- Category: Judge Somers
- Published on 11 June 2009
- Written by Judge Somers
In Re Gateway Ethanol, L.L.C., 08-22579 (Bankr. D. Kan. Jun 6, 2009) Doc. # 407
Case 08-22579 Doc# 407 Filed 06/05/09
SIGNED this 05 day of June, 2009.
Page 1 of 37
Dale L. Somers
UNITED STATES BANKRUPTCY JUDGE
Designated for print publication and on-line use
IN THE UNITED STATES BANKRUPTCY COURT
FOR THE DISTRICT OF KANSAS
GATEWAY ETHANOL, L.L.C., CASE NO. 08-22579
MEMORANDUM OPINION AND ORDER FINDING
DEBTOR'S AGREEMENT WITH INDECK POWER EQUIPMENT IS A TRUE LEASE
The question under advisement is whether Gateway Ethanol's ("Gateway" or "Debtor")
agreement with Indeck Power Equipment Company ("IPE”or “Indeck Power”) with respect to
Gateway’s acquisition of a thermal oxidizer boiler system from IPE is a true lease or a
sale/security agreement. The issue arose in Dougherty Funding L.L.C.'s ("Dougherty")
response1 to the Objection of Indeck Power Equipment Company to the Cure Amount and
Statement of Cure Claim under Debtor's Notice of Intent to Assume and Assign Certain
1 Doc. 227.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 2 of 37
Executory Contracts and Unexpired Leases in Conjunction with the Sale of Assets.2 Whether the
agreement is a true lease was severed from other related issues, such as the cure amount if the
agreement is a lease, and an evidentiary hearing held. IPE appeared by Michael D. Freeborn,
Thomas R. Fawkes, and Kellye L. Fabian of Freeborn and Peters, LLC, Chicago, Illinois.
Dougherty appeared by Paul L. Ratelle and Jeffrey W. Jones of Fabyanske, Westra, Hart &
Thomson, P.A., Minneapolis, Minnesota. Debtor appeared by Laurence M. Frazen of Bryan
Cave LLP, Kansas City, Missouri. There were no other appearances. The Court has
Debtor Gateway Ethanol, LLC is the owner operator of an ethanol plant in Pratt, Kansas.
Lurgi PSI, Inc. ("Lurgi") entered into a contract with Debtor to design and construct a fully
integrated dry-mill plant capable of processing approximately 20 million bushels of local corn
and milo to produce approximately 50 million gallons of fuel grade ethanol, and related by-
products, per year. Dougherty was retained to obtain an approximately $53 million construction
loan. In September 26, 2006, Gateway and IPE entered into an agreement denoted as a lease,
whereby Gateway was to be supplied a thermal oxidizing boiler system (“Equipment”)4 for use
2 Doc. 194.
3 This Court has jurisdiction pursuant to 28 U.S.C. § 157(a) and §§ 1334(a) and (b) and the Standing
Order of the United States District Court for the District of Kansas that exercised authority conferred by §
157(a) to refer to the District’s Bankruptcy judges all matters under the Bankruptcy Code and all proceedings
arising under the Code or arising in or related to a case under the Code, effective July 10, 1984. The
determination of whether the Debtor acquired property in a sale or in a lease, which is subject to assumption
or rejection, and the related question of what interest in such property was transferred in a sale under 11
U.S.C. § 365 are core proceedings which this Court may hear and determine as provided in 28 U.S.C. §
157(b)(2)(A). There is no objection to venue or jurisdiction over the parties.
4 The Equipment which is the subject of the Agreement includes the TO/Boiler (the gas fired boiler,
economizer, fan, burner, and control panel) and related equipment, such as piping, structural steel, and a
Case 08-22579 Doc# 407 Filed 06/05/09 Page 3 of 37
in the plant (hereafter “Agreement”). It is this Agreement which is the subject of this
controversy. When Gateway filed for relief under Chapter 11 on October 5, 2008, the plant had
never produced ethanol to the design standards, ethanol was not being produced, and most of the
payments required under the Agreement with IPE were in default.
On October 24, 2008, Debtor filed its motion to sell all of its right, title, and interest in
substantially all assets owned by Debtor, including the ethanol plant. In conjunction with the
sale, on November 4, 2008, Debtor served an Assumption and Assignment Notice, listing the
IPE Agreement as one of the unexpired leases and executory contracts that Debtor intended to
assume and assign to the purchaser of its asset, but listed the cure amount as "Undetermined."5
On December 8, 2008, IPE objected to the characterization of the cure claim.6 Dougherty, the
stalking horse and the only bidder, offered to purchase the assets by credit bid of approximately
$60 million dollars.7 The sale was approved by order entered on January 5, 2009, but the
objections of IPE and other creditors were preserved.8 Thereafter, on January 13, 2009,
Dougherty filed its response to IPE's objection, raising for the first time the contention that the
Agreement is not a true lease.9
IPE opposes the recharacterization of the Agreement as a sale and security agreement, as
this distinction has major financial implications. If the Agreement is a true lease, before
5 Doc. 148.
6 Doc. 194.
7 Doc. 103.
8 Doc. 221
9 Doc. 227
Case 08-22579 Doc# 407 Filed 06/05/09 Page 4 of 37
Dougherty, the purchaser, may keep the Equipment provided by IPE, the lease must be assumed
and assigned to Dougherty, with Dougherty being liable for future lease payments and the cure
amount owed to IPE as an administrative expense. On the other hand, if the transaction was a
sale, Gateway was the prepetition owner of the Equipment and sold the system to Dougherty,
together with all other assets in the § 363 sale. Because IPE did not file a UCC-1 with respect to
the boiler system, it would have an unsecured claim for the amount owed under the Agreement,
which claim would probably receive no or very little payment.
FINDINGS OF FACT.
Indeck Power Equipment (IPE) was founded in 1960 or 1961. It is an equipment
company which builds packaged steam generating equipment for sale and lease. Indeck Power
has the largest stock of used and new boilers, and related equipment, in the world and is the
largest supplier of rental boilers in the United States. A related company, Indeck Energy
Company, is involved in cogeneration of power; it develops projects from the ground up on an
own and operate basis. It invests in power plants, including ethanol plants. Both these entities
had relationships with Gateway. Indeck Power entered into the Agreement to supply the
Equipment, which includes the thermal oxidizer boiler (“TO/Boiler”), to Gateway. Indeck
Energy invested in Gateway and also was a party to an Energy Services Agreement with
Gateway. The evidence clearly establishes that Indeck Power and Indeck Energy acted
independently, that the individuals involved with Gateway and/or Dougherty on behalf of Indeck
Power and Indeck Energy acted only on behalf of their respective employers, and that Indeck
Power’s investment in Gateway was not a factor influencing the Agreement in any way.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 5 of 37
Dougherty, which had been hired by Gateway as the investment advisor for the project,
began in the fall of 2004 to put together funding for the Gateway Ethanol plant to be built in
Pratt, Kansas. In the fall of 2005, Gateway was planning to utilize a gas fired thermal oxidizer
boiler in the plant to be supplied by IPE. At a meeting in Kansas City, the vice president of
development for Indeck Energy met with a representative of Gateway and proposed the use of a
coal powered boiler system under development by Indeck Energy. It was quickly realized that
implementing a coal-fired system would likely delay the ethanol plant, and the plan to use a gas
fired system to be supplied by IPE was reinstated. However, before the end of 2005, Gateway
and Indeck Energy entered into an Energy Services Agreement which gave Indeck Energy the
right to build, own, and operate the energy plant at the Gateway project using a coal-fired boiler.
