Two “Lease Agreements,” both alike in terminology
But a lease is not always a lease under the UCC.
Act 1: All That Glitters Is Not Gold
A commercial equipment lease is generally defined as an arrangement between a lessor and a lessee in which the lessor transfers possession and use of the property to the lessee in exchange for periodic lease payments. Yet, this general definition is amiss in many instances, as the classification of an alleged lease varies based on the underlying principles being applied to the transaction. As a result, it is vital for equipment leasing professionals to understand how a lease is defined in different contexts. Indeed, when considering whether a supposed lease is in fact a lease, it is important to first establish from which perspective the transaction is viewed. These viewpoints include the Uniform Commercial Code (UCC) definitions, federal tax considerations and accounting treatment.
This article focuses its attention on the definition of a lease under the UCC. Nevertheless, even if a transaction is a lease for legal purposes, it does not necessarily mean that such transaction is also a lease for federal tax or accounting purposes. Instead, one must analyze the respective Internal Revenue Service (IRS) and Generally Accepted Accounting Principles (GAAP) rules in each instance. While there is a significant overlap, each involves its own specific parameters and interpretation.
Federal Tax Perspective
• Rule. IRS Rule 55-540
• Purpose. Determines whether lessor or lessee obtain the tax benefits.
• Rule. GAAP ASC 842
• Purpose. Determines how to represent the contract on financial statements for lessee and lessor.
• Rule. UCC Articles 2A and 9
• Purpose. Determines ownership, whether a UCC-1 is necessary, bankruptcy treatment and available lessor remedies.
Act 2: What’s In a Name?
Simply because a contract is titled “Lease Agreement”
does not make it a lease. Instead, to determine if a so-called lease is a lease as a matter of law, one must look to the UCC and state law. UCC Article 2A, which governs leases of goods, provides for a definition of a lease in § 2A-103. But the more important definition is found in UCC § 1-203, in which a lease is differentiated from a security interest. In brief, § 1-203 (i.e., the “Bright-Line Test”) provides that a transaction always creates a security interest (and not a lease) if the lessee cannot terminate the lease, and (i) the lease term equals or exceeds the equipment’s economic life, or (ii) at the end of the lease, the lessee is required to buy the equipment or has the option to buy it for a nominal amount or automatically owns the equipment; or (iii) at the end of the lease, the lessee is required to renew the lease or has the option to renew it for a nominal amount, if the renewal will cause the lease term to equal or exceed the equipment’s economic life.
However, the Bright-Line Test is not the end of the analysis; there’s still the “play within the play” to consider. Specifically, many courts, including bankruptcy courts, examine the substance of the transaction and the specific facts of the case to determine if an alleged lease is, in fact, a disguised secured transaction. The court must determine whether the only economically sensible action for the lessee is to exercise the option to purchase the property. If the answer is “yes,” then the conclusion under this test would be that the lease is, in fact, a disguised security agreement. This is referred to as the “Economic Realities Test.” If a purported lease is a secured transaction—either under the Bright-Line or Economic Realities Test—such transaction is governed by UCC Article 9, and generally treated as a loan under state law.
Act 3: Wherefore Does It Matter?
Whether a commercial transaction is a lease, or a lease intended as security, is a frequently contested issue. If a transaction is a lease, the lessor is the equipment owner, and they have the right to repossess the equipment if the lessee defaults under the lease. By contrast, if a lease is a secured transaction, the “lessee” is the equipment owner. In that instance, other “lessee” creditors may have the right to repossess the equipment to satisfy the lessee’s unpaid debts. In situations where there is any doubt whether a purported lease is truly a lease, “lessors” should take measures to protect their interests in the equipment pursuant to Article 9. Most importantly, the “lessor” should attach and perfect its security interest in the equipment, which is often accomplished by filing a UCC-1 financing statement.
"Simply because a contract is titled “Lease Agreement” does not make it a lease."
Variability of Specific Laws.
Equipment leasing professionals must also consider the applicability of certain state and federal laws that vary based on the classification of the transaction. For example, if a contract is a lease, state usury laws likely do not apply in most states, as there is no interest being charged. In contrast, if a contract is a disguised secured transaction, payments may be subject to state usury limitations. Furthermore, the recent New York and California enhanced disclosure laws exempt leases, but not disguised secured transactions. Similarly, §1071 of the Dodd-Frank Act requires financial institutions to collect data on small business loans, which includes leases intended as security, but not true leases subject to UCC Article 2A.
Differences in Bankruptcy.
Another important distinction arises in bankruptcy. If a contract is a lease, a lessor has better rights to recover equipment in the event of a lessee default because the lessee must cure defaults to keep the lease in place. Conversely, if a contract is a secured transaction, a “lessee” may force a “cramdown,” in which the reorganization plan will limit the “lessor’s” recovery to the fair market value of the equipment (and not the agreed upon loan repayment). Also, if the “lessor” did not perfect their security interest in the equipment, the “lessor” is an unsecured creditor, thereby greatly reducing their ability to recover from the “lessee.”
Notable Contract Variances.
A lease intended as security shares numerous terms and conditions with a lease. However, there are some crucial differences to consider. For instance, for disguised secured transactions, the “lessor” should review its contract documentation for any improper end-of-term provisions, such as automatic renewals. Furthermore, if interim “rent” is collected on a lease intended as security, the “lessor” should consider how the implicit interest rate is affected over the term. Another notable difference is the UCC contract language. For a lease, a lessor does not need to have a security interest in the equipment or the ability to file a UCC-1, although security interest grants and precautionary filings are quite common and recommended. For a security agreement, a “lessor” needs the “lessee” to grant a security interest in the equipment and/or authorize the filing of a UCC-1.
The Denouement: Parting is Such Sweet Sorrow
As we now must part ways, we wish to leave you with a couple of important suggestions:
- Friends, ELFA members, equipment leasing professionals, lend me your ears. Providing sufficient and regular training to employees and clients to understand the critical differences between a lease and a lease intended as security cannot be underestimated.
- Modest doubt is called the beacon of the wise. As noted, Article 9 does not apply to leases. However, determining whether an agreement titled “Lease Agreement” is truly a lease under the UCC is often unclear, at best. When in doubt (which should be often), a lessor should include a (precautionary) grant of a security interest in their lease, file a (precautionary) UCC-1, and take into consideration potentially applicable laws if the lease may be deemed a secured transaction.