In Re Pillowtex ( 2003 )

Opinions of the United
2003 Decisions States Court of Appeals
for the Third Circuit
11-14-2003
In Re Pillowtex
Precedential or Non-Precedential: Precedential
Docket No. 02-2674
Follow this and additional works at: http://digitalcommons.law.villanova.edu/thirdcircuit_2003
Recommended Citation
"In Re Pillowtex " (2003). 2003 Decisions. Paper 83.
http://digitalcommons.law.villanova.edu/thirdcircuit_2003/83
This decision is brought to you for free and open access by the Opinions of the United States Court of Appeals for the Third Circuit at Villanova
University School of Law Digital Repository. It has been accepted for inclusion in 2003 Decisions by an authorized administrator of Villanova
University School of Law Digital Repository. For more information, please contact Benjamin.Carlson@law.villanova.edu.
PRECEDENTIAL
Filed November 14, 2003
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 02-2674
In re: PILLOWTEX, INC. ET AL.
DUKE ENERGY ROYAL, LLC
Appellant
v.
PILLOWTEX CORPORATION
Appellee
On Appeal from the United States District Court
for the District of Delaware
(Civil Action Nos. 00-CV-4211)
District Judge: The Honorable Sue L. Robinson
Argued: April 10, 2003
Before: ALITO and FUENTES, Circuit Judges
and PISANO,* District Judge
(Opinion Filed: November 14, 2003)
Eric D. Schwartz
Morris, Nichols, Arsht & Tunnell
1201 North Market Street
P.O. Box 1347
Wilmington, DE 19899
* The Honorable Joel Pisano, United States District Judge for the District
of New Jersey, sitting by designation.
2
Daniel P. Winnika [ARGUED]
Jones, Day, Reavis & Pogue
2727 North Harwood Street
Suite 100
Dallas, TX 75266
Counsel for Appellee
Brett D. Fallon [ARGUED]
Morris, James, Hitchens & Williams
222 Delaware Avenue
P.O. Box 2306, 10th Floor
Wilmington, DE 19899
Counsel for Appellant
OPINION OF THE COURT
FUENTES, Circuit Judge:
Duke Energy Royal LLC (“Duke”) appeals from an order
of the District Court denying a motion to compel Pillowtex
Corporation (“Pillowtex” or “debtor”) to make lease
payments owing under the Master Energy Services
Agreement (“MESA”), an agreement its predecessor entered
into with Pillowtex.1 The District Court denied Duke’s
motion on the grounds that the MESA was not a true lease,
but rather a secured financing arrangement. The sole issue
in this appeal is whether the District Court correctly
determined that the MESA entered into between Pillowtex
and Duke prior to Pillowtex’s bankruptcy filing was a
secured financing arrangement rather than a true lease. We
affirm because we agree with the District Court that, based
on the economic realities of the underlying transaction, the
MESA was a secured financing arrangement.
1. On April 30, 2002, DukeSolutions, Inc., a party to the MESA,
transferred its claims against Pillowtex to appellant, Duke Energy Royal
LLC (“Duke Royal”) pursuant to a Bill of Sale, Assignment and
Assumption Agreement. (App. at 251-52). To simplify, we refer to both
simply as “Duke.”
3
I. Facts and Procedural Background
Because the nature of the MESA is at issue, we first turn
to its provisions and the transaction underlying the
agreement. Pillowtex and Duke entered into the MESA on
June 3, 1998. Pursuant to the MESA, Duke agreed to
install certain equipment “for the purpose of improving the
efficiency of energy consumption or otherwise to reduce the
operating costs” incurred by Pillowtex at its facilities.
(MESA § 2.5, App. at 299). The MESA covered two different
sets of energy services projects, one involving production
equipment and the other energy-savings equipment. The
production equipment was provided to Pillowtex by Duke
pursuant to separate stand-alone agreements, which were
recorded as true leases on Pillowtex’s books, and which the
parties agree constituted true leases. Therefore, only the
nature of the parties’ arrangements concerning the energy-
savings equipment is at issue in this appeal.
The energy-savings equipment included certain lighting
fixtures, T8 lamps and electronic ballasts (collectively the
“lighting fixtures”), which were installed in nine of
Pillowtex’s facilities and a new wastewater heat recovery
system that included hot water heating equipment (the
“wastewater system” and together with the lighting fixtures,
the “energy fixtures”), which was installed at Pillowtex’s
Columbus, Georgia plant. The lighting fixtures were
selected, and the wastewater system was constructed,
specifically for Pillowtex’s facilities. (App. at 336-590).
In order to induce Pillowtex to enter into the energy
services projects, Duke offered to originate funding for the
production equipment “on a two-to-one basis (i.e., for every
$1 million of energy projects Duke would originate $2
million for funding of equipment) with a minimum of $28
million in funding for equipment leasing or financing.” (App.
at 153). Another incentive Pillowtex had for entering into
the agreement was “that the energy projects would be cost
neutral to Pillowtex for the term of the agreement; that is,
Pillowtex’s payments to Duke would be equivalent to
Pillowtex’s actual savings . . . and Pillowtex would then
reap the benefits from the cost savings after the end of the
term of the project.” (App. at 153). In keeping with this
4
arrangement, Pillowtex accounted for its payments to Duke
under the MESA as a utility expense. (App. at 155).
