Leases

This survey covers several 2023 cases involving disputes among parties to equipment leases or other personal property financings or involving third parties claiming to have related rights or interests. The courts in these cases considered many of the fundamental issues often raised by parties and others when litigating commercial enforcement, bankruptcy protections, and other claimed rights, including the associated rights, interests, and liability considerations, relating to these leases and financings. The issues covered in cases summarized in this survey include whether a transaction documented as a lease creates a true “lease” or a security interest under the Uniform Commercial Code (the “U.C.C.”), vicarious liability of a lessor, the enforceability and shortcomings of forum selection clauses and the rights of assignees.

Please also note that the 2022 U.C.C. Amendments are likely to impact leases and financings involving goods and, in some cases, the non-goods aspects of those transactions. Perhaps the most noteworthy of these lease-related amendments is the expanded scope of U.C.C. Article 2A, which now includes a “bundled” transaction involving an integrated lease of goods together with related services, licenses or sales of goods, if constituting a “hybrid lease” as now defined in U.C.C. Article 2A. These and the other amendments to U.C.C. Article 2A, and certain related amendments to the scope of U.C.C. Article 2, which now includes “hybrid transactions,” and the amended definition of “chattel paper” under U.C.C. Article 9, are all discussed in detail in the introduction to last year’s U.C.C. Survey.

A. Lease Characterization and Damages

We previously covered Prospect ECHN, Inc. v. Winthrop Resources Corp. in the 2022 survey of leases. As noted in our earlier survey, Prospect ECHN, Inc. (“Prospect”) filed a declaratory judgment action in the U.S. District Court for the District of Minnesota seeking to have the court recharacterize its equipment lease with Winthrop Resources Corporation (“Winthrop”) as a security interest governed by U.C.C. Article 9, rather than as a true “lease” governed by U.C.C. Article 2A. Prospect sought recharacterization to be relieved of its obligations for the remaining term of the lease and to have the more favorable rights of a debtor under U.C.C. Article 9, including avoidance of the statutory “hell-or-high-water” treatment of its obligations as an Article 2A “finance lease.”

In considering the characterization of the lease agreement and related schedules, the district court applied the two-part bright-line test under U.C.C. section 1-203(b), the first part of which requires that “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.” As to what constituted the term of each of the schedules, the court took into account both the initial term and the “evergreening” renewal terms to which Prospect became bound unless it provided advance notice of its intention to terminate, and concluded that the schedules were true leases because Prospect had the right to terminate at the expiration of the initial term and each of the renewal terms. The court also noted that, even if the schedules were non-terminable, Prospect failed to prove the existence of any of the other factors in U.C.C. section 1-203(b)(1)–(4) in order to satisfy the second part of the bright-line test. The lessee appealed that decision to the U.S. Court of Appeals for the Eighth Circuit, which affirmed the district court’s ruling in favor of Winthrop.

Like the district court, the Eighth Circuit also applied the bright-line test under U.C.C. section 1-203(b) to determine whether the schedules created security interests per se, and read the phrase “term of the lease” in section 1-203(b)(1) to mean the “entire term” of the schedules, including both the “initial term and any one-year renewal terms.” Based on this “strict reading” of section 1-203(b)(1) and the agreement’s termination clause, the Eighth Circuit concluded that each schedule was “subject to termination” by Prospect, and because it could terminate, even if only once annually after the initial term, the agreement and schedules did not create security interests under the U.C.C.’s bright-line test.

The Eighth Circuit next examined “the specific facts of the case to determine whether the economics of the transaction suggested such a result,” as contemplated by U.C.C. section 1-203(a). Its primary focus was whether Winthrop possessed an “interest in the economic value or remaining useful life of the goods.” The court found Winthrop’s accounting treatment of the schedules as having no residual value under the applicable accounting rules to be neither dispositive nor relevant in the U.C.C. context. The Eighth Circuit found other evidence regarding the actual and anticipated residual value of the equipment to be more compelling, including testimony by Prospect’s own expert that the “hardware” had a useful life exceeding the term of five of the seven schedules, and it concluded that Winthrop did have the requisite reversionary interest.

