United States District Court, N.D. Illinois, Eastern Division
November 15, 2004.
HSBC BANK USA, Appellant,
UNITED AIR LINES, INC., Appellee. CALIFORNIA STATEWIDE COMMUNITIES DEVELOPMENT AUTHORITY, Appellant, v. UNITED AIR LINES, INC., Appellee.
The opinion of the court was delivered by: JOHN W. DARRAH, District Judge
MEMORANDUM OPINION AND ORDER
This matter comes before the Court on the appeal of the
judgment of the bankruptcy court of March 30, 2004, by HSBC Bank
USA and California Statewide Communities Development Authority
("CSCDA"). For the reasons that follow, the decision of the
bankruptcy court is reversed.
CSCDA is a joint exercise-of-powers government agency
consisting of a number of California counties, cities, and other
local government agencies. CSCDA is organized pursuant to
Chapter 5 of Division 7 of Title 1 of the Government Code of the State of
California ("Joint Powers Act") and an Amended and Restated Joint
Exercise of Powers Agreement dated as of June 1, 1988, among the member local government agencies. Pursuant to the Joint
Powers Act, CSCDA is authorized to exercise the power of its
member local government agencies, among other things, to issue
revenue bonds to pay the cost and expenses of acquiring or
constructing publicly owned or operated commercial aviation
airports and airport-related facilities.
On June 18, 1973, United entered into the "Maintenance Base
Lease" with the City and County of San Francisco. Pursuant to the
lease, United leased certain ramp space and facilities at San
Francisco International Airport ("SFO"). To assist United in
developing certain facilities at SFO, United and CSCDA
consummated a transaction in 1997 pursuant to which CSCDA issued
tax-exempt revenue bonds in the amount of $154,845,000.00. The
funds from the sale of the bonds were made available to United in
accordance with the terms of the 1997 SFO transaction documents.
The 1997 SFO transaction was comprised of multiple documents
and agreements. Three agreements germane to the instant dispute
are: (1) the Site Sublease, (2) the Facilities Lease, and (3) the
Indenture of Mortgage and Deed of Trust ("Indenture").
Pursuant to the Site Sublease, United subleased to CSCDA an
approximately twenty-acre portion of the premises leased to
United under the Maintenance Base Lease for the nominal rent of
one dollar. The term of the Site Sublease is defined as the
period from September 1, 1997 to October 5, 2033, unless a
shorter or longer period is required to retire bonds to be issued
by CSCDA. There are no provisions for remedies for United for any
default by CSCDA.
CSCDA then sub-subleased the leased premises back to United
pursuant to the Facilities Lease. The term of the Facilities
Lease is identical to that of the Site Sublease. The Facilities
Lease's rental is the amount necessary to make the payments
required under the Indenture the amount needed to pay the bonds
in accordance with their terms as well as administrative costs.
The Facilities Lease's rental amount also constituted reasonable
compensation for the use and occupation of the relevant portion
of the SFO Maintenance Base Lease the 20-acre portion of the
130-acres the City and County leased to United. The Facilities
Lease provides default provisions and remedies, including CSCDA's
right to take possession of the leased facilities and relet them
if United fails to make the required payments.
The Indenture provides for the issuance of tax-exempt bonds by
CSCDA, for the SFO trustee to receive the proceeds of the sale of
bonds for purposes of funding construction of defined
improvements benefitting United, and for the SFO trustee to
receive the rental payments from United under the Facilities
Lease for the purpose of paying the debt service on the bonds and
ultimately retiring them. The Indenture indicates that the bonds
are "limited obligations" of CSCDA, payable only from the revenue
received from United and earnings on this revenue. Pursuant to
the Indenture, CSCDA assigned the Facilities Lease, including the
right to collect rents, to the Indenture trustee, presently HSBC
On December 9, 2002, United filed a voluntary petition under
Chapter 11 of Title 11, United States Code. On March 21, 2003,
United filed an Adversary Complaint, seeking a declaratory
judgment that certain of its payment obligations related to
airport improvements were not obligations arising under "leases"
pursuant to Section 365 of the Bankruptcy Code. Subsequently, all
parties moved for summary judgment on the issue of whether the
"leases" were true leases, as opposed to financing instruments.
