bankruptcy lease
Example of True Lease v. Lease intended as Security
<p>In Chapter 11, in the case of True Lease, lessee can assume the lease and continue to make payments or reject the lease and return the asset.</p>

<p>In the case of Lease intended as security, lease is re-characterized as secured credit and asset is subject to automatic stay, which prohibits recovery of or foreclosure on collateral.</p>

<p>What are the examples of True Lease and Lease intended as security, specifically related to the bankruptcy situations? Equipment or trucks? Real estate?</p>

<p>The kind of property leased isn't relevant. Any kind of real or personal property could have either kind of lease.</p>

<p>A lease intended as security will allocate few, if any, obligations (e.g. repair and maintenance, control, insurance, risk of loss) to the lesssor-lender, and will have a term such that the price to purchase the remainder interest in the property at the end of the lease term is minimal. While no one fact is dispositive and each case has to be resolved individually, the amount of the remainder interest and the likelihood that the tenant will eventually own the property or will use it for its entire economic life is the most important factor.</p>

<p>One of the main sources of law for distinguishing between the two is section 203 of Article 1 of the Uniform Commercial Code which states:</p>

<blockquote>
  <p>§ 1-203. Lease Distinguished from Security Interest.</p>
  
  <p>(a) Whether a transaction in the form of a lease creates a lease or
  security interest is determined by the facts of each case.</p>
  
  <p>(b) A transaction in the form of a lease creates a security interest
  if the consideration that the lessee is to pay the lessor for the
  right to possession and use of the goods is an obligation for the term
  of the lease and is not subject to termination by the lessee, and: (1)
  the original term of the lease is equal to or greater than the
  remaining economic life of the goods; (2) the lessee is bound to renew
  the lease for the remaining economic life of the goods or is bound to
  become the owner of the goods; (3) the lessee has an option to renew
  the lease for the remaining economic life of the goods for no
  additional consideration or for nominal additional consideration upon
  compliance with the lease agreement; or (4) the lessee has an option
  to become the owner of the goods for no additional consideration or
  for nominal additional consideration upon compliance with the lease
  agreement.</p>
  
  <p>(c) A transaction in the form of a lease does not create a security
  interest merely because: (1) the present value of the consideration
  the lessee is obligated to pay the lessor for the right to possession
  and use of the goods is substantially equal to or is greater than the
  fair market value of the goods at the time the lease is entered into;
  (2) the lessee assumes risk of loss of the goods; (3) the lessee
  agrees to pay, with respect to the goods, taxes, insurance, filing,
  recording, or registration fees, or service or maintenance costs; (4)
  the lessee has an option to renew the lease or to become the owner of
  the goods; (5) the lessee has an option to renew the lease for a fixed
  rent that is equal to or greater than the reasonably predictable fair
  market rent for the use of the goods for the term of the renewal at
  the time the option is to be performed; or (6) the lessee has an
  option to become the owner of the goods for a fixed price that is
  equal to or greater than the reasonably predictable fair market value
  of the goods at the time the option is to be performed.</p>
  
  <p>(d) Additional consideration is nominal if it is less than the
  lessee's reasonably predictable cost of performing under the lease
  agreement if the option is not exercised. Additional consideration is
  not nominal if: (1) when the option to renew the lease is granted to
  the lessee, the rent is stated to be the fair market rent for the use
  of the goods for the term of the renewal determined at the time the
  option is to be performed; or (2) when the option to become the owner
  of the goods is granted to the lessee, the price is stated to be the
  fair market value of the goods determined at the time the option is to
  be performed.</p>
  
  <p>(e) The "remaining economic life of the goods" and "reasonably
  predictable" fair market rent, fair market value, or cost of
  performing under the lease agreement must be determined with reference
  to the facts and circumstances at the time the transaction is entered
  into.</p>
</blockquote>