The MESA provided that the cost of acquiring and
installing the energy fixtures would be paid by Duke, which
incurred total costs of approximately $10.41 million. (MESA
§ 5, App. at 302; 339). Of this amount, approximately $1.66
million was for material and labor costs for the wastewater
system. (App. at 594). Approximately $4.46 million was for
labor to install the lighting fixtures and $4.29 million was
for material costs for the lighting fixtures, which is to say
that the cost of labor to install the fixtures was higher than
the cost of the actual materials themselves. (App. at 339,
70). Also, Duke paid approximately $223,000 to dispose of
light fixtures and related equipment that it removed from
Pillowtex’s facilities. (App. at 69-70).
In exchange, Pillowtex was to pay Duke on a monthly
basis one-twelfth of Pillowtex’s annual energy savings, in an
amount the parties agreed to in advance, until the end of
the MESA’s 8 year term. (MESA § 7.0, App. at 304). In
addition, the parties agreed that the simple payback of all
of Duke’s costs was not to exceed 5 years. (MESA § 4.1(f),
App. at 302). “Simple payback” is synonymous with
“payback period,” an accounting term which refers to “[t]he
length of time required to recover a venture’s initial cash
investment, without accounting for the time value of
money.” BLACK’S LAW DICTIONARY 1150 (7th ed. 1999). In other
words, the payments were structured to ensure that
Pillowtex would make predetermined, equal monthly
payments and that Duke would recover its costs 3 years
prior to the end of the term of the MESA. Although the
MESA was for an 8 year term, the parties agree that the
useful life of the energy fixtures was 20-25 years. (App. at
74-75).
It is undisputed that Duke and Pillowtex intended to
structure the MESA to have the characteristics of a lease
and that the parties were trying to create a true lease.
Indeed, Pillowtex’s counsel conceded during oral argument
before the District Court, “I don’t disagree that [the MESA]
was structured to have those characteristics for tax
purposes and, you know, to [the] extent they could, the
parties were trying to create a true lease, I would admit
5
that.” (App. at 117). The parties intended for the MESA to
be structured as a true lease, in large part, because
Pillowtex was subject to capital expenditure limitations
under its senior credit facility and did not wish to have the
energy-savings equipment count as capital expenditures
under that facility. Nevertheless, the MESA is not labeled a
lease and it does not refer to the parties as lessee and
lessor. Also, Duke alleges that the parties were concerned
with structuring the MESA’s provisions relating to energy-
savings equipment in accordance with the requirements of
Financial Accounting Standard 13, which sets the
standards for financial accounting and reporting for leases.
(App. at 164). However, the MESA fails to qualify as a true
lease under ¶ 7 of that standard because the present value
of the total payments due under the MESA exceeds the
value of the original cost of the energy fixtures. (App. at
171).
In keeping with their intent to structure the transaction
as a lease, the MESA provides that title to the equipment
would remain with Duke. (MESA § 11.0, App. at 308). Also,
Pillowtex agreed not to claim ownership of the equipment
for income tax purposes, (MESA § 9.13(ii), App. at 307), and
Pillowtex was not obligated to purchase the equipment at
the end of the term of the MESA. Rather, the MESA
provided the following four options to Duke at the
conclusion of its term, if Pillowtex was not then in default:
(I) remove the Equipment installed and replace those
[sic] Equipment with equipment comparable to those
originally in place, provided that no such replacement
shall be required with respect to Production
Equipment; or,
(ii) abandon the Equipment in place; or,
(iii) continue this Agreement until the expiration of
the term hereof and then extend the term of this
Agreement for such additional period(s) and payment
terms as the parties may agree upon; or,
(iv) [g]ive the Customer the option of purchasing all
(but not less than all) of the Equipment at a mutually
agreed upon price.
6
(MESA § 8.3, App. at 304). If Duke elected to exercise
option (I), it was bound to “be responsible for all costs and
expenses in removing such Equipment, including costs to
repair any damage to [Pillowtex’s] Facility caused by such
removal.” (Id.)2 Despite the existence of the option for Duke
to repossess the equipment, Pillowtex’s Vice President for
Engineering, Michael Abba, testified that in his
understanding, there was no chance of that option being
exercised:
It was clearly my understanding that Duke would
abandon the Lighting Fixtures and the Wastewater
System at the conclusion of the MESA and in fact
statements were made to me by Duke sales personnel
to that effect. Moreover, because the energy projects
were of no economic benefit to Pillowtex until the end
of the term when Pillowtex would reap the energy
savings going forward, I would not have signed off on
the projects if the Lighting Fixtures and Wastewater
System were not to be abandoned. I also believe that,
based on the prohibitive cost of removing and replacing
the Lighting Fixtures and the Wastewater System for
Pillowtex, Duke [had] no choice but to abandon the
Lighting Fixtures and the Wastewater System at the
end of the term of the MESA.