After that, Indeck Energy was involved in the Gateway design to be sure that the lay out for the
gas fired boiler system, the TO/Boiler and related equipment, would not interfere with a later
installation of a coal-fired system. Also, by the fall of 2005, Indeck Energy had committed to
investing in the Gateway project, although that commitment was not finalized until some later
On November 29, 2005, a meeting was held to go over the project. It was attended by
representatives of Gateway, Dougherty, and Gateway investors, including Indeck Energy. At
that time, the projected costs of construction had increased significantly and some investors had
withdrawn, so the project was about two and half or three million dollars short. This increased
the ratio of equity to debt above the 45/55 level which Dougherty advised was required to attract
investors. The project could not go forward as planned without a solution to the problem. A
suggestion was made that the TO/Boiler be leased, rather than purchased from IPE. This
Case 08-22579 Doc# 407 Filed 06/05/09 Page 6 of 37
proposal reduced the construction costs funding by eliminating the boiler acquisition costs from
the Lurgi construction budget, but increased Gateway’s projected operating expenses by the
amount of the lease payments. IPE was consulted, and an agreement, entitled Equipment Lease,
dated December 15, 2005, was executed by IPE and Gateway.
The December 15 agreement provides for the lease of one IPE TO/Boiler system for a
term of 60 months. The agreement states the replacement value, which the Court finds is
essentially the purchase cost of the equipment on the date of the transaction, is $3,600,000 and
the payments shall be $64,590.00 per month for 60 months. The scheduled shipping date was to
Dougherty prepared an Information Memorandum dated December 2005 to be distributed
to potential lenders for the $53,150,000 construction/term loan for the Gateway Ethanol project.
The pro forma income statement for Gateway in the memorandum includes lease expense in the
amount of $64,590 per month. The fee to Dougherty for the successful closing of the transaction
was about $900,000. It also was entitled to service fees of .25 per cent.
After the December agreement was executed, Lurgi made changes to the plant design to
increase the output, which required changes in the boiler system. A new agreement, dated
September 26, 2006 (hereafter the “Agreement”), was executed, which incorporated a new
proposal from IPE which included the changes in the system. The September Agreement
provides the replacement value is $5,041,970.00, the payments are $93,474.85 per month for 60
months, and shipment shall be as early as possible in February, 2007. Gateway provided IPE
Case 08-22579 Doc# 407 Filed 06/05/09 Page 7 of 37
with a Kansas sales tax exemption certificate,10 exempting the transaction from the Kansas
Retailers’ sales and compensating tax.11
The material terms and conditions of the Agreement include the following. IPE is
identified as the Lessor and Gateway Ethanol as the Lessee. Typewritten in the Description of
Equipment Leased box is the following:
The equipment shall ship F.O.B. shipping point and returned with
dismantling and freight charges to and from the job site to be paid
Lessee shall have the option to purchase the equipment for a non-
bargain price at $600,000.00 at the end of the minimum lease term
(five (5) years).
IPE is responsible for transportation and installation of the Equipment. The Agreement states it is
“non-cancellable by the Lessee for the Rental Term.” It provides that the equipment is property
of the Lessor and shall remain so, even if attached to real property; that Lessee shall at its own
expense maintain the equipment; that Lessee shall pay all license fees and taxes; that Lessee
assumes all risk of loss; that Lessee shall maintain physical loss insurance naming Lessor as the
primary loss payee; and that the Agreement shall be governed by the laws of the State of Illinois.
At the request of Gateway, as IPE had done in other lease transactions, the warranties are those
which IPE customarily provides in sales transactions.12 As to Gateway’s duties at the end of the
term, the Agreement provides:
Lessee at its expense shall return the Equipment in the same
condition as when received ordinary wear and tear excepted, to
10 Exh. MM.
11 The Court notes that pursuant to K.S.A. 79-3603(a) and (h) the tax applies to both the sale and
rental of personal property.
12 Exh. 6, p. 00021.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 8 of 37
Lessor’s Office above on the ending date of this Lease or sooner
upon demand by Lessor (or permit Lessor to remove said
Equipment if Lessor is to provide transportation).13
In the event of any default by Lessee of any term or obligation of
his Lease, Lessor may, without limitation, terminate this Lease.
Upon such termination, Lessee shall immediately deliver, at its own
cost and expense, the leased Equipment to Lessor at Lessor’s
Office, or shall, at Lessor’s option and without further notice,
permit Lessor to enter the premises where the leased Equipment is
located and permit Lessor to obtain possession of and remove the
same, including disconnection and separation of the leased
Equipment from any other property . . ..14
The President of IPE was solely responsible for determining the economic terms of the
Agreement. When deciding these terms, she considered the 5 year term of the Agreement; the
stock of boilers which IPE had available; the budget for assembly of the system; what IPE could
do with the system if it was returned at the end of the five year term; the estimated cost to return
the system after five years; the risk posed by the contractor, Lurgi; and IPE’s desired return on its
investment. Several factors resulted in significant changes in the economic terms between the
December 2005 and September 2006 agreements. In 2005, Lurgi was using a third party licensed
design for the plant, with which IPE was familiar, but in 2006 Lurgi changed to its own design.
The Lurgi design required a higher capacity boiler. It also required IPE to incur additional design
and engineering costs and to assume increased risk because, if the design was not successful, the
IPE Equipment might be blamed for Lurgi design failures. The replacement value, which is
essentially the initial value of the equipment, increased from $3,600,000 to $5,041,970; the
13Exh. 5, ¶ 3.
14Exh. 5, ¶ 16.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 9 of 37
monthly payments increased from $64,590 to $93,474.85, and the non-bargain price for the
system at the end of five years (the estimated value of the TO/Boiler at the end of five years)
changed from $586,500 to $600,000. The absence of a linear relationship between the changes in
the replacement value and the non-bargain price was because the majority of the increased cost
for the modified system was for engineering and design services and for supplying equipment
external to the boiler itself. The external equipment was estimated to have little value at the end
of five years. A computer program, which computes monthly payments and amortization based
upon selected principal amount, interest rate, number of payments, and balloon amount, was used
when determining the economic terms, but an amortization schedule was not maintained in the
Gateway file at IPE or provided to Gateway. One print out shows that assuming 60 monthly
payments of $93,474.85 and a discount rate of 7.754%, the total principal payment would be
$4,445,822.39 and that approximately $600,000 of the $5,041,970 would be outstanding.15
When determining the economic terms, IPE estimated that the cost to return the TO/Boiler
(but not much of the external equipment)16 from Pratt to IPE at the end of five years would be
$200,000 to $250,000. This estimate, which includes transportation costs, was based upon
adjustments to the costs incurred when IPE a few years earlier had removed two larger steam
boiler systems, one from a Ford Motor plant and one from the GM River Rouge facility. The
adjustments to those charges were fully explained, and Dougherty was unsuccessful in
impeaching IPE’s witness in this regard. The IPE system is modular so that the items which can
be resold, such as the boiler, the economizer, the fan, the burner, and the control panel, can be
15 Exh. Z.
16 The President of IPE testified that the highest value of some of this equipment was as scrap, which
could be realized in Pratt without incurring the cost to return to Illinois.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 10 of 37
separated from the ethanol plant and the items, such as piping, structural steel, and the stack,
which are not worth returning to IPE.
