Lawrence Hsieh
If you're a junior associate, chances are you'll soon be summoned on a Friday afternoon to work on a business combination that has to close on Monday. If you're a bit lost, you can at least take comfort knowing that there are good resources you can access to learn about how deals are structured.1 Once you understand the structure of the deal (including the "how" and the "why"), you can access a variety of good resources to help you to draft, benchmark and negotiate the transaction documents.
Now fast forward a few years, and once again you get the dreaded Friday afternoon call. But this time, you take the call sitting in a cubicle in a suburban corporate park, and it's the GC instead of a partner on the other end of the line. You've got dozens of acquisitions under your belt, but the GC tells you that you'll be negotiating an equipment lease.
You dig around a bit, and soon realize that "standard" equipment lease forms are hard to come by (even if you represent a lessor). And the ones out there vary dramatically in form and substance.2 That's partly because lease classification depends on a combination of economic, state law, bankruptcy, tax and accounting considerations. Just because you call it a "lease" doesn't necessarily make it so, even if you draft the most internally consistent, unambiguous, dreck-free contract in all of legal history. "Substance trumps form" almost every time.
This article will focus on basic drafting issues that impact what is one of the most important (and overlooked) legal issues in equipment lease practice—true lease status under Article 2A of the Uniform Commercial Code. Keep in mind that the parties need also to determine whether the lease is a true tax lease under the federal income tax guidelines and an operating or capital lease under the accounting rules. Many of the determining factors overlap, but an analysis of tax and accounting issues is beyond the scope of this article.
Lease or Sale
Let's start with the fundamentals. Under the UCC, there are two basic ways to transfer equipment to somebody who needs to use it. You can sell it under Article 2 or lease it under Article 2A. If you sell the equipment, you're going to convey both ownership and possession of the equipment to the buyer. If you're a lessor, you're going to convey the exclusive right to use the equipment to the lessee, but retain ownership of the equipment.
If the lessor structures the lease improperly, it makes the lease vulnerable to a UCC true lease attack. This occurs when the lessee attempts to re-characterize the putative lease as a "disguised security interest" (i.e., an Article 2 sale, subject to an Article 9 security interest to secure the purchase price). If the lessee prevails, this significantly reduces the lessor's rights in the equipment.
• First, the "lessee" becomes the owner of the equipment. The "lessor" becomes the proud owner of a security interest in the equipment.
• To add insult to injury, the lessor's security interest is unperfected if it neglected to file a precautionary UCC-1 financing statement.
• Since the transaction is now a sale, rather than a lease, the lessor is deemed to have given (unless disclaimed) the Article 2 rather than Article 2A implied product warranties. This can impact the lessor's warranty disclaimers. For example, the lessor in a UCC finance lease (a special kind of UCC true lease)3 is entitled to an automatic disclaimer of the implied warranty of merchantability. In other words, UCC finance lease lessors don't need to make the disclaimer because Article 2A doesn't impute the warranty to the lessor in the first place. Unfortunately, if the transaction turns out to have been a sale, then the finance lessor (now a seller) will likely be deemed to have given a seller's Article 2 implied warranty of merchantability because it probably never occurred to the lessor to make the disclaimer.
• Since the transaction is now a sale, whose deferred purchase price is deemed a loan, the lessor (as lender) is subject to the usury laws.
• If the lessee goes bankrupt, the equipment becomes part of the lessee's (rather than the lessor's) bankruptcy estate. Among other negative consequences, the lessor may find itself impacted by a cramdown. A cramdown is a bankruptcy procedure where the court confirms the lessee's plan of reorganization of its estate (including the equipment) over the lessor's objection, as long as the plan is fair to each impaired class.
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