THIS SUMMER, the American Law Institute (ALI) and the Uniform Laws Commission (ULC) (the “Sponsors”) completed their approval of the project on the Uniform Commercial Code and Emerging Technologies. This major revision of the UCC now goes to the state legislatures for enactment into law. This article will highlight the most significant changes for equipment finance practitioners.
Chattel Paper Expands. Perfecting a security interest is crucial to establish the transferee’s rights, whether in connection with a sale or a financing of leases and other equipment finance agreements. Under the existing UCC, the paper or the electronic versions of leases and equipment financings are considered to be a type of collateral referred to as “chattel paper.” The UCC permits a security interest in chattel paper to be perfected either by possession or filing a financing statement. Possession is the preferred method because the length and detail of financing statement attachments, and the weeks-long delays in obtaining complete search reports from the filing offices, coupled with the increased velocity of secured transactions involving leases and loans, have conspired to make file-and-search impractical for most situations. Plus, if the “security interest” of a chattel paper purchaser is perfected by possession (if paper) or control (if electronic), it will take priority over competing security interests perfected by filing.
In 2010, the UCC definition of chattel paper was expanded to include software, but the growth of bundled transactions (which could involve services and materials, as well as equipment and software) called out for updating this definition—and the Sponsors came through. The new definition (in UCC section 9-102(a)) simply requires that there be a “monetary obligation” either “secured by specific goods” or “owed by a lessee under a lease agreement of specific goods,” and in either case, evidenced by a record. That record may be tangible or electronic and can be a combination of both. A “hybrid lease” (discussed below) may also be considered “chattel paper” if its “predominant purpose” is to give the lessee “the right to possession and use of the goods.” Just as the goods aspect of a hybrid lease must predominate, the Official Comments to Section 9-102 make clear that “the fact that a secured party also has an interest in other property does not prevent the right to payment from being chattel paper, provided that the creditor relies on the specific goods as the primary collateral” (emphasis added).
Hybrid (“Bundled”) Leases. Recognizing that bundled or “hybrid” sales and leases have become increasingly more common for reasons including emerging technologies, the Sponsors amended both UCC 2 (sales) and UCC 2A (leases) so that they now cover these transactions. A “hybrid lease” is defined in UCC Section 2A-103 as a single transaction involving a lease of goods (the “lease-of-goods aspect”) plus any one or more of the provision of services, a sale of other goods or a license or other transfer of rights to property other than goods. The related Official Comment provides as an example: a lease of a copier, together with a sale of paper, staples and toner, with routine maintenance and repair services, all in return for periodic payments by the lessee.
As amended, UCC Section 2A-102 now provides that UCC 2A applies to both the lease aspects and the other aspects (e.g., services, consumables, software licenses, etc.) of a hybrid lease “if the lease-of-goods aspects…predominate.” Otherwise, only the provisions of UCC 2A “which relate primarily to the lease-of-goods aspects” will apply. In a major victory for the equipment finance industry, if the integrated lease is a UCC 2A “finance lease,” UCC Section 2A-407 (the statutory “hell or high water” rent obligations) will apply to the entire transaction if the lease-of-goods aspects predominate. But, even if they do not predominate, this statutory “hell or high water” protection will still apply to the lessee’s promise to pay rent as consideration for leasing the equipment. Official Comment 5 to Section 2A-102 observes that relevant factors in determining the predominant purpose of a hybrid lease include “the language of the agreement and the portion of the total price that is attributable to the lease of goods,” and helpfully adds that an “agreed-upon allocation [of the price to the possession and use of the goods] is ordinarily binding on the parties.”
To complement the hybrid lease concept, the definition of “Hybrid Transaction” was added to Section 2-106: “a single transaction involving a sale of goods and: (a) the provision of services; (b) a lease of other goods; or (C) a sale, lease, or license of property other than goods.”
Articles 2 and 2A both specify that a Hybrid Lease or Hybrid Transaction “means a single transaction” and their Official Comments make clear that if the goods aspect “is unrelated to the other aspects of the transaction,” and the terms of the single agreement relating to the goods are “readily severable” from the terms of the agreement relating to the other aspects of the transaction, then the document would not create a Hybrid Lease or Hybrid Transaction; i.e., a bundled transaction must truly be bundled!
Digital Assets. We have, for obvious reasons, focused on those amendments that will likely have an immediate and direct impact on equipment finance transactions. But that buries the lead. Significant changes to the model UCC are made very infrequently. The last time was in 2010, and before then in 1998. As was the case with each of those major amendment projects, existing and contemplated changes in the marketplace were the impetus for the new amendments. Ultimately, the ALI/ULC drafting committee determined that amendments were necessary, especially to address the gap in existing commercial law regarding digital assets.
To address that gap, the UCC amendments include a new Article 12 and changes to the other Articles to provide a uniform commercial law approach to transferring and collateralizing existing and future digital assets using new technologies, like blockchain and other distributed ledger technology (DLT) platforms. New Article 12 refers to these digital assets as “controllable electronic records” (CERs). Most of you are already familiar with CERs that have been assigned an economic value, like virtual currencies (e.g., Bitcoin, Ether, etc.) and nonfungible tokens (NFTs). But new Article 12 also covers CERs that have embedded payment rights exercisable by the owner. Any such “tethered” payment rights for goods or services, if meeting certain criteria, are referred to as “controllable accounts” or “controllable payment intangibles.” New Article 12 and related revisions to Article 9 provide “take-free” rights for “qualified purchasers,” the rights and duties of the account debtors (i.e., whether they must pay an assignee; and “negotiability” of the payment rights), and perfection and priority of security interests in these assets.
New Article 12 and the related amendments to the other Articles could ultimately have a meaningful impact on equipment finance transactions. Some examples include: payments by virtual currencies to vendors or other counterparties; full or collateral assignments of CERs with embedded payment rights (e.g., a CER evidencing the right to receive software license payments); NFTs representing collateral; and escrow arrangements managed on a DLT platform.
These UCC amendments will be a major boost for equipment finance—but only if they are enacted at the state level. Please consider volunteering to assist ELFA State Government Relations Director Scott Riehl ([email protected]) in contacting your state legislature when it next convenes in 2023.
For more on legal issues, don’t miss the session “Legal Updates Mean Business” at the 2022 ELFA Annual Convention. Learn more at www.elfaonline.org/ac.
