000 five-year lease of a prefabricated metal utility shed having an FMV purchase option. Clearly, the fair market value of the trailer at the end of that lease will be a substantial percentage of its original $25,000 cost, and the cost to prepare it for shipment back to the lessor, plus the actual shipping costs, would be small in relation to its fair market value. Commentators have said that “nominality is merely a proxy for the questions: 'Is the option price so low that the lessee will certainly exercise it and will, in all plausible circumstances, leave no meaningful reversion for the lessor?” 4 White & Summers, Uniform Commercial Code ' 30-3(e) (5th ed. 2002 & 2008 Supp.) If “only a fool would fail to exercise the option,” then the option will be deemed nominal. In re Taylor, 209 B.R. 482, 486 (1997). In our trailer lease hypothetical, it is fair to say that neither the lessee nor the lessor could have reasonably predicted at the time the lease was written that the lessee would “certainly exercise” the purchase option at the end. Both an intelligent lessee and a fool alike could go either way. Therefore, the lease would almost certainly be judged a true lease under ' 1-203.

The utility shed lease, by comparison, has very different characteristics. Much of the original $25,000 cost of the shed would have been for construction costs. Unlike the trailer, its original value in its pre-constructed state would have been substantially less than $25,000, and to return it to the lessor at the end of the term would require the lessee to incur substantial deconstruction expenses. (And remember, its “fair market value” at the end, for purposes of ' 1-203 analysis, would not be what its value is to the lessee in its still fully constructed state, but its value to a potential buyer or lessee in the market, i.e., its value as a deconstructed pile of metal panels, nuts, and bolts. Therefore, its deconstructed value would be the value that would dictate the amount of the purchase option.) Under these circumstances, surely both the lessee and the lessor would have predicted at the time the lease was written that the lessee would “certainly exercise” the option at the end, and therefore it would be deemed a security agreement.

The point is simply that these two leases, which at first blush might look like they have virtually identical financial characteristics, probably have polar opposite legal characteristics under ' 1-203 (not to mention different accounting characteristics under FAS 13 and different tax characteristics under IRS guidelines ' but those are topics for another day).

Or to put it another way, whether a transaction denominated as a “lease” is subject to loan licensing laws, or usury laws, or installment contract laws, or prepayment penalty laws, or leasing sales tax laws, or the provisions of UCC Article 2A versus Article 9, or ' 365 of the Bankruptcy Code ' and the list goes on ' could turn on a factor that is, too often, simply not thought about by the lessor at the time the lease terms are offered to the lessee.

The failure to adequately anticipate end-of-term practical realities happens most often in the small-ticket market, where profitability depends heavily (and understandably) on speed and “low human touch” transaction origination. These are lessors who typically offer only “vanilla, chocolate and strawberry” (“dollar buyout, 10% buyout and Fair-Market-Value buyout”); and they often have bright-line policies that do not adequately take into account the finer points of ' 1-203(d). We sometimes hear a lessor say, for example, “We offer only FMV buyout leases in such-and-such a state because of the loan licensing and usury laws.” Or, “We don't go to the expense of filing precautionary UCC statements on our FMV leases for deals under $X because, after all, they're all true leases.” It is clear, though, that these lessors should re-examine their bright-line policies, because ' 1-203 sets out anything but a bright-line test.

The Planned 'Giveaway Residual' Lease

Another hidden trap in ' 1-203(d) lies waiting for the lessor who writes what could be called a “giveaway residual” lease, meaning a lease with a fairly high yield on the stream but no purchase option and the lessor plans, at the time the lease is written, to offer the lessee an end-of-term sale price that is below fair market value. The lessor leaves open the possibly that she will change her mind in the end, but it is her usual practice to quickly dispose of the equipment at the end by making the lessee an offer he can hardly refuse. This is the very design of the product. This lessor wants the transaction to be construed as a true lease, and she believes it is. But, in fact, it is not.

A representative case in point is In re Bailey, 326 B.R. 156 (2005). There, the lessee leased two over-the-road tractors having a combined original cost of approximately $43,100. The lease stated that the lessee had no option to purchase the units at the end of the term. The lessor priced the transaction using its standard rates for its “no-purchase-option lease” program. As part of that program, the lessor would always make an offer to its lessees at the end of their leases to purchase the equipment for 10% of the original cost regardless of what the reasonably predictable fair market value might have otherwise been at lease inception. In bankruptcy court, the lessee argued that the transaction was a sale and security agreement while the lessor claimed it was a true lease.

