Unpublished Disposition, 878 F.2d 385 (9th Cir. 1984)

MEMORANDUM^* 

OVERVIEW

Appellants, Airborne Freight Corporation and Airborne Express, Inc. (Airborne), appeal the district court's ruling that they were not entitled to equitable relief under a lease option contract to purchase an airplane because they had "unclean hands." The district court found because Airborne had taken a tax position that was potentially adverse to the appellee, William J. Condren (Condren), that Airborne behaved recklessly and injured Condren.

FACTS AND PROCEEDINGS

On May 7, 1984, the parties executed the following documents concerning the aircraft: Loan Agreement; Promissory Note; Aircraft Lease with Purchase Option (Lease); FAA Bill of Sale and long form Bill of Sale; Escrow Agreement; and Aircraft Chattel Mortgage. The Lease Agreement contained an option to buy provided Airborne gave 120 days prior notice. Airborne took possession of the airplane on May 7th and Condren received $6,180,000 from Airborne. The payments on the Lease equaled the loan payments ($80,000) but were actually paid and treated as separate transactions by both parties. After the execution of the Lease, Airborne Freight (the parent company) submitted the Lease to their accountants to determine the proper way to report the transaction for tax purposes. The accountants, Touche Ross, recommended treating the Lease as a sale under IRS guidelines used when determining if a lease is in fact a sale. Airborne took depreciation on the airplane for 1984. In April of 1985, Airborne neglected to exercise the purchase option.

In June, 1985, Condren notified Airborne that Airborne had not properly exercised the purchase option contained in the May 7th Lease and demanded return of the aircraft upon expiration of the lease term. Airborne contends that Condren, an attorney and tax specialist, structured the deal to suit his needs and that the purchase and sale was changed to a lease option at Condren's request. Airborne states that Condren knew and acquiesced to Airborne's spending $750,000, to modify the airplane, which would be forfeited should Airborne be required to return the aircraft to Condren. The negotiations for the purchase and sale and the negotiations for the lease option resulted in the same out of pocket costs to Airborne, that is, $6,180,000. Airborne contends that in spite of how the parties structured the deal for tax purposes, the "deal" was essentially a sale and Airborne relied on that characterization when it expended the $750,000.

Condren contends that the parties' full agreement is reflected in the Lease and that the Lease was structured in such a way as to give Condren favorable tax treatment. Airborne did not properly exercise the purchase option and Condren alleges a loss suffered from the fact Airborne retains possession of the airplane.

The district court found that the agreement was a lease and not a sale. The February negotiations did not result in a sale because they were tentative pending the execution of an additional document and the executed May 7th Lease was a lease and not a purchase agreement. The court noted both sides were well represented by counsel and held that Airborne was not entitled to specific performance.

The district court further found that Airborne was not entitled to equitable relief from its failure to exercise the option, and held that Airborne's "unclean hands" in treating the Lease as a sale for tax purposes overrode any equitable consideration of the forfeiture of the features it added to the aircraft, especially in view of the lease language which contemplates removal of modifications. The court found that the conduct of Airborne of treating itself as the owner of the aircraft and taking depreciation deductions was related to the transactions, that Airborne was "reckless in disregarding the express contract language that the transaction was a lease," and that Condren was injured because his

position with the Internal Revenue Service ("IRS") is placed in grave jeopardy. The intent of the parties is the first thing that the IRS looks at in deciding whether an agreement is to be treated as a lease or a sale. Airborne's accountant, Gary Grimstad of Touche Ross, pointed this out in his letter to Airborne regarding Airborne's tax treatment of the transaction, even though Grimstad never read the lease between Airborne and made no inquiry of Airborne as to the intent of the parties.

Condren testified at trial that if he waived the notice requirement of the option, his position (as owner of the aircraft who also took a depreciation deduction) with the IRS would be untenable, and he would be agreeing that the Lease was a sham, resulting in a loss to him of $900,000. However, Condren did not tell his accountant about the $6,000,000 "loan" Airborne Freight gave to Condren. The district court found that by choosing to disregard the explicit terms of the Lease and treat itself as the owner that Airborne had "not fully and fairly performed its part of the bargain; plaintiff is left to its legal remedies." Having found that Airborne failed to exercise the option and being limited to legal remedies, the court ordered that Airborne return the aircraft to Condren and that Condren return the balance of the loan made to him by Airborne Freight. Airborne appeals.