Abba Affidavit at ¶ 6 (App. at 155).
After Duke and Pillowtex executed the MESA, Duke
entered into a Master Lease Agreement (“Master Lease”)
with General Electric Capital Corporation (“GECC”), dated
August 2, 1999, pursuant to which GECC agreed to finance
the lighting fixtures for four of the nine Pillowtex facilities
in which Duke was to install new fixtures pursuant to the
MESA. Concurrently with the execution of the Master Lease
and the execution of an equipment schedule listing lighting
fixtures subject to the Master Lease, Duke and GECC
entered into a Collateral Assignment Agreement through
which Duke granted GECC a security interest in all of
Duke’s rights and interests in the MESA, including Duke’s
2. In the event of a default by Pillowtex, Duke would have the right to
remove the equipment at Pillowtex’s expense, without being obligated to
replace it, and could terminate the MESA. (MESA § 13.2, App. at 309).
7
right to payment under the MESA, as security for Duke’s
obligations under the Master Lease. Also, in connection
with the Master Lease transaction, Pillowtex executed an
Acknowledgment Letter which provides that its interest in
the MESA and equipment covered by it “is subject and
subordinate to [GECC’s] rights under . . . the Master Lease
Agreement . . . between GECC and Duke.” (App. at 749).
Shortly after Duke and GECC entered into the Master
Lease, on August 12, 1999, GECC and SouthTrust Bank
executed a Master Assignment Agreement, pursuant to
which GECC assigned all of its rights and interests in the
Master Lease and the Collateral Assignment it had with
Duke, as well as the MESA and certain other documents, to
SouthTrust. Therefore, with respect to the lighting fixtures,
SouthTrust holds the rights and interests under the MESA
for the lighting fixtures at four of Pillowtex’s facilities and
Duke holds the rights and interests under the MESA for the
lighting fixtures at the other five facilities.
On November 14, 2000, Pillowtex and certain of its
subsidiaries filed petitions for relief under Chapter 11 of the
Bankruptcy Code. Thereafter, Pillowtex stopped making
payments due under the MESA. On February 21, 2002,
Duke filed a motion under section 365(d)(10) of the
Bankruptcy Code to compel Pillowtex to make lease
payments on the equipment it had provided to Pillowtex
under the MESA. Section 365(d)(10) requires debtors-in-
possession, such as Pillowtex, to “timely perform all of the
obligations of the debtor . . . first arising from or after 60
days after the order for relief in a case under Chapter 11
. . . under an unexpired lease of personal property . . . until
such lease is assumed or rejected . . . .” 11 U.S.C.
§ 365(d)(10).3 In response to Duke’s motion, Pillowtex filed
3. Although § 365(d)(10) refers to the obligation of a trustee to make lease
payments, its provisions apply to Pillowtex because the Bankruptcy Code
provides that debtors-in-possession, such as Pillowtex, are to perform all
of the functions and duties of a Chapter 11 trustee. See 11 U.S.C.
§ 1107(a).
In addition to seeking an order compelling Pillowtex to make lease
payments, Duke sought an order requiring Pillowtex to provide adequate
protection of its interest in the equipment pursuant to 11 U.S.C. § 363(e)
8
an objection in which it argued that Duke was not entitled
to payment of post-petition monthly obligations, which
Pillowtex represented amounted to $1.8 million, because
the MESA was not a true lease. After a hearing on the
matter, the District Court, sitting in Bankruptcy, denied
Duke’s motion.4 Duke timely appealed.
II. Jurisdiction and Standard of Review
The District Court had subject matter jurisdiction over
Duke’s motion to compel pursuant to 28 U.S.C. § 1334(a),
which provides district courts with subject matter
jurisdiction over bankruptcy cases.5 This Court has
jurisdiction to review the District Court’s order of June 4,
2002 pursuant to 28 U.S.C. § 1291.
Our standard of review over the District Court’s
bankruptcy decision is the same as that exercised by the
District Court. E.g., In re Woskob, 305 F.3d 177, 181 (3d
Cir. 2002). Accordingly, we review the Bankruptcy Court’s
findings of fact for clear error and exercise plenary review
over the Bankruptcy Court’s legal determinations. Id.III. Analysis
Whether an agreement is a true lease or a secured
financing arrangement under the Bankruptcy Code is a
question of state law. In re Continental Airlines, Inc., 932
or, in the alternative, relief from the automatic stay in order to pursue
its state law remedies to recover possession of the equipment. Section
363(e) mandates that adequate protection be provided to entities which
have an interest in property used by the trustee or debtor-in-possession
and “applies to property that is subject to any unexpired lease of
personal property.” See 11 U.S.C. § 363(e).
4. In the same order, the District Court also denied a similar motion filed
earlier in the course of the bankruptcy proceedings by SouthTrust. We
review the decision below only insofar as it pertains to Duke because
SouthTrust did not appeal the District Court’s order.
5. The District Court exercised its original jurisdiction over bankruptcy
cases, as opposed to its appellate jurisdiction over appeals from
bankruptcy courts.
