Mulligan, John T.

English

Case Western Reserve University School of Law

Case Western Reserve Law ReviewVolume 24 | Issue 31973Recent Case: UCC Article 9 - Lease/Option as aSecurity Agreement - Statute of Frauds [In reFinancial Computer Systems, Inc., 474 F.2d 1258 (9thCir. 1973)]John T. MulliganFollow this and additional works at: https://scholarlycommons.law.case.edu/caselrevPart of the Law CommonsThis Note is brought to you for free and open access by the Student Journals at Case Western Reserve University School of Law Scholarly Commons. Ithas been accepted for inclusion in Case Western Reserve Law Review by an authorized administrator of Case Western Reserve University School ofLaw Scholarly Commons.Recommended CitationJohn T. Mulligan, Recent Case: UCC Article 9 - Lease/Option as a Security Agreement - Statute of Frauds [In re Financial Computer Systems,Inc., 474 F.2d 1258 (9th Cir. 1973)], 24 Case W. Res. L. Rev. 619 (1973)Available at: https://scholarlycommons.law.case.edu/caselrev/vol24/iss3/71973]RECENT CASEUCC ARTICLE 9 - LEASE/OPTION AS A SECURITYAGREEMENT - STATUTE OF FRAUDSIn re Financial Computer Systems, Inc.,474 F.2d 1258 (9th Cir. 1973).It has long been held that a debtor may introduce extrinsicevidence to prove that a writing is actually a security agreementeven though it appears to be something else.' Such a rule has beenconsidered essential to protect the debtor's equity of redemption.The Ninth Circuit Court of Appeals, nevertheless, recently held inIn re Financial Computer" Systems, Inc.' that the statute of fraudsbarred inquiry into a bankruptcy trustee's claim that a purportedlease was in fact a disguised security agreement.Equitable Leasing Company had agreed in writing to lease twoair conditioning units to Financial. The terms of the contract pro-vided that the units would at all times be considered the "sole andexclusive" property of Equitable to be returned to Equitable uponthe termination of the lease, and that the writing constituted theentire understanding of the parties and could not be altered oramended without the written approval of both parties.In Financial's bankruptcy proceedings Equitable sought to re-claim the air conditioning units on the simple ground that it ownedthem. The trustee contested the reclamation by claiming that thewritten agreement did not embody the entire understanding of theparties despite its express provisions to the contrary. Over Equi-table's objection, the trustee was permitted to introduce parol evi-dence that indicated Equitable had given Financial a verbal optionto purchase the units for $1,094 at the expiration of the lease. Thetrustee maintained that this option arrangement converted what ap-11 G. GILMORE, SEcuRrTY INTERESTS IN PERSONAL PROPERTY § 2.6, at 47(1965):The rule that the courts will determine the true nature of a security trans-action, and will not be prevented from exercising their function of judicial re-view by the form of words the parties have chosen, long antedates the nine-teenth century chattel mortgage .... Almost without question the rule wastransplanted from the land mortgage to the chattel mortgage.The rule can be traced back to 1470. W. WALSH, MORTGAGES § 3, at 7 (1934). SeeDobbs v. Kellogg, 53 Wis. 448, 452-53, 10 N.W. 623, 624 (1881) (Irrespective of thestatute of frauds, it is "well established" that a deed absolute on its face may be shown byparol evidence to be a mortgage.)2474 F.2d 1258 (9th Cir. 1973).CASE WESTERN RESERVE LAW REVIEW [Vol. 24: 619peared to be a simple chattel lease into a security agreement andthat, since Equitable had failed to record and thus perfect' its in-terest, its claim was subordinated to the claims of third-party credi-tors of Financial.4On appeal5 Equitable argued that the subordination of its claimto the units through the recognition of the alleged oral option wasin the nature of a forced sale to Financial and thus identical to theenforcement of an unwritten sales contract. To allow such subordi-nation would violate the statute of frauds.' In response, the trusteeasserted that the statute of frauds was not applicable since the evi-dence of the oral option was not introduced to enforce the option,but merely to prove that the agreement was a security device andnot a lease.The Court of Appeals for the Ninth Circuit rejected the trustee'sdistinction in a tersely written opinion. The court noted that the re-sult of allowing the trustee to prove the existence of the option wastantamount to enforcing a sale under the option provision. It thusconcluded that since the alleged security agreement acted as an in-strument of sale (causing a transfer of title from Equitable to Fi-nancial's creditors), to uphold the agreement would be equivalentto enforcement of an unwritten sales contract. The court believedthat the