On March 4, 2004, the bankruptcy court granted United's motion
for summary judgment. HSBC Bank and CSCDA appeal that judgment to
this Court. LEGAL STANDARD
A bankruptcy court's grant of summary judgment is reviewed de
novo. Hoseman v. Weinschneider, 322 F.3d 468, 473 (7th Cir.
2003) (Hoseman). All of the facts and the inferences therefrom
are viewed in the light most favorable to the nonmoving party.
Hoseman, 322 F.3d at 473. Similarly, a bankruptcy court's
interpretation of statute is a question of law reviewed de novo.
See Meyer v. Rigolon, 30 F.3d 1375, 1378 (7th Cir. 1994). The
Court reviews the bankruptcy court's factual findings for clear
error. Hoseman, 322 F.3d at 473.
Summary judgment is proper if "the pleadings, depositions,
answers to interrogatories, and admissions on file, together with
affidavits, if any, show that there is no genuine issue as to any
material fact." Fed.R. Civ. P. 56(c); see also Celotex Corp. v.
Catrett, 477 U.S. 317, 322-23 (1986). All the evidence and the
reasonable inferences that may be drawn from the evidence are
viewed in the light most favorable to the nonmovant. Miller v.
American Family Mut. Ins. Co., 203 F.3d 997, 1003 (7th Cir.
2000). Summary judgment may be granted when no verdict could
reasonably be returned for the nonmoving party. See Anderson v.
Liberty Lobby, Inc., 477 U.S. 242, 248 (1986).
The bankruptcy court held that the Site Sublease and the
Facilities Lease between United and CSCDA were not true leases
for purposes of Bankruptcy Code § 365, finding that the 1997 SFO
transactions ". . . are the economic equivalent of leasehold
mortgages. . . ." The bankruptcy court applied federal law to
determine if the instruments were true leases, rather than
applying state law, as argued by the Appellants.
The appeal raises the following issues for review: (1) did the
bankruptcy court err by failing to apply state (California) law
to characterize the Site Sublease and the Facilities Lease; (2)
was it error for the bankruptcy court to ignore Seventh Circuit
precedent; (3) did the bankruptcy court err in denying the
Appellants' motions for summary judgment; and (4) did the
bankruptcy court err in granting United's Motion for Summary
The Appellants' first two arguments on appeal are interrelated.
Appellants argue that the bankruptcy court erred in failing to
apply state law, as required by Seventh Circuit precedent, when
determining whether the Site Sublease and the Facilities Lease
constituted true leases for § 365 purposes.
Section 365(a) provides the trustee, or debtor-in-possession in
Chapter 11 cases, the power to assume or reject unexpired leases.
11 U.S.C. § 365(a). Certain requirements are imposed when the
trustee wishes to assume an unexpired lease in default. The
trustee must cure the default, compensate any parties that have
suffered pecuniary loss from the default, and provide adequate
assurance of future performance under the lease.
11 U.S.C. § 365(b). Leases of nonresidential real property are deemed
rejected unless assumed within sixty days after an order for
relief unless the court, for cause, grants additional time during
that sixty-day period. 11 U.S.C. § 365(d).
The terms "unexpired lease" and "lease of nonresidential real
property," as used in Section 365, are not defined in the
Bankruptcy Code. In defining the terms, courts have relied upon
the legislative history of Section 502(b)(6) of the Bankruptcy
Code, which limits damage claims resulting from lease
terminations which are allowable to a debtor's landlord. The
pertinent legislative history states:
Whether a "lease" is a true or [a] bona fide lease,
or in the alternative, a financing "lease" or a lease
intended as security, depends upon the circumstances
of each case. The distinction between a true lease
and a financing transaction is based upon the
economic substance of the transaction and not, for
example, upon the locus of title, the form of the transaction or the fact that the transaction is
denominated as a "lease."
