A Lease Is a Lease Is a ' Loan? Avoiding Recharacterization

Too often, practitioners add confusion because of the labels they assign to transaction structures. The same structure may go by a different name depending on whether it is being identified for purposes of accounting, tax or commercial law. Accountants divide leases into operating leases and capital leases to decide whether or not the leased asset appears on the lessor's balance sheet. The tax authorities dispense with labels altogether, studying instead how the transaction allocates risks and rewards of ownership to determine who will benefit from tax deferral through depreciating the asset, or reducing income through the payment of rent. For commercial law purposes, lawyers craft the transaction to achieve specific rights and remedies for the parties. A “true” lease gives the title to the leased property to the lessor for commercial law purposes, and differs from what might be called a loan, a lease intended as security, a disguised security interest, an installment sale, a conditional sales contract or even a “dirty” lease, where title in each case is vested in the nominal lessee. References to “leases” in this article are to true leases, and transactions purporting to be leases which are not true leases are referred to as security interests.

Why Characterization Matters

Transactions are often styled as leases because of the flexibility offered to meet the goals of the lessee. Leases may make an acquisition more affordable by providing 100% financing and rental payments that are lower than a fully amortizing loan. A lease offers a hedge against obsolescence of equipment if returns and exchanges are permitted. Leases may be tax-driven, shifting tax credits and deductions to the party best able to use them. Leases may be driven by accounting concerns if off-balance-sheet treatment is desired. For certain regulated entities, such as telecommunications companies which must obtain approval of the regulating authority to issue debt or encumber assets, a lease may streamline or avoid an otherwise lengthy process. Lessors, as owners of the leased property, enjoy the rights and access to remedies that come with ownership.

Lessees benefit from the flexible structures offered by leasing, but following a bankruptcy, these lessees or their bankruptcy trustee often look to have the structure recharacterized as a security interest. In bankruptcy, a lessor has an advantage over the secured lender because of the special treatment of leases, which are executory contracts. Section 365(b)(1) of the Bankruptcy Code requires a lessee to cure defaults and provide adequate assurance of future performance before it is permitted to assume an outstanding lease, and the decision to assume or reject the lease must take place within 60 days of the order for relief (' 365(d)(1)). If the transaction is a loan, no such time pressure exists, and no cure
is mandated.

Under the UCC, the lender has rights to enforce performance and to realize upon the collateral, but these rights are tempered by protections for the owner. If the transaction is a loan, the debtor is the owner, and becomes the beneficiary of the rights provided owners by the UCC. For example, the lender with a security interest bears the burden of proving that all aspects of a sale of the collateral were commercially reasonable (UCC ' 9-610(b)), while a lessor is entitled to deal with its owned property more generally as it sees fit. This scenario played out in VFS Leasing Co. v. J&L Trucking, Inc., 2011 WL 3439525 (U.S. Dist. Ct. N.D. Ohio Aug. 5, 2011) when a lessee sought to avoid a deficiency judgment in favor of the lessor. If the truck lease was a secured loan, as the lessee claimed, the lessor would have to prove that its repossession and sale of the trucks was commercially reasonable. Similarly, a lessor did not need to comply with the UCC requirement to notify the lessee before it disposed of a leased vehicle when the transaction was upheld as a lease. Aniebue v. Jaguar Credit Corp., 708 S.E.2d 4 (Ga. Ct. App. 2011).

The lessor who finds itself with a security interest due to recharacterization may also find that security interest to be unperfected, and lose its rights to the property to the bankruptcy trustee or other perfected secured parties if the lessor failed to properly file a financing statement evidencing that security interest. Precautionary filings in the UCC records are permitted and encouraged (UCC ' 9-505), and provide a lifeline to a lessor on the losing end of a recharacterization battle. In re Miller Brothers Lumber Company, Inc., 2012 WL 1601316 (Bankr.M.D.N.C. May 8, 2012) involved a lessor who failed to continue a financing statement and became unperfected when the “lease” was ultimately deemed to be a security interest.

Aside from enforcement and recovery rights, a lessor enjoys other advantages. Rental payments under a lease may not be subject to laws that restrict interest rates. On the other hand, if the transaction is a secured loan, the lessor's failure to comply with the usury laws could have significant consequences, both in terms of the return it can realize on the transaction, and potential fines and criminal liability. An inadvertent lender may also run afoul of licensing laws for lenders if it did not anticipate being subject to such laws.

