equipment leasing & finance foundationselling lease receivables in a post-enron world –...

Equipment Leasing & Finance Foundation

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VOLUME 21 • NUMBER 1SPRING 2004

Articles in the Journal of

Equipment Lease Financing

are intended to offer

responsible, timely, in-depth

analysis of market segments,

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and sales opportunities,

liability management, tax laws,

regulatory issues, and current

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Clarifying the Ambiguities in Bonus Depreciation RulesBy Arnold E. Grant

Treasury regulations issued last September clarify the application of bonus depreciation to sale-leaseback transactions, syndication transactions, and rebuilt and self-constructed property.This article shows the benefits of bonus depreciation for true lease transactions, as an increasedpercentage of depreciation deductions shift to the start of the lease.

The Imperfect Fit: Making Form Leases Work for High-tech EquipmentBy Barry S. Marks and James M. Johnson, PhD

Forms drive equipment leasing. However, the standard lease form typically is ill-suited to the leasing of desktop and notebook computers and other small, often portable technologyequipment. In short, one size does not fit all. This article looks at some of the pitfalls of those standard forms, offering sound alternatives to traditional lease language.

Selling Lease Receivables in a Post-Enron World: True-sale Opinions and Revenue RecognitionBy William S. Veatch

Auditors are increasingly interested in lessors’ agreements for the sale of lease receivables. Somelessors’ practices may be inconsistent with the notion of a nonrecourse, off-balance sheet, truesale of receivables. Here are some practical approaches to drafting agreements, taking intoconsideration FAS 140 and UCC Article 9.

A Quest for Clarity: 2004 Industry Future Council ReportThe 23rd annual Industry Future Council report evidences signs of encouragement andenthusiasm, at least in the small- and medium-ticket segments. Lessors continue to closelymonitor proposed legal and regulatory changes.

Copyright ©2004 by the Equipment Leasing & Finance Foundation

ISSN 0740-008X

Selling Lease Receivables in a Post-Enron World – True-sale Opinions and Revenue Recognition

By William S. Veatch

This article examines

in detail some of the

many ways in which

accounting rules can

influence how

attorneys draft

agreements for the

sale and purchase of

equipment lease

receivables.

Many lessors, both independent and captive,currently find their agreements for the sale oflease receivables under an increased level ofscrutiny from their auditors. To some extent,this is an unfortunate side effect of widelypublicized abuses of the accounting rules by asmall number of companies. But in part it isdue to a recognition that certain practices havedeveloped in the leasing industry inconnection with the sale of lease receivablesthat may be inconsistent with the notion of anonrecourse, off-balance sheet, true sale ofreceivables.

To further complicate matters, equipmentlease receivables often include a softwareand/or a service fee component. This can havea profound effect on the way in which a sale ofreceivables is treated under the UniformCommercial Code (UCC) as well as under thevarious applicable accounting and true-salelegal rules.

This article examines in detail some of themany ways in which accounting rules caninfluence how attorneys draft agreements forthe sale and purchase of equipment leasereceivables. It also examines some provisionsof Article 9 of the UCC that are relevant to truesales of receivables.1 This article assumes thatthe lessor’s auditors have requested a true-salelegal opinion and that the volume of leasereceivables sold is material to the lessor’sbusiness.

The goal of this article is to illustrate onepossible way to meet the reasonableexpectations of the lessor and the buyer oflease receivables, yet make it possible for thelessor’s counsel to issue a well-reasoned true-sale legal opinion.

IS TRUE-SALE TREATMENTAPPROPRIATE FOR THE

TRANSACTION?

As a threshold matter, the lessor and thebuyer should ask whether “true sale”treatment is appropriate for the transaction inquestion. As a general rule, in order to have atrue sale, (1) the buyer must not haveexcessive recourse to the lessor, and (2) thelessor must be willing to give up control overthe lease portfolio, including the right to anypossible upside in the portfolio. Otherwise, thetransaction looks more like a loan and shouldbe treated as such under the applicableaccounting rules.

For a variety of reasons, such as thefollowing, a nonrecourse true sale may not befeasible.

Lessee credit risk. The buyer may not bewilling to accept the credit risk of the lesseesin the portfolio without recourse to the lessor.With limited exceptions discussed below, inorder to be a true sale the sale must be withoutrecourse to the lessor.

Control by the seller—recapture of upside.The lessor may not be willing to give up thepotential upside in the portfolio and maydesire an option to buy the portfolio back.With limited exceptions discussed below, thelessor must be willing to give up not onlycontrol over the portfolio but also the ability torecapture upside, if the lessor wants to achievetrue-sale treatment.

