Petition for Writ of Certiorari — HSBC Bank USA v. United Air Lines, Inc. (No. 05-690)

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Text

In re Pillowtex, Inc., 349 F.3d 711 (3d Cir. 2003), and

disagreed with the Second and Ninth Circuits. App. at 12

(citing In re PCH Associates, 804 F.2d 193 (2d Cir. 1993),

and In re Moreggia & Sons, Inc, 852 F.2d 1179 (9th Cir.

1988)).

The court, however, ultimately paid only lip service to

Butner and disregarded governing California law that

forbids recharacterization of agreements in the form of a

lease absent clear and convincing evidence of the parties’

contrary intent. The court reasoned that blur ens of

proof and persuasion are supplied by the forum, not by the

source of substantive law.” App. at 13. This directly con-

tradicts Raleigh v. Illinois Department of Revenue, 530

U.S. 15, 20-21 (2000) (“we have long held the burden of

proof to be a ‘substantive’ aspect of a claim” established by

the source of substantive law that provides the rule of

decision).

The court also held that the Bankruptcy Code pre-

empted California’s statute of limitations for challenges to

government contracts like the Facilities Lease (which had

expired long before United filed its bankruptcy case),

concluding that state procedures do not matter in

bankruptcy.” App. at 17. This contravenes both Butner,

which requires that state law be applied, and Guaranty

Trust Co. v. York, 326 U.S. 99 (1945), which holds that

state statutes of limitation are part of the substantive law

to be applied whenever state law provides the rule of

decision.

Finally, the court altogether ignored the contrary

Eleventh Circuit decision of Jn re Martin Brothers Tool-

makers, Inc., 796 F.2d 1435 (11th Cir. 1986), which re-

jected a challenge very similar to that made by United in

this case. In direct contrast to the opinion below, the

Eleventh Circuit holds that transactions consummated

with the purpose of improving public property (like the

San Francisco airport) and enhancing the public welfare

(as every transaction involving the Authority must) are

not susceptible to judicial second guessing like that sanc-

tioned by the court of appeals here.

. „ *

The court of appeal, decision has far-reaching ramifi-

cations. It improperly extends federal law into areas that

this Court has said are specifically governed by state law,

namely the burden of proof for and statute of limitations

on claims where state law provides the rule of decision.

The decision broadly affects the application of the laws of

all states applied in bankruptcy and other areas where

federal courts are required to respect state law, and it

creates the untenable situation in which federal courts

and state courts purportedly applying the same state-law

rule of decision will reach different results.

The decision also has broad implications for the public

finance markets, potentially impacting billions of dollars

of bonds and extending far beyond the parties to this

litigation. Although the immediate concern to the parties

is that United is now able to remain in possession of

leased airport property without paying rent, the decision

means that United may reap a similar windfall with

respect to its other leases that back hundreds of millions of

dollars of government bonds. Indeed, the same panel that

decided this case already has nullified a United lease at

John F. Kennedy airport in New York, and cases involving

leases at the Los Angeles and Denver International Air-

ports are now pending before that panel. More broadly, the

court has thrown into question the validity of all public

bonds issued with lease revenue structures, thereby

jeopardizing a time-honored method of financing im-

provements of all sorts of public property.

The court of appeals’ disregard of this Court’s prece-

dents requiring the application of state law, the clear

conflicts among the circuits, and the far-reaching implica-

tions of the decision all strongly suggest that review by

this Court is necessary and appropriate.

REASONS FOR GRANTING THE WRIT

There are three primary reasons to grant this Peti-

tion. The first is to enable the Court to resolve an impor-

tant question of bankruptcy law that results in a different

answer (and a different justification for the answer) nearly

every time it is confronted by a lower court. In this case,

the court of appeals took it upon itself to rewrite and

recharacterize a contract in a manner that conflicts with

the original intent of the sophisticated contracting parties.

By so doing, it not only created a new legal test — one

neither briefed nor argued by the parties — it established

an entirely new property right by which a debtor may

occupy property without being either an owner or a ten-

ant. The court’s new doctrine adds to a string of conflict-

ing, confusing opinions (both at the circuit level and lower)

regarding the seemingly straightforward question of which

types of agreements are to be enforced as “leases” in a

bankruptcy case and which law is to be applied to answer

that question.

The second reason for granting the writ is to correct

the court of appeals’ manifest disregard of state law in

violation of the clear mandates of this Court. The court’s

sweeping pronouncements that “[bjurdens of proof and

persuasion are supplied by the forum, not by the source of

substantive law,” and that “[s]tate procedures do not

matter in bankruptcy,” are directly at odds with the

decisions of this Court. The court's error in this regard was

outcome determinative, as it resulted in a purported

application of “state law” (as required by Butner) that

rejected fundamental, substantive components of the

California rule of decision. The district court in fact held in

favor of the petitioners precisely because United had failed

to satisfy its state-law burden of clear and convincing

proof.

The final reason for granting this Petition relates to

the vast implications of the court’s de facto nullification of

a widely-employed method of financing renovations to

airports and other essential public properties. The court’s

decision severely and negatively impacts billions of dollars

of airport lease revenue bonds outstanding in the capital

markets, and is likely to make it more expensive and

difficult to build and improve airports and a wide range of

other public facilities.

I. The Opinion Below Adds Confusion To An Al-

ready Conflicting And Incoherent Body Of Cir-

cuit-Level Precedent Regarding An Important

And Recurring Question Of Bankruptcy Law.

This case involves the meaning of the term “lease of

nonresidential real property.” Section 365(d\3) of the

Bankruptcy Code provides, in relevant part, that a trustee

(or, in a chapter 11 reorganization like this case, the

debtor in possession) “shall timely perform all the obliga-

tions of the debtor .. arising from and after the order for

relief under any unexpired lease of nonresidential real

property.” 11 U.S.C. § 365(d)(3). In contrast, the Code

generally does not require a debtor to perform under other

pre-bankruptcy contracts that govern a debtor’s interests

in property (like a mortgage)

The Code states that “leases of real property shall

include any rental agreement to use real property,” 11

U.S.C. § 365(m), but does not further define the term.

Accordingly, the statutory language must be read consis-

tently with its plain meaning. E. g., United States u. Ron

Pair Enterprises, 489 U.S. 235, 241 (1989) (in bankruptcy,

“where, as here, the statute’s language is plain, the sole

function of the courts is to enforce it according to its

terms”) (quotation omitted).

A “lease” is commonly defined as “a contract granting

the use or occupation of property during a specified period

in exchange for a specified rent.” AMERICAN HERITAGE

DICTIONARY (2d ed. 1985) at 721. There is no question that

the Facilities Lease fits squarely within that definition - it

grants United the right to possess the maintenance facility

for a term of forty years in exchange for the payment of a

specified rent. If United fails to pay that rent, it may be

evicted and the property may be re-leased to another.

This is part of bankruptcy’s set of trade-offs for landlords. On one

hand, a landlord is entitled to ongoing payment of rent during the case

(at least until rejection of the lease). On the other hand, the debtor is

authorized to reject the lease and have the landlord's claim for damages

converted into a general unsecured claim and capped at a maximum of

one year's rent or 15% of the total remaining rent under the lease. 11

U.S.C. $§ 365(g), 502(bX6), 502(g). In comparison, the holder of a

mortgage is not automatically entitled to current payment, but is

entitled to recovery of the full value of its interest in the debtor's

property. 11 U.S.C. § 506

The court of appeals deviated from the plain language

approach and concluded that the term “lease” as used in

the statute is merely a meaningless label. App. at 6

(“lease’ is a label rather than a form”). The court con-

cluded that the Bankruptcy Code honors only what it

called “true leases,” and it thus moved beyond the lan-

guage of the statute (and the agreement negotiated by the

parties) to a determination of whether the Facilities Lease

“functioned” more like a “true lease” or a mortgage. App.

at 8.

In the process, the court of appeals minted a brand

new doctrine. It concluded, without argument from the

parties or citation to relevant precedent, that an inquiry

into whether or not an agreement is a “true lease” de-

pended upon what the court deemed to be the Bankruptcy

Code’s “system of separating financial from economic

distress.” App. at 11. The court held that bankruptcy relief

is available to a debtor in “financial” distress by enabling

the “write down” of a debtor’s pre-bankruptcy obligations,

but only when the debtor is not in “economic” distress and

is able to pay its bills on an ongoing basis. App. at 6-8. The

court concluded that a “true lease” is one that payls]l for

new inputs” by giving the debtor the right to occupy

property it otherwise would not be able to occupy. App. at

7. In contrast, the court held that a lease with rent “that

represents the cost of funds for capital assets for past

production or past operations rather than ongoing inputs

into production has the quality of debt” and therefore is

not a “true lease” under which a debtor must continue to

pay rent. App. at 7. Applying this new “economic” analysis,

the court concluded that the Facilities Lease did not

qualify as a “true lease” under its financial/economic

distress rubric because, in the lease-sublease transaction,

United had used its leasehold interest in the maintenance

facility “to secure an extension of credit” and, as a result,

the Facilities Lease rent did not qualify as payment for

“new inputs.” App. at 16.

The court of appeals committed numerous errors.

First, a financial/economic distress dichotomy is not a

touchstone for a “true lease.” The text of the Bankruptcy

Code makes no reference to or distinction between “finan-

cial distress” and “economic distress” nor, to the petition-

ers’ knowledge, does any reported decision. This Court, on

the other hand, has made it abundantly clear that the

“(ulniform treatment of property interests by both state

and federal courts within a State” is of paramount impor-

tance. Butner, 440 U.S. at 55 (quotation omitted). The

court of appeals violated this fundamental rule by apply-

ing its new, anti-textual analysis to sweep aside property

interests that, as explained in Section II below, clearly

would be enforceable by the petitioners under state law.

The court’s decision is al! the more pernicious as a result

of the distinguished panel that issued it, providing, as it

were, an economic rationalization for future courts to

ignore the dictates of a state’s real property law with

which they do not agree.

This false dichotomy resulted in the first decision to

“recharacterize” a lease in bankruptcy in the absence of

any claim of ownership in the subject property by the

debtor. All of the cases cited by United below involved

“leases” that provided the debtor-“lessee” with an option to

purchase “leased” property for a nominal amount, or that

had a lease term that extended for the total useful life of

the property. Those agreements, while in the form of a

lease, were held to represent transactions in which the

debtor in substance owned or would entirely consume the

property.’ Until the court of appeals’ decision in this case,

courts enforced leases absent such a determination that

the debtor actually owned the “leased” property. This

makes sense because debtors, like others, can occupy

property in only one of two ways - they can own it or rent

it. Under the court of appeals’ new doctrine, debtors like

United may stay in possession of property that they do not

own or lease, without paying anything for the privilege.

This is as unprecedented as it is unfair

More importantly for purposes of this Petition is the

fact that other courts have looked at this issue in com-

pletely different ways, reaching different conclusions with

different rationales. The Ninth Circuit, for example, holds

that state law is irrelevant to the question of whether an

See, eg. In re PCH Associates, 804 F.2d 193 (2d Cir. 1986)

(“lease” that separated a hotel from the underlying land on which it was

built, with a total term of 165 years (more than the useful life of the

leased structure)); /nternational Trade Administration v. Rensselaer

Polytechnic Institute, 936 F.2d 744 (2d Cir. 1991) (“lease” with a 99-year

term, with all “rent” paid in the first 3 years); In re Moreggia & Sons,

Inc., 852 F.2d 1179 (Sth Cir. 1988) (“lease” where all rent was prepaid

with a thirty-year term remaining and with no remaining rights to evict

and re-let).

* The legislative history of the Bankruptcy Code confirms that

ownership is a key consideration in the lease/financing analysis. The

legislative history states that the statutory term “lease of real property”

is to apply “only to a ‘true’ or ‘bona fide’ lease and not... to financ-

ing leases of real property.” S. Rep. 95-989 (1978), at 64. It goes on to

state, however, that “lease financing” transactions are those “where, in

substance, the ‘lease’ involves a sale of the real estate and the rental

payments are in substance the payment of principal and interest on a

secured loan or sale.” Jd. Congress used the term “financing lease”

(which never appears in the text of the Bankruptcy Code itself) as the

common shorthand description of a transaction in which the “lessee”

finances its purchase of the “leased” property, not as a description of

every lease executed as part of a financing transaction.

agreement is a lease for purposes of the Bankruptcy Code,

and that the key question is whether the parties intended

to create an “ordinary landlord/tenant relationship.”

Moreggia, 852 F.2d at 1182-86. The Second Circuit appears

to apply an amalgam of state and federal law in an effort

to answer the ultimate question of whether the “economic

substance” of the transaction is that of a “true lease.” PCH

Associates, 804 F.2d at 196-201. The Third Circuit holds

that state law governs exclusively. In re Pillowtex, Inc.,

349 F.3d 711, 716 (3d Cir. 2003).

The Eleventh Circuit, meanwhile, completely rejects

the notion that a court can cast aside the form of agree-

ment negotiated by a governmental entity, at least where

the transaction at issue was not consummated solely for

the benefit of private parties but instead in furtherance of

broader interests like the improvement of public property.

The Eleventh Circuit holds that “[t}he application of

bankruptcy principles in this context would be particularly

inappropriate, because such principles are developed in

the context of only two competing private interests, and in

this case we have a third, public, interest.” Martin Broth-

ers, 796 F.2d at 1440.

Moreover, the Seventh Circuit is now in conflict with

itself as a result of the court’s opinion in this case. In Jn re

Kassuba, 562 F.2d 511 (7th Cir. 1977), a case not cited in

the decision below, the Seventh Circuit rejected an “eco-

nomic substance” analysis in favor of an inquiry based

upon the intent of the parties, concluding that the lease

portion of a sale-leasebeck transaction was a “true lease”

for bankruptcy purposes: “[T]he parties by contract may

create a set of mutual economic benefits that is similar to

a mortgage without conferring on each other the rights

and liabilities of judicial foreclosure, if that is what they

actually intend. The substance of the transaction that a

court of equity will examine is not its economic effect,

which the parties determine by their agreement, but

instead it is what their agreement is.” Jd. at 514.°

Finally, when this Court last addressed the “true

lease” issue (in the tax context), it applied an analysis

completely at odds with the decision below:

Wie hold that where, as here, there is a genuine

multiple-party transaction with economic sub-

stance which is compelled or encouraged by

business or regulatory realities, is imbued with

tax-independent considerations,’ and is not

shaped solely by tax-avoidance features that

have meaningless labels attached, the Govern-

ment should honor the allocation of rights and

duties effectuated by the parties.

Frank Lyon Co. v. U.S., 435 U.S. 561, 583-84 (1978)

(emphasis added).

The lower courts are in similar disarray. Compare In re Omne

Partners II, 67 B.R. 793 (Bankr. DN. H. 1986) (“bankruptcy judges [do

not] have a warrant from Congress to run roughshod over the economic

landscape recharacterizing commercial transactions entered into by

sophisticated parties - restating them in terms of their ‘economic

substance’ contrary to their negotiated and agreed form — in the

absence of some triggering factor permitting such recharacterization”);

with In re Petroleum Prods., 72 B. R. 739 (Bankr. D. Kan. 1987) (follow-

ing state law to hold that agreement is a lease even though, in court's

view, the “economic realities” of the agreement were that of a mort-

gage); with In re Barney’s, Inc., 206 B. R. 328 (Bankr. S. D. N. v. 1997) (it

is not appropriate to recharacterize a lease without consideration of

extrinsic evidence); with In re Hotel Syracuse, Inc., 155 B.R. 824 (Bankr.

N. D. N. V. 1993) (refusing to follow state law and concluding, from the

face of the documents, that an agreement was not a lease).

Thus, the courts have created conflicting rules to

apply when a debtor files for bankruptcy and claims that

an agreement it signed before bankruptcy is not enforce-

able as a lease even though it is called a lease, is in the

form of a lease, and has the normal attributes of a lease.

The outcome of any such challenge is likely to turn not on

established state law property rights (as it should) but

instead on the location of the bankruptcy court (or even

the predilections of the bankruptcy judge).

This arbitrariness is contrary to the uniform applica-

tion of state law mandated by the Court in Butner:

Property interests are created and defined by

state law. Unless some federal interest requires a

different result, there is no reason why such in-

terests should be analyzed differently simply be-

cause an interested party is involved in a

bankruptcy proceeding. Uniform treatment of

property interests by both state and federal

courts within a State serves to reduce uncer-

tainty, discourage forum shopping, and to pre-

vent a party from receiving a windfall merely by

reason of the happenstance of bankruptcy.

Butner, 440 U.S. at 55 (quotation omitted). As things now

stand, there is no “uniform treatment” of leases among the

circuits. This results in precisely that which Butner

condemned: it fosters uncertainty, encourages forum

shopping, and enables debtors like United to receive a

windfall “merely by reason of the happenstance of bank-

ruptcy.”

The Court should clarify and resolve this important

issue.

II. The Court’s Failure To Appiy The State Burden

Of Proof And Statute Of Limitations Contra-

venes Butrer u. United States, Raleigh v. Ni-

nois Department Of Revenue, And Guaranty

Trust Co. v. York.

As noted above, this Court long ago established that,

in bankruptcy, “property interests are created and defined

by state law.” Butner, 440 U.S. at 55; accord, e.g., Barnhill

b. Johnson, 503 U.S. 393, 398 (1992).

