True Lease or Disguised Financing The State of the Law

True Lease or Disguised Financing The State of the Law

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Recent cases have refined the analysis to be applied in determining whether an agreement purporting to be a true lease should be recharacterized as a financing for commercial and bankruptcy law purposes. For leases supporting tax-exempt bond financings, the case law now provides a roadmap for debtors to attack the true lease status. Two decisions by the Seventh Circuit Court of Appeals in the United Air Lines case have held that state law, not federal law, provides the rule of decision and have recharacterized certain leases as disguised financings under applicable state law. In doing so, the Seventh Circuit rejected application of the federal "economic realities" test that has been employed by several courts to recharacterize real estate leases as financing arrangements. The Seventh Circuit's analysis raises interesting questions concerning the treatment of real estate and equipment leases. This article will review the state of the law as identified in the Seventh Circuit's decisions and explore some of the consequences of that analysis for other real estate and personal property leases.

True Lease vs. Disguised Financing

The benefits to a debtor of transforming a lease into a secured financing are familiar and provide ample motivation for a chapter 11 debtor to pursue a recharacterization challenge. First, the debtor may retain possession of the leased property during the case without having to comply with the ongoing post-petition rent payment requirements of §365(b)(3), in the case of real estate leases, or §365(d)(10), in the case of equipment leases. Second, the debtor does not need to assume the lease to retain possession of the property. This means that the debtor need not cure pre-petition arrearages, commit to administrative expense priority treatment for future rent obligations under the assumed lease or contract, or provide adequate assurance of future performance of the lease. With BAPCPA's newly imposed limitations on a debtor's ability to gain extensions of the time to assume or reject leases of nonresidential real property, the chance to escape the strictures of §365 becomes all the more enticing. Undoubtedly the most significant advantage of converting a lease to a secured financing is the ability to modify the resulting secured financing using §506(a)(1) of the Code to bifurcate the claim into a secured claim limited to the current value of the leased property and a general unsecured claim for the deficiency, one that is readily subject to adjustment under a reorganization plan.

If a debtor can convert a lease to something other than a secured claim, it has even greater leverage over the lessor. This can arise if the lessor has not taken adequate steps to perfect its interest under a recharacterized lease, such as by including a grant of an equitable mortgage in the lease or memorandum recorded in the real estate records or filing and maintaining the effectiveness of a protective UCC-1 financing statement for personal property. A complex deal structure also may allow the debtor to argue that a recharacterized transaction is simply an unsecured loan or other form of disguised transaction.1

The Airport Facilities Lease Challenges

One consequence of the rash of commercial airline bankruptcy filings has been the challenge made by the airlines to the leases they have entered into in connection with tax-exempt bond financings for maintenance, terminal and other facilities at major airports across the country. United Air Lines has challenged leases at airports in New York (JFK), Denver, San Francisco (SFO), Los Angeles (LAX) and Indianapolis. Delta Airlines has sought to recharacterize the lease of facilities at LAX, and Northwest Airlines has filed for recharacterization of its lease at Minneapolis/St. Paul. In the case of United's leases at Denver and Indianapolis, United took the further step of attempting to bifurcate a single lease covering ground rents plus rents tied to repayment of bonds into two separate, severable agreements—one constituting a true lease with a market rent component and the other constituting a debt obligation tied to repayment of the bond debt. The challenges by Delta and Northwest are still in the nascent stages, although Delta's declaratory judgment action concerning its lease at LAX is closely tied to the Seventh Circuit's action with respect to United's LAX lease. Other challenges, such as United's challenge to the Indianapolis lease, are as yet unresolved.

In each of these cases, the airline entered into lease or lease-leaseback transactions structured so that the rent would fund the principal and interest payments on tax-exempt bonds issued by the issuing authority. The authority's role in each instance was limited to issuing the bonds, and all rent payments by the airline are made directly to the indenture trustee, which uses the payments to make debt-service payments on the bonds and cover other administrative expenses.

