Bundle Up!

IN RECENT YEARS, lessees have been pressing for equipment leases to include both software used, and services to be provided, in connection with the equipment. The 2001 amendments to Article 9 of the Uniform Commercial Code (the “UCC”) expanded the definition of “chattel paper” to include not only leases and security interests in specific goods, but also security interests, leases and licenses of “software used in the goods.” Consideration is now underway whether to define chattel paper to include transactions involving both software and services, as well as equipment. 

Who Cares? 

Equipment lessors, and third parties that either purchase or finance equipment leases, care about whether the contract constitutes chattel paper, because sales of and security interests in chattel paper can be perfected by possession of the chattel paper instead of (or in addition to) filing a financing statement. A purchaser or financier who relies on a filed financing statement to perfect its interest and wants to verify that its interest is first in line, also must search the recording office for all other statements filed against that lessor to determine whether any conflicting interests might have priority. 

Because an active lessor likely will have many financing statements filed against it, obtaining the UCC search report can be expensive and searching for conflicting filings will be tedious. Worse yet, in most state filing offices it may take weeks before a filed financing statement appears in a search report. The cost structure and velocity of equipment finance transactions will not accommodate either the expense or the delay occasioned by this process. 

In contrast, UCC section 9-330 provides a more streamlined path to perfection and priority—but only if the lease or security agreement constitutes chattel paper: “A purchaser [which includes a secured party] of chattel paper has priority over a security interest in the chattel paper…if the purchaser” gives new value, takes possession of the chattel paper “in good faith, in the ordinary course of the purchaser’s business, and without knowledge that the purchase violates the rights of the [other] secured party (emphasis added).” Official Comment 6 to that Section confirms that the secured party is not compelled to conduct a search of the UCC filings made against the seller or borrower. 

What’s New? 

Technology advances have enlarged the demand for bundled contracts which include services and software along with equipment. One example encountered recently was a lease for high-tech audio/visual/lighting equipment, which included the services of the lessor’s on-site technical personnel who travel with the equipment as it is moved from one performance venue to another. Another example involved the lease of a floating navigation buoy, including the software needed to provide the navigational data and the lessor’s services in installing and maintaining the buoy. 

In each instance, these leases would not have constituted “chattel paper” under Section 9-102(a)(11) of the current UCC. For one thing, it is unclear whether software used “in connection with” the equipment (as opposed to “used in the goods”) would enable such a bundled contract to constitute “chattel paper.” It also is clear that bundling services in connection with the leased equipment would not qualify for chattel paper treatment. 

Worse yet, UCC section 9-102(a)(2) defines an “account” as “a right to payment of a monetary obligation, whether or not earned by performance, (i) for property that has been or is to be …leased [or] (ii) for services rendered or to be rendered.” The implication is that a bundled contract containing services likely would be treated as an “account” rather than as “chattel paper.” Purchasers or financiers of accounts are not able to rely upon perfection by possession of the contract, or to obtain priority under UCC section 9-330; they would have to file a financing statement in order to perfect their ownership/security interest and search the UCC records to confirm that there exist no prior liens. 

Could ALI Come to the Rescue? 

In 2019, an ALI/ULC Joint Committee on the UCC and Emerging Technologies was formed, chaired by Edwin Smith of Morgan, Lewis & Bockius. Six subcommittees also were appointed, including a Bundled Hardware, Software and Service Transactions Subcommittee, chaired by Leianne Crittenden of Oracle and Professor Neil Cohen of Brooklyn Law School. Several in-person and Zoom meetings have been held to discuss numerous issues in addition to that covered by this article. 

Their discussions so far on whether a bundled contract would constitute chattel paper have focused upon the extent to which the contract contemplates use of equipment rather than software and services. The clearest example has been a cable TV box: most would agree that the cost of the box itself is a minor element of the monthly cable charges, and that the charges for access to 500+ cable channels are the greater element of the transaction. Accordingly, a typical cable TV contract would not constitute chattel paper. But the unresolved question remains: how substantial must the equipment element be, in order for the contract to constitute chattel paper? 

The current UCC provides no guidance as to this question. As Section 9-102(a)(11) currently is written, any equipment portion in a goods + software contract would result in the agreement constituting chattel paper. But that conclusion would run afoul of the analysis in the cable TV example above. The Subcommittee co-chairs have suggested that the goods aspect should “predominate,” in order for the contract to constitute “chattel paper” and have provided only two admittedly extreme examples (lease of a Tesla automobile, cable TV contract) to illustrate the meaning of “predominates.” 

Greater clarity is needed if the equipment finance marketplace is to take advantage of the benefits of chattel paper treatment. The Subcommittee wisely has shunned from advancing any quantitative test (51%? 40% versus 30% each for software and services?) lest parties to the bundled contract, and any third party purchaser or financier, be tempted to game the system. 

However, the Subcommittee co-chairs have posited, in their Tesla example, that “the value of the right to possess and use the automobile is significantly greater than the value” of the vehicle’s operating system and periodic software updates (emphasis added). The underlined phrase implies that even a 60/40 split (equipment versus software and services) might not be “significantly greater” than the non-equipment portion and hence inadequate for the agreement to qualify as chattel paper. Certainly, this test does not appear in the current UCC and if adopted by the Joint Committee could impede financing of bundled contracts. 

One alternative test would treat a bundled contract as chattel paper if the value of the goods (equipment) portion is a “material” element of the overall value of the contract. Another suggestion would rely upon whether the periodic payment for use of the goods is a “substantial factor” of the overall periodic payments. These approaches have at least two advantages: 1) they do not imply that the equipment must constitute a super-majority of the overall transaction; and 2) “material” and “substantial” are concepts with which equipment finance professionals are familiar. 

There may be other approaches. Or perhaps readers may prefer one of the three approaches described above. In any case, readers should voice their preference by contacting Chair Edwin Smith and Subcommittee Co-Chairs Crittenden and Cohen. Doing so will inform them at this critical point in time, before a drafting committee is appointed to pursue changes to the UCC in accordance with instructions of the Joint Committee.