Legal risk and documentation risk. In someheavily negotiated lease transactions, theunderlying lease receivable may not constitutea firm, noncancelable payment obligation ofthe lessee. For example, the lease may not

The true-sale legal

opinion primarily turns

on two key questions:

Has risk of loss shifted to

the buyer? Has the buyer

acquired the benefits of

ownership of the lease

receivable?

contain a strong hell-or-high-water clause orwaiver of defenses against assignees. Anotherproblematic example is where a lessor who isalso the manufacturer uses a combined form oflease and maintenance service agreement. Ifthe agreement is not properly drafted, amaintenance breach by the lessor can lead to adefense to payment of rent by the lessee. It isunlikely that a buyer will be willing topurchase a lease portfolio without recourse tothe lessor, if the leases can be canceled upon aperformance breach by the lessor.

Performance risk. Sometimes the receivablesare “future receivables” that do not exist yetand have not yet been earned by performanceof the lessor. For example, receivables thatrelate to future service obligations or futuredeliverables that have not yet been earned byperformance may be difficult to sell on anonrecourse basis. A buyer is often willing toaccept lessee credit risk but not the risk thatthe receivable may not exist or be enforceableat all.2

In all the above examples, either (1) thereare risks inherent in the lease receivables thatthe buyer is unwilling to assume, or (2) thelessor is not willing to give up the potentialupside in the asset for the price that the buyeris willing to pay. As a result, the buyer may notbe willing to purchase the lease receivableswithout recourse to the lessor, or the lessormay not be willing to give up control over thelease receivables.

In any of these cases, the parties shouldacknowledge the situation up front and not tryto get off-balance sheet, true-sale treatment. Iftrue-sale treatment is appropriate, then thelegal counsel for the lessor and the buyer needto be aware of a number of drafting issues.

TRUE-SALE OPINIONS RENDEREDPURSUANT TO FAS 140

In recent months, accounting firms haveincreased the level of scrutiny of many forms

of off-balance sheet financing, including truesales of lease receivables. In order to meet therequirement under FAS 140 that thetransferred receivables have been “isolatedbeyond the reach of the transferor and itscreditors,” even in a bankruptcy of thetransferor, the auditors are increasingly askingthe lessor’s counsel to provide a true-sale legalopinion.3

The true-sale legal opinion primarily turnson two key questions:

Has risk of loss shifted to the buyer? Inorder to constitute a true sale, the buyer mustassume the risk that the lessee is financiallyunable to pay on the lease receivables. In otherwords, the buyer must not have excessiverecourse to the lessor. Prohibited recourse cantake many forms, including direct recourse,contract damages, put rights, holdbacks fromthe purchase price, reserves, guaranties,collateral, or subordination of other paymentstreams owned by lessor. Some forms oflimited recourse that are permitted arediscussed in detail below.

Has the buyer acquired the benefits ofownership of the lease receivable? In order toconstitute a true sale, the buyer must beentitled to all the benefits of ownership,including any upside inherent in the leasereceivables. For example, if the lessor sells alease rental stream at a time when discountrates are high, the lessor might like the idea ofhaving a repurchase right so that the lessorcould repurchase the receivables and refinancethem at a lower rate if discount rates shoulddrop. However, this control over the leasereceivables and ability to recapture upside isinconsistent with the notion of a true sale.

Although these concepts may appear simpleand straightforward, the true-sale analysis in atypical lease portfolio sale transaction canbecome quite complicated. The following aresome of the most important true-sale legalissues that arise in a typical lease portfolio sale.It is important to note that the true-saleanalysis requires careful consideration of all

S E L L I N G E Q U I P M E N T L E A S E R E C E I V A B L E S I N A P O S T - E N R O N W O R L D – T R U E - S A L E O P I N I O N S A N D R E V E N U E R E C O G N I T I O N

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Failure to notify the

underlying obligors of

a transfer of receivables

to a buyer has been

deemed indicative of a

secured loan rather than

a true sale of receivables.

the facts and circumstances, so in many casesno single factor is determinative.4

Intent of the Parties

The intent of the parties, as evidenced byboth the words and the conduct of the parties,is an important factor in the true-sale legalanalysis. As a result, both the lessor and thebuyer should covenant to treat the sale of thelease receivables as a sale for tax, accounting,and all other purposes.

Notice to the Lessees of the Assignment

Failure to notify the underlying obligors of a transfer of receivables to a buyer has beendeemed indicative of a secured loan ratherthan a true sale of receivables.5 Although thisfactor may not in and of itself be fatal to thetrue-sale characterization, the parties shouldconsider carefully whether it is reallynecessary from a business perspective to avoidgiving notice of assignment to the lessees.Even if notice is given, the lessor may be ableto collect the lease receivables as collectingagent for the buyer, although, as discussedbelow, collection by the lessor is a negativefactor in the true-sale analysis.

Representations and Warranties

Customary representations and warrantiesare generally considered acceptable under thetrue-sale analysis if they are made as of thedate of sale, they concern the nature of thereceivables sold, and they do not go to theissue of collectibility or financial inability ofthe lessee to pay. If such an acceptablerepresentation and warranty were breached,the buyer could have full recourse to the lessorfor its damages.

