Leases of Goods: Characteristics - Module 6 of 8

Module 6: Lease Characteristics

Leases and Article 2A of the UCC       

While sales are covered under Article 2 of the UCC, leases of goods are covered by Article 2A. Article 2A was drafted to remedy anomalies in the Code and common law pertaining to the application of legal provisions to leasing situations.  Article 2A has been adopted by almost all US jurisdictions, excluding Louisiana and Puerto Rico.  According to one senior commentator, “seventeen years after Article 2A was first adopted, there is a large population that still does not understand how this article works.”[1]

Article 2A was created to be distinctive from Article 2 and, therefore, Article 2’s provisions are not binding in lease cases, but can be persuasive in interpreting lease provisions and circumstances.[2]  Leases, for example, like sales, are subject to Article 2 rules such as fraud, estoppel and mistake. Moreover, Article 2A generally does not preempt consumer statutory provisions.  While the parties have wide freedom to contract under Article 2A, they may not disclaim the obligations of good faith, diligence reasonableness, and care.[3]  The parties may, however, determine the standards that govern interpretation of those terms.[4]

Leases versus Sales on Credit      

The person or entity who extends the lease of the goods is called the “lessor” and the person or entity who rents the goods is called the “lessee.”  Note that the word “leases” as a verb can be confusing because both the lessor and the lessee in some sense “lease” the goods.  Moreover, a significant source of litigation has been transactions that can be interpreted either as purchases on loans or leases.[5] The former would not be subject to the leasing rules, though would be subject to lending and banking rules.

Still, in a case that a lessor may believe is a lease, the lessor may still want to file a financing statement to secure a security interest in case the transaction is later determined to be a sale and loan of the purchase money instead of a lease.[6]  Also, a lessor may make a “fixture filing” if the lessor anticipates the goods will become attached to real estate.[7]  Certificate of title[8] states additionally require lessors to note the existence of a lease on certificates of title that pertain to automobiles, trailers, mobile homes, boats and farm tractors.[9]

In some situations, leases can be hybrid transactions, incorporating elements of both sales and secured transactions.  A transaction can be a “true lease” or a “lease intended for security,” which is not so much a lease as a secured transaction.[10]  Whether a transaction creates a lease or a security interest depends on the nature of the lessee’s obligation to pay and the interest in the goods retained by the lessor.  If the lessee can end its obligation to pay under the lease at any time, then the transaction is a “true lease.”  The lessee in such a situation will not be expected to retain any of the goods after termination of the agreement. While a lessor may retain the goods after the termination of a valid lease, doing so makes the transaction appear more like a sale on credit than a lease.[11] 

Termination Fees and Purchases at Lease Expiration

The laws of leasing and those of secured transactions are different and, therefore, the rights of the parties will be affected by the characterization of any transaction.[12] If the lease provides a payment for the lessee to purchase or acquire the goods, then the amount will influence whether or not the lessee will likely retain the goods at the expiration of the lease term.[13]  If the amount is a low, or “nominal” amount, then the lessee will likely exercise the option to retain the goods and consequently, the lessor will have little expectation of acquiring the goods back.  However, if the amount is exorbitant then the lessee will be dissuaded from retaining the goods and the lessor will expect their return. In such a case, the transaction is more likely to be considered a sale.

The lessee may also be required to make a payment to the lessor upon expiration or termination of the agreement. If the payment is a one-time payment, it may merely be considered a termination fee or compensation for any remaining payments that will not be made due to early termination. This sort of payment does not convey an expectation on the part of the lessee that he or she will retain any interest in the goods. 

However, a large penalty imposed on the lessee may be intended to serve as a deterrent to the lessee ending the agreement before it has been entirely performed. A punitive termination fee may be indicative of a sale and not a lease, because it demonstrates an expectation that the “lease” would not be terminated. However, adding an option to purchase at a reasonable price after the lease expires can rebut this idea.

For example, a car lease typically features monthly payments for a fixed term; let’s assume $200 per month for 36 months. If an early termination fee assesses a $100 fee on the lessee for each month before the 36 that she terminated the lease, that’s reasonable compensation for the lessor’s revenue loss and would not turn this into a sale. Let’s further assume that the lease agreement contains a $1,000 termination fee at the end of the lease, which the lessee can avoid by continuing the lease until the value of the car is paid in full. This might make the transaction look a little more like a sale. On the other hand, if the lessee is given the option to purchase the car at fair market value after the 36 months, the termination fee might be considered less “punitive,” making the transaction fit more comfortably within the “lease” category.

 Other Factors in Lease Characteristics

Article 2A specifies various factors to determine whether an amount is “nominal.” If the acquisition at the time of purchase or renewal price is the fair market value of the goods, then the amount is not nominal. Also, if the purchase price is less than the outstanding amount owed for the balance of the lease, then the lessee will exercise the right to buy by paying the lower purchase price and, therefore, the amount is not nominal.  Note that the determination of whether a purchase or renewal amount is nominal is determined at the time of agreement and circumstances that would appear to render an amount nominal would be ignored.[14]

For example, Patrick Daniels, a farmer, acquires three tractors from Acme Leasing and Finance Company.  Under the terms of the transaction, Daniels pays monthly installments of $1,000 per tractor for three years and, at the end of the lease, he pays a nominal amount of $2,000.  Upon a missed payment, Acme has a repossession right under the terms of the agreement.  The tractors have a fair market value of about $35,000 each and Daniels acquires title to the tractors at the end of the lease term and upon payment of the nominal lump sum amount.  A court would likely find the transaction was a secured transaction and not a true lease.  

In addition to examining the termination rights under the lease, a further step involves examining whether the lessor has a reasonable expectation of reacquiring the goods that are the subject of the transaction.  The determinative factors here are the lease terms, along with options to renew the agreement and options to buy the goods.  One metric found in such agreements involves the expected term of the lease and the economic life of the goods.  If the lease is for the entire economic life of the goods, then the lessor retains little or no value in the reacquisition, as, by that point, the goods will have been fully consumed by the lessee’s use. A transaction like this is a sale, not a lease.

Similarly, if the lessee must or may renew the lease for the remaining economic life of the goods after the lease term is over, then the lessor has no reasonable expectation of reacquiring the goods.  All of these situations depict “leases intended for security” or, more simply, disguised security interests.  These are not true leases.[15]  In our above example, if the tractors had a five-year useful life and the term of the agreement was five years, then the tractors would provide no residual value to Acme, the lessor, and the lessor’s reacquisition would be largely inconsequential.

Article 2A provides a final set of factors to determine whether a lease is a disguised security interest.  One is whether the consideration paid by the lessee equals or is greater than the fair market value of the goods. Such transactions would be considered sales. Another is whether the lessee is required to pay expenses related to the goods, such as taxes, insurance, filing fees and maintenance. Again, the requirement to maintain is indicative of a lease since, if there is no reasonable expectation of getting the goods back, the “lessor” would not care how well the goods are maintained.

In our next module, we will look at the obligations of both parties to a lease agreement.