MEMORANDUM OPINION
Prior to filing this Chapter 11 case, QDS Components, Inc. (“QDS” or the “Debtor”) entered into agreements, denominated leases, providing for the use of two John-ford TC-35 Turning Centers (the “Lathes”). The issue before the Court is whether the agreements constitute true leases or, as alleged by Lakin Manufacturing Company (“Lakin”), disguised security agreements.
This memorandum opinion constitutes the Court’s findings of fact and conclusions of law. Fed.R.Civ.P. 52 (made applicable here by Fed. R. Bankr.P. 7052 and 9014).
I. Jurisdiction
The Court has jurisdiction over this contested matter pursuant to 28 U.S.C. §§ 157 and 1334 and the general order of reference entered in this district. This is a core proceeding. 28 U.S.C. § 157(b)(2).
II. Factual and Procedural Background
QDS filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code on December 6, 2000 (the “Petition Date”). Prior to the Petition Date, QDS was engaged in the manufacture and sale of non-powered hubs and spindles for the agricultural market and rubber torsion axles used for agricultural equipment, recreational vehicles, and medium-weight trailers. As of the Petition Date, the Debtor’s manufacturing operations were conducted at a
On May 18, 2000, approximately seven months before the Petition Date, QDS and Intech Funding Corp. (“Intech”) entered into the agreements in question — two substantially identical contracts entitled “Equipment Lease Agreement Number L0002447” (“Lease One”) and “Equipment Lease Agreement Number L0002448” (“Lease Two”) (collectively, the “Lease Agreements”). Under the Lease Agreements, QDS obtained the use of the Lathes, which were supplied by a third-party (Absolute Machine Tools, Inc.). The purchase price of each Lathe was $90,650.
The terms of the Lease Agreements are identical. Each of the Lease Agreements requires QDS to make payments to Intech totaling $110,425. Specifically, under each of the Lease Agreements, QDS is required to make: (1) prepayments totaling $27,195, consisting of a one-time, lump-sum payment of $24,326, plus an additional $2,870, which represents the advance payment of two regular monthly installments of $1,435; and (2) 58 monthly payments of $1,435. At the end of the 60-month term of the Lease Agreements, QDS has the option to purchasе each Lathe for $9,065 (the “Option Amount”) plus applicable taxes. The Lease Agreements provide that, if QDS does not exercise its purchase option, it may either: (1) deliver the Lathes to Intech; 1 or (2) continue in possession of the Lathes, in which case the Lease Agreements automatically renew for successive one-month terms at the regular monthly installment amount of $1,435. Lease Agreements, ¶ 15.
The Lease Agreements contain an “Early Termination” provision that states, in relevant part:
EARLY TERMINATION. If no default exists under this Lease, you have the right upon thirty (30) days written notice to purchase all the Equipment, but not less than all the Equipment, and terminate the Lease. The purchase price will be the sum of (a) + (b) + (c) as follows: (a) the net present value of all unpaid Lease payments for the remainder of the term discounted at 7.0% A.P.R.; (b) the net present value of the purchase option discounted at 7.0% A.P.R.; (c) all other amounts due or that become due under the Lease. Upon our receipt from you of the purchase price calculated as (a) + (b) + (c) above we shall transfer our interest in the Equipment to you without representation, recourse, or warranty as is, where-is and we shall deliver all documents reasonably requested to transfer our interest in the Equipment to you.
Lease Agreements, ¶ 10.
Under the Lease Agreements, Intech expressly disclaimed all warranties. Id., ¶ 8. QDS bore the full risk of loss and was required to insure the Lathes at its own expense. Id., ¶¶ 11 and 12. In addition, QDS had to pay directly or reimburse Intech for all applicable taxes and fees. Id., ¶ 13. QDS also was responsible for paying all maintenance expenses. Id., ¶ 14. In the event of a default by QDS, the Lease Agreements afforded Intech the following remedies:
(a) [Intech] may cancel or terminate this Lease or any or all other agreements that we have entered into with you; (b) we may require you to immediately pay us, as compensation for loss of our bargain and not as a penalty, a sum equal to (i) the value of all unpaid Lease Payments for the remainder of the term plus the value of our anticipated residual interest in the Equipment, plus (ii) all other amounts due or that become due under this Lease; (c) we may require you to deliver the Equipment to us as set forth in Section 14; (d) we or our agent may peacefully repossess the Equipment without court order and you will not make any claims against us for damages or trespass or any other reason; and (e) we may exercise any other right or remedy available at law or in equity.
Id., ¶ 18.
The Lease Agreements recite that In-tech is the owner of the Lathes:
TITLE; RECORDING. [Intech is] the owner of and will hold title to the Equipment. You will keep the Equipment free of all liens and encumbrances. Unless the Purchase Option price shown on the front of this Lease is $1.00, you agree that this transaction is a true lease. However, if this transaction is deemed to be a lease intended for security, you grant us a purchase money security interest in the Equipment (including any replacements, substitutions, additions, attachments and proceeds) and the equipment shall secure, in addition to the lease obligations, any indebtedness at any time owed by you to us. You will deliver to us signed financing statements or other documents we request to protect our interest in the equipment. YOU AUTHORIZE U.S. TO FILE A COPY OF THIS LEASE AS A FINANCING STATEMENT AND APPOINT U.S. OR OUR DESIG-NEE AS YOUR ATTORNEY-IN-FACT TO EXECUTE AND FILE, ON YOUR BEHALF, FINANCING STATEMENTS COVERING THE EQUIPMENT.
Id., ¶ 15. Pursuant to the foregoing provision, Intech filed financing statements covering the Lathes with the Ohio Secretary of State and the Shelby County Recorder.
On May 24, 2000, Intech assigned Lease One to Mareap Vendor Finance Corp. (“Marcap”). Two days later, on May 26, 2000, Intech assigned Lease Two to U.S. Bancorp Leasing & Financial (“U.S. Ban-corp”). At approximately the same time that Intech assigned Lease Two to U.S. Bancorp, Heller Financial, Inc. (“Heller”), which held a blanket lien on all the assets of the Debtor, transmitted a letter to U.S. Bancorp acknowledging Heller’s agreement to subordinate its security interest in the Lathe that is the subject of Lease Two (the “U.S. Bancorp Lathe”) to the security interest granted to U.S. Bancorp under the Lease Agreement.
After determining that a reorganization of its business would not be possible, QDS sought and obtained Court authority to sell substantially all of its assets to Lakin pursuant to § 363(b) of the Code (the “Asset Sale”). The order authorizing the Asset Sale, whiсh was entered on January 17, 2001 (the “Sale Order”), also granted the Debtor authority to assume and assign to Lakin its lease of the QDS Facility and a “Gas Vessel Rental Agreement” with BOC Gases. The Sale Order contained the following provision: “Any of the Purchased Assets that are subject to a lease will be transferred and conveyed to [Lakin] without further consideration in the event that the lease is deemed to be a capital lease as compared to a true lease or operating lease” (the “Capital Lease Provision”).