The court of appeals noted the Bankruptcy Code’s

silence as to the definition of a lease and correctly held

that state law governs the question of whether or not an

agreement is a “true lease”: “Leases are state-law instru-

ments, after all, and the norm in bankruptcy law is that

contracts (of which leases are a species) and property rights

in general have the same force they would have in state

court, unless the Code overrides the state entitlerrent.” App.

at 11 (emphasis added). Thus, it held that California law,

which the parties chose in the Facilities Lease to apply,

provided the rule of decision. Instead of applying Califor-

nia law, however, the court then proceeded to replace the

California rule with ite own irterpretation of federal law

based upon its unique theory of the economics of a “true

lease.” While interesting, this economic analysis has no

bearing on governing California law and, under Butner,

has no proper place in the analysis.

The State Burden of Proof. First, the court refused

to enforce California's burden of proof. The rule in Califor-

nia is unambiguous: a debtor has the burden of proving, by

clear and convincing evidence, that an agreement in the

form of a lease is actually a mortgage or financing device.

As the California Supreme Court held in a “sale-leaseback”

case cited and discussed at length (in other respects) by

the court of appeals:

It is without doubt the law, as repeatedly de-

clared in our decisions, that clear and convincing

evidence is required to justify a court in finding

that a deed which purports to convey land abso-

lutely in fee simple was intended to be a mort-

gage. That a deed purporting on its face to

convey the title absolutely may be shown by pa-

rol evidence to be something else - namely, a

mortgage — is a striking exception to the general

rule, and it has been universally held that the

character of the instrument cannot thus be

changed except upon clear and convincing evi-

dence.

Beeler v. American Trust Co., 24 Cal. 2d 1, 7 (1944) (em-

phasis added) (quotation omitted).

The court of appeals purported to wipe away this

established rule in two sentences: “Burdens of proof and

persuasion are supplied by the forum, not by the source of

substantive law. Bankruptcy law uses the preponderance

standard. Grogan v. Garner, 498 U.S. 279 (1991).” App. at

13. Neither is correct.

In Raleigh v. Illinois Department of Revenue, 530 U.S.

15 (2000), the Court held that, when state law provides

the rule of decision in a bankruptcy case, as it does here,

the bankruptcy court must follow and apply the state

burden of proof associated with the state law rule. Raleigh

involved whether a bankruptcy court had to apply the

burden of proof otherwise applicable to Illinois tax claims.

The debtor asserted that the taxing authority bore the

ultimate burden of proof. The taxing authority asserted

that, under state law, the burden was on the debtor and

should continue to apply in a bankruptcy case.

The Court first reiterated the basic principles of

Butner:

The “basic federal rule” in bankruptcy is that

state law governs the substance of claims, But-

ner, supra, at 57, Congress having “generally left

the determination of property rights in the assets

of a bankrupt’s estate to state law.” 440 U.S. at

54 (footnote omitted). “Unless some federal inter-

est requires a different result, there is no reason

why [the state] interests should be analyzed dif-

ferently simply because an interested party is in-

volved in a bankruptcy proceeding.” Id. at 55.

Raleigh, 530 U.S. at 20. The Court concluded that those

principles required the bankruptcy court to apply the

burden of proof that would have been applied had the

claim been litigated in state court:

The scope of the obligation is the issue here. Do

the State’s right and the taxpayer’s obligation in-

clude the burden of proof? Our cases point to an

affirmative answer. Given its importance to the

outcome of cases, we have long held the burden of

proof to be a “substantive” aspect of a claim. That

is, the burden of proof is an essential element of

the claim itself; one who asserts a claim is enti-

tled to the burden of proof that normally comes

with it.

Id. at 20-21 (emphasis added) (citations omitted).

Similarly, Grogan v. Garner, cited by the court of

appeals for the proposition that “(b)ankruptcy law uses the

preponderance standard,” App. at 13, demonstrates the

court's error. Grogan involved a question of whether a

particular debt could be discharged under the Bankruptcy

Code an issue as to which the Code itself, and not state

law, provided the rule of decision. Grogan, 498 U.S. at 283

(“the issue of nondischargeability has been a matter of

federal law governed by the terms of the Bankruptcy

Code”). Because the Code is silent as to the burden of

proof, the Court held that the default civil litigation

“preponderance of the evidence” standard applied. Jd. at

286-90. The Court never held that all questions in bank-

ruptcy are governed by a preponderance standard, or that

the burden of proof somehow always lies with the non-

debtor party. To the contrary, in a precursor to Raleigh, the

Court expressly observed that the validity of a creditor’s

claim is determined by rules of state law.” Jd. at 283.

Thus, unlike the court of appeals’ erroneous refusal to

apply state law in this case, bankruptcy courts regularly

apply clear and convincing standards of proof when

applicable state or other nonbankruptcy law requires it,

which can occur under all states’ laws in a variety of

substantive areas affecting property rights that may be at

issue in a bankruptcy case. This is consistent with the

general rule in the federal courts under Rule 302 of the

Federal Rules of Evidence, which provides that state law

presumptions apply when state law supplies the rule of

decision.

* See, eg, In re Ellis, 324 B.R. 595 (Bankr. M.D. La. 2005) (apply-

ing state law clear and convincing evidence standard regarding

reformation of a mortgage due to alleged mutual mistake); In re

Davenport, 268 BR. 159 (Bankr. N D. III. 2001) (applying state law

clear and convincing evidence standard regarding establishment of

resulting trust); In re Todd, 70 BR. 204 (Bankr ND. Iowa 1986)

(applying state law clear and convincing evidence standard regarding

correction of mortgage amount).

The court of appeals’ error in disregarding this Court’s

holdings and relieving United from its “clear and convinc-

ing” burden was outcome determinative. United submitted

no evidence below. It simply relied on the terms of the

documents. The district court held that this was not a

sufficient showing by United to satisfy its burden under

California law. The petitioners would have prevailed had

the court merely respected the applicable state law rule as

required by this Court’s decisions.

The State Statute of Limitations. The court of

appeals committed another outcome-determinative error

when it held that California’s statute of limitations for

challenges to government contracts like the Facilities

Lease was unenforceable in bankruptcy.

California has a statutory system that provides for

parties who seek to challenge the validity or enforceability

of a government contract to do so within sixty days after

publication of required notices relating to the contract. See

Cal. Civ. P. Code §§ 860-869. No such challenge may be

made after expiration of that period. Jd. § 869.

This statutory system is a statute of limitations.

Friedland v. City of Long Beach, 73 Cal. Rptr. 2d 427, 434

(Cal. Ct. App. 1998). It applies to contracts, like United’s

Facilities Lease with the Authority, that are integrated

components of a municipal bond issuance. Id. at 433-43.

Because no timely challenge was made to the Facilities

Lease, United’s belated, post-bankruptcy action to contest

the nature of the Facilities Lease was barred as a matter

of California law.

The court of appeals, however, refused to recognize the

California statute of limitations, holding, without citation

or analysis, that state procedures do not matter in

bankruptcy.” App. at 17. This is demonstrably false. In

Guaranty Trust Co. v. York, 326 U.S. 99 (1945), the Court

long ago held that state statutes of limitations are a

substantive component of state law and must be applied

by federal courts in cases where state law provides the

rule of decision. The Court framed the question as follows:

And so the question is not whether a statute of

limitations is deemed a matter of “procedure” in

some sense. The question is whether such a stat-

ute concerns merely the manner and the means

by which a right to recover, as recognized by the

State, is enforced, or whether such statutory

limitation is a matter of substance in the aspect

that alone is relevant to our problem, namely,

does it significantly affect the result of a litigation

for a federal court to disregard a law of a State

that would be controlling in an action upon the .

same claim by the same parties in a State court?

Id. at 109 (emphasis added). The Court answered affirma-

tively:

Plainly enough, a statute that would completely

bar recovery in a suit if brought in a State court

bears on a State-created right vitally and not

merely formally or negligibly. As to consequences

that so intimately affect recovery or non-recovery

a federal court in a diversity case should follow

State law. IHF a plea of the statute of limita-

tions would bar recovery in a State court, a fed-

eral court ought not to afford recovery.

Id. at 110 (emphasis added) (citation omitted). The Court

reaffirmed the vitality of this venerable rule as recently as

two years ago. Jinks v. Richiand County, 538 U.S. 456, 465

(2003).

The rule is as true in bankruptcy as it is in diversity

cases. In the Bankruptcy Code, Congress expressly chose

to extend statutes of limitation governing a claim avail-

able to a debtor, but only where the limitations “period has

not expired before the filing of the petition.” 11 U.S.C.

§ 108(a). The Court in fact has observed that a bankruptcy

estate “succeeds to no more or greater causes of action

against third parties than those held by the debtor”

immediately prior to the bankruptcy petition date. United

States v. Whiting Pools, Inc., 462 U.S. 198, 204 n.8 (1983).

Congress likewise observed in the Code's legislative

history: “[The Code] is not intended to expand the debtor’s

rights against others more than they exist at the com-

mencement of the case. For example, if the debtor has a

claim that is barred at the time of the commencement of

the case by the statute of limitations, then the trustee

would not be able to pursue that claim, because he too

would be barred. He could take no greater rights than the

debtor himself had.” S. Rep. 95-989 (1978), at 82 (empha-

sis added).’

As with its disregard of California’s burden of proof,

the court of appeals’ plain error in refusing to enforce the

statue of limitations changed the outcome in this case. If

the court had applied the state statute, the petitioners

would have prevailed. The failure to follow this Court’s

The court of appeals wrongly held that California statute of

limitations was bankruptcy specific and therefore preempted by the

Bankruptcy Code. App. at 17. In fact, the California statute has nothing

to do with bankruptcy law. It applies to all challenges to the validity

and enforceability of a specified category of government agreements.

Those challenges could be and are frequently made outside of bank-

ruptcy, as are challenges to the “true lease” nature of agreements.

decisions is a grievous error worthy of correction by the

Court.

III. The Opinion Below Nullifies An Established

Method Of Funding Improvements Of Public

Property And Has Far-Reaching Negative Con-

sequences.

The context of this case highlights the need for the

Court to articulate a clear, unambiguous rule as to what

constitutes a “lease” for purposes of the Bankruptcy Code.

First, the court of appeals essentially nullified (or at

least made much more expensive) an important mecha-

nism for funding improvements to public property like

airports. For decades, public agencies have used lease

revenue bonds to raise money to renovate and construct

public facilities. Lease revenue bonds involve the lease or

sublease of a portion of public property from a government

agency, coupled with a pledge of the rent payable under

the lease/sublease to the repayment of the bonds. One

fundamental aspect of this structure — and the reason why

it enhances credit ratings and lowers the cost of borrowing

— is the ability of the agency-lessor (or its bond trustee

assignee) to enforce the lease by evicting the lessee and re-

renting the property in the event of nonpayment, just as a

commercial landlord can evict a delinquent tenant and re-

rent office property if rent is not paid.

By concluding that debtors like United can repudiate

or recharacterize the leases that underpin lease revenue

bonds without fear of eviction or other consequences, the

court of appeals may have wiped out an entire category of

municipal financing, one that has been used repeatedly

and extensively in connection with airports and other vital

air transportation facilities. According to the amicus brief

submitted to the bankruptcy court by the Bond Market

Association and the National Federation of Municipal

Analysts:

Recharacterizing the Facilities Leases as “debt”

calls into question the underlying premise of

governmental ownership of the Airport Facilities

financed by the Airport Special Facilities Bonds —

as a matter of the reasonable expectations of the

credit markets, as well as a matter of tax law

and as a matter of economics. The market has re-

lied — not only in the case of United but also in

connection with many other airline special facil-

ity financings involving billions of dollars — on

governmental ownership as a basic premise for

the tax-exempt status of the bonds and for the ba-

sic security structure of the financing. If United

succeeds in its efforts to recharacterize the Lease

Arrangements, United’s position undercuts one

of the most fundamental elements of the care-

fully developed system for airport financing. Ab-

sent the market being able to rely on the

contractual obligations entered into by United

(and other airlines), Airport Special Facility

Bonds will no longer be an economical and effi-

cient tool for the development of air transporta-

tion facilities. To the extent that Airport Special

Facility Bonds can even be brought to market in

an environment where the market can no longer

rely upon the positions being taken by the air-

lines, the market will exact a high cost for taking

on the added risk of those financings. That in-

ability to “tap the market,” or the ability to access

the market only at a high cost, defeats not only

the purpose of Airport Special Facility Bond fi-

nancing, but also threatens the viability of one of

the most heavily utilized development tools for the

air transportation system.

Amicus Curiae Brief Of The Bond Market Association And

The National Federation Of Municipal Analysts Relating

To Debtor’s Motions For Summary Judgment And Cross

Motions For Summary Judgment, at 13 (emphasis added).

These warnings lend particular force to the Eleventh

Circuit’s observation that “the application of bankruptcy

principles in this context [of municipal financing] would be

particularly inappropriate.” Martin Brothers, 796 F.2d at

1440.

Moreover, the court of appeals opened the door to a

potential floodgate of challenges by other airlines. In the

few months following issuance of the court’s opinion, the

nation’s third- and fourth-largest airlines (Delta Air Lines

and Northwest Airlines) filed for bankruptcy in other

districts, and Delta already has initiated challenges

identical to that made by United. Billions of dollars of

airport lease revenue bonds currently are outstanding.

Given the current precarious state of the airline industry,

many of those bonds are now at serious risk of nullifica-

tion as a result of the court’s opinion.

This turn of events, and the opinion’s far-reaching

impact on municipal financing, make this case ripe for

review by the Court. Cf Securities Industry Ass n v. Board

of Governors, 468 U.S. 137, 142 (1984) (granting certiorari

ſblecause of the importance of the issue for the Nation’s

financial markets”).

CONCLUSION

The Petition should be granted to resolve the several

conflicts among the circuits with respect to this irnportant

issue involving the intersection of bankruptcy law, state law,

and municipal financing, and to address the court of appeals’

manifest misapplication of several of this Court’s precedents.

Respectfully submitted,

JAMES O. JOHNSTON

Counsel of Record

HENNIGAN, BENNETT & DORMAN LLP

601 South Figueroa Street, Suite 3300

Los Angeles, California 90017

(213) 694-1200

— and

HAROLD L. KAPLAN

Gary W. GARNER

MARK F. HEBBELN

GARDNER CARTON & DOUGLAS LLP

191 North Wacker Drive, Suite 3700

Chicago, Dlinois 60606

(312) 569-1000

Counsel for Petitioner HSBC

Bank USA, National Association

R. DAL GINTER

DOWNEY BRAND LLP

555 Capitol Mall, Tenth Floor

Sacramento, California 95814

(916) 444-1000

Counsel for Petitioner California

Statewide Communities Authority

App. 1

416 F.3d 609

United States Court of Appeals,

Seventh Circuit.

UNITED AIRLINES, INC., Plaintiff-Appellant,

HSBC BANK USA, N. A., as Trustee, and California

Statewide Communities

Development Authority, Defendants-Appellees.

Nos. 04-4209, 04-4315, 04-4321.

Argued May 5, 2005.

Decided July 26, 2005.

Rehearing and Rehearing

En Banc Denied Aug. 23, 2005.*

Harold L. Kaplan, Gary W. Garner and Mark F.

Hebbeln, Gardner, Carton & Douglas, Chicago, IL, Kirk D.

Dillman, James O. Johnston (argued), Hennigan, Bennett

& Dorman, Los Angeles, CA, for Appellee HSBC Bank

USA, N.A.

R. Dale Ginter, Jamie P Dreher (argued), Downey

Brand, Sacramento, CA, for Appellant.

James H.M. Sprayregen, Marc Kieselstein (argued),

Kirkland & Ellis, Chicago, IL, for Debtor-Appellant.

William P. Smith, McDermott, Will & Emery, Chicago,

IL, for Amicus Curiae, Bank of New York.

Douglas W. Jessop, Jessop & Co., Amicus Curiae, City

of Denver.

Mark E. Abraham, Gould & Ratnet, Chicago, IL, for

Amicus Curiae, U.S. Bank National Association.

* Judge Ripple took no part in the consideration of this matter.

App. 2

David A. Golin, Gesas, Pilati, Gesas & Golin, Chicago,

IL, for Amicus Curiae, Regional Airports Improvement

Corp.

Charles P Schulman, Sachnoff & Weaver, Chicago, IL,

for Amicus Curiae, City of Los Angeles.

Before BAUER, EASTERBROOK, and MANION,

Circuit Judges.

EASTERBROOK, Circuit Judge.

What is a “lease” in federal bankruptcy law? Busi-

nesses that do not pay up front for assets may acquire

them via unsecured debt, secured debt, or lease; in each

event the business pays over time. Similar economic

function implies the ability to draft leases that work like

security agreements, and secured loans that work like

leases. Yet the Bankruptcy Code of 1978 distinguishes

among these devices. A lessee must either assume the

lease and fully perform all of its obligations, or surrender

the property. 11 U.S.C. § 365. A borrower that has given

security, by contrast, may retain the property without

paying the full agreed price. The borrower must pay

enough to give the lender the economic value of the secu-

rity interest; if this is less than the balance due on the

loan, the difference is an unsecured debt. See 11 U.S.C.

§ 506(a) and 5 11296b 2 NA). There are other ways in

which the Code treats leases differently from security

interests, but they don’t matter to today’s dispute.

During the 1990s United Air Lines entered into

complex transactions to obtain money to build or improve

premises at four airports — San Francisco, Los Angeles,

Denver, and John F. Kennedy in New York. For each

airport, a public body issued bonds that, because of the

App. 3

issuer’s status as a unit of state government, paid interest

that is free of federal taxation. The public bodies turned

this money over to United against its promise to retire the

bonds and reimburse administrative costs. At each airport,

United entered into a lease giving the body that had

issued the bonds the right to evict United from operational

facilities if it did not pay.

