In Re Pillowtex

Opinions of the United

2003 Decisions States Court of Appeals

for the Third Circuit

11-14-2003

In Re Pillowtex

Precedential or Non-Precedential: Precedential

Docket No. 02-2674

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PRECEDENTIAL

Filed November 14, 2003

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 02-2674

In re: PILLOWTEX, INC. ET AL.

DUKE ENERGY ROYAL, LLC

Appellant

v.

PILLOWTEX CORPORATION

Appellee

On Appeal from the United States District Court

for the District of Delaware

(Civil Action Nos. 00-CV-4211)

District Judge: The Honorable Sue L. Robinson

Argued: April 10, 2003

Before: ALITO and FUENTES, Circuit Judges

and PISANO,* District Judge

(Opinion Filed: November 14, 2003)

Eric D. Schwartz

Morris, Nichols, Arsht & Tunnell

1201 North Market Street

P.O. Box 1347

Wilmington, DE 19899

* The Honorable Joel Pisano, United States District Judge for the District

of New Jersey, sitting by designation.

2

Daniel P. Winnika [ARGUED]

Jones, Day, Reavis & Pogue

2727 North Harwood Street

Suite 100

Dallas, TX 75266

Counsel for Appellee

Brett D. Fallon [ARGUED]

Morris, James, Hitchens & Williams

222 Delaware Avenue

P.O. Box 2306, 10th Floor

Wilmington, DE 19899

Counsel for Appellant

OPINION OF THE COURT

FUENTES, Circuit Judge:

Duke Energy Royal LLC (“Duke”) appeals from an order

of the District Court denying a motion to compel Pillowtex

Corporation (“Pillowtex” or “debtor”) to make lease

payments owing under the Master Energy Services

Agreement (“MESA”), an agreement its predecessor entered

into with Pillowtex.1 The District Court denied Duke’s

motion on the grounds that the MESA was not a true lease,

but rather a secured financing arrangement. The sole issue

in this appeal is whether the District Court correctly

determined that the MESA entered into between Pillowtex

and Duke prior to Pillowtex’s bankruptcy filing was a

secured financing arrangement rather than a true lease. We

affirm because we agree with the District Court that, based

on the economic realities of the underlying transaction, the

MESA was a secured financing arrangement.

1. On April 30, 2002, DukeSolutions, Inc., a party to the MESA,

transferred its claims against Pillowtex to appellant, Duke Energy Royal

LLC (“Duke Royal”) pursuant to a Bill of Sale, Assignment and

Assumption Agreement. (App. at 251-52). To simplify, we refer to both

simply as “Duke.”

3

I. Facts and Procedural Background

Because the nature of the MESA is at issue, we first turn

to its provisions and the transaction underlying the

agreement. Pillowtex and Duke entered into the MESA on

June 3, 1998. Pursuant to the MESA, Duke agreed to

install certain equipment “for the purpose of improving the

efficiency of energy consumption or otherwise to reduce the

operating costs” incurred by Pillowtex at its facilities.

(MESA § 2.5, App. at 299). The MESA covered two different

sets of energy services projects, one involving production

equipment and the other energy-savings equipment. The

production equipment was provided to Pillowtex by Duke

pursuant to separate stand-alone agreements, which were

recorded as true leases on Pillowtex’s books, and which the

parties agree constituted true leases. Therefore, only the

nature of the parties’ arrangements concerning the energy-

savings equipment is at issue in this appeal.

The energy-savings equipment included certain lighting

fixtures, T8 lamps and electronic ballasts (collectively the

“lighting fixtures”), which were installed in nine of

Pillowtex’s facilities and a new wastewater heat recovery

system that included hot water heating equipment (the

“wastewater system” and together with the lighting fixtures,

the “energy fixtures”), which was installed at Pillowtex’s

Columbus, Georgia plant. The lighting fixtures were

selected, and the wastewater system was constructed,

specifically for Pillowtex’s facilities. (App. at 336-590).

In order to induce Pillowtex to enter into the energy

services projects, Duke offered to originate funding for the

production equipment “on a two-to-one basis (i.e., for every

$1 million of energy projects Duke would originate $2

million for funding of equipment) with a minimum of $28

million in funding for equipment leasing or financing.” (App.

at 153). Another incentive Pillowtex had for entering into

the agreement was “that the energy projects would be cost

neutral to Pillowtex for the term of the agreement; that is,

Pillowtex’s payments to Duke would be equivalent to

Pillowtex’s actual savings . . . and Pillowtex would then

reap the benefits from the cost savings after the end of the

term of the project.” (App. at 153). In keeping with this

4

arrangement, Pillowtex accounted for its payments to Duke

under the MESA as a utility expense. (App. at 155).

