Auto-Renewals and the True Lease Question

If no default exists under this Lease, you [the Lessee] will have the option at the end of the initial or any renewal term to purchase all (but not less than all) of the Equipment at the Purchase Option price shown at the front of this Lease, plus any applicable taxes. Unless the Purchase Option price is $1.00, you must give us [the Lessor] at least 60 days written notice before the end of the initial term that you will purchase the Equipment or that you will return the Equipment to us. If you do not give us such written notice or if you do not purchase or deliver the Equipment in accordance with the terms and conditions of the Lease, this Lease will automatically renew for an additional 12 month term and therefore [sic] renew for successive one month terms until you deliver the Equipment to us. During such renewal(s) the lease payment will remain the same ' . Upon payment of the Purchase Option price, we shall transfer our interest in the Equipment to you “AS IS, WHERE IS” without any representation or warranty whatsoever and the lease will terminate.

Unfortunately for the lessee, it forgot about the initial 60-month term of the lease, and permitted the lessor to continue collecting lease payments by automatic withdrawal from the lessee's bank account for an additional 34 months, at $3,154.18 per month, beyond the end of the initial term. After the lessee realized that fact and contacted the lessor, the latter sent the lessee a bill of sale transferring title to the equipment, but refused to return any of the extra 34 rentals. The lessee had paid the lessor over $100,000 in rental renewals, and had obtained title to equipment having a fixed price purchase option at the end of the initial term of $17, 022 (10% of the original equipment cost of $170,220).

In denying the lessee's demands and granting the lessor's motion for judgment on the pleadings, the Chief Judge of this U.S. district court refers again and again to the “plain language of the Agreement.” Because the lessee had not provided the lessor with notice of either returning or purchasing the equipment, the lease automatically renewed by its own terms until the lessee took steps to terminate it. When the lessee attempted to argue that the transaction was not actually a lease, but a conditional sale under the UCC, the court responded:

The question of whether the Agreement should be characterized as a lease or conditional sale under the Uniform Commercial Code is irrelevant to Plaintiff's claims in this case. That characterization would not change the plain terms of the Agreement or alter Plaintiff's duties under that agreement with respect to terminating the lease or exercising the purchase option.

Irrelevant? What if the lessee's purchase option was $1? While the auto-renewal provision in the lease at issue in this case excludes this possibility explicitly (“Unless the Purchase Option price is $1.00 '”), it is worth considering what the court would have said if this exclusion did not exist. A fair guess would be that the court would have continued to rely entirely upon the plain language of the auto-renewal provision. Or even with the exclusion for a $1 option, what if the actual purchase option in the lease were $10 or $100 instead of the 10% purchase option for $17,022? It seems likely that such differences would have made no difference to this literal-minded court.

What if the Lease Creates a Security Interest?

If instead of a true lease, the transaction is a lease that creates a security interest ' whether termed a conditional sale with a security interest or simply a secured loan ' it is the lessee, not the lessor, who owns the equipment at the outset of the transaction, according to the UCC. The so-called lessor has only a security interest in the equipment owned by the lessee to secure the lessee's obligations under the lease. If the lease is actually a secured loan, isn't there a point at which the lessee's obligations to the lessor are paid in full? If so, when that point comes, should anyone be able to argue that the lessor/secured lender is entitled to more simply because the lessee/debtor forgot to stop paying?

Considered from this point of view, the Pacific Space Design court's reasoning begins to look questionable. In the case of a $1 option lease, when the final rental payment is made, the lessee has completed payment of its secured loan (unless one wants to insist on that last dollar in addition). If the lessor continues to collect, it is collecting money to which it is not entitled ' and thus could be subject to some usury penalties or at least the claim that it has collected more interest than was calculable from the payment stream and equipment cost at the outset.

However, the lease in this case was not a $1 option ' it contained a 10% purchase option equal to $17,022, a not insubstantial amount of money. This is therefore not a case of satisfying one of the automatic or per se conditions for transforming a lease into a security interest. A familiarity with the UCC, the commentary and the cases involving the distinction between a true lease and a security interest indicates that there are circumstances beyond these automatic conditions that can still result in a lease being re-characterized as a security interest. One of the more obvious examples is that of a bargain purchase option, where the lessee can be said to be economically compelled to exercise its purchase option (i.e., if the purchase option price is substantially less than the expected fair market value of the equipment at the end of the lease). In such cases, the lessor is deemed to have no real residual interest in the equipment, and the lessee is to be considered the owner from the outset of the lease. The lessor's economic expectations are to be paid all of the rentals plus the bargain purchase option amount.