statute of frauds for the sale of goods was a dear man-date against such a result.7 In applying the statute of frauds, the3 CAL. COMM. CODE § 9302 (West 1964). The California Commercial Codeis virtually identical to the Uniform Commercial Code in all sections that are pertinentto this discussion.4 CAI_ COMM. CODE § 9301 (West 1964).Both the bankruptcy referee and the federal district court that reviewed his findingsheld for the trustee; neither opinion has been reported.5 Equitable appealed under three other assignments of error: (1) that the oral evi-dence of the option was inadmissible under California Code section 2202 and the parolevidence rule, (2) that it was error to conclude that the "lease" was in reality a condi-tional sales agreement, and (3) that the referee erred in failing to offset, after it hadbeen stipulated that there were rentals due Equitable under the terms of the lease. Thecourt's opinion does not indicate how the trustee met these remaining assignments oferror.0 CAL COMM. CODE § 2201(1) (West 1964):a contract for the sale of goods for the price of $500 or more is not en-forceable by way of action or defense unless there is some writing sufficient toindicate that a contract for sale has been made between the parties and signedby the party against whom enforcement is sought or by his authorized agentor broker.' Although the court's rationale is not exactly clear, it seems to have been basedon the following:(a) As a hypothetical, a suit by Financial to force Equitable to sell the units pur-suant to the option would fail for lack of a written contract of sale.LEASE/OPTION AS SECURITY AGREEMENTcourt gave the written lease an invincibility new to the Californialaws of either real or personal property."The problems presented by this case could have been analyzedand resolved under the provisions and comments of the CommercialCodef Article 9 expressly declares the right and the duty of a courtto investigate beyond the written document. California Code sec-tion 9102(1) (a) states that article 9 is to apply "to any transaction(regardless of its form) which is intended to create a security in-terest in personal property. . .. "I"Official Comments to the Uniform Commercial Code (UCC)affirm the drafters' commitment to preserving the rights of debtors.Comment 4 to UCC section 9-203 states:[T]he requirement of this Section that the debtor sign a securityagreement is not intended to reject, and does not reject, the deeplyrooted doctrine that a bill of sale although absolute in form maybe shown to have been in fact given as security. Under this Ar-tide as under prior law a debtor may show by parol evidence that atransfer purporting to be absolute was in fact for security and maythen, on payment of the debt, assert his fundamental right to re-turn of the collateral and execution of an acknowledgment of satis-faction.(b) Recognition of the oral option would change the lease into an unperfected se-curity agreement and thus result in Equitable's loss of the units to the trustee.(c) The court, through the statute of frauds, avoided recognition of the oral optionand thus achieved the same result - Equitable's reclamation of the units - as wouldhave been achieved in the sale situation.8 California courts have repeatedly held that a deed absolute on its face may beshown to be a mortgage even by parol evidence. As far back as 1859 the Supreme Courtof California addressed this issue in Pierce v. Robinson, 13 Cal. 116, 126 (1859), andstated emphatically that "[ajs the equity upon which the Courts act arises from the realcharacter of the transaction, it is of no consequence in what manner this character is es-tablished, whether by deed, or other writing, or by parol." A basis for the court's policyof looking beyond the instrument was the fear that "[u] nless the parol evidence can beadmitted ... the equity of redemption will elude the grasp of the Court, and rest in thesimple good faith of the creditor." Id. at 126-27. Since Pierce, the California courtshave uniformly followed that rationale. This California case law authority, which mani-fests what Professor Osborne calls the .'traditional solicitude of the courts towards amortgagor's redemption right" (G. OSBORNE, THE LAw OF MORTGAGES 123 (2d ed.1970) ), is complemented by state statute: "[t]he fact that a transfer was made subjectto defeasance on a condition, may, for this purpose of showing such a transfer to be amortgage, be proved . . . though the fact does not appear by the terms of the instru-ment." CAL CIM. CODE § 2925 (West 1954).In contrast to the present case, California state courts have transferred this solicitudefrom the mortgage laws to the law of personalty. E.g., Silverstein v. Kohler & Chase,181 Cal. 51, 183 P. 451 (1919); Lundy Furniture Co. v. White, 128 Cal. 170, 