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Using a True Lease or a TRAC Lease

By Deirdre M. Richards
June 02, 2017

An equipment financing company will often decide whether it wants a transaction to be a true lease or a TRAC lease as opposed to a retail sale. A good reason to be able to make the distinction is to determine what might be the best structure for an equipment financier. This article explores the differences. We also consider what might happen when a lessee/buyer files a bankruptcy proceeding and the judge determines that the deal (that was carefully made a true lease or a TRAC lease) is a determined by the court to be a disguised retail sales agreement.

'Lease' vs. 'Security Interest'

According to the Uniform Commercial Code (UCC), generally adopted as the law in every state, and specifically Section 1-203 therein, “whether a transaction in the form of a lease creates a lease or a security interest is determined by the facts of each case.” UCC § 1-203(a). Looking at the remainder of UCC § 1-203, although the definition of a “lease” is not spelled out, it is clear that it will not be a “lease” “… if the consideration that the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease and is not subject to termination by the lessee and 1) the original term of the lease is equal to or greater than the remaining economic life of the goods; 2) 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; 3) 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 4) 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.”

Uniform Commercial Code § 1-203 (b). This Section of the UCC also provides guidance as to what will not create a security interest, and states:

(c) A transaction in the form of a lease does not create a security interest merely because:

(1) the present value of the consideration the lessee is obligated to pay the lessor for the right to possession and use of the goods is substantially equal to or is greater than the fair market value of the goods at the time the lease is entered into;

(2) the lessee assumes risk of loss of the goods;

(3) the lessee agrees to pay, with respect to the goods, taxes, insurance, filing, recording, or registration fees, or service or maintenance costs;

(4) the lessee has an option to renew the lease or to become the owner of the goods;

(5) the lessee has an option to renew the lease for a fixed rent that is equal to or greater than the reasonably predictable fair market rent for the use of the goods for the term of the renewal at the time the option is to be performed; or

(6) the lessee has an option to become the owner of the goods for a fixed price that is equal to or greater than the reasonably predictable fair market value of the goods at the time the option is to be performed.

Uniform Commercial Code § 1-203 (c).

The Official Comments to UCC Section 1-203 says: “The focus on economics is reinforced by subsection (c). It states that a transaction does not create a security interest merely because the transaction has certain characteristics listed therein. Subparagraph (1) has no statutory derivative; it states that a full payout lease does not per se create a security interest.” Rushton v. Shea, 419 F.Supp. 1349, 1365 (D.Del.1976). Subparagraphs (2) and (3) provide the same regarding the provisions of the typical net lease. Compare All-States Leasing Co. v. Ochs, 42 Or.App. 319 600 P.2d 899 (Ct.App.1979), with In re Tillery, 571 F.2d 1361 (5th Cir. 1978). Subparagraph (4) restates and expands the provisions of the 1978 Official Text of Section 1-201(37) to make clear that the option can be to buy or renew. Subparagraphs (5) and (6) treat fixed price options and provide that fair market value must be determined at the time the transaction is entered into. Compare Arnold Mach. Co. v. Balls, 624 P.2d 941 (9th Cir. 1982).”

What this means for the equipment lessor is that the transaction does not create a security interest just because the transaction has certain characteristics. “The focus is on economics.” See Official Comment. UCC Section 1-203 (c).

What Makes Something a TRAC Lease?

TRAC refers to “terminal rental adjustment clause.” The benefit of this type of arrangement for the lessee includes lower monthly payments and a predetermined residual. This may encourage the lessee to care for and maintain its equipment because its last payment is based on a projected fair market value. Some authorities may say it is a hybrid between a lease and a sale. See Frank Peretore, Workouts and Enforcements for the Secured Creditor and Equipment Lessor, LexisNexis 2015 Edition.

A lessor may desire to use a TRAC lease to be competitive and provide favorable pricing to a lessee (i.e., a lower each month and that the lessee may desire because the residual is predetermined).

