On Appeal from the United States District Court for the District of Delaware (Civil Action Nos. 00-CV-4211) District Judge: The Honorable Sue L. Robinson
Before: Alito and Fuentes, Circuit Judges
and PISANO,*fn1 District Judge
The opinion of the court was delivered by: Fuentes, Circuit Judge
Duke Energy Royal LLC ("Duke") appeals from an order of the District Court denying a motion to compel Pillowtex Corporation ("Pillowtex" or "debtor") to make lease payments owing under the Master Energy Services Agreement ("MESA"), an agreement its predecessor entered into with Pillowtex.*fn2 The District Court denied Duke's motion on the grounds that the MESA was not a true lease, but rather a secured financing arrangement. The sole issue in this appeal is whether the District Court correctly determined that the MESA entered into between Pillowtex and Duke prior to Pillowtex's bankruptcy filing was a secured financing arrangement rather than a true lease. We affirm because we agree with the District Court that, based on the economic realities of the underlying transaction, the MESA was a secured financing arrangement.
I. Facts and Procedural Background
Because the nature of the MESA is at issue, we first turn to its provisions and the transaction underlying the agreement. Pillowtex and Duke entered into the MESA on June 3, 1998. Pursuant to the MESA, Duke agreed to install certain equipment "for the purpose of improving the efficiency of energy consumption or otherwise to reduce the operating costs" incurred by Pillowtex at its facilities. (MESA § 2.5, App. at 299). The MESA covered two different sets of energy services projects, one involving production equipment and the other energy-savings equipment. The production equipment was provided to Pillowtex by Duke pursuant to separate stand-alone agreements, which were recorded as true leases on Pillowtex's books, and which the parties agree constituted true leases. Therefore, only the nature of the parties' arrangements concerning the energysavings equipment is at issue in this appeal.
The energy-savings equipment included certain lighting fixtures, T8 lamps and electronic ballasts (collectively the "lighting fixtures"), which were installed in nine of Pillowtex's facilities and a new wastewater heat recovery system that included hot water heating equipment (the "wastewater system" and together with the lighting fixtures, the "energy fixtures"), which was installed at Pillowtex's Columbus, Georgia plant. The lighting fixtures were selected, and the wastewater system was constructed, specifically for Pillowtex's facilities. (App. at 336-590).
In order to induce Pillowtex to enter into the energy services projects, Duke offered to originate funding for the production equipment "on a two-to-one basis ( i.e., for every $1 million of energy projects Duke would originate $2 million for funding of equipment) with a minimum of $28 million in funding for equipment leasing or financing." (App. at 153). Another incentive Pillowtex had for entering into the agreement was "that the energy projects would be cost neutral to Pillowtex for the term of the agreement; that is, Pillowtex's payments to Duke would be equivalent to Pillowtex's actual savings... and Pillowtex would then reap the benefits from the cost savings after the end of the term of the project." (App. at 153). In keeping with this arrangement, Pillowtex accounted for its payments to Duke under the MESA as a utility expense. (App. at 155).
The MESA provided that the cost of acquiring and installing the energy fixtures would be paid by Duke, which incurred total costs of approximately $10.41 million. (MESA § 5, App. at 302; 339). Of this amount, approximately $1.66 million was for material and labor costs for the wastewater system. (App. at 594). Approximately $4.46 million was for labor to install the lighting fixtures and $4.29 million was for material costs for the lighting fixtures, which is to say that the cost of labor to install the fixtures was higher than the cost of the actual materials themselves. (App. at 339, 70). Also, Duke paid approximately $223,000 to dispose of light fixtures and related equipment that it removed from Pillowtex's facilities. (App. at 69-70).
In exchange, Pillowtex was to pay Duke on a monthly basis one-twelfth of Pillowtex's annual energy savings, in an amount the parties agreed to in advance, until the end of the MESA's 8 year term. (MESA § 7.0, App. at 304). In addition, the parties agreed that the simple payback of all of Duke's costs was not to exceed 5 years. (MESA § 4.1(f), App. at 302). "Simple payback" is synonymous with "payback period," an accounting term which refers to "[t]he length of time required to recover a venture's initial cash investment, without accounting for the time value of money." BLACK'S LAW DICTIONARY 1150 (7th ed. 1999). In other words, the payments were structured to ensure that Pillowtex would make predetermined, equal monthly payments and that Duke would recover its costs 3 years prior to the end of the term of the MESA. Although the MESA was for an 8 year term, the parties agree that the useful life of the energy fixtures was 20-25 years. (App. at 74-75).
It is undisputed that Duke and Pillowtex intended to structure the MESA to have the characteristics of a lease and that the parties were trying to create a true lease. Indeed, Pillowtex's counsel conceded during oral argument before the District Court, "I don't disagree that [the MESA] was structured to have those characteristics for tax purposes and, you know, to [the] extent they could, the parties were trying to create a true lease, I would admit that." (App. at 117). The parties intended for the MESA to be structured as a true lease, in large part, because Pillowtex was subject to capital expenditure limitations under its senior credit facility and did not wish to have the energy-savings equipment count as capital expenditures under that facility. Nevertheless, the MESA is not labeled a lease and it does not refer to the parties as lessee and lessor. Also, Duke alleges that the parties were concerned with structuring the MESA's provisions relating to energysavings equipment in accordance with the requirements of Financial Accounting Standard 13, which sets the standards for financial accounting and reporting for leases. (App. at 164). However, the MESA fails to qualify as a true lease under ¶ 7 of that standard because the present value of the total payments due under the MESA exceeds the value of the original cost of the energy fixtures. (App. at 171).
In keeping with their intent to structure the transaction as a lease, the MESA provides that title to the equipment would remain with Duke. (MESA § 11.0, App. at 308). Also, Pillowtex agreed not to claim ownership of the equipment for income tax purposes, (MESA § 9.13(ii), App. at 307), and Pillowtex was not obligated to purchase the equipment at the end of the term of the MESA. Rather, the MESA provided the following four options to Duke at the conclusion of its term, if Pillowtex was not then in default:
(I) remove the Equipment installed and replace those [sic] Equipment with equipment comparable to those originally in place, provided that no such replacement shall be required with respect to Production Equipment; or,
(ii) abandon the Equipment in place; or,
(iii) continue this Agreement until the expiration of the term hereof and then extend the term of this Agreement for such additional period(s) and payment terms as the parties may agree upon; or,
(iv) [g]ive the Customer the option of purchasing all (but not less than all) of the Equipment at a mutually agreed upon price.
(MESA § 8.3, App. at 304). If Duke elected to exercise option (I), it was bound to "be responsible for all costs and expenses in removing such Equipment, including costs to repair any damage to [Pillowtex's] Facility caused by such removal." ( Id.) *fn3 Despite the existence of the option for Duke to repossess the equipment, Pillowtex's Vice President for Engineering, ...