When United entered bankruptcy in 2002, however, it

took the position that none of these transactions is a

“lease” for purposes of § 365. United proposed to treat each

transaction as a secured loan, so that it could continue

using the airport facilities while paying only a fraction of

the promised “rent.” Chief Bankruptcy Judge Wedoff

concluded that the word “lease” in § 365 — a term not

defined anywhere in the Bankruptcy Code — includes “true

leases” but not transactions where the form of a lease is

used but the substance is that of a security interest.

Applying this approach as a matter of federal law, Judge

Wedoff concluded that the Denver transaction is a true

lease but that the other three are not. Jn re UAL Corp.,

307 B. R. 618 (Bankr. N. D. III. 2004). This meant that United

had to cure the default and resume full payments on its

Denver deal but could reduce its payments on the other

transactions and treat the difference as unsecured debt.

Everyone appealed. The district judge issued four

opinions, one for each airport, and held that al) four

transactions are “true leases.” Two are published: United

Air Lines, Inc. v. HSBC Bank USA, 322 B.R. 347

(N. D. III. 2005) (Denver), and HSBC Bank USA v. United

Air Lines, Inc., 317 B.R. 335 (N. D. III. 2004) (San Fran-

cisco). Relying principally on Butner v. United States, 440

U.S. 48, 99 S.Ct. 914, 59 L.Ed.2d 136 (1979), and In re

Powers, 983 F.2d 88 (7th Cir.1993), Judge Darrah first

App. 4

concluded that state rather than federal law controls the

distinction between security interests and leases. Then,

applying California, Colorado, and New York law, he held

that each transaction must be treated as a “lease.” United

has appealed in all of these adversary actions. The San

Francisco dispute has been fully briefed; the other appeals

are being held for the disposition of this one. Parties to the

Los Angeles, Denver, and New York transactions have

presented their views as amici curiae. We confine our

attention in this opinion to the San Francisco transaction.

Since 1973 United has been the lessee of 128 acres,

used for a maintenance base, at San Francisco Interna-

tional Airport. The lease will end in 2013 unless the

parties negotiate an extension; rent depends on an inde-

pendent party’s estimate of the property’s market value. In

1997 the California Statewide Communities Development

Authority (CSCDA) issued $155 million in bonds itr

United’s benefit. United received the proceeds for use in

improving its facilities at the Airport though not at the

maintenance base. The transaction was accomplished

through four documents.

„ The sublease. United subleases 20 acres of

the 128-acre maintenance base to the CSCDA for

36 years. This term matches the debt-repayment

schedule rather than United’s lease with the Air-

port. The total rent CSCDA pays is $1.

„ The leaseback. The CSCDA leases the 20

acres back to United for a rent (paid to HBSC

Bank as the Indenture Trustee) equal to interest

on the bonds plus an administrative fee. The

lease has a $155 million balloon payment in 2033

to retire the principal. United may postpone final.

payment until 2038; if it does, the sublease also

is extended. United also is entitled to prepay; if it

App. 5

does, the sublease and leaseback terminate. If

United does not pay as agreed, the CSCDA may

evict it from the 20 acres. The leaseback in-

cludes a “hell or high water” clause: United must

pay the promised rent even if its lease from the

Airport ends before 2033, the property is sub-

merged in an earthquake (the Airport abuts San

Francisco Bay), or some other physical or legal

event deprives United of the use or economic

benefit of the maintenance base.

bonds, turns the $155 million over to United

against the promises made in the sublease, and

arranges for the Trustee to receive United’s pay-

ments for distribution to the bondholders. The

bonds are without recourse against the CSCDA.

treasury to repayment of the bonds.

That the sublease and leaseback have the form of

“leases” is unquestioned. But does § 365 use form, or

substance, to distinguish “leases” from secured credit?

Although the statute does not answer that question in

so many words, every appellate court that has considered

the issue holds, and the parties agree, that substance

controls and that only a “true lease” counts as a “lease”

under § 365. See In re PCH Associates, 804 F.2d 193, 198-

200 (2d Cir.1986); In re Pillowtex, Inc., 349 F.3d 711, 716

(3d Cir.2003); In re Moreggia & Sons, Inc., 852 F.2d 1179,

1182-84 (9th Cir. 1988); In re Pacific Express, Inc., 780 F.2d

1482, 1486-87 (9th Cir.1986). See also, e.g., In re Continen-

tal Airlines, Inc., 932 F.2d 282 (3d Cir.1991) (same under

11 U.S.C. § 1110, another part of the Code dealing with

leases). We'll return to what a “true lease” might be; that

term is no more self-defining than the bare word “lease.”

App. 6

Before fleshing out the definition, we explain why we

agree with these decisions, because the reasons for prefer-

ring substance over form affect which substantive features

of the transactions matter.

Whether the word “lease” in a federal statute has a

formal or a substantive connotation is a question of federal

law; it could not be otherwise. See Reves v. Ernst & Young,

494 U.S. 56, 71, 110 S.Ct. 945, 108 L.Ed.2d 47 (1990);

Bryant uv. Yellen, 447 U.S. 352, 370-71 & n. 22, 100 S.Ct.

2232, 65 L.Ed.2d 184 (1980). (Whether federal law incor-

porates state law to answer the questions that result from

this choice is a different issue, to which we turn later. Cf.

United States v. Kimbell Foods, Inc., 440 U.S. 715, 99 S.Ct.

1448, 59 L.Ed.2d 711 (1979).) The Bankruptcy Code

specifies different consequences for leases and secured

loans. If these were formally distinct — in the way that

mergers and asset sales in corporate law are distinct —

then the statutory reference might best be understood as

adopting the established forms. But “lease” is a label

rather than a for. A transaction by which A sells a widget

to B in exchange for periodic payments, with B to own the

asset after the last payment, could be structured as an

installment sale, a loan secured by the asset, or a lease,

with only a few changes in verbiage and none in sub-

stance. It is unlikely that the Code makes big economic

effects turn on the parties’ choice of language rather than

the substance of their transaction; why bother to distin-

guish transactions if these distinctions can be obliterated

at the drafters’ will?

Many provisions in the Code, particularly those that

deal with the treatment of secured credit, are designed to

distinguish financial from economic distress. A firm that

cannot meet its debts as they come due, but has a positive

App. 7

cash flow from current operations, is in financial but not

economic distress. It is carrying toc much debt, which can

be written down in a reorganization. A firm with a nega-

tive cash flow, by contrast, is in economic distress, and

liquidation may be the best option. In order to distinguish

financial from economic distress, the Code effectively

treats the date on which the bankruptcy begins as the

creation of a new firm, unburdened by the debts of its

predecessor. See generally Boston & Maine Corp. v. Chi-

cago Pacific Corp., 785 F.2d 562 (7th Cir.1986). The new

firm must cover all new expenses, while debt attributable

to former operations is adjusted. Section 365, which deals

with leases, classifies payments for retaining airplanes

and occupying business premises as new expenses, just

like payments for labor and jet fuel. The rules for credit,

by contrast, treat debt service as an “old” expense to be

adjusted to deal with financial distress.

This works nicely when rent under a lease really does

pay for new inputs: each monthly payment on an airplane

lease covers another month’s use of a productive asset, just

as payments for jet fuel do. But “rent” that represents the

cost of funds for capital assets or past operations rather

than ongoing inputs into production has the quality of

debt, and to require such obligations to be assumed under

§ 365 to retain an asset would permit financial distress

from past operations to shut down a firm that has a

positive cash flow from current operations. Imagine a lease

of an airplane with a 20-year economic life that provided

for no rental payments during the first 10 years, followed

by rent at 2.5 times the market rate for the last ten (it

exceeds twice the spot-market price because the payments

must cover accrued interest on the deferrals). To separate

financial from economic distress it would be essential to

App. 8

separate the loan components of that “lease” from the

current-consumption components. The cost of capital hired

before the bankruptcy could be written down while the

expenses of current operations continued to be met.

When Congress enacted the Bankruptcy Code in 1978,

the legal system afforded rules that facilitated the disen-

tangling of credit and consumption components of leases.

Since 1939 this had been routine in tax law. See Helvering

v. F & R Lazarus & Co., 308 U.S. 252, 60 S.Ct. 209, 84

L.Ed. 226 (1939). See also, e.g., Frank Lyon Co. v. United

States, 435 U.S. 561, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978).

During the 1940s and 1950s much state law on the subject

was summed up and codified in the Uniform Commercial

Code. Section 1-201(37) of the 1958 Official Text separates

credit components, iri which the asset serves as security,

from consumption components this way:

Unless a lease ... is intended as security, reser-

vation of title thereunder is not a “security inter-

est”.... Whether a lease is intended as security

is to be determined by the facts of each case;

however, (a) the inclusion of an option to pur-

chase does not of itself make the lease one in-

tended for security, and (b) an agreement that

upon compliance with the terms of the lease the

lessee shall become or has the option to become

the owner of the property for no additional con-

sideration or for a nominal consideration does

make the leas? one intended for security.

A lease in which the consumption component domi-

nates often is called a “true lease,” while one in which the

asset serves as security for an extension of credit is

treated as a security agreement governed by the UCC’s

Article 9.

App. 9

No legally sophisticated person writing in 1978 could

have thought that the word “lease” in a text that distin-

guishes between current consumption (which must be paid

for in full) and secured debt (which may be written down

to ease financial distress) means any transaction in the

form of a lease. The need to look through form to sub-

stance would be apparent not only from the structure of

the statute but also from the fact that many of the leased

assets would be covered directly by the UCC. Section 365

in particular deals with leases of both personal and real

property; it would not be sensible to read the same word as

referring to substance when dealing with personal prop-

erty and form when dealing with real property. The

statute thus must refer to substance throughout § 365.

Nothing else respects both the structure of the Bankruptcy

Code and the way the legal community understood the

distinction between leases and security agreements in the

1970s.

Because the parties have made so much of the legisla-

tive history, we add that the understanding that § 365

deals with substance rather than form is reflected in many

of the documents that precede the Code’s enactment. The

passage to which the litigants pay the most attention

reads:

The phrase ‘lease of real property’ applies only to

a ‘true’ or ‘bona fide’ lease and does not apply to

financing leases of real property or interests

therein, or to leases of such property which are

intended as security.

Un a true lease of real property, the lessor re-

tains all risk and benefits as to the value of the

real estate at the termination of the lease...

App. 10

Whether a ‘lease’ is [a] true or bona fide lease or,

in the alternative, a financing ‘lease’ or a lease

intended as security, depends upon the circum-

stances of each case. The distinction between a

true lease and a financing transaction is based

upon the economic substance of the transaction

and not, for example, upon the locus of title, the

form of the transaction or the fact that the trans-

action is denominated as a ‘lease’. The fact that

the lessee, upon compliance with the terms of the

lease, becomes or has the option to become the

owner of the leased property for no additional

consideration [or] for nominal consideration indi-

cates that the transaction is a financing lease or

lease intended as security. In such cases, the les-

sor has no substantial interest in the leased

property at the expiration of the lease term. In

addition, the fact that the lessee assumes and

discharges substantially all the risks and obliga-

tions ordinarily attributed to the outright owner-

ship of the property is more indicative of a

financing transaction than of a true lease. The

rental payments in such cases are in substance

payments of principal and interest either on a

loan secured by the leased real property or on the

purchase of the leased real property.

S.Rep. No. 989, 95th Cong., 2d Sess. 64 (1978). This

passage is interesting because it illustrates how the legal

community thought in 1978 about the roles of form versus

substance in dealing with a werd such as “lease.” It would

be a mistake to find ruler of decision in this un-enacted

passage, see American Hospital Association v. NLRB, 499

U.S. 606, 615-16, 111 S.Ct. 1539, 113 L.Ed.2d 675 (1991),

but it does show that Congress shared the legal commu-

nity’s understanding that some transactions with the form

of a lease are best treated as security agreements.

App. 11

To say that substance prevails over form as a matter

of federal law is not to resolve all issues of detail — or for

that matter to imply that federal law supplies the details.

Which aspects of substance matter? The Senate Report

does not supply the answer. IRlestrictive language con-

tained in Committee Reports is not legally binding.”

Cherokee Nation u Leubitt. U.S. 125 S.Ct.

1172, 1182, 161 L. Ed. 2d 66 (2005). Reports are not enacted

and do not create rules independent of the text in the

United States Code. Anyway, this report sounds like a

reminder to be sensible rather than a formulary.

Because nothing in the Bankruptcy Code says which

economic features of a transaction have what conse-

quences, we turn to state law. All of the states have de-

voted substantial efforts to differentiating leases from

secured credit in commercial and banking law. Leases are

state-law instruments, after all, and the norm in bank-

ruptcy law is that contracts (of which leases are a species)

and property rights in general have the same force they

would have in state court, unless the Code overrides the

state entitlement. See Butner v. United States, 440 U.S.

48, 99 S.Ct. 914, 59 L.Ed.2d 136 (1979); see also, e.g.,

Raleigh v. Illinois Department of Revenue, 530 U.S. 15, 20,

120 S.Ct. 1951, 147 L.Ed.2d 13 (2000); BFP v. Resolution

Trust Corp., 511 U.S. 531, 544-45, 114 S.Ct. 1757, 128

L.Ed.2d 556 (1994); Nobelman v. American Savings Bank,

508 U.S. 324, 329-30, 113 S.Ct. 2106, 124 L.Ed.2d 228

(1993); Barnhill u. Johnson, 503 U.S. 393, 398, 112 S.Ct.

1386, 118 L.Ed.2d 39 (1992). A state law that identified a

“lease” in a formal rather than a functional manner would

conflict with the Code, because it would disrupt the federal

system of separating financial from economic distress; a

state approach that gives a little more or a little less

App. 12

weight to one of several “factors” does not conflict with any

federal rule, because there is none with which it could

conflict. Cf. In re James Wilson Associates, 965 F.2d 160

(7th Cir.1992).

United contends that the second and ninth circuits

have held that federal law supplies the definition of a

“lease” in addition to establishing a functional approach to

the inquiry. Perhaps some language in PCH Associates and

Moreggia could be read that way, though we think it more

likely that both courts were concerned with the first

question (whether the word “lease” in § 365 has a formal

or functional scope), which is a matter of federal law, than

with the second — what body of law identifies a “true lease”

under the functional approach? Neither opinion cites

Butner or any of the Supreme Court's other decisions

specifying that state law must be used whenever possible

to define the interests on which the Code operates. If

either the second or the ninth circuits believes that federal

law answers all questions concerning the operation of

§ 365, then we disagree; for the reasons we h~ve given, the

third circuit (which in Continental Airlines and Pillowtex

used state definitions) got this right. Indeed, we held

exactly this in Powers, a decision under § 365 that the

bankruptcy judge did not mention. Powers involves the

choice between lease and installment sales contract for

personal property; we cannot imagine any reason why

state law would define a “true lease” for personal property

while federal law would supply the definition for real

property.

So what does California law provide? The district

judge thought that California allows form to control, and

because United and the CSCDA chose the form of a lease

United is stuck with that characterization under § 365. If

App. 13

indeed California identifies leases in such a mechanical

fashion, then its law must yield, but we do not understand

it to distinguish leases from secured credit in this way.

Neither do we follow the district court’s conclusion that

form prevails unless “clear and convincing evidence”

supports a different characterization. Burdens of proof and

persuasion are supplied by the forum, not by the source of

substantive law. Bankruptcy law uses the preponderance

standard. See Grogan v. Garner, 498 U.S. 279, 111 S.Ct.

654, 112 L.Ed.2d 755 (1991). Anyway, burdens of persua-

sion are irrelevant to characterization of documentary

transactions. See, e.g., In re Schoonover, 331 F.3d 575, 577

(7th Cir.2003); In re Weinhoeft, 275 F.3d 604 (7th

Cir.2001).

Like the district judge, the parties in this court seek to

find California’s law in the decisions of federal bankruptcy

judges sitting in California, and they debate the signifi-

cance of what these judges have said about the subject. Yet

federal judges are not the source of state law or even its

oracles. To find state law we must examine California’s

statute books and the decisions of its judiciary. California

has enacted the UCC; there can be no doubt that it uses a

functional approach to separating leases from secured

credit with respect to personal property. California takes a

similar approach for real property as a matter of common

law. Burr v. Capital Reserve Corp., 71 Cal.2d 983, 80

Cal.Rptr. 345, 458 P.2d 185 (1969), and Beeler v. American

Trust Co, 24 Cal.2d 1, 147 P.2d 583 (1944), are especially

revealing.

Beeler arose from a sale and leaseback of real property.

When the tenant stopped paying, the court had to decide

whether he could be evicted under landlord-tenant law,

with the landlord retaining the fee title to the property, or

App. 14

whether instead the tenant retained an equity of redemp-

tion under the law of mortgage loans, so that any pay-

ments in excess of the market rental value would redound

to the tenant’s benefit. The Supreme Court of California

characterized the transaction as an equitable mortgage

despite the fact that the papers cast it as an absolute deed

plus a lease. It relied not only on the fact that the landlord

was a financial institution but also on the fact that the

rent was equal to the sum needed to pay off a loan and the

fact that the lessee would become an owner after some

years. (This is the UCC’s per se rule: If the lessee has an

option te acquire ownership at the end of the term for no

or a nominal payment, then the transaction must be

treated as secured credit.) The yearly rent was $3,000,

substantially less than the going rate for similar property

but exactly equal to the amount needed to amortize a

$60,000 extension of credit — and the $60,000 for which the

property had been “sold” initially was less than the market

price of equivalent real estate. The state court thought

that this deal had all the hallmarks of a mortgage loan

except the form — and the form had to yield. This was not a

“true lease” as the court saw it.

