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In Chapter 11, in the case of True Lease, lessee can assume the lease and continue to make payments or reject the lease and return the asset.

In the case of Lease intended as security, lease is re-characterized as secured credit and asset is subject to automatic stay, which prohibits recovery of or foreclosure on collateral.

What are the examples of True Lease and Lease intended as security, specifically related to the bankruptcy situations? Equipment or trucks? Real estate?

  • Fair question. As the 7th Circuit is paraphrased saying in my answer, there is no way that you can know this from the face of the text of the Bankruptcy Code. – ohwilleke Aug 5 at 20:35
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The kind of property leased isn't relevant. Any kind of real or personal property could have either kind of lease.

A lease intended as security will allocate few, if any, obligations (e.g. repair and maintenance, control, insurance, risk of loss) to the lesssor-lender, and will have a term such that the price to purchase the remainder interest in the property at the end of the lease term is minimal. While no one fact is dispositive and each case has to be resolved individually, the amount of the remainder interest and the likelihood that the tenant will eventually own the property or will use it for its entire economic life is the most important factor.

One of the main sources of law for distinguishing between the two is section 203 of Article 1 of the Uniform Commercial Code which states:

§ 1-203. Lease Distinguished from Security Interest.

(a) Whether a transaction in the form of a lease creates a lease or security interest is determined by the facts of each case.

(b) A 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: (1) the original term of the lease is equal to or greater than the remaining economic life of the goods; (2) 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; (3) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement; or (4) the lessee has an option to become the owner of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement.

(c) A transaction in the form of a lease does not create a security interest merely because: (1) the present value of the consideration the lessee is obligated to pay the lessor for the right to possession and use of the goods is substantially equal to or is greater than the fair market value of the goods at the time the lease is entered into; (2) the lessee assumes risk of loss of the goods; (3) the lessee agrees to pay, with respect to the goods, taxes, insurance, filing, recording, or registration fees, or service or maintenance costs; (4) the lessee has an option to renew the lease or to become the owner of the goods; (5) the lessee has an option to renew the lease for a fixed rent that is equal to or greater than the reasonably predictable fair market rent for the use of the goods for the term of the renewal at the time the option is to be performed; or (6) the lessee has an option to become the owner of the goods for a fixed price that is equal to or greater than the reasonably predictable fair market value of the goods at the time the option is to be performed.

(d) Additional consideration is nominal if it is less than the lessee's reasonably predictable cost of performing under the lease agreement if the option is not exercised. Additional consideration is not nominal if: (1) when the option to renew the lease is granted to the lessee, the rent is stated to be the fair market rent for the use of the goods for the term of the renewal determined at the time the option is to be performed; or (2) when the option to become the owner of the goods is granted to the lessee, the price is stated to be the fair market value of the goods determined at the time the option is to be performed.

(e) The "remaining economic life of the goods" and "reasonably predictable" fair market rent, fair market value, or cost of performing under the lease agreement must be determined with reference to the facts and circumstances at the time the transaction is entered into.

A recap of a case from 2006 in the United States Court of Appeals for the 7th Circuit based in Chicago, involving United Airlines, provides a detailed example. It is summarized as follows:

Prior to filing for chapter 11 protection in 2002, United Airlines entered into a series of transactions to fund the improvement of its facilities at four airports. One such lease arrangement involved public financing underwritten by the California Statewide Community Development Authority (the “Authority”). United has been the lessee since 1973 of a 128-acre maintenance base at San Francisco International Airport ("SFO"). The lease expires in 2013 unless the parties negotiate an extension. Rent depends on an independent party's estimate of the property's market value.

In 1997, the Authority issued $155 million in bonds to finance improvements to United's SFO facilities (other than the maintenance base). The bonds are without recourse to the Authority and are guaranteed by United. United subleases 20 acres of the 128-acre maintenance base to the Authority for 36 years — the term matches the bond repayment schedule rather than United's lease with SFO. The Authority paid $1 to sublet the premises.

The Authority leases the 20 acres back to United for rent equal to interest on the bonds plus an administrative fee. This lease has a $155 million balloon payment in 2033 to retire the principal. United may postpone final payment until 2038; if it does, the sublease also is extended. United is entitled to prepay, in which case the sublease and leaseback terminate. If United does not pay as agreed, the Authority can evict it from the 20 acres. The leaseback includes a “hell or high water” clause requiring United to pay the rent even if its lease from the SFO ends before 2033, the property is flooded, or some other physical or legal event deprives United of the use or economic benefit of the maintenance base.

After filing for chapter 11, United took the position that none of the arrangements at the four airports in question is a “lease” for purposes of section 365 of the Bankruptcy Code. Instead, United sought a declaratory judgment that each transaction involves secured financing and that United should have the right to continue using the airport facilities while paying only a portion of the promised “rent.” The bankruptcy court ruled that the arrangement at one of the airports is a true lease, but that the other three transactions (including the SFO arrangement) are not. The district court reversed those rulings in part on appeal, holding that all four transactions involved true leases rather than secured financings. United appealed to the Seventh Circuit.

The Seventh Circuit's Ruling

The Seventh Circuit joined all the other circuit courts of appeal that have considered this issue, ruling that substance rules over form and that only a “true lease” qualifies as a “lease” under section 365 of the Bankruptcy Code. In reaching this conclusion, the Court of Appeals considered the practical meaning of the Bankruptcy Code, the Uniform Commercial Code (the “UCC”) and the historical context of the Bankruptcy Code’s enactment, including the statute's legislative history.