60 P.759 (1900).9 "Commercial Code" is used to indicate both the Uniform Commercial Code andthe California Commercial Code. See note 3 supra.10 CAL. COMM. CODE § 9102(1) (a) (West 1964).19731CASE WESTERN RESERVE LAW REVIEW [Vol. 24:619Although this comment does not envisage the facts of FinancialComputer Systems, its rationale is relevant to the lease/option situa-tion. In addition, comment 4 to UCC section 9-501 offers furthersupport for judicial protection of the debtor:In the area of rights after default, our legal system has tradition-ally looked with suspicion on agreements designed to cut down onthe debtor's rights and free the secured party from his duties....The default situation offers great scope for overreaching; the sus-picious attitude of the courts has been grounded in common sense.Despite this tradition of "suspicion," the court in Financial Com-puter Systems did not consider the impact of article 9 on thissituation; nor did it discuss the protection of Financial's creditorswhose interests the trustee represented. The need for such protec-tion should have brought article 9 into consideration; the policybehind article 9 mandates no less. The comment to UCC section9-101 expressly states, "The rules set out in this Article are princi-pally concerned with the limits of the secured party's protectionagainst purchasers from and creditors of the debtor."Two commentators have recently noted that the ability of arti-cle 9 to protect deserving creditors is severely undercut by an in-flexible adherence to evidentiary rules regulating the sale of goods."Indeed, use of the statute of frauds in the instant case seems con-trary to the statute's policy12 of preventing fraud and perjury. Im-posing a statute-of-frauds barrier to full judicial inquiry in situationslike that in Financial Computer Systems could serve to promotefraud by permitting avoidance of the requirements of article 9 byingenious drafting.'Two sections of the Commercial Code dictate that judicial in-quiry must be comprehensive enough to prevent this sort of scheme.Section 1201(3) defines an agreement to mean "the bargain ofthe parties in fact as found in their language or by implicationfrom other circumstances including course of dealing or usage of11 Peden, Treatment of Equipment Leases As Security Agreements Under the Uni-form Commercial Code, 13 WM. & MARY L. REV. 110, 140 (1971): "The purpose ofArticle 9 would be frustrated if evidentiary rules could be used to shield sham transac-tions."; Note, Leases as Security: Some Problems of Identification, 8 B.C. IND. &COMM. L REV. 764, 768 (1967): "Obviously sections 1-201(37) and 9-102(1)(a) and(2) look to an identification of actual intent regardless of form, and any exclusionary rulewhich would tend to inhibit the success of this inquiry must be regarded suspiciously."12See Joseph E. Seagram & Sons, Inc. v. Shaffer, 310 F.2d 668, 673 (10th Cir.1962); J. WHITE & R. SUMMERS, UNIFORM COMMERCIAL CODE § 2-8 (1972).13 See Corbin, The Uniform Commercial Code - Sales; Should it be Enacted?, 59YALE L.J. 821, 829 (1950) (court enforcement of detailed formal requirements fostersdishonest repudiation without preventing fraud).LEASE/OPTION AS SECURITY AGREEMENTtrade ... ."'I And, more importantly, section 1201(37) states that"[w~hether a lease is one intended as security is to be determinedby the facts of each case.... " This language has long been under-stood as requiring the court to inquire beyond the wording of theagreement in order to discover the true intention of parties whopurported to 'be contracting for a lease.' 6Quite possibly such a full inquiry would have disclosed to thecourt that Equitable Leasing possessed nothing more than a lessorinterest even if the evidence of the alleged optiofi had been ad-mitted. Indeed, Caifornia Code section 1201(37) specifically statesthat the inclusion of an option to purchase in a lease agreementdoes not of itself give rise to a security interest. The court couldhave concluded that, option or no option, the agreement betweenFinancial and Equitable was not one intended for security. Hadthe court reached that conclusion, it could have reversed the ref-eree's decision on Equitable's second assignment of error - thatit was incorrect to conclude that the lease was in reality a conditionalsales agreement. The key to such a determination would havebeen an economic analysis of the alleged $1,094 option price.Section 1201(37) declares that "an agreement that upon the com-pliance with the terms of the lease the lessee shall become or hasthe option to become the owner of the property for no additionalconsideration or for a nominal consideration [makesj the leaseone intended for security." The $1,094 option price "is addition-al consideration"; the determination of whether or not it is nominalconsideration depends on such factors as the fair market value of theair conditioning units at the beginning of the lease, the amount paidunder the lease, and the market value of the units at the expirationof the lease. 