For example, a representation and warrantythat “the lessee is not bankrupt” would beacceptable if made as of the date of sale, but itwould not be acceptable if the representationand warranty were brought down or restatedon a regular basis with respect to the oldreceivables each time new receivables werepurchased. In the latter case, the represen-tation and warranty in effect would be

transformed into a covenant or guaranty of thelessee’s solvency, which would violate the true-sale rules.

Covenants

As a general rule, in a true sale of receivablestransaction, ongoing covenants after the dateof sale should not give rise to recourse to thelessor that would in effect transform thepurported sale into a loan transaction. Ideally,after the date of sale, there would not be anyongoing involvement between the lessor andthe buyer, or the lessor and the soldreceivables. As this frequently is not the case,any ongoing involvement or covenants need tobe carefully scrutinized.

Also, in a true-sale transaction, as a generalrule, covenant breaches should not give rise toa put right or other recourse that in effectrequires the lessor to return the price that waspaid for the lease receivables. If the leasereceivables are noncancelable, fully earnedpayment obligations of the lessee, then thebuyer is typically willing to purchase suchreceivables without recourse to the lessor.

Alleged Breach or Proven Breach?

Supposing that the representation andwarranty is of an acceptable type, what is theappropriate standard for determining whetherthe lessor is in breach? A mere allegation of abreach by the lessor is probably not sufficientunder the true-sale analysis, because everytime a lessee is in default, it is apt to allegesome breach by the lessor.

On the other hand, requiring the buyer toexhaust all remedies in connection withenforcement of the lease—and requiring afinal judgment by the court that the nonpay-ment of rent by the lessee was justified due tothe lessor’s breach—may not be a practicalsolution either. Sometimes the best solution isto be silent in the purchase agreement as towhat the applicable standard is.

Security Interest in the Leased Equipment

As mentioned earlier, generally speaking,


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Given that the purchased

rental stream represents

the right to use the

equipment for the lease

term, it should be

acceptable under the

true-sale analysis for

the equipment to secure

the purchased rent

payments.

the lessor’s granting of a security interest inassets of the lessor to secure the rentconstitutes a form of prohibited recourseunder the true-sale analysis. However, if abuyer purchases the rental stream under alease but not the residual interest in theequipment under a true lease, does that meanthat the buyer cannot take a security interest inthe equipment or enter into some other titleretention mechanism as security?

Given that the purchased rental streamrepresents the right to use the equipment forthe lease term, it should be acceptable underthe true-sale analysis for the equipment tosecure the purchased rent payments. In otherwords, by granting a security interest in theleased equipment to secure the rent payments,the lessor is not giving up anything of value,since the rental stream representing the valueof the equipment during the lease term wasalready sold. The residual interest inequipment that is retained by the lessor is, byits very nature, only what is left over after therent is paid.

Stated another way, the lessor would receivea windfall upon a lessee’s default if the lessorcould dispose of the equipment and keep allthe proceeds. However, since in the examplethe lessor did not sell the residual interest inthe equipment, care must be taken to ensurethat the excess value of the equipment—overand above the present value of the remainingrent—does not secure other amounts owing tothe buyer. In other words, to protect thelessor’s residual interest in the equipment, thesecurity interest should secure only the lessee’srent obligation, not other amounts that mightbe owing to the buyer such as costs ofcollection.6

Upgrades Not Involving Termination of a Lease Schedule

In some circumstances, a lessee may want toreplace, or obtain an add-on to, an item ofleased equipment (collectively, an “upgrade”),which will result in an increase in rent. Oftenthe parties desire to accomplish the upgrade

without terminating the original lease. If so,there are several possible scenarios.

If the buyer of the rent under the originallease (the “original buyer”) is willing tofinance the upgrade, then the original leasecan simply be amended to refer to the upgradeand the increased rent obligation.

If, however, the original buyer is not willingto finance the upgrade, then typically either(1) the lessor finances the upgrade itself, (2) anew funding source finances the upgrade, or(3) the lessee terminates the original lease andrefinances the old equipment and the upgradeunder a new lease that is purchased by the newfunding source.

In these first two scenarios, the partiesshould enter into a simple intercreditoragreement providing for a pro rata sharingbetween the lessor and the original buyer, orbetween the original buyer and the newfunding source, as the case may be. The thirdscenario, where the original lease isterminated, is discussed below. However, theone scenario that is likely not permitted underthe true-sale rules is a put by the originalbuyer to the lessor. An obligation on the partof the lessor to repurchase lease receivables inthe event of an upgrade would appear to beinconsistent with the notion of a true sale.

Upgrades Involving Termination of a Lease Schedule

Often in connection with an upgrade, thelessee wants the right to terminate the leaseprior to the expiration of the original leaseterm. If such a right is negotiated by the lesseein the lease, then the lessor should exercisecare to include an appropriate prepaymentpenalty to be paid by the lessee. Otherwise thelessor may have trouble selling the lease on anonrecourse basis.