9
F.2d 282, 294 (3d Cir. 1991) (citing H.R. Rep. No. 95-595,
at 314 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6271).
In this case, the parties agreed that the MESA would be
interpreted, performed, and enforced in accordance with the
laws of the State of New York. (MESA, Appendix A, § 17.7).
Accordingly, we turn to New York law in order to resolve
whether the MESA constitutes a secured financing
arrangement or a lease. Under New York law, because
Pillowtex is seeking to characterize the MESA as a secured
financing arrangement rather than a lease, Pillowtex bears
the burden of proof on that issue. In re Owen, 221 B.R. 56,
60 (Bankr. N.D.N.Y. 1998).6
Article 2A of the New York Uniform Commercial Code
explains that a lease is “a transfer of the right to possession
and use of goods for a term in return for consideration, but
a sale . . . or retention or creation of a security interest is
not a lease.” N.Y. U.C.C. § 2-A-103(1)(j) (McKinney 2002).
Thus, the definition of a lease expressly excludes security
interests. The exclusion of security interests from the
definition of a lease requires that we turn to the U.C.C.
definition of a security interest.7
6. Pillowtex argues that Duke should bear the burden of proof because
it was Duke that sought relief on the theory that the MESA is a lease.
Pillowtex asserts that Owen is distinguishable because, whereas the
agreement at issue in Owen was labeled a lease and identified the
parties as lessee and lessor, the MESA does neither and therefore does
not purport to be a lease. Pillowtex maintains that its argument does not
recharacterize the MESA and it should not, therefore, bear the burden of
proof. We disagree. Although the MESA is not labeled a lease and does
not identify the parties as lessee and lessor, Pillowtex conceded at oral
argument before the District Court that the parties structured the MESA
to have the characteristics of a lease for tax purposes and were trying to
the extent they could to create a true lease. While we ultimately conclude
that the intent of the parties and the structure of the MESA are not
dispositive as to whether a transaction created a lease or a secured
financing arrangement, the intent of the parties and structure of the
MESA indicate that it is Pillowtex which is seeking to recharacterize the
MESA as something other than what it purports to be and, therefore,
Pillowtex bears the burden of proof.
7. See U.C.C. § 1-201(37), Official Cmt. (“Lease is defined in Article 2A as
a transfer of the right to possession and use of goods for a term, in
return for consideration. Section 2A-103(1)(j). The definition continues by
stating that the retention or creation of a security interest is not a lease.
Thus, the task of sharpening the line between true leases and security
interests disguised as leases continues to be a function of this section”).
10
Section 1-201(37) of the U.C.C. provides that a security
interest “means an interest in personal property or fixtures
which secures payment or performance of an obligation.”
N.Y. U.C.C. § 1-201(37). After defining the term “security
interest,” section 1-201(37) sets out a test for determining
whether a transaction creates a lease or a security interest.
Section 1-201(37) begins by noting that whether a
transaction creates a lease or a security interest is to be
determined on a case-by-case basis. After indicating that
courts are to examine the facts of each case in order to
characterize a transaction, the statute sets out a bright-line
test, sometimes referred to as a per se rule, for determining
whether a transaction creates a security interest as a
matter of law. Specifically, section 1-201(37) provides:
(a) Whether a transaction creates a lease or security
interest is determined by the facts of each case;
however, a transaction creates a security interest if the
consideration 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 not subject to
termination by the lessee, and:
(I) the original term of the lease is equal to or
greater than the remaining economic life of the
goods,
(ii) the lessee is bound to renew the lease for the
remaining economic life of the goods or is bound to
become the owner of the goods,
(iii) the lessee has an option to renew the lease for
the remaining economic life of the goods for no
additional consideration or nominal additional
consideration upon compliance with the lease
agreement, or
(iv) the lessee has an option to become the owner of
the goods for no additional consideration or nominal
additional consideration upon compliance with the
lease agreement.
N.Y. U.C.C. § 1-201(37) (emphasis added). Thus, under the
two-part test set out in New York’s U.C.C., if Pillowtex did
not have the right to terminate the MESA prior to the end
11
of its term, and any of the four factors set out in section 1-
201(37)(a)(I)-(iv) are met, then the MESA would be
considered to create a security interest as a matter of law.
See In re Owen, 221 B.R. at 60-61. If, on the other hand,
it is determined that “the transaction is not a disguised
security agreement per se, [we] must then look at the
specific facts of the case to determine whether the
economics of the transaction suggest such a result.” In re
Taylor, 209 B.R. 482, 484 (Bankr. S.D. Ill. 1997) (citation
omitted). See also In re Murray, 191 B.R. 309 (Bankr. E.D.
Pa. 1996); In re American Steel Prod., 203 B.R. 504, 506-07
(Bankr. S.D. Ga. 1996) (describing the standards for
determining whether a disguised security arrangement
exists).8 In this case, the District Court went directly to the
economic realities of the transaction memorialized in the
MESA. In doing so the Court seems to have implicitly held
that the MESA was not a disguised security agreement
under the bright-line test of section 1-201(37). We agree.