When a user wants to lease equipment, IPE seeks to assure that the present value of the
rental payments for the lease term are less than the fair market value of the leased equipment at
the end of the lease term and buy out price is significantly higher than the removal cost, so the
lessee can treat the monthly cost as an operating expense, rather than a capital expenditure. When
estimating removal costs, IPE assumes that it will control the removal and utilize its experience of
providing removal at the request of former customers. The President of IPE testified that she
understood IPE had the right to control the removal of the TO/Boiler, as this was her
understanding of the paragraphs of the Agreement quoted above.
Dougherty offered no testimony of the costs of removal anticipated at the time of the
Agreement. Gateway’s representative testified that he never considered the removal costs and
was not involved in the negotiations of the terms of the Agreement. Ryan Hennes, called by
Dougherty as an expert, testified and provided a written report that he estimated the cost to
disassemble, remove, and ship the TO/Boiler and all of the external equipment as of February 19,
2009 was $602,500. There are two elements of this cost which the Court finds suspect. First, the
estimate includes $161,000 for shipping costs, estimated using all truck transportation. The
President of IPE testified that its boilers are always shipped by rail, that the ancillary equipment is
shipped by truck, and that it had current bids for providing such transportation for a total cost of
$40,000 to $50,000. Second, the estimate was based upon removing and shipping every piece of
equipment supplied by IPE, including those that lacked resale value. No evidence of the portion
of the estimated cost attributable to this factor was presented. IPE offered a firm bid from Fagan
Case 08-22579 Doc# 407 Filed 06/05/09 Page 11 of 37
for approximately $260,000 to disassemble and remove the TO/Boiler in 2009. The bid does not
include transportation costs, which, according to IPE, would be $40,000 to $50,000.
There is agreement that the anticipated economic life of the TO/Boiler is 15 to 20 years.
As to the value after five years, IPE’s President testified that at the time of the Agreement she
anticipated that the TO/Boiler would have a value of $600,000 after the five year term. Given
IPE’s prominence in the market for new and used boilers, the Court finds this testimony credible.
Gateway’s representative testified that he made no projection of the value of the Equipment at the
end of five years. Dougherty’s expert, retained for the purpose of trial, in his written report stated
a tentative value of the used system, which the Court understands to be the projected value as of
September 2011, based upon conditions in 2009, not in 2006, the date of the Agreement. Mr.
Hennes’ report states:
The value of the Thermal Oxidizer/Boiler system after 5 years is
difficult to gauge. After researching the prices of used boilers and
discussing the value with Jeff Ehm of New Mech Companies, our
opinion is that the system would be worth approximately
$1,000,000. Before a final value of the system could be calculated,
a thorough analysis of the system that provides the condition of the
components would need to be provided.17
IPE’s president testified that if the TO/Boiler were returned to IPE, she would market it as an
ethanol boiler, if that market were viable. If that market were not viable, a present fact which she
did not know at the time of the Agreement, she would convert the boiler package to a straight
boiler, at a cost of approximately $900,000, and sell it for 1.4 to 1.9 million dollars. The
17 Exh. FFF.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 12 of 37
conversion cost estimate was based upon a recent conversation of a thermal oxidizer boiler
undertaken for a customer.
The corporate representative of Gateway who testified at trial, a non lawyer, stated that
Gateway always regarded the Agreement as a true lease. However, the attorney for Dougherty,
who documented the loan transaction with Gateway, testified that he never was asked to render an
opinion whether the transaction was a true lease and never considered that legal issue. There is
no doubt that IPE intended a true lease.
POSITIONS OF THE PARTIES.
The parties agree that, in accord with the Agreement, Illinois law governs this Court’s
analysis. At the time of the Lease, Illinois had adopted the 1987 version of Uniform Commercial
Code section 1-201(37) (hereafter UCC §1-201(37)), which addresses whether a transaction
creates a lease or a security interest.18 Dougherty contends that the Agreement is not a true lease
under this section based upon two separate theories: First, that the transaction created a security
interest under the bright line test of UCC §1-201(37) because Gateway had no right to terminate
the Lease during the five year term and Gateway had an option to become the owner of the boiler
system for nominal additional consideration. As an alternative, Dougherty asserts that even if it
fails to satisfy the bright line test, the transaction created a security interest when all of the facts
and circumstances are considered, as stated in UCC §1-201(37).
IPE responds that Dougherty should be estopped to claim the transaction created a
security interest based upon representations made at the time of the transaction. As to
18 810 Ill. Comp. Stat. 5/1-201(37)(2001) (effective January 1, 2001 to December 31, 2008). The
current version of the Illinois version of the UCC section distinguishing a lease from a security agreement
is found at 810 Ill. Comp. Stat. 5/1-203 (2009).
Case 08-22579 Doc# 407 Filed 06/05/09 Page 13 of 37
Dougherty’s contentions under UCC §1-201(37), IPE asserts that Dougherty has not satisfied its
burden of proof that the transaction was other than a lease.
For the reasons stated below, the Court finds that Dougherty is not estopped to claim the
transaction was other than a lease. As to Dougherty’s claims under UCC §1-201(37), the Court
finds that the bright line test of a security agreement is not satisfied and, when all of the facts and
circumstances are considered, Dougherty has not proven that the Agreement is not a true lease.
ANALYSIS AND CONCLUSIONS OF LAW.
IPE asserts that Dougherty should be estopped from contending that the Agreement is not
a true lease, as defined by Article 9 of the UCC, because it allegedly accepted benefit in the form
of its closing and administrative fees in reliance upon the position that the transaction was a
lease.19 IPE relies upon two closely related estoppel theories: Quasi-estoppel and equitable
estoppel. The traditional elements of the doctrine of equitable estoppel are: “(1)
misrepresentation by the party against whom estoppel is asserted; (2) reasonable reliance on that
misrepresentation by the party asserting estoppel; and (3) detriment to the party asserting
estoppel.”20 The misrepresentation must be of fact; and one cannot be estopped by an erroneous
opinion on a matter of law.21 According to IPE, “quasi-estoppel applies when it would be
19 IPE in its trial brief (Doc.307), makes additional estoppel arguments based upon Dougherty’s and
Debtor’s representations during the § 363 sale process and in the Asset Purchase Agreement. The Court will
not address these contentions since the issue before the Court is limited to whether the Agreement is a true
lease or a disguised sale. IPE does not assert judicial estoppel.
20 Jersey State Bank v. Isringhausen (In re Isringhausen), 151 B.R. 203, 208 (Bankr. S.D. Ill. 1993),
quoting Kennedy v. United States, 965 F.2d 413, 417 (7th Cir. 1982).
Case 08-22579 Doc# 407 Filed 06/05/09 Page 14 of 37
unconscionable to allow a person to maintain a position that is inconsistent with one to which he
or she acquiesced, or from which he or she accepted a benefit.”22 Further, IPE asserts, that
“[u]nlike equitable estoppel, ‘quasi-estoppel does not require a detrimental reliance per se by
anyone, but instead, quasi-estoppel is directly grounded upon a party’s acquiescence or
acceptance of a payment or benefits, by virtue of which that party is thereafter prevented from
maintaining a position that is inconsistent with those acts.’”23 As the Kansas Supreme Court has
said, “quasi-estoppel applies where party has previously taken position which is so inconsistent
with position now taken as to render present claim unconscionable.”24 The burden of proof is on
the party claiming estoppel,25 in this case, IPE.
