The UCC and Commercial Lease Contracts
Leases versus secured transactions: learn the difference.
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The leases covered by the Uniform Commercial Code (UCC) are for personal property, or what the Code calls “goods,” such as machinery, equipment, and vehicles. The UCC does not cover real estate leases. Most of the rules for commercial lease contracts are in Article 2A, which has nearly 80 individual sections. Additional relevant rules are located in other parts of the UCC, such as Article 1 (General Provisions). Here we’ll look briefly just at some of the main UCC lease rules.
Note on lease terminology. Lease contracts involve two parties: (1) the lessor, who owns the leased goods and is making them available for lease, and (2) the lessee, who is leasing the goods for temporary use.
Lease vs. Security Interest
The UCC makes an important distinction between leases and secured transactions. If a business is truly leasing an item, the lessor keeps title to the item, and has the right to repossess the item if the business runs out of money. By contrast, if a business is actually buying an item over time on credit, then it is the business that has title to the item, and if the business runs out of money, other creditors besides the “lessor” may have rights to take the item to satisfy unpaid debts. As stated in the UCC, “A true lease of goods [versus a secured transaction] involves the payment for temporary possession . . . with an expectation that the goods will be returned to the owner at the end of the lease term.”
Transactions may superficially appear to be lease contracts but in fact are secured transactions. In these situations, “lessors” (actually, sellers) need to take additional steps to protect their interests in the goods. Most importantly, the seller should file a UCC financing statement with the appropriate government office. Otherwise, the seller will have fewer rights in the event of the buyer’s bankruptcy. (For more details, see the Nolo articles on secured transactions.)
An apparent lease transaction for goods will create a security interest in the goods if the lessee (buyer) is obligated to make payments on the goods for the entire term of the lease without a right to early termination, and any of the following is true:
- the lease term is equal to or greater than the remaining useful life of the goods
- the lessee is required either to renew the lease for the remaining useful life of the goods or to become the owner of the goods
- the lessee has the option to renew the lease for the remaining useful life of the goods at no additional charge or for a nominal charge upon compliance with the lease agreement; or
- the lessee has the option to become the owner of the goods for no additional charge or for a nominal charge upon compliance with the lease agreement.
This rule, which appears in UCC Section 1-201, may appear somewhat complicated but can be explained with a few short examples.
Example 1. Your business signs a three-year “lease” for a very old office machine that only has an additional two-year useful life. This “lease” is, in fact, a sale on an installment plan, and, per the first listed item above, creates a security interest.
Example2. Your business signs a two-year “lease” for the same old office machine as in Example 1. The lease can be renewed at the end of the two years, at no additional charge. This transaction is effectively a sale, and, per the third listed item above, creates a security interest.
Example 3. Your business signs a five-year “lease” for an office machine that gives you an option to become the owner of the machine at the end of the five-year period at no additional charge. Again, this is effectively a sale, and, per the last listed item, also creates a security interest.
Generally speaking, the UCC applies its warranty rules for the sale of goods to leases. So, just like there are rules for express warranties and implied warranties when goods are sold, there are rules for express warranties and implied warranties when goods are leased. In fact, the rules for the major types of warranties—express warranties, the implied warranty of merchantability, and the implied warranty of fitness for a particular purpose—are all nearly identical for sales and for leases. The rules regarding exclusion of warranties in lease contracts are also quite similar to the exclusion rules for sales contracts. (For additional details, check the Nolo article on UCC warranty rules for sale of goods.)
Leases That Must Be in Writing
In legal lingo, a law requiring a contract to be in writing is known as a “statute of frauds.” The UCC has a statute of frauds for leases. The general rule is that if the total payments to be made under the lease, excluding payments for options to renew or buy, are $1,000 or more, the lease must be in writing. The requirements for the enforceability of a lease are relatively flexible, allowing for omission or incorrect statement of certain terms.
There are also certain exceptions to the $1,000 or more rule. Most notably, in cases involving: (a) “specially manufactured” goods; and (b) goods that have already been received and accepted by the lessee, you may not need a writing.
Default and Remedies
A party is in default on a lease if it fails to meet its obligations under the lease contract. When one party defaults on a lease contract, the other party has the right to a remedy for that default. One section of the UCC states that both the lessor and lessee should look to the lease contract to determine if a party has defaulted, but other sections take older UCC rules regarding default and remedies for sales contracts and adapt them to lease. These latter rules are covered in a separate Nolo article on lease defaults and remedies.
As already noted, many of the UCC’s rules regarding leasing of goods are similar to, and even directly adapted from, older UCC rules regarding sales of goods. Therefore, apart from this article, it may be worth your while to check out the Nolo articles on the UCC and sale of goods.
This article is based on the current version of the model Uniform Commercial Code (UCC). Not all states have adopted all sections of the current model UCC. Moreover, the model UCC specifically leaves it to individual states to determine the precise wording of certain sections. Therefore, you should always check your own state’s commercial code for the most accurate information.