After the Asset Sale closed, the Debtor requested and obtained an order authorizing it to assume and assign to Lakin ten
Following discovery, U.S. Bancorp, Heller, and Lakin agreed to submit the dispute upon the following stipulated facts (the “Initial Stipulation”):
(1) The fair market value of the U.S. Bancorp Lathe will be $12,000 at the expiration of the Lease Agreements — i.e., in May 2005;
(2) The cost of shipping and rigging the U.S. Bancorp Lathe from its present location at the QDS Facility to either Portland, Oregon or Los Angeles, California would not exceed $7,200 (including insurance);
(3) The cost of shipping and rigging the U.S. Bancorp Lathe from its present location to a local storage facility would be approximately $1,500 to $2,500 and would cost approximately $100 per month to store (including insurance); and
(4)The remaining useful life of the U.S. Bancorp Lathe is at least five to six years — i.e., its useful life will extend until at least 2006.
In addition to the Initial Stipulation, the Court also received briefs from the Debt- or, Lakin, U.S. Bancorp, and Heller addressing the issue of whether the Lease Agreements are true leases or disguised security agreements.
After the Court took the U.S. Bancorp Motion under advisement, Marcap filed a motion for relief from stay (the “Marcap Motion”), seeking an order authorizing it to recover the Lathe that is the subject of Lease One (the “Marcap Lathe”). Lakin opposed the Marcap Motion, again arguing that, because the Lease Agreements are in fact disguised security agreements, the Marcap Lathe had been transferred to La-kin free and clear of liens pursuant to the Sale Order. After the Marcap Motion was filed, the parties asked the Court to consolidate the U.S. Bancorp and Marcap Motions. Because the Lease Agreements are identical, and the U.S. Bancorp and Mar-cap Motions present the same legal issue, the Court agreed to the consolidation of the Motions.
On June 10, 2002, Lakin and Marcap filed a stipulation with the Court that essentially tracks the Initial Stipulation, under which Lakin and Marcap agreed to submit the Marcap Motion upon the following facts:
(1) The fair market value of the Marcap Lathe will be $12,000 at the expiration of the Lease Agreements — i.e., in May 2005;
(2) The cost of shipping and rigging the Marcap Lathe from its present location at the QDS Facility to either Portland, Oregon or Los Angeles, California would not exceed $7,200 (including insurance);
(3) The cost of shipping and rigging the Marcap Lathe from its present location to a local storage facility would be approximately $1,500 to $2,500 and would cost approximately $100 per month to store (including insurance); and
(4) The remaining useful life of the Mar-cap Lathe is at least five to six years — i.e., its useful life will extend until at least 2006. 2
III. Arguments of the Parties
Lakin asserts that the Lease Agreements constitute disguised security agreements rather than true leases. Thus, according to Lakin, the Lathes were: (1) owned by QDS at the time of the Asset Sale, subject to secured loans in favor of U.S. Bancorp and Marcap (collectively, the “Lessors”); and (2) transferred to Lakin pursuant to the Sale Order free and clear of liens, claims, and encumbrances, with the liens granted to the Lessors attaching to the proceeds of the Asset Sale. In La-kin’s view, the proceeds of the Asset Sale should be distributed either to the Lessors or Heller, based upon the Court’s determination of the relative priority of their security interests in the Lathes.
Lakin advances several arguments in support of its contention that the Lease Agreements are, in fact, disguised security agreements. First, Lakin maintains that, under § 1-201(37) of the Uniform Commercial Code (“UCC”), the Lease Agreements are conclusively presumed to have created security interests because QDS: (1) could not terminate its obligation to make payments for the entire term of the Lease Agreements; and (2) had the contractual right to become owner of the Lathes for nominal consideration. In support of its contention that the Option Amount contained in the Lease Agreements is nominal, Lakin relies on UCC § l-201(37)(x), arguing that the Option Amount is less than the Debtor’s “reasonably predictable cost of performing under the [L]ease [A]greement[s] if the [purchase option] is not exercised.” UCC § 1-201(37)(x) (West 2002). According to La-kin, the nominality of the Option Amount is also demonstrated by the application of “percentage tests”- — which require a comparison of: (1) the Option Amount and cost of the Lathes; (2) the Option Amount and the total stream of rental payments made by QDS under the Lease Agreements; and (3) the total payment stream and the Lathes’ original cost.
Alternatively, Lakin asserts that even if UCC § l-201(37)’s conclusive presumption does not apply, the Lease Agreements should nonetheless be found to be disguised security agreemеnts because the economics of the transactions reveal that neither Intech (the assignor of the Lease Agreements) nor the Lessors retained a meaningful reversionary interest in the Lathes. Given the cost involved to ship the Lathes back to the Lessors upon termination of the Lease Agreements and the Lathes’ remaining economic life, Lakin maintains that Intech could not have reasonably expected to receive the Lathes back from QDS when the Lease Agreements terminated. Lakin also argues that Intech’s failure to retain a meaningful re-versionary interest in the Lathes is evidenced by “net lease terms” in the Lease Agreements — i.e., the Lease Agreements’ provisions requiring QDS to: (1) pay all applicable taxes, fees, and maintenance expenses; (2) bear the risk of loss; and (3) insure the Lathes. Finally, Lakin points to the subordination agreement between
U.S. Bancorp and Heller challenge La-kin’s contention that UCC § 1-201(37)’s conclusive presumption applies. To trigger the statutory presumption, Lakin must show that: (1) QDS could not terminate its payment obligation under the Lease Agreements; and (2) the Option Amount is nominal. According to U.S. Bancorp and Heller, Lakin has failed on both counts. First, Heller points out that the Lease Agreements afford QDS a contractual right of termination. Second, U.S. Ban-corp and Heller also contend that Lakin has not demonstrated that the Option Amount is nominal. They take issue with the methodology that Lakin employs to establish the Option Amount’s nominality, which factors in the economic value of the Lathes that QDS will forego if it elects not to exercise the purchase option. U.S. Ban-corp and Heller argue that the lost economic value of the Lathes is not a “cost of performing under the [L]ease [AJgree-ments” within the meaning of UCC § 1-201(37)(x).
U.S. Bancorp and Heller also maintain that Lakin’s reliance on percentage tests is misplaced, asserting that percentage tests have been rejected as an unreliable measure of nominality by courts and commentators alike. According to Heller, the most accepted and appropriate test for determining whether a purchase option amount is nominal requires a comparison of the option price with the projected fair market value of the “leased” goods at the time the option arises. Under this test, the option price is not nominal if it bears a reasonable relationship to the predicted residual value. Lakin has failed to demonstrate the nominality of the Option Amount under this standard, Heller argues, because it offered no evidence establishing what the original contracting parties projected the fair market value of the Lathes would be at the end of the term of the Lease Agreements. U.S. Bancorp further contends that a comparison between the stipulated fair market value of the Lathes at the end of the lease term and the Option Amount negates Lakin’s nomi-nality argument. According to U.S. Ban-corp, while the $9065 Option Amount is less than the $12,000 stipulated fair market value of the Lathes, an Option Amount representing over three-fourths of stipulated fair market value is clearly not nominal.