<p>A <a href="https://www.jonesday.com/en/insights/2006/02/when-is-a-lease-not-a-lease-seventh-circuit-adopts-substance-over-form-test-for-true-lease-determination" rel="nofollow noreferrer">recap of a case from 2006</a> in the United States Court of Appeals for the 7th Circuit based in Chicago, involving United Airlines, provides a detailed example. It is summarized as follows:</p>

<blockquote>
  <p>Prior to filing for chapter 11 protection in 2002, United Airlines
  entered into a series of transactions to fund the improvement of its
  facilities at four airports.  One such lease arrangement involved
  public financing underwritten by the California Statewide Community
  Development Authority (the “Authority”).  United has been the lessee
  since 1973 of a 128-acre maintenance base at San Francisco
  International Airport ("SFO").  The lease expires in 2013 unless the
  parties negotiate an extension.  Rent depends on an independent
  party's estimate of the property's market value.</p>
  
  <p>In 1997, the Authority issued $155 million in bonds to finance
  improvements to United's SFO facilities (other than the maintenance
  base).  The bonds are without recourse to the Authority and are
  guaranteed by United.  United subleases 20 acres of the 128-acre
  maintenance base to the Authority for 36 years  — the term matches the
  bond repayment schedule rather than United's lease with SFO.  The
  Authority paid $1 to sublet the premises.</p>
  
  <p>The Authority leases the 20 acres back to United for rent equal to
  interest on the bonds plus an administrative fee. This lease has a
  $155 million balloon payment in 2033 to retire the principal. United
  may postpone final payment until 2038; if it does, the sublease also
  is extended. United is  entitled to prepay, in which case the sublease
  and leaseback terminate. If United does not pay as agreed, the
  Authority can evict it from the 20 acres. The leaseback includes a
  “hell or high water” clause requiring United to pay the rent even if
  its lease from the SFO ends before 2033, the property is flooded, or
  some other physical or legal event deprives United of the use or
  economic benefit of the maintenance base.</p>
  
  <p>After filing for chapter 11, United took the position that none of the
  arrangements at the four airports in question is a “lease” for
  purposes of section 365 of the Bankruptcy Code.  Instead, United
  sought a declaratory judgment that each transaction involves secured
  financing and that United should have the right to continue using the
  airport facilities while paying only a portion of the promised “rent.”
  The bankruptcy court ruled that the arrangement at one of the airports
  is a true lease, but that the other three transactions (including the
  SFO arrangement) are not.  The district court reversed those rulings
  in part on appeal, holding that all four transactions involved true
  leases rather than secured financings.  United appealed to the Seventh
  Circuit.</p>
  
  <p><em>The Seventh Circuit's Ruling</em></p>
  
  <p>The Seventh Circuit joined all the other circuit courts of appeal that
  have considered this issue, ruling that substance rules over form and
  that only a “true lease” qualifies as a “lease” under section 365 of
  the Bankruptcy Code.  In reaching this conclusion, the Court of
  Appeals considered the practical meaning of the Bankruptcy Code, the
  Uniform Commercial Code (the “UCC”) and the historical context of the
  Bankruptcy Code’s enactment, including the statute's legislative
  history.</p>
  
  <p>According to the Seventh Circuit, it “is unlikely that the
  [Bankruptcy] Code makes big economic effects turn on the parties’
  choice of language rather than the substance of their transaction,”
  because to do so would allow the drafters of contracts to obliterate
  the distinction between the two types of transactions through creative
  drafting.  This is consistent with the UCC, which, unlike the
  Bankruptcy Code, contains a detailed description of the distinction
  between a lease and a security interest, emphasizing that "[w]hether a
  transaction creates a lease or a security interest is determined by
  the facts of each case."</p>
  
  <p>The Court of Appeals went on to explain that a lease in which "current
  consumption" (i.e., lease payments at market rates for continued use
  of an asset) dominates is often called a “true lease,” while one in
  which the asset serves as security for an extension of credit is
  treated as a security agreement governed by the UCC.  Finally, the
  Court of Appeals observed, the legal community of the 1970s understood
  that the distinction between leases and security agreements was based
  on substance rather than form, and looked to the relevant legislative
  history from the adoption of the Bankruptcy Code, which explains, in
  relevant part:</p>
  