The MESA provided that the cost of acquiring and

installing the energy fixtures would be paid by Duke, which

incurred total costs of approximately $10.41 million. (MESA

§ 5, App. at 302; 339). Of this amount, approximately $1.66

million was for material and labor costs for the wastewater

system. (App. at 594). Approximately $4.46 million was for

labor to install the lighting fixtures and $4.29 million was

for material costs for the lighting fixtures, which is to say

that the cost of labor to install the fixtures was higher than

the cost of the actual materials themselves. (App. at 339,

70). Also, Duke paid approximately $223,000 to dispose of

light fixtures and related equipment that it removed from

Pillowtex’s facilities. (App. at 69-70).

In exchange, Pillowtex was to pay Duke on a monthly

basis one-twelfth of Pillowtex’s annual energy savings, in an

amount the parties agreed to in advance, until the end of

the MESA’s 8 year term. (MESA § 7.0, App. at 304). In

addition, the parties agreed that the simple payback of all

of Duke’s costs was not to exceed 5 years. (MESA § 4.1(f),

App. at 302). “Simple payback” is synonymous with

“payback period,” an accounting term which refers to “[t]he

length of time required to recover a venture’s initial cash

investment, without accounting for the time value of

money.” BLACK’S LAW DICTIONARY 1150 (7th ed. 1999). In other

words, the payments were structured to ensure that

Pillowtex would make predetermined, equal monthly

payments and that Duke would recover its costs 3 years

prior to the end of the term of the MESA. Although the

MESA was for an 8 year term, the parties agree that the

useful life of the energy fixtures was 20-25 years. (App. at

74-75).

It is undisputed that Duke and Pillowtex intended to

structure the MESA to have the characteristics of a lease

and that the parties were trying to create a true lease.

Indeed, Pillowtex’s counsel conceded during oral argument

before the District Court, “I don’t disagree that [the MESA]

was structured to have those characteristics for tax

purposes and, you know, to [the] extent they could, the

parties were trying to create a true lease, I would admit

5

that.” (App. at 117). The parties intended for the MESA to

be structured as a true lease, in large part, because

Pillowtex was subject to capital expenditure limitations

under its senior credit facility and did not wish to have the

energy-savings equipment count as capital expenditures

under that facility. Nevertheless, the MESA is not labeled a

lease and it does not refer to the parties as lessee and

lessor. Also, Duke alleges that the parties were concerned

with structuring the MESA’s provisions relating to energy-

savings equipment in accordance with the requirements of

Financial Accounting Standard 13, which sets the

standards for financial accounting and reporting for leases.

(App. at 164). However, the MESA fails to qualify as a true

lease under ¶ 7 of that standard because the present value

of the total payments due under the MESA exceeds the

value of the original cost of the energy fixtures. (App. at

171).

In keeping with their intent to structure the transaction

as a lease, the MESA provides that title to the equipment

would remain with Duke. (MESA § 11.0, App. at 308). Also,

Pillowtex agreed not to claim ownership of the equipment

for income tax purposes, (MESA § 9.13(ii), App. at 307), and

Pillowtex was not obligated to purchase the equipment at

the end of the term of the MESA. Rather, the MESA

provided the following four options to Duke at the

conclusion of its term, if Pillowtex was not then in default:

(I) remove the Equipment installed and replace those

[sic] Equipment with equipment comparable to those

originally in place, provided that no such replacement

shall be required with respect to Production

Equipment; or,

(ii) abandon the Equipment in place; or,

(iii) continue this Agreement until the expiration of

the term hereof and then extend the term of this

Agreement for such additional period(s) and payment

terms as the parties may agree upon; or,

(iv) [g]ive the Customer the option of purchasing all

(but not less than all) of the Equipment at a mutually

agreed upon price.

6

(MESA § 8.3, App. at 304). If Duke elected to exercise

option (I), it was bound to “be responsible for all costs and

expenses in removing such Equipment, including costs to

repair any damage to [Pillowtex’s] Facility caused by such

removal.” (Id.)2 Despite the existence of the option for Duke

to repossess the equipment, Pillowtex’s Vice President for

Engineering, Michael Abba, testified that in his

understanding, there was no chance of that option being

exercised:

It was clearly my understanding that Duke would

abandon the Lighting Fixtures and the Wastewater

System at the conclusion of the MESA and in fact

statements were made to me by Duke sales personnel

to that effect. Moreover, because the energy projects

were of no economic benefit to Pillowtex until the end

of the term when Pillowtex would reap the energy

savings going forward, I would not have signed off on

the projects if the Lighting Fixtures and Wastewater

System were not to be abandoned. I also believe that,

based on the prohibitive cost of removing and replacing

the Lighting Fixtures and the Wastewater System for

Pillowtex, Duke [had] no choice but to abandon the

Lighting Fixtures and the Wastewater System at the

end of the term of the MESA.

Abba Affidavit at ¶ 6 (App. at 155).

