Introduction

There has been a growing trend to use the bankruptcy process to effect a sale of most or all of the debtor’s assets during the initial stages of a bankruptcy proceeding under Section 363 of title 11 of the United States Code (the “Bankruptcy Code”). Section 363(f) permits a bankruptcy court to approve the sale of assets “free and clear of any interest in such property of an entity other than the estate.” 11 U.S.C. § 363(f). This provision is highly attractive to purchasers because it “cleanses” the assets, making it more difficult for third parties to assert claims against the assets or purchasers. Secured lenders desire the use of the 363 process because it results in a speedy liquidation of their collateral with their liens attaching to the proceeds of the sale. Thus, a secured lender achieves a fast pay-down of its loan.

A significant portion of the assets, as to the debtor, and collateral, as to the secured lender, are often executory contracts or leases. The characterization and treatment of leases is varied and dependant on the circumstances. Courts are continuously called upon to determine whether a transaction entered into between sophisticated commercial entities whereby one party provides funds, services, supplies and/or goods to enable the other party to acquire or operate tangible business property, constitutes a “true” lease as to the property in question, or, is an advance of funds to acquire or operate such tangible business property which then serves as the collateral for such advance which may then be acquired by the user at the end of the contractual term by the exercise of a purchase option. Indeed, the issue of whether an agreement is a “true” lease or a disguised security agreement is one of the most vexatious and oft-litigated issues under the Uniform Commercial Code (the “UCC”) and bankruptcy law.

In determining whether a lease is a true lease which can be assumed or assumed and assigned to a third party by the debtor or whether it constitutes a disguised security agreement or sale, bankruptcy professionals are familiar with the contrasting consequences to a debtor and its estate if, on the one hand, the debtor is leasing property or other assets owned by third parties and, on the other hand, if the debtor owns such property and the property is subject to the security interests of a creditor.

If a transaction is characterized as a secured transaction, (i.e., a security interest), the debtor may be able to retain possession of the property subject to the lien, sell the encumbered property subject to the lien or convey the encumbered property free of the lien with such lien attaching to the sale proceeds. However, if a transaction is a true lease, the debtor must timely perform its obligations under Section 365 of the Bankruptcy Code and may only retain its interest under the lease by assuming the lease agreement. See In re Edison Bros. Stores, Inc., 207, B.R. 801, 807 (Bankr. D. Del. 1997) (stating that if an agreement constitutes a true lease, debtor must perform its obligations thereunder until the lease is assumed or rejected). If a transaction is characterized as a true lease, the debtor may assume the lease or assume and assign the lease to a third party.

Where to Begin When Asking the “True Lease” Question

When faced with the issue of whether a lease is a true lease or a disguised security agreement, bankruptcy courts look to state law. See In re Powers, 983 F.2d 88, 90 (7th Cir. 1993); In re Falk Farms, Inc., 88 B.R. 254, 256 (B.A.P. 9th Cir. 1988); South Carolina Rentals v. Arthur, 187 B.R. 502, 505 (D.S.C. 1995); In re Homeplace Stores, 228 B.R. 88, 93 (Bankr. D. Del. 1998); In re Wakefield, 217 B.R. 967, 970 (Bankr. M.D. Ga. 1998); In re Yarbrough, 211 B.R. 654, 656 (Bankr. W.D. Tenn. 1997); In re Edison Bros., 207, B.R. at 809; In re Rigg, 198 B.R. 681, 684 (Bankr. N.D. Tex. 1996); In re Wallace, 122 B.R. 222, 226 (Bankr. D.N.J. 1990). The Bankruptcy Code does not provide a definition for the term “lease.” For effective and comprehensive guidance, bankruptcy courts have had to look to the UCC accompanying case law and the legislative history, see In re Victoria Hardwood Lumber Co., Inc., 95 B.R. 947, 952 (Bankr. S.D. Ohio 1988) citing H.R. No. 95-595, 95th Cong., 1st Sess. At 314 (1977) reprinted in U.S. Code Cong. & Admin. News 5878, 6271 (1978), that underlies Section 101(50)2 and 101(51)3 of the Bankruptcy Code which consistently and uniformly points to state law. See Hochstadter Dicker & Campo, FF&E and the True Lease Question: Article 2A and Accompanying Amendments to UCC Section 1-201(37), 7 Am. Bankr. Inst. L. Rev. 517, 519 (Winter 1999).

