Commercial Law Treatment of Synthetic Leases

Commercial Law Treatment of Synthetic Leases By Arnold G. Gough Jr. and Michael G. Robinson Synthetic leases raise certain commercial law and bankruptcy issues. This is the second installment of a two-part article on synthetic leasing. The first installment, printed in the Fall 1994 Journal of Equipment Lease Financing (Vol. 12, No. 2), focused on the tax and accounting issues involved in synthetic leases. To briefly summarize, the primary objective of the synthetic lease is to allow the Synthetic Lessee to have the transaction characterized as an operating lease for financial accounting purposes, but as a loan for federal income tax purposes. The first installment of this article described a hypothetical situation assuming a single lender (the Single Investor ) with the following facts: Printing Corp. needs new printing presses that will cost $50 million. The presses will be treated as seven-year property, are expected to retain most of their value (80 percent including inflation) for seven years and a significant portion of their value (50 percent including inflation) for at least 15 years and have an economic useful life of 20 years. In our Single Investor model, the synthetic lease was achieved by having the Synthetic Lessor purchase the presses from Printing Corp. for $50 million and lease them back to Printing Corp. The term of the synthetic lease was seven years, and the scheduled amortization thereof would reduce the outstanding principal balance by the end of the seven-year term to $40 million (80 percent of the original balance). At the end of the term, Printing Corp. had the option of purchasing the presses for $40 million (the then-unamortized principal balance). If Printing Corp. did not exercise its end-of-term purchase option, it would nonetheless retain most of the residual risk by being required to arrange a sale of the presses. Net proceeds of the sale are required to be paid to Synthetic Lessor up to $40 million. Any excess proceeds are for the account of Printing Corp. If the net proceeds do not equal or exceed $40 million, Printing Corp. will be required to make a contingent rent payment to Synthetic Lessor. This contingent rent payment is subject to a maximum constraint such that the present value of such amount and all rents payable over the term do not exceed 89.9 percent of the original purchase price of the presses. Depending on the interest rate that Printing Corp. s accountants permit it to use in making such calculations, Synthetic Lessor will have to take some residual risk, but the amount of risk would be limited to an amount the present value of which equals 10.1 percent of the equipment s original cost. As noted in the Single Investor example, Synthetic Lessor should feel somewhat comfortable in this situation, because the anticipated fair market value of such equipment at the end of year seven is 80 percent of the original cost. If successfully structured, the synthetic lease can achieve the following consequences: off balance sheet financing for the lessee tax benefits retained by the lessee de minimus residual risk on the lessor lessee retains a residual upside and ability to repurchase without a premium lower rents This article discusses certain commercial law and bankruptcy issues raised by synthetic leases. 28

I n addition to the tax and accounting distinctions for synthetic lease transactions, another important area of inquiry is how will the transaction be characterized for purposes of commercial law? The following is not intended as a comprehensive discussion of all the issues raised in the commercial law analysis of the true lease issue; rather it is an outline of some of the major commercial law considerations that should be addressed in connection with a synthetic lease. 1 For commercial law purposes a synthetic lease could be characterized as a lease or as a lease intended as security (in other words a secured loan). This distinction is important because it raises such fundamental questions as whether the transaction will be governed by Article 2A of the UCC applicable to leases or Article 9 of the UCC applicable to secured transactions and whether the lessor will be treated as the owner of goods or a creditor with a security interest in such goods. TRUE LEASE OR SECURED LOAN - APPLICABLE COMMERCIAL LAW Section 2A of the UCC is generally only applicable to lease transactions involving goods (see U.C.C. 2A-103 (1993)). 