A common tactic of creditors in bankruptcy litigation is the attempt to characterize the nature of their debt in a way that is the most favorable for them. It is almost a version of the philosopher Gottfried Leibniz’s old phrase “the best of all possible worlds”: whatever characterization produces the most favorable outcome, that is generally what the creditor will choose. We have seen, for example, loan contracts (drafted by creditors) that basically contain enough contract provisions that they can claim to be nearly anything: a secured loans, a trust agreement, a purchase money security agreement, or a lease.
Such issues have arisen in the context of the issuance of money orders (a trust agreement or a security agreement?) by businesses or “floor plan” arrangements for used auto sales (is it a trust agreement or a secured loan?) When such contracts are eventually brought before a court during litigation in an adversary proceeding or some other bankruptcy-related proceeding, a creditor may point to any number of various (and sometimes conflicting) contract provisions to try to claim that its debt is somehow “special.”
Not surprisingly, courts will often look past such verbiage to examine the actual nature of the transaction between the parties. In bankruptcy court, it doesn’t matter what you call it, what matters is the underlying nature of the transaction. This issue arose recently in a Kansas case in the context of a vehicle contract for the use of a debtor’s car. The financing company claimed the arrangement was a lease. The debtor (In Re James, case no. 12-23121, decided in the District of Kansas in November 2014) claimed the arrangement was a de facto secured loan.
Judge Robert Berger, who issued the decision, pointed to the Supreme Court case of Butner v. United States, 440 U.S. 48, 54-55 (1979) for the proposition that property right questions must generally focus on state law. Following this logic, the Court focused on K.S.A. §84-1-103, which holds that the economic realities of a transaction must be the primary factors in interpreting its essence. In other words, it doesn’t matter what a party calls something; what matters is the actual nature of the transaction (the “economic realities”) that matters. Looking at the fine print of the contract, the Court noted that the “lease” agreement actually gave the debtors the option to become the owners of the goods for no additional consideration.
In addition, the vehicle contract did not give the debtors the option to terminate it, which is supposed to be one of the main features of a true “lease.” Actually, there was a “cancellation” provision in the contract, but it required the debtors to pay the remaining balance due. For this reason, the cancellation provision was a creditor ruse. “Early termination” of the lease was an illusion. Because the so-called “lease” gave the debtors no rational option but to continue making payments until completion of the contract, it was not a true “lease.” The Court found it to be a security interest, and would treat it as such within the debtor’s Chapter 13 plan. Although the car loan could not be crammed down, the terms of the contract could still be modified somewhat in the Chapter 13 plan (interest rate lowered, different payment terms, etc.).
The James decision highlights a tactic frequently used by creditors: fill a contract with fine print that has features of nearly any scenario that might arise. As stated above, we have seen creditors attempt to characterize ordinary, garden-variety commercial loans as priority trust agreements (deserving special treatment), as statutory trusts, as security agreements, as leases, or as other things. The tactic is also used frequently by payday loan establishments in possession of debtors’ checks.
It is becoming more and more common for large institutional creditors to take advantage of their size and unequal bargaining power to compel debtors to sign agreements that may not be what they appear to be. The practice also is found in business situations and commercial loans. Fortunately, the rule here is clear: it doesn’t matter what a creditor says a contract is; what matters is what the economic realities of the transaction are. If you have been saddled with a contract or agreement that a creditor claims to be one thing or another, it is critical to get independent legal advice. Very often, you may have more rights than you think you have.