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Security Interests in Energy Conservation and Performance Leases and Loans
Section 30 of the Housing Act states that the Secretary of the U.S. Department of Housing and Urban Development (“HUD”) “may authorize a public housing agency to mortgage or otherwise grant a security interest in any public housing project or other property of the public housing agency,” which raises the question of how important a Section 30 approval should be to lenders participating in Energy Conservation Contract or Energy Performance Contract lending to Housing Authorities (“HA”).
The answer depends on the lessor's full understanding of what benefits a Section 30 approval provides them and their risk tolerance, as it relates to their security interest position in contract financing transactions.
This article examines whether a HUD Section 30 approval is necessary to perfect the lessor's security interest in property (the energy conservation project (“ECP”) equipment, the guaranty or related payments due from the ESCO and HUD subsidy funds) associated with the lease of an ECP lease, in addition to what other benefits might accrue to the lessor with this approval. Section 30 has never been interpreted in a reported court case, making any conclusions we reach on the impact tentative.
From an institutional credit risk view, there is positive value for a Section 30 approval of HUD approved liens and disclosures. From the lessor's customer sales viewpoint, the Section 30 approval requirement has negative value due to the length of the approval process and cost for the HA, leading some lending institutions to question the necessity of the approval.
HUD and Section 30: A Brief History
In order to arrive at a conclusion about the necessity of the approvals, it is important to have an understanding of the HUD's history with energy conservation projects as well as the origins of Section 30.
The HUD has an established program that encourages public housing energy conservation projects through HUD subsidies to public housing authorities with an ECP. The structure of the program is such that the energy contractor (“ESCO”) has an agreement, which has an energy savings contract or guaranty contract with the HA, and the lessor buys the ECP equipment and the related payment stream from the ESCO. The lessor then leases the ECP equipment to the HA, usually with a tax-exempt lease purchase. In order for the HA to receive the related HUD subsidy payments, there must be a HUD approval of the ECP and the ESCO contract.
The HUD ECP approval typically states that it is not a Section 30 approval and that separate application must be made to HUD for a Section 30 approval. HUD's current ECP directive states that, “where any financing transaction involves a security interest or other encumbrance in public housing property, public housing authorities (PHAs) are required to obtain written approval from HUD of the security interest or encumbrance pursuant to Section 30 ' HUD approval of EPCs ' do not constitute approval of the security interest, and a separate approval must be obtained.” See HUD Notice PIH-2011-36 (HA) (7/8/2011).
This directive also states that a Section 30 approval is not required if ownership of the equipment is in the lessor, which will be discussed later. Under HUD practice, HUD requires the application for the Section 30 approval to contain the final negotiated lease document, which, as a practical matter, makes it unlikely that the Section 30 approval could be approved before the closing of the lease.
Section 30's language was not in the original 1937 Federal Housing Act. In 1998, there was a thorough revision of the federal housing laws in The Quality Housing Work and Responsibility Act (QHWRA), which added Section 30 to the Housing Act. A review of the legislative history of the 1998 legislation does not provide an explanation of the Congressional reasons for this addition to the law. The subject is not mentioned in either the Senate or House of Representatives reports underlying the legislation, nor is it mentioned in the section-by-section summaries in the reports. Note: The Senate report's discussion of Section 30 of its proposed legislation is on a different subject. See S. Rpt. 105-21, p. 34.
The QWHRA summary written by the HUD shortly after the 1998 Act states that, through restrictions in the Annual Contributions Contract (“ACC”) and the Declaration of Trust (“DoT”), HAs are precluded from establishing a mortgage or security interest “in any public housing property or asset without HUD approval.” Section 516 of QWHRA, now Section 30, authorizes HAs “to pledge or mortgage public housing projects or other property” subject to HUD approval.
The ACC is a standard required contract between HUD and all HAs that get HUD subsidies. On review, it contains no restriction on HAs granting security interests. HUD gets a standard DoT from all HAs it subsidizes, and the DoT grants HUD the “right to require the [HA] to remain seized of the (listed housing properties) and to refrain from transferring ' mortgaging, pledging, or otherwise encumbering ' said property or any part thereof, appurtenances thereto ' (or the rents from the properties).” A review of a representative sample of state housing authorities records indicates the DoT is not generally filed in state records as a UCC security interest.