U.S. Bancorp and Heller also argue that the Lessors did in fact retain a meaningful reversionary interest in the Lathes. They contend that the following factors demonstrate that the Lessors fully expected to receive something of value back from QDS upon expiration of the term of the Lease Agreements: (1) the Lathes’ economic life extends beyond the term of the Lease Agreements; and (2) QDS is required to maintain, and insure the Lathes and return them to the Lessors at the end of the lease term. Moreover, according to U.S. Bancorp and Heller, the fact that the Lease Agreements are “net leases” — i.e., QDS is required to pay all applicable taxes and fees, pay all maintenance expenses, and bear the full risk of loss of the Lathes — simply does not establish that the Lessors relinquished their reversionary interest in the Lathes. They cite decisions holding that the inclusion of net lease terms in a purported lease does not constitute a valid basis for recharacterizing the agreement as a disguised secured sale. Heller also asserts that the fact that the Lathes were obtained from a third-party supplier should not be factored into the
Finally, U.S. Bancorp raises several procedural arguments. First, it asserts that it was not afforded the opportunity to fully protect its rights because it did not receive notice — from either the Debtor or Lakin— prior to the hearing to consider approval of the Asset Sale (the “Sale Hearing”) that Lakin would invoke the Capital Lease Provision and ask the Court to recharacterize the Lease Agreements. Had it received notice of Lakin’s intentions, U.S. Bancorp argues, it would have opposed the Asset Sale. Second, U.S. Bancorp submits that Lakin should have been required to commence an adversary proceeding or an “independent contested matter” in order to challenge U.S. Bancorp’s status as a true lessor. U.S. Bancorp Reply Brief (Doc. No. 104-1) at 6.
IV. Legal Analysis
A. The True Lease vs. Disguised Security Agreement Conundrum
1. Preliminary Statement
a. Applicable Law
The existence, nature, and extent of a security interest in property is governed by state law.
Butner v. United States,
UCC § 1-201(37), which is set forth in full
infra
at pp. 330-31, defines the term “security interest” and provides a test for distinguishing a true lease from a disguised security agreement. In 1988, California adopted the current version of UCC § 1-201(37), which had been amended as a uniform law in 1987.
4
PSINet, Inc. v. Cisco Sys. Cap. Corp. (In re PSINet, Inc.),
b. Burden of Proof
As the party asking the Court to characterize the Lease Agreements as “other than what [they] purport[] to be [,]” Lakin bears the burden of proof.
In
c. Definitions of “Lease” and “Security Interest”
The authors of a leading treatise on the UCC define a lease, a sale, and a transaction creating a security interest as follows:
A lease involves payment for the temporary possession, use and enjoyment of goods, with the expectation that the goods will be returned to the owner with some expected residual interest of value remaining at the end of the lease term. In contrast, a sale involves an unconditional transfer of absolute title to goods, while a security interest is only an inchoate interest contingent on default and limited to the remaining secured debt.
James J. White & Robert S. Summers,
Uniform Commercial Code
vol. 4, § 30-3, 14 n. 18 (5th ed., West 2002). The hallmark of a lease is that it grants the lessee the right to use property for a period less than its economic life with the concomitant obligation to return the property to the lessor while it retains some substantial economic life.
See In re Marhoefer Packing Co.,
While the foregoing concepts appear at first blush to be deceptively simple, courts have had great difficulty distinguishing a true lease from a disguised security agreement.
See
Ronald M. Bayer,
Personal Property Leasing: Article 2A of the Uniform Commercial Code,
43 Bus. Law. 1491, 1497 (August 1988) (referring to an
To fully address and effectively dispose of the arguments raised by the parties, the Court must briefly explore the history of the governing statute — § 1-201(37) of the UCC. The Court traces the development of the current version of § 1-201(37) and the body of hopelessly irreconcilable decisions construing it and the former version of the statute 6 not simply to provide historical perspective. The parties urge the Court to apply a number of different legal tests to determine whether the Lease Agreements are in fact true leases. It is therefore necessary to reviеw the genesis and evolution of the various decisional standards in order to determine which of these various tests provides a sound basis for distinguishing a true lease from a disguised security agreement.
2. Distinguishing a True Lease From a Disguised Security Agreement Under “Old § 1-201(37)”
Prior to the 1987 revision to UCC § 1-201(37), the statute (“Old § 1-201(37)”) read as follows:
Whether a lease is intended as security is to be determined by the facts of each case; however, (a) the inclusion of an option to purchase does not of itself make the lease one intended for security, and (b) an agreement that upon compliance with the terms of the lease the lessee shall become or has the option to become the owner of the property for. no additional consideration or for a nominal consideration does make the lease one intended for security.
UCC § 1-201(37) (West 1986) (amended 1987). Old § 1-201(37) provided only the few express guidelines for distinguishing a true lease from a disguised security agreement listed below:
(1) Whether a lease is intended for security is to be determined by the facts of each case;
(2) The existence of an option to purchase does not create a security interest as a matter of law; and
(3) An option to purchase for no or nominal consideration does make the lease a security interest as a matter of law.
These limited decisional guideposts, as well as the statute’s reference to the intent of the parties, resulted in a “profusion of inconsistent views among the courts regarding the proper criteria to be applied in determining whether an agreement denominated as a lease created a true lease or a security interest.” Kim, 232 B.R. at 329. See also Corinne Cooper, Identifying a Personal Property Lease Under the UCC, 49 Ohio St. L.J. 195, 199 (1987) (noting that under Old § 1-201(37) “the basis in law for distinguishing ... [a sale, a lease, or a security interest] has become hopelessly blurred”).
Courts applying Old § 1-201(37) formulated a variety of tests to distinguish a true lease from a disguised security agreement. The decisions under Old § 1-201(37) generally fall into two broad categories: (1) cases in which courts distinguish a true lease from a disguised security agreement by applying a laundry list of factors (the “Multiple-Factor Approach”); and (2) cases in which courts distinguish a true lease from a disguised security agreement by utilizing various common law tests to determine whether the purchase option amount stated in a purported lease agreement is nominal.
See generally
White & Summers, § 30-3, at 20 (noting that “courts have often used a list of factors to distinguish a lease from a security agreement”); Laurie L. Dawley,
The Continuing Debate Regarding the Lease Versus Disguised Security Interest Issue: Did the Edison Court Correctly Find a True Lease?,
24 J. Corp. L. 169, 182-83 (1998) (observing that “to uncover the economic realities of a transaction,” some courts “apply a multi-factored approach”);
Am. President Lines, Ltd. v. Lykes Bros. S.S. Co. (In re Lykes Bros. S.S. Co.),
a. The Multiple-Factor Approach
The bankruptcy court’s decision in
KL.C., Inc. v. Brookside Drug Store, Inc. (In re Brookside Drug Store, Inc.),
(1) whether there was an option to purchase for a nominal sum;
(2) whether there was a provision in the lease granting the lessee an equity or property interest in the equipment;
(3) whether the nature of the lessor’s business was to act as a financing agency;
(4) whether the lessee paid a sales tax incident to acquisition of the equipment;
(5) whether the lessee paid all other taxes incident to ownership of the equipment;
(6) whether the lessee was responsible for comprehensive insurance on the equipment;
(7) whether the lessee was required to pay any and all license fees for operation of the equipment, and to maintain the equipment at his expense;
(8) whether the agreement placed the entire risk of loss upon the lessee;
(9) whether the agreement included a clause permitting the lessor to accelerate the payment of rent upon default of the lessee and granted remedies similar to those of a mortgagee;
(10) whether the equipment subject to the agreement was selected by the lessee and purchased by the lessоr for this specific lessee;
(11) whether the lessee was required to pay a substantial security deposit in order to obtain the equipment;
(12) whether the agreement required the lessee to join the lessor, or permit the lessor by himself, to execute a UCC financing statement;
(13) whether there was a default provision in the lease inordinately favorable to the lessor;
(14) whether there was a provision in the lease for liquidated damages;
(15) whether there was a provision disclaiming warranties of fitness and/or merchantability on the part of the lessor; and
(16) whether the aggregate rentals approximated the value or purchase price of the equipment.