S.Rep. No. 598, 95th Cong., 2d Sess. 64, reprinted in 1978
U.S.C.C.A.N. 5787, 5850. Based on this legislative history,
courts require that a lease in question must be a "true" or "bona
fide" lease for Section 365 to apply. See In re Powers,
983 F.2d 88
, 89 (7th Cir. 1993) (deciding whether rental agreements
were true leases) (Powers); In re Moreggia & Sons, Inc.,
852 F.2d 1179
, 1182 (9th Cir. 1988) (Moreggia); In re Lunan
Family Restaurants, 194 B.R. 429, 450 (N.D. Ill. 1996); In re
Hotel Syracuse, Inc., 155 B.R. 824, 838 (N.D.N.Y. 1993) (Hotel
Generally, Congress has left the determination of property
rights in the assets of a bankrupt's estate to state law. See
Butner v. United States, 440 U.S. 48, 54 (1979) (Butner). The
application of state law is applied to both ownership interests
in property and security interests in such property. Nobleman v.
American Savings Bank, 508 U.S. 324, 329 (1993). However, state
law may be displaced if "some federal interest requires a
different result." Butner, 440 U.S. at 55. In order to displace
traditional state law, "the federal, statutory purpose must be
`clear and manifest' . . . Otherwise, the Bankruptcy Code will be
construed to adopt, rather than displace, pre-existing state
law." BFP v. Resolution Trust Corp., 511 U.S. 531, 544-45
(1994). "In the absence of any controlling federal law,
`property' and `interests in property' are creatures of state
law." Barnhill v. Johnson, 503 U.S. 393, 398 (1992).
"Lease" is not defined in Section 365. However, the legislative
history applicable to a security interest states that "[w]hether
a consignment or a lease constitutes a security interest under
the bankruptcy code will depend on whether it constitutes a
security interest under applicable state or local law." S.Rep.
No. 595, 95th Cong., 1st Sess. 314, reprinted in 1978
U.S.C.C.A.N. 5963, 6271; see also Powers, 983 F.2d at 90; DWE, 157 B.R. at 330
(citing legislative history of definition of security interest in
support of application of state law in application of Section
365). This legislative history supports a finding that the
bankruptcy code, as applied to leases in Section 365, adopts,
rather than displaces, pre-existing state law.
Furthermore, the legislative history of Section 502(b)(6) cited
above fails to demonstrate a "clear and manifest" statutory
purpose to displace traditional state law. See BFP,
511 U.S. at 544-45. This legislative history indicates that whether a lease
is a true lease depends upon the circumstances of each case. This
requirement is consistent with state laws requiring that the
facts of each case be reviewed to determine whether a lease is
intended as security. See, e.g., Powers, 983 F.2d at 90
(Illinois and Indiana law require court to determine whether a
lease is intended as security by the facts of each case);
Pillowtex, 349 F.3d at 717 (under New York law, whether a
transaction creates a lease or security interest is determined on
a case-by-case basis); Pittsburgh Sports, 239 B.R. at 84
(Pennsylvania law requires an examination of the particular facts
and circumstances of each case).
This legislative history also states that the "distinction
between a true lease and a financing agreement is based upon the
economic substance of the transaction." Reviewing the "economic
substance" or "economic realities" is consistent with state law.
See In re Yarbrough, 211 B.R. 654, 657 (W.D. Tenn. 1997)
(Mississippi law requires the court to look to the economic
realities of the transaction in determining whether a transaction
is a lease or security interest); In re Vital Prod. Co.,
210 B.R. 109, 112 (N.D. Ohio 1997) (Ohio state law, as provided in
the U.C.C., focuses on economic realties of a transaction in
determining whether the transaction is a true lease); In re Nite
Lite Inns, 13 B.R. 900, 907-08 (S.D. Cal. 1981) (Nite Lite)
(considering the economic substance of the transaction in applying California law to determine whether
transaction was a true lease); In re Hoagland, 1996 WL 33406128
(N.D. Ill. Feb. 26, 1996) (the economic realities of the
transaction are relevant factors under Illinois law in
determining whether a lease is a true lease). Accordingly, the
legislative history of Section 502(b) fails to demonstrate a
clear and manifest statutory purpose to displace traditional
state law. See BFP, 511 U.S. at 544-45. In essence, United
concedes this as it argues that the substantive inquiry under
both California law and federal law is the same.