The Court finds that IPE has not sustained that burden of proof. As stated above,
equitable estoppel does not apply to representations of law, and it is Dougherty’s alleged change
in the legal characterization of the Agreement which IPE seeks to preclude. Even if the estoppel
were not being raised to bar an alleged change in legal position, the Court would deny the defense
because IPE has not shown the facts necessary for application of the doctrine. The evidence is
insufficient for the Court to conclude that Dougherty or Gateway represented that the Agreement
was a true lease. Dougherty’s counsel rendered no such opinion. Although the evidence does
establish that Gateway and Dougherty understood the transaction to be a lease, rather than a sale,
22 Doc. 307 at 5, citing 31 C.J.S. Estoppel & Waiver § 146 and In re Kelly, 216 B.R. 806 (Bankr. N.
23 Doc. 307at 6, citing 31 C.J.S. Estoppel & Waiver § 146 and In re Davidson, 947 F.2d 1294 (5th
24 Wichita Fed. Sav. and Loan Ass’n v. Black, 245 Kan. 523, 536, 781 P.2d 707, 716 (1989).
25 In re Isringhausen, 151 B.R. at 208.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 15 of 37
there is no evidence that anyone was using that term as a legal term of art. IPE has not
established reliance on a representation made by either Gateway or Dougherty. There was no
testimony addressing why a UCC-1 was not filed.
As to the doctrine of quasi estoppel, the Court finds that benefit did flow to Dougherty
from the closing of the loan transaction, which was facilitated by changing the acquisition of the
Equipment from a sale transaction to a lease. There was no evidence that this was the only
solution to the problem posed in November 2005 which would have allowed the transaction to
close. In other words, the evidence linking the benefit to Dougherty to the alleged representation
that the Agreement was a true lease is tenuous. Dougherty’s change in position, although
bothersome to the Court, does not rise to the level of unconscionability. To apply quasi estoppel
in these circumstances would be inconsistent with this Court’s obligation under § 365 to examine
the substance of the Agreement, rather than relying upon the form used by the parties.26
B. THE UCC DEFINITION OF WHEN A TRANSACTION CREATES A LEASE.
The Bankruptcy Code recognizes a distinction between true leases and security interests
and treats them differently. However, it is state commercial law which controls the determination
whether a contractual agreement is to be characterized as either a lease or security agreement.27
26 See Sillins v. Sillins (In re Sillins), 264 B.R. 894, 898 (Bankr. N.D. Ill. 2001) (finding quasi-
estoppel inconsistent with court’s duty to examine the substance of a property settlement agreement).
27 Banterra Bank v. Subway Equipment Leasing Corp. (In re Taylor), 209 B.R. 482 (Bankr. S.D. Ill
1997); WorldCom, Inc. v. General Electric Global Asset Management Serv. (In re WorldCom, Inc.), 339
B.R. 56, 63 (Bankr. S.D. N.Y.2006); see Duke Energy Royal, LLC v. Pillowtex Corp. (In re Pillowtex, Inc.),
349 F.3d 711, 716 (3rd Cir. 2003).
Case 08-22579 Doc# 407 Filed 06/05/09 Page 16 of 37
In this case, based upon the choice of law provision of the Agreement, the parties agree that it
should be interpreted under Illinois law.
The parties also agree that because Dougherty is the party contending that the Agreement
is not what it purports to be, Dougherty has the burden of proof to establish that its rights and
obligations under the Agreement are not those of a lessee but those of a purchaser/owner of the
TO/Boiler.28 The Court finds it significant that the party challenging the characterization of the
Lease was not involved in negotiating the terms of the Lease and is not a party to the Lease.
Further, if successful, the recharacterization of the transaction as a secured sale would benefit
only Dougherty, not the Debtor or any other creditors of the estate. Dougherty benefitted from
the initial characterization of the transaction as a lease, and now completely changes its position
apparently for its own financial gain. Indeed Dougherty’s needs regarding the debt to equity ratio
was the reason the transaction was changed to a lease, from the sale initially contemplated.
Although the Court has declined to estop Dougherty from taking this position, the lack of equity
in this reversal is readily apparent.
Under Illinois law, article 2A of the Uniform Commercial Code defines a lease as “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.”29 The exclusion of a security
interest from the definition of a lease requires the Court to focus on the definition of a security
interest, which in 2006 was stated in section 1-201(37) of the Illinois Uniform Commercial Code
(UCC 1-201), which was identical to the 1987 uniform version of the UCC. It states: "‘Security
28 See In re Pillowtex, Inc., 349 F.3d at 716; In re QDS Components, Inc., 292 B.R. 313, 321 (Bankr.
S.D. Ohio 2002)
29 810 Ill. Comp. Stat. 5/2A-103 (2002).
Case 08-22579 Doc# 407 Filed 06/05/09 Page 17 of 37
interest’ means an interest in personal property or fixtures which secures payment or performance
of an obligation.”30 It then provides that “[w]hether a transaction creates a lease or security
interest is determined by the facts of each case.”31 This statement is followed by a two part test.
The first is the bright line test, which is discussed below. However, courts and commentators
agree, that even if the bright line test is not satisfied, the courts must apply a second test,
examination of the specific facts of the case to determine whether the economics of the
transaction support such a result.32
“The hallmark of a lease is that it grants the lessee the right to use property for a period
less than its economic life with the concomitant obligation to return the property to the lessor
while it retains some substantial economic life.”33 In other words, “the lessor retains an
economically meaningful residual interest in the leased property.”34 The 1987 revision of the
UCC eliminated reference to the intent of the parties to create a lease or security agreement,
which had been in the prior version of the UCC and led to unfortunate results, and changed the
focus to the economics of the transaction.35 It reasserted the “significance of residual value as the
touchstone of the common law definition of a true lease.“36 Nevertheless, the 1987 version of the
30 810 Ill. Comp. Stat. 5/1-201(37) (2001).
32 E.g., In re Pillowtex, Inc., 349 F.3d at 717; 4 White & Summers, Uniform Commercial Code § 30-3
(5th ed. 2002 & 2008 Supp.)(hereafter 4 Wright & Summers).
33 In re QDS Components, Inc., 292 B.R. at 322.
34 Id., 292 B.R. at 331.
35 UCC §1-203, Official Comments ¶ 2 (2001).
36 In re QDS Components, Inc., 292 B.R. at 331.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 18 of 37
UCC has not been a panacea, and courts, including this Court, continue to wrestle with the
2. THE BRIGHT LINE TEST.
The bright line test for whether a transaction in the form of a lease creates a security
interest is stated in the first part of 1-201(37). It provides:
. . . 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 . . .
a) the original term of the lease is equal to or greater than the
remaining economic life of the goods;
(b) 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
(c) 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
d) 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.
The first part of the test looks at whether the lessee may terminate the agreement during its term.
The second part looks at what are referred to as the Residual Value Factors. If the lessee may not
terminate the lease during its term and any one of the Residual Value Factors is present, the
transaction is a sale without consideration of any other facts and circumstances.
Dougherty contends that it has sustained its burden to prove the bright line test satisfied.
The first element is present. The parties agree that Gateway did not have an explicit right to
terminate the Agreement during its five year term.37 Dougherty asserts in addition that Residual
37 As to IPE, see Doc. 307.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 19 of 37
Value Factor four - that Gateway had the “option to become the owner of the goods [the
TO/Boiler] for no additional consideration or nominal additional consideration upon completion
with the lease agreement”38 - is also present.
