The economic logic of the lease/loan distinction in bankruptcy.

• Author: Hemel, Daniel

NOTE CONTENTS INTRODUCTION I. LEASES AND LOANS: THE UCC MEETS THE BANKRUPTCY CODE II. A CRITICAL REVIEW OF CURRENT THEORIES A. Shifting Risks and Drawing Lines B. "'Old' Firm/'New' Firm": The Easterbrook Argument III. THE "DEPRECIATION EXTERNALITIES" APPROACH A. Deadweight Loss from Depreciation in a World Without Bifurcation B. The [section] 506 Solution to Deadweight Losses from Depreciation C. How the UCC and the Bankruptcy Code Limit Depreciation-Related Deadweight Losses in Leasing CONCLUSION INTRODUCTION

Over the past few decades, leading law reviews have devoted thousands of pages to articles arguing that the "full priority" treatment of secured credit is economically efficient. (1) Over the same period, perhaps as many pages have been devoted to articles calling into question the efficiency of secured credit. (2) In 1983, Professor R.M. Goode characterized the secured credit debate as a "battle"; (3) in 1997, Professor Elizabeth Warren analogized it to an all-out war. (4) At the dawn of a new decade, the secured credit conflict rages on. (5)

All the while, relatively few scholars have weighed in on whether the full priority treatment of true leases promotes efficient outcomes. (6) But although it has been relegated to the peripheries of legal academia, leasing lies near the base of the capital structure of many U.S. firms. By one estimate, leases account for more than one quarter of all new capital equipment acquisitions by U.S. businesses. (7) Approximately 70% of Fortune 1000 firms (8)--and approximately 80% of all U.S. companies (9)--lease some of their equipment. A recent study of 4718 public companies in the United States found that the firms' off-balance-sheet lease commitments were equal to 35% of their reported liabilities. (10) And, according to one account, leasing is the "largest source of external finance" for small businesses. (11)

Not only does leasing play an important role in the capital structure of individual firms, (12) but personal property leasing is also a significant sector of the U.S. economy. In 2007, the most recent year for which data are available, revenues from the rental and leasing of non-real-estate tangible assets totaled $120 billion (up from $95 billion in 2002). (13) At last count, the non-real-estate rental and leasing sector employed approximately 640,000 people in the United States. (14)

One explanation for the prevalence of leasing is that "[1]easing ... ha[s] lower expected bankruptcy costs to the lessor than borrowing has to the lender, resulting in lower financing costs for the lessee than the borrower, ceteris paribus." (15) Accordingly, a provider of funds (that is, a lessor or lender) will often argue in bankruptcy court that an asset-related transaction should be treated as a lease. Meanwhile, a trustee, a debtor, or a debtor's other creditors will often argue that the same transaction should be classified as a loan. The Bankruptcy Reporter is replete with cases involving disputes of this type. (16)

While huge stakes hinge on the lease/loan distinction, (17) many legal scholars are doubtful that the distinction should exist at all. In 2982, Professor Homer Kripke wrote that "[t]he man from Mars, with a clear eye undistorted by training in law," would find long-term leases and secured loans to be so similar "that the differences should fade into insignificance." (18) One year later, Professor John Ayer characterized the differentiation between leases and loans as "an exercise in false concreteness" (19) and called on the drafters of the Bankruptcy Code to "abolish this pointless and distracting distinction." (20) In the quarter-century that has elapsed since Ayer's article, his view has elicited agreement-though little critical consideration-from other legal academics. In one influential Yale Law Journal article, Professor Lynn LoPucki described Ayer's argument as "persuasive[]." (21) Likewise, Professors Lucian Bebchuk and Jesse Fried cited Ayer approvingly in their seminal 1996 contribution to the secured credit debate. (22) Meanwhile, most scholars who have written about related matters have taken the status quo lease/loan distinction as a given but have declined to defend the distinction as it stands. (23)

This Note attempts to fill that gap. It argues that the lease/loan distinction is no "exercise in false concreteness." To the contrary, it deters market actors from using depreciable assets in value-destroying ways and, as a consequence, increases aggregate welfare. (24) Specifically, the current lease/loan distinction compels market actors to internalize depreciation costs into their decisions regarding asset use. In doing so, the lease/loan distinction incentivizes firms to invest in asset maintenance when the aggregate benefits of maintenance activities exceed the costs, and it deters firms from deploying depreciable assets when the marginal costs of asset use exceed the marginal returns.