Despite the fact that the lessee had no purchase option, the court held that the transaction was a sale and security agreement, not a true lease. (The case was decided under UCC ' 1-201(37), the substantially identical predecessor to ' 1-203.) The decision turned on the lessor's own testimony. The lessor admitted that the originally predictable fair market value of the equipment was in the $27,000 range, but that his plan from the very start was to offer to sell the equipment to the lessee at the end for only 10% ($4,310). When asked why he would plan to give away so much value at the end, he testified simply “because ' that's the program we use.” The court's ultimate conclusion, relying on the statutory language (now UCC ' 1-203(d)), was that the lessee's “reasonably predictable cost of performing under the lease agreement” (by returning the equipment to the lessor, which was his only contractual option) would be far greater than the cost of accepting the lessor's pre-planned, non-contractual purchase offer. The court was saying, in other words, that the phrase “cost of performing” in the statute does not always mean “out-of-pocket cost of performing,” but can also mean loss of economic benefit to the lessee.

One might question the business acumen of both the lessee and lessor in In re Bailey and be tempted to say, for that reason, that the case is somewhat anomalous and therefore unimportant. The case does have value, though, in driving home the point that when a lessor has a non-contractual, non-binding, yet “standard program” of automatically and mechanically making end-of-term purchase offers that are significantly less than the reasonably predictable fair market value of the equipment, the lessor could unwittingly be destroying true-lease status in particular instances.

Summary

A transaction that might at first glance look, feel, and smell like a lease because it has either no purchase option, an FMV option, or an option that is not otherwise “nominal” in the ordinary sense of that word might, in the final analysis, not be a lease at all. Good risk management requires lessors and their counsel to know all the nuances of the concept of nominality in ' UCC 1-203 and to understand all of the different possibilities coming out of the phrase “cost of performing under the lease agreement” in subsection (d). There are too many unexpected and potentially adverse financial, legal, and state regulatory consequences that could result otherwise.

Michael J. Witt is an Iowa attorney whose practice is focused exclusively on equipment finance. He was formerly Managing Counsel at Wells Fargo & Company and Senior Vice President and General Counsel at Advanta Leasing Corp. He can be reached at [email protected] or 515-868-1067.

Can a lease with a 10% purchase option ever not be a true lease? Most lessors know the answer is “yes.” A simple three-year forklift lease is a good example. Surely both the lessee and lessor would predict, at the time the lease is written, that the equipment will be worth far more than 10% after three years. The transaction therefore would fail to pass the nominality test under ' 1-203 of the Uniform Commercial Code (“UCC”) and would be deemed a security agreement. Simple enough.

So can a lease with a fair market value (“FMV”) purchase option ever not be a true lease? Some lessors would say “yes,” but probably many more would say “no,” or at least would hedge and say “I don't think so.” The correct answer, though, is “absolutely yes.”

But now, can a lease with no purchase option ' a lease with an end-of-term provision specifically denying the lessee an option to purchase and requiring the lessee to return the equipment ' ever not be a true lease? On this question, many lessors would say “absolutely no.” And again, they would be absolutely wrong.

Section 1-203 contains five sections, 12 subsections, and many more than 12 twists and turns. There are also more than a few pitfalls into which a lawyer or lease asset manager can stumble and get badly hurt if she does not study the statutory test carefully and understand the different kinds of transactions that, while they might superficially look like leases, cannot pass the test. The unexpected (and, for a lessor, sometimes unfortunate) consequences that can result by not understanding all the nuances of ' 1-203 are many and varied.

For example, if a transaction in the form of a lease does not pass the true-lease test under ' 1-203, then it could be subject to state loan-licensing requirements, retail-installment statutes, usury restrictions, and other state laws that do not apply to true leases. (Some of these state laws would apply to loans but not conditional sales, and vice-versa.) To take another example, if the transaction is not a true lease, then ' 365 of the Bankruptcy Code (“Unexpired Leases and Executory Contracts”) will not apply; and if the lessee files for bankruptcy and the lessor failed to file a UCC financing statement, then the lessor, who will not be deemed the owner of the equipment, could lose it to another creditor who filed a blanket lien on the lessee's assets.

There are many more examples, but suffice it say that understanding the more obscure components of ' 1-203 is important in managing risk. This article explores two of the lesser-known pitfalls embedded in the statute, both of which arise (or maybe a better word is “descend”) from subsection (d).

