A frequent topic of articles and seminars is whether transactions called lease agreements are, in fact, not leases, but instead disguised loans, leases intended as security or dirty leases. However, another important aspect of this discussion remains: What happens to a lease transaction once the court determines the lease to be a loan? What if the transaction is invalid? Does the court enforce some of the lease but not all of it?

A court is faced with several issues after the lease is recharacterized as a loan. This recharacterization happens most often in bankruptcy because of the different treatment a lease has in bankruptcy as opposed to a loan. As the recharacterization of lease transactions has been thoroughly addressed, this article will focus on the issues concerning recharacterization of a lease to be a loan outside of bankruptcy.

Consider the following example: One of the issues in lease transactions, in which there is not an abundance of law, concerns the bundling of goods or equipment with items that are not goods, such as installation costs, payment of taxes, inclusion of maintenance or service agreements, build out or working capital. Pursuant to the definition of a lease in Uniform Commercial Code Article 2A-103(a)(10), a lease means a transfer of the right to possession and use of goods for a term in return for consideration. However, a sale, including a sale on approval, or a sale on return, retention or creation of a security interest is not a lease. With this in mind, if a lease transaction contains 90% goods and 10% funding of other non-goods items, does that destroy the transaction’s ability to be a true lease? What if the transaction contains the leasing of 60% goods and 40% non-goods?

Using a different example, most well-drafted leases specifically state that the lease is a finance lease pursuant to Article 2A-103(a)(7), and the lessee agrees in writing that the lessor did not select, manufacture or supply the goods; that the lessor acquired the goods or the right to possession and use of the goods in connection with the lease; and that, for example, the lessor knew of all of the statements of promises and warranties, disclaimers of warranties, limitations or modifications with respect to the goods.

If all of the foregoing were true statements regarding the lease, then the transaction would achieve finance lease status, and the lessor would have Article 2A protection with respect to issues, defenses or claims based on problems with the equipment (i.e. 2A-407). Let’s assume for the purpose of this example that the goods were used during a period of time and were found to be defective. Does the fact that the transaction is not a true lease — because it is a mixed bag of goods and other non-goods — mean that it cannot be a “finance lease” as a matter of law since it is not a lease, but a loan? Does it mean that the terms of the lease contract between the parties are to be avoided, notwithstanding that the lessee and lessor agreed in writing that the transaction created a finance lease?

Another question to be posed: What happens to the purchase option in the lease if it is recharacterized as a loan with the security interest in the equipment? Can the lessor still receive its purchase option when it is not the owner of the equipment?

Once the lease is recharacterized as a loan what will happen as to the enforceability of the transaction? Will the lessor get the benefit of its bargain?

Let’s answer some of these questions. The starting point is Uniform Commercial Code Article 1-302, which specifically states that the Commercial Code may be varied by agreement except for the obligations of good faith, diligence, reasonableness and care. The parties, by agreement, may determine the standards by which the performance of those obligations is to be measured if those standards are not manifestly unreasonable. In other words, the contract is a contract which should be enforced by its terms regardless of whether it is a lease or a secured loan.

With respect to the determination of whether a transaction that is not a finance lease, for one reason or another, may be determined by the parties in writing to be a finance lease, Uniform Commercial Code comment G to Section 2A-103 states: “If a transaction does not qualify as a finance lease, the parties may achieve the same result by agreement; no negative implications are to be drawn if the transaction does not qualify.”

In support of this proposition there are a number of cases across the country holding that contracts between parties can be treated as finance leases whether they comply with the technical definition set forth in Article 2A-103 of the Uniform Commercial Code or not.¹

Moreover, in some states, like California, the language in a contract is conclusively presumed to be true, whether true or not, pursuant to California Evidence Code section 622. Therefore, if the parties agree in a lease agreement that it is a finance lease, this agreement should be enforced by a court whether the transaction does or does not qualify as a finance lease.²

Additionally, when there is an express contractual “hell or high water” clause — language which states that the lease is noncancellable, no matter what happens — in the lease, courts have held that such a clause is enforceable since the parties have agreed to it.³