Another possible true-sale issue can arise ifthe lessor, on behalf of the lessee, negotiates inthe agreement with the buyer a right to prepaythe lease receivables. The problem is that sucha prepayment right could allow the lessor to



Often the lessor wants to

continue to collect the

sold receivables after the

sale to the buyer—

typically for valid

business reasons, as the

lessor has an interest in

maintaining control

over the customer

relationship.

refinance lease receivables at a lower discountrate and for a higher purchase price, if interestrates drop. Such a right to refinance the leasereceivables and recapture upside due to a dropin interest rates would appear to be inconsis-tent with the notion of a true sale. The keyhere is to exercise care in the drafting of anyupgrade provisions. Ideally, the earlytermination right should be in the lease, not inthe purchase agreement between the lessorand the buyer.

Taxes and Insurance

In a true-sale transaction, the buyer mustaccept both the benefits and the burdens ofownership of the transferred receivables. In atypical triple net lease, the lessee will bear theburden of taxes (other than taxes on theincome of the lessor) and insurance. If,however, the lessee fails to pay taxes orinsurance, then as between the lessor and thebuyer of the lease receivables, the buyershould bear this risk for the term of the lease.

Maintenance of Leased Products

If the buyer purchases service fees, thepurchase often can be with full recourse to thelessor. The reason for this is that the lessortypically cannot recognize revenue on theservice fees until the services are performedanyway. Therefore, it is not necessary for thesale of maintenance and other servicereceivables to be documented as a true sale.

It is critical to the true sale of leasereceivables, however, that a maintenance orother service breach not give rise to a right ofthe buyer to put the purchased leasereceivables back to the lessor or a right toexercise some other form of recourse againstthe lessor. Otherwise, the purported sale startsto look more like a loan.

For example, if the buyer has a right to putthe lease receivables back to the lessor upon alessor breach of related service contracts withthe lessees, then in the event of a liquidation ofthe lessor in bankruptcy—a situation wherethe lessor is not likely to be able to continue

servicing—the buyer could put all the leasereceivables back to the lessor. This is the exactopposite of the result required in order to havea true sale of receivables.

Replacement Maintenance Service Provider

One possible solution to the maintenanceservices issue is to provide that, in the event ofa service breach by the lessor, the lessor willagree to assign the maintenance fees to areplacement service provider. This arrangementcould also be supported by a security interestin the maintenance fees to secure thiscovenant, and a lockbox or collection accountinto which the maintenance fees are deposited,so that the maintenance fees can be redirectedto the replacement servicer upon a servicedefault by the lessor.

Of course, this approach assumes that theservices are of a type that can be performed bya third-party replacement servicer and that themaintenance fees negotiated by the lessor areat a market rate. Otherwise, the buyer mighthave to cover any shortfall in the event that thereplacement servicer charges a higher fee.

Collection of the Lease Receivables

Often the lessor wants to continue to collectthe sold receivables after the sale to the buyer.This is typically done for valid businessreasons, as the lessor has an interest inmaintaining control over the customerrelationship. The lessor may have other leasesand/or service agreements with the samecustomer, and it is desirable from a businessstandpoint for the lessor to bill and collectamounts owing from that customer.

Although collection by the lessor is anegative factor in the true-sale analysis, it canoften by outweighed by other positive factors,including (1) notifying the lessee of the sale,even though the lessor will continue to act ascollecting agent for the buyer, and (2) givingthe buyer an unfettered right to take overservicing at any time, or in any event upon acollection default by the lessor.



The cost of enforcement

of the lease is one of the

risks that a buyer accepts

in a true sale of

receivables. Therefore,

the lessor must be

careful that it does not

inadvertently end up

bearing the costs of

enforcement.

Cost of Enforcement of the Lease

The cost of enforcement of the lease is one ofthe risks that a buyer accepts in a true sale ofreceivables. Therefore, the lessor must becareful that it does not inadvertently end upbearing the costs of enforcement. For example,provisions regarding the collection ofreceivables sometimes allow for a paymentwaterfall, where the buyer receives its costsand expenses of collection before the lessorreceives its residual interest or related servicefees. This subordination of residual interestand/or service fees is a negative factor in thetrue-sale analysis.

Remarketing of Equipment upon Lessee Default

One of the burdens that the buyer of leasereceivables accepts in a true-sale transaction isthe risk that the lessee may default and that thebuyer may have to sell or foreclose on itssecurity interest in the related equipment. Inthe vendor finance context, the buyer oftenwants the manufacturer-lessor to assist withremarketing the equipment.

Such remarketing assistance is permittedunder the true-sale analysis, so long as (1) thelessor is receiving market rate compensationfor its remarketing services, and (2) if thelessor retained the residual interest in theequipment, the lessor receives any excessproceeds of remarketing after the buyerrecovers the net present value of the unpaid rents.

Naturally, if the buyer purchased theequipment residuals for fair value, then thebuyer would keep all the remarketingproceeds. However, if the equipment is not so purchased, but title to it is nonethelesstransferred along with the assigned rent, withtitle reverting back to the lessor for nominalconsideration at the end of the lease term, thetransfer would be deemed to be merely asecurity interest in the equipment, and thelessor would be entitled to any surplusproceeds of foreclosure.