The Eighth Circuit also considered testimony regarding the parties’ negotiations when structuring the transaction and the resultant economic terms to be indicative of a true lease characterization. Among other things, it mentioned Winthrop’s refusal of the request by ECHN, Prospect’s predecessor-in-interest, to include a $1 purchase option upon termination and its recognition that it was paying lower monthly rent because it would not own the equipment upon termination. Prospect also provided evidence that its payments during the initial terms of most of the schedules equaled or slightly exceeded the cost of the equipment. However the court explained that those economic terms do “not necessarily indicate that the transactions created security interests.” Further, even though the rent included an amount in the nature of a repayment, together with an interest charge, the court instead found “compelling” Winthrop’s argument that the “implied interest rates for the initial terms [of the schedules] would be well below those for a secured loan and, with respect to one schedule, negative.” Accordingly, the Eighth Circuit concluded that “[t]hese economic realities do not indicate a sale.”

As context for its final ruling regarding recharacterization, the court provided its perspective regarding the parties’ respective intentions when entering into the transaction and Prospect’s motivation for seeking recharacterization. First, the court noted that the parties intended each schedule to be an Article 2A “finance lease,” and, as such, the inclusion of a “hell-or-high-water” clause that made rental payments mandatory and that disallowed Prospect from terminating any schedule during its initial term was not only consistent with the unique nature of a finance lease, but also statutorily authorized. Consistent with those intentions, ECHN entered into the agreement and schedules with Winthrop and agreed to be bound by the rent, termination and other terms, when it was advantageous for ECHN to rent and not own the equipment. Nevertheless, after assuming ECHN’s obligations under the agreement and schedules, “Prospect realized that—unless it terminated the ironclad agreement—it was under a continuing obligation to pay Winthrop the amounts due under each schedule,” and “tried to use legal recharacterization offensively to escape the obligations to which ECHN had agreed.” “Although the U.C.C. demands recharacterization under its bright-line test or when so compelled by the facts of the case, it does not demand so . . . where the parties negotiated a lease agreement and related schedules that skirt the line of creating security interests without crossing it.”

For those reasons, the Eighth Circuit concluded that the district court correctly granted summary judgment in Winthrop’s favor regarding the true lease characterization of the schedules. The Eighth Circuit also rejected Prospect’s challenge to the award of damages to Winthrop, given the “well settled” rule that “a contract provision for liquidated damages can be enforced without proving actual damages as long as the amount stated is reasonable.”

The Eighth Circuit’s opinion is instructive in several respects. It provides useful insight as to the intentions of the parties, the contract terms and its considerations regarding the equipment’s useful life. Also useful was its explanation of why it followed what might be considered a lessor-favorable interpretation of the text and purposes of section 1-203, including why that was consistent with Article 2A. In that regard, it is interesting to note that, when considering the characterization, the court chose to “primarily consider hardware” in its analysis, even though “each schedule includes a variety of hardware, software licenses, and services.” The court noted that Article 2A involves the transfer of “goods,” whose definition covers hardware but seems to exclude software licenses, and that the “U.C.C. simply does not apply when the predominant purpose of the contract is services.” Perhaps a different conclusion might have been reached regarding the issues raised in Prospect if the schedules were treated as “hybrid leases” under U.C.C. section 2A-102, as amended in 2022, the scope of which now includes leases of equipment together with a related software license, services and other property. The Eighth Circuit might have been alluding to the implications of the expanded scope of Article 2A when it noted that “[t]his area of law, particularly with respect to transactions involving hardware, software licenses, and services, is unsettled and developing.”

B. Vicarious Liability

The Graves Amendment provides certain statutory protections to owners of motor vehicles that are in the business of renting or leasing vehicles and that are sued under a theory of vicarious liability. The cases from 2023 involving the Graves Amendment focused on whether the vehicle owner at issue was negligent or committed some criminal wrongdoing, either of which is expressly excluded from such statutory protection.

For instance, in Haskell v. Perez, Peter Haskell alleged he was struck by a vehicle operated by Alexis Perez. The vehicle operated by Perez was rented by EAN Holdings, LLC, CAMRAC, LLC, and ELRAC, LLC—all doing business as Enterprise Rent-A-Car (“Enterprise defendants”)—to Jaritza Velez. Haskell alleged the Enterprise defendants negligently entrusted the vehicle to Perez. The Enterprise defendants argued that count one of Haskell’s complaint was a lessor liability claim barred by the Graves Amendment, while count two failed to sufficiently allege facts showing the Enterprise defendants were negligent by having actual or constructive knowledge of its renter’s incompetence.

