Menu    7 ABR 514 

JUDGE HERB ROSS (Recalled)

 

UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF ALASKA

605 West 4th Avenue, Room 138, Anchorage, AK 99501-2296

(Phone 907/271-2655 - Fax 907/271-2692 - Website: www.akb.uscourts.gov)

 

 

 

 

 

In re


JOHN A. SANKEY,

 

Debtor(s)

Case No. A03-00237-HAR

In Chapter 11

 

MEMORANDUM DECISION GRANTING MOTION FOR ADEQUATE PROTECTION


 

Contents

Page

1. INTRODUCTION

514
 

2. FACTS

515
 

3. ISSUE

517
 

4. LEGAL ANALYSIS

517

4.1. State Law Governs Whether the Contracts Are Leases or Security Agreements

517

4.2. UCC 1-201(37) Is the Controlling State Law

518

4.3. The Debtor Has Not Shown the Contracts Were Security Agreements Under the Per Se Provisions of 1-201(37)

521

4.4. The Debtor Has Failed to Offer Sufficient Proof to Show the Contracts Were Security Agreements Under the Facts and Circumstances

523
 

5. CONCLUSION

524
 

APPENDIX A –- UCC 1-201(37)

525

 



 


 


                        1.  INTRODUCTION- The debtor leases exercise equipment and is behind on prepetition and postpetition lease payments. The lessor moved for adequate protection (commencing lease payments, proof of insurance, etc.), or relief from stay. The debtor argues that the leases should be treated as security agreements under UCC 1-201(37) because there is a nominal purchase option at the end of the terms. I conclude that the debtor has not established under 1-201(37) that the leases should per se be treated as security interests TOP     7 ABR 515  because debtor has not shown that the option price is nominal, nor otherwise shown that the court should treat the leases as security agreements.


                        2.  FACTS-  John Sankey, the debtor, is assignee of two leases in which ABCO Leasing, Inc. is the lessor. One is for exercise equipment (Precor cross-trainers, a treadmill, etc.), and the other for tanning beds.


                        The leases are for 60 months each and are in mid-term. Sankey has committed to pay the monthly rent for the entire term of the lease, and bears the cost of insuring and returning the equipment at the end of the term if an option to purchase is not exercised.


                        Sankey filed a chapter 11 petition in March 12, 2003. At that time, he was three and a half months in arrears on each lease, and he has not made postpetition payments. The total pre- and postpetition arrears, including some late charges and delinquent property taxes exceeds $30,000. A summary of the financial status of the leases, including the option prices, is summarized in the following table:


                                           Factor

Lease 1 (Exercise Equipment)

Lease 2 (Tanning Beds)

Term of leases

60 months

60 months

Term of lease began on about

June 2000

February 2001

Current monthly installments

$2,050.00/month

$2,568.00/month

Prepetition arrearage (excluding atty fees, $22,806.20)

$10,735.36

$12,070.84

Postpetition payments (as of 03/12/03)

None

None

Option to purchase price at end of lease

$8,062.50

$10,110.00

Debtor’s value per schedules

$12,500.00

$20.500.00


TOP     7 ABR 516 

                        ABCO moved for adequate protection 1 Footnote to require Sankey to:

                                  Begin making monthly lease payments totaling $4,618 per month (presumably for rent beginning with the 60th day after the petition 2 Footnote );

 

                                  Permit access to inventory the equipment;

 

                                  Give proof of insurance covering ABCO’s interests;

 

                                  Permit ABCO to apply the security deposit to its claims; or,

 

                                  Suffer having the stay lifted if Sankey does not comply by May 12, 2003. 3 Footnote


                        Sankey responded that the leases should be treated as security agreements under AS 45.01.201(38), Alaska’s version of UCC 1-201(37), because the consideration for exercising the purchase option at the end of the lease is nominal in his opinion. He notes the cost of returning the equipment to Washington state would make it foolish for a lessee not to exercise the option. He argues that the following calculations show the option price is nominal for Lease 1 (the exercise equipment) 4 Footnote :


Total Least Payments

Option Price

Percentage of Option Price (Option Price Divided by Total Lease Payments)

Option Price Reduced to Present Value Using 18.06% Discount Rate

60 mos x $2,050 = $123,000

$8,062

6.554%

$3,290


TOP     7 ABR 517 

                        ABCO replied that the Washington, not the Alaska, statute applies, 5 Footnote and that Sankey has failed to establish the lease should be treated like a security agreement under the per se or “bright-line” test. 6 Footnote The legal arguments are discussed below in more detail.


