Leases vs. mortgages in bankruptcy – is it really a lease?

By Mark J. Sandlin

Merely calling the agreement a lease and setting out the terms does not guarantee that an agreement will be treated as a lease; a bankruptcy court will look beyond the surface of an agreement and examine its substance to determine whether it is a lease or a financing agreement/mortgage. The following are some of the differences between true leases and financing arrangements in a bankruptcy context. Courts will generally look at a host of factors in determining whether the instrument is a lease or a financing arrangement. This analysis is based wholly on a review of Sixth Circuit decisions.

Calculation of RentsRents must be calculated using the fair market value of the property and without considering certain other factors. Where rent was to be paid was calculated, not on the fair market value of the property, but on a ten percent return on the lessor’s investment the agreement was found to be a financing agreement. A court which found rents were calculated exclusively to ensure a return for the lessor and not for the use of the property held the agreement to be a financing agreement not a lease.

Similarly, if the rental payments are essentially the payment of principal and interest on a loan, the transaction will be viewed as a financing agreement. A strong indicator of whether this is occurring is if the rental payments are approximately equal to the mortgage payments due on the property. However, even if rent payments are equal to mortgage payments, the agreement will be viewed as a lease if the rent payments extend well beyond when the mortgage is repaid. Although, it does not appear to be fatal to a lease if the payments are made on an installment basis during the early years of the lease, it is not as desirable as if the lease payments continue through the entire lease term. Having rent payments that are tied to the lessee’s profits might be an indicator that the agreement is not a true lease. If possible, keep rent payments from looking like loan payments by having the rent and mortgage payments differ in value. Although, if it is more desirable to have the rent payments mirror the mortgage payments, it is not fatal to the lease unless the lease is set to expire at the end of the mortgage.

Purchase OptionsIf the agreement has the option to renew or purchase the property for no additional or nominal consideration, it is highly indicative of a financing agreement. However, an option to renew the lease or purchase the property does not automatically qualify an agreement as a financing arrangement. If the option to renew or purchase is at a pre-determined amount that reflects the anticipated fair market value of the property, then the agreement is more likely to be viewed as a lease.

Purchase options themselves are not a problem; it is the purchase price that causes issues. The purchase option cannot offer the land for no or nominal consideration. Otherwise, it makes the lease payments appear more like loan payments with the lessee taking possession outright at the end of the lease. Two possible ways to successfully include a purchase option are to provide in the lease an anticipated fair market value at which the property will be offered or provide that, prior to the option being exercised, an independent appraisal will be conducted to determine the purchase price.

Sale-Leaseback AgreementThe decisions we reviewed seem to give weight to the reason the parties entered into the sale-leaseback agreement and the purpose behind the consideration given. Factors that are particularly important are whether the lessee solicited the lessor’s investment for its own benefit and whether the purchase price paid by the lessor was based on the lessee’s financing needs as opposed to the fair market value of the property, the former being a financing agreement. In one case the lessee’s agent solicited the lessor’s investment to achieve tax benefits for the lessee as well as a higher guaranteed return for the lessor. It was also determined that the purchase price paid by the lessor was not based on the fair market value of the property but rather on the lessee’s financing needs. In another case the purchase price paid by the lessor was intended to be used by the lessee to fund construction on the property. In both of these cases the agreements were held not to be leases but instead financing arrangements.

Term. Generally, leases for excessively long terms are more likely to be viewed as a financing arrangement. One of the factors that will weigh against the agreement being considered a true lease is whether the agreement is for a term of ninety-nine years. A court has held that such an agreement constituted a financing agreement not a lease. In that case rent was paid in three installments during the first three years of the term. Even if the lease term is not excessively long, it may indicate a financing arrangement if the lease extends beyond the useful life of the property.

Risk of LossIf the lessee bears the full risk of loss of the property, then the agreement is much more likely to be viewed as a financing arrangement as opposed to a true lease. However, requiring the lessee to pay certain taxes, maintenance, repair, and insurance does not indicate that substantially all risk has been transferred to the lessee. Where the lessor was still responsible for all repairs to the property that was not caused by the lessee; was responsible for the repairs and gave lessee a reduction in rent based on the damage the court found that the agreement was a lease. Where a lessee’s risk of loss was specifically defined in the lease as the greater of 1 percent or $1,000 the court found that the agreement was a true lease.

While the lease is allowed to shift some risk to the lessee, it cannot shift all or substantially all of the risk to the lessee. However, to make it clear that the lessee is not bearing all of the risk, we suggest that the lease should include provisions that state the obligations of the lessor, such as maintenance and repairs for damages not caused by the lessee. Also, while it may not be sufficient without more to support it, the lease should include a clause that makes it clear that the lessee is not assuming all of the risks related to the property.

Assignability. Courts will generally give weight to the fact that the lessee has no authority to assign, sublet, or mortgage the property in determining that the agreement is a lease. Also considered is that the lease explicitly stated that nothing herein shall give or convey to the lessee any right, title, or interest in or to the property leased hereunder. In order to have this factor weigh in favor of the agreement being viewed as a lease it should not grant the lessee any rights to transfer or encumber the property, at least not without the prior consent of the lessor. In addition, it would be a good idea to include a clause that explicitly provides that ownership remain with the lessor and nothing in the lease grants the lessee any interest in the property.

Conclusion. There is no one factor that will determine whether an agreement is viewed as a true lease or a secret financing arrangement by a bankruptcy court, so the best move is to try to align as many factors as possible in your favor. Factors that seem to be particularly important are how rent is calculated, the terms of a purchase option, and which party bears the risk. These three factors seem to be the ones given the most weight by the courts, and are also the ones most easily addressed in the lease. Rent needs to represent the fair market value of the property and should not be tied to the lessee’s profits or the lessor’s mortgage on the property. If a purchase option is to be included in the lease, it cannot be for no or nominal consideration. And, the lease cannot shift substantially all of the risk to the lessee.