Equipment Leases in Bankruptcy: 5 Tests for Whether It Is Really a Lease or a Loan

The title printed across the top of an equipment agreement decides nothing in a bankruptcy case. A document called a lease may be a sale on credit with the seller's name left on the title, and the difference controls whether the business must keep paying in full to keep the machine or may treat the financer as a secured creditor whose claim is measured against what the machine is worth.

The test comes from state commercial law, in the provision the uniform text numbers UCC Section 1-203, as each state has enacted it. Its first sentence refuses to give an easy answer: whether a transaction "creates a lease or security interest is determined by the facts of each case." The five tests below are how the statute narrows those facts.

1. Whether the Business Can Walk Away Before the Term Ends

Every bright-line test in Section 1-203(b) begins with a gateway condition. The payments must be "an obligation for the term of the lease" that "is not subject to termination by the lessee." If the business may hand the equipment back partway through and stop paying, none of the four tests that follow can make the agreement a security interest by operation of the rule, and the question returns to the facts of each case.

A clause that makes the payments unconditional for the full term (the trade calls it hell or high water) satisfies that condition. The clause is there to protect the financer, and it is also what opens the door to recharacterization.

So read the termination section before anything else. If it says the lessee may not cancel, the next four tests matter. If it allows a walk away, most of what follows can be set down.

2. Whether the Term Outlasts the Machine

The first test asks whether "the original term of the lease is equal to or greater than the remaining economic life of the goods." A sixty-month agreement on a delivery van that will be worn out in five years has consumed the entire useful value of the vehicle. Nothing of economic substance returns to the lessor at the end, and a lessor that expects nothing back has, in substance, sold the van.

Economic life is measured, Section 1-203(e) says, "with reference to the facts and circumstances at the time the transaction is entered into." Hindsight does not count. A machine that happened to last twelve years does not convert a seven-year lease signed when the machine was expected to last six.

3. Whether the Business Is Bound to Renew or to Buy

The second test is met if "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." The word that matters is bound. An obligation to purchase at the end, whatever the price, means the lessor never expected the goods back.

These clauses tend to hide in the schedule rather than the master agreement, under a heading about end-of-term options, and a business that signed a master lease years ago and a new schedule for each piece of equipment since then may have several different answers in one file drawer.

4. Whether a Renewal Option Costs Almost Nothing

The third test covers an option "to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal additional consideration." A lessee who may keep the equipment for the rest of its life for a trivial sum will always do so, and everyone knew that when the agreement was signed.

Nominal has a statutory meaning. Under Section 1-203(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." Put in plain terms, if returning the machine (crating it, shipping it to the lessor's yard, paying the restoration charges the lease imposes) would cost more than the renewal, the renewal is nominal, whatever the dollar figure looks like on paper.

5. Whether the Purchase Option Is One Dollar or Fair Market Value

The fourth test is the one most owners have heard of without knowing its source: an option "to become the owner of the goods for no additional consideration or for nominal additional consideration." The one-dollar buyout at the end of a sixty-month schedule is the familiar version. The lessee pays the dollar. Of course it does.

The fair market value option sits on the other side of the line. Section 1-203(d)(2) provides that a purchase price "stated to be the fair market value of the goods determined at the time the option is to be performed" is not nominal, and Section 1-203(c) adds that a fixed price at or above the "reasonably predictable fair market value" does not by itself create a security interest. Between those poles lie fixed percentage buyouts (take a hypothetical option at ten percent of original cost, where whether it is nominal depends on what the equipment will be worth and what returning it would cost, which is not something one can answer from the percentage alone).

A lease is a promise to give the thing back. When nobody expects the thing back, the promise was never the point.

Section 1-203(c) also removes several arguments owners sometimes raise. An agreement does not create a security interest "merely because" the payments equal or exceed the equipment's value when signed, or because the lessee bears the risk of loss, or pays taxes, insurance, and maintenance. Those features are common in true leases too. They may count for something in combination, though the statute speaks only to what they cannot do alone.

When none of the four tests is met and the gateway condition is, the bright-line rule does not decide the matter, and Section 1-203(a) sends the court back to the facts. That is where litigation over recharacterization tends to live.

What follows from the answer is the reason to ask. A true lease is an unexpired lease under Bankruptcy Code Section 365. In Chapter 11, Section 365(d)(5) requires the debtor to perform lease obligations first arising 60 days or more into the case until the lease is assumed or rejected (unless the court orders otherwise on the equities), and assumption requires curing defaults under Section 365(b)(1). A disguised security interest is a secured claim, which Section 506(a) values only to the extent of the equipment's worth, with the rest unsecured. And if the financer never perfected its interest because it believed it owned the machine, the trustee's power under Section 544(a)(1) to take the position of a hypothetical lien creditor on the petition date puts that unperfected interest at risk, subject to how the governing state's commercial code ranks the two.

The landlord cap in Section 502(b)(6) does not help here. It applies to leases of real property only.

Where Delancey Street Fits in an Equipment Dispute

An owner deciding whether to challenge a lease's characterization needs a bankruptcy lawyer, and Delancey Street, which is not a law firm, does not litigate recharacterization or file cases. Its role is narrower. When equipment payments sit next to merchant cash advance debt that is draining the account, Delancey Street reviews the advance debt without charge and in confidence, and where a legal issue surfaces it works with attorneys who are separately licensed. Some owners need the lawyer first, and should call one before they call anyone else.

The schedule with the buyout clause is usually a single page, stapled behind the master agreement.