                        Each lease has an option provision which states that

. . . the purchase price contained in this option is the closest approximation which the parties can now make of the reasonable value of the property at the end of the lease term, after consideration of anticipated depreciation, potential obsolesence, the extent to which the Lessee intends to use the property during the lease term . . .



                        The parties stipulated that Sankey would testify that Sankey inquired of a resale broker who, sight unseen, estimated it would pay a little over $25,000 for the exercise equipment (Lease 1). They also stipulated that Sankey had determined from a shipping agent that the cost of shipping the property to Seattle would between $ 7,980 - $9,980.


                        Sankey further argues the option prices are not indicative of economic reality because the disparate type of equipment under Lease 1 and Lease 2 are nonetheless have purchase options calculated on the same 10% of purchase price formula.


                        3.  ISSUE-  Are the two contracts (Lease 1 and Lease 2) leases or security interests for the purposes of requiring adequate protection for the creditor, ABCO?


                        4.  LEGAL ANALYSIS  -  


                        4.1.  State Law Governs Whether the Contracts Are Leases or Security Agreements-If the two contracts are deemed to be leases, ABCO might be entitled to adequate protection for the use of the property. 7 Footnote More to the point, in chapter 11 cases, a TOP     7 ABR 518  debtor is required to perform the obligations under a personal property lease from the 60th day after filing until the lease is assumed or rejected, unless the court orders otherwise. 8 Footnote


                        If the two contracts are security agreements, ABCO might be entitled to adequate protection also, however, the determination of whether adequate protection is due is based on different criteria. If the contracts are security agreement, the debtor must generally provide an undersecured creditor whose collateral is deteriorating in value with adequate protection. 9 Footnote


                        The determination of whether the contracts are leases or security agreements for the purposes of this bankruptcy case is determined with reference to state law, 10 Footnote in this case, the Uniform Commercial Code.


                        The debtor has cited the Alaska Statute version of the pertinent section, 11 Footnote and ABCO has cited the Washington state version. 12 Footnote The statutes of the two states are substantially similar to each other and to the official “new” version of UCC 1-201(37), which was adopted by a number of states in the 1990s. Since neither party has cited cases under the new version from Washington or Alaska, I will refer to the official version in this memorandum.


                        4.2.   UCC 1-201(37) Is the Controlling State Law -  Both parties agree that UCC 1-201(37) is the controlling law in this case. Before the current version was adopted in TOP     7 ABR 519  Washington and Alaska, the UCC provided scant guidance whether a contract, denominated as a lease, should be treated as a security agreement. The original version provided, essentially:


'security interest' means an interest in personal property or fixtures which secures payment or performance of an obligation . . . whether a lease is intended as security is to be determined by the facts of each case; however, (A) the inclusion of an option to purchase does not of itself make the lease one intended for security, and (B) an agreement that upon compliance with the terms of the lease the lessee shall become or has the option to become the owner of the property for no additional consideration or for a nominal consideration does make the lease one intended for security . . .. 13 Footnote


 


Due to a lack of direction in the statute, the case law was all over the ball park. 14 Footnote The new version of 1-201(37) is an improvement, but not a panacea. 15 Footnote A copy of new UCC 1-201(37) is attached in Appendix A.


                        Focusing on the words “whether a lease is intended,” many courts, under the old version, held that there was an element of intent the court had to determine, in deciding whether the specific contract was a lease or security agreement. 16 Footnote The drafters of the new version of 1-201(37) made it clear that intent is not the issue:


Reference to the intent of the parties to create a lease or security interest has led to unfortunate results. In discovering intent, courts have relied upon factors that were thought to be more consistent with sales or loans than leases. Most of these criteria, however, are as applicable TOP     7 ABR 520  to true leases as to security interests. Examples include the typical net lease provisions, a purported lessor's lack of storage facilities or its character as a financing party rather than a dealer in goods. Accordingly, amended Section 1-201(37) deletes all reference to the parties' intent. 17 Footnote



                        The new 1-201(37) works this way. First, there is a two part test to see if the contract is a security agreement by definition, sometime called the “bright-line” test. 18 Footnote This is composed of two elements: (a) a requirement in the lease that the lessee irrevocably pay the lease payments and perform the lease obligations to th end of the lease (sometimes called the “hell or high water” factor, 19 Footnote and (b) the presence of at least one of four other factors (sometimes called the “residual value factors” 20 Footnote ):


- the original term of the lease equals or is greater than the remaining economic life of the property;

 

- the lessee must renew for the remaining economic life or is bound to become the owner;

 

- the lessee has an option to renew for the remaining economic life of the goods or for no additional consideration or a nominal additional consideration on complying with the lease terms; or

 

- the lessee has the option to become the owner for no additional consideration or a nominal consideration upon compliance with the lease.