Burr posed the question whether a lease of personal

property should be treated as a loan; the answer mattered

because at the time California's usury law set a 10%

maximum interest rate on loans, but there was no price

control on leases. Burr needed money to expand his

business. He obtained cash by selling some of the existing

business’s property to a bank and immediately leasing it

back at a rental designed to amortize the extension of

credit. The Supreme Court of California held that this

form must be pierced to get at the substance: Burr had

borrowed money on security of the property subject to the

App. 15

lease, and as the interest rate in one of the parties’ three

transactions exceeded 10% the bank could not collect the

full agreed payment.

California has applied this approach in many other

cases, which we need not recount. See, e.g., Lovelady v.

Bryson Escrow, Inc., 27 Cal.App.4th 25, 32 Cai. Rptr. 2d 371

(1994). It has been more willing to follow form when that

will enhance tax revenues, denying parties a right to

pierce their own form at the state’s expense, when the

state treasury was not privy to the original choice. See,

e.g., Rider v. San Diego, 18 Cal.4th 1035, 77 Cal.Rptr.2d

189, 959 Pad 347 (1998); Dean u Kuchel, 35 Cal.2d 444,

218 Pad 521 (1950). The only state decision to which the

district judge referred is of this kind and held that it just

did not matter whether a given transaction was a “lease”

or something else. Desert Hot Springs v. Riverside County,

91 Cal.App.3d 441, 154 Cal.Rptr. 297 (1979). Instead the

question was whether a person who had leased some land

from a city for 50 years, built a city hall there, and leased

the improved parcel back to the city for a 15-year term

(substantially less than the structure’s useful life), had

retained a “possessory interest” subject to taxation under

Cal. Rev. & Tax Code § 107. The court’s affirmative answer

is unhelpful on a question of the kind we confront.

Whether the CSCDA has an interest that some other arm

of California’s government could tax is neither here nor

there.

The transaction between United and the CSCDA is

not a “true lease” under California law. (i) The “rent” is

measured not by the market value of 20 acres within the

maintenance base but by the amount United borrowed.

The hell or high water clause demonstrates the lack of

connection between the maintenance base’s rental value

App. 16

and United’s financial obligation. (ii) At the end of the

lease, the CSCDA has no remaining interest. The CSCDA

stresses that United will not “own” anything as of 2033; it

still would be the Airport’s tenant. But its full tenancy

interest reverts to it for no additional charge. Reversion

without additional payment is the UCC’s per se rule for

identifying secured credit. (iii) The balloon payment has

no parallel in a true lease, though it is a common feature

of secured credit. (iv) If United prepays, the lease and

sublease terminate immediately; in a true lease, by con-

trast, prepayment would secure the tenant’s right to

occupy the property for an additional period. The parties

have not cited any case from any state deeming an ar-

rangement of this kind to be a “true lease.”

We do not doubt that many financing devices are true

leases; the lessor owns the property and thus finances its

acquisition, relieving the lessee of the need to raise funds

itself, and net leases may measure rent by the lessor’s

financial commitments. United acquired many of its

airplanes that way. But in such a transaction the lessee

acquires an asset; from the lessee’s perspective, it is

engaged in securing assets with current value, and it can

escape the rental obligation by surrendering the asset.

United did not obtain the maintenance base from CSCDA;

it already had the base under its lease from the Airport,

and could not end the obligation to the CSCDA by vacating

the maintenance base. What United did was use an asset

(its leasehold interest in the maintenance base) to secure

an extension of credit, just as the business did in Burr, and

as in Beeler it agreed to pay “rent” equal to the price of

that credit rather than any element of value in the

“leased” premises.

App. 17

The CSCDA has filed a cross-appeal to argue that

United’s failure to contest the lease within 60 days of its

execution disables it from arguing that the arrangement is

not a “true lease.” California has what the parties call a

“validation statute,” which provides this deadline.

Cal.Code Civ. P. § 860, § 869. The cross-appeal is pointless.

The CSCDA wants us to affirm rather than alter the

judgment, and appellees may advance in support of their

judgments any argument preserved in the district court.

Massachusetts Mutual Life Insurance Co. v. Ludwig, 426

U.S. 479, 96 S.Ct. 2158, 48 L.Ed.2d 784 (1976). The cross-

appeal is dismissed as surplusage.

The district judge rejected the CSCDA’s contention,

stating that it had not been presented to the bankruptcy

judge. Although the CSCDA says otherwise, we need not

resolve that dispute. State procedures do not matter in

bankruptcy. State law defines property rights, but federal

law prescribes the hoops through which the litigants must

jump. California could not enact a law saying: “§ 365

always must be applied to documents with the form of

leases unless the debtor takes specified steps before

entering bankruptcy.” Matters that could not have been

determined before bankruptcy can't be foreclosed because

they were not so determined. See Brown v. Felsen, 442 U.S.

127, 99 S.Ct. 2205, 60 L.Ed.2d 767 (1979). Nor may states

insist that questions affecting the outcome of a bankruptcy

be adjudicated in state court; the federal bankruptcy

jurisdiction is exclusive. Issues that have been resolved in

state court (say, in pre-bankruptcy litigation) may well

have preclusive effect in the federal litigation. See, e.g.,

Grogan, 498 U.S. at 284-85 n. 11, 111 S.Ct. 654; Brown,

442 U.S. at 139, 99 S.Ct. 2205; Kelly v. Robinson, 479 U.S.

36, 47-49, 107 S.Ct. 353, 93 L.Ed.2d 216 (1986). But states

App. 18

may not compel potential debtors in bankruptcy to use

state tribunals before repairing to federal court.

What is more, the state validation statute does not

apply on its own terms. United is not challenging the

validity of the sublease and leaseback. It concedes that the

transaction is valid as a matter of state law and that it

owes the money. The question under § 365 is whether it

must pay in full to enjoy continued occupancy or whether,

instead, it may reduce payments to the value of the inter-

est secured by the leasehold and treat the residue as

unsecured debt. California’s validation statute does not

address that question and so is irrelevant in this litiga-

tion.

The transaction between United and the CSCDA at

San Francisco Airport is a secured loan and not a lease for

the purpose of § 365. The judgment of the district court is

reversed, and the case is remanded for further proceedings

consistent with this opinion.

App. 19

317 B.R. 335

United States District Court,

N.D. Illinois,

Eastern Division.

HSBC BANK USA, Appellant,

UNITED AIR LINES, INC., Appellee.

California Statewide Communities Development Author-

ity, Appellant,

United Air Lines, Inc., Appellee.

Nos. 04 C 2836, 04 C 2837.

Nov. 16, 2004.

Mark F. Hebbeln, Gary W. Garner, Harold Kaplan,

Gardner Carton & Douglas LLP, Chicago, IL, Kirk D.

Dillman, James O. Johnston, Joshua M. Mester, Henni-

gan, Bennett & Dorman, Los Angeles, CA, for Appellant.

James Howard Mandell Sprayregen, Marc Kiesel-

stein, Todd A. Gale, Colby Anne Kingsbury, Kirkland &

Ellis LLP, Chicago, IL, for Appellee.

Robert Dale Ginter, Downey Brand LLP, Sacramento,

CA, for Defendant.

MEMORANDUM OPINION AND ORDER

DARRAH, District Judge.

This matter comes before the Court on the appeal of

the judgment of the bankruptcy court of March 30, 2004,

by HSBC Bank USA and California Statewide Communi-

ties Development Authority (“CSCDA”). For the reasons

that follow, the decision of the bankruptcy court is re-

versed.

App. 20

BACKGROUND

CSCDA is a joint exercise-of-powers government

agency consisting of a number of California counties,

cities, and other local government agencies. CSCDA is

organized pursuant to Chapter 5 of Division 7 of Title 1 of

the Government Code of the State of California (“Joint

Powers Act”) and an Amended and Restated Joint Exercise

of Powers Agreement dated as of June 1, 1988, among the

member local government agencies. Pursuant to the Joint

Powers Act, CSCDA is authorized to exercise the power of

its member local government agencies, among other

things, to issue revenue bonds to pay the cost and ex-

penses of acquiring or constructing publicly owned or

operated commercial aviation airports and airport-related

facilities.

On June 18, 1973, United entered into the “Mainte-

mance Base Lease” with the City and County of San

Francisco. Pursuant to the lease, United leased certain

ramp space and facilities at San Francisco International

Airport (“SFO”). To assist United in developing certain

facilities at SFO, United and CSCDA consummated a

transaction in 1997 pursuant to which CSCDA issued tax-

exempt revenue bonds in the amount of $154,845,000.00.

The funds from the sale of the bonds were made available

to United in accordance with the terms of the 1997 SFO

transaction documents.

The 1997 SFO transaction was comprised of multiple

documents and agreements. Three agreements germane to

the instant dispute are: (1) the Site Sublease, (2) the

Facilities Lease, and (3) the Indenture of Mortgage and

Deed of Trust (“Indenture”).

App. 21

Pursuant to the Site Sublease, United subleased to

CSCDA an approximately twenty-acre portion of the

premises leased to United under the Maintenance Base

Lease for the nominal rent of one dollar. The term of the

Site Sublease is defined as the period from September 1,

1997 to October 5, 2033, unless a shorter or longer period

is required to retire bonds to be issued by CSCDA. There

are no provisions for remedies for United for any default

by CSCDA.

CSCDA then sub-subleased the leased premises back

to United pursuant to the Facilities Lease. The term of the

Facilities Lease is identical to that of the Site Sublease.

The Facilities Lease’s rental is the amount necessary to

make the payments required under the Indenture — the

amount needed to pay the bonds in accordance with their

terms as well as administrative costs. The Facilities

Lease’s rental amount also constituted reasonable com-

pensation for the use and occupation of the relevant

portion of the SFO Maintenance Base Lease the 20-acre

portion of the 130-acres the City and County leased to

United. The Facilities Lease provides default provisions

and remedies, including CSCDAs right to take possession

of the leased facilities and relet them if United fails to

make the required payments.

The Indenture provides for the issuance of tax-exempt

bonds by CSCDA, for the SFO trustee te receive the

proceeds of the sale of bonds for purposes of funding

construction of defined improvements benefiting United,

and for the SFO trustee to receive the rental payments

from United under the Facilities Lease for the purpose of

paying the debt service on the bonds and ultimately

retiring them. The Indenture indicates that the bonds are

“limited obligations” of CSCDA, payable only from the

App. 22

revenue received from United and earnings on this reve-

nue. Pursuant to the Indenture, CSCDA assigned the

Facilities Lease, including the right to collect rents, to the

Indenture trustee, presently HSBC Bank USA.

On December 9, 2002, United filed a voluntary peti-

tion under Chapter 11 of Title 11, United States Code. On

March 21, 2003, United filed an Adversary Complaint,

seeking a declaratory judgment that certain of its payment

obligations related to airport improvements were not

obligations arising under “leases” pursuant to Section 365

of the Bankruptcy Code. Subsequently, all parties moved

for summary judgment on the issue of whether the

“leases” were true leases, as opposed to financing instru-

ments.

On March 4, 2004, the bankruptcy court granted

United’s motion for summary judgment. HSBC Bank and

CSCDA appeal that judgment to this Court.

LEGAL STANDARD

A bankruptcy court’s grant of summary judgment is

reviewed de novo. Hoseman v. Weinschneider, 322 F.3d 468,

473 (7th Cir.2003) (Hoseman). All of the facts and the

inferences therefrom are viewed in the light most favor-

able to the nonmoving party. Hoseman, 322 F.3d at 473.

Similarly, a bankruptcy court’s interpretation of statute is

a question of law reviewed de novo. See Hiram Walker &

Sons, Inc. v. Kirk Line, 30 F.3d 1370, 1378 (11th Cir.1994).

The Court reviews the bankruptcy court’s factual findings

for clear error. Hoseman, 322 F.3d at 473.

Summary judgment is proper if “the pleadings, depo-

sitions, answers to interrogatories, and admissions on file,

App. 23

together with affidavits, if any, show that there is no

genuine issue as to any material fact.” Fed.R.Civ.P. 56(c);

see also Celotex Corp. v. Catrett, 477 U.S. 317, 322-23, 106

S.Ct. 2548, 91 L.Ed.2d 265 (1986). All the evidence and the

reasonable inferences that may be drawn from the evi-

dence are viewed in the light most favorable to the non-

movant. Miller v. American Family Mut. Ins. Co., 203 F.3d

997, 1003 (7th Cir.2000). Summary judgment may be

granted when no verdict could reasonably be returned for

the nonmoving party. See Anderson v. Liberty Lobby, Inc.,

477 U.S. 242, 248, 106 S.Ct. 2505, 91 L.Ed.2d 202 (1986).

DISCUSSION

The bankruptcy court held that the Site Sublease and

the Facilities Lease between United and CSCDA were not

true leases for purposes of Bankruptcy Code § 365, finding

that the 1997 SFO transactions “... are the economic

equivalent of leasehold mortgages....” The bankruptcy

court applied federal law to determine if the instruments

were true leases, rather than applying state law, as argued

by the Appellants.

The appeal raises the following issues for review: (1)

did the bankruptcy court err by failing to apply state

(California) law to characterize the Site Sublease and the

Facilities Lease; (2) was it error for the bankruptcy court

to ignore Seventh Circuit precedent; (3) did the bank-

ruptcy court err in denying the Appellants’ motions for

summary judgment; and (4) did the bankruptcy court err

in granting United’s Motion for Summary Judgment.

The Appellants’ first two arguments on appeal are

intervelated. Appellants argue that the bankruptcy court

erred in failing to apply state law, as required by Seventh

App. 24

Circuit precedent, when determining whether the Site

Sublease and the Facilities Lease constituted true leases

for § 365 purposes.

Section 365(a) provides the trustee, or debtor-in-

possession in Chapter 11 cases, the power to assume or

reject unexpired leases. 11 U.S.C. § 365(a). Certain re-

quirements are imposed when the trustee wishes to

assume an unexpired lease in default. The trustee must

cure the default, compensate any parties that have suf-

fered pecuniary loss from the default, and provide ade-

quate assurance of future performance under the lease. 11

U.S.C. § 365(b). Leases of nonresidential real property are

deemed rejected unless assumed within sixty days after an

order for relief unless the court, for cause, grants addi-

tional time during that sixty-day period. 11 U.S.C.

§ 365(d).

The terms “unexpired lease” and “lease of nonresiden-

tial real property,” as used in Section 365, are not defined

in the Bankruptcy Code. In defining the terms, courts

have relied upon the legislative history of Section 502(b)(6)

of the Bankruptcy Code, which limits damage claims

resulting from lease terminations which are allowable to a

debtor’s landlord. The pertinent legislative history states:

Whether a “lease” is a true or la] bona fide lease, or in

the alternative, a financing “lease” or a lease intended

as security, depends upon the circumstances of each

case. The distinction between a true lease and a fi-

nancing transaction is based upon the economic sub-

stance of the transaction and not, for example, upon

the locus of title, the form of the transaction or the

fact that the transaction is denominated as a “lease.”

App. 25

S.Rep. No. 598, 95th Cong., 2d Sess. 64, reprinted in

1978 U.S.C.C.A.N. 5787, 5850. Based on this legislative

history, courts require that a lease in question must be a

“true” or “bona fide” lease for Section 365 to apply. See In

re Powers, 983 F.2d 88, 89 (7th Cir.1993) (deciding whether

rental agreements were true leases) (Powers); In re Moreg-

gia & Sons, Inc., 852 F.2d 1179, 1182 (9th Cir.1988) (Mo-

reggia),; In re Lunan Family Restaurants, 194 B.R. 429,

450 (Bankr. N. D. III. 1996), In re Hotel Syracuse, Inc., 155

B. R. 824, 838 (Bankr N. DN. V 1993) (Hotel Syracuse).

Generally, Congress has left the determination of

property rights in the assets of a bankrupt's estate to state

law. See Butner v. United States, 440 U.S. 48, 54, 99 S.Ct.

914, 59 L.Ed.2d 136 (1979) (Butner). The application of

state law is applied to both ownership interests in prop-

erty and security interests in such property. Nobelman v.

American Savings Bank, 508 U.S. 324, 329, 113 S.Ct.

2106, 124 L.Ed.2d 228 (1993). However, state law may be

displaced if “some federal interest requires a different

result.” Butner, 440 U.S. at 55, 99 S.Ct. 914. In order to

displace traditional state law, “the federal, statutory

purpose must be ‘clear and manifest. Otherwise, the

Bankruptcy Code will be construed to adopt, rather than

displace, pre-existing state law.” BFP v. Resolution Trust

Corp., 511 U.S. 531, 544-45, 114 S.Ct. 1757, 128 L.Ed.2d

556 (1994). “In the absence of any controiling federal law,

‘property’ and ‘interests in property’ are creatures of state

law.” Barnhill v. Johnson, 503 U.S. 393, 398, 112 S.Ct.

1386, 118 L.Ed.2d 39 (1992).

“Lease” is not defined in Section 365. However, the

legislative history applicable to a security interest states

that “|wjhether a consignment or a lease constitutes a

security interest under the bankruptcy code will depend

App. 26

on whether it constitutes a security interest under appli-

cable state or local law.” S. Rep. No. 595, 95th Cong., Ist

Sess. 314, reprinted in 1978 U.S.C.C.A.N. 5963, 6271; see

also Powers, 983 F.2d at 90; DWE, 157 B.R. at 330 (citing

legislative history of definition of security interest in

support of application of state law in application of Section

365). This legislative history supports a finding that the

bankruptcy code, as applied to leases in Section 365,

adopts, rather than displaces, pre-existing state law.