DISCUSSION

This is a diversity case and Washington is the forum state. A federal court sitting in Washington will apply Washington law, including Washington's conflicts law. Tomlin v. Boeing Co., 650 F.2d 1065, 1067 (9th Cir. 1981); Klaxon Co. v. Stentor Electric Manufacturing Co., 313 U.S. 487, 496 (1941). Section 16 of the Lease provides that New York law should be applied in matters of construction, validity and performance and the contract "shall in all respects be governed by, and construed in accordance with, the laws of the State of New York." Washington recognizes valid forum selection clauses; thus, New York law applies. Baffin Land Corp. v. Monticello Motor Inn, Inc., 70 Wash. 2d 893, 425 P.2d 623, 627 (1967).

We review the district court's findings of fact and contract interpretation that looks to extrinsic evidence under the clearly erroneous standard. Rozay's Transfer v. Local Freight Drivers, L. 208, 850 F.2d 1321, 1326-27 (9th Cir. 1988). We review de novo questions of law or interpretation of a contract based on a district court's analysis of the contractual language and application of contract interpretation principles. Kern Oil and Refining Co. v. Tenneco Oil Co., 840 F.2d 730, 736 (9th Cir.), cert. denied, 109 S. Ct. 378 (1988).

Equitable Relief

Generally, under New York law, notice exercising an option is legally effective only if it is made within the specific time and manner in the lease. Optivision, Inc. v. Syracuse Shopping Ctr. Assoc., 472 F. Supp. 665, 682 (N.D.N.Y.1979) citing J.N.A. Realty Corp. v. Cross Bay Chelsea, Inc., 42 N.Y.2d 392, 397 N.Y.S.2d 958, 960, 366 N.E.2d 1313 (1977). Generally, defaulting on an option does not invite the application of equity as the option itself does not create any interest in the property and no rights accrue until the condition precedent has been met by giving notice within the time specified. Equity will not intervene because the loss of the option does not ordinarily result in the forfeiture of any vested rights. J.N.A. Realty Corp., 397 N.Y.S.2d at 960. The New York courts will relieve a tenant from forfeiture if the tenant's failure to exercise his renewal option was the result of an honest mistake or excusable fault, even if due to the tenant's own negligence or inadvertence. Optivision, Inc., 472 F. Supp. at 681-82.

The three elements necessary to maintain a cause of action for equitable relief are 1) that the tenant's [here the lessee's] delay in exercising their option to renew was the result of an excusable default; 2) that the tenant had made substantial improvements on the premises and had a valuable interest in the leasehold interest, and 3) that the landlord had not been prejudiced by the delay. Pepe's Shamrock, Inc. v. Vecchio, 128 A.D.2d 599, 512 N.Y.S.2d 858, 860 (1987); Godnig v. Belmont Realty Co., Inc., 124 A.D.2d 701, 508 N.Y.S.2d 213, 215 (1986); Blumenthal v. 162 East 80th Tenants, Inc., 88 A.D.2d 871, 451 N.Y.S.2d 771, 772 (1982) (court found principles of equity that apply to options to renew leases applicable to options to purchase).

The district court held Airborne to the consequences at law for its failure to exercise the option as it found that Airborne was barred from invoking equity because it had unclean hands. We affirm the district court, but on different legal grounds. The findings by the district court established that Airborne did not meet the first element necessary to maintain a cause of action for equitable relief. Pepe's Shamrock, Inc., 512 N.Y.S.2d at 860 (first element necessary for equitable relief is to show failure to exercise option was inadvertent). Airborne states that it failed to exercise the option because the persons who negotiated and approved the transaction are located in Ohio and the persons responsible for paying the Lease are in Washington. Condren contends that Airborne's failure to give notice was advertent because Airborne had argued that the transaction was essentially a sale and not a lease. The district court found Airborne disregarded the Lease by taking a tax position adverse to Condren and further found that

after Airborne failed to exercise the purchase option, Dorland [Airborne Express Chairman Graham Dorland] sent Condren a letter stating that the "transaction was, is, and always was intended to be a purchase and sale of the aircraft." Dorland testified at trial that he felt that the lease agreement was a meaningless document.

Airborne's rights to the airplane come solely from the Lease. Under the district court's findings we hold that Airborne cannot invoke equity because the record shows that their intention was to treat the Lease as a sale, that they never exercised the option and thus, their failure to exercise the option to buy was not the result of excusable default. Id.

AFFIRMED.