The court stated that:

[L]iability cannot be imposed upon an owner merely because he entrusts [a vehicle] to another to drive upon the highways . . . . [H]owever, … the owner may be liable for injury resulting from the operation of [an] automobile he loans to another when he knows or ought reasonably to know that the one to whom he entrusts it is so incompetent to operate it by reason of inexperience or other cause that the owner ought reasonably to anticipate the likelihood that in its operation injury will be done to others.

The court found Haskell offered only “conclusory statements without pleading any facts to support his theory that the … Enterprise [defendants] had either constructive or actual knowledge that . . . Perez … was incompetent to operate a motor vehicle prior to the time … Perez operated the Enterprise vehicle.” The court noted that:

[T]he allegations, even viewed in a light most favorable to the plaintiff, are that the defendant owner knew or should have known of the defendant operator’s irresponsible and unsafe driving [as] of [the date of the accident] without alleging that the defendant operator had dangerous propensities or any incompetencies before that date.

The court held “the Graves Amendment expressly prohibits this type of vicarious liability claim alleged by the plaintiff without a showing of negligence or criminal wrongdoing on the part of the defendant. . . .” The court concluded that “[t]he plaintiff … failed to demonstrate that there was any negligent entrustment by the … Enterprise [defendants].”

In Stanford v. Nogiec, the plaintiffs alleged that, when Clayton Nogiec struck Liam Stanford, Nogiec was driving a vehicle owned by EAN Holdings, LLC, doing business as Enterprise Rental Car (“EAN”), and that EAN was vicariously liable for Nogiec’s negligence.

The court noted that the plaintiffs’ claims were based on the fact that “Nogiec was prohibited from operating a vehicle that did not have an ignition interlock device installed … [and] that [EAN] knew or should have known of Nogiec’s license restriction, but still entrusted him with a vehicle without an ignition interlock device, which Nogiec operated negligently causing … Stanford’s serious injuries.” The court further noted that:

The plaintiff has identified no evidence that EAN had actual knowledge that Nogiec was prohibited from operating a vehicle without an ignition interlock device. The plaintiffs’ claim rests on the proposition that EAN had a duty to investigate the status of Nogiec’s license and therefore should have known that his license was restricted.

The court found that the “plaintiffs’ argument is inconsistent with the weight of authority holding that ‘a rental car company can only be charged with constructive knowledge of a renter’s driving “incompetence” based on facts that are openly apparent and readily discernible, with no duty to investigate the renter’s criminal background or driving history.’”

A representative of EAN “state[d] that he inspected Nogiec’s license, which ‘was facially valid, contained no restrictions on its face, and was unexpired’ … [and] that he … observe[d] Nogiec’s demeanor and that Nogiec ‘did not demonstrate any signs of mental or physical impairment, or any other unfitness to operate a motor vehicle.’” The court noted that the plaintiffs failed to offer any evidence that contradicted or undermined that statement. Therefore, the court found “[t]he undisputed facts establish that the plaintiffs cannot demonstrate that EAN had actual or constructive knowledge that Nogiec was prohibited from operating a motor vehicle without an ignition interlock device or was otherwise incompetent to operate a motor vehicle. Therefore, the plaintiffs’ claims of negligence directly against EAN fail.”

In Garcia v. Steele, a pedestrian sued a car dealership and its customer alleging negligence and negligent entrustment of a loaner vehicle. The customer parked the vehicle illegally in a drop-off zone and exited it to run an errand, which prompted the customer’s unlicensed spouse to get into the driver’s seat. Intending to deactivate the turn signal, the customer’s spouse pushed a button that allowed the vehicle to roll through a red traffic light, striking the plaintiff, who was in the crosswalk. The court found that, “looking at the substance of the transaction between [the dealership] and [its customer], the courtesy vehicle meets the ordinary meaning of ‘rent[ ]’ or ‘lease[ ]’ [under the Graves Amendment] because it was provided to [the customer] in exchange for consideration—namely, the opportunity to service [the customer]’s car.” The court further found that, “[s]ince 2014, [the dealership] has ‘regularly provide[d] loaner vehicles to customers as a courtesy when a customer’s car is being serviced for more than three hours.’” The court held that the dealership was engaged in the trade or business of renting or leasing motor vehicles; therefore, “the Graves Amendment protects the automobile dealership from being held viciously liable for the tortious conduct of the driver of its courtesy vehicle.”