Subsection 1-203(37) defines when additional consideration is nominal,39 stating in part:
“Additional consideration is nominal if it is less than the lessee' s reasonably predictable cost of
performing under the lease agreement if the option is not exercised.” Commentators have opined
that “nominality is merely a proxy for the questions: ‘Is the option price so low that the lessee
will certainly exercise it and will, in all plausible circumstances, leave no meaningful reversion
for the lessor?’”40 Establishing nominality where there is a purchase option price and cost
associated with performance if the option is not exercised requires a comparison of the option
purchase price with the reasonably predictable costs of performance under the lease if the
purchase option is not exercised.41
The nominality determination must be made as of the time of the agreement based upon
the expectations of the parties when entering into the transaction. Subsection(y) of 1-201(37)
38 UCC 1-201(37)(1)(d).
39 (x) Additional consideration is not nominal if (i) when the option to renew the lease is granted to
the lessee the rent is stated to be the fair market rent for the use of the goods for the term of the renewal
determined at the time the option is to be performed, or (ii) when the option to become the owner of the goods
is granted to the lessee the price is stated to be the fair market value of the goods determined at the time the
option is to be performed. Additional consideration is nominal if it is less than the lessee's reasonably
predictable cost of performing under the lease agreement if the option is not exercised;
(y) "Reasonably predictable" and "remaining economic life of the goods" are to be determined with
reference to the facts and circumstances at the time the transaction is entered into; . . ..
40 4 White & Summers., at § 30-3(e).
41 See In re QDS Components, Inc., 292 B.R. at 335.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 20 of 37
provides that “reasonably predictable” is to be “determined with reference to the facts and
circumstances at the time the transaction is entered into.” Commentators state:
First, nominality is tested at the time the agreement is
signed. As we have indicated, that is explicit in . . . 1-201(37);
something is a security agreement or lease when it is signed.
Nominality, therefore, must be determined by considering the
parties’ prediction of concluding value at signing, not by
considering the actual value at the conclusion of the term . . .. 42
“When the parties sign the contract and become bound, they have either made a lease or a security
agreement.”43 “[P]resent judgments about values, useful life, inflation, risk of non-payment, and
other matters”44 are reflected in the agreement. Although the agreement may at the end favor one
party over the other, that does not change the character of the transaction. “Foresight not
Courts agree that nominality must be based upon the expectations at the time of signing
and have held the security agreement proponent failed to satisfy its burden of proof when not
presenting evidence of parties’ expectations of the factors relevant to nominality. For example, in
WorldCom, the Bankruptcy Court for the Southern District of New York, stated, “Thus, in
analyzing nominality, the ‘reasonably predictable’ cost of performance is the cost of performance
42 4 White & Summers, at § 30-3(e).
43 Id. at § 30-3(c)(3).
45 Id.; see Matter of Marhoefer Packing Co., Inc., 674 F.2d 1139, 1144-45 (7th Cir. 1982) (holding
under Illinois law that in determining whether an option price is nominal, the proper figure to compare it with
is not the actual fair market value of the leased goods at the time the option arises, but the value anticipated
at the time the lease was signed. If because of inflation or other matters the lessee’s option becomes more
favorable than either party anticipated at the time of singing, this does not change the true character of the
Case 08-22579 Doc# 407 Filed 06/05/09 Page 21 of 37
as anticipated by the parties at the time the Agreement was signed.”46 and held Worldcom had not
sustained its burden of proof as to nominality because it did not seriously attempt to assert that its
evidence reflected the parties’ expectations at the time the Agreement was signed.47 In QDS
Components, because the record contained no evidence establishing what the original parties to
the transaction anticipated at contract inception concerning QDS’s cost of performing under the
lease, including the cost of returning the goods to the lessor, the court held that the party objecting
to characterization of the transaction as a true lease had failed to demonstrate the nominality of
the option amount under the bright line test.48
As stated above, under the Agreement Gateway has the option at the end of the five year
lease to either return the Equipment to IPE, with Gateway paying the cost of removal and
shipment, or to retain the Equipment upon payment of the Fixed Option Price of $600,000. When
arguing that price to retain the TO/Boiler is nominal, Dougherty contends the cost of performance
equals or exceeds the Fixed Option Price based upon consideration of four factors: The cost of
removal; the fact that the Fixed Option Price is only 12% of the Replacement Value of
$5,041,970 stated in the Lease; the cost to replace the TO/Boiler, which is necessary for operation
of the ethanol plant; and the equity in the TO/Boiler which would have been built up if Gateway
had fully performed the Lease.
The Court agrees with Dougherty that the cost to remove and return the Equipment to IPE
is relevant to the nominality determination. However, as discussed above, the relevant cost for
46 In re WorldCom, 339 B.R. at 68.
47 Id., 339 B.R. at 69.
48 In re QDS Components, 292 B.R. at 337-338.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 22 of 37
application of the bright line test is that anticipated in September 2006, when the Agreement was
executed. Dougherty has provided no evidence that the anticipated cost approached $600,000.
Although Dougherty’s expert, Mr. Hennes testified that it would cost $602,500 to remove the
TO/Boiler and related equipment and ship it to IPE in Illinois, this is his estimated cost for
removal and shipment in 2009. Mr. Hennes was not involved in arranging the transaction and
could not testify as to the cost of return anticipated by the parties in 2006. Mr. Barker, a
Dougherty witness who was designated as the representative of Gateway for purposes of the trial,
stated that in 2005 and 2006 he made no projections of the costs of removal after expiration of the
Ms. Forsythe-Fournier, the President of IPE who determined the economic terms of the
Agreement offered and accepted by Gateway, was called as a witness on behalf of Dougherty.
She testified that at the time the Agreement was signed she estimated that the cost to remove and
return the TO/Boiler was approximately $200,000, based upon IPE’s experience in removing two
multi-boiler systems in 2002 or 2003. Further examination revealed that this estimate might have
been some what low, and an estimate of up to $250,000 might have been more accurate. Her
testimony is the only evidence in the record as to the anticipated cost of removal and shipment of
the TO/Boiler at the time of Agreement. That cost, $200,000 to $250,000, was significantly less
than the Purchase Option Price of $600,000.49
The Court finds, contrary to the position of Dougherty, that the fact that the Agreement
provides the Fixed Option Price ($600,000) is approximately 12% of the Replacement Value
49 The Court surmises that this estimate did not include removal and return of the portion of the
Equipment whose highest value was as scrap.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 23 of 37
($5,041,970) does not establish nominality. First, the 1987 version of the UCC “disavows
percentage tests.”50 Second, the option price should not be compared with the Replacement Cost,
which includes not only the value of the Equipment at the time of the Agreement but also the
costs to develop, ship, and install the entire system. Rather, nominality of the option price
amount is determined by comparison of the option amount with the expected value of the
TO/Boiler at the time the option is to be exercised,51 in this case five years after September 2006.
Mr. Hennes, Dougherty’s expert, stated in his report that in his opinion the value of the TO/Boiler
after 5 years would be approximately $1,000,000. But this value is his tentative opinion formed
in 2009 and was not the value anticipated by the parties in 2006. Further, this value is not final,
as Mr. Hennes wanted to do more research before opining as to the value after 5 years.
IPE, on the other hand, did provide evidence of the anticipated value of the TO/Boiler at
the end of the term. Ms. Forsythe-Fournier, President of IPE, which has the largest stock of new
and used boilers in the world, testified that when she determined the terms of the Agreement she
anticipated that after five years the value would be $600,000. There is no evidence contradicting
this estimate. In addition, Ms. Forsythe-Fournier testified that if the boiler is returned in 2009,
when there is no market for ethanol boilers, and converted to a straight boiler, with a conversion
cost of $900,000, she would expect a sale price of 1.4 to 1.9 million dollars. Accordingly, from
the record the Court can not conclude, as urged by Dougherty, that the Fixed Option Price is
50 4 White & Summers, at §30-3(b)(1).