2 Under Article 2A of the UCC a lease is defined 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. Unless the context clearly indicates otherwise, the term includes a sublease. Article 2A does not cover transactions that create or are intended to create security interests. Secured transactions are governed by Article 9 of the UCC. To distinguish between a lease subject to Article 2A of the UCC and a secured transaction subject to Article 9 of the UCC, the courts generally rely on the definition of security interest in Section 1-201(37) of the UCC. Under Section 1-201(37), whether a transaction creates a lease or a security interest is determined by the facts of each case; however, a transaction will be characterized as creating a security interest if (a) the original term of the lease equals or exceeds the remaining economic life of the goods, (b) the lessee must renew for a term equal to or in excess of the remaining economic life of the goods or the lessee is bound to become the owner of the goods, (c) the lessee has bargain renewals for the remaining economic life of the goods, or (d) the lessee has a bargain or nominal purchase option for the goods. When one or more of these four factors exists, a transaction is deemed to be a lease intended as security and not a true lease. The underlying rationale is that if one or more of these factors exists the lessee and not the lessor has the economic residual risk and the transaction is really a disguised loan. However, the absence of these four factors does not necessarily mean a true lease exists. Conversely, a transaction will not necessarily create a security interest merely because it entails (a) a full payout lease (i.e., the present value of the rentals equals or exceeds the original fair market value of the leased goods), (b) triple net lease provisions, (c) renewal and purchase options, (d) a fixed price renewal option (so long as the fixed renewal rent is equal to or greater than expected fair market value rentals at the time of renewal), or (e) a fixed price purchase option (so long as the fixed purchase price is equal to or greater than expected fair market value at the time of purchase. (See U.C.C. 1-201(37).) One would expect the restrictions of Statement of Financial Accounting Standards No. 13 (SFAS 13, discussed in part 1 of this article in the Fall 1994 issue) to cause the characterization of a synthetic lease transaction to fall within the definition of a true lease because (a) there is no automatic transfer of ownership of the leased property, (b) the lease does not contain a bargain purchase option, (c) the term must be less than 75 percent of the estimated economic life of the leased property, and (e) the present value of the rentals and other minimum lease payments is less than 90 percent of the fair market value of the leased property. Even though these tests are met the most critical test applied by the courts in determining whether a transaction involves a true lease or a lease intended as security is whether or not the lessor has real (as opposed to nominal) residual exposure. Though some courts have attempted to apply bright line percentages to determine whether the lessor has a meaningful residual (e.g., 15 percent or 10 percent residual risk) 3 there have been some conflicting decisions and the better view is that the determination of whether or not the lessor has meaningful residual exposure must be made on a case by case basis in light of the economic and legal facts of each such case. On its face, a synthetic lease would appear to meet the meaningful residual criteria. As described in the Single Investor Example (see For commercial law purposes a synthetic lease could be characterized as a lease or as a lease intended as security. JOURNAL OF EQUIPMENT LEASE FINANCING 29

if a transaction is subject to Article 9, the lessor must perfect its security interest in the leased goods, which now should be thought of as collateral. part 1), the lease term, rent, and buyout restrictions of SFAS 13 would appear to impose real residual risk upon the lessor. However, in our Single Investor Example the requirement that Printing Corp. arrange for the sale of the presses and make a contingent rent payment equal to the shortfall below $40 million passes a significant portion of the residual risk to Printing Corp. Potential residual upside is also passed to Printing Corp. because in our example Printing Corp. is paid proceeds in excess of $40 million. For this reason synthetic leases in which the lessor does not retain meaningful residual risk will be characterized for purposes of commercial law as a lease intended as security. The above described sale requirement is analogous to termination rent adjustment clauses typically found in vehicle TRAC leases. TRAC leases have been held to be leases intended as security in many though not all instances. 4 The consequences of the distinction between true lease and lease intended as security for commercial law purposes affects many of the fundamental rights of the respective parties, including controlling law, perfection and priority of security interests, remedies, implied warranties and bankruptcy treatment, each of which is briefly discussed below. CONTROLLING LAW - ARTICLE 2A VS. ARTICLE 9 If a synthetic lease is deemed to be a lease it will be subject to Article 2A of the UCC. If a synthetic lease is deemed to be a secured loan, the transaction will be subject to Article 9 of the UCC. The distinctions between Article 2A and Article 9 are many and include such issues as the scope of remedies and warranties and the applicability of usury laws (not applicable to leases) and consumer protection restrictions (for consumer leases). Most importantly though, if a transaction is subject