Article by Reed Smith Commercial Restructuring & Bankruptcy Team

The U.S. Court of Appeals for the Seventh Circuit has ruled that a United Airlines airport facilities lease was not a true lease but in fact a secured loan. The holding in United Airlines, Inc. v. HSBC Bank USA, N.A., Nos. 04-4209, 04-4315 & 04-4321 (7th Cir., July 26, 2005) allows United to continue using the facilities while paying less than the agreed upon rental payments. The decision delineates the circumstances in which the Seventh Circuit will consider purported leases to be secured finance arrangements, and may affect how United’s leases are treated at three other airports.

Under §365 of the U.S. Bankruptcy Code, a debtor-lessee either must assume the lease and fully perform all of its obligations, or surrender the property. A borrower that has provided a security interest in property must pay the economic value of the security interest, but if this is less than the balance due on the loan, the difference becomes unsecured debt.

The United Airlines case stems from several complex transactions the airline entered into to build and improve its premises at the San Francisco, Los Angeles, Denver and John F. Kennedy airports. In each case, a public entity issued bonds and agreed to turn over the funds to United. In exchange, United entered into leases giving each public body the right to evict United from certain facilities if it didn’t pay its obligations.

When United entered into bankruptcy in 2002, it maintained that none of these transactions was a true lease for the purposes of §365, and proposed to treat each as a secured loan. The Chief Bankruptcy Judge concluded that the Denver transaction was a true lease but that the other agreements were secured loans. All parties appealed, and the District Court held that all four transactions are true leases.

On further appeal, the Seventh Circuit examined only the transaction involving the San Francisco Airport. Under that agreement, United, which had leased airport facilities from the California Statewide Communities Development Authority (CSCDA), subleased a portion of those facilities back to the CSCDA for $1. The CSCDA then leased the property back to United for a rent equal to the interest on the bonds plus an administrative fee, with a balloon payment at the end of the term of the agreement.

In parsing whether the arrangement should be considered a true lease or a secured finance arrangement, the Seventh Circuit noted that the Bankruptcy Code seeks to distinguish rental payments that cover current consumption, and therefore should be paid in full by a reorganized entity, from payments to retire past debt.

The court concluded the transaction was a secured financing arrangement rather than a true lease because: 1) the "rent" was measured not by the market value of the property but by the amount United borrowed; 2) a "hell or high water" clause obligated United to make lease payments even if the property became unusable; 3) at the end of the lease, tenancy would revert to United with no additional charge; 4) the balloon payment has no parallel in a true lease but is a common feature of a secured loan; 5) if United prepaid the lease, the lease and sublease would terminate immediately (whereas in a true lease, prepayment entitles the tenant to occupy the property for an additional period). In its decision, the court noted that the Uniform Commercial Code has established a per se rule that if the lessee has an option to acquire ownership at the end of the term for no or nominal payment, the transaction must be treated as secured credit.

Note: The ruling is a harsh one for the CSCDA, which faces the prospect of a portion of its expected rental income being treated as unsecured debt. However, in its decision, the Seventh Circuit has further refined the circumstances under which a lease will be characterized as a secured loan for bankruptcy purposes.

This article is presented for informational purposes only and is not intended to constitute legal advice.