51 Id., at §30-3(e).
Case 08-22579 Doc# 407 Filed 06/05/09 Page 24 of 37
nominal when compared with the value after five years as anticipated at the time of the
The cost to replace the TO/Boiler if it is returned after five years is not a consideration
when determining nominality. It is not a “reasonably predictable cost of performing under the
lease agreement,” as required by the UCC definition of nominality.53 The cost to replace the TO/
Boiler is a cost to return the ethanol plant to operational status if the TO/Boiler is returned, not a
cost to perform the Agreement. This case is therefore clearly distinguished from Pillowtex,54
relied upon by Dougherty. In Pillowtex, Duke agreed to install certain energy saving equipment,
and Pillowtex agreed to make payment over eight years. At the end of the term, Duke had four
options, one of which was to remove the installed equipment and replace it with equipment
similar to that originally in place. Because of this option, the cost of replacement was relevant
when examining, for purposes of the facts and circumstances test, whether Duke anticipated
residual value in the equipment at the end of the term.55 In this case, the Agreement is silent as to
replacement costs if the boiler is removed. Further, as noted by the court in QDS Components,
the inclusion of replacement cost would have the “effect of converting ‘the most obvious true
lease [into] a security agreement.’”56 Interpreting the “phrase ‘cost of performing under the lease
52 White & Summers opines that any option price above 50% of the predicted fair market value
should be accepted as not nominal. 4 Wright & Summers, at §30-3(e). Even if the Court accepted
Dougherty’s expert’s opinion that the value of the TO/Boiler afer five years would be $1,000,000, the option
price would not be nominal under this test.
53 810 Ill. Comp. Stat. 5/1-201(37)(x)(2001).
54 In re Pillowtex, 349 F.3d at 711.
55 Id, 349 F.3d at 714, 720.
56 In re QDS Components, Inc., 292 B.R. at 338, n.15.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 25 of 37
agreement if the purchase option is not exercised’ broadly so as to include the economic value a
lessee chooses to forego when it declines to exercise a purchase option would produce absurd
results.”57 In Pillowtex, the question of consideration of the cost to replace the installed
equipment arose under the facts and circumstances test, not the bright line test.
Likewise the Court declines to find that the equity which Dougherty alleges Gateway
would have built up in the TO/Boiler at the end of the lease term relevant to the bright line
nominality test.58 Under the UCC 1-201, the question is whether the lessee “has an option to
become the owner of the goods for no consideration or nominal consideration.” A lessee’s
alleged equity, like replacement cost of the equipment if returned, simply is not a cost of
performance under the Agreement. The test is what the lessee would be required to expend to
retain the leased goods, not what it would give up if it were returned.
For the foregoing reasons, the Court holds that Dougherty has failed to establish that the
Lease is a disguised sale based upon the bright line test of UCC 1-201(37). Dougherty has not
sustained its burden of proof that the anticipated cost to Gateway to exercise its option to
purchase the TO/Boiler at the end of five years was nominal, as that term is defined in the
3. ALL THE FACTS AND CIRCUMSTANCES TEST.
When the bright line test is not satisfied, UCC §1-201(37) requires the court to consider
“the facts of each case.” This consideration is guided by the fact that the drafters of amended
UCC §1-201(37) sought to “preserve common law principles,” under which the “central feature
58 The argument is relevant to the facts and circumstances test and is discussed below.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 26 of 37
of a true lease is the reservation of an economically meaningful interest to the lessor at the end of
the lease term.”59 The Official UCC Comments states: “If a transaction creates a lease and not
security interest, the lessee’s interest in the goods is limited to its leasehold estate; the residual
interest in the goods belongs to the lessor.”60 When the bright line test is not satisfied, the court
must then answer the question whether the lessor retained a reversionary interest, either an upside
or downside risk.61 “To have a true lease, the original agreement must leave the lessor with some
meaningful economic interest in the residual.”62 The challenge to the courts “therefore is first to
establish the indicia that evidence a reversionary interest in the leased goods and then determine
whether those indicia are apparent in the case at hand.”63
The UCC does not provide an explicit test for reservation of a meaningful reversionary
interest. The UCC only states that “a transaction in the form of a lease does not create a security
interest merely because” one of the following is true:
(a) the present value of the consideration the lessee is obligated to
pay the lessor for the right to possession and use of the goods is
substantially equal to or is greater than the fair market value of the
goods at the time the lease is entered into;
(b) the lessee assumes risk of loss of the goods, or agrees to pay
taxes, insurance, filing, recording, or registration fees, or service or
maintenance costs with respect to the goods;
59 Edwin E. Huddleson, Old Wine in New Bottles: UCC Article 2A-Leases, 39 Ala L. Rev. 615, 625
60 UCC §1-203, Official Comment ¶ 2 (2001).
61 4 White & Summers, at § 30-3(d); In re WorldCom, Inc., 339 B.R. at 71 (concluding the “majority
of courts and commentators have agreed that the principle inquiry [of the facts of each case] is ‘whether the
lessor has retained a meaningful reversionary interest in the goods.”).
62 Huddleson, Old Wine in New Bottles, 39 Ala. L. Rev. at 631.
63 In re WorldCom, Inc., 330 B.R. at 72.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 27 of 37
(c) the lessee has an option to renew the lease or to become the
owner of the goods;
(d) the lessee has an option to renew the lease for a fixed rent that is
equal to or greater than the reasonably predictable fair market rent
for the use of the goods for the term of the renewal at the time the
option is to be performed; or
(e) the lessee has an option to become the owner of the goods for a
fixed price that is equal to or greater than the reasonably predictable
fair market value of the goods at the time the option is to be
Commentators opine that the drafters intended by including this list to overrule a series of bad
decisions under the pre-1987 version of UCC §1-201(37)64 and that generally, with the possible
exception of element (a) that the factors are not only “not enough” to indicate a sale, but are
Court decisions likewise have not adopted a consistent set of factors for identifying a
lessor’s residual interest. As one court has stated, “Indeed, there seem to be nearly as many
different approaches to determining the existence of a meaningful residual interest as there are
reported decisions.”66 The Agreement states that it shall be controlled by Illinois law, but the
Court has been unable to find cases from Illinois which are helpful here. Marhoefer Packing67
appears to be a leading case, but it was decided in 1982, before Illinois’ adoption of the 1987
version of the UCC. Another frequently cited case is In re Taylor.68 It lists the following factors
as relevant: “(1) whether the lessee has the option to renew the lease or to become the owner of
64 4 White & Summers, at §30-3(c)(2).
66 In re QDS Components, Inc., 292 B.R. at 342.
67 In re Marhoefer Packing Co., Inc., 674 F.2d at 1139 (applying Illinois law).
68 In re Taylor, 209 B.R. at 482.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 28 of 37
the property; (2) whether the amount of rent exceeds the fair market value of the property; (3)
whether the debtor is responsible for the payment of taxes, insurance and other costs incident to
ownership; and (4) whether the useful life of the property exceeds the length of the term of the
lease.”69 The first three of these considerations are included in the statutory list of factors which
standing alone do not indicate a transaction has created a security, and are therefore at most of
marginal importance. Further, Taylor relies upon Marhoefer Packing,70 decided under prior law.