Id.
at 122-23.
See also Venn v. Howell’s Auto Repair Ctr. (In re Howell),
The rationale underlying the Multiple-Factor Approach is that certain rights and obligations — “incidents of ownership” — are allocated to one party under a lease and to the other in a sale.
APB Online,
Among the factors that courts employing the Multiple-Factor Approach find indicative of a disguised security agreement are “net lease” terms — i.e., provisions in the purported lease agreement imposing on the lessee the obligation to bear risks of loss, pay taxes, insurance, and license/registration fees (“Net Lease Provisions”). See,
e.g., HPSC, Inc. v. Wakefield (In re
The Multiple-Factor Approach has been criticized by many courts and commentators as being a flawed methodology for distinguishing a true lease from a disguised security agreement.
See, e.g., In re Aspen Impressions, Inc.,
b. Common Law Nominality Tests
i. Percentage Tests
Courts applying Old § 1-201(37) developed percentage tests to determine whether the option price contained in a purported lease is nominal (“Percentage Tests”). Percentage Tests compare: (1) the option price contained in the agreement with the original purchase price of the “leased” goods; (2) the option price with the total stream of rental payments made under the contract; and (3) the original cost of the “leased” goods with the total payment
ii. The Option Price/FMV Test
A widely utilized test for assessing the nominality of a purchase option price under Old § 1-201(37) compares the option price with the anticipated fair market value of the leased goods at the time the option will be exercised (the “Option Price/ FMV Test”).
See APB Online,
Properly applied, the Option Price/FMV Test focuses on lease inception — i.e., courts must determine what the parties, at the outset of the transaction, anticipated the fair market value of the leased goods would be at the time the option is to be exercised.
See Orix Credit Alliance,
Intending a true lease, parties might at the signing select an option price that they believe will equal the fair market value of the property at the end of the lease. Yet actual value at the end of the lease may be substantially higher or lower than their estimate. If the option were “nominal” at the conclusion of the lease (because the property had not depreciated as expected), but would not have been “nominal” had the parties’ estimate proved true, should the agreement be regarded as a lease or a security agreement? We beliеve it should be a lease.
Parties make their agreement at the outset. Only there do they have the common intention to create a lease or security agreement, and it is at that time we should determine their true intention. If subsequent events make the option price small in comparison with the asset’s value at the end of the lease, so be it. That fact does not change what was once a true lease into a security agreement.
White
&
Summers, § 30-3, at 15; Cooper,
iii. The Economic Realities Test
Yet another common law nominality test developed by courts applying Old § 1-201(37) is the so-called “Economic Realities Test.” Under the Economic Realities Test,
7
“[wjhere the terms of the lease and option to purchase are such that the only sensible course for the lessee at the end of the lease term is to exercise the option and become the owner of the goods, the lease was intended to create a security interest.”
Steele v. Gebetsberger (In re Fashion Optical, Ltd.),
The Economic Realities Test, like the Option Price/FMV Test, should focus on all the facts and circumstances surrounding the transaction as anticipated by the parties at contract inception, rather than at the time the option arises.
See Kimco Leasing,
B. The Proposed Solution — “New § 1-201(37)”
As discussed above, the caselaw interрreting Old § 1-201(37) is not a seamless web, but rather a disjointed patchwork of decisions that simply cannot be reconciled.
See also Kim,
[Reference to the intent of the parties to create a security interest has led to unfortunate results. In discovering intent, courts have relied upon factors that were thought to be more consistent withsales or loans than leases. Most of these criteria however, are as applicable to true leases as to security interests .... Accordingly, amended Section 1-201(37) deletes all reference to the parties’ intent.
Official Comment to New § 1-201(37) (West 2002).
New § 1-201(37), which was adopted by the California legislature in 1988 and made effective January 1,1990, reads:
“Security interest” means an interest in personal property or fixtures which secures payment or performance of an obligation.
Whether a transaction creates a lease or security interest is determined by the facts of each case; however, a transaction creates a security interest if the consideration 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 not subject to termination by the lessee, and
(a) the original term of the lease is equal to or greater than the remaining economic life of the goods,
(b) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods,
(c) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement, or
(d) the lessee has an option to become the owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement.
A transaction does not create a security interest merely because it provides that
(a) the present value of the consideration the lessee is obligated to pay the lessor for the right to possession and use of the goods is substantially equal to or is greater than the fair market value of the goods at the time the lease is entered into,
(b) the lessee assumes risk of loss of the goods, or agrees to pay taxes, insurance, filing, recording, or registration fees, or service or maintenance costs with respect to the goods,
(c) the lessee has an option to renew the lease or to become the owner of the goods,
(d) the lessee has an option to renew the lease for a fixed rent that is equal to or greater than the reasonably predictable fair market rent for the use of the goods for the term of the renewal at the time the option is to be performed, or
(e) the lessee has an option to become the owner of the goods for a fixed price that is equal to or greater than the reasonably predictable fair market value of the goods at the time the option is to be performed.
For purposes of this subsection (37): (x) Additional consideration is not nominal if (i) when the option to renew the lease is granted to the lessee the rent is stated to be the fair market rent for the use of the goods for the term of the renewal determined at the time the option is to be performed, or (ii) when the option to become the owner of the goods is granted to the lessee the price is stated to be the fair market value of the goods determined at the time the option is to be performed. Additional consideratiоn is nominal if it is less than the lessee’s reasonably predictable cost of performing under the lease agreement if the option is not exercised;
(y) “Reasonably predictable” and “remaining economic life of the goods” areto be determined with reference to the facts and circumstances at the time the transaction is entered into; and (z) “Present value” means the amount as of a date certain of one or more sums payable in the future, discounted to the date certain. The discount is determined by the interest rate specified by the parties if the rate is not manifestly unreasonable at the time the transaction is entered into; otherwise, the discount is determined by a commercially reasonable rate that takes into account the facts and circumstances of each case at the time the transaction was entered into. 8
As discussed above, an essential characteristic of a lease agreement is that the lessor retains an economically meaningful residual interest in the leased property. New § 1-201(37) attempted “to reassert the significance of residual value as the touchstone of the common law definition of a true lease.” Gregory J. Naples,
A Review and Analysis of the New Article 2A
— Leases
Amendment to the UCC and Its Impact on Secured Creditors, Equipment and Finance Lessors,
