For many decades, companies in the business of leasing “over-the-road” vehicles such as trucks, tractors, and trailers, have used terminal rental adjustment clause (TRAC) leases to maximize the value they can provide to their customers. Traditionally speaking, TRAC leases combine the tax advantages of leasing with an option to purchase the equipment at the end of the lease term for a residual amount determined at the inception of the lease. Since 1981, it has been well-settled that TRAC leases constitute “true” leases, and not disguised financing transactions, for federal tax purposes. See, e.g., Swift Dodge v. Commissioner, 76 T.C. 547 (1981); affirmed Swift Dodge v. Commissioner of Internal Rev. 692 F.2d 651 (9th Cir. 1982). By contrast, however, whether TRAC leases are treated as true leases or disguised financing transactions in the context of a bankruptcy case is anything but settled.

The difference between characterizing a TRAC lease as a true lease or a disguised financing transaction within a bankruptcy case can be profound.

If a lease is determined to be a true lease, the debtor is obligated to continue to pay the full monthly rental amounts due under the lease on and after the sixtieth day following the bankruptcy petition date, and must either assume or reject the lease under section 365 of the U.S. Bankruptcy Code. If the debtor opts to assume the lease, the lease terms remain unchanged, and all pre-petition monthly rental payments in arrears must be cured. 11 U.S.C. § 365. In contrast, if a TRAC lease is determined to be a disguised financing transaction, a debtor need only pay the lender adequate protection payments sufficient to guard against the depreciation of the collateral during the bankruptcy. Upon plan confirmation, the debtor must compensate the lender only for the value of the collateral at that time, and the remainder of the lender’s claim is paid as a general unsecured claim. For lessors of most vehicles, which do not depreciate on a straight-line basis, the financial repercussions of a recharacterization from a true lease to a disguised financing transaction can be significant, and there can be substantial financial benefits if a lessor is able to maintain the true lease nature of the agreement.

The analysis, however, is not always straightforward. Among other things, there is not a single body of law that governs lease recharacterization. The substantive provisions of the agreement and the parties’ conduct, rather than the particular terminology used in the agreement, guide the analysis. Furthermore, because each agreement is governed by state law, and not the Bankruptcy Code, the conclusion reached by one bankruptcy court can vary widely from that reached by another. Even so, there are some common considerations that will guide the recharacterization inquiry, including the provisions of section 1-203 of the Uniform Commercial Code.

Nearly all courts that have considered the issue have determined that the central feature of a true lease is the reservation of an economically meaningful interest to the lessor at the end of the lease term.

See, e.g., In re Grubbs Constr. Co., 319 B.R. 698, 715 (Bankr. M.D. Fla. 2005). If the lessor retains a meaningful reversionary interest – either an up-side right or a down-side risk – then the parties have signed a lease, not a security agreement. If there is no reversionary interest, then the parties have signed a security interest, not a lease. White and Summers, Uniform Commercial Code § 30:14 (6th Ed. 2017).

The U.S. Bankruptcy Court for the District of Maryland recently considered these issues, and determined that a TRAC lease was a disguised financing transaction, and not eligible for the more favorable treatment of bankruptcy section 365. Ford Motor Co. v. Lasting Impressions Landscape Contractors, Inc. (In re Lasting Impressions Landscape Contractors, Inc.), 579 B.R. 43 (Bankr. D. Md. 2017). In that case, the court considered the nature of a lease for vehicles used in the debtor’s landscaping business. The vehicles, which had a useful life of between 10 and 15 years, were leased for a 60-month term. At the end of the term, the debtor had the option to purchase the vehicles for 10 percent of the original capitalized cost, or approximately five and a half months of additional rental payments.

In evaluating the economics of the transaction, the Maryland bankruptcy court found that “only a fool would fail to exercise the purchase option.” Id., at 56, citing In re Triplex Marine Maint., Inc., 258 B.R. 659, (Bankr. E.D. Tex 2000). As such, the bankruptcy court held that “the transaction was not structured in such a way that the lessor has an objectively reasonable economic expectation that the goods will come back to it at the end of the lease term….Thus, the lessor has no interest in the economic value or remaining useful life of the goods, and therefore the lessor transferred title to the goods, in substance if not in form.” Id. (internal citations omitted); compare, Hitchin Post Steak Co. v. General Electric Capital Corp. (In re HP Distribution, LLP), 436 B.R. 679 (Bankr. D. Kan 2010) (holding that TRAC agreements which contained no lessee-purchase option were true leases because, among other things, the lessee would be obligated to bid a non-nominal amount at lease termination to acquire title to the vehicles).

Notably, in its analysis, the court did not consider the impact of Maryland’s “TRAC-neutral” statute, which provides that “[n]otwithstanding any other provision of law, in the case of a motor vehicle or trailer that is not leased, or used, primarily for person, family or household purposes, a transaction does not create a sale or security interest merely because the contract on which the transaction is based contains a terminal rental adjustment clause.” MD Transp Code §13-211. Similar TRAC-neutral statutory provisions have been an important factor in other bankruptcy opinions holding that TRAC leases are true leases. See, e.g., In re HB Logistics, LLC, 460 B.R. 291 (Bankr. N.D. Ala 2011)HP Distribution, 436 B.R. 679. As such, it is unclear whether the vehicle lessor’s failure to highlight the existence of the Maryland TRAC-neutral statute for the Maryland bankruptcy court impacted the court’s ultimate ruling. Since the majority of states have enacted these TRAC-neutral statutes, practitioners should be mindful of their existence and should rely on them when possible as an additional factor that weighs in favor of preserving the true lease nature of leases.

As it stands, the characterization of TRAC leases as true leases or disguised financing transactions in bankruptcy continues to be a significant area of dispute. The particular facts at issue, as well as the state law that governs the agreement, often lead to conflicting results. When drafting and negotiating their TRAC leases, lessors are encouraged to be mindful of the termination provisions and anticipated reversionary interests in their agreements. In particular, the preservation of early-termination options and inclusion of fair market value purchase options have often been upheld as terms indicative of a true lease. Finally, lessors should investigate whether the state law governing their agreements includes a TRAC-neutral statute, and should highlight the existence of those statutes in the event their lease come under attack as a disguised financing transaction.