In the present case, Sankey relies only on the final factor.


TOP     7 ABR 521 

                        Secondly, if the lease is not a security agreement per se under the bright-line test, the court must still determine if it is lease or a security agreement based on the facts of the case. 21 Footnote To aid in this, various rules of interpretation are given. 22 Footnote A transaction in the form of a lease is not a security agreement merely because:


- the present value of the consideration equals or exceeds the value of the goods at the time the lease is entered into;

 

- the lease is a “net lease” in that the lessee is to pay the taxes, insurance, etc.;

 

- the lessee has the option to renew or purchase, even at a price more than the predictable fair rent or value at the time the option is to be performed;

 

- additional consideration is not “nominal” for the purchase or renewal when it is stated to be the fair purchase or rental value when the option is to be performed, but is “nominal” if less than the reasonably predictable cost of performing if the option is not exercised.



                        4.3. The Debtor Has Not Shown the Contracts Were Security Agreements Under the Bright-Line Provisions of 1-201(37)-  The parties agree that the first test of 1-207(37)(b), the “hell or high water” test, is met –- i.e., that Sankey is required to perform – pay rent, etc. – for the full term of the leases. And, Sankey concedes that the only one of the four conditions of the second test which is applicable is the forth one (“the lessee has an option to become the owner of the goods for . . . nominal additional consideration”). His argument is that the remaining amount will be much less than 10% of the purchase price at the end of the lease, and probably be less than the cost of returning the goods to Seattle.


TOP     7 ABR 522 

                        ABCO counters that it would not require a return to Seattle, but have it returned to a broker in the Anchorage area. The parties have left the court with insufficient evidence regarding this matter to make a completely reasoned decision on that fact issue.


                        What I can determine is that the evidence does show that the parties identified, at the commencement of the lease, what they determined the fair value of the equipment would be at the time of the option. Sankey on the other hand, has not established that the additional consideration chosen as the option price is an amount less than his reasonably predictable cost of performing under the lease. He did not establish that the equipment would have had to be returned to Seattle. He did not establish, as of the beginning of the lease, the predictable value of the equipment at the end of the lease. He only offered a mid-lease estimate of value of Lease 1.


                        To determine if whether the value is “nominal” under new UCC 1-201(37), one treatise describes the procedure as follows:

Finally, the drafters included three "definitions," indicating when additional consideration is not nominal, how a court should determine whether something is reasonably predictable and the remaining economic life of goods, and what present value means. According to the amended subsection 1-201(37), additional consideration is not nominal if the renewal option rent is stated to be the fair market rent for the goods at the time the option is to be performed or the purchase option price is stated to be the fair market value of the goods at that time. Additional consideration is nominal, however, if it is less than the lessee's reasonably predictable cost of performing under the lease agreement if the option is not exercised. Courts are to determine whether something is reasonably predictable and the remaining economic life of the goods by reference to all of the facts and circumstances existing at the time the transaction is entered into, and present value is defined to mean the discounted value of sums payable in the future. The parties may determine their own discount rate if it is not manifestly unreasonably or the court will determine the discount rate by using a commercially reasonable rate that takes into account all the TOP     7 ABR 523  facts and circumstances of each case at the time that the transaction was entered into. 23 Footnote



                        I can commiserate with Sankey’s plight; the cost of producing evidence to meet his evidentiary burden for equipment of relatively modest value is perhaps prohibitive. Nonetheless, it was his burden, so the court is without discretion to decide in his favor. 24 Footnote


                        The cases cited by Sankey largely rely on the “percentage test” – i.e., that 10% or less is on its face nominal. 25 Footnote These cases are not persuasive as guides to the interpretation of the new version of UCC 1-201(37).


                        4.4. The Debtor Has Failed to Offer Sufficient Proof to Show the Contracts Were Security Agreements Under the Facts and Circumstances-  If the court cannot find a per se determination that the contracts are security agreements, it can, nonetheless, make such a determination under the facts of the case before it. This is characterized as whether the lessor retained a meaningful reversionary interest in the goods. 26 Footnote


                        The only issue, however, is whether the option price is nominal. Having determined there was a failure of proof under the per se analysis, it would not be rational to TOP     7 ABR 524  find the purchase price was nominal as “determined by the facts of [the] case.” Therefore, I find that a security agreement has not been established under the reversionary test.


                        5. CONCLUSION-  The motion for adequate protection in the form of requiring lease payment from May 12, 2003, shall be granted. Also, ABCO will be entitled to inspect the goods, and the debtor shall provide proof of insurance. I will give debtor 15 days to comply, and failing to comply, I will conduct a preliminary relief from stay hearing at the request of ABCO.


                        A separate order will be issued.


