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True Lease or Secured Financing?
In the Chapter 11 context, it is common for interested parties to challenge the characterization of a Chapter 11 debtor's obligations under an agreement styled as a lease. See In re APB Online, Inc., 259 B.R. 812, 815 (Bankr. S.D.N.Y. 2001). A Bankruptcy Court's determination as to whether a transaction is a “true” lease or a secured financing can have far-reaching consequences on the administration of a debtor's Chapter 11 case and the respective rights of each party to the agreement. As the recent decision by the Third Circuit Court of Appeals in Duke Energy Royal, LLC v. Pillowtex Corp. (In re Pillowtex, Inc.), 349 F.3d 711 (3d Cir. 2003) illustrates, when faced with the question of whether a transaction constitutes a “true” lease or a secured financing, bankruptcy courts will look beyond the form to the substance of the parties' agreement.
In Pillowtex, the Third Circuit recharacterized as a secured financing transaction a transaction intended by both parties to be an equipment lease. The decision highlights the risk to equipment lessors in the Chapter 11 context if they do not 1) retain (as a matter of form) an economically meaningful “residual value” in the leased property, and 2) expect (as a matter of substance) to be economically motivated at the end of the lease term to take possession of the property in order to recover the residual value of such leased property.
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