In our April 21, 2022 Newsletter, we reported to you that a special committee was in the process of amending the Uniform Commercial Code (the “UCC”) to reflect emerged and emerging technologies and trends. The technology-related amendments addressed, among other things, transactions involving distributed ledger technology, virtual currencies, nonfungible tokens and other digital assets. The amendments of particular interest to equipment leasing and financing parties are intended to reflect emerged and emerging industry practices. The referenced emerged industry practice is the creation and vaulting of equipment leasing and financing transactions existing only in electronic format. The emerging industry practice is the offering of financing products related to “bundled” transactions, which bundle a sale or lease of equipment, together with, among other things, a related software license, maintenance or other services, consumables or other related property, services or rights.
As explained in our previous article, the UCC is a “model commercial code which serves as the basis for state laws that govern most commercial transactions originated in the United States.” It facilitates sales, leases, secured financings and other transactions involving personal property by providing a uniform approach by states to the various legal considerations relating to these transactions. The practical benefit intended by this uniform approach is that the outcome of disputes among parties to, or impacted by, these transactions should be equitable and predictable.
Significant amendments to the UCC are made very infrequently, and are typically driven by a recognized need to align the UCC’s coverage of transactional matters with evolved or evolving market circumstances, trends and practices. As noted in our previous article, a special committee of commercial lawyers began the process of amending the model UCC in 2019 when it became clear that the existing model version did not cover, either adequately or at all, certain emerged and emerging technologies and trends. Since then, the amendments were finalized and are currently being considered for enactment by the states.1
The final version of the amendments–generally.
The UCC is the legal underpinning for structuring, documenting, syndicating, securitizing and enforcing the spectrum of equipment finance and capital markets transactions. Accordingly, the amendments could have an impact on these transactions upon becoming effective in the various states, especially in New York because New York governing law is often the popular choice for many domestic and foreign transactions. Upon enactment, the amendments could afford certain market advantages if leveraged, or disadvantages if ignored.
The amendments that are likely to be of greatest interest to equipment finance providers relate to “chattel paper,” a category of collateral covered by revised UCC 9,2 and to “hybrid leases,” a newly recognized category of true leases covered by revised UCC 2A.3 The digital asset laws created by the amendments are provided in a new UCC 12, and in revisions to UCC 9. Executive summaries of these amendments are provided below.
Chattel paper amendments.
References to “chattel paper” refer to a category of collateral covered by UCC 9. Although UCC 9 is typically associated with secured transactions, in addition to covering loans secured by collateral, it also covers purchases of chattel paper, including syndications, securitizations, and other capital markets transactions involving equipment leases and/or financings. Currently, “chattel paper” refers to the tangible or electronic original of an equipment lease or financing designated by the parties as being the “chattel paper” original. Whether in the context of a secured financing or purchase of the receivables evidenced by a related lease or financing, the secured lender or purchaser must satisfy the applicable UCC 9 requirements in order to establish the priority of its interest in the associated chattel paper. Perfection may be achieved by either physical possession of the tangible copy, or control of the electronic record, of the designated chattel paper originals of the related lease or secured financing documents. Establishing that a secured party or purchaser has validly perfected its interest in any associated chattel paper original is a very significant focus of most capital markets transactions.
Amended Definition of Chattel Paper.
The amended defintion of “chattel paper” under UCC 9 now relates to the payment right of a lessor or secured party, not the paper or electronic record evidencing that right.
Specifically, Section 9-102(a)(11) has been amended to read as follows:
“‘Chattel paper’ means:
(A) a right to payment of a monetary obligation secured by specific goods, if the right to payment and security agreement are evidenced by a record; or (B) a right to payment of a monetary obligation owed by a lessee under a lease agreement with respect to specific goods and a monetary obligation owed by the lessee in connection with the transaction giving rise to the lease, if:
- (i) the right to payment and lease agreement are evidenced by a record; and
- (ii) the predominant purpose of the transaction giving rise to the lease was to give the lessee the right to possession and use of the goods.” (emphasis added)
But, as was the case before being amended, the term “chattel paper” does not include certain other payment rights, including with respect to a vessel charter or the use of a credit or charge card.