The United cases began with the filing of adversary proceedings seeking recharacterization of the JFK, Denver, SFO and LAX lease arrangements as disguised financings. In March 2004, the bankruptcy court ruled that the JFK, SFO and LAX leases were, in reality, disguised financing arrangements and therefore not subject to §365, but that the Denver lease was a true lease not subject to recharacterization.2 Bankruptcy Judge Eugene Wedoff analyzed each of the leases under federal law and utilized the "economic realities" test, citing the analysis in such cases as Liona Corp. v. PCH Assocs. (In re PCH Assocs.), 804 F.2d 193 (2d Cir. 1986); City of San Francisco Mkt. Corp. v. Walsh (In re Moreggia & Sons, Inc.), 852 F.2d 1179 (9th Cir. 1988); and City of Olathe v. KAR Dev. Assocs. L.P. (In re KAR Dev. Assocs. L.P.), 180 B.R. 629 (D. Kan. 1995). Under that analysis, the court looked to the substance of each lease structure as opposed to the form adopted by the parties. The bankruptcy court then reviewed the five factors cited in Hotel Syracuse Inc. v. City of Syracuse Indus. Dev. Agency (In re Hotel Syracuse Inc.), 155 B.R. 824, 838 (Bankr. N.D.N.Y. 1993), namely (1) whether the rental payments were structured to ensure a particular return on an investment, (2) whether the lessor's purchase price was tied to the fair market value of the property or was calculated as the amount necessary to finance the transaction, (3) whether the property was purchased by the lessor for the lessee's use, (4) whether the lease structure was used to secure tax advantages and (5) whether the lessee assumed obligations normally associated with outright ownership, such as payment of property taxes and insurance. Only in the Denver case, which involved a single lease as opposed to a lease-leaseback structure, did the bankruptcy court find that the lease to United should be viewed as a true lease subject to §365 of the Code.

On appeal, the district court took issue with the bankruptcy court's approach and conclusions. Instead of applying federal law to determine whether a lease should be recharacterized as a financing arrangement, it looked to state law. It held, in four separate opinions, that the lease at Denver was a true lease under Colorado law and that the leases at SFO and LAX were true leases under California law, but that the lease at JFK was a financing under New York law.3 In choosing state law as the governing principle and rejecting the adoption of a federal common law standard, the district court relied on the pronouncement in Butner v. United States, 440 U.S. 48, 54 (1979), that Congress has left the determination of property rights in the assets of a bankrupt's estate to state law.4 Absent clear and manifest evidence of a federal interest that requires the adoption of a federal standard, the Code should be construed to adopt rather than to displace state property law.5

The Current "State" of the Law

The Seventh Circuit agreed with the district court that state law provides the appropriate standard by which to evaluate a lease, but reached the opposite conclusion with respect to the SFO and LAX leases, holding that each was a disguised financing arrangement.6 The court rejected one of the critical foundations for the federal economic realities test, namely that references to "bona fide" leases in the Code's legislative history were sufficient evidence of a federal interest that would justify the adoption of a federal common law standard to evaluate leases.7

In its ruling on United's San Francisco lease, the Seventh Circuit focused on five aspects of the transaction to conclude, as a matter of California law, that the lease-leaseback arrangement constituted a secured loan not subject to §365.8 First, the rental payments under the leaseback to United were tied to the amount borrowed from the bondholders and not to the market value of the maintenance base covered by the lease. Second, the rent was structured to make interest-only payments on the bonds for 36 years with a $155 million balloon payment in 2033, thereby making the payments appear to be debt repayments rather than payments of rent. Third, the leaseback agreement included a hell-or-high-water clause that obligated United to pay the rent even if the premises became unusable. Fourth, if United were to pre-pay the bond debt, the lease-leaseback structure would terminate. Finally, the court focused on the absence of any meaningful residual interest by the authority at the conclusion of the leaseback agreement.

The Seventh Circuit's recent ruling concerning United's lease at LAX, United Air Lines Inc. v. U.S. Bank, 2006 U.S. App. LEXIS 11074 (7th Cir. May 4, 2006), applied the rationale from the SFO ruling and reached the same result by recharacterizing the LAX lease-leaseback arrangement as a secured loan. As in the SFO case, rent payments were explicitly tied to repayment of interest, principal and administrative costs, with balloon payments being due in 2012 and 2021 to coincide with the maturity dates on the bonds. The LAX agreements similarly contained a hell-or-high-water clause, and the lease agreements would terminate if United were to pre-pay the bond debt. Finally, at the end of the LAX lease-leaseback agreement, the property would revert to the City of Los Angeles, and the bond-issuing authority would have no reversionary interest in the property.