The Lessee's Cost to Return the Equipment

Every lessor knows that a non-cancelable lease containing a “nominal” purchase option is not a true lease. The statutory language, which is found in UCC ' 1-203(b)(4), seems simple enough at first glance:

A transaction in the form of a lease creates a security interest if the consideration that the lessee is to pay the lessor ' is an obligation for the term of the lease and not subject to termination by the lessee; and ' the lessee has an option to become the owner of the goods for no additional consideration or for nominal consideration upon compliance with the lease agreement.

The difficulty comes in understanding the many facets of the concept of nominality and being able to imagine the myriad transaction structures that will not meet the statutory test. One of the more elusive statutory provisions is found in the first sentence of subsection (d), which provides: “Additional consideration is nominal if it is less than the lessee's reasonably predictable cost of performing under the lease agreement if the option is not exercised.” (And pursuant to ' 1-203(e), this means “reasonably predictable” at the time the lease commenced.)

A lessee's cost to comply with an equipment-return provision in a lease is an example of what is contemplated in subsection (d). Although there are not many reported decisions on this subject, clearly it is a factor that could determine the outcome of a case. See generally, In re Gateway Ethanol, L.L.C., 415 B.R. 486 (2009) (a lease having a $3.6 million equipment cost and a $600,000 purchase option was held to be a true lease, but only after the court rejected testimony that the cost to return was in excess of the purchase option amount).

A typical equipment-return provision states, in essence, that unless the lessee purchases the equipment or renews the lease at the end of the term, she must return the equipment, at her own expense, to a location determined by the lessor, and the equipment must be in good condition and ready for immediate resale. One could imagine any number of examples of equipment types and contractual return requirements in which the lessee's reasonably predictable cost to ship the equipment (and recondition it, if necessary to make it presentable for resale) exceeds the reasonably predictable end-of-term fair market value.

Compare, for example, a hypothetical $25,000 five-year tractor-trailer lease having an FMV purchase option to a hypothetical $25,000 five-year lease of a prefabricated metal utility shed having an FMV purchase option. Clearly, the fair market value of the trailer at the end of that lease will be a substantial percentage of its original $25,000 cost, and the cost to prepare it for shipment back to the lessor, plus the actual shipping costs, would be small in relation to its fair market value. Commentators have said that “nominality is merely a proxy for the questions: 'Is the option price so low that the lessee will certainly exercise it and will, in all plausible circumstances, leave no meaningful reversion for the lessor?” 4 White & Summers, Uniform Commercial Code ' 30-3(e) (5th ed. 2002 & 2008 Supp.) If “only a fool would fail to exercise the option,” then the option will be deemed nominal. In re Taylor, 209 B.R. 482, 486 (1997). In our trailer lease hypothetical, it is fair to say that neither the lessee nor the lessor could have reasonably predicted at the time the lease was written that the lessee would “certainly exercise” the purchase option at the end. Both an intelligent lessee and a fool alike could go either way. Therefore, the lease would almost certainly be judged a true lease under ' 1-203.

The utility shed lease, by comparison, has very different characteristics. Much of the original $25,000 cost of the shed would have been for construction costs. Unlike the trailer, its original value in its pre-constructed state would have been substantially less than $25,000, and to return it to the lessor at the end of the term would require the lessee to incur substantial deconstruction expenses. (And remember, its “fair market value” at the end, for purposes of ' 1-203 analysis, would not be what its value is to the lessee in its still fully constructed state, but its value to a potential buyer or lessee in the market, i.e., its value as a deconstructed pile of metal panels, nuts, and bolts. Therefore, its deconstructed value would be the value that would dictate the amount of the purchase option.) Under these circumstances, surely both the lessee and the lessor would have predicted at the time the lease was written that the lessee would “certainly exercise” the option at the end, and therefore it would be deemed a security agreement.

The point is simply that these two leases, which at first blush might look like they have virtually identical financial characteristics, probably have polar opposite legal characteristics under ' 1-203 (not to mention different accounting characteristics under FAS 13 and different tax characteristics under IRS guidelines ' but those are topics for another day).

