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Tales From the Byzantine… Perfecting Interests in Payment Streams; Lease Strip Deals

Dispatches from the Trenches

Commercial Money Center, Inc. v. NetBank, FSB, 2005 WL 1365055; 56 UCC Rep. Serv.2d 54 (Bankr. S.D. Cal. Jan. 27, 2005)

This action arose in bankruptcy court to determine the legal status of payment streams due under commercial equipment leases. A Chapter 7 bankruptcy debtor named Commercial Money Center, Inc. (CMC) originated equipment leases with sub-prime end users. CMC then obtained surety bonds guaranteeing the lease payments and assigned the insured payment streams due under the leases to third party "Investors." NetBank was a third party investor who paid $47 million to obtain certain rights associated with these "lease pools," namely, the right to receive the lease payments due under the leases. The documentation between NetBank and CMC was labeled as a Sale and Servicing Agreement.

NetBank did not take possession of the underlying leases or file a UCC Financing Statement to "perfect" its interest in the associated lease pools. The Trustee challenged NetBank's interest, arguing that NetBank’s interest in the lease pools constituted an interest in Chattel Paper and that NetBank was therefore required to perfect its interest by either taking possession of the underlying leases or filing a Financing Statement. Since Article 9 of the Uniform Commercial Code (UCC) requires perfection regardless of whether Chattel Paper is sold outright or assigned as security, NetBank could not afford to have the lease pools considered to be "Chattel Paper" by the court. See UCC §9-109 and comments (noting that Article 9 covers a security interest in chattel paper as well as the sale of chattel paper); see also UCC §9-102(71)(D)(defining "Secured Party" to include a person to whom chattel paper has been sold).

Since Article 9 of the UCC does not impose the same restrictions with respect to the sale of "Payment Intangibles" under Article 9 — as special type of general intangible where the obligor's principal obligation is a monetary obligation — NetBank argued that the lease pools constituted payment intangibles and that the Sale and Servicing Agreement accomplished an outright sale of such payment intangibles.

The bankruptcy court analyzed the applicable UCC provisions and other relevant sources of authority to determine whether the lease pools should be considered chattel paper or “payment intangibles under the UCC and whether the payment streams assigned to NetBank constituted a true sale or a loan. Resolution of these issues would determine whether CMC’s bankruptcy Trustee could use his strong-arm powers pursuant to 11 U.S.C. §544 to avoid any monetary obligations incurred by CMC.

NetBank and CMC both agreed that the underlying equipment leases constituted chattel paper under the UCC since that term is defined as "a record or records which evidence both a monetary obligation and a security interest in … or a lease of specific goods…" See UCC §9-102(11). However, NetBank claimed that the monetary obligations that were actually assigned to it by CMC should still be considered payment intangibles under the UCC. The Trustee argued conversely that the payment streams still constitute chattel paper since they arise from chattel paper (the underlying equipment leases).

The United States Bankruptcy Court, Southern District of California, agreed with the Trustee's position and found that the lease payment streams were considered chattel paper under the UCC. The Court noted that the definition of payment intangibles clearly excluded chattel paper. As such, if the payment streams fell within the definition of chattel paper, they could not be considered payment intangibles. The Court then noted that the definition of chattel paper included three elements: 1.) the presence of a record or writing; 2.) evidence of a monetary obligation; and 3.) a security interest in or lease of specific goods. According to the Court, characterizing the monetary obligation as a payment intangible "would essentially delete the monetary obligation requirement from the definition." As such, the Court held that the payment streams constituted chattel paper.

The Court further supported its holding by analyzing the Official Commentary in the UCC (which is persuasive, although not binding, authority) as well as experts in the industry who have analyzed this issue in treatises and law review articles.

The Court’s conclusion that the payment stream constituted chattel paper rendered moot the issue of whether or not the Sale and Servicing Agreement affected a sale of the payment stream or merely evidenced a loan secured by the payment stream. The lack of relevance stems from the fact that, either way, NetBank was required to perfect. Nonetheless, the Court provided some analysis of the outright sale versus loan issue as well.

CMA Consolidated, Inc v. Commissioner of Internal Revenue, 2005 WL 209951 (U.S. Tax Ct. Jan. 31. 2005)

In this petition against the Commissioner of the Internal Revenue Service (the "IRS"), a corporate taxpayer petitioned for a re-determination of income tax deficiencies and additions to tax. Petitioner claimed substantial income deductions, operating losses and bad debt losses arising from many complicated transactions, and the tax court had to determine if those transactions should be respected for tax purposes, and whether petitioner is eligible for the deductions he claimed.

Among the transactions in question were two lease "strip" deals arranged by petitioner that involved tax-indifferent parties. The Tax Court had to determine, among other things, whether the lease strip deals should be respected transactions for tax purposes. If the transactions are found to have no economic substance, they should be ignored, and petitioner will not be able to claim deductions which totaled over $ 2.7 million and which originated from the lease strip transactions.

Lease strip deals are designed to separate equipment rental income from depreciation and related rental expenses. The rental income is allocated to a tax indifferent or a tax neutral party in order to allow another party to claim a greatly disproportionate share of the related tax benefits. One such tax-neutral party that participated in these lease strip deals with petitioner was the Iowa Tribe of Oklahoma, who was not subject to Federal income received from these transactions.

The ultimate beneficiary/customer of the lease deals would invest perhaps several million dollars in the transactions, and would eventually be able to claim income deductions many millions of dollars more than its initial investment. Through a series of complex, preconceived, multi-party transactions involving equipment purchases, leases, and related expenses, petitioner stripped out the rental income from these end-user leases and allocated that income to the Iowa Tribe. The Court described these transactions as a "Byzantine Labyrinth."

In determining whether a transaction is legitimate for tax purposes, the court examined several factors but grouped these factors into two main categories. The first category involved the determination of whether the petitioner had a subjective, legitimate non-tax purpose for participating in the transaction. In the case at bar, the court found that petitioner entered in the first lease strip deal for a legitimate business purpose, namely, to make a profit. However, the court found no subjective legitimate pre-tax profit motive in the second lease strip deal other than petitioner’s intent to claim $4.2 million in tax benefits.

The second category involved the determination of whether the lease strip deal had an objective, economic profit potential aside from the tax benefits. The court analyzed expert opinions on this subject obtained by petitioner and the IRS and focused on whether the underlying rental equipment would have any estimated residual value or whether the fair market value of the residual lease interests was nominal.

The Court found the first lease strip deal to have economic substance. However, with respect to the second lease strip deal, the Court held that: a.) the transaction did not have economic substance, b.) petitioner had no legitimate reason for entering in the deal other than to claim a large tax deduction and c.) the complex transactions involved in that deal involved many participating entities that were closely related to petitioner or owned by those who regularly cooperated with petitioner such that the participants were not acting at arm’s length, and shared a common interest in inflating the values of the leases and residual interests to generate substantial tax benefits for the ultimate customer (in this case, petitioner). Not only was the petitioner not entitled to claim deductions from the second lease strip deal, but it was also subject to tax penalties pursuant to 26 USC §6662.

Article appeared in the May,  2006 issue of the Monitor.
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