We searched a NC County Recorder of Deeds' online site to see if HUD's DoT was recorded as a mortgage and found no reference to a HUD filing of any kind against a sample Housing Authority. A deed of trust or other document between HUD and the HA is nothing but a contract between two parties unless it is filed in such a way as to give third parties notice that the property is subject to a restriction. From this limited exercise, it appears that HUD practice is not to treat the DoT as some sort of mortgage or deed of trust.
Since the DoT restriction on HA encumbrance is limited to the housing properties, it would not appear to cover personal property that is not a fixture or appurtenance or other items, such as rights in EPC guaranties. By its terms, the DoT only grants HUD the right to require the HA not to encumber, which would require some kind of action or notice by HUD to actually restrict the HA.
Section 30 designates several important liens and disclosures as part of the lessors' and lenders' rights. A Section 30 approval grants the lessor or lender certain defined benefits with regard to the ability to file for:
- A lien on the installed equipment provided in the EPC contract.
- A lien against energy incentives received by the HA from HUD as listed in the HUD documentation.
- A lien against any amounts payable to the HA by the ESCO pursuant to the existing EPC contract.
As a part of the documentation, both the HA and HUD will state that there are no other pledges or recourse to other HA assets, receipts, capital funds, or reserves unless disclosed at that time.
Section 30 in Action
There are a few very important limitations to note about the way Section 30 is drafted. First, it does not, by its terms, invalidate a HA-granted security interest ( e.g. , state that a security interest granted without HUD approval is not effective). Second, it does not restrict HA authority to grant a security interest; instead, it is a grant of power to HUD to authorize an HA to encumber. Third, it does not address the validity of a security interest perfected under UCC Article 9, which is the source of the Lessor's security interest in assets associated with an ECP lease (Section 30 is federal legislation, while the Uniform Commercial Code is a uniform act adopted by every state; while federal law is supreme, generally, courts require some evidence of Congress' intent for its supremacy to be exercised).
There are three ways in which the absence of a HUD Section 30 approval could be pertinent to the lessor's interests under an ECP lease: 1) lessee default under the lease, where the lessor tries to exercise its Article 9 secured party rights against a defaulting lessee; 2) conflicts among secured parties; and 3) lessee HA bankruptcy.
Below is a more in-depth analysis of each situation.
1. Lessee default can be covered by getting an HA warranty that the security interest is valid. This would estop the lessee from contending the lessor's security interest is not valid, enforceable and perfected on filing in state records as between the parties to the lease.
2. Because priorities among secured parties are strictly governed by Article 9, not federal law, Section 30 would not likely govern mediation of conflicts among secured parties. These conflicts typically arise when the same property is encumbered twice and are covered by the rules in Article 9, Title 3 on priorities among various secured parties. They are not a subject of federal law, and, unless a court were to hold that Section 30 means that federal law automatically invalidates state law-perfected security interest when there is no HUD Section 30 approval, there appears to be no federal interest in having Section 30 mediate the dispute between competing lenders for the same property.
3. Lessee HA bankruptcy would be the most risky context in which the issue might arise. As there are no cases interpreting Section 30 and the HUD regulations [24 CFR sec 905.500] do not address what is the effect of absence of a separate HUD Section 30 approval, we must defer to the general rules of bankruptcy law as a starting point for considering the impact of lack of a Section 30 approval on a bankruptcy dispute. Under bankruptcy law, the bankruptcy trustee's “strong arm” powers in a hypothetical bankruptcy simply say the trustee has priority over an unperfected secured party, 11 USC ' 544; In re DCI Donaco Constr. Co. , 141 B. R. 7 (EDNY 1992). Note, these rules would also apply to a debtor in possession or a municipal bankruptcy.