Buehne Farms, Inc.,71 decided in 2005, found a disguised sale rather than a lease under the bright
line test, so does not provide guidance to the Court when evaluating all of the facts and
Rather than applying a laundry list of factors identified by other courts, the Court will
focus upon the economic factors of the Agreement and evaluate whether they evidence IPE
retained a residual interest in the TO/Boiler. The Court, finds the Agreement to be a true lease
based upon consideration of: (1) The anticipated useful life of the TO/Boiler; (2) IPE’s ability to
market the TO/Boiler at the end of the lease term; (3) the amount of the lease payments in relation
to the value of the TO/Boiler; (4) whether the TO/Boiler is unique because it was designed for
installation in the Gateway plant; (5) whether at the time of the Agreement, the long term
operation of the ethanol plan required Gateway’s continued possession of the TO/Boiler; and (6)
the economic benefit to Gateway and Dougherty from the transaction being structured as a lease
rather than a sale.
69 Id., 209 B.R. at 487.
70 In re Marhoefer Packing Co., Inc., 674 F.2d at 1139, cited in In re Taylor, 209 B. R. at 487 and
71 In re Buehne Farms, Inc., 321 B.R. 239 (Bankr. S.D. Ill. 2005).
Case 08-22579 Doc# 407 Filed 06/05/09 Page 29 of 37
First, the evidence is unrefuted that the expected useful life of the TO/Boiler is 15 to 20
years.72 The Agreement is a five year contract.
Second, the Court finds that the TO/Boiler will have value to IPE if returned at the
expiration of the five year lease. Such value was anticipated when the Agreement was executed
in 2006 and exists today. IPE is a worldwide leader in the sale and leasing of boilers, both new
and used. It has supplied boilers to ethanol plants, a growing business in 2006. Although the
ethanol industry has hit hard times, the TO/Boiler has marketability for other uses. IPE could, for
a cost of approximately $900,000, convert the TO/ Boiler to a steam boiler, after which it could
be sold for 1.4 to 1.6 million dollars.
Third, the payment terms do not evidence a sale. Under the Agreement, Gateway, if it
had made all of the lease payments for 60 months, discounted at the rate of 7.754%, would not
have paid the full Replacement Price, or purchase price. The record includes calculations
showing that, using an interest or discount rate of 7.754%, if the transaction had been structured
as a financed sale, after five years, approximately $600,000 of the $5,041,970 purchase would not
have been paid.73 There was no testimony challenging this discount rate. Thus, if the transaction
were considered a sale, and the monthly lease payments were considered payments of principle
and interest, the non-bargain purchase price of $600,000 would have been approximately equal to
the remaining loan balance. Further, even if the Agreement provided for the full price to be paid
during the lease term, this would not conclusively establish a sale. UCC §1-201(37) expressly
states: “A transaction [in the form of a lease] does not create a security interest merely because it
72 Some equipment external to the TO/Boiler had a shorter expected life, but this fact did not play a
role in the parties’ arguments.
73 Exh. Z.
Case 08-22579 Doc# 407 Filed 06/05/09 Page 30 of 37
provides that: (1) the present value of the consideration the lessee is obligated to pay the lessor for
the right to possession and use of the goods is substantially equal to or is greater than the fair
market value of the goods at the time the lease is entered into.” The official comments interpret
this provision as stating that “a full payout lease does not per se create a security agreement.”74
Commentators find this provision “puzzling,” stating that “[n]ormally one would assume that
when that test is met the parties have a secured sale, not a lease.”75 They explain the provision as
Could tax and other benefits to the lessee change the
equation? To see how that might be so, consider Rushton v. Shea,
cited in the comment to section 1-201(37), in which one party
leased railroad tank cars. Over the 15-year lease, the lessor would
have received payments with a present value equal to the fair
market value of the tank cars plus approximately 1% per month
interest. This would seem to indicate that the transaction was a
secured sale. But because the tank cars were expected to retain
significant residual value which would revert to the lessor at the end
of the 15-year lease, the court found the transaction to be a true
The question remains, why would a lessee enter into such a
transaction? There are several possibilities. First, the lessor and
lessee might be controlled by the same party and the lease might be
a device for shifting income from one to the other. Second, there
may be unique tax benefits to be gained by the lessee . . .. Of
course, the lessee might be making payments to the lessor to enjoy
certain other benefits of the lease such as the avoidance of debt
limitations in other loan documents or the avoidance of state and
local personal property taxes. . . .. The end result is that the lessee
realizes a valuable benefit which, when offset against the payments
to the lessor, means the net amount the lessee is paying to the lessor
is not equal to or greater than the fair market value of the goods.76
74 UCC §1-203, Official Comment ¶2 (2001).
75 4 Wright & Summers, at § 30-3(c)(2).
Case 08-22579 Doc# 407 Filed 06/05/09 Page 31 of 37
In this case, not only were the total payments, when discounted, less than the value of the
Equipment, but, a lease rather than a sale had other benefits. As examined below, Gateway and
Dougherty received an economic benefit from the lease form, and lease of the TO/Boiler
facilitated the future change to a gas fired system to be developed by Indeck Energy. In addition,
after five years the TO/Boiler retained significant value, which reverted to IPE. The payment
terms are not sufficient to establish a sale transaction.
Fourth, Gateway and Dougherty benefitted economically from the transaction being
handled as a lease rather than a sale. Initially, Lurgi planned to purchase the boiler needed for the
ethanol plant and to include the purchase cost in the construction budget. In November 2005, a
status meeting was held involving Lurgi, Gateway, and those providing capital and financing for
the project, including Dougherty and Indeck Energy. One of the problems to be addressed was the
short fall of equity investment if the 45/55 ratio of equity to debt was to be maintained, as thought
necessary by Dougherty to obtain third party purchasers for the loans to Gateway to be furnished
through Dougherty. At the meeting it was proposed that this problem could be solved in part if
Gateway were to lease the boiler, rather than it being purchased by Lurgi. The proposal was
approved, and on December 15, 2005, the initial lease with IPE for the TO/Boiler was executed.
The Offering Memorandum prepared by Dougherty for consideration by those interested in
participating in the $53 million loan to Gateway includes a pro forma income statement showing
annual lease expense in the amount of the December 15, 2005 lease with IPE. As a result of
leasing rather than purchasing the IO Boiler, Gateway reduced the amount of capital/loan required
and facilitated Dougherty’s marketing of participations based upon projected 45/55 equity to debt
ratio without the need to raise additional capital. Dougherty had to believe that the transaction had
Case 08-22579 Doc# 407 Filed 06/05/09 Page 32 of 37
the financial characteristics of a true lease in order to market loan participations to the banks,
because to believe otherwise would have meant that Dougherty knew the 45/55 equity to debt ratio
was not true.
Fifth, although the TO/Boiler was designed for installation in the Gateway plant, there was
no evidence that the principle components are unique. Other ethanol plants use similar boilers.
IPE designs its systems in modules which facilitates adaptation to various uses. As stated above, if
the TO/Boiler is returned to IPE, it can be marketed for use in an ethanol facility or, after
modification, for a different installation.