Thus, in the Pacific Space Design case, the court should have considered whether or not the lease created a security interest ' and, in particular, whether the 10% purchase option was enough of a bargain (e.g., much less than what the fair market value of the equipment at lease end was expected to be at the beginning of the lease) to warrant a re-characterization. If the lease did create a security interest ' due to the existence of a bargain purchase option or for any other reason ' then the lessor's legitimate expectations of repayment of its investment would include only the 60 regularly scheduled monthly rentals plus 10% of the original cost of the equipment. At the point that the value of the extra rental payments came to that 10% (taking the time value of money into account), the lessor should not have been entitled to retain more.

Conclusion

Automatic renewal provisions have sparked controversy and engendered legislation designed to prevent what happened in the Pacific Space Design case ' forcing lessees to pay rent beyond the initial term when those lessees may have simply forgotten to deliver a required notice some time in advance of the end of that term. These provisions have helped cast lessors in a bad light ' at least in some quarters. In any event, those consequences come in the context of employing such provisions in true leases.

Lessors should be that much more concerned with employing such provisions in the context of leases creating a security interest. Notwithstanding the questionable reasoning of the Pacific Space Design court, it should be apparent that attempting to collect more from their customers who have paid in full what is owed under what is legally equivalent to a secured loan could not only engender negative publicity, but subject lessors to potentially severe legal penalties.

A more detailed discussion of elements of the true lease/security interest distinction and its significance in various legal contexts can be found in the following works written by the author of this article: “How the Uniform Commercial Code and Common Law Distinguish a True Lease from a Security Interest,” Chapter 4 in Equipment Leasing (Matthew Bender 2014); and “Seeking a Meaning for 'Meaningful Residual Value' and the Reality of 'Economic Realities' ' An Alternative Roadmap for Distinguishing True Leases from Security Interests” in The Business Lawyer, Vol. 62, No. 4 (August 2007).

Robert W. Ihne, a member of this newsletter's Board of Editors, is an attorney with more than 25 years of experience in commercial financing, primarily in the areas of secured transactions and equipment leasing. He may be reached at [email protected].

Whether a transaction called a lease is indeed a lease ' i.e., a true lease ' or instead a lease that creates a security interest is an issue that arises frequently in case law. It often comes up in the context of bankruptcy proceedings, where the treatment of true leases and secured transactions differs in very significant ways. Outside of bankruptcy, if the rights of a lessor against a lessee in default are to be enforced, there is likewise a very material difference in the rights and obligations of both parties depending upon whether the Uniform Commercial Code (UCC) Article to be applied is Article 2A governing true leases or Article 9 governing secured transactions.

Pacific Space Design

A recent case illustrates yet another context in which the true lease/security interest distinction can arise, and demonstrates how not fully appreciating this distinction can lead to a questionable result. In Pacific Space Design Corp. v. PNC Equipment Finance, LLC, 2014 WL 6603288, 2014 U.S.Dist. LEXIS 162274 (S.D.Ohio Nov. 19, 2014), the plaintiff/lessee had entered into a lease with an automatic renewal provision expressed as follows:

If no default exists under this Lease, you [the Lessee] will have the option at the end of the initial or any renewal term to purchase all (but not less than all) of the Equipment at the Purchase Option price shown at the front of this Lease, plus any applicable taxes. Unless the Purchase Option price is $1.00, you must give us [the Lessor] at least 60 days written notice before the end of the initial term that you will purchase the Equipment or that you will return the Equipment to us. If you do not give us such written notice or if you do not purchase or deliver the Equipment in accordance with the terms and conditions of the Lease, this Lease will automatically renew for an additional 12 month term and therefore [sic] renew for successive one month terms until you deliver the Equipment to us. During such renewal(s) the lease payment will remain the same ' . Upon payment of the Purchase Option price, we shall transfer our interest in the Equipment to you “AS IS, WHERE IS” without any representation or warranty whatsoever and the lease will terminate.

Unfortunately for the lessee, it forgot about the initial 60-month term of the lease, and permitted the lessor to continue collecting lease payments by automatic withdrawal from the lessee's bank account for an additional 34 months, at $3,154.18 per month, beyond the end of the initial term. After the lessee realized that fact and contacted the lessor, the latter sent the lessee a bill of sale transferring title to the equipment, but refused to return any of the extra 34 rentals. The lessee had paid the lessor over $100,000 in rental renewals, and had obtained title to equipment having a fixed price purchase option at the end of the initial term of $17, 022 (10% of the original equipment cost of $170,220).

In denying the lessee's demands and granting the lessor's motion for judgment on the pleadings, the Chief Judge of this U.S. district court refers again and again to the “plain language of the Agreement.” Because the lessee had not provided the lessor with notice of either returning or purchasing the equipment, the lease automatically renewed by its own terms until the lessee took steps to terminate it. When the lessee attempted to argue that the transaction was not actually a lease, but a conditional sale under the UCC, the court responded:

The question of whether the Agreement should be characterized as a lease or conditional sale under the Uniform Commercial Code is irrelevant to Plaintiff's claims in this case. That characterization would not change the plain terms of the Agreement or alter Plaintiff's duties under that agreement with respect to terminating the lease or exercising the purchase option.

