Lessors Beware

Shipping containers are large reusable boxes designed for the efficient carriage of cargo worldwide. Because they are intermodal (they can be used in the shipment of goods by rail, sea or highway) and secure (after goods are loaded at their origin, the container is typically sealed until unloaded at its final destination), shipping containers have been instrumental in promoting the growth of world trade. Shipping containers are financed in many different ways. One common structure is for an owner to hire a manager, such as Textainer Equipment Management, to manage the containers and lease them out to a third party on a short- or long-term lease. The third party, in turn, may sublease the containers to yet another party.

Textainer Equipment Management Limited

Those were basically the facts in Textainer Equipment Management Limited v. The United States, 2012 WL 5465983 (Fed.Cl.). The equipment managers (Textainer, CAI International, and Cronos Containers) leased certain intermodal containers to a company called TOPtainer. TOPtainer, in turn, subleased the containers to the U.S. Army pursuant to a Master Lease Agreement. The Master Lease between TOPtainer and the Army was already in place when the managers signed their respective leases with TOPtainer.

The Master Lease provided that the government took title to any containers that were lost or deemed lost 90 days after the end of the lease term, and that the government would pay TOPtainer for such containers. The leases between the equipment managers and TOPtainer expressly prohibited TOPtainer from selling the containers or transferring title to the containers without their consent. At the end of the Master Lease term, the government paid TOPtainer for approximately 1,000 containers that the government claimed it could not find after the lease expired. TOPtainer either did not pay or only partially paid the managers for the lost containers. TOPtainer is no longer in existence.

Accordingly, the managers sued the government, alleging that the government had taken title to their property (the containers) without paying just compensation in violation of the Fifth Amendment of the U.S. Constitution. The Federal Claims court held that to the extent the government was acting in its proprietary capacity ' as opposed to its sovereign capacity ' when it took title to and paid TOPtainer for the containers, there was no “taking” and the managers' sole remedy would be against TOPtainer for breach of contract.

The crux of the case concerned the timing of the notice of default sent by the managers and when the government took title to the containers. As indicated above, under the Master Lease, containers not redelivered within 90 days from the date of expiration (July 1, 2004) may be deemed lost. The Master Lease specifically provided that title will transfer at the time a container is deemed lost, and that the government would reimburse TOPtainer for the lost units upon proper invoice, at the depreciated reimbursement price.

The undisputed evidence showed that CAI notified the government on Feb. 8, 2005 that TOPtainer did not have the right to sell any of CAI's containers, more than four months after the 90-day period had expired. However, the evidence also showed that TOPtainer had invoiced the government for the lost containers on Dec. 29, 2004, and not later than Jan. 14, 2005 the government stopped paying its per diem rates to TOPtainer, meaning that the government had declared the containers lost no later than that date. Payment for the lost containers occurred in March and May 2005. Based on these facts, the court held that title transferred prior to the time when CAI sent the default notice to the government.

The Court's Ruling

Why were the dates important? The court looked to UCC 2-403(2) and 2A-305(2) (Article 2A is Division 10 in California), which recognize the “entrustment” doctrine. Under UCC 2-403(2), a “buyer in ordinary course” may take good title from a “merchant” even for goods that the merchant does not own, but that were entrusted to that merchant. UCC 2A-305(2) extends this concept from sales to leases. Here, the court held that TOPtainer qualified as a “merchant” because its business involved leasing and managing containers. The court further held that the government qualified as a “buyer in the ordinary course” and therefore took valid title to the containers in its proprietary, not sovereign, capacity, because the government obtained title prior to learning of TOPtainer's default. The timing of payment for the lost containers did not affect this result because it was contractually determined.

One may argue with the decision of the court that TOPtainer was a “merchant”; very little evidence is cited in the opinion which shows that TOPtainer was “a person who deals in goods of the kind or otherwise by his occupation holds himself out as having knowledge or skill peculiar to the practices or goods involved … ” (UCC 2-104(1)). But leaving that issue to one side, the case highlights an important risk for leasing companies ' and not just container leasing companies.