Sixth, the Gateway plant was designed to facilitate the removal of the gas fired TO/Boiler
and replacement with a coal-fired boiler. Before the acquisition of a boiler was changed from a
sale to a lease, consideration had been given to the use of coal rather than gas to fire the boiler at
the plant, since at that time gas was considerably more expensive than coal. Indeck Energy
Services had negotiated an Energy Services Agreement with Gateway whereby Energy would
permit, build, and operate a coal-fired plant and Gateway would agree to purchase steam from that
plant. When it was decided that coal was not feasible initially because permitting and installation
of a coal plant would delay the project, it was decided that a gas fired plant would be installed, but
care was taken to assure that the design of the ethanol plant was compatible with replacing the
boiler. Therefore, the Court finds that Gateway had a interest in not purchasing a gas fired system
because of the possibility of replacement of the TO/Boiler before the expiration of its expected
The role of intent when distinguishing between a lease and a security agreement under all
the facts and circumstances test of the 1987 version of the UCC is not certain. It seems clear that
Case 08-22579 Doc# 407 Filed 06/05/09 Page 33 of 37
the drafters intended economic factors to predominate, but it is not clear that they intended intent
of the parties to be irrelevant. In this case, it is uncontroverted that at the time of the Lease, IPE,
Gateway, and Dougherty intended the transaction to be a lease. In addition to the facts stated in
the above paragraph regarding the November 2005 meeting, those involved in the transaction
uniformly testified that a lease was intended. The representative of Gateway testified that at the
closing of the financing provided by Dougherty, the transaction was identified as a lease, and he
first learned that this status was being challenged in mid December 2008, after the Gateway
bankruptcy had been filed. Counsel for Dougherty who documented the Gateway financing
testified that it was no secret that the TO/Boiler was to be leased. The President of IPE certainly
intended the transaction to be a true lease.
Based upon the foregoing, the Court concludes that IPE preserved a meaningful
reversionary interest in the TO/Boiler. As discussed below, the Court has considered the
numerous facts which Dougherty contends exhibit that the transaction is not a true lease and
rejects them as being insufficient to sustain its burden of proof.
First, Dougherty contends a sale occurred because IPE calculated payment terms by
amortizing the replacement value. IPE did use an amortization computer program which
computed the effect of the monthly lease payments if the purchase had been a financed sale with
an interest rate of 7.754 %. However, these calculations do not evidence that the transaction was a
sale. There is no evidence that the schedules were supplied to Gateway as a part of the transaction.
They became known to Dougherty only through discovery in this case. The President of IPE
testified that the documents were created by IPE’s bookkeeping department to assist with booking
of the transaction after the Agreement was entered into. Moreover, as discussed above, although
Case 08-22579 Doc# 407 Filed 06/05/09 Page 34 of 37
the total amount of the payments in relation to the value of the Equipment at the time of the
agreement approached “full pay out lease,” under the facts of this case the payments do not
indicate a sale. The TO/Boiler has residual value after five years. Gateway benefitted from the
lease economically through shifting the cost of the boiler out of the construction costs to operating
costs and facilitating the contemplated change to the gas fired system being developed by Indeck
Second, the facts that Gateway was obligated to insure the equipment for its full
replacement value, to maintain the equipment, and to assume risk of loss do not in the Court’s
view strongly support Dougherty’s position. The 1987 version of UCC 1-201(37) provides that
these conditions standing alone do not evidence a sale.77 Generally, such provisions are
compatible with either a lease or a sale. Under Article 2A of the UCC, section 2A-218, the parties
to a lease may by their agreement determine that one or more parties have an obligation to insure
the goods and to determine the beneficiary of the proceeds of insurance. Although Article 2A, in
section 2A-219 provides that risk of loss does not pass to a lessee, except in a finance lease, UCC
section 1-302 provides that the effect of the UCC may be varied by agreement.
Third, the Court rejects Dougherty’s argument that a disguised sale is present because the
TO/Boiler was specially designed for the Gateway ethanol plant. Although custom designed
equipment may be indicative of a sale,78 in this case the evidence convinces the Court that the
77 The cases that Dougherty relies upon were for the most part decided under prior law, when intent
rather than economic reality was the focus. See In re Loop Hosp. P’ship, 35 B.R. 929 (Bankr. N.D. Ill. 1983);
Orix Credit Alliance, Inc. v. Pappas, 946 F.2d 1258 (7th Cir. 1991); Mid-America Packing Specialists
Division v. General Motors Acceptance Corp. (In re Tulsa Port Warehouse Co., Inc.), 690 F.2d 809 (10th
78 See In re The Answer - the Elegant Large Size Discounter, Inc., 115 B.R. 465, 469 (Bankr. S.D.
N.Y. 1990)(one factor in finding a sale instead of a lease was that fixtures were custom designed and there
Case 08-22579 Doc# 407 Filed 06/05/09 Page 35 of 37
common features of the TO/Boiler predominate over those which are unique to the Lurgi
installation. The testimony of the President of IPE establishes that the equipment after removal
would be useful in other situations.
Fourth, although the fact that the warranties are those which IPE customarily provides with
a sale would normally indicate a sale transaction, that indication is not true in this case. The sale
warranties were included at the special request of Gateway, who concurrently requested that the
transaction be in the form of a lease. The disclaimer of warranties of merchantability and fitness
for a particular purpose are permitted in both sales and leases.79
Fifth, Dougherty’s next argument is that the impracticality of relocating the Equipment
evidences a sale. This argument has superficial appeal. The TO/Boiler is a piece of equipment
necessary to the operation of the ethanol plant, removal would interrupt operations, and the cost of
removal is not insignificant. However there is testimony which convinces the Court not to weigh
this fact very heavily. IPE specifically designs its boilers in modules so that they are removable.
At the time of the Lease, Gateway was a party to the Energy Services Agreement, under which
Indeck Energy would permit, build, and operate a coal-fired boiler to replace the gas fired system.
Since, this change would have required the removal of the leased system, Gateway at the time of
the Agreement must have regarded the impracticality of relocating the Equipment as insignificant.
Sixth, it is uncontroverted that Gateway was responsible for sales taxes and for securing
licenses and permits. In Kansas a sales tax is charged on leased as well as purchased equipment,
was no evidence that they had value to other potential users).
79 UCC §2-316 (sales); UCC §2A-214 (leases).
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so the possibility of a sales tax being collected is not indicative of the nature of the transaction.80
Further, there is evidence that the Equipment was exempt from taxation, so the allocation of
liability had no financial impact. As to the licenses and permits which must be secured by
Gateway, there was no evidence as to what licenses or permits were involved and no argument as
to how they indicate the presence of a sale. Dougherty fails to explain how Gateway’s
responsibility for licenses or permits impacts the characterization of the transaction.
For the foregoing reasons, when all of the circumstances of the Agreement are considered,
the Court holds that Dougherty has not sustained its burden of proof to establish that Agreement is
other than a lease. The economic terms of the Agreement were such that IPE retained a
meaningful residual interest in the TO/Boiler at the end of the five year term of the Agreement.
The Court finds that the September 2006 lease between IPE and Gateway was a true lease
under Illinois law. Accordingly, it is subject to assumption or rejection under § 365 of the Code.
The additional issues raised in the Objection of Indeck Power Equipment Company to the Cure
Amount and Statement of Cure Claim under Debtor's Notice of Intent to Assume and Assign
Certain Executory Contracts and Unexpired Leases in Conjunction with the Sale of Assets81
remain to be determined by agreement of the parties or in subsequent proceedings.
The foregoing constitute Findings of Fact and Conclusions of Law under Rules 7052 and
9014(c) of the Federal Rules of Bankruptcy Procedure which make Rule 52(a) of the Federal Rules
of Civil Procedure applicable to this matter.
80 See K.S.A. 79-3603(a) and (h).
81 Doc. 194.
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IT IS SO ORDERED.