On appeal, Pillowtex argues that the MESA is a secured
financing agreement both under this bright-line test and
also based on the economics of the MESA transaction.
Specifically, Pillowtex argues that the second and fourth
factors set out in the second part of the statutory two-part
test are present: (1) that at the end of the MESA’s term
Pillowtex was bound to become the owner of the energy
fixtures and (2) that it was bound to become the owner of
the fixtures for no or nominal additional consideration
upon compliance with the terms of the MESA. Duke
concedes that the first part of the two-part test is satisfied:
that the MESA prohibits Pillowtex from terminating its
obligation to pay Duke the full cost of the energy fixtures
before the termination of the MESA’s term. However, Duke
maintains that none of the four factors in section 1-
201(37)(a)(I)-(iv) are present. These factors are hereafter
referred to as “residual value factors” because they relate to
8. Because N.Y. U.C.C. § 1-201(37) is based on the Uniform Commercial
Code, decisions from other jurisdictions interpreting this same uniform
statute are instructive. See, e.g., In re Edison Bros. Stores, Inc., 207 B.R.
801, 809 n.7 (Bankr. D. Del. 1997) (applying the reasoning of cases from
a variety of jurisdictions to analysis of N.Y. U.C.C. § 1-201(37)); In re
Owen, 221 B.R. at 61 n.6.
12
whether residual value will remain for the purported lessor,
Duke, at the end of the term of the MESA. See E. Carolyn
Hochstadter Dicker and John P. Campo, FF&E and the True
Lease Question: Article 2A and Accompanying Amendments
to UCC Section 1-201(37), 7 Am. Bankr. Inst. L. Rev. 517,
552 (1999).
As an initial matter, we note that the first and third
residual value factors are not satisfied. The first factor is
whether “the original term of the lease is equal to or greater
than the remaining economic life of the goods.” N.Y. U.C.C.
§ 1-201(37)(a)(I). Here, the term of the MESA is eight years
and Pillowtex concedes that the expected useful life of the
equipment is 20-25 years. Thus, the economic life of the
equipment exceeds the term of the MESA by a factor of
three and the first residual value factor set out in section
1-201(37) is not met. The third factor indicative of a
security interest is met where “the lessee has an option to
renew the lease for the remaining economic life of the goods
for no additional consideration or nominal additional
consideration upon compliance with the lease agreement.”
N.Y. U.C.C. § 1-201(37)(a)(iii). This factor is not met because
the terms of the MESA do not give Pillowtex the option to
renew the lease for the remaining life of the equipment for
no or nominal consideration.
As to the second factor, Pillowtex argues that it was
bound, if not formally then in a de facto sense, to become
the owner of the energy fixtures because the only way that
the fixtures would be removed from Pillowtex’s facilities is
if Duke paid millions of dollars to acquire and install
replacements. Along the same lines, Pillowtex argues with
respect to the fourth residual value factor that, although
the MESA does not expressly give it the option to become
the owner of the energy fixtures for no or nominal
consideration, in effect it has this option because it can
compel Duke to abandon the energy fixtures by refusing to
negotiate an extension of the MESA or a purchase of the
energy fixtures at the end of the MESA’s term.
We agree with Duke that neither the second nor the
fourth residual value factors are present here because
Pillowtex is not contractually bound to become the owner of
the energy fixtures, nor does the MESA provide Pillowtex
13
with the option to become the owner of the energy fixtures
for no or nominal consideration. Rather, the existing
options as to how to proceed at the end of the term of the
MESA were to be exercised only by Duke. Pillowtex provides
no authority for the proposition that a de facto arrangement
is enough to satisfy the requirements of section 1-
201(37)(ii) and (iv). If anything, the relevant caselaw points
us to the opposite conclusion. See Edison Bros., 207 B.R.
at 810 (“If the lease agreement explicitly provides that the
lessee has an option to purchase the leased goods for
nominal consideration (e.g., for $1), the agreement is
presumed to be a disguised security agreement”) (emphasis
added). Accordingly, we conclude that none of the four
residual value factors set forth in N.Y. U.C.C. § 1-
201(37)(a)(I)-(iv) are met.
The parties agree that, where none of the four factors set
out in section 1-201(37) are present, courts are to consider
the economic reality of the transaction in order to
determine, based on the particular facts of the case,
whether the transaction is more fairly characterized as a
lease or a secured financing arrangement. They also agree
that the District Court applied the correct standard for
evaluating the economic reality of their transaction. As the
District Court explained:
Under relevant case law, courts will look to various
factors in evaluating the “economic reality of the
transaction . . . in determining whether there has been
a sale or a true lease,” Pactel Fin. v. D.C. Marine Serv.
