Hitchin Post Steak Co v General Electric Capital Corporation (In re HP Distribution, LLP), 436 B.R. 679 (Bankr. D. Kan. 2010)

CASE SNAPSHOT

The United States Bankruptcy Court for the District of Kansas considered whether commercial vehicle leases that contained Terminal Rental Adjustment Clauses (or TRAC provisions) were true leases under Section 365 of the Bankruptcy Code or, instead, disguised financing transactions. The court held that the TRAC leases were true leases that must be either assumed or assigned pursuant to the terms of Section 365.

FACTUAL BACKGROUND

Hitchin Post Steak Co. filed for bankruptcy protection in July 2009. At that time, it was party to seven equipment leases with General Electric Capital Corporation, each of which contained a TRAC provision. Pursuant to the terms of the leases, the Debtor was obligated, at the end of the original lease term, to return the leased equipment – in this case tractors and trailers – and GE Capital was obligated to sell the returned equipment and liquidate its value. In the event that the equipment sold for more than the pre-negotiated residual value, the excess proceeds would be returned to the Debtor. In the event the equipment sold for less than the negotiated residual, the Debtor was obligated to compensate GE Capital for the shortfall. In all but one of the leases at issue before the Bankruptcy Court, the residual value of the equipment – negotiated at the outset of the leases – was approximately 20 percent of the original equipment costs; for the seventh lease, the residual value was equal to approximately 12 percent of the original equipment costs. Both the Debtor and GE Capital agreed that the average useful life of the equipment was greater than the original lease term, and that the value of the equipment at the end of the least term was not nominal.

Because it could not afford to pay the monthly lease payments – required to be paid under Section 365(d)(5) of the Bankruptcy Code – the Debtor filed an adversary action seeking to recharacterize the leases as disguised financing transactions. If successful, the Debtor would be obligated to compensate GE Capital only for the depreciation of the equipment prior to plan confirmation, and could subject GE Capital to a “cramdown” on the value of the equipment following confirmation of the plan. As such, the recharacterization of the leases might have had a substantial economic benefit to the Debtor both during the pendency of its bankruptcy case, and following confirmation.

COURT ANALYSIS

In its purest form, a lease has two distinguishing attributes: (i) the lessor retains an “entrepreneurial stake” in the leased property, and (ii) keeps a valuable “reversionary” interest. In contrast, a security interest involves a lender who lends money to a purchaser and retains a lien on the purchased goods to secure the repayment of the loan. With a loan, the lender has an interest in making sure the value of the collateral does not decline below the loan balance, but this is the extent of the entrepreneurial interest in the property. A TRAC lease, however, represents a non-traditional mix of these two archetypal forms.

In the GE Capital TRAC leases before the Bankruptcy Court, as is typical of many TRAC leases, GE Capital was entitled to the return of the leased equipment once the lease term had ended, but GE Capital was then required to sell the equipment. If the equipment sold for more than the pre-negotiated “residual” amount, the excess would go to the lessee. If it sold for less, the lessee was required to compensate GE Capital for the difference. This “true up” provision, the lessee argued, meant that GE Capital retained no entrepreneurial stake in the equipment. The Bankruptcy Court, however, disagreed, and granted summary judgment in favor of GE Capital.

In examining the TRAC leases within the context of Section 1-203 of the Uniform Commercial Code, which distinguishes leases from security interests, the Bankruptcy Court was first obligated to determine if the TRAC leases satisfied the “bright line” test outlined in Section 1-203(b). This “bright line” test involves a two-step analysis, namely: (i) a determination as to whether the leases were terminable by the lessee; and (ii) the consideration of certain enumerated factors indicative of a disguised financing transaction (e.g., the original term of the leases are equal to or longer than the useful life of the equipment, the lessee can purchase the leased goods for nominal consideration at the end of the lease term, etc.). Had the court found that the bright line test was satisfied, recharacterization of the leases would have been mandatory. In the instant case, however, the court declined to make such a finding.

First, the Bankruptcy Court determined that the leases expressly provided for early termination by the lessee, and that, because of the financial benefits the lessee might receive upon termination, the TRAC leases were terminable, and the lessee’s right to terminate was more than just illusory. Next, the court examined the leases in the context of four signposts outlined in UCC section 1-203(b) that are often indicative of a disguised financing transaction, and found them all to be lacking in this instance. Having found that the TRAC leases did not satisfy the requirements of section 1-203(b), the court determined that the TRAC leases were not financing agreements as a matter of law.  

This, however, did not end the inquiry. Even if the leases did not satisfy the bright line test, the court could determine that they were financing transactions if “totality of the circumstances” supported a finding that they were not true leases. Specifically, the court considered whether the TRAC provisions in the leases left GE Capital with a meaningful residual interest. In considering this point, the court noted that many states have enacted so-called TRAC-neutral statutes that provide, in essence, that the presence of a TRAC clause has no bearing on whether a transaction is a security interest or a true lease. (See, e.g., Tex. Transp. Cod Ann. § 501.112; Kan Stat. Ann. § 84-2a-110(a).) As such, the existence of a TRAC provision was not dispositive, and the court must look beyond the TRAC provision to determine the economic realities.  

The lessee argued that the TRAC provision protects GE Capital from any downside risk by assuring that, to the extent the equipment sells for less than the pre-negotiated amounts, the lessee was required to make GE Capital whole. In response, GE Capital argued that this protection is illusory unless the lessee is creditworthy, and that the existence of the TRAC provision is merely a mechanism to encourage the lessee to care for the leased equipment and protect its value.

After examining the intricacies of more than 30 years of TRAC lease jurisprudence, the court ultimately concluded that GE Capital did retain a meaningful reversionary interest in the leased equipment, and that this was consistent with the leases being characterized as true leases. Essential to this finding was the fact that the lessee had no right to renew and/or extend the term of the leases beyond their original term, and that the lessee had no rights to purchase the equipment other than those available to an independent third party to place a bid for the equipment at a public sale. Indeed, even were the debtor to be the ultimate purchaser of the equipment, it would likely have to bid the residual amount (in this case approximately 20 percent of the original equipment cost for much of the equipment) in order to acquire the goods. Finally, while GE Capital may not own the equipment after the sale, it would possess the proceeds of the equipment, which is the economic equivalent.

The Bankruptcy Court held that the leases failed to satisfy the bright line test of Section 1-203(b) of the Uniform Commercial Code. In addition, the economic reality of the leases confirmed that they should be considered true leases, and not disguised financing transactions.  

PRACTICAL CONSIDERATIONS

The TRAC provisions included within many leases permit the lessor to obtain the benefits of true lessor status in bankruptcy, while, at the same time, protect the lessor from asset value risk associated with traditional leases that makes it difficult for financial institutions to book lease residuals at full value. From the practitioner’s point of view, this case solidly reaches the conclusions that: (i) a lessor retains a meaningful economic interest in the lease residual even though the residual is proceeds of the asset, as opposed to the asset itself; and (ii) the fact that the asset “secures” the credit risk that the lessee will not perform the TRAC, translates into the lessor’s retaining an interest in the asset even though the lessor has no economic upside or downside on disposition of the asset. Both these conclusions considerably advance the jurisprudence on this issue in the lessor’s favor.