After Duke and Pillowtex executed the MESA, Duke

entered into a Master Lease Agreement (“Master Lease”)

with General Electric Capital Corporation (“GECC”), dated

August 2, 1999, pursuant to which GECC agreed to finance

the lighting fixtures for four of the nine Pillowtex facilities

in which Duke was to install new fixtures pursuant to the

MESA. Concurrently with the execution of the Master Lease

and the execution of an equipment schedule listing lighting

fixtures subject to the Master Lease, Duke and GECC

entered into a Collateral Assignment Agreement through

which Duke granted GECC a security interest in all of

Duke’s rights and interests in the MESA, including Duke’s

2. In the event of a default by Pillowtex, Duke would have the right to

remove the equipment at Pillowtex’s expense, without being obligated to

replace it, and could terminate the MESA. (MESA § 13.2, App. at 309).

7

right to payment under the MESA, as security for Duke’s

obligations under the Master Lease. Also, in connection

with the Master Lease transaction, Pillowtex executed an

Acknowledgment Letter which provides that its interest in

the MESA and equipment covered by it “is subject and

subordinate to [GECC’s] rights under . . . the Master Lease

Agreement . . . between GECC and Duke.” (App. at 749).

Shortly after Duke and GECC entered into the Master

Lease, on August 12, 1999, GECC and SouthTrust Bank

executed a Master Assignment Agreement, pursuant to

which GECC assigned all of its rights and interests in the

Master Lease and the Collateral Assignment it had with

Duke, as well as the MESA and certain other documents, to

SouthTrust. Therefore, with respect to the lighting fixtures,

SouthTrust holds the rights and interests under the MESA

for the lighting fixtures at four of Pillowtex’s facilities and

Duke holds the rights and interests under the MESA for the

lighting fixtures at the other five facilities.

On November 14, 2000, Pillowtex and certain of its

subsidiaries filed petitions for relief under Chapter 11 of the

Bankruptcy Code. Thereafter, Pillowtex stopped making

payments due under the MESA. On February 21, 2002,

Duke filed a motion under section 365(d)(10) of the

Bankruptcy Code to compel Pillowtex to make lease

payments on the equipment it had provided to Pillowtex

under the MESA. Section 365(d)(10) requires debtors-in-

possession, such as Pillowtex, to “timely perform all of the

obligations of the debtor . . . first arising from or after 60

days after the order for relief in a case under Chapter 11

. . . under an unexpired lease of personal property . . . until

such lease is assumed or rejected . . . .” 11 U.S.C.

§ 365(d)(10).3 In response to Duke’s motion, Pillowtex filed

3. Although § 365(d)(10) refers to the obligation of a trustee to make lease

payments, its provisions apply to Pillowtex because the Bankruptcy Code

provides that debtors-in-possession, such as Pillowtex, are to perform all

of the functions and duties of a Chapter 11 trustee. See 11 U.S.C.

§ 1107(a).

In addition to seeking an order compelling Pillowtex to make lease

payments, Duke sought an order requiring Pillowtex to provide adequate

protection of its interest in the equipment pursuant to 11 U.S.C. § 363(e)

8

an objection in which it argued that Duke was not entitled

to payment of post-petition monthly obligations, which

Pillowtex represented amounted to $1.8 million, because

the MESA was not a true lease. After a hearing on the

matter, the District Court, sitting in Bankruptcy, denied

Duke’s motion.4 Duke timely appealed.

II. Jurisdiction and Standard of Review

The District Court had subject matter jurisdiction over

Duke’s motion to compel pursuant to 28 U.S.C. § 1334(a),

which provides district courts with subject matter

jurisdiction over bankruptcy cases.5 This Court has

jurisdiction to review the District Court’s order of June 4,

2002 pursuant to 28 U.S.C. § 1291.

Our standard of review over the District Court’s

bankruptcy decision is the same as that exercised by the

District Court. E.g., In re Woskob, 305 F.3d 177, 181 (3d

Cir. 2002). Accordingly, we review the Bankruptcy Court’s

findings of fact for clear error and exercise plenary review

over the Bankruptcy Court’s legal determinations. Id.

III. Analysis

Whether an agreement is a true lease or a secured

financing arrangement under the Bankruptcy Code is a

question of state law. In re Continental Airlines, Inc., 932

or, in the alternative, relief from the automatic stay in order to pursue

its state law remedies to recover possession of the equipment. Section

363(e) mandates that adequate protection be provided to entities which

have an interest in property used by the trustee or debtor-in-possession

and “applies to property that is subject to any unexpired lease of

personal property.” See 11 U.S.C. § 363(e).

4. In the same order, the District Court also denied a similar motion filed

earlier in the course of the bankruptcy proceedings by SouthTrust. We

review the decision below only insofar as it pertains to Duke because

SouthTrust did not appeal the District Court’s order.

5. The District Court exercised its original jurisdiction over bankruptcy

cases, as opposed to its appellate jurisdiction over appeals from

bankruptcy courts.

9

F.2d 282, 294 (3d Cir. 1991) (citing H.R. Rep. No. 95-595,

at 314 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6271).