The Distinction Between a Lease and Security Agreement Under 1-201(37) of UCC

A lease is defined under Section 2A-103(1)(j) of the UCC as a “transfer of the right to possession and use of goods for a term in return for consideration, but a sale, including a sale on approval or a sale or return, or retention or creation of a security interest is not a lease.” See U.C.C. § 2A-103(1)(j). As a result of this definition, to determine what type of transaction constitutes a “lease,” the focus must then shift to the term “security interest,” whereby Section 1-201(37) of the UCC comes into play.4

Section 1-201(37) defines a security interest as the following:

“Whether a transaction creates a lease or security interest is determined by the facts of each case; however a transaction creates a security interest if the consideration 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 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 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 nominal additional consideration upon compliance with the lease agreement.

A transaction does not create a security interest merely because it provides that:

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 or agrees to pay taxes, insurance, filing, recording, or registration fees, or service or maintenance costs with respect to the goods;
3. the lessee has an option to renew the lease or to become the owner of the goods;
4. 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 terms of the renewal at the time the option is to be performed; or
5. 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.

For purposes of this subsection (37):

1. Additional consideration is not nominal if (i) when the option to renew the lease is granted to the lessee the rent is stated to be the fair market rent for the use of the goods for the term of the renewal determined at the time the option is to be performed, or (ii) when the option to become the owner of the goods is granted to the lessee the price is stated to be the fair market value of the goods determined at the time the option is be performed. Additional consideration is nominal if it is less than the lessee’s reasonably predictable cost of performing under the lease agreement if the option is not exercised;
2. “Reasonably predictable” and “remaining economic life of the goods” are to be determined with reference to the facts and circumstances at the time the transaction is entered into; and
3. “Present value” means the amount as of a date certain of one or more sums payable in the future, discounted to the date certain. The discount is determined by the interest rate specified by the parties if the rate is not manifestly unreasonable at the time the transaction is entered into; otherwise, the discount is determined by a commercially reasonably rate that takes into account the facts and circumstances of each case at the time the transaction was entered into.”

UCC § 1-201(37) (1998).

In addition to setting forth a detailed definition of “security interest,” Section 1-201(37), sets forth a two-part statutory test for determining if a transaction is a secured one. See Clark, Barkley, The Law of Secured Transactions Under the Uniform Commercial Code, 1-73 (1999). A court will deem a transaction secured if (1) the obligation to pay rent extends for the entire term of the lease and cannot be subject to termination by the lessee, see PSINet Inc. v. Cisco Sys. Capital Corp., 271 B.R. 1, 45 (Bankr. S.D.N.Y. 2001) and (2) the transaction meets any of the four independent standards, commonly referred to as the “residual value factors,” enumerated in Section 1-201(37). See Id. Moreover, Section 1-201(37) focuses on the economic reality of the transaction. Id.; see also International Trade Admin. v. Rensselaer Polytechnic Inst., 936, F.2d 744, 748 (2d Cir. 1991) (stating that the lease before the court resembled a hybrid containing characteristics of both a lease and a sale of property with rights retained in the grantor); In re PCH Associates, 804 F.2d 193, 200 (2d Cir. 1986); In re Lefrak, 223 B.R. 431, 435 (Bankr. S.D.N.Y. 1998); In re Edison Bros., 207 B.R. at 809. Essentially, the four residual value factors beg the question: “Will the lessee enjoy possession and use of the goods for the entire economic life (1) under a lease whose term exceeds the useful economic life of the goods, (2) by reason of a mandatory ‘put’, (3) by reason of a nominal purchase or renewal option, or (4) for some other reason?” PSINet Inc., 271 B.R. at 45.