The court ultimately affirmed summary judgment in favor of the dealership, based on the Graves Amendment, because the plaintiff had not raised a genuine dispute of material fact as to whether the dealership negligently caused the accident. However, the court reversed the summary judgement in favor of the customer, who had entrusted the vehicle to his spouse, because the court determined there were genuine issues of fact as to the potential negligence of the customer under a theory of negligent entrustment.

In Olsen v. First Team Ford, Ltd., an injured driver sued both the driver of a dealership courtesy loaner car, alleging direct negligence, and the car dealership that owned the loaner car, alleging vicarious liability. The trial court held that, “even though [the driver of the loaner car] did not have his [car] serviced, it was his intent to have the [car] serviced that day which determined that he rented the [car] under the Graves Amendment … [and] this exchange constituted a valid rental under the Graves Amendment to shield the Dealership from liability.”

The appellate court did not challenge the concept of a dealership being able to avail itself of Graves Amendment protections for loaner cars, but instead noted “the facts … demonstrate that [the driver]’s purpose could have been to just take the [loaner car] home for a test drive, as opposed to taking the [loaner car] home because his [personal car] was still awaiting service.” The appellate court held “there is a genuine dispute regarding whether [the driver of the loaner car] ever submitted his vehicle for servicing at the Dealership, which is what formed the basis for the trial court’s ruling that there was a valid rental agreement between [such driver] and the Dealership.” The appellate court ruled that summary judgment was therefore not appropriate because “there are genuine disputes of material fact that relate to the Dealership’s Graves Amendment defense.”

C. Forum Selection Clauses

In Rheinhart v. Nissan North America, Inc., an equipment lessee sued the manufacturer, the vehicle dealer and the equipment lessor for violations of the California Song-Beverly Consumer Warranty Act (“Act”), claiming that the vehicle’s safety camera system repeatedly malfunctioned and had not been repaired and that the defendants failed to repurchase or replace the vehicle.

This case did not involve a forum selection clause. However, as part of the court’s decision regarding whether a release executed as part of pre-litigation settlement agreement between the lessee and the defendants was void as against public policy, the court considered California case law regarding public policy considerations involving various contractual contexts, including whether forum selection clauses violate public policy. By way of analogy, the court noted that “California courts will not give effect to a contractual forum selection clause, normally favored under California law, ‘if to do so would substantially diminish the rights of California residents in a way that violates [that] state’s public policy.’”

This decision is not otherwise relevant for purposes of this survey, other than this public policy discussion and the following additional consideration regarding the burden of proof:

[O]rdinarily the party opposing enforcement of a forum selection clause bears the burden of proving why it should not be enforced. . . . But that burden is reversed ‘when the claims at issue are based on unwaivable rights created by California statutes. In that situation, the party seeking to enforce the forum selection clause bears the burden to show litigating the claims in the contractually-designated forum ‘will not diminish in any way the substantive rights afforded … under California law.’”

As a practical tip, it is important to be mindful of any relevant state public policy considerations when seeking to enforce forum selection clauses, and the related potential in California for shifting the burden of proof.

D. Rights of Assignees

Interflow Factors Corp. v. Hilton Holdings, LLC involved a factoring transaction whereby Interflow purchased accounts that Hilton owed to Gulf Coast for security services. Initially, Hilton made direct payment to Interflow, pursuant to a notice of assignment from Interflow to Hilton covering present and future accounts receivable that Hilton owed to Gulf Coast. When Gulf Coast encountered financial difficulties, it requested that Hilton pay invoices to it, contrary to both the notice of assignment and the Interflow payment address that was printed on each invoice, to which Interflow objected. The appellate court reversed the trial court’s denial of Interflow’s motion for summary judgment and entered judgment for Interflow, citing U.C.C. section 9-406(a) and PEB Commentary No. 21 to support its conclusion that “Article 9 applies to both an outright assignment of ownership of specified payment rights and to assignment of specified payment rights for security . . ., such as a security interest.”