In this case, the parties agreed that the MESA would be

interpreted, performed, and enforced in accordance with the

laws of the State of New York. (MESA, Appendix A, § 17.7).

Accordingly, we turn to New York law in order to resolve

whether the MESA constitutes a secured financing

arrangement or a lease. Under New York law, because

Pillowtex is seeking to characterize the MESA as a secured

financing arrangement rather than a lease, Pillowtex bears

the burden of proof on that issue. In re Owen, 221 B.R. 56,

60 (Bankr. N.D.N.Y. 1998).6

Article 2A of the New York Uniform Commercial Code

explains that a lease is “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.” N.Y. U.C.C. § 2-A-103(1)(j) (McKinney 2002).

Thus, the definition of a lease expressly excludes security

interests. The exclusion of security interests from the

definition of a lease requires that we turn to the U.C.C.

definition of a security interest.7

6. Pillowtex argues that Duke should bear the burden of proof because

it was Duke that sought relief on the theory that the MESA is a lease.

Pillowtex asserts that Owen is distinguishable because, whereas the

agreement at issue in Owen was labeled a lease and identified the

parties as lessee and lessor, the MESA does neither and therefore does

not purport to be a lease. Pillowtex maintains that its argument does not

recharacterize the MESA and it should not, therefore, bear the burden of

proof. We disagree. Although the MESA is not labeled a lease and does

not identify the parties as lessee and lessor, Pillowtex conceded at oral

argument before the District Court that the parties structured the MESA

to have the characteristics of a lease for tax purposes and were trying to

the extent they could to create a true lease. While we ultimately conclude

that the intent of the parties and the structure of the MESA are not

dispositive as to whether a transaction created a lease or a secured

financing arrangement, the intent of the parties and structure of the

MESA indicate that it is Pillowtex which is seeking to recharacterize the

MESA as something other than what it purports to be and, therefore,

Pillowtex bears the burden of proof.

7. See U.C.C. § 1-201(37), Official Cmt. (“Lease is defined in Article 2A as

a transfer of the right to possession and use of goods for a term, in

return for consideration. Section 2A-103(1)(j). The definition continues by

stating that the retention or creation of a security interest is not a lease.

Thus, the task of sharpening the line between true leases and security

interests disguised as leases continues to be a function of this section”).

10

Section 1-201(37) of the U.C.C. provides that a security

interest “means an interest in personal property or fixtures

which secures payment or performance of an obligation.”

N.Y. U.C.C. § 1-201(37). After defining the term “security

interest,” section 1-201(37) sets out a test for determining

whether a transaction creates a lease or a security interest.

Section 1-201(37) begins by noting that whether a

transaction creates a lease or a security interest is to be

determined on a case-by-case basis. After indicating that

courts are to examine the facts of each case in order to

characterize a transaction, the statute sets out a bright-line

test, sometimes referred to as a per se rule, for determining

whether a transaction creates a security interest as a

matter of law. Specifically, section 1-201(37) provides:

(a) Whether a transaction creates a lease or security

interest is determined by the facts of each case;

however, 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:

(I) the original term of the lease is equal to or

greater than the remaining economic life of the

goods,

(ii) 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 goods,

(iii) 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

agreement, or

(iv) 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.

N.Y. U.C.C. § 1-201(37) (emphasis added). Thus, under the

two-part test set out in New York’s U.C.C., if Pillowtex did

not have the right to terminate the MESA prior to the end

11

of its term, and any of the four factors set out in section 1-

201(37)(a)(I)-(iv) are met, then the MESA would be

considered to create a security interest as a matter of law.

See In re Owen, 221 B.R. at 60-61. If, on the other hand,

it is determined that “the transaction is not a disguised

security agreement per se, [we] must then look at the

specific facts of the case to determine whether the

economics of the transaction suggest such a result.” In re

Taylor, 209 B.R. 482, 484 (Bankr. S.D. Ill. 1997) (citation

omitted). See also In re Murray, 191 B.R. 309 (Bankr. E.D.

Pa. 1996); In re American Steel Prod., 203 B.R. 504, 506-07

(Bankr. S.D. Ga. 1996) (describing the standards for

determining whether a disguised security arrangement

exists).8 In this case, the District Court went directly to the

economic realities of the transaction memorialized in the

MESA. In doing so the Court seems to have implicitly held

that the MESA was not a disguised security agreement

under the bright-line test of section 1-201(37). We agree.

On appeal, Pillowtex argues that the MESA is a secured

financing agreement both under this bright-line test and

also based on the economics of the MESA transaction.