93 Comm. L.J. 342, 349 (1988).
See also In re Allen,
The bankruptcy court in
In re Lerch,
The initial portion of the first sentence of the second unnumbered paragraph [of New § 1-201(37)] contains the basic direction that the [true lease versus disguised security agreement] determination is made based on the facts of each case. The latter portion of the first sentence of the second unnumbered paragraph starting with the word “however” creates an exception to the basic direction that the determination is made on the facts of each case, as it provides that without looking at all the facts, a lease will be construed as a security interest if a debtor cannot terminate the lease, and if one of the four enumerated terms is present in the lease. Absent a mandated classification, the determination is based on the facts of the case. At this point the third unnumbered paragraph comes into effect. Focusing on the economics of the transaction, it states that a security interest is not created merely because it contains any of the five terms enumerated in the third unnumbered paragraph.
See also Owen,
As the
Lereh
court notes, New § 1-201(37)[2] first requires a court to apply what has been referred to as the “Bright-Line Test.”
See PSINet,
If a determination is made that a debt- or’s payment obligation under a purported lease is not subject to termination, then the second prong of the test must be satisfied in order to find a security interest as a matter of law. The second part of the Bright-Line Test looks to whether any of the so-called “Residual Value Factors” is present.
9
PSINet,
After determining that the Bright-Line Test has not been satisfied, an examination of all the facts and circumstances of the case must be made to determine whether the agreement in question is a true lease or disguised security agreement.
Triplex Marine,
C. New § 1-201(37) Applied
1. The Bright-Line Test
a. Terminability of Debtor’s Payment Obligation
The Lease Agreements expressly grant the Debtor a right of termination. Lease Agreements, ¶ 10. Latín argues, however, that the Debtor has no meaningful right to terminate its payment obligations to the Lessors. Latín points out that the Lease Agreements condition the Debtor’s right of termination on its payment of all remaining contractual obligations, including all monthly installments due through the end of the lease term, plus the Option Amount, less a
7%
discount factor.
Id.
In support of its argument, Latín relies on
In re Nationwise Automotive, Inc.,
The first prong of New § l-201(37)’s Bright-Line Test focuses not on whether a lessee has a contractual right to terminate under the agreement in question, but rather on whether “the consideration 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 not subject to termination by the lessee.” UCC § 1-201(37)[2] (West 2002). The Lease Agreement requires the Debtor to pay the Lessors upon termination the present value of precisely what they wоuld receive if QDS made all required monthly installment payments for the full contract term and then exercised the purchase option. Thus, the Debtor’s payment obligation is not subject to termination within the meaning of New § 1-201(37)[2],
While Lakin relies on, and Heller seeks to distinguish, the
Nationwise
and
Fox
decisions, the Court need not compare and contrast the termination provisions examined in those cases with the Early Termination Provision contained in the Lease Agreements. Because the bankruptcy court in
In re Architectural Millwork of Virginia, Inc.,
b. Nominality
The parties agree that three of the four Residual Value Factors enumerated in New § l-201(37)[2](a) through (d) are not applicable: the original term of the Lease Agreements is not equal to or greater than the remaining economic life of the Lathes, QDS is not required to renew the Lease Agreements for the remaining economic life of the Lathes or to become the owner of the Lathes, and QDS is not afforded the option to renew the Lease Agreements for nominal or no additional consideration. See UCC § 1-201(37)[2](a) — (c) (West 2002). Their dispute centers on the fourth Residual Value Factor contained in the statute and whether QDS “has the option to become the owner of the goods for nominal or no additional consideration upon compliance with the [L]ease [A]greement[s].” UCC § 1 — 201(37)[2](d) (West 2002).
As discussed previously, courts applying Old § 1-201(37) formulated a variety of common law tests for determining whether the option price stated in a purported lease agreement is nominal. These common law tests included Percentage Tests, the Option Price/FMV Test, and the Economic Realities Test.
See Lykes Bros. S.S. Co.,
i. Lakin’s Nominality Calculation
Lakin argues that a “cost of performing” that QDS must incur if it elects not to exercise the purchase option is the lost economic value of the Lathes (the “Lost Equipment Value”). By factoring in the Lost Equipment Value, Lakin concludes
Option Amount Cost of Performing
$9,065 $12,000 Lost Equipment Value +$ 7,200 12 Cost to Remove, Crate, and Return the Lathe to U.S. Bancorp/Marcap
$9,065 < $19,200
ii. Heller’s Nominality Calculation
Heller contends that the Lost Equipment Value should not be included as a “cost of performing” under the Lease Agreement, correctly asserting that Lakin has failed to cite any authority whatsoever for the proposition that the lost economic value of equipment returned to the lessor should be deemed a cost of performance under New § l-201(37)(x). According to Heller, including the economic value a lessee opts to forego when it returns leased equipment as a “cost of performing” under New § 1 — 201(37) (x) “would make even the most obvious true lease a security agreement.” Heller Reply Memorandum at 8. Heller applies the Option Price/Performance Cost Test as follows:
Option Amount Cost of Performing
$9,065 $7,200 Cost to Remove, Crate, and Return the Lathe to U.S. Bancorp/Marcap
$9,065 > $7,200
iii. U.S. Bancorp’s Nominality Calculation
Notwithstanding Lakin’s failure to cite authority supporting its proposed methodology for applying the Option Price/Performance Cost Test, U.S. Bancorp nonetheless inexplicably concedes that the Lost Equipment Value should be factored into the statutory equation. U.S. Bancorp submits, however, that the $9,065 Option Amount should be deducted from the $12,000 Lost Equipment Value since QDS would not have to pay the Option Amount if it elected to return the U.S. Bancorp Lathe. U.S. Bancorp’s nominality calculation is as follows:
Option Amount Cost of Performing
$9,065 $2,935 Lost Equipment Value ($12,-000 stipulated residual value of the U.S. Bancorp Lathe less the $9,065 Option Amount) +$1,500-$2,500 Cost to Ship to Local Storage Facility
$9,065 > $4,435-$5,435 (plus $100 per month local storage charges)
But under the foregoing methodology, if the full costs of shipping the U.S. Bancorp Lathe back to Portland, Oregon is included in the statutory calculation — which the Court believes is appropriate given the Debtоr’s contractual obligation to return the U.S. Bancorp Lathe to the U.S. Ban-corp facility — then, as shown below, the Option Amount would be deemed nominal under U.S. Bancorp’s methodology:
Option Amount Cost of Performing
$9,065 $ 2,935 Lost Equipment Value +$ 7,200 Cost to Remove, Crate, and Return the Lathe to U.S. Bancorp/Marcap
$9,065 < $10,135
The parties’ respective nominality calculations reflect their disagreement on a fun
New § 1-201(37)(y) expressly states that a lessee’s reasonably predictable cost of performing under a lease agreement is “to be determined with reference to the facts and circumstances at the time a transaction is entered into.” UCC § 1-201(37)(y) (West 2002). Here, the parties have stipulated that the cost of returning each Lathe to either Intech (in Los Ange-les) or U.S. Bancorp (in Portland, Oregon)
13
would not exceed $7,200, including insurance. But this figure was not the sum projected by the original parties to the transaction — QDS and Intech — at the inception of the Lease Agreements. Put differently, the record does not allow the Court to determine — by referring “to the facts and circumstances at the time [the Lease Agreements were] entered into”— what the Debtor’s reasonably predictable cost of performing would be if it chose not to exercise its purchase option. The parties also stipulated as to (1) the fair market value of the Lathes at the end of the term of the Lease Agreements, and (2) the expected remaining economic life of the Lathes upon contract termination. Yet no evidence was offered to establish what, if any, projections were made by QDS and Intech at lease inception as to the Lathes’ fair market value and remaining economic life upon lease termination. In place of this critical information, Lakin, Heller, U.S. Bancorp., and Marcap have offered their estimates of the fair market value and remaining economic life of the Lathes, as well as the cost to return them to the Lessors, made nearly a year after the Lease Agreements were executed. The record therefore contains no evidence establishing what the original parties to the transaction anticipated at contract inception concerning QDS’s “cost of performing under the [L]ease [A]greement[s] if the option is not exercised.”
