Lease or security interest?

It is imperative when signing contracts to be explicit in your agreement before a contract is assigned. For example, it is critical to understand if there is a lease interest or a security interest. Learn what happened when a contract had ambiguity between the two parties.

In this Chapter 11 action, the court was tasked with determining whether a contract constitutes a true lease or security interest. Ford Motor Credit Company, LLC (“Ford”) brought motions for relief from stay to exercise its rights against trucks that are the subject of a master lease agreement with the debtor, Lasting Impressions Landscape Contractors, Inc. (“Debtor”).

The debtor leased a number of vehicles used by its employees in their daily tasks. Ford entered into a master lease agreement (the Master Lease) and several related supplements (the “Supplements”) for seven trucks. The master lease contained the terms governing all leases, while the supplements provided the monetary terms for each leased vehicle, specifically, the capitalized costs of each vehicle, the monthly lease charges, term (60 months), and the vehicle’s assumed residual value.

The Master Lease provided that upon expiration or termination of the lease, the lessee would return the vehicles to the lessor. If the lessee did not return the vehicles, with title, the lessee would pay the lessor the then applicable Early Termination Value and lessor would transfer all its rights and title and interest in such leased vehicles to lessee.

The debtor testified at hearing that the parties intended to create a security agreement and that the parties designed the agreement as a lease to allow debtor to maintain the requisite debt-to-income ratio required by its loan covenants. (Essentially, structuring the transaction as a lease to allow the debtor to obtain the vehicles and keep them off the books as long term debt). He also testified that he expected to keep the vehicles for 10 to 15 years and would pay the 10% residual at the end and would keep the trucks.

The court, relying on Maryland law (In re Grubbs Construction Co., 319 B.R. 698, 715), noted that a central feature of a true lease is the reservation of an economically meaningful interest to the lessor at the end of the lease term, either an up-side right or down-side risk. If there is no reversionary interest, the parties have signed a security agreement, not a lease. In other words, the court went on, is the transaction structured in such way that the lessor has reasonable economic expectation that the goods will come back to it at the end of the lease term?

The court found that the Master Lease was ambiguous on what is paid to Ford if the debtor retained the vehicle at the expiration of the lease or the debtor terminated the lease early.

The court noted that courts have employed numerous tests to determine  whether the lessor has retained a meaningful reversionary interest:

One such test is the Economics-of-the-Transaction test, where the court looks to "(1) whether the lease contains a purchase option price that is nominal; and (2) whether the lessee develops equity in the property, such that the only economically reasonable option for the lessee is to purchase the goods." In re Purdy, 763 F.3d at 520 (internal quotations omitted); GEO Fin., LLC v. Univ. Square 2751, LLC, 105 F. Supp. 3d 753, 763 (E.D. Mich. 2015); In re QDS, 292 B.R. at 342.

Another set of cases apply the Economics-of-the-Transaction test, but the court considers other factors. In re WorldCom, Inc., 339 B.R. at 72 ("Though these two factors have been considered the most relevant and useful, there is no suggestion . . . that no other factors may be considered."); Park Western Fin. Corp. v. Phoenix Equip. Co. (In re Phoenix Equip. Co.), No. 2:08-bk-13108-SSC, 2009 Bankr. LEXIS 3123, 2009 WL 3188684 (Bankr. D. Ariz. Sep. 30, 2009). The other factors considered include the  practical inability of the lessee to return the leased goods, In re WorldCom, 339 B.R. at 74; which party bore responsibility for the return of the leased goods, id.; and whether the purchase option was exercised in previous agreements between the same parties, In re Phx. Equip. Co., 2009 Bankr. LEXIS 3123, 2009 WL 3188684 at *11.

Other courts apply the "all the facts and circumstances" test. Under this test, the court looks to the economic factors of the agreement to determine whether the lessor retained a meaningful reversionary interest. In re Gateway Ethanol, L.L.C., 415 B.R. 486, 504 (Bankr. D. Kan. 2009); In re UNI Imaging Holdings, LLC, 423 B.R. 406, 419 (Bankr. N.D.N.Y. 2010).