Specifically, Pillowtex argues that the second and fourth

factors set out in the second part of the statutory two-part

test are present: (1) that at the end of the MESA’s term

Pillowtex was bound to become the owner of the energy

fixtures and (2) that it was bound to become the owner of

the fixtures for no or nominal additional consideration

upon compliance with the terms of the MESA. Duke

concedes that the first part of the two-part test is satisfied:

that the MESA prohibits Pillowtex from terminating its

obligation to pay Duke the full cost of the energy fixtures

before the termination of the MESA’s term. However, Duke

maintains that none of the four factors in section 1-

201(37)(a)(I)-(iv) are present. These factors are hereafter

referred to as “residual value factors” because they relate to

8. Because N.Y. U.C.C. § 1-201(37) is based on the Uniform Commercial

Code, decisions from other jurisdictions interpreting this same uniform

statute are instructive. See, e.g., In re Edison Bros. Stores, Inc., 207 B.R.

801, 809 n.7 (Bankr. D. Del. 1997) (applying the reasoning of cases from

a variety of jurisdictions to analysis of N.Y. U.C.C. § 1-201(37)); In re

Owen, 221 B.R. at 61 n.6.

12

whether residual value will remain for the purported lessor,

Duke, at the end of the term of the MESA. See E. Carolyn

Hochstadter Dicker and John P. Campo, FF&E and the True

Lease Question: Article 2A and Accompanying Amendments

to UCC Section 1-201(37), 7 Am. Bankr. Inst. L. Rev. 517,

552 (1999).

As an initial matter, we note that the first and third

residual value factors are not satisfied. The first factor is

whether “the original term of the lease is equal to or greater

than the remaining economic life of the goods.” N.Y. U.C.C.

§ 1-201(37)(a)(I). Here, the term of the MESA is eight years

and Pillowtex concedes that the expected useful life of the

equipment is 20-25 years. Thus, the economic life of the

equipment exceeds the term of the MESA by a factor of

three and the first residual value factor set out in section

1-201(37) is not met. The third factor indicative of a

security interest is met where “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 agreement.”

N.Y. U.C.C. § 1-201(37)(a)(iii). This factor is not met because

the terms of the MESA do not give Pillowtex the option to

renew the lease for the remaining life of the equipment for

no or nominal consideration.

As to the second factor, Pillowtex argues that it was

bound, if not formally then in a de facto sense, to become

the owner of the energy fixtures because the only way that

the fixtures would be removed from Pillowtex’s facilities is

if Duke paid millions of dollars to acquire and install

replacements. Along the same lines, Pillowtex argues with

respect to the fourth residual value factor that, although

the MESA does not expressly give it the option to become

the owner of the energy fixtures for no or nominal

consideration, in effect it has this option because it can

compel Duke to abandon the energy fixtures by refusing to

negotiate an extension of the MESA or a purchase of the

energy fixtures at the end of the MESA’s term.

We agree with Duke that neither the second nor the

fourth residual value factors are present here because

Pillowtex is not contractually bound to become the owner of

the energy fixtures, nor does the MESA provide Pillowtex

13

with the option to become the owner of the energy fixtures

for no or nominal consideration. Rather, the existing

options as to how to proceed at the end of the term of the

MESA were to be exercised only by Duke. Pillowtex provides

no authority for the proposition that a de facto arrangement

is enough to satisfy the requirements of section 1-

201(37)(ii) and (iv). If anything, the relevant caselaw points

us to the opposite conclusion. See Edison Bros., 207 B.R.

at 810 (“If the lease agreement explicitly provides that the

lessee has an option to purchase the leased goods for

nominal consideration (e.g., for $1), the agreement is

presumed to be a disguised security agreement”) (emphasis

added). Accordingly, we conclude that none of the four

residual value factors set forth in N.Y. U.C.C. § 1-

201(37)(a)(I)-(iv) are met.

The parties agree that, where none of the four factors set

out in section 1-201(37) are present, courts are to consider

the economic reality of the transaction in order to

determine, based on the particular facts of the case,

whether the transaction is more fairly characterized as a

lease or a secured financing arrangement. They also agree

that the District Court applied the correct standard for

evaluating the economic reality of their transaction. As the

District Court explained:

Under relevant case law, courts will look to various

factors in evaluating the “economic reality of the

transaction . . . in determining whether there has been

a sale or a true lease,” Pactel Fin. v. D.C. Marine Serv.

Corp., 518 N.Y.S.2d 317, 318 (N.Y. Dist. Ct. 1987),

including the following: “[a] whether the purchase

option is nominal; [b] whether the lessee is required to

make aggregate rental payments having a present

value equaling or exceeding the original cost of the

leased property; and [c] whether the lease term covers

the total useful life of the equipment.” In re Edison

Bros. Store, Inc., 207 B.R. 801, 809-10 and n.8, 9, 10

(Bankr. D. Del. 1997). See also [N.Y. U.C.C.] § 1-

201(37) (McKinney Supp. 1996). “In this regard, courts

are required to examine the intent of the parties and

the facts and circumstances which existed at the time

the transaction was entered into.” In re Edison, 207

B.R. at 809.

