The buyer of a debtor’s assets in a bankruptcy wants to buy the debtor’s assets free and clear of the lessor’s lien in a bankruptcy §363 sale. So the buyer contends that the lease is not really a true lease that must be assumed or rejected under §365 of the Bankruptcy Code, but instead contends that the lease is a lease intended as security and the leased equipment is one of the assets being acquired for a bulk purchase price. If the lease is a true lease, then the buyer must cure the delinquent payments to assume the lease and continue to make lease payments throughout the term of the lease or reject the lease, which would allow the lessor relief from the stay to take possession of the leased equipment. But the buyer needs the leased equipment because it is an integral part of the business so the buyer challenges the lease to recharacterize it as nothing more than a loan with a security interest in the equipment.
This was the scenario in the bankruptcy case of In re Gateway Ethanol, LLC, 415 B.R. 486 (Bkrtc. D. Kan. 2009), which has an extensive discussion of the true lease versus lease intended as security issues lessors are commonly faced with in litigation or bankruptcy. This recent case is now being cited as authority by other Courts when looking at the true lease/lease intended as security dichotomy (see e.g., recent cases of Gibralter Financial Corp. v. Prestige Equipment Corp., 925 N.E. 2d 751 (Ind. APP 2010); In re Uni Imaging Holdings, LLC 2010 WL 148422 (Bankr. N.D. N.Y. 2010)). The Kansas Court in the case In re Gateway Ethanol was applying Illinois law, which is similar to the law in most states, in making the determination whether the lease at issue was a true lease or a lease intended as security. Therefore, a short discussion of In re Gateway Ethanol and the law as applied to the facts is the subject of this article. This article merely summarizes the case and the law contained therein and cannot, for brevity sake, be a complete discussion of all of the law, facts, arguments and contentions in that case.
The debtor and lessor entered into a lease with respect to a thermal oxidizer boiler system (equipment). The original purchase cost of the equipment was $5,041,970; payments were $93,474.85 per month for 60 months and there was an option to purchase the equipment for $600,000 at the end of the five-year lease term. The lease had the normal “hell and high water” clause, disclaimers of warranties, finance lease language and net lease language. The evidence showed that the lessor was solely responsible for determining the economic terms of the lease. When determining the economic terms at the inception of the lease, the lessor estimated that the cost to return the equipment at the end of five years would be $200,000 to $250,000, which included transportation costs. The buyer of the debtor’s assets at the §363 sale of assets (buyer) contended that the lease was a lease intended as security and, therefore, the equipment was an asset the buyer purchased at the sale and did not have to be assumed or rejected by the buyer.
Quite simply, the buyer did not want to make the cure payment necessary to assume the lease or make lease payments thereafter since the buyer needed the equipment in place for the continued operation of the business. The buyer offered no testimony as to the cost of removal anticipated at the time when the lease transaction was executed. The buyer did submit testimony that the estimated cost to disassemble, remove and ship the equipment and all of its external equipment at the time of the hearing, years after the lease was entered into, was $602,500. Therefore, the buyer argued that the cost of removal was greater than the $600,000 purchase option and, as a result, the equipment had no real residual value. The lessor, on the other hand, offered evidence that, at the time of the hearing, the approximate cost to remove the equipment would be $300,000. Both parties did agree that the useful economic life of the equipment was 15 to 20 years. The lessor testified that it believed that the value of the equipment after five years would be the net amount of $1,000,000. Interestingly, the debtor testified that its intent was to enter into a true lease, which certainly did not help the buyer’s cause.
The court looked to Article 2A of the Uniform Commercial Code (UCC) under Illinois law to make the legal determination as to whether the transaction was a true lease or lease intended as security. The court discussed the fact that whether a transaction creates a lease or security interest is a two-part test. The first test is “the bright line test” set forth in §1-201(37) in Illinois at that time. The first part of the bright line test looks at whether the lessee may terminate the lease during its term. If the lease can be terminated, it is not a true lease but a lease intended as security.
The second part of the bright line test looks at what are referred to as the “Residual Value Factors.” If the lessee may not terminate the lease during its term and any one of the Residual Value Factors is present, the transaction is a sale without consideration of any other facts and circumstances. These factors are: a.) The original term of the lease is equal to or greater than the remaining economic life of the goods; b.) 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; c.) the lessee has an option to renew the lease for the remaining economic life of the goods or for no additional consideration or nominal additional consideration upon compliance with the lease agreement; or d.) 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.
After determining that there was no right to terminate the agreement during the five-year lease term, it was contended by the buyer that the debtor had the option to become the owner of the goods for no additional consideration or nominal additional consideration upon completion of the lease agreement and the transaction should be a sale with the lessor having a security interest in the equipment and not a true lease. The focus here was whether the option price was so low that the lessee would certainly exercise it when the five-year term was over and will, in all possible circumstances, leave no meaningful reversionary interest for the lessor. Establishing “nominality” where there is a purchase option price and cost associated with performance of the option is not exercised, requires a comparison of the option purchase price with the reasonably predictable cost of performance under the lease if the purchase option is not exercised (see In re QDS Components, Inc., 292 B.R. 313, 335 (Bankr. S.D. Ohio 2002).