Certain of the identified aspects of United's leaseback agreements at SFO and LAX are not necessarily inconsistent with true leases, particularly the presence of hell-or-high-water clauses or the fact that rent payments were calculated based on the amount needed to repay financing costs. Moreover, while the authority had no significant residual interest in the premises at the conclusion of the leaseback agreement, neither did United, which had no option to become the owner of the premises. Indeed, in the personal property context, it is most often the lessee's right to become the owner of the leased property for nominal consideration at the end of the lease term that causes the lease to be treated as one that creates a security interest under §1-201(37) of the UCC. The court clearly was influenced in the SFO case by the fact that the rent payments under the leaseback agreement there were tied to repayment of bond proceeds used to improve other facilities at the airport and not to the leased premises. However, the absence of this disconnect in the LAX case did not prevent the court from reaching the same result in both cases.

Open Issues

The Seventh Circuit did not rule out the possibility that state law could be found to conflict with the Code if, for example, it "identified a 'lease' in a formal rather than a functional manner."9 Thus, under the court's analysis, there still is room to argue for the adoption of a federal common law doctrine using a "functional" approach to leases. Indeed, the Seventh Circuit's analysis of the critical aspects of true leases and secured financings is not all that different from many of the Hotel Syracuse factors originally considered by the bankruptcy court under the federal economic realities test.

Arguably, the Seventh Circuit should have more firmly rejected the notion that federal common law could override state law in the absence of some other identified federal interest. Under United States v. Kimbell Foods Inc., 440 U.S. 715 (1979), relied on by the Seventh Circuit in support of its use of state law to define property rights, federal common law should only supplant state law when there is a need for a uniform rule to protect interest under some other federal program or statute.10 A judicially created federal standard also should not be imposed if it would upset commercial expectations that state law would govern.11

The United rulings may have implications for certain kinds of personal property leases. For example, 48 states have enacted laws preventing leases of commercial vehicles or trailers subject to so-called TRAC leases from being recharacterized as secured financings or conditional sales based on terminal rent-adjustment clauses in the leases.12 Those statutes clearly are designed to avoid recharacterization under the functional analysis under the UCC or a federal economic realities standard. Yet those state laws do not threaten any federal property interest or programs, and refusing to apply state TRAC lease statutes in bankruptcy certainly would upset commercial expectations that state law would govern. Accordingly, there should be no reason under the rationale in Kimbell Foods or Columbia Gas Systems to override the application of those state laws, even though the statutes cut off one functional attack on the TRAC leases as true leases.

Given the long history of litigation over true lease issues and the numerous airport facility lease disputes still pending, it is unlikely that the Seventh Circuit has written the final chapter in this continuing saga. Not only does the Seventh Circuit's standard require a case-by-case analysis under state law, other circuits undoubtedly will be called upon to weigh in on these issues in the not-too-distant future.



1 See, e.g., In re Barney's Inc., 206 B.R. 328 (Bankr. S.D.N.Y. 1997) (attempt by debtor to recharacterize the lease of its flagship store as a preferred guaranteed return component of an alleged global retailing partnership).

2 United Air Lines Inc. v. HSBC Bank USA (In re UAL Corp.), 307 B.R. 618 (Bankr. N.D. Ill. 2004).

3 HSBC Bank USA v. United Air Lines Inc., 317 B.R. 335 (N.D. Ill. 2004) (SFO); United Air Lines Inc. v. HSBC Bank USA, 322 B.R. 347 (N.D. Ill. 2005) (Denver); U.S. Bank v. United Air Lines Inc., 331 B.R. 765 (N.D. Ill. 2005) (LAX); and Bank of New York v. United Air Lines Inc., 2005 WL 670528 (N.D. Ill. 2005) (JFK).

4 HSBC Bank USA v. United Air Lines Inc., 317 B.R. 335, 340 (N.D. Ill. 2004).

5 Id.

6 United Air Lines Inc. v. HSBC Bank USA, 416 F.3d 609 (7th Cir. 2005).

7 Id. at 614.

8 Id. at 617.

9 United Air Lines Inc. v. HSBC Bank USA, 416 F.3d at 615.

10 See, e.g., In re Columbia Gas Sys. Inc., 997 F.2d 1039, 1055-56 (3d Cir. 1993) (applying federal trust law construing the interest of the bankruptcy estate in refunds order by FERC to protect significant federal interests under the National Gas Act).

11 Id. at 1055, citing Kimbell Foods.

12 See Mayer, David G. "True Leases Under Attack," 23 Journal of Equipment Lease Finance, Fall 2005, Part B at 11-12.

Bankruptcy Code: 
Journal Date: 
Thursday, June 1, 2006