The Bright-Line Tests and Economic Realities

UCC ' 1-203 provides that “[w]hether a transaction in the form of a lease creates a lease or a security interest is determined by the facts of each case.” As mentioned above, this section dispenses with any consideration of the intent of the parties, providing instead a bright-line test of what makes a lease a security interest. The bright-line is found when the transaction is terminable by the lessee. If so, the transaction is a lease. However, if the lessee may not terminate, ' 1-203 provides four further fact-based tests, based in the economic reality of the transaction, to consider before the transaction can be said to be a security interest. These are:

• The original term of the lease is equal to or greater than the remaining economic life of the goods;
• The lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods;
• The lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement; or
• The lessee has an option to become the owner of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement.

In New York, the substance of UCC ' 1-203 is included within the definition of “security interest” in ' 1-201(35), as it has not yet adopted the revisions to Article 1.

The tests are applied with reference to the facts and circumstances as they exist at the inception of the transaction, or, if the lease undergoes modification, at the time of such modification. Note how the four tests focus on facts that would give the benefits and burdens of ownership of the property to the lessee. An owner has the right to control the property over its entire useful life. An owner would not be obligated to pay additional consideration to remain the owner. If the lessee is functionally the owner, the transaction is reasonably viewed as a sale with reservation of title by the lessor, or, a disguised security interest. Section 1-203(c) specifies other tests that are not determinative, in and of themselves, of a security interest, even though they are typically associated with ownership. The fact that a lessee agrees to pay to maintain the goods, assumes the risk of loss, or has an option to purchase the goods is not enough to recharacterize the lease as a security interest.

This seems straightforward, yet lessees and others continue to mount challenges to the lease structure. Much of the litigation revolves around what is “nominal additional consideration.” Most courts make quick work of leases containing purchase options of a dollar, or another equally obvious bargain amount. A recent decision involving an obvious bargain purchase option is In re KY USA Energy, Inc., 449 B.R. 745 (Bank. W.D. Ky. 2011) ($1), and the court in Aniebue (cited above) had no problem finding a $19,684 purchase option on a four-year lease of an automobile not nominal. However, other purchase options may fall in a gray area, leaving the parties uncertain as to the outcome. The bankruptcy court in In re Del-Maur Farms, Inc., 2011 WL 2847709 (Bankr. D. Neb. 2011) decided that a purchase option equal to 10% of the original purchase price of the equipment was also nominal additional consideration for purposes of ' 1-203. The only way to understand why some purchase options are nominal and others are not requires an analysis of the expected value of the goods at the time of exercise of the option. Section 1-203(d) provides guidance, defining “nominal” as “less than the lessee's reasonably predictable cost of performing under the lease agreement if the option is not exercised” and specifying fair market value of the goods as not nominal. This part of the statute permits the courts to consider the economic realities of the transaction, that is to say, whether the economics of the structure are such that the lessee has paid or will be illogical not to pay the amount stipulated to purchase the goods. This means that if the purchase option price is anything less than the expected residual value, the only sensible course of action for the lessee is to exercise the option and then dispose of the goods for their greater value, rather than allowing the lessor to gain that value. The economic realities test is a subjective assessment of the residual value of the goods, which accounts for inconsistent outcomes to recharacterization challenges.

Summary

Any transaction styled as a lease is at risk of a challenge to recharacterize it as a security interest, whether in the context of a bankruptcy of the lessee or otherwise. Legal advisers to lessors must structure their transactions with an eye to withstanding these challenges and protecting the goals of the transaction whether as a lease or a loan. In particular, lessors can avail themselves of the ability to file UCC financing statements so that a lease recharacterized as a security interest is perfected, and safeguards the priority that a secured creditor would expect. Documenting the expected residual value of the leased goods, and setting a purchase option in light of that expected value, is also recommended. Until inconsistent decisions are a thing of the past, lessors who structure transactions as leases must consider how a recharacterization of that lease as a security interest would affect rights and remedies.

Pamela J. Martinson is a partner in the Palo Alto and Los Angeles offices of Sidley Austin LLP, and a member of the firm's Global Finance Practice. She represents lenders and lessors in a wide variety of commercial loan and lease transactions, and is a member of this newsletter's Board of Editors. She can be reached at [email protected].

The topic of recharacterizing leases as secured loans is not a new one, and is a staple of programs on yearly developments in commercial law. The drafters of the revisions to the 1978 Official Text of the UCC recognized that the focus on whether a lease was “intended as security” in the definition of security interest in ' 1-201(37) had the “unfortunate result” of courts looking to inconsistent factors to discover the intent of the parties. (See the Official Comment to UCC ' 1-203.) The drafters put forward the current definition of security interest in ' 1-201(35) with no reference to the parties' intent, and moved the rules distinguishing leases from security interests to ' 1-203, hoping to achieve “greater certainty” for commercial transactions. Yet, practitioners and courts alike continue to ignore the statutory bright-line tests and persist in applying a variety of other tests and interpretations that have resulted in conflicting decisions as to what is a lease and what is a disguised security interest. The applicability of UCC Article 9 to transactions styled as leases is a question that is debated in courts repeatedly year after year, with recent years being no exception. This article explores the impact of recharacterization, and discusses the tests developed by courts to determine whether a lease will be considered to be a secured loan. Then, a review of the most recent cases shows the characterization tests in practice.