Irrelevant? What if the lessee's purchase option was $1? While the auto-renewal provision in the lease at issue in this case excludes this possibility explicitly (“Unless the Purchase Option price is $1.00 '”), it is worth considering what the court would have said if this exclusion did not exist. A fair guess would be that the court would have continued to rely entirely upon the plain language of the auto-renewal provision. Or even with the exclusion for a $1 option, what if the actual purchase option in the lease were $10 or $100 instead of the 10% purchase option for $17,022? It seems likely that such differences would have made no difference to this literal-minded court.

What if the Lease Creates a Security Interest?

If instead of a true lease, the transaction is a lease that creates a security interest ' whether termed a conditional sale with a security interest or simply a secured loan ' it is the lessee, not the lessor, who owns the equipment at the outset of the transaction, according to the UCC. The so-called lessor has only a security interest in the equipment owned by the lessee to secure the lessee's obligations under the lease. If the lease is actually a secured loan, isn't there a point at which the lessee's obligations to the lessor are paid in full? If so, when that point comes, should anyone be able to argue that the lessor/secured lender is entitled to more simply because the lessee/debtor forgot to stop paying?

Considered from this point of view, the Pacific Space Design court's reasoning begins to look questionable. In the case of a $1 option lease, when the final rental payment is made, the lessee has completed payment of its secured loan (unless one wants to insist on that last dollar in addition). If the lessor continues to collect, it is collecting money to which it is not entitled ' and thus could be subject to some usury penalties or at least the claim that it has collected more interest than was calculable from the payment stream and equipment cost at the outset.

However, the lease in this case was not a $1 option ' it contained a 10% purchase option equal to $17,022, a not insubstantial amount of money. This is therefore not a case of satisfying one of the automatic or per se conditions for transforming a lease into a security interest. A familiarity with the UCC, the commentary and the cases involving the distinction between a true lease and a security interest indicates that there are circumstances beyond these automatic conditions that can still result in a lease being re-characterized as a security interest. One of the more obvious examples is that of a bargain purchase option, where the lessee can be said to be economically compelled to exercise its purchase option (i.e., if the purchase option price is substantially less than the expected fair market value of the equipment at the end of the lease). In such cases, the lessor is deemed to have no real residual interest in the equipment, and the lessee is to be considered the owner from the outset of the lease. The lessor's economic expectations are to be paid all of the rentals plus the bargain purchase option amount.

Thus, in the Pacific Space Design case, the court should have considered whether or not the lease created a security interest ' and, in particular, whether the 10% purchase option was enough of a bargain (e.g., much less than what the fair market value of the equipment at lease end was expected to be at the beginning of the lease) to warrant a re-characterization. If the lease did create a security interest ' due to the existence of a bargain purchase option or for any other reason ' then the lessor's legitimate expectations of repayment of its investment would include only the 60 regularly scheduled monthly rentals plus 10% of the original cost of the equipment. At the point that the value of the extra rental payments came to that 10% (taking the time value of money into account), the lessor should not have been entitled to retain more.

Conclusion

Automatic renewal provisions have sparked controversy and engendered legislation designed to prevent what happened in the Pacific Space Design case ' forcing lessees to pay rent beyond the initial term when those lessees may have simply forgotten to deliver a required notice some time in advance of the end of that term. These provisions have helped cast lessors in a bad light ' at least in some quarters. In any event, those consequences come in the context of employing such provisions in true leases.

Lessors should be that much more concerned with employing such provisions in the context of leases creating a security interest. Notwithstanding the questionable reasoning of the Pacific Space Design court, it should be apparent that attempting to collect more from their customers who have paid in full what is owed under what is legally equivalent to a secured loan could not only engender negative publicity, but subject lessors to potentially severe legal penalties.

A more detailed discussion of elements of the true lease/security interest distinction and its significance in various legal contexts can be found in the following works written by the author of this article: “How the Uniform Commercial Code and Common Law Distinguish a True Lease from a Security Interest,” Chapter 4 in Equipment Leasing (Matthew Bender 2014); and “Seeking a Meaning for 'Meaningful Residual Value' and the Reality of 'Economic Realities' ' An Alternative Roadmap for Distinguishing True Leases from Security Interests” in The Business Lawyer, Vol. 62, No. 4 (August 2007).

Robert W. Ihne, a member of this newsletter's Board of Editors, is an attorney with more than 25 years of experience in commercial financing, primarily in the areas of secured transactions and equipment leasing. He may be reached at [email protected].