  <p>Whether a "lease" is [a] true or bona fide lease or, in the
  alternative, a financing "lease" or a lease intended as security,
  depends upon the circumstances of each case.  The distinction between
  a true lease and a financing transaction is based upon the economic
  substance of the transaction and not, for example, upon the locus of
  title, the form of the transaction or the fact that the transaction is
  denominated as a "lease."</p>
  
  <p>Thus, the Seventh Circuit concluded that substance, rather than form,
  should be considered in determining whether a transaction is a “true
  lease” or a disguised secured financing for purposes of section 365 of
  the Bankruptcy Code.</p>
  
  <p>The Court of Appeals then examined which law should apply to divine
  the true nature of any given transaction.  Explaining that "nothing in
  the Bankruptcy Code says which economic features of a transaction have
  what consequences," the Seventh Circuit concluded that state law is
  determinative on this issue — in this case California law. 
  California, the Court of Appeals observed, has adopted a functional
  approach to the question in both the UCC and the common law governing
  real property transactions.  It went on to discuss California court
  rulings examining various features of lease and financing
  transactions.</p>
  
  <p>The Seventh Circuit ultimately determined that the transaction between
  United and the Authority was not a “true lease” under California law
  for the following reasons:  (i) the “rent” was not measured by the
  market value of the property; (ii) at the conclusion of the lease, the
  Authority had no residual interest; (iii) the balloon payment had no
  counterpart in a true lease, but was a common feature of a secured
  financing; and  (iv) upon prepayment, the lease and sublease
  terminated immediately, whereas in a true lease, prepayment secures
  the tenant’s right to use the property for the term of the tenancy. 
  Based upon this conclusion, the Court of Appeals reversed the district
  court's decision and remanded the case for further proceedings.</p>
</blockquote>

<p><strong>Footnote</strong></p>

<p>The question, in setup discussion not directly relevant to the answer states that the security interest v. lease distinction is important because if it is a security interest, rather than a lease:</p>

<blockquote>
  <p>[the] asset is subject to automatic stay, which prohibits recovery of
  or foreclosure on collateral.</p>
</blockquote>

<p>This is actually true of both security interests and leases. </p>

<p>The main distinction between a security interest and a lease is that debt secured by collateral may be "crammed down" (i.e. partially discharged) so that only the amount of debt equal to the value of the collateral remains in force. In contrast, if an agreement is a true lease, the debtor must either accept it and fully comply with the lease, or reject it entirely. A debtor may not "cram down" a true lease in the way that a debtor could a secured debt payable in installments, without the express consent of the lessor.</p>

<p><strong>Background Insight: Why Do Businesses Enter Into Finance Leases?</strong></p>

<p>Why would any debtor want a financing lease rather than a security agreement?</p>

<p>This is mostly income tax driven.</p>

<p>If you own property, you get to deduct depreciation according to an IRS formula and interest paid as it is paid. Principal payments on the loan aren't deductible. While in the long run this adds up to the total amount paid with respect to the property, it doesn't match up exactly, so sometimes, you have cash flow without income, and sometimes, you have income without cash flow. Principal payments attributable to land value can never be deducted as an expense by a business (which is why many commercial buildings are built on land that they lease from non-profits so that the business, which can't deduct the land value expense if it owns the land, can deduct the land value expense since it is a lease payment; the non-profit only cares about cash flow and doesn't need the depreciation deduction because it doesn't pay income taxes).</p>

<p>If you lease property, you get a deduction for the full amount of the lease payment, when paid, so cash flow always exactly matches your tax deductions for the property.</p>

<p>Section 179 and accelerated depreciation for tangible personal property, especially the kind with a fairly short useful life, favor buying rather than leasing smaller purchases. But, in the case of very expensive business assets (especially for big businesses) and in the case of real estate, it is usually more favorable from a tax perspective for a business to lease an asset than to buy it.</p>