Repurchase or Put Rights

Generally speaking, rights on the part of thebuyer to cause the lessor to repurchase thelease portfolio as a remedy should be limited tobreaches of customary representations andwarranties made as of the date of sale, asdiscussed above. If the buyer’s put right ismore broadly exercisable upon other events,such as a credit default by the lessee, then thetransaction will look more like a loan than atrue sale.

Indemnities from the Lessor

In some circumstances the lessor may bepermitted under the true-sale analysis toindemnify the buyer for third-party claimsother than claims brought by the lessee. If,however, the lessor indemnifies the buyer forclaims made by the lessee, resulting from analleged breach by the lessor, this could beinconsistent with the notion of a true sale. Ineffect, the buyer could put the rent back to thelessor upon a mere allegation of a breach bythe lessor.

On the other hand, an indemnity for third-party claims brought by other than the lesseefor infringement of copyright or patent rightsprobably would be permitted as a customaryindemnity, so long as there was no reason tobelieve that the technology embedded in theleased equipment actually violated some thirdparty’s intellectual property rights.

Although several examples of negativefactors are illustrated in the examples above, itis important to note that the true-sale legalanalysis requires a balancing of all of the factsand circumstances in the transaction. No onefactor is necessarily determinative.Unfortunately, there is no safe harbor for truesales of receivables, so true-sale legal opinionsare typically reasoned opinions that arecomplicated and can be very difficult torender. Even if the lessor’s counsel renders atrue-sale legal opinion, the lessor must stillcomply with all the other accounting rules setforth in FAS 140.



Although UCC Article 9

provides rules for

perfection and priority,

it does not provide

guidance for determining

whether a purported sale

of receivables is a true

sale or a disguised loan.

SELECTED ISSUES UNDER UCC

Perfection by Filing or Possession

UCC Article 9 governs the perfection andpriority of both loans secured by leasereceivables and true sales of receivables.7

The basic rules are familiar to most lessors:

1. Loans secured by accounts, instruments,chattel paper, or payment intangibles canbe perfected by filing a UCC-1 financingstatement (UCC Sec. 9-310 and Sec. 9-312(a)).

2. Loans secured by tangible chattel paper or instruments can also be perfected bytaking possession of the collateral (UCC Sec. 9-313).

3. Sales of accounts (unless covered by theautomatic perfection rule) and tangiblechattel paper can be perfected by filing aUCC-1 financing statement (UCC Sec. 9-310).

4. Sales of tangible chattel paper can also beperfected by taking possession of thetangible chattel paper (UCC Sec. 9-313).

5. Certain other sales of receivables areautomatically perfected upon attachment,as discussed below (UCC Sec. 9-309).

Automatic Perfection

UCC Sec. 9-309 provides that certaintransactions are perfected automatically uponattachment,8 including, among others (1) anassignment of accounts (such as softwarelicense royalties) or payment intangibles (suchas unsecured loans) that does not transfer asignificant part of the assignor’s outstandingaccounts or payment intangibles,9 (2) a sale ofa payment intangible, or (3) a sale of apromissory note (such as an installmentpayment agreement used to finance softwarelicense fees).

The prevailing view at this time is thatautomatic perfection is the only means ofperfecting the above sale transactions; in other

words, filing a UCC-1 financing statementwould be ineffective. One of the implicationsof this rule is that a buyer cannot lock in a dateof priority with respect to future sales of suchreceivables by filing a UCC-1 financingstatement, because the security interest doesnot attach until the seller has rights in thereceivables.

In contrast, in the case of loans secured byreceivables, the UCC allows a lender to prefilewith respect to future advances, in effectlocking in the date of priority to the date offiling of the UCC-1 financing statement. As apractical matter, the buyer of receivablesgoverned by the automatic perfection rulemust order regular UCC searches to ensurethat there are no intervening secured loanssince the last purchase was made.

Because the sales of receivables listed aboveare automatically perfected, a prior sale wouldnot show up in a UCC search. Therefore, abuyer must rely on representations andwarranties of the seller to ensure that there hasnot been a prior sale of such receivables,which of course could happen only if therehad been fraud or gross negligence on the partof the seller.

Distinguishing Loans from True SalesUnder UCC

Although UCC Article 9 provides rules forperfection and priority, it does not provideguidance for determining whether a purportedsale of receivables is a true sale or a disguisedloan. There are, however, several sections inUCC Article 9 that treat true sales and securedloans differently, including the following ones.