Official Comments and Examples. Although the “Official Comments” and related examples which follow Section 9-102(a)(11) are not legally binding, they provide useful as context for the intentions of the drafting committee when considering the text of the amended definition.
Official Comment 5(b) is particularly helpful, and includes the following explanation: “What distinguishes chattel paper from other rights to payment is the fact that the creditor has an interest in specific goods to enforce the right to payment. For example, the fact that a secured party also has an interest in other property does not prevent the right to payment from being chattel paper, provided that the specific goods are the primary collateral.” (emphasis added)
Examples 8 and 9 and the related commentary regarding what might constitute “chattel paper” provide some further insight as to the practical circumstances contemplated by the drafting committee when amending the definition.
Example 8. “To secure a loan, Borrower grants Lender a security interest in a specified item of equipment and a deposit account. The loan and the security interest are evidenced by one or more records. The right to payment is chattel paper, assuming the equipment is the primary collateral.” In this example, the inclusion of some incidental collateral, such as a deposit account, does not prevent the characterization of the Lender’s right to payment as chattel paper. Another typical example would be the inclusion of after-acquired replacement parts to be installed on the specified equipment.
Example 9. “To secure a loan, Borrower grants Lender a security interest in all of Borrower’s existing and after-acquired inventory. The loan and the security interest are evidenced by one or more records. The right to payment is not chattel paper.” In order to be chattel paper, a right to payment must be accompanied by a security interest in specific goods or a lease of specific goods. Accordingly, a right to payment secured by a security interest in inventory or similar rotating collateral is not chattel paper.
Achieving priority of interests in “chattel paper.”
In order to achieve priority over other parties claiming an interest in chattel paper either being pledged as collateral securing a loan or purchased in a capital markets transaction, a secured party or purchaser must “perfect” its interest by satisfying the applicable requirements in UCC 9. In larger capital markets transactions, perfection by possession or control by the purchaser of the related tangible or electronic records is often required because it could, together with the satisfaction of certain other criteria, afford the purchaser “superpriority” over competing third-party claims.
New Section 9-314A. New Section 9-314A amends the manner by which a purchaser or secured party may perfect the interest granted or conveyed to it with respect to chattel paper. Aside from filing a financing statement, a purchaser or secured party may also perfect its security interest by taking and retaining possession of each tangible (paper), and “control” of each electronic, “authoritative” copy or copies of the records evidencing the chattel paper. Official Comment 1 to new Section 9-314A explains the practical purpose underlying the differences in the perfection requirements when comparing new Section 9-314A to current Section 9-314 “[t]o accommodate current practices and future technology, parties are allowed considerable flexibility in determining the method used to establish whether a particular copy is authoritative, provided that third parties are able to reasonably identify the authoritative copies that must be possessed or controlled to achieve perfection.”4
Essentially, perfection may be achieved by having either, or a combination of, tangible or electronic records so long as the party having possession or control of such records can establish that it is the “authoritative” copy of the tangible or electronic records that evidence the chattel paper. The revisions are intended to reflect current industry practices by certain lessors and financing providers who documents these using one or the other of paper or electronic records and either converting them to or supplementing them with records in the other medium. As is the case with references to “authoritative” in current UCC § 9-105(b) covering perfection by control of the authoritative copy of electronic chattel paper, the term “authoritative” is not defined, but is now also applied to tangible records.5 “Whether an electronic or tangible record evidencing chattel paper is authoritative depends on the facts and circumstances,” as noted in Official Comment 1 to new Section 9-314A, but some guidance is also provided in the Official Comment as to practices, systems and protocols that exist or may be developed to determine which copies of a record are authoritative and which are not.6
Amended Section 9-105. For the purposes of perfection by “control” under new Section 9-314A, a secured party must establish control under the general test in Section 9-105(a), including by satisfying the safe harbor tests in subsection (b) or (c) of Section 9-105. Subsections (a) and (b) are substantially unchanged by the amendments. Subsection (b) has been retained to assure viability after the amendments are enacted regarding systems for control of chattel paper evidenced by electronic records. Because subsection (b) would be inapplicable when the relevant record is maintained on a distributed ledger, subsection (c) has now been included and generally follows the conditions for control of controllable electronic records under new Section 12-105.7 Compliance with the conditions in subsection (c) would satisfy the conditions in subsection (b).8
Amended Section 9-330. Under amended Section 9-330(b), a purchaser may achieve superpriority over a security interest in chattel paper claimed other than merely as proceeds of inventory subject to a security interest if the purchaser gives new value (e.g., pays the purchase price), takes possession of each authoritative tangible copy of the record evidencing the chattel paper and obtains control under Section 9-105 of each authoritative electronic copy of the record evidencing the chattel paper, in good faith, in the ordinary course of the purchaser’s business, and without knowledge that the purchase violates the rights of the secured party. A mostly similar superpriority status may be achieved by a purchaser over a security interest in chattel paper claimed merely as proceeds of inventory by satisfying the requirements in Section 9-330(a).