It is important to note that should the two-part statutory test not be satisfied, a court will look to all attendant facts surrounding the transaction. In re Victoria Hardwood Lumber, 95 B.R. at 952 (stating that the appropriate course to follow is to analyze all relevant factors surrounding lease agreement and relationships created therein, in determining if the parties created a security agreement due to fact sensitive nature of inquiry); In re Edison Bros., 207 B.R. at 809 (stating that question of whether a lease is intended as a security agreement is to be determined based upon the facts of each case); In re Pan Am Corp., 130 B.R. 409, 413 (S.D.N.Y 1991).

The outcome of a “lease vs. security agreement” question will serve as a crucial distinction in a bankruptcy case in light of Sections 363 and 365 of the Bankruptcy Code and their application. For example, if a court does not consider a lease to be a “true lease,” but rather a disguised financing or sale, then Section 365(d)(10) will be inapplicable and the debtor will not be obligated to perform under the terms of the lease. Moreover, secured creditors will not be entitled to the protections of the unexpired lease assumption and rejection provisions as set forth in Bankruptcy Code Section 365. See In re Homeplace Stores, Inc. 228 B.R. 88, 90 (Bankr. D. Del. 1998).

From the Secured Creditors’ Perspective: In re Circuit-Wise and In re PSINet

In Circuit-Wise, the Chapter 11 debtor entered into a lease with Celtic Leasing Corp. (together with its relevant successors in interest, “Wells Fargo”) in May 1996. In re Circuit-Wise, Inc., 277 B.R. 460, 461 (Bankr. D. Conn. 2002). On March 28, 2001, the debtor filed for Chapter 11 protection and ceased making payments under the lease. As a result of the debtor failing to make such payments, Wells Fargo filed a motion in January 2002, asserting, among other things, that pursuant to Bankruptcy Code Section 365(d)(10), the debtor was required to pay all amounts due or that would become due under the lease until the debtor assumed or rejected the lease. The debtor, with the support of the official committee of unsecured creditors, responded by raising the issue that the lease was not a “true lease,” but rather, a disguised security agreement within the purview of Bankruptcy Code Section 101(50). Accordingly, the debtor argued that Wells Fargo was not entitled to the protections of Section 365(d)(10). Ultimately, the court held that, unless and until the court determined that the alleged lease was a “true lease” or a security agreement, Wells Fargo was not entitled to the protection of Section 365(d)(10). Id. at 464.

In the court’s opinion, Judge Weil acknowledged that the Bankruptcy Code provides different rights and remedies for lessors and holders of “security interests” (as defined in Bankruptcy Code Section 101(50)). Id. at 462; see also In re Sweetwater, 40 B.R. 733 (Bankr. D. Utah 1984) (superseded in part by statute), aff’d 57 B.R. 743 (D.Utah 1985). In addition, Judge Weil emphasized that upon a plain reading of Section 365(d)(10), it was clear that for a person or entity to obtain the protections of 365(d)(10), that person or entity must be a lessor and not the holder of a security interest. Judge Weil further stated that under other subsections of Section 365, “it is well-settled that the terms ‘lease’ (which is not specifically defined in the Code) refers only to ‘true leases’ or ‘bona fide leases’ and does not refer to agreements which, although labeled ‘leases,’ are actually disguised ‘security agreements’ within the purview of Bankruptcy Code Section 101(50). Id. (citing International Trade Admin., 936 F.2d at 748 (lease as used in Section 365(d)(4) means “true” or “bona fide” lease); PCH Associates, 804 F.2d at 198 (“lease” as used in Section 365(d)(3) and (4) means “true” or “bona fide” lease; In re Moreggia & Sons, Inc., 852 F.2d 1179, 1182 (9th Cir. 1988) (“lease” as used in Section 365(d)(4) means “bona fide” lease)).