Federal courts, including the Seventh Circuit, have applied
state law in determining whether a lease is a true lease for
purposes of Section 365, citing Butner. See Powers,
983 F.2d at 90; In re Pillowtex, Inc., 349 F.3d 711, 716 (3rd Cir. 2003)
(Pillowtex); In re Sankey, 307 B.R. 674, 678 (D. Alaska
2004); In re Pittsburgh Sports Assoc. Holding Co., 239 B.R. 75,
83 (W.D. Pa. 1999) (Pittsburgh Sports); In re Fox,
229 B.R. 160, 164 (N.D. Ohio 1998); In re DWE Screw Prod., Inc.,
157 B.R. 326, 330 (N.D. Ohio 1993) (DWE).
In contrast, some courts, including the bankruptcy court here,
have applied a federal rule of law, known as the economic
realities test, to determine whether a lease is a true lease for
purposes of Section 365. These courts cite the above-quoted
language of the legislative history of Section 502(b)(6), read
together with Section 365, in support of their finding that a
federal rule of law must be applied in determining whether a
lease of real property*fn1 is a true lease for purposes of
Section 365 because these aspects provide an adequate "federal
interest" to justify using a federal rule of law rather than state law to define this particular property
interest. See Moreggia, 852 F.2d at 1182; In re PCH Assoc.,
804 F.2d 193, 200 (2nd Cir. 1986) (PCH); In re Kar Dev.
Assoc., L.P., 180 B.R. 629, 638 (D. Kan. 1995) (Kar); In re
Tak Broadcasting Corp., 137 B.R. 728, 732 (W.D. Wis. 1992).
However, based on the legislative history and the case law,
particularly Butner and Powers, the bankruptcy court erred in
applying federal law in determining whether the leases at issue
were true leases.
The Appellants' third and fourth issues are also related.
Appellants argue that the bankruptcy court erred in granting
United's motion for summary judgment and denying the Appellants'
motions for summary judgment. United argues that summary judgment
was proper under either federal law or California law because,
substantively, the law is the same.
Under California law, an agreement is presumptively a lease
of real property if it includes a designation of the parties,
contains a definite description of the leased property, provides
for periodic payment of rent for the term of the lease, and
provides a right to occupy the property to the exclusion of the
grantor. See In re SCCC Assoc. II Ltd., 158 B.R. 1004, 1013
(N.D. Cal. 1993) (SCCC) (emphasis added).
Here, the Facilities Lease designates the parties, contains a
definite description of the leased property, provides for
periodic payment of rent over the term of the lease, and provides
United with a right to occupy the leased premises to the
exclusion of the grantor. Accordingly, the Facilities Lease is
presumed to be a true lease under California law. This
presumption may be rebutted by United by establishing by clear
and convincing evidence that the parties intended for the
Facilities Lease to disguise a substantive transfer of ownership of or an
encumbrance of the leased SFO Maintenance Facility. See SCCC,
15 B.R. at 1009-14; Fox v. Peck Iron & Metal Co., 25 B.R. 674,
688 (S.D. Cal. 1982) (Fox) (emphasis added).
Whether a lease agreement is a true lease or one intended
solely for security is determined by determining the intent of
the parties at the time of the execution of the document. See
Fox, 25 B.R. at 688. The intent of the parties is determined by
reviewing all facts and circumstances of the transaction,
including the economic substance of the transaction. See Fox,
25 B.R. at 688; Nite Lite, 13 B.R. at 908. Factors considered
in this analysis include: (1) whether the transaction actually
transfers the normal risks and responsibilities of landlord to
the lessor; (2) whether the payments under the lease are
reasonably designed to compensate the lessor for the use of the
property or simply reflect the repayment of the lessor's
acquisition cost plus interest; Fox, 25 B.R. at 688; and (3)
whether the lessor retains an economically significant interest
in the property, SCCC, 158 B.R. at 1013.
The application of these factors to the facts demonstrates that
the Facilities Lease was a true lease. Under the Facilities
Lease, United is required to pay the taxes, maintenance, and
insurance generally referred to as a triple net lease. While
the payment of taxes, maintenance, and insurance are typically
viewed as usual obligations indicating ownership, as opposed to a
landlord-tenant relationship, the use of triple net leases are
not unusual terms in ground leases. See SCCC, 158 B.R. at 1013.
Furthermore, United concedes that it could never own the leased
property or facilities. As such, United's responsibilities under
the lease that are generally an indicia of ownership fail to
demonstrate that the lease is not a true lease.