A lease is a financing vehicle much like a loan is. A lease involves a lessor acquiring an asset which is then provided to a lessee for a specified term in exchange for rental payments. A loan involves a lender giving a borrower the funds to purchase the desired asset in exchange for a promise to repay the loan. In both situations, the user of the asset obtains that use through financing provided by another. However, while leases and loans are each financing tools, the classification of the individual transaction as one or the other matters greatly.

The Terminology of Leasing

Too often, practitioners add confusion because of the labels they assign to transaction structures. The same structure may go by a different name depending on whether it is being identified for purposes of accounting, tax or commercial law. Accountants divide leases into operating leases and capital leases to decide whether or not the leased asset appears on the lessor's balance sheet. The tax authorities dispense with labels altogether, studying instead how the transaction allocates risks and rewards of ownership to determine who will benefit from tax deferral through depreciating the asset, or reducing income through the payment of rent. For commercial law purposes, lawyers craft the transaction to achieve specific rights and remedies for the parties. A “true” lease gives the title to the leased property to the lessor for commercial law purposes, and differs from what might be called a loan, a lease intended as security, a disguised security interest, an installment sale, a conditional sales contract or even a “dirty” lease, where title in each case is vested in the nominal lessee. References to “leases” in this article are to true leases, and transactions purporting to be leases which are not true leases are referred to as security interests.

Why Characterization Matters

Transactions are often styled as leases because of the flexibility offered to meet the goals of the lessee. Leases may make an acquisition more affordable by providing 100% financing and rental payments that are lower than a fully amortizing loan. A lease offers a hedge against obsolescence of equipment if returns and exchanges are permitted. Leases may be tax-driven, shifting tax credits and deductions to the party best able to use them. Leases may be driven by accounting concerns if off-balance-sheet treatment is desired. For certain regulated entities, such as telecommunications companies which must obtain approval of the regulating authority to issue debt or encumber assets, a lease may streamline or avoid an otherwise lengthy process. Lessors, as owners of the leased property, enjoy the rights and access to remedies that come with ownership.

Lessees benefit from the flexible structures offered by leasing, but following a bankruptcy, these lessees or their bankruptcy trustee often look to have the structure recharacterized as a security interest. In bankruptcy, a lessor has an advantage over the secured lender because of the special treatment of leases, which are executory contracts. Section 365(b)(1) of the Bankruptcy Code requires a lessee to cure defaults and provide adequate assurance of future performance before it is permitted to assume an outstanding lease, and the decision to assume or reject the lease must take place within 60 days of the order for relief (' 365(d)(1)). If the transaction is a loan, no such time pressure exists, and no cure
is mandated.

Under the UCC, the lender has rights to enforce performance and to realize upon the collateral, but these rights are tempered by protections for the owner. If the transaction is a loan, the debtor is the owner, and becomes the beneficiary of the rights provided owners by the UCC. For example, the lender with a security interest bears the burden of proving that all aspects of a sale of the collateral were commercially reasonable (UCC ' 9-610(b)), while a lessor is entitled to deal with its owned property more generally as it sees fit. This scenario played out in VFS Leasing Co. v. J&L Trucking, Inc., 2011 WL 3439525 (U.S. Dist. Ct. N.D. Ohio Aug. 5, 2011) when a lessee sought to avoid a deficiency judgment in favor of the lessor. If the truck lease was a secured loan, as the lessee claimed, the lessor would have to prove that its repossession and sale of the trucks was commercially reasonable. Similarly, a lessor did not need to comply with the UCC requirement to notify the lessee before it disposed of a leased vehicle when the transaction was upheld as a lease. Aniebue v. Jaguar Credit Corp. , 708 S.E.2d 4 (Ga. Ct. App. 2011).

The lessor who finds itself with a security interest due to recharacterization may also find that security interest to be unperfected, and lose its rights to the property to the bankruptcy trustee or other perfected secured parties if the lessor failed to properly file a financing statement evidencing that security interest. Precautionary filings in the UCC records are permitted and encouraged (UCC ' 9-505), and provide a lifeline to a lessor on the losing end of a recharacterization battle. In re Miller Brothers Lumber Company, Inc., 2012 WL 1601316 (Bankr.M.D.N.C. May 8, 2012) involved a lessor who failed to continue a financing statement and became unperfected when the “lease” was ultimately deemed to be a security interest.