When a Lessee Files for Bankruptcy

The fact is that a lessee/purchaser may file a voluntary bankruptcy proceeding and leave the equipment lessor in a precarious position. In such a scenario, a lessee may not pay the equipment lessor and you will need to determine how to remedy the situation and minimize your loss. In my experience, all equipment lessors/financiers file UCC financing statements, and if that is the case, the lessor will be able to file a Motion for Relief from the Automatic Stay. The filing of this motion usually gets the communications rolling with debtor's counsel and the equipment lessor's counsel regarding monthly payments. As a secured creditor, you will have to weigh whether you want to let a judge decide if you meet the grounds for obtaining stay relief (the debtor has no equity in the property and it is not necessary for a reorganization) or if it might be best to try to work out an arrangement whereby the debtor commences monthly payments and if the debtor misses a payment you can declare a default (usually after a short grace period) and obtain your equipment.

In some instances, the debtor may take the position that it is a lease and the debtor need not make a payment for 60 days under the Bankruptcy Code. In others, the debtor may say it is a disguised financing arrangement and it has no intention of paying the monthly payments.

Presuming that a creditor has filed a UCC-1, it may just choose to file a Motion for Relief from the Automatic Stay to let the Debtor know that it is serious about taking back its collateral unless payment resumes. This often results in a debtor agreeing to enter into a stipulation to keep up the monthly payments. As a creditor, you will want to include a default provision that gives the creditor the right to file a default notice with the bankruptcy court if the debtor misses a payment, and after a certain grace period, if the payment is not made, or if the debtor takes advantage of the grace period for more than several months, the creditor may obtain automatic stay relief and take back its equipment. This must be clearly structured, and the stipulation must be submitted to the bankruptcy court with an order approving the stipulation so the court orders the relief the creditor seeks in the stipulation. Otherwise, the creditor would be in violation of the automatic stay, and face strict sanctions from the court.

Has an Adverse Motion Been Granted?

Many debtors in Chapter 11 file motions to sell substantially all of their assets free and clear of all liens claims and encumbrances, and a bankruptcy judge may grant such a motion permitting a debtor to sell your equipment because it is an asset of the estate, unless you oppose the relief by filing an objection in the bankruptcy case. Such a motion usually includes the debtor's request for permission to assume and assign executory contracts to a purchaser of the debtor's assets. Sometimes, the best protection against such a motion by a debtor is to file a Motion for Relief from the Automatic Stay if you have not already done so. This will give you the ability to be on the offensive as opposed to only on the defensive.

If the judge allows your equipment to be sold free and clear of any liens, claims and encumbrances and permits the debtor to assume and assign its “executory” contracts and leases, an equipment lessor could see its equipment slipping away from it unless it objects to the debtor's proposed cure payment and objects that the assignee cannot provide adequate protection to the lessor.

If it is a matter where the debtor seeks to assume and assign the lessor's lease, the creditor may argue that the debtor failed to cure the lease under Bankruptcy Code Section 365(b) and cannot assign it to a purchaser if it has not first cured a default. A creditor may also argue that the assignee does not have the financial wherewithal to be an assignee and that the assignee must show adequate assurance of future performance — that it will be able to perform under the lease.

Conclusion

Equipment lessors should pick the best type of financing arrangement for its business needs, but once a lessee becomes a debtor in a bankruptcy case, a judge can alter the type of financing the lessor thought it created. This can happen when a lessor files a Motion for Relief from the Automatic Stay, and also when a debtor files a Motion to Sell Substantially all of its Assets free and clear of liens, claims and encumbrances.

*****
Deirdre M. Richards is a partner at Fineman Krekstein & Harris PC in Philadelphia. Ms. Richards concentrates her practice in bankruptcy litigation, loan workouts and commercial litigation in Pennsylvania, New Jersey and Delaware. She is a member of the Legal Committee for the Equipment Leasing and Finance Association, and can be reached at [email protected].