Why the chattel paper amendments matter to the equipment finance industry.
Participants in these transactions, whether as originators, purchasers, lenders or investors, should be considering related changes to their equipment finance, loan and capital markets documents, transaction practices, and technology systems, so that they might take advantage of the amended laws. Upon enactment, certain transition rules will address prospective application of the UCC 9 amendments relating to post-enactment transactions involving chattel paper, or require compliance by a specified adjustment date with the amendments, in order to protect the perfection and priority of existing security interests.9
Hybrid lease amendments.
Background. The UCC amendments included a new category of (true) leases covered by UCC 2A—a “hybrid lease.” Creating this new category of lease for inclusion within the scope of UCC 2A was responsive to industry requests that leasing law be amended to better address the respective rights and remedies of parties to so-called “bundled transactions.” Transactions involving a lease of goods (i.e., the spectrum of equipment types) together with a related agreement by a lessor to provide something else to a lessee represent a growing trend in the vendor finance market. The growing popularity of these transactions is attributable to demand by customers seeking to acquire the use of certain equipment together with other related aspects of the transactions. Generally, these customers are seeking a “solution” transaction documented by a single contract, entered into with a single counterparty to whom the customer will make a single periodic payment.
Certain of these transactions include an integrated lease of equipment, but the predominant purpose is something other than the lessee’s use and possession of the equipment. By way of example, cloud services and other “…as a service” transactions sometimes include an integrated lease of the related technology or other equipment, with the associated rent payments being included in the total payment for whatever constitutes the service. Other bundled transactions may be more obvious as to the predominance of the integrated equipment lease over the other aspects of the transaction. But in either case, equipment finance participants (“observers”) involved in the amendment drafting process sought to have the scope of UCC 2A amended so that the lessor-favorable provisions could apply to all or (at least) the equipment lease provisions of UCC 2A.
What is a “hybrid lease”?
New Section 2A-103(1)(h.1) defines “hybrid lease” as “a single transaction involving a lease of goods and; (i) the provision of services; (ii) a sale of other goods; or (iii) a sale, lease, or license of property other than goods.”
As previously mentioned, the Official Comments and related examples typically provide useful insight as to the purpose and construction of each of the UCC provisions, as is the case with this new definition. As an example of what might constitute a “hybrid lease,” the Official Comments include one of the most common examples: a lease of a copier, together with a sale of paper, staples and toner, with routine maintenance and repair services, all in return for periodic payments by the lessee. There are other examples, but the customer’s predominant purpose of having the use of the copier when compared to the consumables and services is obvious.
The related Official Comment also explains that whether a bundled transaction constitutes a “hybrid lease” will be a fact-specific determination. Among one of the most important considerations is whether the purported hybrid lease is a single transaction. This is an essential factor in the definition in new Section 2A-103(1)(h.1), which specifies that a hybrid lease “means a single transaction.” Further to that, the Official Comments make clear that if the goods aspect “is unrelated to the other aspects of the transaction,” and the terms of the single agreement relating to the goods are “readily severable” from the terms of the agreement relating to the other aspects of the transaction, then the document would not create a hybrid lease. In other words, it must be a “bundled” transaction.
What does it matter if a lease is a “hybrid lease”?