Part I of this Note provides an overview of the lease/loan status quo. It compares the treatment of lessors and secured creditors under the Bankruptcy Code and explains why--until now--the consensus view among scholars and practitioners has been that the Bankruptcy Code affords much more favorable treatment to equipment lessors than to their secured-creditor counterparts. Part II of this Note analyzes existing arguments against and in support of the status quo. It shows that neither critics nor supporters of the status quo have demonstrated why the lease/loan distinction is--or is not-normatively defensible. Insofar as the lease/loan distinction rests on any normative basis, that basis has yet to be identified.

Part III presents the heart of this Note's argument. It shows that, under current law, the distinction between a lease and a loan hinges on whether the transaction shifts depreciation costs to the lessee/debtor's unsecured creditors. If the transaction does cause such a shift, then the transaction creates a security interest, not a true lease. This Note presents a rudimentary formal model to show that if the parties to a durable goods transaction do not bear the full cost of depreciation, then depreciation may occur at a faster rate than if the asset were put to its most economically efficient use. But as long as the lessor's residual interest in the asset at the end of the lease term is more than nominal, the lessor has an incentive to monitor the lessee's use of the asset (including the lessee's investment in maintenance) and to intervene if the lessee's use of the asset amounts to economic waste. By allowing courts to reallocate depreciation costs in the case of a secured loan-but not in the case of a lease--the Bankruptcy Code promotes the efficient use of durable goods. (25)

Ultimately, what distinguishes a lease from a loan is that in a lease, the provider of funds (the lessor) retains a residual interest in the underlying asset regardless of whether the asset user (the lessee) remains solvent, whereas in a loan, the provider of funds (the creditor) has an interest in the underlying asset only if the user (the debtor) becomes insolvent. While others have drawn attention to the concept of "meaningful residual interest" in the lease/loan context, (26) this Note uniquely explains why the law should care about the allocation of the residual interest. The distinction encourages the allocation of physical capital to its most productive uses because it forces parties to factor depreciation costs into their decisions regarding asset utilization and asset maintenance.

1. LEASES AND LOANS: THE UCC MEETS THE BANKRUPTCY CODE

   Although leasing is central to America's economic system, it occupies an interstitial position in the country's legal system. While lease-related issues are litigated largely in the bankruptcy context, the Bankruptcy Code itself never defines the word "lease." (27) Thus, federal bankruptcy courts faced with disputes over leases must turn to state commercial law for guidance. (28) In forty-nine states and the District of Columbia, (29) section 1-203 of the Uniform Commercial Code (UCC) controls the definition of true leases for personal property. (30) But the UCC's drafters made only passing mention of the bankruptcy implications when crafting the lease/loan distinction. (31)

   Although the UCC's official comments do not dwell on the bankruptcy implications of the lease/loan distinction, the Bankruptcy Code "accords radically different consequences" to transactions based on whether they fall on the "lease" or "loan" side of the divide. (32) More precisely, the Bankruptcy Code accords considerably more favorable treatment to the lessor than to the secured lender. While lessors and secured creditors are both subject to the automatic stay at the outset of the bankruptcy process, (33) the treatment of lessors and secured creditors diverges as the process moves forward. Under [section] 365 of the Bankruptcy Code, the bankruptcy trustee may decide whether to assume or reject the debtor's leases at any point prior to the confirmation of the bankruptcy plan. (34) However, the trustee may assume the lease only if she "cures, or provides adequate assurance that the trustee will promptly cure" the debtor's default. (35) Moreover, [section] 365 does not give the court any authority to modify the terms of the lease agreement. Thus, if the trustee assumes the lease, then the lessor acquires a priority claim for the full amount of all lease obligations (both past and future).

   The Bankruptcy Code likewise allows the trustee to abandon the collateral that secures any of the debtor's loans if the property "is burdensome ... or ... of inconsequential value and benefit to the estate." (36) But there the similarity between the bankruptcy treatment of leases and loans comes to an end. If the trustee chooses to keep the collateral, the secured lender does not necessarily receive a priority claim to the outstanding principal and interest. Under...