The “nominality” determination must be made at the time of entering into the lease based upon the expectation of the parties and not some later time (see Matter of Marhoefer Packing Co., Inc., 674 F.2d 1139, 1144-45 (7th Cir. 1982); In re WorldCom, 339 B.R. 56, 68 (Bankr. S.D. N.Y. 2006)). The buyer argued that because the cost of performance equals or exceeds the fixed option price based on the cost of removal, the purchase option becomes nominal ($602,000 cost versus $600,000 purchase option). This was a similar argument previously advanced in the case In re Pillowtex, 345 F.3d 711 (3rd Cir. 2003) and many courts also look to the “economic realities” of the transaction to determine if the transaction is really not a true lease. This test focuses on the fact that even though the equipment has a meaningful residual value, which would make the transaction a true lease, the cost of removal may equal or exceed the residual value and therefore the transaction should not be considered a true lease.
However, because of the lack of evidence produced by the buyer at the time when the lease was entered into, and because the court determined that the lessor’s evidence of the cost of removal at the time of the hearing was more reliable than the evidence produced by the buyer, the court concluded that the option price was not nominal when compared with the true value after five years as anticipated at the time when the lease was entered into by lessor and debtor.
The buyer then argued that because the debtor had built up equity in the equipment at the end of the lease term given that its useful life was 15 to 20 years and not five years, for that reason, the purchase option was nominal. The court rejected this contention as a test for “nominality,” and stated the test is what the lessee would be required to expend to retain the leased goods, not what it would give up if the leased goods were returned. Therefore, under the “bright line test” of UCC 1-201(37), the buyer of the equipment had not proven that the purchase option was nominal.
Once the court determined that the bright line test determined that the lease was a true lease and not a disguised sale, the court then looked to “the facts of each case” test to determine whether the lease was a true lease or lease intended as security. Under this test, the court must then answer the question whether the lessor retained a meaningful reversionary or residual interest, either an upside or downside risk, so that the lessor would have a meaningful economic interest in the equipment at the end of the lease term. There is a list of factors set forth in UCC §1-201(37) (now in many states §1203).
The court focused upon these factors and other economic indicators and evaluated whether these factors evidenced that the lessor retained a meaningful residual interest in the equipment under “the facts of the case” test. Based on the consideration of: 1.) the anticipated useful life of the equipment; 2.) lessor’s ability to market the equipment at the end of the lease term; 3.) the amount of the lease payments in relation to the value of the equipment; 4.) whether the equipment was unique because it was specifically designed for installation in the debtor’s plant; 5.) whether at the time of the lease, the long-term operation of the ethanol plant required the debtor’s continued possession of the equipment; and 6.) the economic benefit to the debtor and the lessor from the transaction being structured as a lease rather than a sale, weighed heavily in favor of the lessor.
The buyer also argued that because the debtor was obligated to insure the equipment for its full replacement value, maintain the equipment, assume the risk of loss, and there were disclaimers of warranties, this was indicative of a sale not a lease. The court rejected this argument citing to specific sections of Article 2A of the UCC, which state that such provisions may be included in a lease and therefore these facts should not have any bearing on whether the transaction is a true lease or disguised sale.
As a result, the court found that the lease was a true lease under Illinois law and it was subject to assumption or rejection under §365 of the Bankruptcy Code, which meant that to retain the equipment, the buyer had to pay the cure amounts. A complete discussion of the factual discussion regarding the “facts of the case” test is beyond the scope of the article because of space limitations, but it is recommended that the case be reviewed because there is a good discussion of the court analyzing the economics of the transaction and the facts the court looked to in making the determination, which may be useful in future disputes over this issue.
The determination of whether a lease is a true lease or lease intended as security is important in any litigation. True lease treatment determines whether Article 2A (Article 10 in California) applies to the transaction or whether Article 9 of the Commercial Code applies; whether a lease is a lease intended as security or a true lease for bankruptcy purposes and therefore there is subject to different treatment; in some states, whether there are potential claims for usury because the transaction is a loan subject to usury limitations rather than a lease, which is not subject to usury; and also potential lien priority issues if UCC-1 Financing Statements are not filed by a lessor or lender or, if filed, not timely filed within the 20 days necessary to perfect a purchase money security interest. The In re Gateway Ethanol case is therefore recommended reading for those involved in the leasing and lending industries.
Andrew K. Alper is a partner with the law firm of Frandzel Robins Bloom & Csato, LC in Los Angeles. Alper has been representing equipment lessors, funding sources and other financial institutions since 1978. Alper obtained his Bachelor of Arts degree in Political Science, magna cum laude, from the University of California at Santa Barbara, and received his Juris Doctor from Loyola Marymount University School of Law making the Dean’s List. Alper’s practice emphasizes the representation of equipment lessors and funding sources in all aspects of equipment leasing including litigation, documentation, bankruptcy and transactional matters. Besides representing equipment lessors and funding sources, Alper represents banks and other financial institutions in the area of commercial litigation, insolvency, secured transactions, banking law, real estate and business litigation.
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