Or to put it another way, whether a transaction denominated as a “lease” is subject to loan licensing laws, or usury laws, or installment contract laws, or prepayment penalty laws, or leasing sales tax laws, or the provisions of UCC Article 2A versus Article 9, or ' 365 of the Bankruptcy Code ' and the list goes on ' could turn on a factor that is, too often, simply not thought about by the lessor at the time the lease terms are offered to the lessee.

The failure to adequately anticipate end-of-term practical realities happens most often in the small-ticket market, where profitability depends heavily (and understandably) on speed and “low human touch” transaction origination. These are lessors who typically offer only “vanilla, chocolate and strawberry” (“dollar buyout, 10% buyout and Fair-Market-Value buyout”); and they often have bright-line policies that do not adequately take into account the finer points of ' 1-203(d). We sometimes hear a lessor say, for example, “We offer only FMV buyout leases in such-and-such a state because of the loan licensing and usury laws.” Or, “We don't go to the expense of filing precautionary UCC statements on our FMV leases for deals under $X because, after all, they're all true leases.” It is clear, though, that these lessors should re-examine their bright-line policies, because ' 1-203 sets out anything but a bright-line test.

The Planned 'Giveaway Residual' Lease

Another hidden trap in ' 1-203(d) lies waiting for the lessor who writes what could be called a “giveaway residual” lease, meaning a lease with a fairly high yield on the stream but no purchase option and the lessor plans, at the time the lease is written, to offer the lessee an end-of-term sale price that is below fair market value. The lessor leaves open the possibly that she will change her mind in the end, but it is her usual practice to quickly dispose of the equipment at the end by making the lessee an offer he can hardly refuse. This is the very design of the product. This lessor wants the transaction to be construed as a true lease, and she believes it is. But, in fact, it is not.

A representative case in point is In re Bailey, 326 B.R. 156 (2005). There, the lessee leased two over-the-road tractors having a combined original cost of approximately $43,100. The lease stated that the lessee had no option to purchase the units at the end of the term. The lessor priced the transaction using its standard rates for its “no-purchase-option lease” program. As part of that program, the lessor would always make an offer to its lessees at the end of their leases to purchase the equipment for 10% of the original cost regardless of what the reasonably predictable fair market value might have otherwise been at lease inception. In bankruptcy court, the lessee argued that the transaction was a sale and security agreement while the lessor claimed it was a true lease.

Despite the fact that the lessee had no purchase option, the court held that the transaction was a sale and security agreement, not a true lease. (The case was decided under UCC ' 1-201(37), the substantially identical predecessor to ' 1-203.) The decision turned on the lessor's own testimony. The lessor admitted that the originally predictable fair market value of the equipment was in the $27,000 range, but that his plan from the very start was to offer to sell the equipment to the lessee at the end for only 10% ($4,310). When asked why he would plan to give away so much value at the end, he testified simply “because ' that's the program we use.” The court's ultimate conclusion, relying on the statutory language (now UCC ' 1-203(d)), was that the lessee's “reasonably predictable cost of performing under the lease agreement” (by returning the equipment to the lessor, which was his only contractual option) would be far greater than the cost of accepting the lessor's pre-planned, non-contractual purchase offer. The court was saying, in other words, that the phrase “cost of performing” in the statute does not always mean “out-of-pocket cost of performing,” but can also mean loss of economic benefit to the lessee.

One might question the business acumen of both the lessee and lessor in In re Bailey and be tempted to say, for that reason, that the case is somewhat anomalous and therefore unimportant. The case does have value, though, in driving home the point that when a lessor has a non-contractual, non-binding, yet “standard program” of automatically and mechanically making end-of-term purchase offers that are significantly less than the reasonably predictable fair market value of the equipment, the lessor could unwittingly be destroying true-lease status in particular instances.

Summary

A transaction that might at first glance look, feel, and smell like a lease because it has either no purchase option, an FMV option, or an option that is not otherwise “nominal” in the ordinary sense of that word might, in the final analysis, not be a lease at all. Good risk management requires lessors and their counsel to know all the nuances of the concept of nominality in ' UCC 1-203 and to understand all of the different possibilities coming out of the phrase “cost of performing under the lease agreement” in subsection (d). There are too many unexpected and potentially adverse financial, legal, and state regulatory consequences that could result otherwise.

Michael J. Witt is an Iowa attorney whose practice is focused exclusively on equipment finance. He was formerly Managing Counsel at Wells Fargo & Company and Senior Vice President and General Counsel at Advanta Leasing Corp. He can be reached at [email protected] or 515-868-1067.