7  Although numerous courts have used an economic14CAI_ COMM. CODE § 1201(3) (West 1964); UNIFORM COMMERCAL CODE§ 1-201 (3).1 CAL. COMM. CODE § 1201(37) (West 1964); UNIFORM COMMERCIAL CODE§ 1-201 (37).16E.g., In re Walter W. Willis, Inc., 313 F. Supp. 1274, 1278 n.2 (N.D. Ohio1970):One can argue that the Court's approach in viewing evidence outside the leaseis violative of the parole evidence rule.... The Court disagrees.... [T]he pro-vision reads that the facts in each case determine whether a lease is intended assecurity. To the Court, this implies that facts within and without the leasemust be viewed in ascertaining the intent of the parties to the transaction.See also In re Transcontinental Industries, Inc., 3 UCC REP. SERv. 235 (N.D. Ga. 1965).17 A recent California bankruptcy referee's decision, In re Washington ProcessingCo., 3 UCC REP. SERV. 475 (Ref. Dec. S.D. Cal. 1966), focused on the market value19731CASE WESTERN RESERVE LAW REVIEW [Vol. 24: 619analysis approach under similar circumstances,'" the court in Finan-cial Computer Systems did not make such a comparison, nor did itmention the market value of the air conditioning units at the timethe alleged option could have been exercised.Perhaps the court's decision in Financial Computer Systems re-sulted in the correct disposition of the disputed air conditioningunits. However, in reaching this determination without the fullanalysis demanded by articles 1 and 9 of the California CommercialCode, the court has established a questionable precedent. Creditorsmay now be able to thwart a debtor's right to redeem his collateralby using an instrument purporting to be other than a security agree-ment and objecting to the introduction of external evidence to proveotherwise. Third-party creditors of the debtor, who have a rightto look to his equity interests for satisfaction of their claims, willbe unjustly denied access to the totality of those interests.I Ironically, this fraud would result from invoking a statute whosepurpose was to prevent fraud. Further, the Article 2 statute offrauds is inapplicable in the context of security interests where ananalysis of the economic facts of a lease/option agreement is essen-tial if a court is to determine whether or not a security interest wasintended. The chance of fraud is minimized where a court engagesin a thorough probe; where it fails to do so, as in Financial Compu-ter Systems, the chances of successful fraud are increased.JOHN T. MULLIGANat the expiration of the lease and concluded that an option price of $1,350 was "nom-inal consideration" for goods which at the time of the exercise of the option had amarket value of nearly $10,000.18 One approach is market value analysis. As indicated by CAL. COMM. CODE §1201 (37) (West 1964), where the option price is nominal, the agreement most likelywill be deemed a security device. In re Universal Medical Sources, 8 UCC REP. SERV.614 (Ref. Dec. ED. Pa. 1970); In re Oak Mfg., Inc., 6 UCC REP. SERv. 1273 (Ref.Dec. S.D.N.Y. 1969); In re Alpha Creamery Co., 4 UCC REP. SERv. 794 (Ref. Dec.W.D. Mich. 1967). On the other hand, if the option price were nearly equivalent tothe market value at the time of the option, it would indicate that the lessee was actuallypaying true rent based on normal wear and tear plus an allowance for profit for thelessor. J. WHITE & R. SUMMERS, UNIFORM COMMERCIAL CODE § 22-3 (1972).Under a second approach, if the option price amounts to more than 25 percent ofthe list price, the purported lease is not deemed a security interest. In re Alpha Cream-ery Co., 4 UCC REP. SERV. 794 (Ref. Dec. W.D. Mich. 1967); In re Wheatland lec.Prods. Co., 237 F. Supp. 820 (W.D. Pa. 1964).A third approach involves an analysis of the relationship of the actual rent paid andthe fair rental value of the item. A lease will generally be upheld as a lease and notconsidered a sale if the actual rent paid does not exceed the fair rental value and if thelessee has the right to discontinue the lease and return the goods to the lessor. De-Rochav. Macomber, 330 Mass. 611, 116 N.E.2d 139 (1953).

Recent Case: UCC Article 9 - Lease/Option as a Security Agreement - Statute of Frauds [\u3ci\u3eIn re Financial Computer Systems, Inc.\u3c/i\u3e, 474 F.2d 1258 (9th Cir. 1973)]

https://scholarlycommons.law.case.edu/cgi/viewcontent.cgi?article=2961&amp;context=caselrev

Recent Case: UCC Article 9 - Lease/Option as a Security Agreement - Statute of Frauds [\u3ci\u3eIn re Financial Computer Systems, Inc.\u3c/i\u3e, 474 F.2d 1258 (9th Cir. 1973)]

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