According to the Seventh Circuit, it “is unlikely that the [Bankruptcy] Code makes big economic effects turn on the parties’ choice of language rather than the substance of their transaction,” because to do so would allow the drafters of contracts to obliterate the distinction between the two types of transactions through creative drafting. This is consistent with the UCC, which, unlike the Bankruptcy Code, contains a detailed description of the distinction between a lease and a security interest, emphasizing that "[w]hether a transaction creates a lease or a security interest is determined by the facts of each case."

The Court of Appeals went on to explain that a lease in which "current consumption" (i.e., lease payments at market rates for continued use of an asset) dominates is often called a “true lease,” while one in which the asset serves as security for an extension of credit is treated as a security agreement governed by the UCC. Finally, the Court of Appeals observed, the legal community of the 1970s understood that the distinction between leases and security agreements was based on substance rather than form, and looked to the relevant legislative history from the adoption of the Bankruptcy Code, which explains, in relevant part:

Whether a "lease" is [a] true or bona fide lease or, in the alternative, a financing "lease" or a lease intended as security, depends upon the circumstances of each case. The distinction between a true lease and a financing transaction is based upon the economic substance of the transaction and not, for example, upon the locus of title, the form of the transaction or the fact that the transaction is denominated as a "lease."

Thus, the Seventh Circuit concluded that substance, rather than form, should be considered in determining whether a transaction is a “true lease” or a disguised secured financing for purposes of section 365 of the Bankruptcy Code.

The Court of Appeals then examined which law should apply to divine the true nature of any given transaction. Explaining that "nothing in the Bankruptcy Code says which economic features of a transaction have what consequences," the Seventh Circuit concluded that state law is determinative on this issue — in this case California law. California, the Court of Appeals observed, has adopted a functional approach to the question in both the UCC and the common law governing real property transactions. It went on to discuss California court rulings examining various features of lease and financing transactions.

The Seventh Circuit ultimately determined that the transaction between United and the Authority was not a “true lease” under California law for the following reasons: (i) the “rent” was not measured by the market value of the property; (ii) at the conclusion of the lease, the Authority had no residual interest; (iii) the balloon payment had no counterpart in a true lease, but was a common feature of a secured financing; and (iv) upon prepayment, the lease and sublease terminated immediately, whereas in a true lease, prepayment secures the tenant’s right to use the property for the term of the tenancy. Based upon this conclusion, the Court of Appeals reversed the district court's decision and remanded the case for further proceedings.

Footnote

The question, in setup discussion not directly relevant to the answer states that the security interest v. lease distinction is important because if it is a security interest, rather than a lease:

[the] asset is subject to automatic stay, which prohibits recovery of or foreclosure on collateral.

This is actually true of both security interests and leases.

The main distinction between a security interest and a lease is that debt secured by collateral may be "crammed down" (i.e. partially discharged) so that only the amount of debt equal to the value of the collateral remains in force. In contrast, if an agreement is a true lease, the debtor must either accept it and fully comply with the lease, or reject it entirely. A debtor may not "cram down" a true lease in the way that a debtor could a secured debt payable in installments, without the express consent of the lessor.

Background Insight: Why Do Businesses Enter Into Finance Leases?

Why would any debtor want a financing lease rather than a security agreement?

This is mostly income tax driven.

If you own property, you get to deduct depreciation according to an IRS formula and interest paid as it is paid. Principal payments on the loan aren't deductible. While in the long run this adds up to the total amount paid with respect to the property, it doesn't match up exactly, so sometimes, you have cash flow without income, and sometimes, you have income without cash flow. Principal payments attributable to land value can never be deducted as an expense by a business (which is why many commercial buildings are built on land that they lease from non-profits so that the business, which can't deduct the land value expense if it owns the land, can deduct the land value expense since it is a lease payment; the non-profit only cares about cash flow and doesn't need the depreciation deduction because it doesn't pay income taxes).

If you lease property, you get a deduction for the full amount of the lease payment, when paid, so cash flow always exactly matches your tax deductions for the property.

Section 179 and accelerated depreciation for tangible personal property, especially the kind with a fairly short useful life, favor buying rather than leasing smaller purchases. But, in the case of very expensive business assets (especially for big businesses) and in the case of real estate, it is usually more favorable from a tax perspective for a business to lease an asset than to buy it.

  • is renting an apartment an example of true lease? I am confused because apartment landlords usually require security deposit worth of at least 1.5 month, so this seems like a secured lending? – Frank Swanton Aug 6 at 14:19
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    Renting an apartment is usually a true lease. In a finance lease of an apartment, you'd have a 15-30 year lease term and a mandatory or optional option to buy for say $1,000 a the conclusion of the lease, and it would be triple net with all repairs handled directly by the tenant. In the case of a security deposit the collateral is the money in the security deposit bank account and the debt is the contingent obligations under the lease if amounts due aren't paid as agreed. In a finance lease the collateral is the property leased. – ohwilleke Aug 6 at 15:45
  • thank you for the clarification. So, a finance lease is equivalent to a lease intended as security, right? So a car lease would be an example of a finance lease, then? – Frank Swanton Aug 7 at 12:38
  • @FrankSwanton A finance lease is equivalent to a lease intended as security. A car lease is sometimes a true lease and sometimes a finance lease, it depends upon the terms of the lease. The type of collateral is irrelevant. – ohwilleke Aug 7 at 19:37

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