Furthermore, the legislative history of Section

502(b\6) cited above fails to demonstrate a “clear and

manifest” statutory purpose to displace traditional state

law. See BFP, 511 U.S. at 544-45, 114 S.Ct. 1757. This

legislative history indicates that whether a lease is a true

lease depends upon the circumstances of each case. This

requirement is consistent with state laws requiring that

the facts of each case be reviewed to determine whether a

lease is intended as security. See, e.g., Powers, 983 F.2d at

90 (Illinois and Indiana law require court to determine

whether a lease is intended as security by the facts of each

case); Pillowtex, 349 F.3d at 717 (under New York law,

whether a transaction creates a lease or security interest

is determined on a case-by-case basis); Pittsburgh Sports,

239 B.R. at 84 (Pennsylvania law requires an examination

of the particular facts and circumstances of each case).

This legislative history also states that the “distinc-

tion between a true lease and a financing agreement is

based upon the economic substance of the transaction.”

Reviewing the “economic substance” or “economic reali-

ties” is consistent with state law. See In re Yarbrough, 211

B.R. 654, 657 (Bankr.W.D.Tenn.1997) (Mississippi law

requires the court to look to the economic realities of the

transaction in determining whether a transaction is a

App. 27

lease or security interest); In re Vital Prod. Co., 210 B.R.

109, 112 (Bankr.N.D.Ohio 1997) (Ohio state law, as pro-

vided in the U.C.C., focuses on economic realities of a

transaction in determining whether the transaction is a

true lease); Jn re Nite Lite Inns, 13 B.R. 900, 907-08

(Bankr.S.D.Cal.1981) (Nite Lite) (considering the economic

substance of the transaction in applying California law to

determine whether transaction was a true lease); In re

Hoagland, 1996 WL 33406128 (Bankr.C.D.Ill. Feb. 26,

1996) (the economic realities of the transaction are rele-

vant factors under Illinois law in determining whether a

lease is a true lease). — — legislative history of

Section 502(b) fails to demonstrate a clear and manifest

statutory purpose to displace traditional state law. See

BFP. 511 U.S. at 544-45, 114 S.Ct. 1757. In essence,

United concedes this as it argues that the substantive

inquiry under both California law and federal law is the

same.

Federal courts, including the Seventh Circuit, have

applied state law in determining whether a lease is a true

lease for purposes of Section 365, citing Butner. See Pow-

ers, 983 F.2d at 90; In re Pillowtex, Inc., 349 F.3d 711, 716

(3rd Cir.2003) (Pillowtex); In re Sankey, 307 B.R. 674, 678

(D.Alaska 2004); In re Pittsburgh Sports Assoc. Holding

Co., 239 B.R. 75, 83 (Bankr.W.D.Pa.1999) (Pittsburgh

Sports), In re Fox, 229 B.R. 160, 164 (Bankr.N.D.Ohio

1998); In re DWE Screw Prod., Inc., 157 B.R. 326, 330

(Bankr.N.D.Ohio 1993) (DWE).

In contrast, some courts, including the bankruptcy

court here, have applied a federal rule of law, known as

the economic realities test, to determine whether a lease is

a true lease for purposes of Section 365. These courts cite

the above-quoted language of the legislative history of

App. 28

Section 502(b\6), read together with Section 365, in

support of their finding that a federal rule of law must be

applied in determining whether a lease of real property’ is

a true lease for purposes of Section 365 because these

aspects provide an adequate “federal interest” to justify

using a federal rule of law rather than state law to define

this particular property interest. See Moreggia, 852 F.2d at

1182; In re PCH Assoc., 804 F.2d 193, 200 (2nd Cir.1986)

(PCH), In re KAR Dev. Assoc., L.P, 180 B.R. 629, 638

(D.Kan.1995) (KAR); In re Tak Broadcasting Corp., 137

B.R. 728, 732 (W.D.Wis.1992).

However, based on the legislative history and the case

law, particularly Butner and Powers, the bankruptcy court

erred in applying federal law in determining whether the

leases at issue were true leases.

The Appellants’ third and fourth issues are also

related. Appellants argue that the bankruptcy court erred

in granting United’s motion for summary judgment and

denying the Appellants’ motions for summary judgment.

United argues that summary judgment was proper under

either federal law or California law because, substantively,

the law is the same.

Under California law, an agreement is presumptively

a lease of real property if it includes a designation of the

parties, contains a definite description of the leased

property, provides for periodic payment of rent for the

term of the lease, and provides a right to occupy the

Those sections of Section 365 applicable to both real and personal

property are specifically indicated. See, eg. 11 U.S.C. § 365(d)(1). Any

section applicable to only real property is specifically identified See,

eg. 11 U.S.C. § 365(dX4).

App. 29

property to the exclusion of the grantor. See In re SCCC

Assoc. II Ltd., 158 B. R. 1004, 1013 (Bankr.N.D.Cal.1993)

(SCCC) (emphasis added).

Here, the Facilities Lease designates the parties,

contains a definite description of the leased property,

provides for periodic payment of rent over the term of the

lease, and provides United with a right to occupy the

leased premises to the exclusion of the grantor. Accord-

ingly, the Facilities Lease is presumed to be a true lease

under California law. This presumption may be rebutted

by United by establishing by clear and convincing evidence

that the parties intended for the Facilities Lease to dis-

guise a substantive transfer of ownership of or an encum-

brance of the leased SFO Maintenance Facility. See SCCC,

158 B.R. at 1009-14; Fox v. Peck Iron & Metal Co., 25 B. R.

674, 688 (Bankr.S.D.Cal. 1982) (Fox) (emphasis added).

Whether a lease agreement is a true lease or one

intended solely for security is determined by determining

the intent of the parties at the time of the execution of the

document. See Fox, 25 B.R. at 688. The intent of the

parties is determined by reviewing all facts and circum-

stances of the transaction, including the economic sub-

stance of the transaction. See Fox, 25 B.R. at 688; Nite

Lite, 13 B.R. at 908. Factors considered in this analysis

include: (1) whether the transaction actually transfers the

normal! risks and responsibilities of landlord to the lessor;

(2) whether the payments under the lease are reasonably

designed to compensate the lessor for the use of the

property or simply reflect the repayment of the lessor’s

acquisition cost plus interest; Fox, 25 B.R. at 688; and (3)

whether the lessor retains an economically significant

interest in the property, SCCC, 158 B.R. at 1013.

App. 30

The application of these factors to the facts demon-

strates that the Facilities Lease was a true lease. Under

the Facilities Lease, United is required to pay the taxes,

maintenance, and insurance — generally referred to as a

triple net lease. While the payment of taxes, maintenance,

and insurance are typically viewed as usual obligations

indicating ownership, as opposed to a landlord-tenant

relationship, the use of triple net leases are not unusual

terms in ground leases. See SCCC, 158 B.R. at 1013.

Furthermore, United concedes that it could never own the

leased property or facilities. As such, United’s responsibili-

ties under the lease that are generally an indicia of owner-

ship fail to demonstrate that the lease is not a true lease.

The payments under the lease are also reasonably

designed to compensate Appellants. The aggregate rental

payments required by the Facilities Lease include the

amount needed to pay the bonds in accordance with their

terms and the administrative costs associated therewith.

However, the amount of the rental payments also consti-

tuted reasonable compensation for the use and occupation

of the 20-acre portion of the 180-acre SFO Maintenance

Facilities. HSBC’s expert demonstrated that United’s rent

payments were reasonable compensation for the use and

occupation of the relevant portion of the SFO Maintenance

Facilities. United provided no evidence to the contrary.

Furthermore, rent payments are frequently calculated

with reference to payment in respect to financing obliga-

tions. See City of Desert Hot Springs v. County of River-

side, 91 Cal.App.3d 441, 154 Cal.Rptr. 297, 301 (1979)

(Desert Springs). A lease-leaseback' arrangement ‘as a

method of financing construction’ is not inconsistent with

the existence of a lease.” Desert Springs, 154 Cal.Rptr. at

301. In addition, United could terminate the Facilities

App. 31

Lease by prepaying the rent due for the lease term, and

there was no reduction in rent corresponding to the

shorter lease term in the event of prepayment. An absolute

obligation to pay rent for the full lease term is indicative of

a true lease. See 7 Miller & Star California Real Estate §

19.86 (3d ed. 2001).

Lastly, the lessor retained an economically significant

interest in the property leased to United, and United

retained no interest in the leased property. United con-

cedes that it did not own, will not own, and cannot ever

own any of the facilities leased to United. The Facilities

Lease does not have an option to purchase at the end of

the lease. United has retained no interest at the end of the

lease.

United argues, and the bankruptcy court found, that

because CSCDA does not retain an ownership interest at

the end of the Facilities Lease, the Facilities Lease cannot

be a true lease. The bankruptcy court held this factor to be

the most important and concluded that the Facilities

Lease was not a true lease based on this factor alone.

However, this analysis and resultant finding focus on the

lessor instead of the lessee. The finding also fails to take

into account that CSCDA had a right to re-let the relevant

portion of the SFO Maintenance Facilities if United

defauited. The right to re-let is indicative of a true lease,

not a financing arrangement.

Under the bankruptcy court’s logic, every sublease

that has a term equal to the term of the underlying lease

would be a disguised financing arrangement rather than a

true lease because the sublessor has a lack of reversionary

interest at the end of the lease term. For example, if lessor

A executed a one-year lease of an apartment with lessee B,

App. 32

and lessee B subleased the apartment six months later to

sublessee C for the remaining six months, at the conclu-

sion of the sublease, the apartment reverts back to lessor

A. Under the bankruptcy court’s reasoning, the sublease

would not be a true lease because lessee B did not have a

reversionary interest at the end of the lease term. Accord-

ingly, the lack of a reversionary interest in CSCDA at the

end of the Facilities Lease does not dictate that the Facili-

ties Lease was not a true lease.

The Appellants also argue that United is equitably

estopped from changing its previous position that the

Facilities Lease was a lease. Under California law, the

elements of equitable estoppel are: (1) the party to be

estopped must be appraised of the facts; (2) that party

must intend that its conduct be acted upon, or must so act

that the other party has a right to believe that it was so

intended; (3) the other party must be ignorant of the true

state of facts; and (4) the other party must rely on the

conduct to its injury. See Ace Am. Ins. Co. v. Walker, 121

Cal.App.4th 1017, 18 Cal. Rptr.3d 1, 8 n. 2 (2004). Here,

there is no evidence demonstrating that United was

appraised of the fact that it would be filing for bankruptcy

and that the Facilities Lease would be an issue of dispute.

Accordingly, he doctrine of equitable estoppel is not

applicable.

Lastly, the Appellants argue that, under California

law, United had sixty days to challenge the Facilities

Lease and that United failed to do so; therefore, United

cannot now challenge the lease. Nothing in the record

indicates that Appellants presented this argument to the

bankruptcy court, and the bankruptcy court did not

address the issue in its March 30, 2004 judgment now on

appeal before this Court. Accordingly, this issue is waived

App. 33

on appeal. See In re Image Worldwide, Ltd., 139 F.3d 574,

581 (7th Cir. 1998).

CONCLUSION

Based on the foregoing, the March 30, 2004 judgment

of the bankruptcy court order, granting summary judg-

ment in favor of United based on its finding that the

Facilities Lease was not a true lease, is reversed.

App. 34

United States District Court,

Northern District of Illinois

Name of As- John W. | Sitting Judge

signed Judge Darrah if Other than

or Magistrate Assigned

Judge Judge

CASE 04 C 2836 DATE 11/15/2004

NUMBER

CASE TITLE HSBC Bank USA vs. UAL

In the following box (a) indicate the party fil-

ing the motion, e.g., plaintiff, defendant, 3rd

party plaintiff, and (b) state briefly the nature

of the motion being presented.

MOTION:

DOCKET ENTRY:

(1) © Filed motion of [use listing in “Motion” box above.

(2) (©) Briefin support of motion due

(3) © Answer brief to motion due Reply to answer brief

due

(4) (©) Ruling Hearing on set for at

(5) © Status hearing ſheld/ continued to} (set for/re-set for]

on set ſor at

(6) U Pretrial conference held/ continued to] (set for/re-set

for on set ſor at

(7) (©) Trial [set for/re-set for] om at

(8) © [Bench/Jury trial] [Hearing] held/continued to at

App. 35

(9) O This case is dismissed (with/without) prejudice

and without costs [by/agreement/pursuant to

D FRCP4(m) Local Rule 41.1

(10) @ [Other docket entry] For the reasons stated in

the attached memorandum opinion and order,

the March 30, 2004, judgment of the bankruptcy

court order, granting summary judgment in

favor of United based on its finding that the

facilities lease was not a true lease, is reversed.

Enter Memerandum Opinion and Order

(11) @ For further detail see order attached to the

original minute order |

No notices required,

|_| advised in open court.

No notices required.

Filed | docketed

Notified counsel by Nov. 15, 2004

telephone. /s/ JTP

Docketing to mail =

¥ | notices. *

|_| Mail AO 450 form.

; date

Copy to judge/ meiled

magistrate judge. Date! notice

courtroom | received in mailing

MF deputy’s central Clerk's} deputy

initials Office initials

BEST AVAILABLE COPY

04 C 2837

11/15/2004

UAL vs. California Statewide

Communities Development Authority

In the following box (a) indicate the party fil-

party plaintiff, and (b) state briefly the nature

of the motion being presented.

Filed motion of fuse listing in “Motion” box above

Brief in support of motion due

Answer brief to motion due Reply to answer brief

due

ea ae ae

Status hearing [held/continued to] (set for/re-set for]

on get ſor att

Pretrial conference held / continued to] [set for/re-set

forljon _setfor at

Trial (set for/re-set for om at

[Bench/Jury trial) (Hearing) held/continued to at

App. 37

(9) © This case is dismissed [with/without] prejudice

and without costs (by/ agreement pursuant to]

O FRCP4(m) Local Rwe 41.1

O FRCP41(a\1) U FRCP41(a)2)

(10) @ (Other docket entry] For the reasons stated in the

attached memorandum opinion and order, the

March 30, 2004, judgment of the bankruptcy court

order, granting summary judgment in favor of

United based on its finding that the facilities lease

was not a true lease, is reversed. Enter Memoran-

dum Opinion and Order. (Original opinion under

case number, 04 C 2836, HSBC Bank USA v. UAL).

(11) @ [For further detail see order attached to the

original minute order.

No notices required,

— advised in open court.

* No notices required.

Notices mailed by

2828 _ Filed

Notified counsel by NOV 15, 2004—

telephone.

Docketing to mail

A notices.

— Mail A0 450 form.

Copy to judge

istrate judge

|. __ magistra Date

court- received in

MF Soom central Clerk’s

deputy’s Office

initials

App. 38

307 B.R. 618

United States Bankruptcy Court,

N.D. Illinois,

Eastern Division.

In re UAL CORPORATION, et al., Debtors.

United Air Lines, Inc., Plaintiff,

HSC Bank USA, as trustee, the California Statewide

Communities Development

Authority, the City and County of San Francisco, and

the Airports Commission

for the City and County of San Francisco,

Defendants.

United Air Lines, Inc., Plaintiff,

The Bank of New York, Inc.,, as trustee, the Port

Authority of New York and New

Jersey, and the New York City Industrial

Development Agency, Defendants.

United Air Lines, Inc., Plaintiff,

U.S. Bank N. A., as trustee, the Regional Airports

Improvement Corporation, and

the City of Los Angeles, Defendants.

United Air Lines, Inc., Plaintiff,

HSC Bank USA, as paying agent, and the City and

County of Denver, Defendants.

Bankruptcy No. 02 B 48191.

Adversary Nos. 03 A 00975, 03 A 00976, 03 A 00977, 03

A 00978.

March 30, 2004.

James H.M. Sprayregen, Marc Kieselstein, David R.

Seligman, Todd Gale, Kirkland & Ellis, Chicago, IL, for

Debtors.

App. 39

Ronald Barliant, Andrew Weissman, Goldberg, Kohn,

Bell, Black, Rosenbloom & Moritz, Ltd., Chicago, IL; and

Katherine A. Constantine, Steven J. Heim, Dorsey &

Whitney, LLP, Minneapolis, MN; Mark J. Prager, Jill L.

Murch, Foley & Lardner, Chicago, IL, for U.S. Bank

National Association.

R. Dale Ginter, Sallie B. Armstrong, Jenna L. Clark,

Downey Brand LLP, Sacramento, CA, for California

Statewide Communities Development Authority.

Paul E. Chronis, Kristin L. Cantu, Hannah J. Mufson,

Nathan F. Coco, McDermott, Will & Emery, Chicago, IL,

for JFK.

Charles P Schulman, Arlene Gelman, Sachnoff &

Weaver, Ltd, Chicago, IL; John J. Bingham, Jr., Aaron E.

DeLeest, David A. Gill, Danning, Gill, Diamond & Kollitz,

LLP, Los Angeles, CA; Steven J. Heim, Patrick J.

McLaughlin, Katharine A. Constantine, Dorsey & Whit-

ney, LLP, Minneapolis, MN, for LAX and City of Los

Angeles.

David A. Golin, Gesas, Pilati, Gesas & Golin, Ltd.,

Chicago, IL; Rockard J. Delgadillo, Eduardo Angeles, John

M. Werlich, Office of the Los Angeles City Attorney, Los

Angeles, CA, for The Regional Airports Improvement Corp.

William W. Kannel, Timothy J. Langella, George

Hofman, Mintz, Levin, Cohen, Ferris, Glovsky & Popeo,

PC, Boston, MA; Douglas W. Jessop, Kerstin Cass, Jessop

& Company, PC., Andrew M. Schauer, Krys Boyle, PC.,

Denver, CO, for Denver Airport.

Gary W. Garner, Harold Kaplan, Mark F. Hebbeln,

Stephanie Wickouski, Gardner, Carton & Douglas, Chi-

cago, IL, for HSBC Bank USA.