An equipment financing company will often decide whether it wants a transaction to be a true lease or a TRAC lease as opposed to a retail sale. A good reason to be able to make the distinction is to determine what might be the best structure for an equipment financier. This article explores the differences. We also consider what might happen when a lessee/buyer files a bankruptcy proceeding and the judge determines that the deal (that was carefully made a true lease or a TRAC lease) is a determined by the court to be a disguised retail sales agreement.

'Lease' vs. 'Security Interest'

According to the Uniform Commercial Code (UCC), generally adopted as the law in every state, and specifically Section 1-203 therein, “whether a transaction in the form of a lease creates a lease or a security interest is determined by the facts of each case.” UCC § 1-203(a). Looking at the remainder of UCC § 1-203, although the definition of a “lease” is not spelled out, it is clear that it will not be a “lease” “… if the consideration that the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease and is not subject to termination by the lessee and 1) the original term of the lease is equal to or greater than the remaining economic life of the goods; 2) 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; 3) 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 4) 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.”

Uniform Commercial Code § 1-203 (b). This Section of the UCC also provides guidance as to what will not create a security interest, and states:

(c) A transaction in the form of a lease does not create a security interest merely because:

(1) the present value of the consideration the lessee is obligated to pay the lessor for the right to possession and use of the goods is substantially equal to or is greater than the fair market value of the goods at the time the lease is entered into;

(2) the lessee assumes risk of loss of the goods;

(3) the lessee agrees to pay, with respect to the goods, taxes, insurance, filing, recording, or registration fees, or service or maintenance costs;

(4) the lessee has an option to renew the lease or to become the owner of the goods;

(5) the lessee has an option to renew the lease for a fixed rent that is equal to or greater than the reasonably predictable fair market rent for the use of the goods for the term of the renewal at the time the option is to be performed; or

(6) the lessee has an option to become the owner of the goods for a fixed price that is equal to or greater than the reasonably predictable fair market value of the goods at the time the option is to be performed.

Uniform Commercial Code § 1-203 (c).

The Official Comments to UCC Section 1-203 says: “The focus on economics is reinforced by subsection (c). It states that a transaction does not create a security interest merely because the transaction has certain characteristics listed therein. Subparagraph (1) has no statutory derivative; it states that a full payout lease does not per se create a security interest.” Rushton v. Shea , 419 F.Supp. 1349, 1365 (D.Del.1976). Subparagraphs (2) and (3) provide the same regarding the provisions of the typical net lease. Compare All-States Leasing Co. v. Ochs , 42 Or.App. 319 600 P.2d 899 (Ct.App.1979), with In re Tillery , 571 F.2d 1361 (5th Cir. 1978). Subparagraph (4) restates and expands the provisions of the 1978 Official Text of Section 1-201(37) to make clear that the option can be to buy or renew. Subparagraphs (5) and (6) treat fixed price options and provide that fair market value must be determined at the time the transaction is entered into. Compare Arnold Mach. Co. v. Balls , 624 P.2d 941 (9th Cir. 1982).”

What this means for the equipment lessor is that the transaction does not create a security interest just because the transaction has certain characteristics. “The focus is on economics.” See Official Comment. UCC Section 1-203 (c).

What Makes Something a TRAC Lease?

TRAC refers to “terminal rental adjustment clause.” The benefit of this type of arrangement for the lessee includes lower monthly payments and a predetermined residual. This may encourage the lessee to care for and maintain its equipment because its last payment is based on a projected fair market value. Some authorities may say it is a hybrid between a lease and a sale. See Frank Peretore, Workouts and Enforcements for the Secured Creditor and Equipment Lessor, LexisNexis 2015 Edition.

A lessor may desire to use a TRAC lease to be competitive and provide favorable pricing to a lessee (i.e., a lower each month and that the lessee may desire because the residual is predetermined).