Whether a lessor in a lease purchase is secured as against the bankruptcy trustee is determined under state law ( see In re Hastie , 2 F. 3d 1042 (10th Cir. 1993) (issue of perfection in 11 USC 544 dispute is governed by state law). Article 9 is the pertinent state law, and since Article 9 of the UCC governs perfection of security interests, id ., where the Lessor is fully perfected under Article 9, a bankruptcy trustee for a bankrupt HA would not be able to argue the Lessor's security interest is destroyed by the trustee's “strong arm” powers. It is theoretical that a hypothetical trustee could argue that Section 30 trumps Article 9, but, since the text of Section 30 does not speak to the validity or timing of the perfected security interest, this appears to be a poor argument.
How to Proceed
Given this information, is a Section 30 approval important to lenders in Energy Conservation Contract or Energy Performance Contract lending to Housing Authorities? Based on the lack of decisional law and legislative history and the absence of explicit HUD regulations on the subject, it would be prudent to pursue a HUD Section 30 approval so as to make moot any possible disputes over its application. Since HUD's procedures don't seem to allow for the Section 30 approval in advance of completion of the lease documents, it would appear the best approach would be to have the lease require the HA to apply for the Section 30 approval as soon as it can, most likely upon lease execution, and to use best efforts to obtain HUD Section 30 approval but not hold up execution the lease for receipt of the Section 30 approval.
This would accommodate the lessor's and lessee's need to have the basic agreement to fund the lease in place, and would allow for the slow-moving administrative procedures. Although it might make sense to have the lease provide that the lessor is owner of the ECP property, in a tax-exempt lease or other lease purchase, this will not be considered a true lease. The controlling interpretations under the Uniform Commercial Code would re-characterize any such lease to provide that the lessor is not an owner, but a secured party. See, e.g., Duke Energy Royal v. Pillowtex Corp., 349 F. 3d 711 (3rd Cir. 2003) (property in ECP lease re-characterized as lessee owned despite lease recital of lessor ownership). Also note, HUD's latest directive states that it does not require a Section 30 approval if there is no security interest in HA property, see HUD Notice PIH 2011-14(HA) (2/24/2011, exp. 2/28/2012), and the directive controlling ECPs states Section 30 approval is not required if the lessor owns the ECP equipment.
Conclusion
For that reason, although it might satisfy a particular HUD rule, it is not prudent, in our judgment, on the structure of these transactions to put any reliance on a declaration of lessor ownership for HUD benefit or to fail to perfect under UCC Article 9 under such a lease as if the lessor is really only a secured party.
Section 30 of the Housing Act states that the Secretary of the U.S. Department of Housing and Urban Development (“HUD”) “may authorize a public housing agency to mortgage or otherwise grant a security interest in any public housing project or other property of the public housing agency,” which raises the question of how important a Section 30 approval should be to lenders participating in Energy Conservation Contract or Energy Performance Contract lending to Housing Authorities (“HA”).
The answer depends on the lessor's full understanding of what benefits a Section 30 approval provides them and their risk tolerance, as it relates to their security interest position in contract financing transactions.
This article examines whether a HUD Section 30 approval is necessary to perfect the lessor's security interest in property (the energy conservation project (“ECP”) equipment, the guaranty or related payments due from the ESCO and HUD subsidy funds) associated with the lease of an ECP lease, in addition to what other benefits might accrue to the lessor with this approval. Section 30 has never been interpreted in a reported court case, making any conclusions we reach on the impact tentative.
From an institutional credit risk view, there is positive value for a Section 30 approval of HUD approved liens and disclosures. From the lessor's customer sales viewpoint, the Section 30 approval requirement has negative value due to the length of the approval process and cost for the HA, leading some lending institutions to question the necessity of the approval.
HUD and Section 30: A Brief History
In order to arrive at a conclusion about the necessity of the approvals, it is important to have an understanding of the HUD's history with energy conservation projects as well as the origins of Section 30.
The HUD has an established program that encourages public housing energy conservation projects through HUD subsidies to public housing authorities with an ECP. The structure of the program is such that the energy contractor (“ESCO”) has an agreement, which has an energy savings contract or guaranty contract with the HA, and the lessor buys the ECP equipment and the related payment stream from the ESCO. The lessor then leases the ECP equipment to the HA, usually with a tax-exempt lease purchase. In order for the HA to receive the related HUD subsidy payments, there must be a HUD approval of the ECP and the ESCO contract.