to Article 9, the lessor must perfect its security interest in the leased goods, which now should be thought of as collateral. Otherwise, the lessor will have an unperfected security interest in the goods, not a desirable position. Though perfection is an essential step, in practice there is little chance that a well-advised lessor in a synthetic lease transaction would not be fully perfected because the well-advised lessor will always file precautionary financing statements under Section 9-408 of the UCC. Under Section 9-408 of Article 9 a lessor that files a precautionary statement will have all the protection that a secured party has by filing under Article 9. In the event the synthetic lease is characterized as a lease intended as security, the lessor will have a perfected security interest in the leased property to the same extent as if such filing were made in connection with a secured loan. Of course, if there are competing creditors a lessor would, if possible, try to characterize the transaction as a true lease because the owner of goods will have priority over some of those creditors who may be able to prime the security interest of even a perfected secured party. APPLICABLE REMEDIES The statutory limits on a lessor s remedies in a security lease are one of the most important differences between security leases and true leases. When a transaction is deemed to create a security interest, the lessor s remedies will be limited by Article 9. Upon a default the Article 9 lessor will, among other things, be required to give reasonable notice of any disposition of the goods and will be required to sell the collateral in a commercially reasonable manner and turn over the excess proceeds to the lessee/debtor. (See U.C.C. 9-504.) Under Article 2A the lessor has much greater leeway to fashion applicable remedies by contract. Lessor s remedies are generally cumulative and lessor is entitled to put itself in as good a position as if lessee had fully performed the lease. (See U.C.C. 2A-523, Official Comment.) Lessor will be entitled to terminate the lease and recover its asset and, subject to commercially reasonable standards of mitigation, recover discounted accelerated rent payments and/or some reasonable measure of liquidated damages. (See U.C.C. 2A- 501, 2A-504, 2A-505, 2A-523, 2A-525.) The ability of a lessor in a true lease to recover liquidated damages is a significant benefit. Liquidated damages under Article 2A may include indemnity for loss or diminution of anticipated tax benefits or damage to lessor s residual interest but must be reasonable in light of the then anticipated harm. (See U.C.C. 2A-504(l).) The official comment to Section 2A-504 notes that stipulated loss or stipulated damage schedules are also com- 30

mon. Whether these formulas are enforceable will be determined in the context of each case by applying a standard of reasonableness in light of harm anticipated when the formula is agreed to. (See U.C.C. 2A-504, Official Comment.) IMPLIED WARRANTIES Many courts have applied some or all of UCC Article 2 seller s warranties to the lessor in a true lease or a security lease. However, this is most common in cases where the lessor is a manufacturer, vendor, or supplier of the goods. This will most likely not happen in a synthetic lease, even if characterized as a true lease, for two reasons. First, the synthetic lease will in most instances be a finance lease (see U.C.C. 2A-103(g)), which basically means (1) the lessor is an independent financing party that does not manufacture, select or supply the goods, (2) lessor acquires the goods in connection with the lease and (3) if lessor acquires the goods through a purchase contract directly between the lessor and the supplier, the lessee receives a copy or approves the purchase contract prior to the effectiveness of the lease. The courts will not typically impose any implied warranties on a lessor in a finance lease (in other words a party to the transaction that merely provides financing). The second reason that the synthetic lessor will not have seller s warranties imposed on it is that the well drafted synthetic lease will contain in BOLDFACE TYPE a full and complete disclaimer of warranties that will state, among other things, that the lessee selected the goods, approves the goods, takes the goods as is-where is, and without any warranty of merchantability or fitness for a particular purpose, express or implied. BANKRUPTCY ISSUES A lessor of goods under a true lease and a lessor of goods under a security lease are subject to very different treatment under the Bankruptcy Code. Because the Bankruptcy Code does not define a true lease, the commercial law analysis outlined above will be used to make such characterization in bankruptcy. The following are a few of the bankruptcy considerations relevant to such characterization. In bankruptcy a lessor under a true lease will be treated as the owner of the goods subject to lease and, if the lease is unexpired, the trustee or debtor-in-possession ( debtor ) has the right, pursuant to Section 365 of the Bankruptcy Code, to assume, assign, or