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Equipment ‘lessors,' beware if your lessee goes bankrupt

May 2012

Many companies lease equipment to other businesses. The parties often enter into "lease" agreements that typically contain provisions associated with leases, such as specific terms of duration, regularly-scheduled rent payments and default remedies.

However, commercial equipment lessors should be aware that, in the event of a lessee's bankruptcy, the "leases" between the parties may be recharacterized as disguised financing agreements. This can have a dramatic and negative impact on lessors' rights and remedies. It is important for commercial equipment lessors to understand the nature of these issues and be proactive to protect themselves.

A lessor is entitled to a variety of protections in the event of a lessee's bankruptcy. Among other things, a lessee that elects to "assume" the lease must cure any past defaults and provide adequate assurance that it is able to perform its obligations going forward.

If, on the other hand, the lessee chooses to "reject" the lease or is unable to cure its past defaults, the lessor is entitled to recover possession of the leased property and to assert a claim for any damages. In this scenario, the lessor remains the owner of the leased property throughout the bankruptcy proceeding.

In addition, although a debtor generally is given an indefinite period of time in which to decide whether to assume or reject the lease, after an initial period of 60 days after the case is filed the debtor is required to perform all of its obligations under the lease (including making rent payments) while it determines which course of action to take.

Also, even if the debtor ultimately rejects the lease, any obligations of the debtor that arise after the case is filed and before the rejection are entitled to priority status.

If, on the other hand, the "lease" is recharacterized as a secured financing arrangement, the debtor, as purchaser, actually owns the "leased" equipment. If the property is worth more than the amount of the debt against it, the "lessor" should be paid in full and is also entitled to adequate protection (often in the form of cash payments or additional security) against potential diminution of the value of the collateral (although the period of the payoff may be extended significantly without the lessor's consent).

But when the collateral is worth less than the amount of the debt against it, the lessor's claim will be bifurcated. It will receive, at best, a secured claim equal to the value of the collateral, and an unsecured claim (which may be paid at pennies on the dollar) in the amount of the deficiency. Worse, if the lessor did not take steps to obtain and perfect a security interest, it may be left with a claim that is unsecured altogether, without recourse either to meaningful payment or to the collateral itself.

Because of the disparity in treatment under bankruptcy law, whether an agreement is a "true" lease or a disguised financing arrangement can be critically important. When making that determination, the court will look to the economic substance of the transaction (an issue of state law).

While the designation of the agreement and the intentions of the parties are relevant factors for consideration, they are not dispositive. Instead, the court will weigh a variety of factors, including the definitions of "lease" and "security interest" found in various sections of the Uniform Commercial Code.

Commonly considered factors include:

  • Is the equipment at issue unique? For example, was it specifically designed for installation in the lessee's facility? Do the lessee's continued business operations depend on continued possession and use of the equipment?
  • What is the anticipated useful life of the equipment? Does the term of the lease exceed the useful economic life of the goods? Is the lessee required to renew the lease for the full economic life of the goods?
  • What happens to the equipment at the end of the lease? Does the agreement permit (or require) the lessee to purchase the goods at the end of the lease term for nominal consideration? Is the lessee required to purchase the property upon occurrence of certain events?
  • What is the total amount of the lease payments in relation to equipment value? Are "rent" payments calculated to compensate the lessor for the lessee's ongoing use of the lessor's property, or are they really payments of principal and interest?
  • Did the lessee assume the typical risks and obligations of ownership (such as responsibility for paying insurance, taxes, maintenance and upkeep)?
  • Did the lessor manufacture or purchase the property specifically for the lessee's use?
  • Did the lessor obtain credit to purchase the leased equipment?
  • What is the economic benefit to each party if the transaction is structured as a lease rather than as a sale? Was the deal structured that way to secure tax or other benefits?

In general, if the property has little or no value at the end of the lease's term, or the lessee is able to purchase the property for nominal value, the transaction is likely to be deemed a sale rather than a true lease.

The determination of whether an agreement is a true lease or a disguised secured financing arrangement can be of critical importance in the event of a bankruptcy filing by the lessee. When entering into such a transaction, an equipment lessor should bear in mind that economic substance – not the agreement's title or the parties' subjective understandings – is the determinative factor.

Parties entering into a lease transaction on either side should consider carefully the consequences of the agreement's recharacterization as a financing agreement, and should consult with experienced business and bankruptcy counsel at the time they enter into an equipment lease.

Related Practice Areas

Business Restructuring & Bankruptcy

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