Among the implications of the amendments to UCC 9 regarding chattel paper mentioned above is that the revised definition now includes payment rights under a “hybrid lease” of specific equipment. That amendment is particularly useful in capital markets transactions involving a purchase or financing of leases which might constitute hybrid leases. Industry observers advocated for that amendment so as to address uncertainties as to how those transactions might be characterized in the representations, warranties and other provisions in capital markets documents involving portfolio sales or financings. Having hybrid leases being deemed chattel paper also provides clarity as to how purchasers and secured lenders may perfect and achieve priority with respect to their interests in the associated payment rights.
Other than the creation of the defined term “hybrid lease,” the primary amendment was to expand the scope (i.e., what’s covered) provision in Section 2A-102.
Under existing Section 2A-102, UCC 2A applies to any transaction, regardless of form, that creates a lease. As amended, UCC 2A will also provide for the application of UCC 2A to hybrid leases to the extent provided in new subsection (2) of amended Section 2A-102. Subsection (2)(a) addresses the application of UCC 2A with respect to hybrid leases if the lease-of-goods aspects do not predominate, and in that event, only the provisions of UCC 2A “which relate primarily to the lease-of-goods aspects” will apply. Under subsection 2(b), UCC 2A will apply to both the lease aspects and the other aspects (e.g., services, consumables, software licenses, etc.) of a hybrid lease “if the lease-of-goods aspects… predominate.”
Industry observers participating in the amendment drafting process were particularly focused on having hybrid leases be covered by UCC 2A because of what could be considerable advantages for lessors, financing providers and investors. Underlying the pursuit of expanding the scope of UCC 2A was the hope that its lessor-favorable provisions might be applied to all or (at least) part of a bundled transaction. Although, at first, the drafting committee was skeptical about the need to consider the expansion, including because certain of the members were either unfamiliar with this industry practice or it did not arise because of emerging technology, they ultimately recognized the beneficial market implications and included the related amendments.
Although, as noted above, UCC 2A is considered to be generally lessor-favorable, the UCC 2A protections available to lessors with respect to a “finance lease” are even more desirable. Pursuant to Section 2A-103(1)(g), a lease is likely to be a “finance lease” if the lessor is merely providing acquisition financing structured as a true lease, and is not the supplier, of the leased equipment. The ultimate goal industry observers sought to achieve was “finance lease” treatment with respect to all of the transactions constituting a hybrid lease, or (at least) the integrated equipment lease.
If an equipment lease that is integrated into a hybrid lease transaction is a UCC 2A “finance lease,” Section 2A-407 which makes statutory the “hell or high water” nature of a lessee’s rent obligations, will apply to the entire transaction, not just the lease if the lease-of-goods aspects predominate the transaction. But, even if the lease-of-goods aspects do not predominate, this statutory “hell or high water” protection will still apply to the lessee’s promise to pay rent as consideration for leasing the equipment.
By way of example, consider the “finance lease” implications associated with the hybrid copier lease mentioned above. That hybrid lease included an integrated lease of a copier together with a sale of paper, staples and toner, and an agreement to provide routine maintenance and repair services, all in return for periodic payments (including the lease rentals) by the lessee. Assuming that the lease of the copier aspects of that integrated transaction predominate, and that the copier lease is a “finance lease,” the lessee’s obligation to pay the entire amount due under the hybrid lease may be deemed to be “hell or high water” upon the lessee’s acceptance of the copier. However, even if the lease of the copier aspects do not predominate, but the integrated copier lease is a “finance lease,” the lessee’s obligation to pay the copier rent portion of the periodic payments could be deemed to be “hell or high water.” In either case, the lessor’s ability to monetize all or at least part of the revenue associated with a hybrid lease will be greatly enhanced.
Why the hybrid lease amendments matter to the equipment finance industry.
The Official Comments to Section 2A-102 provide some helpful guidance as to structuring and documenting hybrid leases so as to support a determination that the lease-of-goods aspects predominate. The Official Comments mention that the characterization of a transaction for the purposes of Section 2A-102 is a “question of fact,” as well as those transaction attributes that might support the predominant purpose for both UCC 9 chattel paper treatment and UCC 2A lease coverage. Per the comments, relevant factors include: “the language of the agreement and the portion of the total price that is attributable to the lease of goods.”
