How is a defaulted lease treated?

True leases and nontax leases receive different treatment in bankruptcy.  The US Bankruptcy Code distinguishes between a true lease – in which the lessor retains legal ownership – and a financing arrangement, such as a conditional sale or secured loan, that establishes a security interest in an asset.  The ability of the lessor to repossess the leased asset in the event of lessee default is an advantage of true leases for lessors over nontax leases since only the owner of an asset is able to repossess it in the event of a lessee’s default.  In a nontax lease, as defined in UCC Article 2A, the lessor is not the owner of the underlying asset and, thus, not able to repossess the asset in the event of the lessee defaults on the transaction.

US Nontax Lease = Secured Loan in Substance = UCC Secured Transaction ≠ UCC Lease

The US Uniform Commercial Code (UCC) bright-line test is used to determine whether a transaction should be treated as a true lease or a secured loan – a “disguised security agreement”.   If a transaction is a true lease, it is common for the lessor to file a UCC-1 to confirm that a security interest in the property is retained until the lease financing is paid off and title passes to the lessee/buyer.

Moreover, under the Bankruptcy Code, unfulfilled executory contracts and security interests in assets to secure the performance of an obligation become the property of a bankruptcy estate upon a bankruptcy filing.  An executory contract is the legal requirement of the contractual parties to a transaction to perform all obligations that they have not yet fully performed, whereby failure of either party to complete performance constitutes a breach of contract and excuses performance of the other party or parties.  Debtors and bankruptcy administrators are permitted to retain only those unfulfilled executory contracts in bankruptcy – including unexpired true leases – that are beneficial and abandon those that are burdensome.

If a lessee retains a defaulted lease, the default must be remedied and scheduled rental payments must be resumed, whereby the lease will then become a post-petition liability of the lessee and the lessor will effectively become a creditor with a first priority security interest in the leased asset.  If the lessee rejects the defaulted lease, the leased asset must be returned to the lessor, with any additional claim that the lessor has against the bankrupt lessee becoming an unsecured claim in bankruptcy.

Bankruptcy laws generally impose an automatic stay on creditors of a debtor in bankruptcy that prohibits foreclosure on property that secures the claim of the creditors for a given period of time.  An automatic stay is an injunction that arises upon the filing of a bankruptcy petition that halts actions by creditors, with certain exceptions, to collect debts from a bankrupt debtor and protects the property of the bankruptcy estate from the exercise of creditor remedies.  An automatic stay prohibits secured creditors from seizing assets, proceeding to judgment, termination of contract or changing terms, unless the creditor can obtain relief from the automatic stay from the bankruptcy court.  Although an automatic stay allows the debtor to continue to use the asset, a secured creditor is generally entitled to protection against a decline in the asset’s collateral value.