The issue of whether a lease is a true lease or merely a disguised security instrument comes up frequently in connection with bankruptcy filings by a lessee or as a defense to lease enforcement actions filed in state court. State law determines whether an agreement is characterized as a lease or a security agreement. While the revisions to the Uniform Commercial Code have eliminated reference to the intent of the parties as being determinative, the focus now is the underlying economics of the transaction.[i] The important point to keep in mind is that for it to be a lease, the transaction should grant the right of the lessee to use the equipment for a period shorter than its economic life and obligate the lessee to return the equipment while there is still remaining economic life in the equipment. Section 1.203[ii] of Texas Uniform Commercial Code (hereinafter the “U.C.C.”) entitled “Lease Distinguished from Security Interest” controls the determination of whether a transaction in the form of a lease, creates a lease or a security interest in Texas.[iii] Section 1.203(a) of the U.C.C. states that each transaction is determined by the facts of each case. Section 1.203(b) of the U.C.C. sets forth a two-part test to determine whether the transaction creates a lease or security interest.
The first part of the test requires that the rental payments the lessee must pay cannot be terminable by the lessee during the term of the lease. This requires the existence of a “hell or high water” clause.[iv] A “hell or high water” clause means that the lessee is obligated to pay regardless of whether the leased equipment works and regardless of the conduct of the lessor.[v] The second part of the test requires the existence of one of four possible factors, one of which must also exist for the lease to be deemed a security interest. The four factors are: (1) the original term of the lease is equal to or greater than the remaining economic life of the equipment; (2) the lessee is bound or obligated to renew the lease for the remaining economic life of the equipment or is obligated to become the owner of the equipment; (3) the lessee has the option to renew the lease for the remaining economic life for no additional consideration or nominal consideration upon compliance with the lease agreement; or (4) the lessee has the option to become the owner of the equipment for no additional consideration or nominal consideration upon compliance with the lease agreement.[vi] These four factors are commonly referred to as the “residual value factors.”[vii]
Section 1.203 (c) of the U.C.C. also sets out factors that do not create a security interest just because they exist. These factors are: (1) the present value of the lessee’s consideration is substantially equal to or greater than the FMV of the equipment at the time the lease is entered into; (2) the risk of loss is assumed by lessee; (3) lessee agrees to pay taxes, insurance, filing and recording fees or maintenance costs on the equipment; (4) lessee has an option to purchase or renew the lease; (5) lessee has an option to renew the lease for a fixed rental equal to or greater than the reasonably predictable fair market rent; or (6) lessee has an option to become owner of the equipment for a fixed price equal to or greater than the reasonably predictable FMV of the goods. In addition to being addressed by Section 1.203(c) of the U.C.C., the fact that a lessee pays certain costs and fees has also been held to be typical of true leases, not secured transactions because it is a recognition by courts of the relative bargaining power between the parties and the fact that a lessor will include those costs within the rental charge or agree to lower the rental payment.[viii]
For leases which satisfy the two-part test under Section 1.203(b), the inquiry comes to an end-such leases constitute security interests as a matter of law.[ix] If the two-part bright-line test is not satisfied, a court may examine additional facts, recognized by statute, to determine whether the economic realities of the transaction create a security interest.[x] One of those factors is whether the lessee has any equity interest in the equipment. Courts have held that if a lessee does not have an equity interest in the equipment, the lease may be a true lease and not a security interest.[xi]
Courts (and lawyers) continue to struggle with the issue of whether a transaction creates a lease or a security instrument in Texas. Hopefully, the information provided in this blog entry will be useful in your next appearance. The opinions are those of the author and not those of the Bickerstaff Heath Law firm. Comments, replies and suggestions can be sent to me at JJONES@bickerstaff.com. Happy New Year from my family to you and yours!
[i] 4 ECKLICN 16:21, citing, Nimmer, “U.C.C. Article 2A: The New Face of Leasing?, 3 DePaul Bus. & Com. L.J. 559, 565 (2005).
[ii] By enacting Section 1.203, Texas adopted the official version of Uniform Commercial Code Section 1-201(37) and therefore, Texas courts will look to other jurisdictions to interpret the uniform statute. Excel Auto and Truck Leasing LLP v. Alief Independent School District, 249 S.W.3d 46, 63 (Tex. App.-Houston [1st Dist.] 2007, pet. denied), citing, Franklin Nat’l Bank v. Boser, 972 S.W.2d 98, 103 (Tex. App.-Texarkana 1998, pet. denied).
[iii] Excel Auto and Truck Leasing LLP v. Alief Independent School District, 249 S.W.3d 46, 63 (Tex. App.-Houston [1st Dist.] 2007, pet. denied) (denying defense of non-ownership and finding leases were true leases and taxes due by lessor).
[iv] In re Triplex Marine Maint., Inc. 258 B.R. 659, 669 (Bankr. E.D. Tex. 2000).
[v] Id. at n. 20.
[vi] Tex. Bus. & Comm. Code Ann § 1.203(b) 1-4.
[vii] 4 ECKLICN § 16:21 (2012)
[viii] Excel Auto and Truck Leasing LLP v. Alief Independent School District, 249 S.W.3d 46, 63 (Tex. App.-Houston [1st Dist.] 2007, pet. denied), citing, Rainier Nat’l Bank v. Inland Mach. Co., 29 Wash. App. 725, 631 P.2d 389, 395 (1981).
[ix] In re Triplex Marine Maint. Inc., 258 B.R. at 668-669.
[xi] Excel Auto and Truck Leasing LLP v. Alief Independent School District, 249 S.W.3d 46, 63 (Tex. App.-Houston [1st Dist.] 2007, pet. denied), citing, Touch of Class Leasing v. Mercedes-Benz Credit of Canada, Inc., 248 N.J.Super. 426, 591 A.2d 661, 656-66 (1991).