TRUE LEASE V. DISGUISED SECURITY INTEREST

- The characterization of a transaction as either a true “lease” or a secured transaction is likely to impact the putative lessor’s rights and remedies both with respect to the calculation of damages recoverable under the transaction documents as well as to the residual value of the subject equipment, especially if the lessee files for bankruptcy. In disputes between the putative lessor and another creditor claiming to have a security interest in the subject equipment, as in In re Purdy, the characterization of the transaction will determine which of those parties will be entitled to recover the value of the equipment. The court in Purdy was asked to consider the characterization of a purported lease of cattle, so as to determine whether the purported lessor or the secured creditor would be entitled to the disposition proceeds after the cattle were sold. Sunshine Heifers, LLC (“Sunshine”) and Lee Purdy, a dairy farmer, entered into several dairy cow leases over three years, in which Sunshine agreed to provide Purdy with dairy cows in exchange for monthly rent. Prior to entering into the dairy cow leases, Purdy entered into a loan arrangement with Citizens First Bank (“Citizens First”), in which “Purdy granted Citizens First a purchase money security interest in ‘all . . . Equipment, Farm Products, [and] Livestock . . . currently owned [or] hereafter acquired.’”When Purdy’s farm petitioned for bankruptcy protection, Sunshine moved to retake possession of its cattle. Citizens First argued that the leases were “disguised security agreements” and, as a result, Purdy owned the subsequently acquired cattle, and such ownership was subject to the bank’s security interest. The bankruptcy court agreed. The United States Court of Appeals for the Sixth Circuit reversed the bankruptcy court’s decision that the dairy cow leases were per se security agreements.

The court applied a two-step factual analysis to consider the appropriate characterization of the transaction. First, the court applied the so-called bright line test under Arizona’s version of U.C.C. section 1-203, including a determination both of whether the lease obligation could be terminated early (of which there was no dispute), and whether the original term of the lease was equal to or greater than the remaining economic life of the cattle. If the lease term exceeded the economic life of the cattle, then the leases to Purdy would constitute security agreements, but if not, the court would examine the facts of the case to determine whether the economic realities of the transaction suggested how the transaction should be characterized. Unlike the bankruptcy court, the Sixth Circuit determined that the leased herd included cattle originally leased as well as replacements for cattle that had been culled from that original herd, and that the herd as so comprised had an “economic life far greater than the lease term.”Accordingly, the purported leases “flunk[ed] the bright line test,” and the court found that the leases were not per se security agreements.

Originally published in The Business Lawyer (Vol. 70, No. 4, Fall 2015).