reject the lease. If the lease is assumed, the debtor generally may assign its lease rights notwithstanding a prohibition against assignment contained in the lease if adequate assurance of future performance is provided. (See 11 U.S.C. 365.) If the lease is rejected, the lessor s claim for damages will be a pre-petition unsecured claim, provided, with respect to personal property leases, that the debtor complies with its ongoing payment obligations commencing 60 days after the bankruptcy filing and continuing until the lease is rejected. Such obligations will be treated as an administrative expense. Prior to rejection, the lessor s interest may also be entitled to adequate protection, although provision of adequate protection will waive any rights of the lessor to terminate the automatic stay. (See 11 U.S.C. 363(e).) Rejection damages will be subject to mitigation to the same extent as a lease termination under state law. To assume the lease under Section 365, the lessee generally must cure all defaults (including payment of all unpaid rentals), and subsequent accruals of post-petition rent will be treated as an administrative expense. In a chapter 11 case, the debtor s decision to assume or reject a lease of goods may be delayed until plan confirmation. 5 As outlined above, if a synthetic lease is characterized as a lease intended as security, the debtor lessee is treated as the owner of the leased goods. If the lessor has not perfected its security interest (i.e., filed a precautionary financing statement under Section 9-408 of the UCC or otherwise perfected its security interest), the lessor is an unsecured pre-petition creditor in the bankruptcy case. If the interest of the lessor in a security lease is perfected, the lessor will be treated as a secured pre-petition creditor with a security interest in the goods subject to the synthetic lease ( secured lessor ). The debtor generally will be permitted to retain possession of the goods, provided that the lien interest is adequately protected either by an equity cushion or by the methods prescribed by Section 361 of the Bankruptcy Code. (See 11 U.S.C. 361 and 362(d).) Adequate protection may consist of cash payments or replacement collateral, depending In bankruptcy a lessor under a true lease will be treated as the owner of the goods subject to lease. JOURNAL OF EQUIPMENT LEASE FINANCING 31

The debtor may be able to assess the collateral for expenses incurred in preserving the property. on the circumstances. If the secured lessor is oversecured, it may be entitled to post-petition interest. (See 11 U.S.C. 506(b).) On the other hand, the debtor may be able to assess the collateral for expenses incurred in preserving the property. (See 11 U.S.C. 506(c).) Upon sale or foreclosure of the leased goods, any proceeds in excess of the amount of lessor s claim will be returned to the debtor. 6 Arnold G. Gough Jr. and Michael G. Robinson are partners at Winston & Strawn s Chicago office, with a practice focusing on tax advantaged financings, including equipment and real estate leveraged and synthetic leasing and project finance transactions. This article is based on an outline prepared with the assistance of John C. Lorentzen, Terrence R. Brady and Thomas F. Blakemore for a presentation by Michael Robinson to the Equipment Leasing Association s 1994 Legal Forum. Endnotes 1 See generally, Jeffrey J. Wong and Robert D. Strauss, Commercial Law Aspects of Equipment Leasing, Equipment Leasing 1993 (Practising Law Institute, 1993); Jeffrey J. Wong, Article 2A (Lease) of Uniform Commercial Code: Selected Issues and Recommended Documentary and Procedural Changes for the Equipment Lessor, Equipment Leasing 1993 (Practising Law Institute, 1993). See also, Amelia H. Boss, True Lease or Secured Transaction: The New Definition of U.C.C. Section 1-201(37), 44 Consumer Finance Law Quarterly Rep. 3 (1990). 2 This portion of the paper will deal only with transactions covering goods. Real estate transactions are not covered by the UCC and involve an analysis of real property law on a state-by-state basis. 3 See Wong and Strauss, supra, note 1 at p. 24 citing Midatlantic Commercial Leasing Corp. v. Architectural Shapes Inc. and Kerry Dale, No. 89-0399, 1990 WL 42257 (E.D. Pa. Apr. 10, 1990), and Royal Food Markets v. Royal Food Machines Inc., 121 B.R. 913 (Bankr. S.D. Fla. 1990). 4 See Wong and Strauss, supra, note 1 at p. 24 citing, e.g., In re Tulsa Port Warehouse Co., 690 F.2d 809 (11th Cir. 1982), In re Zerkle Trucking Co., 132 B.R. 316 (Bankr. S.D. W.VA. 1991), In re Otasco, 111 B.R. 976 (Bankr. N.D. Okla. 1991), but cf. In re Cole, 114 B.R. 278 (N.D. Okla. 1990). 5 For a detailed discussion of these issues, see Gerald F. Munitz, Executory Contracts and Unexpired Leases Under the Bankruptcy Code, in Bankruptcy Litigation Manual, chapter 6 (1993-94 ed.). 6 For a detailed discussion of adequate protection issues in bankruptcy, see Gerald F. Munitz and Karen M. Gebbia, Adequate Protection, the Automatic Stay, and the Use, Sale or Lease of Property, in Basics of Bankruptcy and Reorganization, Practising Law Institute, 1993. 32