14

In re Pillowtex, Inc. et al., Nos. 00-4211 to 00-4234, slip op.

at 5-6 (Bankr. D. Del. June 4, 2002) (“Dist. Ct. Op.”)

(footnote omitted). The District Court found that the MESA

was substantively better characterized as a security

agreement than a true lease because the second Edison

Bros. factor clearly weighed in Pillowtex’s favor, and the first

and third factors were largely neutral. We agree with the

District Court’s conclusion in this regard.

Specifically, with respect to the second factor, Duke

concedes that the aggregate rental payments owing by

Pillowtex under the MESA had a present value equal to or

exceeding the cost of the energy fixtures. The Edison Bros.

court cogently explained the importance of such a fact in

showing the existence of a security agreement:

The rationale behind this second factor is that if the

alleged lessee is obligated to pay the lessor a sum

equal to or greater than the full purchase price of the

leased goods plus an interest charge over the term of

the alleged lease agreement, a sale is likely to have

been intended since what the lessor will receive is more

than a payment for the use of the leased goods and

loss of their value; the lessor will receive a

consideration that would amount to a return on its

investment.

Edison Bros., 207 B.R. at 814 (quoted in Owen, 221 B.R. at

61-62). Applying that logic to this case, Duke has already

been well-compensated for the transferral of the lighting

fixtures to Pillowtex, undercutting the proposition that the

fixtures were merely leased.

Like the District Court, we are unpersuaded by Duke’s

attempt to rely on the first and third Edison Bros. factors.

With respect to the first factor, Duke points out that the

MESA provides that it “has the option to . . . give [Pillowtex]

the option of purchasing all (but not less than all) of the

Equipment at a mutually agreed price.” App. at 304

(emphasis added). Based on this provision of the MESA,

Duke asserts that “Pillowtex does not have the option to

purchase the Equipment unless Duke offers it such option,

and even then only if Pillowtex agrees on a satisfactory

price with Duke.” Duke’s Br. at 21. Duke concludes that,

15

therefore, the first economic realities factor weighs in favor

of a finding that the MESA is a lease. We agree, however,

with Pillowtex’s contention that, although the MESA

nominally required Pillowtex to bargain for an option price,

Pillowtex could essentially ensure a nominal option price by

refusing to bargain. This refusal would “effectively compel

Duke to abandon the [e]nergy [f]ixtures to avoid the

exorbitant expense of acquiring and installing

replacements.” Pillowtex’s Br. at 28. Thus, as an economic

reality the option price at the end of the MESA was illusory,

nullifying the weight of this factor.

With respect to the third factor, Duke observes that the

useful life of the energy fixtures is longer than the term of

the MESA, and cites to Edison Bros. for the proposition that

the long life of the fixtures is indicative of a true lease. In

relevant part, the Edison Bros. court explained that:

An essential characteristic of a true lease is that there

be something of value to return to the lessor after the

term. Where the term of the lease is substantially equal

to the life of the lease property such that there will be

nothing of value to return at the end of the lease, the

transaction is in essence a sale. Conversely, if the

lessor expected a remaining useful life after the

expiration of the lease term, it can be reasonably

inferred that it expected to retain substantial residual

value in the leased property at the end of the lease

term and that it therefore intended to create a true

lease.

207 B.R. at 818 (citations omitted). We agree that under

certain circumstances, the fact that transferred goods have

a useful life extending beyond the term of the transferring

agreement could reveal the transferor’s expectation of

retaining residual value in those goods. Such an inference

would only be proper, however, where the evidence showed

a plausible intent by the transferor to repossess the goods.

The economic realities of the particular transaction in

this case belie any such intent. Although the useful life of

the lighting fixtures is 20-25 years, eclipsing the MESA’s 8-

year term, it would be unreasonable for Duke to incur the

high costs necessary to repossess the fixtures: namely, the

16

costs associated with removing, scrapping, and replacing

the fixtures. Also, the uncontroverted evidence in this case

establishes that there is little (if any) market value for used

lighting fixtures.9 In short, it would have made no economic

sense for Duke to spend large amounts of money to reclaim

the fixtures, especially in the face of poor resale prospects.

We therefore conclude that the District Court did not err by

discounting the significance of the useful life of the lighting

fixtures as compared to the length of the MESA when

conducting its analysis of the economic realities of the

transaction underlying the MESA. On balance, then,

applying the three Edison Bros. factors to this case leads us

to conclude that the MESA was not a true lease.

Beyond reiterating its arguments on the three factors,

Duke argues that (1) the mutual subjective intent of the

parties was to structure the MESA as a lease; (2) Pillowtex’s

accounting for the MESA payments as a utility expense is

evidence that it did not treat the MESA as a repayment of

9. During the course of the hearing held by the District Court on

SouthTrust’s motion to compel, counsel for Pillowtex called James

Klemic to the stand to testify as an “expert in the used building

materials market.” App. at 85. Klemic detailed for the Court the

processes and costs associated with removing and reselling lighting

fixtures as follows:

We would have to carefully remove the lighting fixtures where they

would have to be wrapped, brought down wrapped, stored,

transferred to a storage place. The cost would probably be, it’s

speculative, but it would be somewhere maybe $30-$40 a fixture

perhaps, ultimately, depending on how long you had to keep them

to sell them, if you could find a market. And again, I’ve been

universally told there is no market, with very minor exception [sic].