Under 2A-305(2) a sublessee can obtain good title to equipment that was leased (“entrusted”) to the sublessor, so long as the sublessor is a merchant and the sublessee qualifies as a buyer in ordinary course of business. A buyer in ordinary course of business is a person who, in good faith and without knowledge that the sale is in violation of the ownership rights of a third party, buys in ordinary course from a person in the business of selling goods of that kind (the court failed to cite any evidence indicating TOPtainer was in the business of selling containers.) (UCC 2A-103(a)(1)). As the opinion noted, “good faith” takes on a different meaning depending on which state's law is applied. In California, for example, “good faith” means honesty in fact and the observance of reasonable commercial standards of fair dealing (UCC 1-201(b)(20)).

Practical Implications

How can an equipment lessor protect itself against having its equipment “sold out from under it” by a lessee? The obvious answer is to include covenants against subleasing in the equipment lease, or to condition the sublease on the consent of the head lessor or require that the sublessee expressly agree to subordinate its interest in the equipment to the interest of the head lessor.

It would also be helpful to have the lessee represent and warrant that it is not in the business of selling goods of the kind that are being leased. But what happens if the lessee breaches these provisions, subleases anyway, and then sells the equipment to the sublessee (such as pursuant to a purchase option)?

Here, the opinion suggests that it is crucial that the lessor monitor what the lessee is doing and act immediately to notify the sublessee of the breach. (Interestingly, according to the opinion, CAI learned of the breach in 2004, but did not notify the government until February 2005.) Once notified, the sublessee will have a much harder time proving good faith or that it was without knowledge that the sale was in violation of the ownership rights of the head lessor. In some cases, it may also be wise to include a sticker or plate on the equipment itself stating that ABC leasing company is the owner and that any sale of the equipment would violate its rights. (For shipping containers under management, this may not be a practical solution.)'

In short, as with any business relationship, it is important not only to write good agreements, but to remain vigilent in carrying them out.

Barry A. Graynor is a special counsel in the San Francisco office of Cooley LLP. A member of this newsletter's Board of Editors, Graynor specializes in credit finance and equipment leasing, in particular shipping containers and other transportation equipment. He may be reached at [email protected].

Shipping containers are large reusable boxes designed for the efficient carriage of cargo worldwide. Because they are intermodal (they can be used in the shipment of goods by rail, sea or highway) and secure (after goods are loaded at their origin, the container is typically sealed until unloaded at its final destination), shipping containers have been instrumental in promoting the growth of world trade. Shipping containers are financed in many different ways. One common structure is for an owner to hire a manager, such as Textainer Equipment Management, to manage the containers and lease them out to a third party on a short- or long-term lease. The third party, in turn, may sublease the containers to yet another party.

Textainer Equipment Management Limited

Those were basically the facts in Textainer Equipment Management Limited v. The United States, 2012 WL 5465983 (Fed.Cl.). The equipment managers (Textainer, CAI International, and Cronos Containers) leased certain intermodal containers to a company called TOPtainer. TOPtainer, in turn, subleased the containers to the U.S. Army pursuant to a Master Lease Agreement. The Master Lease between TOPtainer and the Army was already in place when the managers signed their respective leases with TOPtainer.

The Master Lease provided that the government took title to any containers that were lost or deemed lost 90 days after the end of the lease term, and that the government would pay TOPtainer for such containers. The leases between the equipment managers and TOPtainer expressly prohibited TOPtainer from selling the containers or transferring title to the containers without their consent. At the end of the Master Lease term, the government paid TOPtainer for approximately 1,000 containers that the government claimed it could not find after the lease expired. TOPtainer either did not pay or only partially paid the managers for the lost containers. TOPtainer is no longer in existence.

Accordingly, the managers sued the government, alleging that the government had taken title to their property (the containers) without paying just compensation in violation of the Fifth Amendment of the U.S. Constitution. The Federal Claims court held that to the extent the government was acting in its proprietary capacity ' as opposed to its sovereign capacity ' when it took title to and paid TOPtainer for the containers, there was no “taking” and the managers' sole remedy would be against TOPtainer for breach of contract.