AmeriFactors Financial Group, LLC v. Dunham Price Group, LLC reached a different outcome under a factoring agreement between AmeriFactors and Genesis Venture Logistics, LLC, whereby AmeriFactors purchased accounts receivables owed by Dunham Price to Genesis under a Barge Transportation Agreement. AmeriFactors delivered both a general notice of assignment and a verification form for each invoice to Dunham Price, which paid the first six invoices to AmeriFactors but then (when it learned that Genesis had not been paying its subcontractors) directed payment of seven other verified invoices to those subcontractors for the project to which the barge contract was connected. When AmeriFactors sued Dunham Price to collect the unpaid invoices, the court—after finding that U.C.C. section 9-403(b) was inapplicable—erroneously held that:

[T]here was a reasonable basis in the record for the jury to conclude that Dunham Price did not breach the verification agreements considering the fact that it would be an absurd result if … the money Dunham Price paid to AmeriFactors would not go toward paying the subcontractors, who were doing all of the work.

The record does not reveal why the court did not consider the effect of U.C.C. section 9-406(a), which requires only that the notice of assignment be authenticated either by the assignor or the assignee.

Edwards v. Superior Court of Santa Clara County involved a lease of charged-off accounts receivable, including those owed by the account debtor, who had challenged whether the sale and subsequent lease of the accounts was governed by Article 9 or whether it was “an assignment of accounts … which is for the purpose of collection only.” The lease agreement stated that the lessor remained the owner of the receivables, that the lease (of the lessor’s entire interest in the receivables pool) was for a period of five years, and that “this Lease is a true Lease for tax and other purposes.” The appellate court upheld the trial court ruling that the lease agreement “had other purposes besides collection,” held that Article 9 applied to the lease agreement, and ruled that the account debtor had failed to demonstrate that a financing statement must have been filed by either the lessor or lessee of the accounts.

Wintrust Specialty Finance v. Pinnacle Commercial Credit, Inc. highlights a growing problem in three-party financing transactions: hackers intercepting wire transfer instructions and directing payment to a fictitious account. Pursuant to a program agreement, Wintrust agreed to purchase a secured loan that Pinnacle made to the purchaser of a concrete mixing truck. On behalf of Pinnacle, Wintrust was to remit payment of the purchase price directly to the vendor of the truck. The vendor emailed Pinnacle wiring instructions, which Pinnacle forwarded to Wintrust, but a hacker had invaded the vendor’s email system and inserted a fictitious account as the wire transfer payee. When Wintrust discovered the fraud, it demanded that Pinnacle repurchase the loan pursuant to the program agreement’s repurchase clause, which was triggered by a breach of any representation or warranty. Instead, the court relied upon the agreement’s indemnification clause, which covered “any … injury and damage … which the Bank may hereafter incur … as a result of [Pinnacle’s] acts,” to compel Pinnacle to indemnify Wintrust because “it was [Pinnacle’s] act of sending [Wintrust] the incorrect wire payment instructions that caused [Wintrust’s] loss.” This decision illustrates the value of including broad indemnification clauses as well as typical “warranty repurchase” provisions in multiparty financing arrangements.

In re Avianca Holdings S.A. involved an unusual fee arrangement in which the brokers, which arranged financing and leasing for several aircraft, structured their compensation in the form of “Additional Rental Payments” (“ARPs”), payable to the respective lessors but for the ultimate benefit of the brokers, which were designated in each lease agreement as “express third-party beneficiaries with the power to enforce their rights” under the lease agreements. In 2020, Avianca petitioned for relief under the Bankruptcy Code. After the Bankruptcy Code’s sixty-day grace period, but before rejecting the payments required under the lease agreements, Avianca failed to pay any of the ARPs. The district court upheld the bankruptcy court’s determination that the obligation to make the ARPs “arose,” for purposes of section 365(d)(5) of the Bankruptcy Code, upon their respective rental payment dates, rather than upon execution of the lease agreements, and noted the parties “explicitly likened the ARPs to traditional rent payments, the most basic obligation under any lease (and one that unequivocally arises when it comes due monthly or otherwise).” Practitioners should note the significance that the courts attributed to the designation of the third-party payments as additional rent, as well as the lease agreements’ specifying that the brokers were express third-party beneficiaries.