When a contract looks like a lease, but operates more like a security agreement, how should the contract be treated in bankruptcy? The United States Bankruptcy Court for the District of Kansas recently considered this question in In re James, noting that the issue of categorizing a transaction as a lease or security agreement is a “problem that has ‘vexed the court for many years.’” Ultimately, the court applied a test analyzing the underlying economics of the transaction to find that what appeared to be a car lease was, in fact, a disguised financing arrangement.

The “Lease”

The debtors in James had an agreement with an automotive company that required them to make weekly payments in exchange for the use of a car. The company argued that the arrangement was a lease, and that the debtors could retain the use of their car only by assuming the lease and curing any monetary defaults. The debtors, on the other hand, asserted that the contract was a disguised security interest and purchase money sale agreement and proposed to treat the claim as a secured claim (a “910 claim”) under their chapter 13 plan.

Intent vs. Economic Realities

The court cited to the decision of the United States Supreme Court in Butner v. United States for the principle that the Bankruptcy Code “generally leaves intact the determination of property rights under state law.” Under Kansas state law, a two-prong test examining the “economic realities” of the transaction, rather than the parties’ subjective intent, is applied to determine whether an agreement is a lease or a security interest. Both prongs are required to be satisfied to find that a lease is a disguised financing. To satisfy the first prong, the consideration paid by the lessee must be an obligation for the term of the lease that is not subject to termination by the lessee. The second prong requires one of four elements to be present to establish a security interest:

  1. the original lease term is equal to or greater than the remaining economic life of the collateral;
  2. the lessee is bound to renew the lease for the remaining economic life of the collateral or, alternatively, become the owner thereof;
  3. the lessee has an option to renew the lease for the remaining economic life of the goods for no (or nominal) additional consideration upon compliance with the agreement; or
  4. the lessee has an option to become the owner of the goods for no (or nominal) additional consideration upon compliance with the agreement.

Applying the Test

The court found that the first prong of the economic realities test was satisfied because the debtors’ obligation to pay for their car was an obligation for the term of the contract that they could not terminate. Although the contract did contain an early termination provision, exercising that option required the debtors to pay the total of any unpaid monthly payments due, an early termination fee, and the amount of the adjusted lease balance that exceeded the vehicle’s realized value at termination. The court found that the debtors’ right to terminate was thus a fiction, as they remained liable for the full contract amount even upon early termination.

The court held that the second prong of the economic realities test was satisfied because the debtors had the option to become the owners of the goods for no (or nominal) additional consideration. The court did not consider the first three elements available to satisfy this prong because they required an examination of the car’s economic life in relationship to the lease term, and both parties failed to provide evidence to support their position on this issue. The contract, however, contained a purchase option available upon early termination allowing the debtors to pay the balance of the unpaid contract payments at the time of early termination, as well as a termination penalty (which was capped at the amount remaining under the contract). The court noted that several courts have held that an arrangement giving a lessee no rational economic alternative but to purchase the goods at the end of the lease is a security agreement. It added that, in this case, a rational lessee would exercise the purchase option when the sum of the early termination penalty and the amount due under the lease is less than the car’s fair market value at the end of the contract’s term. Finally, the court found sufficient evidence to indicate that the reasonably predictable cost of exercising the purchase option would be nominal in comparison to the vehicle’s fair market value on the date of early termination.

Conclusion

The decision in James highlights the importance of the test used to determine whether a contract is a lease or a disguised financing. The court noted that the debtors in this case had little bargaining power, and that the automotive company may have drafted its contract to give itself the flexibility to argue that the agreement was either a lease or a disguised financing. The opinion demonstrates that analyzing the substance of a transaction may result in a different outcome and protect different interests than analyzing the contract’s form or the intent of the parties.