The court considers six factors:

1. The anticipated useful life of the equipment;
2. The ability of the lessor to market the equipment at the end of the lease term;
3. The amount of the lease payments over the term of the contract in relation to the initial value of the equipment;
4. Whether the equipment is unique because it was designed for installation in the debtor's facility;
5. Whether at the time of the agreement the long term operation of the debtor's facility required its continued possession of the equipment; and
6. The economic benefit to the debtor in having the transaction structured as a lease rather than a sale.

In re UNI Imaging, 423 B.R. at 419.

Some courts have also considered the following, non-exclusive, factors:

1. Whether the lease is terminable at will by the lessee;
2. Whether the lessor has the duty to repair;
3. The goods at the termination of the lease;
4. Whether mandatory payments due under the lease are equal to or greater than the value of the leased goods; and
5. Whether the useful life of the leased property exceeds the term of the lease.

Assembly Techs., Inc. v. Phx. Elec. Mfg. Servs., LLC (In re Phx. Elec. Mfg. Servs., LLC), 429 B.R. 195 (Bankr. D.S.C. 2010); In re Parker, 363 B.R. 769, 775 (Bankr. D.S.C. 2006).

At least one court has found a meaningful reversionary interest where at the end of the agreement, the interest in the leased property reverts to the lessor and the lessor is free to lease the property to another party. Frontier Energy, LLC v. Aurora Energy, Ltd. (In re Aurora Oil & Gas Corp.), 439 B.R. 674 (Bankr. W.D. Mich. 2010). Another court has defined the test as:

Under the terms of the lease, does the lessor retain either an up-side gain or a down-side risk at the end of the lease period? In the context of this case it may be stated: If the lease terms provide that at the end of the lease the lessor will receive either return of the leased goods or the reasonably predicted fair market value the goods will have at the time the option is to be performed, the lessor has retained a meaningful reversionary interest.

Sankey v. ABCO Leasing, Inc. (In re Sankey), 307 B.R. 674, 682 (D. Alaska 2004).

Another test is called the "Economic Realities" or "Sensible Person" test. It provides:

Where the terms of the lease and option to purchase  are such the only sensible course for the lessee at the end of the lease term is to exercise the option and become the owner of the goods, the lease was intended to create a security interest. Articulated in a less genteel manner, if only a fool would fail to exercise the purchase option, the option is generally considered nominal and the transaction characterized as a disguised security agreement. No matter how the option amount is expressed, if the only sensible course of action is to exercise the option, then it is one intended for security.

In re Triplex Marine Maint., Inc., 258 B.R. 659, 672 (Bankr. E.D. Tex. 2000) (citations and quotations omitted); In re ECCO Drilling, 390 B.R. at 229; Kentuckiana Med. Ctr. LLC v. Leasing Grp. Pool II, LLC (In re Kentuckiana Med. Ctr. LLC), 455 B.R. 694, 701-02 (Bankr. S.D. Ind. 2011).

Other courts have found that a lessor retains no meaningful reversionary interest where the lessor will only receive the residual value of the leased property at the end of the lease term. Brankle Brokerage & Leasing, Inc. v. Volvo Fin. Servs. (Brankle Brokerage & Leasing, Inc.), 394 B.R. 906, 914 (Bankr. N.D. Ind. 2008); see also In re Grubbs Constr. Co., 319 B.R. at 718-19 ("Upon the recognition of [a pecuniary] interest [in the lessee], the parties are deemed as a matter of law to have intended the lease as security. For instance, if the lessee is entitled to any surplus of proceeds after the lessor claims liquidated damages under the agreement, then the agreement recognizes an 'equity' in the lessee.") (citations omitted). The courts that have reached this conclusion share the rationale that no meaningful reversionary interest can be retained where the lessor has neither up-side right nor a down-side risk. Brankle, 394 B.R. at 914. Regardless of how the property is disposed of at the end of the lease, the lessor receives the same amount. Id. By contrast, the lessee bears the risk of any deficiency and reaps the profits of any equity. Id. Accordingly, these courts conclude that the lessee in such situations maintain an ownership interest in the property. Id.

HELD

The court found that review of the Master Lease and the Supplements under any of the tests described above leads to the conclusion that Ford did not reserve a meaningful reversionary interest. By not preserving a reversionary interest, Ford entered in a security arrangement with the debtor, not a lease. The court particularly found the line of cases holding that a security agreement is created where a lessor will only receive the residual value of the leased property at the end of the lease term to be most compelling. At the termination of the lease, Ford will receive only the Assumed Residual.