UCC Expert’s Corner: Court Finds Lease Arrangement was Disguised Security Interest
December 3, 2015
The parties to a lease, consignment, sale, or other arrangement may not realize that the transaction is governed by UCC Article 9. Article 9 applies to any transaction, regardless of form, that creates a security interest in personal property by contract. If the transaction does fall within the scope of Article 9, the lessor, consignor, or seller must comply with the statutory perfection requirements. Failure to comply could prove costly, as the purported lessor learned in a recent case, In re: Hunt, 2015 WL 6501074 (Bankr. D. Idaho Oct. 27, 2015).
In 2011, the owner of Malad Plumbing, a sole proprietorship, offered to sell his business to an employee and the employee’s spouse (the “Debtors”), but only if they could close within a very short deadline. The Debtors were unable to obtain sufficient financing, but a friend, Shephard, offered to help. With Shephard’s financial assistance, the Debtors were able to acquire the business.
The Debtors continued to operate the plumbing business as a sole proprietorship. However, the business did not work out and the Debtors filed for chapter 7 bankruptcy in 2014. The Debtor’s bankruptcy petition schedules listed Shephard both as a secured creditor and as the lessor under a “rent-to-own” agreement.
The chapter 7 trustee (“Trustee”) brought a motion seeking to have the Debtors turn over a backhoe, trencher, plus other plumbing equipment and tools (the “Property”). The Trustee argued that the Property was property of the estate and subject to liquidation.
The Debtors, however, claimed that the Property belonged to Shephard until they completed all payments to him. Therefore, the Property was not property of the estate and was not subject to turnover.
The court noted that determining the nature of the Property was complicated because the agreement between the Debtors and Shephard was never reduced to writing. However, the available evidence indicated that the transaction was as likely a loan as a lease. The Debtors and Shephard repeatedly referred to the arrangement as a “loan” and stated that the money was provided for the Debtors to purchase the business and its assets.
Even if the transaction was a lease, the court determined that the evidence showed it was actually a disguised security interest under state law (UCC § 1-203). There was no set term for the lease. There was no evidence that the Debtors had the right to terminate the lease until they had made full payment to Shephard. Finally, the Debtors would acquire ownership of the Property without further consideration once they completed payments to Shephard.
The court concluded that the transaction was a sale and not a true lease. Therefore, the Debtors were required to turn over the Property to the Trustee.
The important thing to take away from this case is that the scope of Article 9 extends to transactions that create a disguised security interest. Whether the Article 9 perfection requirements apply to a particular transaction does not depend on the intent of the parties or how they characterize the arrangement. The legal characterization of the deal and, therefore, the application of Article 9 will depend on the facts and circumstances of the transaction. If there is any question regarding the characterization of a particular transaction, the creditor should comply with the Article 9 requirements for creation and perfection of a security interest.
Paul Hodnefield is associate general counsel for CSC and a frequent speaker/writer on UCC due diligence issues. Please feel free to contact him with questions or comments at firstname.lastname@example.org or 800-927-9801, ext. 61730.