14
UCC § 1-201(37)(x) (West 2002). Without this evidence, the Court is unable to make the statutory calculation required under New § l-201(37)’s Option Price/Performance Cost Test.
See APB Online,
Lakin urges the Court to apply the Percentage Tests, arguing that they demonstrate the Option Amount’s nominality because: (1) the Option Amount ($9065) represents only 10% of the original purchase price of each Lathe ($90,650); (2) the Option Amount equals only 8.2% of the total stream of payments the Lessors are to receive from QDS under the Lease Agreements; and (3) the total payment stream to be received by the Lessors exceeds the original cost of the Lathes by 21.8%. Heller disputes this final point, noting that if the payment stream the Lessors
As previously discussed, several different common law tests for assessing the nominality of the option price stated in a purported lease agreement emerged from the caselaw interpreting Old § 1-201(37). The drafters of New § 1-201(37) incorporated two distinct nominality tests into the amended statute: the FMV Standard and the Option Price/Performance Cost Test. If the drafters of New § 1-201(37) had intended for nominality to be measured by the Percentage Tests, then they presumably would have incorporated these standards (or some variation thereof) into the current version of the statute. Thus, it would not be appropriate to measure nomi-nality using a common law test that the drafters of New § 1-201(37) opted not to include in the statute.
See Charles,
[a] transaction does not create a security interest merely because it provides that ... the present value of the consideration the lessee is obligated to pay the lessor for the right to possession and use of the goods is substantially equal to or is greater than the fair market value of the goods at the time the lease is entered into.
UCC § 1 — 201(37) [3] (a) (West 2002). Moreover, even if the Percentage Tests had survived the enactment of New § 1-201(37),
16
courts and commentators have pointed out that such tests are not a reliable indicator of nominality.
See APB Online,
Heller and U.S. Bancorp also suggest that the Court should apply the Option Price/FMV Test to determine whether the Option Amount is nominal. As explained above, this test requires a comparison of the option price and the fair market value of the leased goods at the time the option is to be exercised — as anticipated by the parties at lease inception. Heller argues that Lakin cannot demonstrate nominality under this standard because it failed to offer “evidence of what the parties would have expected the Lathes to be worth when the Lease Agreements expired, at the time they signed the Lease[s].” Heller Reply Memorandum at ll. 17 While this statement is correct, and the Option Price/FMV Test was widely accepted as an accurate measure of nomi-nality under Old § 1-201(37), 18 the Court again declines to employ a common law test that the drafters of New § 1-201(37) did not see fit to include in the amended statute.
c. Retention of a Meaningful Rever-sionary Interest
Having concluded that the Lease Agreements are not terminablе and that none of the conditions set forth in New § l-201(37)[2](a) through (d) have been met, the Court must address the outcome-determinative question: Did the Lessors
By failing to include an explicit test for assessing whether a lessor has retained a meaningful reversionary interest, the drafters of New § 1-201(37) have created the same confusion and unpredictability in the caselaw that existed under Old § 1-201(37).
See
Gaines, 18 Stetson L.Rev. at 83 (“Simply put, this is a poorly drafted Code provision purporting to clarify one of the most litigated and convoluted areas of the law relating to lease transactions. The language employed in subsection 1-201(37)(x) results in a definitional nightmare both for those attempting to structure a lease transaction and those subsequently called upon to interpret it.”); Barnes, 25 U. Mem. L.Rev. at 891 (“The new version of section 1-201(37) even encourages the continued development of a judicial gloss on the test.”); Bayer, 43 Bus. Law. at 1498 (“Despite the improvements, the revisions to section 1-201(37) fall far short of creating a bright line test for determining whether a transactiоn creates a lease or a security interest.”); Dawley,
The above-cited cases reflect the marked lack of uniformity in the reported deсisions as to the appropriate test for determining the existence of a meaningful reversionary interest. But it is not for the Court to attempt to harmonize these discordant lines of authority or select what it deems to be the most salient decisional criteria. Since California law governs, the Court follows the sound reversionary interest analysis found in Addison.
Addison
involved a purported lease of a Ferrari 330GTC roadster having an original value of $244,800. At the trial court level, the defendant lessee moved to dismiss the action brought by the lessor’s assignee for breach of the lease, asserting that the plaintiff was not entitled to recover his deficiency following the vehicle’s sale at auction due to his noncompliance with UCC § 9-504’s foreclosure sale provisions. The trial court denied the motion and, at the conclusion of the jury trial, the jury found the defendant liable under the lease. The
Addison
court affirmed the lower court’s decision, concluding that the agreement was a true lease and thus UCC § 9-504 did not apply. The court began its analysis by determining that the Bright-Line Test failed to establish a per se security agreement since none of the Residual Value Factors were present.
Addison,
Application of Addison’s decisional framework here leads to the inescapable conclusion that the Lessors retained a meaningful reversionary interest in the Lathes. The Court has determined — in the context of applying the Bright-Line Test — that Lakin failed to meet its burden of demonstrating that the Option Amount is nominal. 21 Thus, the first element of Addison’s two-prong test has not been established. And Lakin does not allege, nor do the Lease Agreements establish, that QDS acquired an equity interest in the Lathes. Hence, under test adopted by the Addison court, Lakin has not met its burden of proving that the Lessors failed to retain a meaningful reversionary interest in the Lathes.
According to Lakin, the Lessors relinquished their reversionary interest in the Lathes because, given the economics of the
Lakin’s remaining arguments are equally unavailing. It simply does not follow from the Lease Agreement’s inclusion of Net Lease Provisions that the Lessors relinquished their residual interest in the Lathes. This argument is refuted by the statutory text,
see
UCC § 1 — 201(37)[3](b) (West 2002), and ample case authority
see, e.g., Addison, 41
Cal.App.4th at 1299,
In sum, Lakin has not established that the Lessors parted with their reversionary interest in the Lathes. Lakin therefore has failed to meet its burden of proving that the Lease Agreements are in fact disguised security agreements. 23
Based on the foregoing, the Court concludes that the Lease Agreements are true leases rather than disguised security agreements. An order granting the U.S. Bancorp Motion, the Rejection Motion, and the Marcap Motion will be entered separately.