The HUD ECP approval typically states that it is not a Section 30 approval and that separate application must be made to HUD for a Section 30 approval. HUD's current ECP directive states that, “where any financing transaction involves a security interest or other encumbrance in public housing property, public housing authorities (PHAs) are required to obtain written approval from HUD of the security interest or encumbrance pursuant to Section 30 ' HUD approval of EPCs ' do not constitute approval of the security interest, and a separate approval must be obtained.” See HUD Notice PIH-2011-36 (HA) (7/8/2011).
This directive also states that a Section 30 approval is not required if ownership of the equipment is in the lessor, which will be discussed later. Under HUD practice, HUD requires the application for the Section 30 approval to contain the final negotiated lease document, which, as a practical matter, makes it unlikely that the Section 30 approval could be approved before the closing of the lease.
Section 30's language was not in the original 1937 Federal Housing Act. In 1998, there was a thorough revision of the federal housing laws in The Quality Housing Work and Responsibility Act (QHWRA), which added Section 30 to the Housing Act. A review of the legislative history of the 1998 legislation does not provide an explanation of the Congressional reasons for this addition to the law. The subject is not mentioned in either the Senate or House of Representatives reports underlying the legislation, nor is it mentioned in the section-by-section summaries in the reports. Note: The Senate report's discussion of Section 30 of its proposed legislation is on a different subject. See S. Rpt. 105-21, p. 34.
The QWHRA summary written by the HUD shortly after the 1998 Act states that, through restrictions in the Annual Contributions Contract (“ACC”) and the Declaration of Trust (“DoT”), HAs are precluded from establishing a mortgage or security interest “in any public housing property or asset without HUD approval.” Section 516 of QWHRA, now Section 30, authorizes HAs “to pledge or mortgage public housing projects or other property” subject to HUD approval.
The ACC is a standard required contract between HUD and all HAs that get HUD subsidies. On review, it contains no restriction on HAs granting security interests. HUD gets a standard DoT from all HAs it subsidizes, and the DoT grants HUD the “right to require the [HA] to remain seized of the (listed housing properties) and to refrain from transferring ' mortgaging, pledging, or otherwise encumbering ' said property or any part thereof, appurtenances thereto ' (or the rents from the properties).” A review of a representative sample of state housing authorities records indicates the DoT is not generally filed in state records as a UCC security interest.
We searched a NC County Recorder of Deeds' online site to see if HUD's DoT was recorded as a mortgage and found no reference to a HUD filing of any kind against a sample Housing Authority. A deed of trust or other document between HUD and the HA is nothing but a contract between two parties unless it is filed in such a way as to give third parties notice that the property is subject to a restriction. From this limited exercise, it appears that HUD practice is not to treat the DoT as some sort of mortgage or deed of trust.
Since the DoT restriction on HA encumbrance is limited to the housing properties, it would not appear to cover personal property that is not a fixture or appurtenance or other items, such as rights in EPC guaranties. By its terms, the DoT only grants HUD the right to require the HA not to encumber, which would require some kind of action or notice by HUD to actually restrict the HA.
Section 30 designates several important liens and disclosures as part of the lessors' and lenders' rights. A Section 30 approval grants the lessor or lender certain defined benefits with regard to the ability to file for:
- A lien on the installed equipment provided in the EPC contract.
- A lien against energy incentives received by the HA from HUD as listed in the HUD documentation.
- A lien against any amounts payable to the HA by the ESCO pursuant to the existing EPC contract.
As a part of the documentation, both the HA and HUD will state that there are no other pledges or recourse to other HA assets, receipts, capital funds, or reserves unless disclosed at that time.
Section 30 in Action
There are a few very important limitations to note about the way Section 30 is drafted. First, it does not, by its terms, invalidate a HA-granted security interest ( e.g. , state that a security interest granted without HUD approval is not effective). Second, it does not restrict HA authority to grant a security interest; instead, it is a grant of power to HUD to authorize an HA to encumber. Third, it does not address the validity of a security interest perfected under UCC Article 9, which is the source of the Lessor's security interest in assets associated with an ECP lease (Section 30 is federal legislation, while the Uniform Commercial Code is a uniform act adopted by every state; while federal law is supreme, generally, courts require some evidence of Congress' intent for its supremacy to be exercised).