App. 40

Jason E. Rios, Dale R. Ginter, Downey Brand, LLP,

Sacramento, CA, for California Statewide Communities.

Kirk Dillman, Michael Morris, Josh Mester, Henni-

gan, Bennett & Dorman, LLP, Los Angeles, CA, for HSBC

Bank.

MEMORANDUM OF DECISION

EUGENE R. WEDOFYF, Chief Judge.

Four related adversary proceedings are before the

court in these jointly administered cases. In each of the

proceedings, one of the debtors, United Air Lines, Inc.

(“United”), seeks a declaratory judgment that certain of its

payment obligations related to airport improvements are

not obligations arising under “leases” pursuant to § 365 of

the Bankruptcy Code (Title 11 U.S.C., the “Code”). The

defendants in the proceedings are other parties to the

instruments giving rise to the payment obligations. The

defendants have all asserted that these instruments are in

fact “leases” under § 365. Both United and the defendants

seek summary judgment. As discussed below, a “lease”

under § 365 must be a “true” lease, as opposed to a financ-

ing instrument. Because this is not the situation in three

of the four adversary proceedings, United is entitled to

summary judgment in those proceedings. In the fourth

proceeding, involving the Denver airport, a true lease is

involved, and the defendants are entitled to judgment.

Jurisdiction

Federa! district courts have exclusive jurisdiction over

bankruptcy cases. 28 U.S.C. 5 1334(a). Pursuant to 28

U.S.C. § 157(a), district courts may refer bankruptcy cases

App. 41

to the bankruptcy judges for their district, and, by Inter-

nal Operating Procedure 15(a), the District Court for the

Northern District of Dlinois has referred the pending

cases. When presiding over a referred case, a bankruptcy

judge has jurisdiction under 28 U.S.C. § 157(b)(1) to enter

appropriate orders and judgments in core proceedings

within the case. The pending adversary proceedings are

core proceedings under 28 U.S.C. § 157(b)(2)A) (matters

concerning the administration of the estate), § 157(b)(2B)

(allowance or disallowance of claims against the estate),

§ 157(b)(2M) (orders approving the use or lease of prop-

erty), and § 157(b)(2)(O) (“other proceedings affecting

the adjustment of the debtor-creditor or equity security

holder relationship”). See In re PCH Assocs., 60 B.R. 879,

872-73 (S.D.N.Y.), aff'd, 804 F.2d 193 (2d Cir.1986) (de-

claratory judgment action to determine the “lease” status

of an agreement is a core proceeding). This court therefore

has jurisdiction to enter final orders with respect to the

pending proceedings.

Undisputed Facts

The four adversary proceedings that produced the

present motions all involve a similar situation: tax-exempt

bonds were issued to finance the construction of airport

improvements for the benefit of United, and the debt

service on the bonds was to be paid with funds received

from United. The parties dispute the effect in bankruptcy

of the documents giving rise to United’s payment obliga-

tions, but there is no dispute about the identity or content

of these documents.

J. San Francisco International Airport (SFO) -

Adversary Proceeding No. 03 A 00975. At the San

App. 42

Francisco International Airport, United entered into a

Ground Lease with the City and County of San Francisco,

administered by their Airports Commission, on June 18,

1973 (the “SFO Ground Lease”). United was to use the

leased land for “construction and operation of aircraft

maintenance hangar, test and storage facilities” and for

administrative and supervisory operations, rather than for

loading and unloading commercial passengers and cargo.

(SFO Ground Lease at 4-5.) The lease had an initial term

of 20 years and was subject to two ten-year extensions at

the option of United. (Id. at 7.) Thus, the lease would

expire no later than 2113 [sic].

Some 24 years after the Ground Lease was executed,

United, the California Statewide Communities Develop-

ment Authority (a governmental agency authorized to

issue bonds, the “CSCDA”), and an indenture trustee (now

HSC Bank USA, the “SFO trustee”) entered into four

interrelated agreements, all dated August 1, 1997, in order

to finance a number of improvements in United's facilities

at the airport. The agreements included (1) a Site Sub-

lease (the “SFO Sublease”), (2) a Facilities Lease (the

“SFO Leaseback”), (3) an Indenture of Mortgage and Deed

of Trust (the “SFO Indenture”), and (4) a Guaranty

Agreement.

United leased to the CSCDA a portion of the property

covered by the FO Ground Lease. (SFO Sublease at 2 and

Exhibit A.) The term of the SFO Sublease is defined as the

period from September 1, 1997 to October 5, 2033, unless a

shorter or longer period (ending no later than October 5,

2038) is required to retire bonds to be issued by the

CSCDA (with the parties expressly recognizing that the

SFO Ground Lease might expire before the expiration of

App. 43

the SFO Sublease). (Id. at 2.) The rent that the CSCDA

was required to pay United for the entire term of the

sublease was $1, and there is no provision for remedies on

the part of United for any default by the CSCDA. (/d.)

CSCDA leased back to United the identical property

leased to it in the SFO Sublease. (SFO Leaseback at 2.)

The term of the SFO Leaseback is also identical to the

term of the SFO Sublease. (Id. at 3.) However, the rent

United agreed to pay for leasing back the property that it

subleased to the CSCDA is defined by the amounts neces-

sary to make payments on the bonds to be issued under

the SFO Indenture, together with the costs of administer-

ing the financing. (Id. at 3-4.) The SFO Leaseback pro-

vides a full set of default provisions and remedies,

including the CSCDA’s right to take possession of the

leased facilities and relet them if United ‘ails to make the

required payments. (/d. at 16-19.)

provides (a) for the issuance of tax-exempt bonds by the

Io see that the identical property is involved requires some effort.

The SFO Leaseback defines its “Leased Facilities” as they are defined

in the SFO Indenture. The SFO Indenture, in turn, defines “Leased

Facilities” as the “Demised Premises and the improvements to be

acquired, constructed ... and installed thereon or therein.” (SFO

Indenture at 9.) The Indenture defines “Demised Premises” as the real

property described in Exhibit A to the Indenture. (SFO Indenture at 6.)

Exhibit A to the SFO Indenture is identical to Exhibit A to the SFO

Sublease, which defines the property leased in that instr’... :ent.

* The SFO Leaseback requires United to pay as acditional rent

“Administrative Fees and Expenses.” (SFO Leaseback at 4.) The SFO

Indenture defines this term as “any administrative or other expenses

incurred by the |(CSCDA! or the Trustee” in connection with the SFO

Sublease, Leaseback, or Indenture. (SFO Indenture at 5.)

App. 44

CSCDA (SFO Indenture at 15, 37), (b) for the SFO trustee

to receive the proceeds of the sale of the bonds for pur-

poses of funding construction of defined improvements

benefiting United (id. at 20-22), and (c) for the SFO

trustee to receive the rental payments from United under

the SFO Leaseback for the purpose of paying the debt

service on the bonds and ultimately retiring them (id. at

29-33). The SFO Indenture makes clear that the bonds are

“limited obligations” of the CSCDA, payable only from

revenue received from United and earnings on this reve-

nue. (Id. at 15.)

¢ Guaranty Agreement. The Guaranty Agreement sets

out a guaranty from United to the SFO trustee of all

payments due under the bonds.

2. JFK International Airport (JFK) — Adversary

Proceeding No. 03 A 00976. At JFK International Air-

port in New York, United leases land from the Port Au-

thority of New York and New Jersey (the “Port Authority”)

under an Agreement of Lease (the “JFK Ground Lease”)

dated August 1, 1995. The Port Authority's rights in the

property derive from an “Agreement with respect to

Municipal Air Terminals” between the Port Authority and

the City of New York, dated April 17, 1947. The JFK

Ground Lease involves premises consisting of two adjacent

areas. (JFK Ground Lease at 2 and Exhibit A.) United was

required to surrender one of the areas (Area II- referred

to as Area 2 in the Exhibit and later agreements) no later

than July 31, 1999. The lease on the other area (Area 1

referred to as Area 1 in the Exhibit and later agreements)

has an initial term expiring on December 30, 2015, subject

to extension to July 31, 2024 if the Port Authority procures

an extension of its lease with the City of New York. (/d. at

3.)

App. 45

Within two vears of the execution of the JFK Ground

Lease, United, the Port Authority, the New York City

Industrial Development Authority (a governmental! agency

authorized to issue bonds, the “NYCIDA”), and an inden-

ture trustee (now the Bank of New York, Inc., the “JFK

trustee”) entered into a series of agreements to finance

construction of a United cargo handling and warehousing

facility and a ground service equipment facility at the

airport. These agreements — all but the first of which are

dated July 1, 1997 — include (1) a Company Sublease

Agreement, dated January 1, 1997 (the “JFK Sublease”),

(2) a Lease Agreement (the “JFK Leaseback (3) a Con-

sent to Subleases Agreement (the “Consent Agreement”),

(4) an Indenture of Trust (the “JFK Indenture”), (5) a First

Supplemental Indenture of Trust (the “JFK Supplemental

Indenture”), and (6) a Guaranty Agreement.

„ The JFK Sublease. Pursuant to the JFK Sublease,

United leased to the NYCIDA the “Facility Realty,”

consisting of Area 1 of the JFK Ground Lease. (JFK

Sublease at 2, Indenture at 9.) The term of the sublease

has several variables, but will extend no longer than the

maturity date of the bonds to be issued under the JFK

Indenture (October 1, 2032). (ad) The sublease also

terminates with the expiration or earlier termination of

the JFK Leaseback or the JFK Ground Lease. (Id. at 2-3.)

The rental to be paid by the NYCIDA to United for the

The JFK Sublease does not itself define the “Facility Realty”

involved, but it does incorporate definitions of capitalized terms from

the JFK Indenture. (JFK Sublease at 1). The Indenture, in turn, defines

“Facility Realty” as the land described in its appendices (JFK Indenture

at 9), and Appendix A to the Indenture describes the Facility Realty as

Area 1 of the JFK Ground Lease, using the same drawing as in Exhibit

A to the Ground Lease.

App. 46

entire term of the sublease is $10, and there is no provi-

sion for remedies on the part of United for any default by

the NYCIDA. Gd. at 4.)

NYCIDA leased back to United the identical property

leased to it in the JFK Sublease. (JFK Leaseback at 15.)

The term of the JFK Leaseback is also substantially

identical to the term of the JFK Sublease. (Id at 15-16.)

However, the rent United pays for leasing back the prop-

erty that it subleased to the NYCIDA is defined by the

amounts necessary to make payments on the bonds to be

issued under the JFK Indenture. (Id. at 17-18.) The JFK

Leaseback provides a set of default provisions and reme-

dies, including the right on behalf of the NYCIDA (with

the consent of the JFK trustee) to terminate United's

interests in the subleased property if United fails to make

the required payments, but not including a right to take

possession of the leased facilities and relet them. (Id. at

39-43.)

the Port Authority consented to the JFK Sublease and

Leaseback, with the proviso that “[t}he Subleases and the

financing transaction of which the Subleases are a part

are expressly and in all respects subject and subordinate

to all of the terms ... of the (JFK Ground Lease].”

(Consent Agreement at 2-3.)

* The JFK Indenture (at 59) provides for United to pay the

expenses of administering the Indenture “as provided in the AFK

Leaseback),” but the JFK Leaseback itself does not appear to provide

for such payment. This may be an inadvertent omission, since the JFK

Leaseback (at 17) makes reference to payment of rent in a $3.5 but

does not actually include such a section

App. 47

The JFK Indenture and Supplemental Indenture generally

provide (a) for the issuance of tax-exempt bonds by the

NYCIDA (JFK Indenture at 22-32, JFK Supplemental

Indenture at 1-13, 15-16), (b) for the JFK trustee to receive

the proceeds of the sale of the bonds for purposes of fund-

ing construction of defined improvements benefiting

United (JFK Indenture at 33-35, JFK Supplemental

Indenture at 20-21), and (c) for the JFK trustee to receive

the rental payments from United under the JFK Lease-

back for the purpose of paying the debt service on the

bonds and ultimately redeeming them (JFK Indenture at

35-42). The Indenture makes clear that the bonds are

“limited obligations” of the NYCIDA, payable only from

revenue received from United and earnings on this reve-

nue. (JFK Indenture at 27-28, JFK Supplemental Inden-

ture at 3.)

sets out a guaranty from United to the JFK trustee of all

payments due under the bonds.

3. Los Angeles International Airport (LAX) -

Adversary Proceeding No. 03 A 00977. United conducts

terminal operations at Los Angeles Internationa! Airport

(LAX) on property rented from the City of Los Angeles

pursuant to a Terminal Facilities Lease (the “LAX Ground

Lease”) dated June 4, 1981. This lease anticipated that

United would construct expanded terminal facilities with

financing possibly provided by or through the Regional

Airports Improvement Corporation, a governmental

agency authorized to issue bonds (the “RAIC”). (LAX

Ground Lease at 2, 13, 72.) The term of the lease, as

amended, was to commence November 15, 1981 (or later,

in the event of delayed City Council approval) and was to

App. 48

extend for 40 years, subject to earlier termination at the

time of the expiration of any long term tax-exempt bond

financing. (LAX Ground Lease at 15.) On November 15,

1982, United, the City of Los Angeles, the RAIC, and an

indenture trustee entered into a series of agreements to

effectuate the anticipated financing, including: (1) a

Partial Assignment of Terminal Facilities Lease (the “LAX

Assignment”), (2) a Facilities Sublease (the “LAX Lease-

back”), (3) a Contingent Lease Agreement, (4) an Inden-

ture of Mortgage and Deed of Trust (the “LAX Indenture”),

(5) a First Supplemental Indenture of Mortgage and Deed

of Trust (the “LAX Supplemental Indenture”), and (6) a

Guaranty Agreement.

„ The LAX Assignment. In the LAX Assignment,

United assigned to the RAIC all of United’s right and

interest in the LAX Ground Lease “as it relates and

applies to the RAIC Facilities“ the facilities that would

be constructed with the financing to be obtained through

the RAIC. (LAX Assignment at 2 and Exhibit A.) The only

consideration stated for this assignment is “the agree-

ments and undertakings by the parties hereto.” (Jd. at 2.)

The LAX Assignment terminates upon termination of the

LAX Leaseback. (/d.)

„ The LAX Leaseback. In the LAX Leaseback, the

RAIC leased back to United the right and interest in the

RAIC Facilities that the RAIC received through the LAX

Assignment. (LAX Leaseback at 1-2, 5.) The term of the

LAX Leaseback commenced on November 15, 1982 and

extends “until payment or redemption of the Bonds” to be

issued under the LAX Indenture and Supplemental

Indenture. (/d. at 3.) The rent to be paid by United for

leasing back the right and interest that it assigned to

the RAI’ ie defined as the amounts necessary to make

App. 49

payments on the bonds to be issued under the LAX Inden-

ture together with RAIC’s expenses of administering the

financing project. (Id at 4-5.) The LAX Leaseback contains

a full set of default and remedy provisions, including an

authorization for the RAIC to remove United from the

RAIC Facilities in the event of default and to “make efforts

to relet the RAIC Facilities.” (Jd. at 19-23.)

Lease Agreement effectuated the RAlC's rights in the

event of a default by United under the LAX Leaseback.

The agreement provides that, in the event that United's

rights under the LAX Leaseback are terminated because

of United's default, the City of Los Angeles will grant the

RAIC a 90-day option to enter into a new Ground Lease,

on the same terms offered to United, for the balance of the

remaining term of the Ground Lease. (Contingent Lease

Agreement at § 1.)

The LAX Indenture and Supplemental Indenture gener-

ally provide (a) for the issuance of tax-exempt bonds by the

RAIC (LAX Indenture at 1, 13-20; LAX Supplemental

Indenture at 1, 3-4), (b) for the LAX trustee to receive the

proceeds of the sale of the bonds for purposes of funding

construction of the RAIC Facilities (LAX Indenture at 22,

LAX Supplemental Indenture at 6), and (c) for the LAX

trustee to receive the rental payments from United under

the LAX Leaseback (either directly from United or from

RAIC within one day of RAIC’s receipt of the payment

from United) for the purpose of paying the debt service on

the bonds and ultimately redeeming them (LAX Indenture

at 31-36). The bonds issued under the Indentures are to be

“payable both as to principal and interest, and premium, if

any, from the Revenues to be derived by the [RAIC] from

App. 50

the lease [back] of the RAIC Facilities to [United] ... and

from amounts received by the [Indenture] Trustee from

UAL, Inc .... pursuant to [the] Guaranty Agreement.”

(LAX Indenture at 93, LAX Supplemental Indenture at C-

2.)

„ The Guaranty Agreement. The LAX Guaranty

Agreement sets out a guaranty from UAL, Inc., the parent

of United (and a debtor in one of the related bankruptcy

cases) to the indenture trustee of all payments due under

the bonds issued pursuant to the LAX Indenture. The

guaranty does not address United's obligations under the

LAX leaseback.

The bonds issued pursuant to the LAX Indenture and

Supplemental Indenture were redeemed by subsequent

bond issues, pursuant to further supplemental indentures,

for which U.S. Bank N.A. serves as indenture trustee. The

later indentures incorporate the terms of the original LAX

Indenture relevant to the present dispute.

4. Denver International Airport (DEN) - Adver-

sary Proceeding No. 03 A 00978. At the Denver Interna-

tional Airport, the financing of improvements for United

was accomplished by three documents: (a) a “Special

Facilities and Ground Lease” (the “Denver Lease”), dated

October 1, 1992, (b) an ordinance of the City of Denver,

Ordinance No. 712, approved on October 14, 1992 (the

“Ordinance”), and (c) a Guaranty of United, dated October

1, 1992.