Let’s go back to the previous example where the equipment was defective after delivery. Whether a court will enforce acceptance of equipment, regardless of whether a delivery and acceptance receipt was signed or not, and regardless of whether the parties knew that all of the equipment had not been delivered at the time, a lessee cannot simply hold the equipment for a long period of time and later contend that the equipment is non-conforming. The lessee also cannot later contend that the lessor breached the lease by delivering non-conforming equipment.⁴

Another issue previously discussed is what happens when the leased goods are bundled with items that are not goods in a lease transaction? There are cases which hold that if a contract involves both goods and advances for other purposes, the contract qualifies as a Commercial Code contract if its “predominant thrust” is the purchase of goods and the other purpose is “incidental”.⁵

Thus, notwithstanding the fact that the lease may not have 100% goods, depending on the transaction, a court should still enforce the transaction as a lease — so long as the lease predominantly includes goods — assuming that all other aspects of a true lease are apparent. Certainly, if the predominant thrust of the contract is not goods, then the court should not hold that the transaction is a lease.

While this article has discussed some of the issues and law concerning what a lessor can argue when it has a lease agreement, but the transaction is really a loan and is recharacterized by the Court to be a loan, remember, for the most part, a contract will remain enforceable as a matter of law regardless of whether it is a determined to be a lease or loan. However, there is no substitute for careful drafting. Avoiding situations where a court has to make any determination is always best since predicting what a court will do is difficult, to say the least.

Footnotes

1. See, e.g. General Electric Capital Corporation v National Tractor Trailer School, Inc., 175 Misc.2d 80, 667 N.Y.S.2d 614, 619 (N.Y. Supp. 1997); Information Leasing Corporation v. Ting, 155 OhioApp.3d 201 (Ohio App. 2003); De Lage Landen Financial Services Inc. v. Rozentsvit (2007) PA. Super. 389 (PA Super 2007); De Lage Landen Financial Services, Inc. v. M.B. Management Co., Inc. (2005) PA Super. 409 (PA Super. 2005)
2.  See e.g. Great America Leasing Corporation v. Wahoo Productions of Florida, Inc., 2011 U.S. Dist. Lexis 43467 at 21-22 (N.D. Iowa April 21, 2011); and Wells Fargo Financial Leasing, Inc. v. Mountain Rentals of Gatlinburg, Inc. (2008) Tenn. at Lexis 32 7-9 (Tenn. App. January 24, 2008)
3. See, e.g., Wells Fargo Bank Minnesota N.A. v. BrooksAmerica Mortgage Corporation, 2004 U.S. Disc. Lexis 18573 at 15-16 (S.D. N.Y. 2004); C&J Vantage Leasing Co. v. Wolfe, 795 N.W.2d 65, 78 (Iowa 2011)
4. See, e.g., Uniform Commercial Code, section 10515; In re Rafter Seven Ranches LP, 546 F.3d 1994, 1200-1201 (10th Cir. 2008)(use of a non-conforming good constitutes acceptance – ten months delay in doing so is unreasonable); Great America Leasing Corporation v. Wahoo, 2011 U.S. Dist Lexis 5056 at 13-14 (lessee’s statement that the equipment was installed and working coupled with making 10 months of payments before refusing to make further lease payments constituted acceptance); Allen & Company L.C. v. Sanford USD Medical Center, 2011 U.S. Dist Lexis 2709813 (N.D. Ill. March 15, 2011) ( by executing the master lease agreement and an equipment acceptance and making payments, defendant induced plaintiff to finance the transaction and defendant is estopped from denying its obligation to pay
5. See Gelles Racing, Inc. v. Ferris, 75 VA Cir. 273, 274, 69 UCC Rep. Serv.2d 868 (VA Cir. 2008); Films Service Labs v. Harvey Bernhard Entertainment, 208 Cal.App.3d 1297, 1305 (1989); RRX Industries, Inc. v. Lab-Con, Inc., 772 F.2d 543, 546 (9th Cir. 1985)