                        DATED: June 2, 2003

 



 

                                                                                                                                                           /s/ Herb Ross     

                                                                                                                                                   HERB ROSS

                                                                                                                                              U.S. Bankruptcy Judge


Serve:

Deborah Crabbe, Esq., for ABCO Leasing, Inc.

Robert Crowther, Esq., for the Debtor

U.S. Trustee Office- Anchorage





TOP     7 ABR 525 

APPENDIX A –- UCC 1-201(37) 27 Footnote


UCC § 1-201(37). General Definitions: "Security Interest".

 

             (37) . . . .

 

            (a) Whether a transaction creates a lease or security interest is determined by the facts of each case.

 

            (b) A transaction creates a security interest if the consideration 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 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 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 nominal additional consideration upon compliance with the lease agreement.

 

            (c) A transaction does not create a security interest merely because it provides that

 

(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,

TOP     7 ABR 526 

 

(3) the lessee agrees to pay taxes, insurance, filing, recording, or registration fees, or service or maintenance costs with respect to the goods,


(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.

 

            (d) 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. 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;

 

            (e) "Reasonably predictable" and "remaining economic life of the goods" are to be determined with reference to the facts and circumstances at the time the transaction is entered into; and "Present value" means the amount as of a date certain of one or more sums payable in the future, discounted to the date certain. The discount is determined by the interest rate specified by the parties if the rate is not manifestly unreasonable at the time the transaction is entered into; otherwise, the discount is determined by a commercially reasonable rate that takes into account the facts and circumstances of each case at the time the transaction was entered into.

 







N O T E S:

1.   11 USC § 363(e).


2.   11 USC § 365(d)(10).


3.   Docket Entry 21.


4.   Debtor’s objection, Docket Entry 30, at page 5-6.


5.   RCW 62A.01-201(37).


6.   ABCO’s reply at Docket Entry 40.


7.   11 USC § 363(e); In re MS Freight Distribution, Inc., 172 BR 976, 980 fn 14 (Bankr WD Wash 1994) (dealing with a real estate lease).


8.   11 USC § 365(d)(10).


9.    11 USC § 361; 3 Collier on Bankruptcy, ¶ 361.02[2] (15th ed Rev].


10.   In re Wakefield, 217 BR 967, 970 (Bankr MD Ga 1998), In re Taylor, 209 BR 482, 484 (Bankr SD Ill 1997).


11.   AS 45.01.201(38).


12.   RCW 62A.01-201(37).


13.   McGhallard v Liberty Leasing Co., Inc,, 534 P2d 528, 532 fn 12 (Alaska 1975), citing former AS 45.05.020(37).


14.   In re QDS Components, Inc., 292 BR 313, 323-29 (Bankr SD Ohio 2002).


15.   See, citations in In re QDS Components, Inc., 292 at 340.


16.   In re QDS Components, Inc., 292 BR at 324.


17.   Uniform Laws Annnotated, Uniform Commercial Code, § 1-201(37), Official Comment (ALI 2002).


18.   UCC 1-201(37)(b); In re Super Feeders, Inc., 236 BR 267, 270 (Bankr D Del 1999).


19.   E. Carolyn Hocstadter Dicker, John P. Campo, FF&E and the True Lease Question: Article 2A and Accompanying Amendments to UCC Section 1-201(37),, 7 ABI Law J 517, 534-36 (Winter 1999).


20.   Id at 537-39; UCC 1-201(37)(b) (see, Appendix A).


21.   UCC 1-201(37)(a) (see, Appendix A).


22.   UCC 1-201(37)( c-e) (see, Appendix A).


23.   8 Hawkland Uniform Commercial Code Series, § 9-102: Title Retention Contracts, Leases and Consignment in General (2002).


24.   See, similarly, In re QDS Components, Inc., 292 BR at 337.


25.   In re Bevis Company, Inc., 201 BR 923 (Bankr SD Ohio 1996) (note, this is an old UCC 1-201(37) case); In re Super Feeders, Inc., 236 BR 267 (Bankr D Neb 1999); In re Wakefield, 217 BR 967 (Bankr MD Ga 1998), which, at 217 BR 971 relied on Orix Credit Alliance, Inc. v Pappas, 946 F2d 1258, 1261-63 (7th Cir 1991), which was interpreting the old New York version of UCC 1-201(37).


26.   4 White & Summers, Uniform Commercial Code, § 30-3, d. Reversionary Interest (5th ed 2002.; In re QDS Components, Inc., 292 BR at 340-45.


27.   The subsection number is that of UCC 1-203, which is substantially similar to UCC 1-207(37), but easier cross-reference in some of the footnotes in this memorandum decision.