* The Denver Lease. The Denver Lease conveys rights

to United in two distinct sets of property: (1) about 45

acres of real property (described in Exhibit B to the Den-

ver Lease), and (2) a number of “facilities,” including

buildings, fixtures, and personal property (set out in

App. 51

Exhibit A), whose purchase and construction were to be

financed through bonds issued by the City of Denver. (Id.

at 1-2, 7-8, 15-16.) United’s obligations to pay rent under

the lease have two components: (1) “Ground Rentals,”

payable monthly, based on a rate per square foot plus costs

for common use services, and (2) “Facilities Rentals,”

payable at the times and in the amounts necessary for

debt service on the bonds through which the facilities are

financed. (Id. at 20-21.) Failure by United to make pay-

ment of either type of rent is an event of default, which

may result in termination of the lease and removal of

United from possession. (Id. at 45-47.)

„ The Ordinance. The Ordinance provides (a) for the

issuance and sale of tax exempt bonds by the City (Ordi-

nance at 10-11; Exhibit A at A-5), (b) for a “paying agent”

(now HSC Bank USA) to receive the proceeds of the sale of

the bonds for purposes of funding construction of the

facilities (id. at 15-16), and (c) for the paying agent to

receive the Facilities Rentals from United under the

Denver Lease for the purpose of debt service on the bonds

and their ultimate redemption (id. at 18). The bonds

issued under the Ordinance are “payable solely from the

Facilities Rentals payable under the Lease and amounts

payable under the Guaranty.” (/d. at 2, Exhibit A at A-2.)

„ The Guaranty. The Guaranty sets out a guaranty

from United to the paying agent of all payments due under

the bonds issued pursuant to the Ordinance.

United and twenty-seven related corporations filed

the pending Chapter 11 cases in December 2002. In March

2003, United filed the pending adversary proceedings.

Each seeks a declaratory judgment that United’s obliga-

tions to make payments on account of the outstanding

App. 52

bond issues do not arise under “leases,” but rather that the

documents outlined above constitute “disguised financing

arrangements.” In each adversary, the defendants an-

swered and counterclaimed for a declaration that the

payment obligations in question did arise under leases.

The parties engaged in discovery and then filed, briefed,

and argued the cross-motions for summary judgment now

pending.

Legal Discussion

Summary judgment is appropriate where the plead-

ings, affidavits, and other materials on file demonstrate

that there exists no genuine issue as to any material fact

and that the moving party is entitled to a judgment as a

matter of law. Fed.R.Civ.P. 56(c), incorporated into Fed. R.

Bankr.P. 7056; Massachusetts Bay Ins. Co. v. Vic Koenig

Leasing, Inc., 136 F.3d 1116, 1119- 20 (7th Cir. 1998). There

are no material facts in dispute in these proceedings.

The significance of a “lease” in bankruptcy. There are

a variety of financial arrangements in which one party

occupies real property while making payments to another

party which has an interest in the property. The two most

common are mortgages and leases, and in many respects

they are similar. In both, the party occupying the property,

the mortgagor or lessee, has an obligation to make periodic

payments to the other party, the mortgagee or lessor. And

in both, the consequence of a default in the required

payments is a loss of occupancy rights, either through

foreclosure or eviction. But in other respects, and particu-

larly under the Bankruptcy Code, the two situations are

quite different.

App. 53

If a Chapter 11 debtor occupies non-residential real

property as owner under a mortgage, the debtor may

retain the property by paying the mortgagee no more than

the current value of the property, with any additional

amounts owing on the mortgage treated as an unsecured

claim, pursuant to §§ 506(a) and 1129(b\(2)A) of the Code.

In re Smith, 287 B.R. 882, 884 (Bankr.W.D.Tex.2002). On

the other hand, if the debtor does not retain the property,

the mortgagee is entitled under § 506(a) of the Code to an

unsecured claim for the full difference between the

amounts due on the mortgage at the time of the filing and

the property value.

However, if the debtor holds the property as tenant

under a lease, the situation is governed by § 365 of the

Code, under which the debtor may retain its occupancy

and other rights only by “assuming” the lease. Lease

assumption requires that the debtor cure any defaults

that occurred before the bankruptcy, maintain payment

obligations during the bankruptcy, and give assurance

that there will be no defaults in future payment obliga-

tions. In re Resource Technology Corp., 254 B.R. 215, 221

(Bankr. N. D. III. 2000) On the other hand, if the debtor

surrenders the property and rejects the lease, the landlord

is entitled to an unsecured claim as limited by § 502(b\6)

of the Code, which may be less than the balance due under

the lease.

In this way, the Bankruptcy Code gives greater

protection to the occupancy rights of the owner of leased

property than to the occupefcy rights of a lender on

mortgaged property, but it gives less protection to the

owner's total claim. The owner of leased property is denied

repossession only if the debtor makes full payment under

the lease, but the owner may receive a claim for less than

App. 54

the full amount due under the lease if the debtor surren-

ders the property; the lender on mortgaged property will

be denied repossession if the debtor merely pays the

lender’s claim up to the value of the property, but the

lender receives an unsecured claim in the fui. amount of

any deficiency.

At the four airports involved in the pending adversary

proceedings, United occupies property under agreements

calling for it to make periodic payments used for debt

service on tax-exempt bonds. As set out above, the agree-

ments for each airport property are denominated “leases.”

United brought the pending adversary proceedings seek-

ing a declaratory judgment that the agreements should

not be treated as leases under § 365, with the potential

effect of allowing United to retain its occupancy without

lease assumption.

The meaning of “lease” under § 365. The term “lease”

is not defined in the Bankruptcy Code. See Jn re Resource

Technology Corp., 254 B.R. at 225-26 (distinguishing

between leases and other executory contracts). However,

the decisions construing § 365 of the Code uniformly hold

that the simple employment of the word “lease” does not

bring every agreement calling itself a lease within that

section. This understanding is necessary to avoid absurd

results. The simplest home mortgage could be called a

“lease,” with the down payment called a “security de-

posit,” the monthly payments of principal and interest

called “rent,” and the “tenant” provided with a title to the

property after a 30-year “lease term.” Rather than allow-

ing such manipulation of terminology to control the

results in bankruptcy, courts look to the economic reality

underlying a questioned agreement. Liona Corp. v. PCH

Assocs. (In re PCH Assocs.), 804 F2d 193, 198 (2d

App. 55

Cir. 1986) (“We interpret section 365(d)(3), (4) of the Bank-

ruptcy Code to apply solely to a ‘true’ or ‘bona fide’ lease.”);

City of San Francisco Market Corp. v. Walsh (In re Moreg-

gia & Sons, Inc.), 852 F.2d 1179, 1183 (9th Cir.1988) ([Wie

have ... declined to require assumption or rejection of a

purported lease that is in substance a security agree-

ment, even where the agreement has taken on the sur-

face formalities of a contract or unexpired lease that

might otherwise corae within the reach of section 365.”);

City of Olathe v. KAR Dev. Assocs., L.P. (In re KAR Dev.

Assocs., L. P), 180 B. R. 629, 636 (D.Kan.1995) (“[Tlhis

court is persuaded that Congress intended § 365(d)(4) to

apply only to ‘true’ or bona fide’ leases ... ”); Marriott

Family Restaurants, Inc. v. Lunan Family Restaurants

(In re Lunan Family Restaurants), 194 B.R. 429, 450

(Bankr. N. D. III. 1996) (“Labeling an agreement a ‘lease’

does not make it one.”).

This limitation of § 365 to true leases is well

grounded. Before the adoption of the Bankruptcy Code in

1978, a distinction had become firmly established in the

context of statutes regulating economic activity between

“true” leases and financing arrangements “disguised” as

leases. Since at least Helvering v. F & R Lazarus & Co,,

308 U.S. 252, 60 S.Ct. 209, 84 L.Ed. 226 (1939), federal tax

law has treated as leases only those agreements that

function as true leases in an economic sense.” In Frank

Lyon Co. v. United States, 435 U.S. 561, 98 S.Ct. 1291, 55

Lazarus allowed a taxpayer to claim a depreciation deduction on

property that the taxpayer had nominally sold to a bank and leased

back from the bank, upon a finding that “the transaction ... was

actually a loan secured by the property involved.” 308 U.S. at 255, 60

S.Ct. 209.

App. 56

L.Ed.2d 550 (1978), decided while Congress was consider-

ing the legislation giving rise to the Bankruptcy Code, the

Supreme Court affirmed that, for purposes of tax law,

“courts are concerned with substance and realities, and

formal written documents are not rigidly binding,” id. at

573, 98 S.Ct. 1291, so that the Court would not condone

“manipulation by a taxpayer through arbitrary labels and

dealings that have no economic significance,” id. at 583, 98

S.Ct. 1291. Thus, the Court ruled, a taxpayer can safely

treat leases as genuine for tax purposes only if the tax-

payer “retains significant and genuine attributes of the

traditional lessor status.” Jd. at 584, 98 S.Ct. 1291.

Similarly, the Uniform Commercial Code (“UCC”),

widely adopted during the 1960s, defined “security inter-

est” as including financing agreements in the form of

personal property leases. Section 1-201(37) of the 1958

Official Text of the UCC provided, in part:

Unless a lease . is intended as security, reservation

of title thereunder is not a “security interest” ...

Whether a lease is intended as security is to be de-

termined by the facts of each case; however, (a) the

inclusion of an option to purchase does not of itself

make the lease one intended for security, and (b) an

agreement that upon compliance with the terms of

the lease the lessee shal] become or has the option to

become the owner of the property for no additional

consideration or for a nominal consideration does

make the lease one intended for security.

By the 1970s, this provision had generated consider-

able litigation and academic commentary, with particular

emphasis on the interests of claimants in bankruptcy. See,

e.g., Feldman v. First National City Bank (In re Leasing

App. 57

Consultants, Inc.), 486 F.2d 367, 372 (2d Cir. 1973) (hold-

ing, in a reclamation action against a bankruptcy trustee,

that “the determination of whether the lease instruments

were ‘true leases’ or security agreements is critical“)

DeVita Fruit Co. v. FCA Leasing Corp. (In re DeVita Fruit

Co), 473 F.2d 585, 589 (6th Cir.1973) (holding that the

question of whether a bankruptcy trustee or a putative

lessor was entitled to the proceeds of an equipment sale

depended on whether a true lease was involved: “When the

lease is intended as a security interest, Article 9 applies

However, a bona fide lease is not affected by Article

9."); Louis F. Del Duca, Evolving Standards for Distin-

guishing a “Bona Fide Lease” from a “Lease Intended as

Security” Impact on Priorities, 75 Com. L.. 218 (1970);

William B. Davenport & Daniel R. Murray, Secured

Transactions § 2.04(a) (1978):

[A] considerable number of agreements called leases

are really disguised conditional sales and will be held

to be such if they are questioned in appropriate litiga-

...

Under the 1962 Text of Article 9, it is important

to determine whether the transaction is one intended

as security because filing is required to perfect the

security interest of the lessor-secured party. In the

absence of proper filing, the unperfected security in-

terest will be subordinate to ... the rights of lien

creditors (including a trustee in bankruptcy)... .

With these principles of economic regulation well

established, it is highly likely that in creating special

treatment for “leases” in § 365 of the Bankruptcy Code,

Congress intended to include only economically “true”

leases — and the legislative history confirms this. In

App. 58

discussing the language now found at § 502(b)\6), limiting

damages resulting from rejection of a lease under § 365,

the Senate Report restricts the Code’s “lease” treatment to

true leases and incorporates the concepts underlying the

UCC’s definition of “security interest”:

(Tihe phrase ‘lease +f real property’ applies only to a

‘true’ or ‘bona fide’ ase and does not apply to financ-

ing leases of real property or interests therein, or to

leases of such property which are intended as secu-

rity.

In a true lease of real property, the lessor retains all

risk and benefits as to the value of the real estate at

the termination of the lease...

Whether a “lease” is la] true or bona fide lease or, in

the alternative, a financing “lease” or a lease intended

as security, depends upon the circumstances of each

case. The distinction between a true lease and a fi-

nancing transaction is based upon the economic sub-

stance of the transaction and not, for example, upon

the locus of title, the form of the transaction, or the

fact that the transaction is denominated as a “lease”.

The fact that the lessee, upon compliance with the

terms of the lease, becomes or has the option to be-

come the owner of the leased property for no addi-

tional consideration or for nominal consideration

indicates that the transaction is a financing lease or

lease intended as security. In such cases, the lessor

has no substantial interest in the leased property at

the expiration of the lease term. In addition, the fact

that the lessee assumes and discharges substantially

all the risks and obligations ordinarily attributed to

the outright ownership of the property is more indica-

tive of a financing transaction than of a true lease.

The rental payments in such cases are in substance

payments of principal and interest either on a loan

App. 59

secured by the leased real property or on the purchase

of the leased real property.

S. Rep. No. 989, 95th Cong., 2d Sess. 64 (1978), reprinted

in 1978 U.S. C. C. A. N. 5850.

Thus, just as the term is understood in ſederal tax law

and under the UCC, “lease” in § 365 of the Bankruptcy

Code means “true lease.”

* Some cases suggest that state law determines the kind of real

estate “lease” that is subject to assumption or rejection under § 365.

See, eg, Martin Bros. Toolmakers, Inc. v. Industrial Dev. Bd. (In re

Martin Bros. Toolmakers, Inc), 796 F.2d 1435, 1440 (Lith Cir 1986)

(citing Alabama law in determining “not to pursue a bankruptcy lew

analysis” of whether a true lease was involved); Fox vu. Peck Iron &

Metal Co, 26 B.R. 674, 688-90 (Bankr.S.D.Cal.1982) (relying on

California law to determine that a sale/leaseback did not involve a true

lease). It has been argued that Congress intended state law to control,

based on the legislative history of the definition of “security interest”

(now in § 101(51) of the Code): “A security interest is a lien created

by an agreement. Whether a . lease constitutes a security interest

under the bankruptcy code will depend on whether it constitutes «

security interest under applicable State or local law.” S Rep No. 989, 2d

Sess. 26 (1978), reprinted in 1978 US.C.C_A.N. 56812. This statement,

however, does not contradict those portions of the same report indicat-

ing that §§ 365 and 502(bX6) apply only to true leases. Compliance with

local law is necessary to create the lien that gives rise to any security

interest. As a result, to be considered a security interest under the

Bankruptcy Code, a lease must constitute a lien under local law. It is

certainly possible for a given agreement to fall outside the coverage of

§ 365, because it is not a true lease, and also fail to confer a “security

interest” because the requirements of local law for creation of a lien

have not been satisfied. Because the Bankruptcy Code itself uses

“lease” in § 365 to mean a true lease, state law should not be used to

reach a contrary result. See Perez v. Campbell, 402 U.S. 637, 652-63, 91

S. Ct. 1704, 29 L.Ed.2¢ 233 (1971) (holding in a bankruptcy context that

“any state legislation which frustrates the full effectiveness of federal

law is rendered invalid by the Supremacy Clause”).

App. 60

The standards for determining a true lease. According

to the language of the Senate Report on the Bankruptcy

Code, and consistent with the legal standards developed

under the UCC and federal tax law, a “lease” under § 365

of the Bankruptcy Code requires that the lessor retain

significant “risk and benefits as to the value of the [puta-

tively leased] real estate at the termination of the lease.”

The Supreme Court emphasized risk to the lessor, includ-

ing “all building depreciation risks,” in finding a true lease

for tax purposes in Frank Lyon Co., 435 U.S. at 582-83, 98

S.Ct. 1291. And the need for a true lessor to retain risk at

lease termination is reflected in the UCC’s prescription

that a true lease does not exist where “upon compliance

with the terms of the lease the lessee shall become or has

the option to become the owner of the property for no

additional consideration or for a nominal consideration.”

In such a situation, the lessee has effectively purchased

the property through the mechanism of the lease, and so

the lessee, not the lessor, has the benefit or burden of

changes in the value of the property when the lease

terminates. Similarly, if the lease lasts for the economic

life of the property being leased, the lessee, not the lessor,

bears the risk of changes in value. This is because the

lessee will be paying a fixed amount to the lessor for

whatever value the property has during its economic life,

with the lessor having no risk other than nonpayment (the

same risk that any secured lender bears).’

" The UCC definition of “security interest” was amended to state

expressly that a transaction denominated a lease is a financing

agreement (rather than a true lease) “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 . the origina! term of the lease is equa! to or greater than

(Continued on following page)

App. 61

Beyond this central issue — how a questioned lease

allocates ownership risk — courts determining the status

of a lease for purposes of § 365 have considered a variety

of factors ordinarily associated with ownership rather

than lessor status. The most frequently cited list is in

Hotel Syracuse, Inc. v. City of Syracuse Indus. Dev.

Agency (In re Hotel Syracuse, Inc, 155 B.R. 824, 838

(Bankr.N.D.N.Y.1993), citing PCH Assocs., 804 F.2d at

200-01:

(i) whether the “rental” payments were calculated to

compensate the lessor for the use of the land, or

rather were structured for some other purpose, such

as to ensure a particular return on an investment;

(ii) whether the [lessor’s] purchase price was related

to the fair market value of the land, or whether it was

calculated as the amount necessary to finance the

transaction,

(iii) whether the property was purchased by the lessor

specifically for the lessee’s use;

(iv) whether the transaction was structured as a lease

to secure certain tax advantages;

(v) whether the lessee assumed many of the obliga-

tions normally associated with outright ownership,

including the responsibility for paying property taxes

and insurance.

In applying the standards for determination of a true

lease to the leases in question here, it is helpful to divide

the leases into two categories: in the first category are the

the remaining economic life of the goods UCC § 1-20(37Xb) (1987).

The current version of Article 1 |sic) the UCC sets out the same

definition in § 1-203(b) 1) (2001).