IT IS SO ORDERED.
Notes
. The Lease Agreements state:
Unless you purchase the Equipment in accordance with this Lease, at the end of this Lease, you will immediately deliver the Equipment to us in as good condition as when you received it, except for ordinary wear and tear, to a location selected by us. You will pay all expenses of deinstalling, crating and shipping, and you will insure the Equipment for its full replacement value during shipping.
Lease Agreements, ¶ 14.
. Marcap did nothing more than execute a stipulation that tracks the Initial Stipulation. It chose not to brief any of the contested legal issues.
. Because the UCC is a uniform law, decisions from other state and federal courts interpreting § 1-201(37) also may be considered.
PSINet,
. UCC § 1-201(37) has been codified as § 1201(36) of the California Commercial Code. Cal. Comm.Code § 1201(36) (West 2002). UCC § 1-201(37) and Cal. Comm. Code § 1201(36) are virtually identical: the minor deviations from the text of the UCC contained in California's version of the statute are nonsubstantive. For the sake of clarify, this Memorandum Opinion will refer to UCC § 1-201(37) rather than Cal. Comm.Code § 1201(36).
. Section 2A-103(l)(j) of the UCC defines “lease” as "a transfer of the right to possession and use of goods for a term in return for consideration, but a sale, including a sale on approval or a sale or return, or retention or creation of a security interest is not a lease.” UCC § 2A — 103(l)(j) (West 2002).
. See Bayer, 43 Bus. Law. at 1497 & n. 39 (noting the existence of " 'a significant number of authorities ... to support almost every position imaginable dealing with the lease-security interest issue.’ ” (quoting Charles W. Mooney, Jr., Personal Property Leasing: A Challenge, 36 Bus. Law. 1605, 1611 (1981))); Gaines, 18 Stetson L.Rev. at 71 ("The development of the case law interpreting instruments purporting to be lease agreements has led to widely diverse analyses and results.”).
. The Economic Realities Test has also been variously referred to as the "sensible person test,”
see Triplex
Marine,
. New § 1-201(37) is somewhat difficult to reference given the drafters’ failure to number its first three paragraphs. See White & Summers, § 30-3, at 23 ("Why the persons who revised the Code in 1987, when this concatenation came into existence, thought it wise to include separate subsections with the same identifying letters, is not clear to us. It is important to read it carefully so as not to confuse the first (a) with the second and vice versa.”). For ease of reference, the Court will refer to New § l-201(37)'s first three unnumbered paragraphs as § 1 — 201 [1], § 1-201[2], and § 1-201[3],
Some of the confusion caused by the structure of the statute may be eliminated upon the states' adoption of new UCC § 1-203. This new statute will contain those portions of UCC § 1-201(37) that distinguish true leases from security intеrests, except for current § l-201(37)(z) — containing the definition of "present value” — which will be placed in UCC § 1-201(30). Kathleen Patchel & Boris Auerbach, The Article 1 Revision Process, 54 SMU L.Rev. 603, 607-09 (Spring 2001); National Conference of Comm’rs on Uniform State Laws, Revision of Uniform Commercial Code Article 1 — -General Provisions <http:/ /www.law.upenn. edu/óll/ulc/uccl/ uccl070500.htm> (accessed Sept. 28, 2002). New § 1-203 sets out five tests ((a) through (e)), four of which have numbered sub-parts. Thus, even though the section is substantively identical to New UCC § 1-201(37), the format change will make it somewhat easier to reference. To date, new UCC § 1-203 has been adopted only by the U.S. Virgin Islands. It has been introduced in the California Assembly as SB 1522. See <http:ll www.nccusl.org/nccusl/pubndrafts.asp> (accessed Sept. 28, 2002); and <http://www.nccusl.org/nccusl/LegByAct.pdf> (accessed Sept. 28, 2002).
. The presence of one or more of the following Residual Value Factors set forth in New § 1 — 201 (37)[2] establish that a non-terminable "lease” agreement is a disguised security agreement as a matter of law:
1. First, if the original term of the lease is equal to or greater than the remaining economic life of the goods.
2. Second, if the lessee is bound to renew the lease for the remaining economiclife of the goods or to become the owner of the goods.
3. Third, if the lessee has the option to renew the lease for nominal or no additional consideration upon compliance with the lease agreement.
4. Fourth, if the lessee has an option to become the owner of the goods for nominal or no additional consideration upon compliance with the lease agreement.
UCC § 1-201(37)[2] (West 2002).
. In
Nationwise,
the debtor could terminate the purported lease no earlier than 24 months into the 36-month term and only if it provided three month's notice, was current on all other contractual obligations, and paid termination charges and other fees to the lessor.
Nationwise,
. The Option Price/Performance Cost Test set forth in New § 1-201 (3 7)(x) is essentially a codification (with refinements) of the Economic Realities Test.
See Taylor,
. The First and Second Stipulations establish that the cost of removal and return of each Lathe could be as low as $1,500 to $2,500 if U.S. Bancorp or Marcap elected to have the Debtor ship the Lathe to a local facility for storage until resale. U.S. Bancorp suggests that this is its customary practice, rather than requiring return of leased equipment to U.S. Bancorp's facility in Portland, Oregon. U.S. Bancorp Reply Brief at 6. Yet, because U.S. Bancorp has the contractual right to require QDS to ship the U.S. Bancorp Lathe to Portland, Oregon, the Court concludes that the full $7,200 cost of removing, crating, and shipping the Lathe back to U.S. Bancorp is the appropriate figure to be used in applying the Option Price/Performance Cost Test.
. No evidence was presented establishing Marcap’s place of business.
. After receiving and reviewing the parties' stipulations, the Court informed counsel that the stipulations do not contain the evidence necessary for the Court to assess nominality under New § 1-201(37)'s statutory test. Although the Court afforded the parties an opportunity to amend the stipulations or supplement the record, they did not do so.
