In a split decision, the Sixth Circuit Court of Appeals in its opinion in Sunshine Heifers, LLC v. Citizens First Bank (In Re: Lee H. Purdy), 763 F.3d 513 (6th Cir. 2014) held a long term lease of livestock extending beyond the economic life of the individual leased livestock can still be a true lease and not a disguised security interest.
The dispute arose over competing claims to the debtor’s herd of dairy cattle. The debtor borrowed money from Citizens Bank, securing it with a lien on his herd of dairy cattle. The bank properly perfected its security interest. Subsequently, the debtor decided to increase the size of his herd, and entered into a series livestock leases with Sunshine Heifers under which the debtor leased a total of 435 cattle for fifty months. The leases prohibited the debtor from terminating the leases, and the debtor was required to return the cows to Sunshine at the end of the lease term without an option to purchase. In addition, the leases provided that the debtor would replace any cows that were culled from the herd during the lease term. The debtor executed a security agreement to Sunshine, which was filed with the state.
The court noted the customary practice of “culling,” under which a dairy farmer culls a portion of his herd every year, replacing older and less productive cows with younger, healthier ones. Many dairy farmers replaced culled cows with their calves. The debtor, however, sold off the calves of Sunshine’s cows and replaced them with more mature cows which he purchased. This conduct violated the leases, but Sunshine was aware of and consented to the conduct. In addition, both the leases and the loan agreement with the bank required the debtor to place ear tags on the cows subject to the leases and the loan. The bank’s loan agreement required white tags and Sunshine’s leases required yellow tags plus a brand on the cow. By the time the debtor filed bankruptcy, his herd was reduced to 389 cows, most of which had white ear tags but also a Sunshine brand. After the debtor filed bankruptcy, a dispute arose between the bank and Sunshine over whether Sunshine’s leases were true leases or disguised security agreements. The bankruptcy court ruled in favor of the bank, and in a split decision the Sixth Circuit reversed.
The court began its analysis with the principle that whether the leases were true leases is to be determined by state law. In this case, the leases were governed by Arizona law. Under Arizona law, whether a lease is a true lease or a secured transaction is a fact-intensive analysis which employs two steps: (1) a bright line test and (2) an economics of the transaction test, which is utilized if the goods retain meaningful value after the lease expires. Under the bright line test, a “transaction in the form of a lease creates a security interest if the consideration that the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease and is not subject to termination by the lessee, and . . . [t]he original term of the lease is equal to or great than the remaining economic life of the goods.” Under this test, if the lease runs longer than the economic life of the goods, then the lease is a per se security agreement. If, however, the goods retain meaningful value after the lease expires, then a court is to go to the economics of the transaction test, look at the specific facts of the case and determine whether the economics of the transaction suggest that the arrangement is a lease or a security interest.
The bank argued that, since the economic life of the cattle leased from Sunshine was less than the fifty month term of the lease, the bankruptcy court properly stopped at the bright line test and determined the lease was a per se secured transaction. The Circuit Court found the bankruptcy court’s focus on the economic life of the individual cows rather than the economic life of the herd was erroneous. Because the leases envisioned that the cows would be culled and required the debtor to replace culled cows into the herd, the Circuit Court held that the proper analysis would be whether the herd had an economic life beyond fifth months. The Court found that the “relevant ‘good’ is the herd of cattle, which has an economic life far greater than the lease term.” Therefore, the leases were not per se security agreements, and the court then turned to the economics of the transaction test.
This second test focuses on two factors: (1) whether the lease contains a purchase option price that is nominal and (2) whether the lessee develops equity n the property, such that the only economically reasonable option for the lessee is to purchase the goods, with the ultimate question being whether the lessor retains a meaningful reversionary interest in the goods. In this case, the economics of the transaction between the debtor and Sunshine—with Sunshine retaining title to the cows, and the debtor having no right to purchase the cows at any price—cause the Circuit Court to reverse and remand the proceedings to the bankruptcy court to enter judgment in favor of Sunshine.