UCC Sec. 9-318(a). UCC Sec. 9-318(a)states that “A debtor that has sold an account,chattel paper, payment intangible, orpromissory note does not retain a legal orequitable interest in the collateral sold.” Thissection assumes, however, that the sale is a“true sale” and not a disguised loan, and thissection does not provide any guidance formaking the distinction between a sale and aloan, which is an issue governed by other state



A buyer of chattel paper

or instruments is well

advised either to take

possession of the original

paper or to legend the

paper appropriately so

as to put a subsequent

purchaser on notice.

law. It would seem, however, that under theterms of the purchase agreement, a seller ofreceivables would be well advised to not retainany legal or equitable interest in thereceivables sold, so as not to create a conflictwith this section.

UCC Sec. 9-318(b). Under UCC Sec. 9-318(b), a seller of an account or chattel paperin an unperfected true-sale transaction can stillsell the account or chattel paper to a secondbuyer, although it would amount to fraud orgross negligence on the part of the seller. If thesecond buyer perfects the second sale, then thesecond buyer will have priority over the firstbuyer who failed to perfect, notwithstandingthe true sale to the first buyer.

Lessons to be learned from these rules are:(1) the first buyer of lease receivables in a true-sale transaction may not have priority oversubsequent buyers or other secured creditorsof the seller if the first sale is not perfected, and(2) implicit in UCC Sec. 9-318(b) is theassumption that perfection is not a necessaryelement of a true sale of accounts or chattelpaper. Stated another way, a true-sale legalopinion should not be viewed as a perfectionor priority opinion.10 Clearly, if a buyer wantsto have priority with respect to purchasedlease receivables, then the buyer shouldperfect and take appropriate steps to ensure afirst-priority position.

UCC Sec. 9-330(b) and (d). Note that salesof existing payment intangibles andpromissory notes are automatically perfectedupon attachment (that is, upon execution ofthe agreement of sale), so lack of perfection isnot an issue in such transactions. However,UCC 9-330 provides that a second buyer11 ofchattel paper or instruments (includingpromissory notes) who takes possession of theoriginal chattel paper or instruments in goodfaith, for value, and without knowledge thatthe purchase violates the rights of a securedparty (and who meets certain otherrequirements) takes priority over prior buyersor secured creditors.

Lessons to be learned from these rules are:

1. Notwithstanding a perfected true sale ofchattel paper or instruments to a firstbuyer, a seller can, albeit fraudulently orwith gross negligence, sell to a secondbuyer and the second buyer will havepriority in the transferred receivables ifthe second buyer takes possession of theoriginal chattel paper or instrument.

2. Implicit in the UCC rules is anassumption that a first-priority securityinterest is not a necessary element of atrue sale of chattel paper or instruments.

In light of these rules, a buyer of chattelpaper (such as equipment leases) orinstruments is well advised either to takepossession of the original paper or to legendthe paper appropriately so as to put asubsequent purchaser on notice. The buyershould not rely on a true-sale opinion asevidence of perfection or priority.

UCC Sec. 9-323(c) future advances. Therules in UCC 9-323(c) regarding futureadvances do not apply to sales of accounts,chattel paper, payment intangibles, orpromissory notes.

UCC Sec. 9-601(g) duties of a securedparty. UCC Sec. 9-601(g) provides that, exceptfor certain exceptions in UCC Sec. 9-607(c)regarding the duty to act in a commerciallyreasonable manner, Part 6 of Article 9 of UCC“imposes no duties upon a secured party thatis a consignor or is a buyer of accounts, chattelpaper, payment intangibles, or promissorynotes.”

Interestingly, it is unclear how this sectionwould be applied in the context of UCC Sec. 9-623, which gives the debtor a statutory right toredeem the collateral, which in the context of asale could mean a right to repurchasetransferred receivables. Although UCC Sec. 9-623 gives the lessor a right to redeem, thebetter view is that UCC Sec. 9-601(g) meansthat the buyer-secured party has no duty tocomply with the lessor’s request.



Both parties should

recognize that not all

transactions are

deserving of off-balance

sheet, true-sale

treatment, acknowledge

this fact early on,

and structure the

deal accordingly.

UCC Sec. 9-608(b). UCC Sec. 9-608(b)provides that “[i]f the underlying transactionis a sale of accounts, chattel paper, paymentintangibles, or promissory notes, the debtor isnot entitled to any surplus, and the obligor isnot liable for any deficiency.” As was the casewith UCC Sec. 9-318, UCC Sec. 9-608(b)presumes that the purported sale is a true saleand not a disguised loan.

Risks Associated with Failure to GiveNotice of Assignment

Note that there are certain risks to a buyer ofreceivables if a notice of assignment is notgiven to the lessee. For example, under UCCSec. 9-404(a)(2), unless there is an enforceablewaiver of defenses against assignees, the rightsof the buyer are subject to defenses or claimsagainst the lessor that accrue before the lesseereceives notification of assignment. Also,under UCC Sec. 9-405(b)(2), prior toreceiving notification of assignment, the lessorand lessee can enter into a modification of, orsubstitution for, an assigned lease; and themodification or substitution is effective againstthe buyer so long as it was made in good faith.

