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NY Bankruptcy Court Clarifies True Lease and Disguised Secured Transaction Under UCC
Practical Law Legal Update w-002-9761 (Approx. 7 pages)
NY Bankruptcy Court Clarifies True Lease and Disguised Secured Transaction Under UCC
by Practical Law Commercial Transactions
| Published on 15 Aug 2016 • USA (National/Federal) |
An update discussing the decision in In re Ajax Integrated, LLC, where the Bankruptcy Court for Northern District of New York determined that the equipment lease agreement was a disguised secured transaction and not a UCC true lease under New York law.
On August 4, 2016, the Bankruptcy Court for the Northern District of New York held that an equipment lease should be recharacterized from a UCC true lease to sale of assets subject to a secured interest. In its analysis, the court found that the transaction met the requirements for recharacterization under the two-prong, bright line test set forth in former NY UCC Section 1-201(37) because:
- The lessee could not terminate the lease without the payment of all amounts due over the lease term.
- The lessor did not retain a residual interest since the purchase option was nominal when compared to the lessee's reasonably predictable cost of performance.
Background
Vehifax Corporation (Vehifax) purchased three pieces of John Deere equipment for $169,000 and then entered into a commercial lease agreement with Ajax Integrated, LLC (Ajax) under which Ajax took possession and used the equipment.
Under the terms of the agreement, Ajax could only terminate the agreement if it:
- Provided 30 days' notice.
- Paid all current and future amounts due under the lease.
- Exercised the option to purchase the equipment for $16,900.
Otherwise, upon maturity of the agreement, Ajax could either:
- Exercise the purchase option.
- Continue to make monthly lease payments until it returned the equipment at its cost and in the same condition as it was delivered with only reasonable wear.
Ajax defaulted on its monthly payment obligation after six months. After Ajax entered state court receivership, it's trustee sought to claim the equipment as part of its assets. Ajax argued that the equipment lease was not a true lease but a secured transaction. Vehifax opposed this claim, seeking a court finding that the equipment lease was a true lease under which Vehifax retained ownership of the equipment.
Outcome
The Bankruptcy Court for the Northern District of New York found that the equipment lease was a disguised security interest by applying the two-prong, bright line test for a true lease defined in former NY UCC Section 1-201(37), which is nearly identical to Section 1-203(b) of the UCC. After the agreement in this case was signed, but before the court's consideration of the agreement, New York changed its UCC code section to eliminate some extraneous language and more closely follow the UCC. NY UCC Section 1-203(b) is now identical to Section 1-203(b) of the UCC.
Both Section 1-203(b) of the UCC and the former NY UCC Section 1-201(37) applied by the court prescribe a two-step, bright line test to determine whether a lease in form is a UCC true lease or a disguised security interest. The test looks beyond the form of the agreement to the economic substance of the transaction, finding a security interest if both:
- The lessee has the non-terminable obligation to make lease payments.
- The lessor does not have a significant residual interest.
The court found that the first prong was met because the debtor could not terminate the agreement without paying all current and future amounts due, plus the purchase option.
The court then determined whether the lessor has a significant residual interest in the equipment by analyzing four mutually exclusive residual factors from former NY UCC Section 1-201(37). If any of the following were true the lessor would not have a significant residual interest:
- The term of the lease is at least equal to the economic life of the equipment.
- Lessee has an obligation to renew or purchase.
- Lessee has an option to renew for no additional consideration or nominal additional consideration.
- Lessee has an option to purchase for no additional consideration or nominal additional consideration.
For more information on the residual interest test, see Practice Note, Equipment Lease: Types of Leases: State Law: Uniform Commercial Code: UCC True Lease Test.
The court found that none of the first three factors were met because:
- Affidavits showed that both parties expected that the equipment would retain economic life at the end of the term.
- Ajax was not bound to renew because it had the option to terminate the lease and return the equipment.
- The lease did not have a renewal option.
However, the court found that the purchase option amount was nominal. The court applied former NY UCC Section 1-201(37)(c), which states that additional consideration is:
- Not nominal if the purchase option amount determined at the time of the agreement is the expected fair market value of the goods when the option can be executed.
- Nominal if the purchase option amount is less that the lessee's reasonably predictable cost of performing under the lease agreement if the option is not exercised.
The court was unable to determine the expected fair market value of the goods based on the information available. The court rejected arguments that a subsequent auction price supported the fair market value because that is not indicative of the parties' expectations when the contract was formed. The court found that the option price of ten percent of Vehifax's acquisition cost did not appear to be based on any estimation of future fair market value.
The court could determine that the purchase option price was less than the reasonably predictable cost of both:
- Transporting the equipment to Vehifax.
- Restoring the equipment to its original condition, with only reasonable wear and tear.
Ajax claimed that it had anticipated that the costs to repair and transport the equipment would be substantially more than the option price. Vehifax admitted that the costs of transportation alone would have been substantial and failed to counter Ajax's claims as to repair costs. Thus the court found that the option price was nominal and that the two prongs of the bright line test for a disguised security interest had been satisfied.
Practical Implications
In re Ajax Integrated, LLC, demonstrates the importance of structuring equipment leases to avoid a true lease attack in bankruptcy. When a lessor loses a true lease attack, its rights in the equipment can be reduced in several ways, including:
- The lessor's interest in the equipment may be unperfected if it did not file a UCC-1, making it junior to the perfected security interests of other creditors and rank equal with other unsecured claims in the bankruptcy.
- Adequate protection (the right of a secured creditor to receive protection against the decrease in value in its interest during bankruptcy) is impacted.
- The court may bifurcate the lessor's interest into both a secured and unsecured claim.
- The lessor may be subject to cramdown.
Reclassification of a lease as a security interest also has other implications, including:
- The application of Article 2 of the UCC to the sales part of the transaction, as opposed to Article 2A, which applies to leases of goods.
- The application of usury law.
To avoid reclassification, lessors must be careful to structure the lease to protect their ownership interest. They should consider how the following terms of the lease could impact the outcome of a true lease attack:
- The lessee's options to purchase or renew the lease.
- The value of the purchase option and how it is defined.
- The lessee's predictable costs of performance and how they compare to the purchase option amount.
- The expected fair market value of the goods at the time the purchase option is exercised.
The following resources may be valuable to both parties in structuring an equipment lease agreement: