If something looks like, walks like and quacks like a duck, then it just may be a duck. Although this type of abductive reasoning can be useful in a wide range of circumstances, it can lead to poor conclusions when it comes to the proper characterization of a document labeled as a lease. Indeed, members of the equipment industry know that a lease may be nothing more than a secured loan pursuant to which the “lessee” owns the equipment and the “lessor” has a security interest in it as collateral for the obligations of the lessee. Moreover, the answer to the question of whether you have a secured loan as opposed to a true lease in which the lessor owns the equipment and the lessee has only a lease-hold interest can vary depending upon whether the transaction is analyzed under accounting rules, federal tax law, state or local tax law or commercial law. This edition of Dispatches from the Trenches will provide a refresher on the commercial law test found in the Uniform Commercial Code.
In order to determine whether a transaction is a true lease, one must look to the definition of “lease” under Article 2A of the UCC. That section defines a lease as “a transfer of the right to possession and use of goods for a term in return for consideration” and further adds that the “creation of a security interest is not a lease.” Thus, the crucial provision in distinguishing a true lease from a disguised security interest under the UCC is the definition of “security interest” found in the statute.1
This definition means that whether a transaction in the form of a lease creates a lease or security interest is determined by the facts of each case. It also means that transaction, in the form of a lease, creates a security interest 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:
The Bright Line Test
If a transaction satisfies the criteria just listed, it creates a security interest as a matter of law. For this reason, this test is sometimes referred to as a “bright line test.” The bulleted sections we just covered usually receive the most attention. These sections are intended to determine whether the alleged lessor retains a valuable interest in the goods at the end of the lease term (known as its residual interest). If the lessee will almost certainly own the equipment at the end of the term (either because it is legally required to purchase the equipment or because the economics of the purchase option are such that the lessee will almost certainly exercise the purchase option), these provisions conclude that the lessee should be viewed as the owner during the lease term, too.
Similarly, if the lease term exceeds the useful life of the equipment, the lessee will have the equipment for its entire remaining life and should be viewed as the owner. When considering the just-mentioned useful life criteria, the lease term will include any renewal term that will almost certainly occur (again, either because the lessee is legally required to exercise the renewal option or because the economics of the renewal option are such that the lessee will almost certainly exercise it).
The One-Factor Test
Even though the economic life, purchase option and renewal option components of the bright line test receive most of the attention, one should not forget that the lead-in language to the applicable UCC section provides that “[a] transaction in the form of a lease creates a security interest if [one of the factors we discussed earlier are satisfied and] 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.”
Consider carefully a situation in which the lease term exceeds the useful life of the equipment or there is a purchase option at the end of the term for no additional consideration or nominal consideration, but the lessee has the option of terminating the lease early. So long as it is a legitimate termination right, and the lessee does not incur a penalty for exercising it, there is some reasonable possibility the lessee would terminate the lease. In this case, the lessee is not bound to be the owner or to use the entire economic life of the goods, and the bright line test does not result in a security interest as a matter of law.
A recent case provides a nice example of this concept in action.2 In this case, the lessor and lessee were friends for 20 years and shared four grandchildren, their children having been married for 16 of the 20 years. With this relationship, which remained good notwithstanding the lessee’s bankruptcy, the lessor and lessee entered into a handshake agreement for the lessee to use the lessor’s John Deere manure spreader and wheel loader.
The agreement resulted in a five-year lease with annual payments of $35,000 per year. At the end of the five-year period, the lessee could acquire title for the nominal amount of $1. The lessee could also buy the equipment at any time for current fair market value. In addition, the lessee had the right to terminate the lease and return the equipment at any time without any penalty or other payments.
When faced with these facts, rather than being distracted by the $1 purchase option, the court focused on the lessee’s termination right. It described this right as the cornerstone of what it referred to as the “one-factor test” to determine whether a lease created a security interest. The court noted there was a split of authority on this issue, listing several cases holding that a lease terminable by the lessee at will is automatically a true lease and other cases that rejected this view. The court noted, however, that cases rejecting this view “involve[d] consumer ‘rent to own’ leases [and that c]ourts rejecting the ‘one-factor’ test with these leases generally are concerned that the right to terminate is illusory because it would involve a forfeiture of a down payment or security deposit.”3 Since there was no deposit or penalty to terminate, the court held there to be a true lease under the one-factor test.
Facts and Circumstances
Of course, as is often the case in areas of the law ripe with nuance and complexity, promises of bright line and single factor tests sometimes fail to deliver. Such is the case with the circumstances and tests mentioned in this article, since the beginning of the applicable statutory section states that “[w]hether a transaction creates a lease or security interest is determined by the facts of each case,” giving courts flexibility to look at other circumstances.
Consider, for example, a carefully structured sale-leaseback in which the purchase option at the end of the term is for the greater of 10% of its original cost or the then-current fair market value of the equipment. These were the facts in Triplex Marine Maintenance, Inc.4 However, since the sale-leaseback involved basically all of the lessee’s assets, the court noted that the only way the lessee could terminate the lease without purchasing the equipment would be to “either engage in a comprehensive program to locate and purchase (or lease?) replacements for its entire asset portfolio or … cease its business activities.”5 The court therefore concluded there was a security interest under the facts and circumstances test, holding that, given the economic realities of the situation, no sensible person in the lessee’s position would fail to purchase the equipment at the end of the lease term.
To make a long story short, it is important to have a good understanding of the UCC framework for distinguishing a lease from a loan rather than relying on the “duck test,” particularly since the type of creative structuring sometimes seen in the equipment finance industry can result in transactions that have a duck’s bill turning out to be platypuses.
1Although the applicable test is in UCC §1-203 in most states and in §1-201(37) in a handful of states (including New York), the test is substantively the same.
2In re Roberts, 620 B.R. 336 (Bkrtcy.D.N.M, 2020)
3Id. at 31.
4258 B.R. 659 (2000); 45 UCC Rep.Serv.2d 977
5Id. at 672.
Kenneth P. Weinberg is a shareholder at Rimon, P.C., and practices in the area of commercial finance, focusing on equipment leasing, equipment finance and renewable energy project finance. He has penned Dispatches from the Trenches since 2002.
No categories available
No tags available
One Reply to “Is it a Duck or Platypus? Examining Lease vs. Loan Analysis Under the UCC”
Ken: Thanks for you great article. It simplified a complicated issue. I suppose it bears mentioning that in terms of default remedies, they are the same (demand, remote disabling, repo, etc.) except in the event of a bankruptcy, in which case leases are treat quite differently than secured loans. I’d be happy to collaborate with you on a follow-up piece to that effect if you’re interest. Nice work.