Further, the comments provide what could be considered as structuring and drafting hints. Among other things, the comments note that an “agreed-upon allocation [of the price to the possession and use of the goods] is ordinarily binding on the parties.” Accordingly, lessors desiring to achieve this favorable characterization should consider including some or more of the following in their hybrid lease documents: lessee acknowledgments supporting the lease-of-goods aspects as the predominant purpose; the “finance lease” treatment of the integrated lease; and/or the extent to which payments in a non-predominant hybrid lease relate to the use and possession of the leased goods.
New UCC 12–Digital assets, etc.
What are digital assets?
As previously noted, existing and contemplated changes in the marketplace were the impetus for the new amendments, especially to address the gap in existing commercial law regarding digital assets. The UCC amendments address that gap by including a new UCC 12 and revising certain other Articles with the intention of providing a uniform commercial law approach to transferring and collateralizing these assets. The amendments also cover the commercial law implications of existing and new technologies by which transactions may be conducted, like blockchain and other distributed ledger technology (“DLT”) platforms.
The digital assets covered by new UCC 12 are referred to as “controllable electronic records” (“CERs”), including virtual currencies, nonfungible tokens and other CERs that have been assigned an economic value. New UCC 12 also creates a new type of digital asset—CERs that have embedded payment rights for goods or services which are exercisable by the owner. Tethered payment rights meeting certain criteria in UCC 12 are referred to as “controllable accounts” or “controllable payment intangibles.” A number of the relevant considerations associated with monetizing these tethered payment rights pursuant to new UCC 12 are similar to the considerations when monetizing accounts receivables associated with a sale of goods or services pursuant to current UCC 9.
Essentially, the pertinent provisions of new UCC 12 and related revisions to UCC 9 should facilitate selling or financing these digital payment rights evidenced by electronic records on a distributed ledger platform. The new or amended UCC provisions afford “take-free” rights for “qualified purchasers,” establish the rights and duties of the account debtors, and the perfection and priority of security interests in these assets. The effect of these amendments should be to provide greater certainty as to the CER account debtor’s obligation to pay a purchaser or collateral assignee, and to afford CERs “negotiability” status (i.e., free of defenses, etc.) similar to the status afforded to a tangible negotiable instrument under UCC 3.
Why the digital asset amendments matter to the equipment finance industry.
As the equipment finance industry continues to evolve, equipment leases and financings are likely to involve transactional aspects addressed in new UCC 12 or the related amendments. Examples could include: transactional aspects evidenced by smart contracts; payments by virtual currencies; full or collateral assignments of CERs with embedded payment rights (e.g., a CER evidencing the right to receive software license payments); nonfungible tokens representing collateral; or escrow arrangements managed on a DLT platform.
Enactment, Effective Date and Transition Rules.
As mentioned above, the amendments were finalized in July 2022, and are currently being considered for enactment by the states.10 When enacted, the amendments will include an effective date as determined by that state, as well as transition rules providing for prospective application of the amendments, with certain exceptions regarding new UCC 12 (digital assets) and amended UCC 9 (perfecting and obtaining priority of security interests). The transition rules will include a uniform adjustment date of January 1, 2025 (or if later, one year after the effective date), intended to provide sufficient time for a person to achieve perfection or priority of a security interest under the amendments following the effective date, or to protect its established priority before the priority might otherwise be lost on the adjustment date.11 These compliance requirements must be carefully considered and addressed by document and systems strategies so as to protect any existing interests that might be impacted by the amendments.
Leveraging the Advantages Afforded by the Amendments.
The systems and practices associated with sales or financings of receivables evidenced by tangible or electronic leases or secured financings of specific equipment, could require adjustments by the parties to those transactions so as to achieve the desired priority status. The amendments relating to digital assets, including new UCC 12, should facilitate transacting on distributed ledger platforms, financing digital payment rights, and relying on virtual currencies as an exchange of value will be facilitated and accelerated. Lastly, lessors who originate bundled transactions so as to accommodate the greater demand for those transactions could achieve significant advantages by structuring and documenting those transactions to conform to the UCC 2A scope amendments regarding hybrid leases.