Q. And that has been your experience as well?

A. That has been my experience for 17 years, and it’s been the

experience of major wrecking companies that have been in the

business much longer than I have.

Q. Have you actually looked at the lighting fixtures in the debtors’

plants?

A. Yes.

App. at 89-90.

17

debt incurred to purchase the energy fixtures; (3) it is of no

consequence that the MESA is not labeled a lease; and (4)

Duke maintained a meaningful reversionary interest in the

fixtures at the end of the MESA’s term. None of these

arguments is persuasive to us.

First, Duke argues that the District Court erred by failing

to analyze the intent of the parties. Duke asserts that the

record shows that the parties structured the MESA so that

it would qualify as a lease under relevant accounting

standards. That way, Pillowtex would not reduce the

amount of credit available to it under its senior credit

facility. Duke also cites a statement that counsel for

Pillowtex made to the District Court, which Duke

characterizes as a concession: “I don’t disagree that it was

structured to have that, those characteristics for tax

purposes and, you know, to the extent that they could, the

parties were trying to create a lease, I would admit that.”

App. at 117.

Duke’s intent argument fails, however, because the New

York U.C.C. no longer looks to the intent of the drafting

parties to determine whether a transfer is a lease or a

security agreement. Specifically, the 1992 version of § 1-

201(37) directed courts to determine “[w]hether a lease is

intended as security” (emphasis added); this language was

amended in 1995 to read “[w]hether a transaction creates a

lease or security interest” (emphasis added). In this way,

the reference to parties’ intent was explicitly omitted. The

Official Comment to the amended version confirms the

importance of the changed language:

Prior to this amendment, [s]ection 1-201(37) provided

that whether a lease was intended as security (i.e., a

security interest disguised as a lease) was to be

determined from the facts of each case . . . Reference

to the intent of the parties to create a lease or security

agreement has led to unfortunate results. In

discovering intent, courts have relied upon factors that

were thought to be more consistent with sales or loans

than leases. Most of these criteria, however, are as

applicable to true leases as to security interests . . .

Accordingly, amended section 1-201(37) deletes all

references to the parties’ intent.

18

U.C.C. § 1-201(37), Official Cmt; accord In re Murray, 191

B.R. at 314 (stating that “judicial opinions construing

U.C.C. § 1-201(37) and the Official Uniform Commercial

Code Comments . . . clearly place the focus of the inquiry

under the revised statute on the economics of the

transaction rather than on the intent of the parties as had

been the emphasis previously”).

Duke relies on Edison Bros., 207 B.R. at 809, for the

proposition that “[c]ourts are required to examine the intent

of the parties and the facts and circumstances which

existed at the time the transaction was entered into.”

Edison Bros., however, explicitly relied on the 1992 version

of the statute in looking at intent, and therefore has been

superseded by the 1995 version of the U.C.C. Indeed,

Judge Walsh, the author of Edison Bros., noted in a later

opinion: “I am persuaded by th[e] clear weight of authority

that the intent of the parties, no matter how clearly spelled

out in the parties’ representations within the agreement,

can not control the issue of whether the agreement

constitutes a true lease or a security agreement.” In re

Homeplace Stores, 228 B.R. 88, 94 (Bankr. D. Del. 1998).

Judge Walsh observed that the shift away from intent had

been remarked upon by various commentators. Id. (citing

Richard L. Barnes, Distinguishing Sales and Leases: A

Primer on the Scope and Purpose of UCC Article 2A, 25 U.

Mem. L. Rev. 873, 882 (1995) (“What had been a test of

intention has become a test of economic realities; that is,

intention has been dropped from section 1-201(37). . .

Thus, the parties to a transaction may create a secured

transaction under the revised definition even though their

every intention was to create a lease”)).

Based on the foregoing authority, we are unwilling to

characterize the MESA as a lease on the basis that the

parties intended it to appear to be one for tax purposes.

Duke admonishes the Court in its brief that “[e]quipment

leasing between sophisticated commercial entities dealing

at arms length for their mutual benefit is an important

commercial activity and one that should not be lightly

recharacterized.” Duke’s Br. at 11. This admonition rings

hollow in the context of bankruptcy cases, however,

because every dollar that is used to pay a purported lessor

19

depletes the pool of assets available to pay other

constituencies of the estate. In other words, refusing to

defer to the intent of contracting parties in resolving

whether their agreement is a lease is particularly

appropriate in bankruptcy, as otherwise the costs of the

agreement would be externalized to third-party creditors.