. As noted above, given the evidentiary deficiencies in the record, the Court need not decide whether, under New § l-201(37)(x), the Lost Equipment Value should be counted as a "cost of performing under the [L]ease [A]greement[s] if the purchase option is not exercised." UCC § l-201(37)(x) (West 2002). The Court concurs, however, with Heller's point that inclusion of foregone economic value as a performance cost in the application of the Option Price/Performance Cost Test would have the effect of converting "the most obvious true lease [into] a security agreement.” Heller Reply Memorandum at 8. For example, assume the following hypothetical facts: Lessor and lessee execute a three-year rental agreement under which the lessee obtains the use of equipment having an original cost of $100,000. The equipment has a projected economic life of six years from lease inception. The agreement calls for the lessee to make monthly payments of $1700 per month for 36 months (a stream of payments totaling $61,200) and grants the lessee an option to purchase the equipment at the end of the lease term for $50,000. The parties project that the equipment’s fair market value of the equipment at the end of the 36-month lease term will approximate the $50,000 option amount. Under the agreement, if the lessee chooses not to exercise the purchase option, then it is obligated to pay the lessor $5,000 to defray its cost to have the equipment deinstalled and shipped to the lessor's place of business. An option price of $50,000, which is one-half of the equipment's original cost and approximates its fair market value at option time, clearly would not be nominal. Yet if the lost economic value of the equipment is included as a performance cost under the Option Price/Performance Cost Test, as Lakin urges the Court to do here, then the $50,000 option price would be found to be nominal, as the following calculation demonstrates:
Option Amount ' Cost of Performing
$50,000 $50,000 Lost Equipment Value + $ 5,000 Cost to Deinstall and _ _ Return the Equipment
$50,000 < $55,000
Thus, interpreting New § l-201(37)(x)’s phrase "cost of performing under the lease agreement if the purchase option is not exercised” broadly so as to include the economic value a lessee chooses to forego when it declines to exercise a purchase option would produce absurd results.
See Burkhart v. U.S. Commerce Equip. Fin., LLC,
No. E2001-00069-COA-R3-CV,
. Notwithstanding the enactment of New § 1-201(37), some courts continue to apply the Percentage Tests to determine whether the option price contained in a purported lease agreement is nominal.
See, e.g., Triplex Marine,
. U.S. Bancorp seems to have missed this point altogether. As discussed above, in distinguishing a true lease from a disguised security agreement, it is well-settled that courts must look to lease inception (see caselaw and commentary discussed supra at 338-40). It is at that point in time that either a true lease or a security agreement is created. Thus, it is the parties’ projections at the outset of a transaction — of the expected fair market value of the leased goods, their remaining economic life, if any, at lease end, and the cost of continued performance under the lease agreement if the option is not exercised — -that must be examined in determining whether an agreement is or is not a true lease. Despite the wealth of authority supporting the proposition that lease inception, rather than some later date, must be the Court's focal point, the parties have presented stipulations that do not focus on lease inception and therefore do not contain the information necessary to determine whether the Lease Agreements are true leases or disguised security agreements. In view of the fact that Lakin bears the burden of proving that the Lease Agreements are othеr than what they purport to be, it is difficult to understand why U.S. Bancorp, Heller, and Marcap agreed to the submission of the stipulations in the first instance. Had they simply put Lakin to its proof — requiring it to come forward at a hearing with evidence establishing what the parties to the Lease Agreements projected at the outset of the transaction as to the Lathes’ residual value, remaining economic life at lease end, etc. — this dispute may well have been avoided.
. Both courts applying Old § 1-201(37) and legal commentators have described the Option Price/FMV Test as perhaps the most accurate common law standard for assessing the nominality of the option price stated in a purported lease agreement.
See, e.g., Edison Bros. Stores,
. New § 1 — 201 (37)[3] provides that a transaction does not create a security interest merely because one or more of the following five conditions exist:
1. That the present value of the consideration the lessee is obligated to pay the lessor is substantially equal to or greater than the fair market value of the goods at the time the lease is entered into;
2. That the lessee assumes the risk of loss of the goods, or undеrtakes the obligation to pay taxes, insurance, filing, recording or registration fees or service or maintenance costs;
3. That the lessee has an option to renew the lease or become the owner of the leased goods;
4. That the lessee has an option to renew the lease for a fixed rent that is equal to or greater than the reasonably predictable fair market rent for the use of the goods for the term of the renewal at the time the option is to be performed; or
5. That the lessee has an option to become the owner of the goods for a fixed price that is equal to or greater than the reasonably predictable fair market value of the goods at the time that the option is to be performed. UCC § 1-201 (37)[2](a)(e) (West 2002).
. Since California law controls, in determining whether the Lessors have retained a meaningful reversionary interest in the Lathes, the Court has followed the approach outlined in
Addison. Addison’s
reversionary interest analysis, however, does seem to be logically flawed in one respect. Applying the Bright-Line Test, the
Addison
court made a threshold determination that the option price was not nominal and thus failed to find as a matter of law that the purported lease created a security interest. Having made this determination, it seems somewhat redundant and incongruous for the
Addison
court to have then considered the nominality of the option price a second time in connection with its reversionary interest analysis. Put differently, once a court has applied the Option Price/Performance Cost Test and concluded that the option price stated in a non-terminable "lease” agreement is not nominal, it appears to be unnecessary to revisit the issue of nominality in analyzing whether the lessor has retained a meaningful reversionary interest. And it seems particularly inappropriate to reexamine nominality using a common law nominality standard, as the courts did in the decisions cited with approval by the
Addison
court.
See Zaleha,
. The Addison court also noted that:
The remaining terms of this dоcument support its construction as a true lease. Paragraph 13 expressly states that the vehicle is "the sole property of Lessor, and Lessee shall have no right, title or interest therein as to the ownership thereof ... and this instrument is a lease and not a contract of sale.”
Addison,
. Since Marcap and U.S. Bancorp took assignments of the Lease Agreements six and eight days, respectively, after they were signed, it is logical to infer that the assignments were contemplated at the time QDS and Intech executed the Lease Agreements. Thus, if Marcap and/or U.S. Bancorp made projections — at or about the time they took the assignments — of the Lathes' anticipated fair market value at the time the options would arise, their remaining economic life, if any, at option time, and the Debtor’s cost to return the Lathes if it elected not to exercise its purchase option, such information would have been relevant to the Court's nominality analysis. No such information was supplied by the parties (and may not exist).
. Given its ruling on the merits, the Court need not dwell at length on U.S. Bancorp’s procedural arguments. According to U.S. Bancorp, it was denied the opportunity to fully protect its rights because it was not notified prior to the Sale Hearing — by either the Debtor or Lakin — that Lakin would take the position that the Lease Agreements were in fact disguised security agreements. According to U.S. Bancorp, if it had known that Lakin would challenge its status as a true lessor, then it would have objected to the Asset Sale. To be sure, U.S. Bancorp should have been provided with notice of Lakin’s intentions prior to the Sale Hearing. But notwithstanding its failure to receive prior notice of Lakin's position, U.S. Bancorp clearly has had a full and fair opportunity to litigate the issue of whether the Lease Agreements are true leases or disguised security agreements. Under well-settled Sixth Circuit authority, in order for a debtor to gain the approval of the sale of substantially all of its assets outside the ordinary course of business, it must establish a sound business justification for the sale.
Stephens Indus., Inc. v. McClung,
U.S. Bancorp’s second procedural argument — that Lakin should have been required to commence an adversary proceeding or an "independent contested matter” to seek re-characterization of the Lease Agreements
(see
U.S. Bancorp Reply Brief at 6) — is equally specious. U.S. Bancorp fails to cite a single authority to support this proposition. And even a modest investment in legal research would have revealed that the lease versus disguised security interest dispute is frequently litigated outside the context of an adversary proceeding or an "independent contested matter.”
See, e.g., APB Online,