Therefore, under both UCC and under thetrue-sale rules, it is advisable for the parties toprovide notice of assignment to the lesseeunder the assigned lease. Note that even ifnotice of assignment is provided, the lessorcan still collect the lease payments on behalfthe buyer with the buyer’s consent.

Preemption by Federal Law RegardingCopyrights

It is important to note that, although beyondthe scope of this article, perfection of securityinterests in registered copyrights and proceedsof registered copyrights is preempted byfederal law. Therefore, a purchaser of accountsthat are royalties under a software licensewould be well advised to file a notice of thesale in the U.S. Copyright Office if the softwarelicense relates to registered copyrights.12 Thisissue can arise in connection with thepurchase of a lease portfolio if the productsfinanced are software. If the software license

relates to unregistered copyrights, a UCC-1financing statement may be sufficient toperfect the security interest.13

However, there is always the risk that theowner of the unregistered copyright maysubsequently register the copyright, at whichpoint the secured party who filed only a UCC-1 financing statement would becomeunperfected. As a result, some secured partiesrequire the debtor to register all materialcopyrights.

Another argument holds that a true sale ofcopyright proceeds, as opposed to a loansecured by copyright proceeds, should not begoverned by the Copyright Act.14 However, itwill be interesting to see how the courtsinterpret the relevant cases and statutes inlight of the fact that the definition of “securityinterest” as used in revised UCC Article 9 afterJuly 2001 now includes the interest of a buyerof software license royalties, whereas it did notprior to July 2001.

CONCLUSION

In the current post-Enron environment,lessors who are interested in selling their leasereceivables need to reexamine both theirstandard customer lease documentation andtheir agreements for the purchase and sale oflease receivables. With care in drafting, lessorscan draft documents that both comply withthe applicable true-sale legal rules and meetthe reasonable expectations of both the buyerand the seller of lease receivables.

However, it is equally important for theparties to recognize that not all transactionsare deserving of off-balance sheet, true-saletreatment, in which case the parties would bewell advised to acknowledge this fact early onand structure the deal accordingly. Wheretrue-sale legal opinions are required, the legalcounsel rendering the opinion should closelyscrutinize any continuing involvementbetween the lessor and the transferred



In addition to meeting

the requirements of the

true-sale rules, it is critical

to consider the UCC

rules regarding

perfection and priority,

as these perfection and

priority rules go beyond

the scope of the true-sale

analysis.

receivables, or the lessor and the buyer,carefully considering the effect that suchcontinuing involvement would likely have on the true-sale analysis should thecharacterization of the transaction bechallenged.

In addition to meeting the requirements ofthe true-sale rules, it is critical to consider theUCC rules regarding perfection and priority, asthese perfection and priority rules go beyondthe scope of the true-sale analysis.

Acknowledgment

The author would like to thank Marvin D. Heileson of Morrison & Foerster LLP forhis helpful comments, although the authortakes full responsibility for any errors oromissions. The ideas and conclusions in thisarticle do not necessarily reflect the views ofMorrison & Foerster LLP.

Endnotes1 This article focuses on FAS 140 and the

requirement for a true-sale legal opinion. There are,however, other accounting guidelines, such as SOP97-2, that may have a profound effect on the draftingof agreements for the sale of receivables, but that arebeyond the scope of this article.

2 There is also a performance risk issue that iscodified in UCC Sec. 9-405(b)(1), which states that a modification or substitution for an assigned lease is effective against an assignee if made in good faithand “[t]he right to payment or a part thereof underan assigned contract has not been fully earned byperformance.” The purchase agreement between the lessor and the buyer could provide that amodification or substitution without the buyer’sapproval would be a default under the purchaseagreement, but the change to the lease would still be effective.

3 Note that there are a number of proposed changesand amendments to FAS 140 in progress. Seegenerally, www.FASB.org/project/qualifying_spe.shtml for an update. For example, one proposedSFAS 140 amendment would require that thetransferred assets in a true sale be beyond the reach ofcreditors that have a “legal right of offset.” Theimplications of such an amendment could besignificant.

4Cases discussing the true-sale legal issue includethe following:

—Bear v. Coben (In re Golden Plan of CaliforniaInc.), 829 F.2d 705, 709 (9th Cir. 1986). (“Whetherthe parties intended outright sales or loans forsecurity is determined from all the facts and circum-stances surrounding the transactions at issue.”)

—Mapco Inc. v. United States, 556 F.2d 1107, 1111-12 (Ct. Cl. 1977). (Buyer’s failure to reportreceivables purchased as income earned deemedevidence that the transaction was a loan.)

—Major’s Furniture Mart Inc. v. Castle Credit Corp.,602 F.2d 538, 545 (3d Cir. 1979). (Seller retained fullrisk of account uncollectibility.)

—Reaves Brokerage Co. Inc. v. Sunbelt Fruit &Vegetable Co. Inc., 336 F.3d 410 (5th Cir. 2003). (The court determined that despite the parties’labeling of the transaction as a true sale and therequired notice to the account debtors, certain“recourse” provisions—including a security interestin favor of the assignee covering assets in addition tothe purportedly sold accounts receivable—overrodethe purported nature of the transaction and caused it to be a secured loan.)