Duke’s accounting argument is similarly meritless. Duke

argues that the District Court erred by attaching

significance to the fact that Pillowtex did not account for

the energy projects under the MESA as true leases. Duke

argues that Pillowtex’s accounting for the MESA payments

as a utility expense should instead be viewed as evidence

that it did not treat the MESA as a repayment of debt

incurred to purchase the energy fixtures.10 We disagree.

Pillowtex’s accounting for the MESA payments as utility

expenses seems to us to be consistent with the parties’

agreement that Pillowtex’s payments to Duke under the

MESA would be equivalent to Pillowtex’s actual savings.

Moreover, as the District Court noted in its opinion,

Pillowtex “entered into separate Production Equipment

leases, each of which was recorded as a true lease on

Pillowtex’s books.” Dist. Ct. Op. at 6. We agree with the

District Court that it is significant that, while payments for

the energy fixtures were treated as utility expenses by

Pillowtex, the agreements with respect to manufacturing

and production equipment (which are not at issue in this

case) were recorded on Pillowtex’s books as true leases.

This distinction suggests that Pillowtex did not find it

appropriate to record its MESA payments as leases, which

bolsters our conclusion that they were not in fact true

leases.

Next, Duke argues that the District Court erred by taking

into consideration that the MESA was not labeled a lease.

The District Court merely observed in passing, however,

that “[t]he MESA is not labeled a lease,” Dist. Ct. Op. at 9,

and that there is no indication that the court relied heavily

on this observation. Even if it did rely to some extent on

this fact, this reliance was harmless since the economic

10. We express no opinion as to whether this accounting practice

comports with the provisions of the Internal Revenue Code.

20

realities independently dictate that the MESA was in fact

not a lease. Accordingly, we do not believe that the District

Court committed reversible error by mentioning the labeling

of the MESA.

Duke goes on to insist that it had a “meaningful residual

interest” in the fixtures, such an interest being “the

fundamental characteristic distinguishing a lease from a

security interest.” E.g., In re Thummel, 109 B.R. 447, 448

(Bankr. N.D. Okla. 1989). As discussed earlier, however,

Duke only has a nominal residual interest, not a

meaningful one: the combination of the cost of retrieving

the fixtures and their poor market value renders the

residual interest negligible. Duke claims that we should not

“speculate” as to what it might do for economic reasons at

the end of the MESA’s term, and instead look to the parties’

intent at the time of drafting the agreement. As we have

mentioned above, however, Duke’s argument is backwards:

the Court must subordinate the parties’ intent to the

economic reality that Duke would not have plausibly

reclaimed the fixtures at the end of the MESA’s term. This

is not mere speculation on our part. The uncontroverted

evidence shows that removal of the fixtures would be

prohibitively expensive, and that the fixtures’ value on the

market would not make it worth Duke’s while to reclaim

them. In short, the economic realities analysis not only

permits, but requires us to examine the state of affairs at

the end of the MESA’s term.

Finally, Duke asserts that the District Court erred by

characterizing the Master Lease between Duke and

SouthTrust as a secured financing agreement, as opposed

to a lease. The Master Lease applies only to the lighting

fixtures that were SouthTrust’s collateral and SouthTrust

did not elect to appeal the District Court’s order. Therefore,

the District Court’s holding that the Master Lease was a

secured financing is not before us on appeal.

IV. Conclusion

After carefully considering the arguments discussed

above and all other arguments advanced by appellant, we

conclude that the District Court correctly determined that

21

the MESA was not a lease and, therefore, that Duke was

not entitled to lease payments under 11 U.S.C. § 365(10).

We will remand this case to the District Court so that it

may determine whether Duke is entitled to adequate

protection.11

A True Copy:

Teste:

Clerk of the United States Court of Appeals

for the Third Circuit

11. Pillowtex asserts that the District Court denied Duke’s request for

adequate protection under section 363(e) of the Bankruptcy Code.

Pillowtex reasons that “[b]ecause the Duke [m]otion included the request

for adequate protection and the Memorandum Opinion denied the Duke

[m]otion in toto . . . the Memorandum Opinion necessarily denied Duke’s

request for adequate protection.” Pillowtex’s Br. at 10 n.3. Duke

responds that the parties did not present evidence on the adequate

protection issue at either the hearing on SouthTrust’s motion to compel

or on Duke’s motion to compel because the District Court understood

that it would first resolve the lease/secured financing issue and, if it

determined that the MESA was a secured financing, then it would hold

a separate hearing on the adequate protection issue. Duke’s Reply Br. at

12. Additionally, Duke represents to the Court that “[t]he exact value of

the Equipment is the subject of a pending proceeding before the

Delaware Bankruptcy Court pursuant to Duke’s and SouthTrust’s

motion to value the collateral in light of the District Court’s decision that

the MESA was a secured financing.” Id. at 5 n.1. Based on the foregoing,

we believe that the District Court anticipated further proceedings on the

adequate protection issue.