As a result of Judge Weil’s determination, Wells Fargo raised a concern on behalf of all secured creditors. Wells Fargo posited that if all courts were to reach Judge Weil’s determination, debtors routinely would raise the “true lease” issue for no other reason than to delay their timely performance under Section 365(d)(10). Judge Weil acknowledged Wells Fargo’s concern and addressed such concern by stating that bankruptcy courts should be sensitive to the issue raised by Wells Fargo and offered two solutions: (1) granting expedited trials to adjudicate such matters; or (2) that debtors post appropriate security to protect the creditors accruing claim under a lease in the event that the creditor prevails. Circuit-Wise, 277 B.R. at 463. Moreover, the court assured Wells Fargo that if a debtor were to raise the “true lease” issue for an improper purpose, an award of attorney’s fees in the lessor’s favor may be warranted under Rule 9011(b)(1) of the Federal Rules of Bankruptcy Procedure. Id. at 464.

The issue as to whether certain agreements between Chapter 11 debtors and secured creditors constituted leases or sales agreements with retained security interests was determined in In re PSINet, Inc., 271 B.R. 1 (Bankr. S.D.N.Y. 2001) (holding that debtors’ equipment leases were, in reality, sales agreements with retained security interests, so that equipment was included in property of the estate and debtor did not have to assume or reject leases). The Chapter 11 debtors brought adversary proceedings for recharacterization, as disguised security agreements, of their alleged equipment leases. The secured creditor (“Cisco”) had previously filed a number of pleadings with respect to sale approval motions, seeking to protect its interest in equipment that might be transferred as a part of such sales and raised other subsequent objections. Id. at 4.

The debtors, much like the debtor in Circuit-Wise, moved for a stay of any payments that would be due Cisco under Bankruptcy Code Section 365(d)(10). As previously stated in the Circuit-Wise discussion, Section 365(d)(10) of the Bankruptcy Code requires post-petition payments to lessors under personal property leases 60 days after the debtor’s petition date. See id. at 5; 11 U.S.C. § 365(d)(10). Prior to the debtors’ Chapter 11 filing, the debtors and Cisco had entered into agreements with respect to certain equipment under which Cisco retained title and leased the equipment to the debtors. Under the terms of the agreements, the debtors were required to pay Cisco the full invoiced cost of the equipment, plus a rate of interest agreed to by the debtors and Cisco. The debtors had the right to purchase the equipment for $1.00 at the expiration of the lease term.

In reaching a decision in PSINet, Judge Gerber looked first to California law since the master lease agreement was governed by the law of the State of California. PSINet 271 B.R. at 43. Second, the court looked to UCC 1-201(37) as amended, codified and adopted by California law. Id. Throughout his decision, Judge Gerber enumerated the two-part statutory test under UCC 1-201(37) and the residual value factors in accordance with accompanying case law. After such analysis, the court determined that the debtors and Cisco had not entered into a “true lease,” but, in fact, the parties had entered into a series of secured transactions. Id.

The first part of the court’s inquiry focused on whether the lease prohibited the debtors from terminating its obligation to pay Cisco the full cost of the equipment covered by the lease before the expiration of the lease terms. Id. Judge Gerber found that the debtor was able to terminate the lease early, but not without incurring an obligation for the total cost of the equipment. Id. at 44. The second part of the court’s inquiry hinged upon the presence of any one of the four residual value factors being present. The presence of any one of these factors would indicate that Cisco did not retain any residual interest in the leased property and that the lease was not a true lease. Id. at 45 citing In re Owen, 221 B.R. 56, 61 (Bankr. N.D.N.Y 1998). Judge Gerber found two such residual value factors present.

The first factor found present by Judge Gerber was that the debtors’ master lease agreement provided that the debtors could purchase the equipment listed on the schedules to the agreement for a dollar at the end of the lease term. The court determined that the price of a dollar to exercise such purchase option was considered nominal consideration. Next, the court cited a second, wholly independent factor which satisfied the second part of the two-part test under UCC 1-201(37). The court stated that the “statute provides that a true lease does not exist when the first part of the statutory test is met and the original term of the lease is equal to or greater than the remaining economic life of the goods,” and the debtors had previously asserted that the equipment would have no remaining economic value at the end of each lease term. PSINet, 271 B.R. at 45. Based on these factors, the court could not conclude that the agreement entered into between the debtors and Cisco were “true leases.”