Corp., 518 N.Y.S.2d 317, 318 (N.Y. Dist. Ct. 1987),
including the following: “[a] whether the purchase
option is nominal; [b] whether the lessee is required to
make aggregate rental payments having a present
value equaling or exceeding the original cost of the
leased property; and [c] whether the lease term covers
the total useful life of the equipment.” In re Edison
Bros. Store, Inc., 207 B.R. 801, 809-10 and n.8, 9, 10
(Bankr. D. Del. 1997). See also [N.Y. U.C.C.] § 1-
201(37) (McKinney Supp. 1996). “In this regard, courts
are required to examine the intent of the parties and
the facts and circumstances which existed at the time
the transaction was entered into.” In re Edison, 207
B.R. at 809.
14
In re Pillowtex, Inc. et al., Nos. 00-4211 to 00-4234, slip op.
at 5-6 (Bankr. D. Del. June 4, 2002) (“Dist. Ct. Op.”)
(footnote omitted). The District Court found that the MESA
was substantively better characterized as a security
agreement than a true lease because the second Edison
Bros. factor clearly weighed in Pillowtex’s favor, and the first
and third factors were largely neutral. We agree with the
District Court’s conclusion in this regard.
Specifically, with respect to the second factor, Duke
concedes that the aggregate rental payments owing by
Pillowtex under the MESA had a present value equal to or
exceeding the cost of the energy fixtures. The Edison Bros.
court cogently explained the importance of such a fact in
showing the existence of a security agreement:
The rationale behind this second factor is that if the
alleged lessee is obligated to pay the lessor a sum
equal to or greater than the full purchase price of the
leased goods plus an interest charge over the term of
the alleged lease agreement, a sale is likely to have
been intended since what the lessor will receive is more
than a payment for the use of the leased goods and
loss of their value; the lessor will receive a
consideration that would amount to a return on its
investment.
Edison Bros., 207 B.R. at 814 (quoted in Owen, 221 B.R. at
61-62). Applying that logic to this case, Duke has already
been well-compensated for the transferral of the lighting
fixtures to Pillowtex, undercutting the proposition that the
fixtures were merely leased.
Like the District Court, we are unpersuaded by Duke’s
attempt to rely on the first and third Edison Bros. factors.
With respect to the first factor, Duke points out that the
MESA provides that it “has the option to . . . give [Pillowtex]
the option of purchasing all (but not less than all) of the
Equipment at a mutually agreed price.” App. at 304
(emphasis added). Based on this provision of the MESA,
Duke asserts that “Pillowtex does not have the option to
purchase the Equipment unless Duke offers it such option,
and even then only if Pillowtex agrees on a satisfactory
price with Duke.” Duke’s Br. at 21. Duke concludes that,
15
therefore, the first economic realities factor weighs in favor
of a finding that the MESA is a lease. We agree, however,
with Pillowtex’s contention that, although the MESA
nominally required Pillowtex to bargain for an option price,
Pillowtex could essentially ensure a nominal option price by
refusing to bargain. This refusal would “effectively compel
Duke to abandon the [e]nergy [f]ixtures to avoid the
exorbitant expense of acquiring and installing
replacements.” Pillowtex’s Br. at 28. Thus, as an economic
reality the option price at the end of the MESA was illusory,
nullifying the weight of this factor.
With respect to the third factor, Duke observes that the
useful life of the energy fixtures is longer than the term of
the MESA, and cites to Edison Bros. for the proposition that
the long life of the fixtures is indicative of a true lease. In
relevant part, the Edison Bros. court explained that:
An essential characteristic of a true lease is that there
be something of value to return to the lessor after the
term. Where the term of the lease is substantially equal
to the life of the lease property such that there will be
nothing of value to return at the end of the lease, the
transaction is in essence a sale. Conversely, if the
lessor expected a remaining useful life after the
expiration of the lease term, it can be reasonably
inferred that it expected to retain substantial residual
value in the leased property at the end of the lease
term and that it therefore intended to create a true
lease.
207 B.R. at 818 (citations omitted). We agree that under
certain circumstances, the fact that transferred goods have
a useful life extending beyond the term of the transferring
agreement could reveal the transferor’s expectation of
retaining residual value in those goods. Such an inference
would only be proper, however, where the evidence showed
a plausible intent by the transferor to repossess the goods.
The economic realities of the particular transaction in
this case belie any such intent. Although the useful life of
the lighting fixtures is 20-25 years, eclipsing the MESA’s 8-
year term, it would be unreasonable for Duke to incur the
high costs necessary to repossess the fixtures: namely, the
16
costs associated with removing, scrapping, and replacing
the fixtures. Also, the uncontroverted evidence in this case
establishes that there is little (if any) market value for used
lighting fixtures.9 In short, it would have made no economic
sense for Duke to spend large amounts of money to reclaim
the fixtures, especially in the face of poor resale prospects.
We therefore conclude that the District Court did not err by
discounting the significance of the useful life of the lighting
fixtures as compared to the length of the MESA when
conducting its analysis of the economic realities of the
transaction underlying the MESA. On balance, then,
applying the three Edison Bros. factors to this case leads us
to conclude that the MESA was not a true lease.