Aside from enforcement and recovery rights, a lessor enjoys other advantages. Rental payments under a lease may not be subject to laws that restrict interest rates. On the other hand, if the transaction is a secured loan, the lessor's failure to comply with the usury laws could have significant consequences, both in terms of the return it can realize on the transaction, and potential fines and criminal liability. An inadvertent lender may also run afoul of licensing laws for lenders if it did not anticipate being subject to such laws.

The Bright-Line Tests and Economic Realities

UCC ' 1-203 provides that “[w]hether a transaction in the form of a lease creates a lease or a security interest is determined by the facts of each case.” As mentioned above, this section dispenses with any consideration of the intent of the parties, providing instead a bright-line test of what makes a lease a security interest. The bright-line is found when the transaction is terminable by the lessee. If so, the transaction is a lease. However, if the lessee may not terminate, ' 1-203 provides four further fact-based tests, based in the economic reality of the transaction, to consider before the transaction can be said to be a security interest. These are:

• The original term of the lease is equal to or greater than the remaining economic life of the goods;
• The lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods;
• The lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement; or
• The lessee has an option to become the owner of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement.

In New York, the substance of UCC ' 1-203 is included within the definition of “security interest” in ' 1-201(35), as it has not yet adopted the revisions to Article 1.

The tests are applied with reference to the facts and circumstances as they exist at the inception of the transaction, or, if the lease undergoes modification, at the time of such modification. Note how the four tests focus on facts that would give the benefits and burdens of ownership of the property to the lessee. An owner has the right to control the property over its entire useful life. An owner would not be obligated to pay additional consideration to remain the owner. If the lessee is functionally the owner, the transaction is reasonably viewed as a sale with reservation of title by the lessor, or, a disguised security interest. Section 1-203(c) specifies other tests that are not determinative, in and of themselves, of a security interest, even though they are typically associated with ownership. The fact that a lessee agrees to pay to maintain the goods, assumes the risk of loss, or has an option to purchase the goods is not enough to recharacterize the lease as a security interest.

This seems straightforward, yet lessees and others continue to mount challenges to the lease structure. Much of the litigation revolves around what is “nominal additional consideration.” Most courts make quick work of leases containing purchase options of a dollar, or another equally obvious bargain amount. A recent decision involving an obvious bargain purchase option is In re KY USA Energy, Inc., 449 B.R. 745 (Bank. W.D. Ky. 2011) ($1), and the court in Aniebue (cited above) had no problem finding a $19,684 purchase option on a four-year lease of an automobile not nominal. However, other purchase options may fall in a gray area, leaving the parties uncertain as to the outcome. The bankruptcy court in In re Del-Maur Farms, Inc., 2011 WL 2847709 (Bankr. D. Neb. 2011) decided that a purchase option equal to 10% of the original purchase price of the equipment was also nominal additional consideration for purposes of ' 1-203. The only way to understand why some purchase options are nominal and others are not requires an analysis of the expected value of the goods at the time of exercise of the option. Section 1-203(d) provides guidance, defining “nominal” as “less than the lessee's reasonably predictable cost of performing under the lease agreement if the option is not exercised” and specifying fair market value of the goods as not nominal. This part of the statute permits the courts to consider the economic realities of the transaction, that is to say, whether the economics of the structure are such that the lessee has paid or will be illogical not to pay the amount stipulated to purchase the goods. This means that if the purchase option price is anything less than the expected residual value, the only sensible course of action for the lessee is to exercise the option and then dispose of the goods for their greater value, rather than allowing the lessor to gain that value. The economic realities test is a subjective assessment of the residual value of the goods, which accounts for inconsistent outcomes to recharacterization challenges.

Summary

Any transaction styled as a lease is at risk of a challenge to recharacterize it as a security interest, whether in the context of a bankruptcy of the lessee or otherwise. Legal advisers to lessors must structure their transactions with an eye to withstanding these challenges and protecting the goals of the transaction whether as a lease or a loan. In particular, lessors can avail themselves of the ability to file UCC financing statements so that a lease recharacterized as a security interest is perfected, and safeguards the priority that a secured creditor would expect. Documenting the expected residual value of the leased goods, and setting a purchase option in light of that expected value, is also recommended. Until inconsistent decisions are a thing of the past, lessors who structure transactions as leases must consider how a recharacterization of that lease as a security interest would affect rights and remedies.

Pamela J. Martinson is a partner in the Palo Alto and Los Angeles offices of Sidley Austin LLP, and a member of the firm's Global Finance Practice. She represents lenders and lessors in a wide variety of commercial loan and lease transactions, and is a member of this newsletter's Board of Editors. She can be reached at [email protected].