“True Lease” Versus “Disguised Security Interests”

“Lease” means a transfer of the right to possession and use of goods for a term in return for consideration, but a sale, including a sale on approval or a sale or return, or retention or creation of a security interest is not a lease. Unless the context clearly indicates otherwise, the term includes a sublease. (810 ILCS 5/2A-103) “Security interest” means an interest in personal property or fixtures which secures payment or performance of an obligation. (810 ILCS 5/1-201) 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. 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 (810 ILCS 5/1-203)

The characterization of a lease as creating either a “true” lease or a security interest is commonly litigated in bankruptcy matters, enforcement cases, and priority disputes and has a significant impact on the ability of the lessor to recover its investment.  For instance, in the bankruptcy context, the Bankruptcy Code requires a debtor to assume or fulfill its obligations under a lease or return the relevant property, but a debtor is only liable to a lender for the value of the property and the remainder of the debt (if any) is unsecured debt.  In re Montgomery Ward, L.L.C., 469 B.R. 522 (D. Del. 2012) (citing 11 U.S.C. § 365 and 11 U.S.C. §§ 506(a), 1129(b)(2)(A)).  See also, U.S. ex rel. Pileco, Inc. v. Slurry Systems, Inc., 872 F. Supp.2d 710, 720-22 (N.D. Ill. 2012); In re Gateway Ethanol, LLC, 415 B.R. 486, 496 n. 18 (D. Kansas 2009).

Illinois, like many other states, has adopted the Uniform Commercial Code as it relates to this issue.  The Illinois code defines a lease as “a transfer of the right to possession and use of goods for a term in return for consideration, but a sale, including a sale on approval or a sale or return, or retention or creation of a security interest is not a lease”, and a security interest as an “interest in personal property or fixtures which secures payment or performance of an obligation”.  810 ILCS 5/2A-103(1)(j) (2013); 810 ILCS 5/1-201(35) (2009). 

Section 5/1-203 of the ILCS adopted Section 1-203 of the Uniform Commercial Code and sets forth the tests that govern the distinction between a lease and a security interest.  This section is discussed in brief below.

Section 5/1-203(a) of the ILCS emphasizes that the determination between a lease and a security interest is a fact-based analysis – the determination is based upon the “facts of each case”.  810 ILCS 5/1-203 (2009).

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

Section 5/1-203(b) of the ILCS sets forth the “per se” or “bright line” test for determining whether an agreement is a lease or a security interest, meaning in a general sense that a lease will be construed as a security interest if the purported debtor/lessee cannot terminate the lease and one of the other requirements enumerated in Section 1-203(b) (copied below) is met.  In re Royal T Energy, LLC, 596 B.R. 525, 530 (Bankr. E.D. Tex. 2019) (quoting Banterra Bank v. Subway Equipment Leasing Corp. (In re Taylor), 209 B.R. 482, 484 (Bankr. S.D. Ill. 1997)).  If the court cannot determine if the purported lease is a security interest “per se, the court must look to the specific facts of the case to determine whether the economics of the transaction suggest such a result”, which is commonly referred to as the “economic realities test”.  In re Royal T Energy, 596 B.R. at 530 (citing Mason v. Heller Financial Leasing (In re JII Liquidating, Inc.), 341 B.R. 256, 268 (Bankr. N.D. Ill. 2006) and In re Taylor, 209 B.R. at 484).  In the bankruptcy context, there is a rebuttable presumption the contract is a lease and the debtor has the burden of rebutting the presumption by proving (1) the elements of Section 1-203(b) or (2) that the economic realities of the deal created a security interest.  In re Royal T Energy, 596 B.R. at 530 (citing In re JII Liquidating, 341 B.R. at 259).  Notably, intent of the parties is irrelevant to a court’s interpretation of this section.  Lyon Fin. Servs., Inc. v. Illinois Paper & Copier Co., 247 F. Supp. 3d 923, 932 (N.D. Ill. 2017) (quoting 810 ILCS 5/1-203 (2009) cmt. 2)