When a Lessee Files for Bankruptcy

The fact is that a lessee/purchaser may file a voluntary bankruptcy proceeding and leave the equipment lessor in a precarious position. In such a scenario, a lessee may not pay the equipment lessor and you will need to determine how to remedy the situation and minimize your loss. In my experience, all equipment lessors/financiers file UCC financing statements, and if that is the case, the lessor will be able to file a Motion for Relief from the Automatic Stay. The filing of this motion usually gets the communications rolling with debtor's counsel and the equipment lessor's counsel regarding monthly payments. As a secured creditor, you will have to weigh whether you want to let a judge decide if you meet the grounds for obtaining stay relief (the debtor has no equity in the property and it is not necessary for a reorganization) or if it might be best to try to work out an arrangement whereby the debtor commences monthly payments and if the debtor misses a payment you can declare a default (usually after a short grace period) and obtain your equipment.

In some instances, the debtor may take the position that it is a lease and the debtor need not make a payment for 60 days under the Bankruptcy Code. In others, the debtor may say it is a disguised financing arrangement and it has no intention of paying the monthly payments.

Presuming that a creditor has filed a UCC-1, it may just choose to file a Motion for Relief from the Automatic Stay to let the Debtor know that it is serious about taking back its collateral unless payment resumes. This often results in a debtor agreeing to enter into a stipulation to keep up the monthly payments. As a creditor, you will want to include a default provision that gives the creditor the right to file a default notice with the bankruptcy court if the debtor misses a payment, and after a certain grace period, if the payment is not made, or if the debtor takes advantage of the grace period for more than several months, the creditor may obtain automatic stay relief and take back its equipment. This must be clearly structured, and the stipulation must be submitted to the bankruptcy court with an order approving the stipulation so the court orders the relief the creditor seeks in the stipulation. Otherwise, the creditor would be in violation of the automatic stay, and face strict sanctions from the court.

Has an Adverse Motion Been Granted?

Many debtors in Chapter 11 file motions to sell substantially all of their assets free and clear of all liens claims and encumbrances, and a bankruptcy judge may grant such a motion permitting a debtor to sell your equipment because it is an asset of the estate, unless you oppose the relief by filing an objection in the bankruptcy case. Such a motion usually includes the debtor's request for permission to assume and assign executory contracts to a purchaser of the debtor's assets. Sometimes, the best protection against such a motion by a debtor is to file a Motion for Relief from the Automatic Stay if you have not already done so. This will give you the ability to be on the offensive as opposed to only on the defensive.

If the judge allows your equipment to be sold free and clear of any liens, claims and encumbrances and permits the debtor to assume and assign its “executory” contracts and leases, an equipment lessor could see its equipment slipping away from it unless it objects to the debtor's proposed cure payment and objects that the assignee cannot provide adequate protection to the lessor.

If it is a matter where the debtor seeks to assume and assign the lessor's lease, the creditor may argue that the debtor failed to cure the lease under Bankruptcy Code Section 365(b) and cannot assign it to a purchaser if it has not first cured a default. A creditor may also argue that the assignee does not have the financial wherewithal to be an assignee and that the assignee must show adequate assurance of future performance — that it will be able to perform under the lease.

Conclusion

Equipment lessors should pick the best type of financing arrangement for its business needs, but once a lessee becomes a debtor in a bankruptcy case, a judge can alter the type of financing the lessor thought it created. This can happen when a lessor files a Motion for Relief from the Automatic Stay, and also when a debtor files a Motion to Sell Substantially all of its Assets free and clear of liens, claims and encumbrances.

*****
Deirdre M. Richards is a partner at Fineman Krekstein & Harris PC in Philadelphia. Ms. Richards concentrates her practice in bankruptcy litigation, loan workouts and commercial litigation in Pennsylvania, New Jersey and Delaware. She is a member of the Legal Committee for the Equipment Leasing and Finance Association, and can be reached at [email protected].

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