There are three ways in which the absence of a HUD Section 30 approval could be pertinent to the lessor's interests under an ECP lease: 1) lessee default under the lease, where the lessor tries to exercise its Article 9 secured party rights against a defaulting lessee; 2) conflicts among secured parties; and 3) lessee HA bankruptcy.
Below is a more in-depth analysis of each situation.
1. Lessee default can be covered by getting an HA warranty that the security interest is valid. This would estop the lessee from contending the lessor's security interest is not valid, enforceable and perfected on filing in state records as between the parties to the lease.
2. Because priorities among secured parties are strictly governed by Article 9, not federal law, Section 30 would not likely govern mediation of conflicts among secured parties. These conflicts typically arise when the same property is encumbered twice and are covered by the rules in Article 9, Title 3 on priorities among various secured parties. They are not a subject of federal law, and, unless a court were to hold that Section 30 means that federal law automatically invalidates state law-perfected security interest when there is no HUD Section 30 approval, there appears to be no federal interest in having Section 30 mediate the dispute between competing lenders for the same property.
3. Lessee HA bankruptcy would be the most risky context in which the issue might arise. As there are no cases interpreting Section 30 and the HUD regulations [24 CFR sec 905.500] do not address what is the effect of absence of a separate HUD Section 30 approval, we must defer to the general rules of bankruptcy law as a starting point for considering the impact of lack of a Section 30 approval on a bankruptcy dispute. Under bankruptcy law, the bankruptcy trustee's “strong arm” powers in a hypothetical bankruptcy simply say the trustee has priority over an unperfected secured party, 11 USC ' 544; In re DCI Donaco Constr. Co. , 141 B. R. 7 (EDNY 1992). Note, these rules would also apply to a debtor in possession or a municipal bankruptcy.
Whether a lessor in a lease purchase is secured as against the bankruptcy trustee is determined under state law ( see In re Hastie , 2 F. 3d 1042 (10th Cir. 1993) (issue of perfection in 11 USC 544 dispute is governed by state law). Article 9 is the pertinent state law, and since Article 9 of the UCC governs perfection of security interests, id ., where the Lessor is fully perfected under Article 9, a bankruptcy trustee for a bankrupt HA would not be able to argue the Lessor's security interest is destroyed by the trustee's “strong arm” powers. It is theoretical that a hypothetical trustee could argue that Section 30 trumps Article 9, but, since the text of Section 30 does not speak to the validity or timing of the perfected security interest, this appears to be a poor argument.
How to Proceed
Given this information, is a Section 30 approval important to lenders in Energy Conservation Contract or Energy Performance Contract lending to Housing Authorities? Based on the lack of decisional law and legislative history and the absence of explicit HUD regulations on the subject, it would be prudent to pursue a HUD Section 30 approval so as to make moot any possible disputes over its application. Since HUD's procedures don't seem to allow for the Section 30 approval in advance of completion of the lease documents, it would appear the best approach would be to have the lease require the HA to apply for the Section 30 approval as soon as it can, most likely upon lease execution, and to use best efforts to obtain HUD Section 30 approval but not hold up execution the lease for receipt of the Section 30 approval.
This would accommodate the lessor's and lessee's need to have the basic agreement to fund the lease in place, and would allow for the slow-moving administrative procedures. Although it might make sense to have the lease provide that the lessor is owner of the ECP property, in a tax-exempt lease or other lease purchase, this will not be considered a true lease. The controlling interpretations under the Uniform Commercial Code would re-characterize any such lease to provide that the lessor is not an owner, but a secured party. See, e.g.,
Conclusion
For that reason, although it might satisfy a particular HUD rule, it is not prudent, in our judgment, on the structure of these transactions to put any reliance on a declaration of lessor ownership for HUD benefit or to fail to perfect under UCC Article 9 under such a lease as if the lessor is really only a secured party.
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