Predominant Purpose: What’s That?

Equipment Leasing & Finance Magazine October 2023

THE 2022 AMENDMENTS TO THE UNIFORM COMMERCIAL CODE (THE “2022 AMENDMENTS”) constitute a sweeping expansion and revision of the UCC. Among other things, the new rules greatly facilitate financing of chattel paper leases and security agreements, including “hybrid leases” and “hybrid transactions”—what many call “bundled transactions.”

But there is a catch: specific goods must be the “predominant purpose” of the hybrid lease and in a hybrid transaction, the creditor must rely on specific goods as the “primary collateral.” This article will provide guidance on how to navigate the new requirements for predominant purpose.

What Happened?

Starting in 2019, the American Law Institute and the Uniform Law Commission (the “Sponsors”) commenced a comprehensive review of the UCC, with the goal of revising the UCC to reflect emerging technologies such as blockchain and digital assets. Vigorous advocacy by several ELFA members convinced the Sponsors to study bundled transactions, which include not only goods, but also software, materials and services.

Last year, the Sponsors approved the 2022 Amendments and recommended they be enacted by the states. Most noteworthy for equipment finance practitioners were revised or new definitions for the following: Chattel Paper, Hybrid Lease, and Hybrid Transaction.

Under the 2022 Amendments, Chattel Paper now means (A) a right to payment of a monetary obligation secured by specific goods, if the right to payment and security agreement are evidenced by a record; or (B) a right to payment of a monetary obligation owed by a lessee under a lease agreement with respect to specific goods and a monetary obligation owed by the lessee in connection with the transaction giving rise to the lease, if… the predominant purpose of the transaction giving rise to the lease was to give the lessee the right to possession and use of the goods.

As under current law, Chattel Paper can consist of either a lease of goods or a secured transaction. However, unlike current law, a Chattel Paper lease can now include any other monetary obligation, not only with respect to software, but also “the provision of services, the sale of other goods, or a sale, lease or license of property other than goods.”

Why Do We Care?

There are two reasons to care: the growth of hybrid leases and transactions, and the ability to perfect a security interest in Chattel Paper by possession. Lessors and lenders want to syndicate or securitize hybrid leases and hybrid transactions efficiently, and their investors want the advantage of super-priority (which is available for Chattel Paper perfected by possession) over any competing creditor that may have perfected its interest by filing a financing statement.

There are several catches. First, as under current law, the lease or secured transaction must pertain to “specific goods.” For historical reasons, the Official Comments to the 2022 Amendments insist that a right “to payment secured by a security interest in rotating collateral is not chattel paper” and that the “special rules for chattel paper contemplate that specific goods are the primary collateral.” Otherwise, a lessor or secured lender could skirt the requirement to file a financing statement simply by having the lease or security agreement grant it rights, perfected by possession, in all the lessee’s or debtor’s property—a classic case of a “secret lien.”

A second catch is that the overall monetary obligation must be “owed by the lessee in connection with the transaction giving rise to the lease.” The Official Comments to the 2022 Amendments emphasize that if the right to payment covers just a specific piece of equipment, plus a multitude of other property, then “it would be possible to convert virtually any monetary obligation…into chattel paper merely by including…a specific item of goods.” But if two or more records (to use the UCC term for what used to be called a “writing”) contain a lease of equipment plus a security interest in a deposit account (such as to secure the obligations of the lessee under the lease), then the documents, taken together, would constitute chattel paper.

Predominant Purpose?

The most important catch in the new definition of Chattel Paper is the requirement that “the predominant purpose of the transaction giving rise to the lease [is] to give the lessee the right to possession and use of the goods.” This requirement inspired spirited discussion with the Sponsors; many ELFA commentators wanted the UCC to use “majority” or “principal” purpose, but the Sponsors held firm, pointing to case law that had used the concept of predominant purpose.

Official Comments to the 2022 Amendments were included to help practitioners navigate this requirement. Indeed, Official Comment 11 postulates that a customer and car dealer enter into an agreement under which, for a fixed monthly payment, the customer “is entitled to possession of a specific vehicle for 36 months” and the dealer provides 24/7 monitoring of the vehicle’s location and condition, roadside assistance and periodic updates to the vehicle’s operating system. If the “value of the right to possess and use the vehicle is significantly greater than the value of the services and updates,” then the Comment concludes that the goods aspect would predominate, and the agreement would constitute Chattel Paper.

Official Comment 12 describes a different situation, in which a customer enters into a contract with Cableco to receive, for a fixed amount each month, the cable “box” and access to several hundred identified television channels. The Comment assumes that if “the components of the transaction were priced separately, the price for the programming would be substantially more than the price for possession and use of the device” and concludes that the goods aspect of the transaction would not predominate, and the contract would not constitute Chattel Paper.

Any Case Law?

There are nearly 100 reported judicial decisions construing predominant purpose or predominant thrust. Unsurprisingly, the overwhelming majority deal with sales of goods along with sales of ancillary services. One 2008 decision, Gelles Racing v. Ferris, involved a vehicle lease during the six-month Formula One BMW racing season, and under which the lessor provided mechanical support (such as fuel and data analysis) and engineering services. The court ruled that UCC Article 2A only applies if the predominant thrust (a bad pun, where a racing car is involved) is the goods and the services are only “incidentally involved.” The court observed that the mere presence of Gelles Racing drivers at the first three racing events did not constitute a course of performance, which would amount to the lessor’s providing a “team” of drivers (for the leased vehicle) that might have converted the lease into a service contract.

Another oft-cited 2000 decision, Palmetto Linen Service, Inc. v. U.N.X., Inc., involved the sale of chemicals to the Linen Service along with installation of a pump system to regulate the injection of the chemicals during the cleaning process. Similar to the Gelles Racing opinion, the decision in this instance distinguished between a sale of goods and a services contract by ruling that the agreement would constitute a sale of goods if the services element was “incidentally involved.” The court ruled that the predominant thrust was the sale of chemicals and equipment, rather than the provision of services.

Any Other Clues?

The 2022 Amendments contain further guidance regarding “predominant purpose.” The lengthy Official Comments to UCC Section 2-102 (Sales; Scope) describe factors that may be relevant in determining the predominant purpose of a hybrid transaction involving sale of goods and other elements, such as services. Official Comment 3 lists possible relevant factors as “the language of the agreement, the portion of the total price that is attributable to the sale of goods (as to which an agreed-upon allocation will ordinarily be binding on the parties) [emphasis added], the purposes of the parties…and the nature of the businesses of the parties.”

Official Comments 5 and 6 to UCC Section 2A-102 (Leases; Scope) echo, in the context of determining whether a contract constitutes a “hybrid lease,” the foregoing factors: the language of the agreement and the agreed-upon allocation of the total price to the right to possess and use the goods—but adds that “neither is determinative” and that, ultimately, the determination “is a question of fact” for the court to decide.

As more jurisdictions adopt the 2022 Amendments, determining “predominant purpose” will occupy greater attention for counsel in documenting bundled transactions. It may be anticipated that an update to this subject may be appropriate for a 2025 Leasing Law essay.