By Robert J. Gillispie

A US district court in Illinois said in mid-November that a lease is a “lease” if local law says it is.

The decision is important because bankrupt companies that have leased power plants, airplanes or other equipment must catch up on missed rental payments or risk losing their assets. However, if the arrangement is not really a lease but merely a financing, then the lessor must get in line with other creditors and the bankrupt company can continue using the asset.

The district court was responding to an appeal from a decision by the US bankruptcy court that is handling the United Air Lines bankruptcy. The case is called HSBC Bank USA v. United Air Lines.

Background

In 1973, United leased 130 acres at the San Francisco International Airport from the city as a site for ramp space as well as various facilities.

A tax-exempt revenue bond financing was subsequently arranged in 1997 with the California Statewide Communities Development Authority – called the CSCDA – to cover the construction cost of a maintenance facility. As part of the revenue bond financing, United subleased 20 of the 130 acres at the airport to the CSCDA for a nominal rent of $1. The sublease had a term of approximately 36 years. The CSCDA then sub-subleased the premises back to United under a facilities lease, also for a 36-year term. The facilities lease rentals were in an amount sufficient to pay the revenue bonds, administrative costs and reasonable compensation for the use and occupancy of the 20 acres. The CSCDA collaterally assigned the facilities lease, including the right to collect rents, to an indenture trustee who was acting for the holders of the revenue bonds.

United filed for bankruptcy in December 2002.

United immediately found itself in a quandary. It obviously needed the maintenance facility at the airport. If United could persuade the bankruptcy court that the facilities lease was not a “true lease” for purposes of the US bankruptcy code, then United would be relieved of the choice under section 365 of the bankruptcy code to assume the facilities lease, with all the burdensome financial obligations that assumption entails, or to reject the facilities lease and surrender the airport maintenance facility. Section 365 of the US bankruptcy code lets the bankrupt company in a so-called chapter 11 bankruptcy case where the bankrupt company is trying to reorganize rather than liquidate – or a trustee appointed by the bankruptcy court to manage the company’s affairs – assume or reject unexpired leases. But the right to assume comes with some strings. If the company wants to keep the lease, then it must cure all defaults (including payment defaults), compensate any party that has suffered a pecuniary loss from the default and provide adequate assurance of future performance under the lease.

If, however, United could have the facilities lease characterized as merely a “financing,” then United would be permitted to retain the airport maintenance facility, and the CSCDA (and the indenture trustee as security assignee) would be relegated to secured lender status, if appropriate steps had been taken to “perfect” its security interest, or unsecured lender status, if not.

Lease?

United argued, and the bankruptcy court agreed, that the facilities lease was not a true lease for purposes of section 365 of the bankruptcy code. The bankruptcy court found that the facilities lease was, under federal law as opposed to state law, the “economic equivalent of a leasehold mortgage”; in other words, the airport maintenance facility was merely security for a loan.

The term “unexpired lease,” as used in section 365, is not defined in the bankruptcy code. Accordingly, courts have relied upon legislative history of an analogous section of the bankruptcy code, namely section 502(b)(6) which limits damage claims from terminations of real estate leases. The relevant legislative history states: “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’.” Based on this legislative history, courts have required a lease to be a “true” or “bona fide” lease for section 365 to apply.

The bondholders appealed the decision by the bankruptcy court that the facilities lease was merely a financing document. The appeal went to a US district court in Illinois.

The district court observed that Congress has generally left the determination of property rights in the assets of a bankrupt company to state law, with the caveat that state law may be displaced with a federal common law if “some federal interest requires a different result.” Finding no “clear and manifest” statutory purpose to displace traditional state law, the district court applied California law in determining whether the facilities lease was a true lease for purposes of section 365.

Under California law, an agreement is presumptively a lease of real property if it is called a lease by the parties, contains a definite description of the leased property, provides for periodic payment of rent for the term of the lease and provides a right to occupy the property to the exclusion of the lessor.

The facilities lease met these touchstones and was, therefore, presumed to be a true lease under California law. The presumption could have been rebutted if United had established that the parties intended something else – for example, if they had intended to use the facilities lease to disguise a sale of the airport maintenance facility or to act merely as an encumbrance on the maintenance facility. The intention of the parties is determined by reviewing all facts and circumstances of the transaction, including the underlying economic substance. Factors considered by the district court in this case were: whether the facilities lease transferred risks and responsibilities that would normally be borne by a landlord to the lessee, whether the payments under the lease are reasonably designed to compensate the lessor for the use of the property or simply to reflect the repayment of the lessor’s own financing costs plus interest, and whether the lessor retains an economically-significant interest in the property.

Applying these factors, the district court concluded that the facilities lease was a true lease under California law. While United was required to pay the taxes, upkeep and insurance for the maintenance facility –  obligations typically borne by an owner –  the district court concluded that the use of triple net leases is not unusual in the real estate context.

The district court also determined that the aggregate rental payments required by the facilities lease included an amount needed to amortize the revenue bonds as well as reasonable compensation for the use and occupancy of the 20-acre site.

United argued that because the CSCDA did not retain an ownership interest at the end of the facilities lease, the facilities lease cannot be a true lease. This important factor was the sole basis the bankruptcy court gave for its conclusion that the arrangement was not a true lease. The district court observed that a “lease-leaseback” arrangement as a method of financing is not inconsistent with the existence of a lease. United conceded that it did not own and could not ever own the airport maintenance facility. In fact, it had no option to purchase the facility at the end of the facilities lease. Accordingly, the district court concluded that the lack of a reversionary interest for the CSCDA at the end of the facilities lease did not rule out treating the facilities lease as a true lease.

The bottom line: the facilities lease is a true lease under California law.

Aftermath

Interestingly, courts that have had to address this issue under the Uniform Commercial Code have similarly struggled with determining whether an agreement should be characterized as a true lease as opposed to a lease intended for security or a financing agreement. Section 1-201(37) of the UCC was amended in response to perceived ambiguities and over reliance on the parties’ intent engendered by the old statutory language. Accordingly, amended section 1-201(37) deletes all references to the parties’ intent.

As amended, section 1-201(37) provides, in pertinent part, as follows:

“Whether a transaction creates a lease or security interest is determined by the facts of each case; however, 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:

(i)   the original term of the lease is equal to or greater than the remaining economic life of the goods,

(ii)  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,

(iii) the lessee has the 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

(iv)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.”

If the district court’s decision in the HSBC Bank case correctly articulates the law – United has not yet decided whether it will appeal – then a court would be strongly influenced by the UCC analysis, with the result that a significant residual interest would be the most compelling factor in determining whether an arrangement is a lease.