The payments under the lease are also reasonably designed to
compensate Appellants. The aggregate rental payments required by the Facilities Lease
include the amount needed to pay the bonds in accordance with
their terms and the administrative costs associated therewith.
However, the amount of the rental payments also constituted
reasonable compensation for the use and occupation of the 20-acre
portion of the 180-acre SFO Maintenance Facilities. HSBC's expert
demonstrated that United's rent payments were reasonable
compensation for the use and occupation of the relevant portion
of the SFO Maintenance Facilities. United provided no evidence to
the contrary. Furthermore, rent payments are frequently
calculated with reference to payment in respect to financing
obligations. See City of Desert Hot Springs v. County of
Riverside, 154 Cal. Rptr. 297, 301 (1979) (Desert Springs). A
"`lease-leaseback' arrangement `as a method of financing
construction' is not inconsistent with the existence of a lease."
Desert Springs, 154 Cal. Rptr. at 301. In addition, United
could terminate the Facilities Lease by prepaying the rent due
for the lease term, and there was no reduction in rent
corresponding to the shorter lease term in the event of
prepayment. An absolute obligation to pay rent for the full lease
term is indicative of a true lease. See 7 Miller & Star
California Real Estate § 19.86 (3d ed. 2001).
Lastly, the lessor retained an economically significant
interest in the property leased to United, and United retained no
interest in the leased property. United concedes that it did not
own, will not own, and cannot ever own any of the facilities
leased to United. The Facilities Lease does not have an option to
purchase at the end of the lease. United has retained no interest
at the end of the lease.
United argues, and the bankruptcy court found, that because
CSCDA does not retain an ownership interest at the end of the
Facilities Lease, the Facilities Lease cannot be a true lease.
The bankruptcy court held this factor to be the most important
and concluded that the Facilities Lease was not a true lease based on this factor alone. However, this
analysis and resultant finding focus on the lessor instead of the
lessee. The finding also fails to take into account that CSCDA
had a right to re-let the relevant portion of the SFO Maintenance
Facilities if United defaulted. The right to re-let is indicative
of a true lease, not a financing arrangement.
Under the bankruptcy court's logic, every sublease that has a
term equal to the term of the underlying lease would be a
disguised financing arrangement rather than a true lease because
the sublessor has a lack of reversionary interest at the end of
the lease term. For example, if lessor A executed a one-year
lease of an apartment with lessee B, and lessee B subleased the
apartment six months later to sublessee C for the remaining six
months, at the conclusion of the sublease, the apartment reverts
back to lessor A. Under the bankruptcy court's reasoning, the
sublease would not be a true lease because lessee B did not have
a reversionary interest at the end of the lease term.
Accordingly, the lack of a reversionary interest in CSCDA at the
end of the Facilities Lease does not dictate that the Facilities
Lease was not a true lease.
The Appellants also argue that United is equitably estopped
from changing its previous position that the Facilities Lease was
a lease. Under California law, the elements of equitable estoppel
are: (1) the party to be estopped must be appraised of the facts;
(2) that party must intend that its conduct be acted upon, or
must so act that the other party has a right to believe that it
was so intended; (3) the other party must be ignorant of the true
state of facts; and (4) the other party must rely on the conduct
to its injury. See Ace Am. Ins. Co. v. Walker,
18 Cal. Rptr. 3d 1, 8 n. 2 (2004). Here, there is no evidence
demonstrating that United was appraised of the fact that it would be filing
for bankruptcy and that the Facilities Lease would be an issue of
dispute. Accordingly, the doctrine of equitable estoppel is not
applicable. Lastly, the Appellants argue that, under California law, United
had sixty days to challenge the Facilities Lease and that United
failed to do so; therefore, United cannot now challenge the
lease. Nothing in the record indicates that Appellants presented
this argument to the bankruptcy court, and the bankruptcy court
did not address the issue in its March 30, 2004 judgment now on
appeal before this Court. Accordingly, this issue is waived on
appeal. See In re Image Worldwide, Ltd., 139 F.3d 574, 581 (7th
Based on the foregoing, the March 30, 2004 judgment of the
bankruptcy court order, granting summary judgment in favor of
United based on its finding that the Facilities Lease was not a
true lease, is reversed.