“To Lease or Not to Lease?”
Whether an equipment lease is characterized as a true lease or a disguised financing in a bankruptcy setting determines what rights and remedies are available to the lessor. For example, if the lease is deemed to be a disguised financing, a debtor may retain possession of the leased property during the bankruptcy case without having to comply with the ongoing post-petition rent payment requirements of section 365(b)(5) of the Bankruptcy Code. In such instance, the debtor also does not need to assume the lease, cure pre-petition or post-petition arrearages, or commit to administrative expense priority treatment for future rent obligations under the assumed lease.
Moreover, if the lease is not deemed a true lease, the debtor may modify the resulting secured financing using section 506(a)(1) of the Code to bifurcate the lessor’s claim into a secured claim for the current value of the leased property and a general unsecured claim for the deficiency. In some instances, the debtor may even be able to avoid the lessor’s entire secured claim if the lessor has not taken adequate steps to perfect its interests prepetition (e.g., by properly filing and maintaining the effectiveness of a UCC-1 financing statement for personal property).
Thus, there is a lot at stake whenever a hybrid agreement either labelled a “lease” or containing elements of a lease can be recharacterized as a disguised financing.
Pioneer Health Services
In First Guaranty Bank v. Pioneer Health Services, Inc. (In re Pioneer Health Services, Inc.), Case No. 17-60824, 2018 WL 3747537 (5th Cir. August 7, 2081), the Fifth Circuit Court of Appeals recently reminded us that a disguised financing instrument is not entitled to administrative priority claims generally afforded to true leases under sections 365(d)(5) and 503(b)(1)(A) of the Bankruptcy Code.
The facts in the Pioneer Health are straight-forward. The debtor (Pioneer Health) owned several hospitals and healthcare facilities. Prior to filing bankruptcy, the debtor had entered into several contracts with a licensor for “limited, nonexclusive, nontransferable, non-sublicensable, perpetual license” to an electronic health record system used for billing, scheduling, record retention and organization. Id. at *1.
To pay for the electronic health record system, which cost $8.5 million, the debtor entered into 3 contracts with a financing company (which was not the licensor). Id. Two of the contracts were labelled “Conditional Sales Agreement.” Id. Each of the Conditional Sales Agreements provided that (a) the financing company was selling the health record system to the debtor, (b) the sale was non-cancelable, (c) title to the system remained with the financing company until full payment of the purchase price (which was being paid in installments), and (d) the financing company was authorized to file a UCC-1 financing statement to evidence a security interest in the system. Id.
Notwithstanding the above provisions, the two contracts also provided that the financing company was leasing—not selling—the software comprising the health record system to the debtor and, upon payment default, the license to this software could be terminated.
The third contract with the financing company contained (a) an acknowledgement that that the transaction to purchase the health record system was a financing transaction and (b) a provision allowing the licensor to terminate the license for the software upon a payment default by the debtor.
After the debtor filed bankruptcy, the financing company filed a motion to compel payments owed under the Conditional Sales Agreements, arguing that missed post-petition payment were (a) “actual and necessary” costs of preserving the debtor’s business, in accordance with section 503(b)(1)(A) of the Code, and (b) entitled to administrative priority treatment pursuant to section 365(d)(5) of the Code.
The Fifth Circuit first addressed the section 365(d)(5) claim, noting that, while section 365(d)(5) does require post-petition performance under an unexpired lease of personal property, “’[i]f a lease is merely a disguised sale and security agreement, [Bankruptcy] Code § 365 will not be applicable.’” Pioneer Health, 2018 WL 3747537, at *2 (quoting 7 Norton Bankr. L. & Prac., § 127:8 (3d ed. April 2018 update)). The Court also noted that the determination of whether a contract is a true lease is governed by state law.
Under Utah law, the governing state law, courts look beyond the form of an agreement to determine whether it creates a true lease or secured financing transaction. See, e.g., Bd. Of Equalization of Salt Lake Cty. v. First Sec. Leasing Co., 881 P.2d 877, 878 (Utah 1994). Utah also adopted the common version of the Uniform Commercial Code, which establishes a per se test to determine when a transaction constitutes a secured transaction. Under section 70A-1a-203(2)(b) of the Utah Code, a transaction is per se a secured transaction—instead of a lease—when the agreement is not subject to cancellation by the lessee and the lessee is bound to be the owner of the goods.
The financing company argued that the sale of the health record system created a true lease because the relevant agreements provided that (a) the debtor was leasing the software for the system and (b) the software license could be terminated at any time upon a payment default. But the Fifth Circuit did not buy this argument, elevating form over substance and reasoning that the Conditional Sales Agreements (a) were, in fact, noncancelable and (b) bound the debtor to become the owner of the equipment (including the software) upon full payment of the purchase price. Pioneer Health, 2018 WL 3747537, at *3
Turning to section 503(b)(1)(A) of the Code, which requires payment for “the actual and necessary costs and expenses of preserving [an] estate,” the Fifth Circuit found that section 503(b)(1)(A) contains a temporal element that requires the costs and expenses to have arisen post-petition. Id. at *4. Because the debt under the Conditional Sales Agreements arose several years before the bankruptcy, the Court held, however, that such old debt did not meet the temporal requirement and thus was not entitled to administrative priority treatment under section 503(b)(1)(A). Id. at *4.
In the end, Fifth Circuit held that the financing company was not entitled to administrative priority claims under either section 365(d)(5) or section 503(b)(1)(A).
Secured lenders, which sometimes face limited recourse in a bankruptcy, often look to recharacterize their transactions as leases to obtain additional remedies under the Bankruptcy Code. Indeed, in Pioneer Health, the financing company was not being paid post-petition and the health record system (the collateral) likely was not worth the same value as when it was first purchased, leaving the financing company with a substantial (and uncollectible) undersecured claim and little chance of obtaining a meaningful recovery from its collateral. Facing a substantial loss, the financing company probably felt compelled to seek additional remedies under sections 365(d)(5) and 503(b)(1)(A).
Because of the limited recourse to lenders in the same shoes as the financing company in Pioneer Health, the debate about what constitutes a true lease or disguised financing will likely continue in the future. There will often be room to debate this issue when there exist hybrid agreements that contain elements of both a lease and a secured transaction.