Beyond reiterating its arguments on the three factors,
Duke argues that (1) the mutual subjective intent of the
parties was to structure the MESA as a lease; (2) Pillowtex’s
accounting for the MESA payments as a utility expense is
evidence that it did not treat the MESA as a repayment of
9. During the course of the hearing held by the District Court on
SouthTrust’s motion to compel, counsel for Pillowtex called James
Klemic to the stand to testify as an “expert in the used building
materials market.” App. at 85. Klemic detailed for the Court the
processes and costs associated with removing and reselling lighting
fixtures as follows:
We would have to carefully remove the lighting fixtures where they
would have to be wrapped, brought down wrapped, stored,
transferred to a storage place. The cost would probably be, it’s
speculative, but it would be somewhere maybe $30-$40 a fixture
perhaps, ultimately, depending on how long you had to keep them
to sell them, if you could find a market. And again, I’ve been
universally told there is no market, with very minor exception [sic].
Q. And that has been your experience as well?
A. That has been my experience for 17 years, and it’s been the
experience of major wrecking companies that have been in the
business much longer than I have.
Q. Have you actually looked at the lighting fixtures in the debtors’
plants?
A. Yes.
App. at 89-90.
17
debt incurred to purchase the energy fixtures; (3) it is of no
consequence that the MESA is not labeled a lease; and (4)
Duke maintained a meaningful reversionary interest in the
fixtures at the end of the MESA’s term. None of these
arguments is persuasive to us.
First, Duke argues that the District Court erred by failing
to analyze the intent of the parties. Duke asserts that the
record shows that the parties structured the MESA so that
it would qualify as a lease under relevant accounting
standards. That way, Pillowtex would not reduce the
amount of credit available to it under its senior credit
facility. Duke also cites a statement that counsel for
Pillowtex made to the District Court, which Duke
characterizes as a concession: “I don’t disagree that it was
structured to have that, those characteristics for tax
purposes and, you know, to the extent that they could, the
parties were trying to create a lease, I would admit that.”
App. at 117.
Duke’s intent argument fails, however, because the New
York U.C.C. no longer looks to the intent of the drafting
parties to determine whether a transfer is a lease or a
security agreement. Specifically, the 1992 version of § 1-
201(37) directed courts to determine “[w]hether a lease is
intended as security” (emphasis added); this language was
amended in 1995 to read “[w]hether a transaction creates a
lease or security interest” (emphasis added). In this way,
the reference to parties’ intent was explicitly omitted. The
Official Comment to the amended version confirms the
importance of the changed language:
Prior to this amendment, [s]ection 1-201(37) provided
that whether a lease was intended as security (i.e., a
security interest disguised as a lease) was to be
determined from the facts of each case . . . Reference
to the intent of the parties to create a lease or security
agreement has led to unfortunate results. In
discovering intent, courts have relied upon factors that
were thought to be more consistent with sales or loans
than leases. Most of these criteria, however, are as
applicable to true leases as to security interests . . .
Accordingly, amended section 1-201(37) deletes all
references to the parties’ intent.
18
U.C.C. § 1-201(37), Official Cmt; accord In re Murray, 191
B.R. at 314 (stating that “judicial opinions construing
U.C.C. § 1-201(37) and the Official Uniform Commercial
Code Comments . . . clearly place the focus of the inquiry
under the revised statute on the economics of the
transaction rather than on the intent of the parties as had
been the emphasis previously”).
Duke relies on Edison Bros., 207 B.R. at 809, for the
proposition that “[c]ourts are required to examine the intent
of the parties and the facts and circumstances which
existed at the time the transaction was entered into.”
Edison Bros., however, explicitly relied on the 1992 version
of the statute in looking at intent, and therefore has been
superseded by the 1995 version of the U.C.C. Indeed,
Judge Walsh, the author of Edison Bros., noted in a later
opinion: “I am persuaded by th[e] clear weight of authority
that the intent of the parties, no matter how clearly spelled
out in the parties’ representations within the agreement,
can not control the issue of whether the agreement
constitutes a true lease or a security agreement.” In re
Homeplace Stores, 228 B.R. 88, 94 (Bankr. D. Del. 1998).
Judge Walsh observed that the shift away from intent had
been remarked upon by various commentators. Id. (citing
Richard L. Barnes, Distinguishing Sales and Leases: A
Primer on the Scope and Purpose of UCC Article 2A, 25 U.
Mem. L. Rev. 873, 882 (1995) (“What had been a test of
intention has become a test of economic realities; that is,
intention has been dropped from section 1-201(37). . .
Thus, the parties to a transaction may create a secured
transaction under the revised definition even though their
every intention was to create a lease”)).
Based on the foregoing authority, we are unwilling to
characterize the MESA as a lease on the basis that the
parties intended it to appear to be one for tax purposes.
Duke admonishes the Court in its brief that “[e]quipment
leasing between sophisticated commercial entities dealing
at arms length for their mutual benefit is an important
commercial activity and one that should not be lightly
recharacterized.” Duke’s Br. at 11. This admonition rings
hollow in the context of bankruptcy cases, however,
because every dollar that is used to pay a purported lessor
19
depletes the pool of assets available to pay other
constituencies of the estate. In other words, refusing to
defer to the intent of contracting parties in resolving
whether their agreement is a lease is particularly
appropriate in bankruptcy, as otherwise the costs of the
agreement would be externalized to third-party creditors.