App. 62

three leases (SFO, JFK, and LAX) involved in lease/

leaseback transactions: in the second category is the single

lease (DEN) not involved in such a lease/leaseback.

The lease/leaseback transactions: financing arrange-

ments. The transactions described above involving San

Francisco, JFK, and Los Angeles International Airports all

have a common feature: a bond-issuing agency received an

interest in a leasehold held by United and leased that

interest back to United in exchange for rent equaling the

debt service and administrative costs associated with

bonds issued by the agency, with a lease term ending with

final payment of the bonds. United is correct in contending

that these leaseback transactions are not true leases

subject to assumption or rejection under § 365, as is

apparent from three distinct considerations.

First, and most important, the status of the three

leasebacks is governed by the principle that there cannot

be a true lease where the lessor has no ownership interest

at the end of the lease term. Here, the bond-issuing

agencies have no such ownership interest because the

property interest they are leasing to United is itself a

leasehold that terminates at the end of the term of the

leaseback. In each of the leaseback arrangements, United

transferred to the agency (either by sublease or assign-

ment) a leasehold interest in airport property that United

held under a ground lease from the operator of the airport,

and in the leasebacks the agencies transferred the identi-

cal interest to Unite“ ch of the leaseback arrangements

has the following def » ig features:

* United has no right to terminate the leaseback be-

fore the redemption of the bonds issued by the agency

for United’s benefit;

App. 63

the leasehold interest transferred from United and

the leaseback of that interest to United both have the

same term, coinciding with the redemption of bonds;

and

s the rent payable by United exactly equals the debt

service and administrative expenses connected to the

bond issues.

Thus, unlike a true lease — where the leased property

reverts to the lessor at the end of the lease term with

substantial value remaining, as to which the lessor takes

the ownership risk the leasebacks terminate with no

property interest reverting to the bond-issuing agencies.

Since the leasehold that is the subject of each leaseback

expires during the term of the leaseback, its entire eco-

nomic value is exhausted during the leaseback, and

nothing reverts to the agencies.

The agencies, trustees, and airport operators dispute

this, observing that the airport property involved in

United’s ground leases retains value after the termination

of the leasebacks. Though accurate, this observation does

not affect the ownership analysis. The airport property

itself was not leased back; only a leasehold interest in that

property was, and that leasehold does not survive the end

of the term of the leasebacks. The absence of a surviving

ownership interest dictates a determination that the

leasebacks are not true leases.

* Of course, if the leaseback terminated prematurely because of a

default by United, the agency might assert an interest in the leasehold,

but this sort of interest — active only on default — is a hallmark of

secured financing, not true leasing. The test for a true lease is the

interest reverting to the lessor, in the absence of default, at the end of

the stated term of the lease.

App. 64

Second, the Syracuse Hotel factors, to the extent that

each is relevant, confirm this determination.

(i) The rental payments from United under the lease-

backs were not calculated to compensate the agencies for

the use of the transferred leasehold, but were defined by

the amounts needed to pay the bonds. It may be that the

periodic payments on the bonds required under the lease-

backs approximated the fair rental value of the property

interests conveyed by the leasebacks, but the bond pay-

ments — not the use values of the property — were control-

ling. This is evident from the result under the leasebacks

in situations where the value of the leasehold is reduced:

(1) if United makes sufficient payments to redeem the

bonds early, the leasebacks terminate immediately, with

no reduction in rental payments by United corresponding

to the shorter lease term; and (2) if a portion of the prop-

erty involved in the leasebacks is lost through condemna-

tion, there is again no diminution of the leaseback rent.”

(ii) The agencies did not acquire the interests that

they leased back to United for market value. Rather, they

paid nomina) (if any) consideration to United, and the real

consideration for the leaseholds transferred by United was

the promise by the agencies to issue bonds on United's

behalf.

(iii) The property interest involved in the leasebacks

(the leasehold interest under the ground leases) was

acquired by the agencies specifically for United’s use.

* SFO Leaseback at 5, LAX Leaseback at 5-6, and JFK Leaseback

at 25.

N App. 65

(iv) The leases were part of an arrangement struc-

tured to obtain tax advantages (although tax exempt

bends might have been issued without leasebacks, as was

done in the situation of the Denver International Airport).

(v) The lessee (United) had all of the ordinary obliga-

tions associated with ownership, including the need to

maintain insurance and pay property taxes.

Finally, the leaseback transactions at issue here are

the economic equivalent of leasehold mortgages, a recog-

nized real estate financing mechanism again supporting

the conclusion that the leasebacks are financing arrange-

ments. See Grant S. Nelson & Dale A. WI ‘tman, Real

Estate Finance Law § 15.14 (4th ed.2002)." In a typical

leasehold mortgage, a lender receives a lien on the debtor’s

leasehold interest, and in the event of default on the loan,

the lender may terminate the debtor’s rights in the mort-

gaged lease. Then, the lender may either occupy the real

estate or re-lease it to another party. The leasebacks here

have the same effect: United, as the “owner” of the lease-

hold created by its ground leases, effectively mortgaged a

portion of its leasehold interest as security for the bond

payments. As long as United pays the “rent” equaling debt

A leasehold mortgage is a security interest in the lessee’s rights

and interests under a ground lease, including the lessee’s leasehold

estate in the leased premises. A leasehold mortgage ordinarily also

encumbers any buildings and other improvements not included in the

leased premises, but owned by the less e. Although the typical lease-

hold mortgage secures a lessee-borrower’s obligation to repay a loan, a

leasehold mortgage may be given as security for the performance of any

obligation capable of being secured by a mortgage or security interest

under applicable state law.“ Richard F. Casher et al., Leasehold

Mortgages in Bankruptcy: Look Before You Leasehold, 402 PLI/Real 689,

697 (1993).

App. 66

service on the bonds, it retains its full rights under ground

leases. If it repays the bonds in full, the lease/leaseback

ends, and the agencies have no further claim on the

leasehold. But if United defaults, the agencies may accel-

erate the rental payments and (as to two of the leasebacks)

terminate United's possession and relet the property."

Indeed, lease/leaseback arrangements have been

recommended as a financing alternative to leasehold

mortgages, with the pointed caveat that bankruptcy

courts tend to focus on the economic substance of a

transaction and not the nomenclature that the parties to

the deal have used” so that a court may “recharacterize

the lease/leaseback transaction as a secured loan rather

thar an operating lease.” See Kathi W. Borkholder,

Ground Leases-Lease/Leaseback Financing Alternatives

to Mortgages, 13-FEB Prob. & Prop. 37, 41 (1999). In

what appears to be the only reported opinion considering

the question, Scottsdale Assocs., Inc. v. Seatrain Lines,

Inc. (In re Seatrain Lines, Inc.), 20 B.R. 577, 582

(Bankr. S. D. N. V 1982), the court recharacterized a lease/

leaseback arrangement as a form of mortgage. Recharac-

terization is similarly required here; United has overcome

the presumption that the terminology used by the parties

accurately reflected the economic substance of their

* The SFO and LAX Leasebacks, and SFO and LAX Indentures

provide for this remedy. (SFO Leaseback at 15-17, SFO Indenture at 40-

41, LAX Leaseback at 21, and LAX Indenture at 54-55.) The JFK

Leaseback does not. (JFK Leaseback at 40-42.)

App. 67

agreements. See In re PCH Assocs., 804 F.2d at 200 (rec-

ognizing presumption and finding that it was overcome).

Other arguments of the leaseback defendants. Two

arguments remain to be considered in connection with the

leasebacks. First, the LAX trustee argues that the court

must consider the LAX Leaseback together with the LAX

Ground Lease in determining its status as a true lease

under § 365. In other words, the LAX trustee asserts that

the two documents should be integrated into a single

agreement. Since no provision of the Bankruptcy Code

deals with the integration of agreements, this is an issue

to be determined under applicable nonbankruptcy law,

here the law of California. Moore v. Pollock (In re Pollock),

139 B.R. 938, 940 (9th Cir. BAP 1992). The factors rele-

vant to that determination are: “(1) [w)hether the nature

and purpose of the obligations are different; (2) whether

the consideration for the obligations is separate and

distinct; and (3) whether obligations of the parties are

interrelated.” Id., at 940-41 (citing In re Gardinier, 831

F.2d 974, 976 (11th Cir.1987)).

These factors establish that the LAX Leaseback is not

integral to the LAX Ground Lease. First, the purposes of

the two agreements are different. The ground lease (LAX

Ground Lease §3, pp. 3-12) involves United’s overall

airport operations, covering a wide range of necessary

facilities. Although it contemplates RAIC bonding, it also

provides for financing from other sources (id. at § 4A, p.

12) and so is independent of any financing that RAIC

However, no finding is made as to whether the leasebacks have

met the requirements of local law for an enforceable leasehold mort-

gage

App. 68

might effectuate. The leaseback, on the other hand, covers

only the facilities affected by the RAIC bond financing,

and is intended to support repayment of the bonds. Sec-

ond, the consideration for the two agreements is separate,

with rent under the ground lease (id. at § 6, pp. 16-25) in

no way connected to the leaseback rent, which is defined

by the debt service on e bonds. And third, the obligations

of the parties are distinct: United has separate payment

obligations under the ground lease and leaseback; the City

of Los Angeles has traditional duties of a lessor under the

ground lease; and RAIC has no significant duties under

the leaseback. The rest of the leaseback defendants have

conceded that their agreements respecting United’s bond

financing are not subject to integration with the ground

leases.

The other argument that various defendants advance

is a quasi-estoppel claim — that because United treated the

leasebacks as leases for purposes of accounting and for

obtaining financing and tax benefits, United should not

now be allowed to deny that the leasebacks are true leases

under § 365 of the Bankruptcy Code. To some extent, these

arguments are grounded in Martin Bros. Toolmakers, 796

F.2d at 1440, which employs state law to determine the

status of a lease under § 365. As discussed above, this view

is not adopted here. Furthermore, to the extent that the

defendants are asserting a claim of equitable estoppel, it

has no basis: they have pointed to no false statement of

fact by United that they have relied on to their detriment.

See Hotel Syracuse, 155 B. R. at 836 (discussing the ele-

ments of estoppel in connection with a determination of

lease status under § 365). To refer to the leasebacks as

leases is no misstatement, since thai is their form, and the

tax and accounting treatment properly accorded to the

App. 69

leasebacks presents issues separate from the bankruptcy

question involved here. And regardless of the appropri-

ateness of United’s tax and accounting treatment of the

leasebacks, these issues do not present factual matters on

which the defendants could reasonably have relied. The

defendants, all represented by counsel in connection with

the negotiation of these complex agreements, were respon-

sible for drawing their own conclusions about the legal

impact of the leasebacks in bankruptcy.

The Denver Lease: a true lease. The Denver Lease is

substantially different from the leasebacks discussed

above. Unlike the bond-issuing agencies who were the

nominal lessors in the leasebacks, the City of Denver

unquestionably occupies a traditional lessor’s position

under the Denver Lease. It owns the leased property, and

at the conclusion of the lease term it will receive the

return of the property, with a substantial part of its

economic life remaining. The City bears a genuine risk of

changes in the property value at the end of the lease term.

Recognizing that the lease, taken as a whole, is a true

lease subject to assumption or rejection under § 365,

United has argued that the lease should be severed into

two agreements: one (a true lease) governing its use of the

The Supreme Court recognized in Frank Lyon that the treatment

of an agreement for purposes of tax law might be different from its

treatment in other contexts: [ Wle are mindful that the characterization

of a transaction for financial accounting purposes, on the one hand, and

for tax purposes, on the other, need not necessarily be the same.” 435

U.S. at 577, 98 S.Ct. 1291; accord Thor Power Tool Co. v. C.1.R., 439

U.S. 622, 541, 99 S.Ct. 773, 58 L.Ed.2d 785 (1979). Similarly, the

treatment of a lease may be different under § 365 than in non-

bankruptcy contexts.

App. 70

airport real estate and another (a financing arrangement)

providing for its repayment of bonds issued by the City.

Like the question of contract integration discussed

above, the question of contract severability must be deter-

mined under applicable nonbankruptcy law, since the

Bankruptcy Code does not address the issue. Jn re Cafeteria

Operators, L. p, 299 B.R. 384, 389 (Bankr.N.D.Tex.2003)

(collecting authorities). By its terms, the Denver Lease is

to be interpreted according to the law of Colorado. (Denver

Lease § 12.11, p. 53.) A recent decision of the Colorado

Supreme Court applies Colorado’s rule for contract sever-

ability. In Univex Int'l, Inc. u. Orix Credit Alliance, Inc.,

914 Pad 1355 (Colo.1996), the court dealt with a claim by

a would-be purchaser of equipment under an oral contract

to be financed by the seller. The purchaser sought applica-

tion of a liberal statute of frauds under Article 2 of the

Uniform Commercial Code, rather than the more stringent

statute of frauds governing financing agreements, on the

ground that there were two separate contracts involved:

one for the sale of goods, the other for financing. The court

rejected this argument, holding that “under Colorado law,

a contract cannot be severed unless the language of the

contract manifests each partys intent to treat the contract

as divisible.” Jd. at 1357.

Nothing in the Denver Lease manifests an intent

either by the City of Denver or by United to treat the lease

as divisible into separate ground lease and financing

components. United's principal argument in favor of

severability is that its payment of the “Facilities Rentals”

(the payments on account of the bonds issued by the City)

is to be made to the paying agent for the bondholders

rather than to the City. (Denver Lease, § 6.1, p. 20.) This,

however, is no indication that the parties considered that

App. 71

payment obligation severable from the rest of the lease. To

the contrary, the lease provides that United’s payments to

the paying agent are “for the account of” the City (id.

§ 6.1(a), p. 20), and the lease treats a failure by United to

make “Facilities Rentals” (bond) payments (id. § 11.1(a), p.

45) as an event of default equivalent to a failure to make

any other payment required under the lease (id. § 11.1(b)).

The City’s major remedies on default draw no distinction

between the various payment obligations. (/d., § 11.2(a),

(c), and (d), pp. 46-48.) In the absence of an indication of

the parties’ intent that the lease be severable, Colorado

law requires that it be treated as an integrated, single

agreement. And because the Denver Lease, taken as a

whole, is a true lease for purposes of § 365, it is not neces-

sary to address the arguments of the parties as to whether

the financing aspects of the lease, considered separately,

would have that status.

Conclusion

For the reasons set out above, in Adversary Proceed-

ing Nos. 03 A 00975, 03 A00976, and 03 A 00977, United’s

motions for summary judgement are granted and the

defendants’ motions for summary judgment are denied. In

Adversary Proceeding No. 03 A 00978, the defendants’

motion for summary judgment is granted and United’s

In determining severability for purposes of assumption or

rejection under § 365, a bankruptcy court applying the law of the

District of Columbia came to a similar conclusion, holding that a lease

incorporating financing by the lessor could not be divided into separate

lease and financing contracts. In re Cafe Portners / Washington 1983, 90

B.R. 1 (Bankr.D.D.C.1988).

App. 72

mc’ for summary judgment is denied. Separate orders

wil entered to that effect.

App. 73

UNITED STATES BANKRUPTCY COURT

NORTHERN DISTRICT OF ILLINOIS

EASTERN DIVISION

In re: ) Chapter 11

UAL Corporation, et al., ) Case No. 02 B 48191

Debtors.

United Air Lines, Inc., )

Plaintiff, .

v. )

)

HSC Bank USA, as trustee, the ) Adversary

California Statewide Communities ) Proceeding No.

Development Authority, the City ) 03 A 00975

and County of San Francisco, and

the Airports Commission for the )

City and County of San Francisco, )

Defendants. )

JUDGMENT ORDER

This proceeding has come before the court on a motion

for summary judgment on behalf of United Air Lines, Inc.

(“United”), seeking a declaratory judgment that certain of

its obligations to make payments related to airport im-

provements are not obligations arising under a “lease”

pursuant to §365 of the Bankruptcy Code (Title 11

U.S.C.). HSBC Bank USA, as Trustee, the California

Communities Development Authority, and the City and

County of San Francisco (the “Defendants”) have filed

cross-motions for summary judgment. The court — having

considered the memoranda filed by the parties and the

arguments made in open court — has determined to grant

United’s motion, and deny the motions of the Defendants,

App. 74

for the reasons set out in the memorandum of Decision

filed with this order.

Accordingly, it is hereby ordered (1) that judgment is

entered in favor of United, declaring the “Facilities Lease”

at San Francisco International Airport, by and between

United and the California Statewide Communities Devel-

opment Authority, dated August 1, 1997, is not a lease for

the purposes of assumption or rejection pursuant to § 365

of the Code, and (2) that the Defendants’ cross-motions for

summary judgment are denied.

Dated: March 30, 2004

/s/ Eugene R. Wedoff

Eugene R. Wedoff

United States Bankruptcy

Judge

App. 75

United States Court of Appeals

For the Seventh Circuit

Chicago, Illinois 60604

August 23, 2005

Before

Hon. WILLIAM J. BAUER, Circuit Judge

Hon. FRANK H. EASTERBROOK, Circuit Judge

Hon. DANIEL A. MANION, Circuit Judge

UNITED AIRLINES, INC.,

Plaintiff- llant, Appeals from the

ve United States District

Nos. 04-4209, 04-4315 V. Court for the Northern

& 04-4321 District of Illinois,

HSBC BANK USA, N. A., as Trustee, Eastern Division.

and CALIFORNIA STATEWIDE Nos. 04 C 2836 & 2837

COMMUNITIES DEVELOPMENT John W. Darrah,

AUTHORITY, Judge.

Defendants-Appellees.

Order

Defendants-appellees each filed a petition for rehear-

ing and rehearing e

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