5 See Commercial Security Co. v. Holcombe, 262 F.657, 661 (5th Cir. 1920); People v. Service InstituteInc. 421 N.Y.S.2d 325 (Sup. Ct. 1979).

6 Note that under UCC Sec. 9-330(c)(2), apurchaser having priority in chattel paper also haspriority in proceeds of chattel paper consisting of thespecific goods covered by the chattel paper or cashproceeds of the specific goods, even if the purchaser’ssecurity interest in the proceeds is unperfected. Thepriority may be limited, however, to the present valueof the rent during the lease term. (See Comment 11 toUCC Sec. 9-330.) Therefore, strictly speaking, a buyerof chattel paper does not need to take a specificsecurity interest in the leased good unless it wants to(1) take a security interest in the lessor’s residualinterest in goods under a true lease (which may createa true-sale issue), or (2) avoid potential disputes withthe lessor’s inventory lender, if any, as to the scope ofthe buyer’s priority under UCC Sec. 9-330.

7 See the definition of “security interest” in UCCSec. 1-201 and UCC Sec. 9-109, which defines thescope of transactions covered by UCC Article 9.

8 Under UCC Sec. 9-203(b), generally speaking,attachment occurs if each of the following conditionsis satisfied: (1) value has been given, (2) the debtorhas rights in the collateral or the power to transferrights in the collateral to a secured party, and (3) the debtor has authenticated a security agreement. In the context of a sale of future receivables,attachment is not likely to occur until the debtor has rights in the receivable.




J O U R N A L O F E Q U I P M E N T L E A S E F I N A N C I N G • S P R I N G 2 0 0 4 • V O L . 2 2 / N O . 1 1 1

9 Interestingly, there is no guidance in the UCC fordetermining what is a “significant part.” This rulewould seem to require (1) some inquiry on the partof the buyer regarding the total outstanding accountsor payment intangibles of the lessor on each date ofsale, and (2) a determination of whether the amountpurchased is significant.

10 Of course, it remains to be seen how the courtswill interpret the 2001 revisions to UCC Article 9.Notwithstanding the approach taken in Article 9where the true-sale issue is treated as a separate issuefrom perfection and priority, it is conceivable that abankruptcy court might hold that perfection is anecessary element of a true sale.

11 Note that Sec. 9-330(b) and Sec. (d) each use theterm “purchaser,” which under UCC 1-201 (whenread together with the definition of “purchase” inUCC Sec. 1-201) includes both a buyer in a true saleand a lender who takes a security interest in property.

12 See generally, In re Peregrine Entertainment, Ltd.,116 B.R. 194 (C.D. Cal. 1990); Zenith Prods. v. AEGAcquisition Corp. (In re AEG Acquisition Corp.), 161B.R. 50 (B.A.P. 9th Cir. Cal. 1993); and In re AvalonSoftware, 209 B.R. 517 (Bankr. D. Ariz. 1997). A hostof other complicated issues involving copyrights isbeyond the scope of this article. For example, if theroyalties arise from a sublicense of an exclusivelicense of a copyright, then the exclusive licenseshould also be registered. Also, materialmodifications of a copyright need to be registeredfrom time to time.

13 See Aerocon Engineering Inc. v. Silicon Valley Bank(In re World Aux. Power Co.), 303 F.3d 1120 (9th Cir.Cal. 2002).

14 See Broadcast Music v. Hirsch, 104 F.3d 1163 (9thCir. Cal. 1997). In Hirsch, the 9th Circuit stated, “Itis sufficient that this case does not involve anassignment of a security interest—there is noevidence that Miller owned a copyright and had asecurity interest he could assign. Rather, this is a caseof outright assignments of a right to receive royaltiesfor the purpose of satisfying a debt. Thus, therationale for recordation underlying the Peregrinecase—to provide notice to prospective creditors orpurchasers of the copyright who may rely to theirdetriment on the appearance of ownership of rightsunder a copyright—is inapposite.”

William S. [email protected]

William S. Veatch is partner inthe financial transactionspractice group and a memberof the business department,

resident in the San Francisco office of the lawfirm Morrison & Foerster LLP. His practice isfocused on representing foreign and domesticbanks, equipment leasing companies, and otherinstitutional lenders in the structuring,documentation, and administration of variousforms of complex debt and equity financings,including asset-based and leveraged leasefinancings. He formerly practiced with CooleyGodward in its San Francisco office. Mr. Veatchdevotes a substantial portion of his practice toadvising financial institutions and companyclients on the structuring of global equipmentand software vendor programs. He obtained aJD degree in 1987 from the University ofCalifornia, Hastings College of the Law. Heearned an LLB in 1985 from the University ofManitoba School of Law in Winnipeg and a BAdegree in history from the University ofWinnipeg in 1985.

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