Duke’s accounting argument is similarly meritless. Duke
argues that the District Court erred by attaching
significance to the fact that Pillowtex did not account for
the energy projects under the MESA as true leases. Duke
argues that Pillowtex’s accounting for the MESA payments
as a utility expense should instead be viewed as evidence
that it did not treat the MESA as a repayment of debt
incurred to purchase the energy fixtures.10 We disagree.
Pillowtex’s accounting for the MESA payments as utility
expenses seems to us to be consistent with the parties’
agreement that Pillowtex’s payments to Duke under the
MESA would be equivalent to Pillowtex’s actual savings.
Moreover, as the District Court noted in its opinion,
Pillowtex “entered into separate Production Equipment
leases, each of which was recorded as a true lease on
Pillowtex’s books.” Dist. Ct. Op. at 6. We agree with the
District Court that it is significant that, while payments for
the energy fixtures were treated as utility expenses by
Pillowtex, the agreements with respect to manufacturing
and production equipment (which are not at issue in this
case) were recorded on Pillowtex’s books as true leases.
This distinction suggests that Pillowtex did not find it
appropriate to record its MESA payments as leases, which
bolsters our conclusion that they were not in fact true
leases.
Next, Duke argues that the District Court erred by taking
into consideration that the MESA was not labeled a lease.
The District Court merely observed in passing, however,
that “[t]he MESA is not labeled a lease,” Dist. Ct. Op. at 9,
and that there is no indication that the court relied heavily
on this observation. Even if it did rely to some extent on
this fact, this reliance was harmless since the economic
10. We express no opinion as to whether this accounting practice
comports with the provisions of the Internal Revenue Code.
20
realities independently dictate that the MESA was in fact
not a lease. Accordingly, we do not believe that the District
Court committed reversible error by mentioning the labeling
of the MESA.
Duke goes on to insist that it had a “meaningful residual
interest” in the fixtures, such an interest being “the
fundamental characteristic distinguishing a lease from a
security interest.” E.g., In re Thummel, 109 B.R. 447, 448
(Bankr. N.D. Okla. 1989). As discussed earlier, however,
Duke only has a nominal residual interest, not a
meaningful one: the combination of the cost of retrieving
the fixtures and their poor market value renders the
residual interest negligible. Duke claims that we should not
“speculate” as to what it might do for economic reasons at
the end of the MESA’s term, and instead look to the parties’
intent at the time of drafting the agreement. As we have
mentioned above, however, Duke’s argument is backwards:
the Court must subordinate the parties’ intent to the
economic reality that Duke would not have plausibly
reclaimed the fixtures at the end of the MESA’s term. This
is not mere speculation on our part. The uncontroverted
evidence shows that removal of the fixtures would be
prohibitively expensive, and that the fixtures’ value on the
market would not make it worth Duke’s while to reclaim
them. In short, the economic realities analysis not only
permits, but requires us to examine the state of affairs at
the end of the MESA’s term.
Finally, Duke asserts that the District Court erred by
characterizing the Master Lease between Duke and
SouthTrust as a secured financing agreement, as opposed
to a lease. The Master Lease applies only to the lighting
fixtures that were SouthTrust’s collateral and SouthTrust
did not elect to appeal the District Court’s order. Therefore,
the District Court’s holding that the Master Lease was a
secured financing is not before us on appeal.
IV. Conclusion
After carefully considering the arguments discussed
above and all other arguments advanced by appellant, we
conclude that the District Court correctly determined that
21
the MESA was not a lease and, therefore, that Duke was
not entitled to lease payments under 11 U.S.C. § 365(10).
We will remand this case to the District Court so that it
may determine whether Duke is entitled to adequate
protection.11
A True Copy:
Teste:
Clerk of the United States Court of Appeals
for the Third Circuit
11. Pillowtex asserts that the District Court denied Duke’s request for
adequate protection under section 363(e) of the Bankruptcy Code.
Pillowtex reasons that “[b]ecause the Duke [m]otion included the request
for adequate protection and the Memorandum Opinion denied the Duke
[m]otion in toto . . . the Memorandum Opinion necessarily denied Duke’s
request for adequate protection.” Pillowtex’s Br. at 10 n.3. Duke
responds that the parties did not present evidence on the adequate
protection issue at either the hearing on SouthTrust’s motion to compel
or on Duke’s motion to compel because the District Court understood
that it would first resolve the lease/secured financing issue and, if it
determined that the MESA was a secured financing, then it would hold
a separate hearing on the adequate protection issue. Duke’s Reply Br. at
12. Additionally, Duke represents to the Court that “[t]he exact value of
the Equipment is the subject of a pending proceeding before the
Delaware Bankruptcy Court pursuant to Duke’s and SouthTrust’s
motion to value the collateral in light of the District Court’s decision that
the MESA was a secured financing.” Id. at 5 n.1. Based on the foregoing,
we believe that the District Court anticipated further proceedings on the
adequate protection issue.