Secured Creditor or Lender Considerations

At the outset or during the embryonic stages of any bankruptcy proceeding the secured creditor or lender should investigate, review and complete an analysis of the debtor’s leases, equipment leases or security agreements and executory contracts The review and determination should consist of at least the following:

1. Whether the lease is a true lease or financing arrangement;
2. Whether the lease is an asset or liability;
3. Whether the lease is critical to the debtor’s business and an integral part of the assets to be sold;
4. What is the current amount of arrearages or cure amounts;
5. What are the carrying costs;
6. Whether the debtor is timely performing its post-petition obligations under the lease;
7. If the lease is a liability or unnecessary to achieve a sale, has the debtor sought to reject the lease, or in the event that the lease is a financing arrangement, return the collateral to the equipment lessor;
8. Is the lease financing rather than a true lease and part of the lender’s collateral and if so, what is the priority of liens;
9. Are the post-petition lease payments covered by any budget under the existing or proposed debtor-in-possession financing or cash collateral order; and
10. Is the equipment or other property which is the subject of the lease in the possession of the debtor.

During the initial stages or formulation of the 363 sale process, the secured creditor or lender should also review the proposed asset purchase agreement and determine:

1. What leases are covered by the sale;
2. Does the purchaser have a right to designate additional leases to be assumed and assigned or exclude leases at a future date;
3. If the characterization of the lease is correct;
4. Is the lease being properly treated under bankruptcy and state law;
5. Is the determination of cure amounts correct and does the determination process work;
6. Is the proposed allocation of value received for the assets sold acceptable to the lender;
7. Are the lender’s liens attaching to the proceeds of the sale; and
8. Does the equipment lessor or any other secured parties have liens in the sale proceeds.

Given the current state of the case law and the interplay of Sections 363 and 365 of the Bankruptcy Code, the preliminary analysis set forth above is critical to protecting a secured creditor’s interests and maximizing value for the Secured Creditor.

Conclusion

For all creditors, including secured creditors, the determination in a particular Chapter 11 bankruptcy case of whether a transaction involving a debtor is a lease or secured transaction can have important ramifications with respect to classification of claims, unlocking value from paper, the ability of the debtor to reorganize, to continue operating its business and to pay its creditors. Although the rules appear to be clear and plain on their face, each case must be analyzed on its own facts. Creditors will find it useful to undertake this analysis early in the proceedings. At very least, a preliminary analysis will assist such creditors to understand all the parties’ relative positions and the possible classification and treatment of claims.

1. Mr. Silfen is a member of the Financial Restructuring and Bankruptcy Group in the New York Office of Arent Fox. Lisa McIntyre is an associate in the Financial Restructuring and Bankruptcy Group of Arent Fox based in New York.
2. 11 U.S.C § 101(50) defines a “security agreement” as an “agreement that creates or provides for a security interest.”
3. 11 U.S.C. § 101(51) defines a “security interest” as a “lien created by an agreement.”
   Article 2A of the UCC, first codified in 1987, underwent revisions that were completed in 1990. As part of such revisions, UCC Section 1-201(37), which sets forth the definition of “security interest,” was amended to conform to the provisions set forth in new Article 2A.
4. Commentators have made noteworthy mention that “although, technically, Article 2A and New UCC 1-201(37) may not be applicable to leases entered into prior to the effective dates of these provisions, the majority of courts in jurisdictions that have adopted these provisions tend to either apply the new provisions or look to them for guidance in analyzing pre-effective date leases. In fact, even in situations where these amendments have yet to be adopted, or in the absence of guidance within their own jurisdiction, courts look to other jurisdictions that have adopted the new provisions. Conversely, courts applying the new version of the law also look to the body of case law that developed under old UCC 1-201(37) in the absence of case law authority or guidance to the New UCC. Accordingly, in conducting a true lease analysis, a court might apply the new version of the law, the old version or a combination of both.” See Hochstadter Dicker & Campo, FF&E and the True Lease Question: Article 2A and Accompanying Amendments to UCC Section 1-201(37), 7 Am. Bankr. Inst. L. Rev. 517, 519 (Winter 1999).