The crux of the case concerned the timing of the notice of default sent by the managers and when the government took title to the containers. As indicated above, under the Master Lease, containers not redelivered within 90 days from the date of expiration (July 1, 2004) may be deemed lost. The Master Lease specifically provided that title will transfer at the time a container is deemed lost, and that the government would reimburse TOPtainer for the lost units upon proper invoice, at the depreciated reimbursement price.

The undisputed evidence showed that CAI notified the government on Feb. 8, 2005 that TOPtainer did not have the right to sell any of CAI's containers, more than four months after the 90-day period had expired. However, the evidence also showed that TOPtainer had invoiced the government for the lost containers on Dec. 29, 2004, and not later than Jan. 14, 2005 the government stopped paying its per diem rates to TOPtainer, meaning that the government had declared the containers lost no later than that date. Payment for the lost containers occurred in March and May 2005. Based on these facts, the court held that title transferred prior to the time when CAI sent the default notice to the government.

The Court's Ruling

Why were the dates important? The court looked to UCC 2-403(2) and 2A-305(2) (Article 2A is Division 10 in California), which recognize the “entrustment” doctrine. Under UCC 2-403(2), a “buyer in ordinary course” may take good title from a “merchant” even for goods that the merchant does not own, but that were entrusted to that merchant. UCC 2A-305(2) extends this concept from sales to leases. Here, the court held that TOPtainer qualified as a “merchant” because its business involved leasing and managing containers. The court further held that the government qualified as a “buyer in the ordinary course” and therefore took valid title to the containers in its proprietary, not sovereign, capacity, because the government obtained title prior to learning of TOPtainer's default. The timing of payment for the lost containers did not affect this result because it was contractually determined.

One may argue with the decision of the court that TOPtainer was a “merchant”; very little evidence is cited in the opinion which shows that TOPtainer was “a person who deals in goods of the kind or otherwise by his occupation holds himself out as having knowledge or skill peculiar to the practices or goods involved … ” (UCC 2-104(1)). But leaving that issue to one side, the case highlights an important risk for leasing companies ' and not just container leasing companies.

Under 2A-305(2) a sublessee can obtain good title to equipment that was leased (“entrusted”) to the sublessor, so long as the sublessor is a merchant and the sublessee qualifies as a buyer in ordinary course of business. A buyer in ordinary course of business is a person who, in good faith and without knowledge that the sale is in violation of the ownership rights of a third party, buys in ordinary course from a person in the business of selling goods of that kind (the court failed to cite any evidence indicating TOPtainer was in the business of selling containers.) (UCC 2A-103(a)(1)). As the opinion noted, “good faith” takes on a different meaning depending on which state's law is applied. In California, for example, “good faith” means honesty in fact and the observance of reasonable commercial standards of fair dealing (UCC 1-201(b)(20)).

Practical Implications

How can an equipment lessor protect itself against having its equipment “sold out from under it” by a lessee? The obvious answer is to include covenants against subleasing in the equipment lease, or to condition the sublease on the consent of the head lessor or require that the sublessee expressly agree to subordinate its interest in the equipment to the interest of the head lessor.

It would also be helpful to have the lessee represent and warrant that it is not in the business of selling goods of the kind that are being leased. But what happens if the lessee breaches these provisions, subleases anyway, and then sells the equipment to the sublessee (such as pursuant to a purchase option)?

Here, the opinion suggests that it is crucial that the lessor monitor what the lessee is doing and act immediately to notify the sublessee of the breach. (Interestingly, according to the opinion, CAI learned of the breach in 2004, but did not notify the government until February 2005.) Once notified, the sublessee will have a much harder time proving good faith or that it was without knowledge that the sale was in violation of the ownership rights of the head lessor. In some cases, it may also be wise to include a sticker or plate on the equipment itself stating that ABC leasing company is the owner and that any sale of the equipment would violate its rights. (For shipping containers under management, this may not be a practical solution.)'

In short, as with any business relationship, it is important not only to write good agreements, but to remain vigilent in carrying them out.

Barry A. Graynor is a special counsel in the San Francisco office of Cooley LLP. A member of this newsletter's Board of Editors, Graynor specializes in credit finance and equipment leasing, in particular shipping containers and other transportation equipment. He may be reached at [email protected].