## Facts

- Pillowtex Corporation, a textile manufacturer, entered into a Master Energy Services Agreement (MESA) in 1998 with a counterparty later succeeded by Duke Energy Royal LLC.
- Duke agreed to obtain and install energy-savings equipment at Pillowtex facilities, including lighting fixtures at multiple sites and a wastewater heat-recovery/hot-water system at a Georgia plant.
- The MESA required Pillowtex to make predetermined monthly payments for eight years and was drafted and recorded as a “lease.”
- The equipment’s useful life was approximately 20–25 years, substantially longer than the eight-year term.
- The payment structure ensured Duke would recover all of its costs within five years, indicating amortization of Duke’s investment plus return.
- At term end, Duke could: (1) remove and replace the equipment at its own expense, (2) abandon the equipment, (3) extend the agreement, or (4) sell the equipment to Pillowtex at a mutually agreeable price.
- Testimony indicated removal and replacement would be economically impractical and that the parties expected Duke would abandon the equipment.
- Pillowtex later filed for Chapter 11 and stopped making payments; Duke moved to compel postpetition “lease” payments as a lessor, while Pillowtex contended the MESA created a security interest.

## Issues

1. Whether the MESA was a “true lease” or a secured financing arrangement (security interest) under applicable commercial law for bankruptcy purposes.

## Decision

- The Third Circuit affirmed the district court’s order denying Duke’s motion to compel payments.
- The court held the MESA was a secured financing arrangement rather than a true lease.
- The court applied an economic-realities analysis under New York’s UCC, treating the agreement’s “lease” label and accounting/tax treatment as non-controlling.
- The court emphasized Duke’s cost recovery within five years, the equipment’s long remaining useful life, and the absence of a meaningful residual interest because repossession was not realistically expected and abandonment was anticipated.

## Legal Principles

- Bankruptcy courts characterize purported leases by examining the transaction’s economic substance rather than the parties’ labels or accounting/tax treatment.
- Under the UCC, a transaction is a security interest when the “lessor” lacks a meaningful residual economic interest and the payment stream functions to amortize the goods and provide a return.
- Where removal or repossession is economically unrealistic and the goods are expected to remain with the debtor after the term, the arrangement is more consistent with secured financing than a true lease.

## Conclusion

The court classified the MESA as a secured financing arrangement because its payment and end-of-term structure left Duke without a meaningful residual interest in the equipment, defeating Duke’s attempt to obtain lessor-style payment protections in the debtor’s Chapter 11 case.


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