Recharacterization of Synthetic Leases How a Lease Becomes a Secured Claim

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Nov 1999

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Increasingly, various financial institutions offer "off-balance-sheet" financing for corporate
real estate acquisition, construction and expansion. These "synthetic leases" attract corporate
real estate users because the lessee/corporate user can expense rental payments to the lessor
without "tainting" balance sheets with a real property asset, ownership or mortgage debt.

While avoiding these detriments, the lessee/corporate user retains tax benefits, including
depreciating improvements and obtaining appreciation upon subsequent purchase or resale.
Notwithstanding these significant economic benefits, practitioners must be aware that, in a
subsequent bankruptcy case, a court may recharacterize a synthetic lease as secured financing,
with a corresponding limitation of rights and remedies.

<h3>Recharacterization and Corresponding Claim Limitations</h3>

Ignoring the potential for recharacterization may prove dangerous to synthetic lessors due to
the Bankruptcy Code's differing treatment of lessors vs. secured creditors. Indeed, the Code
treats lessor claims far differently from secured creditor claims.

For example, a non-residential real property lessee/debtor must affirmatively assume or
reject a lease within 60 days from the petition date. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(d)(4)</a>. If a debtor fails to
affirmatively and timely assume a lease, however, the lease is deemed rejected. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; A deemed
rejection is the equivalent of lease termination, which logically leads to automatic stay
termination. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re M & R Apparel Inc., 92 B.R. 565, 567 (Bankr. D. Conn. 1988)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Escondido West Travel Lodge, 52 B.R. 376, 378 (Bankr. S.D. Cal. 1985)</a>.

On the other hand, upon rejection or deemed rejection, §502(b)(6) provides for specific
"rejection damages" arising from lease termination, thereby both requiring and limiting a
rejected lease claim. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §502(b)(6)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Steven Windsor Inc., 201 B.R. 133, 135
(Bankr. D. Md. 1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Fifth Ave. Jewelers, 203 B.R. 372, 377 (Bankr. W.D. Pa. 1996)</a>;
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Gantos, 176 B.R. 793, 795 (Bankr. W.D. Mich. 1995)</a>.

<big><center>
Despite the intentions of parties to a synthetic lease, a
subsequent bankruptcy case may result in the
recharacterization of a synthetic lease as a security
agreement. Accordingly, documents evidencing a synthetic
lease should contain typical mortgage provisions to protect the synthetic lessor's interests.
</center></big>
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To assume a lease, however, a debtor must cure all existing defaults thereunder and provide
adequate assurance of future lease obligations. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(b)(1)</a>. Accordingly, a debtor
cannot alter the terms of the lease and, in fact, must strictly comply with lease terms until and
unless it rejects the lease. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §§365(b)</a> and (d). However, upon bankruptcy court
recharacterization of a lease as secured financing, a lessor/lienholder's claim becomes a
secured claim, thereby greatly altering available rights and remedies. For example, a debtor
can restructure and limit a secured claim to fair market value. Consequently, particularly in a
cramdown situation, a debtor may reduce principal and interest, as well as alter maturity dates
and/or repayment schedules. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §§506(a)</a> and 1123(a), (f) and (h). Thus, the
Bankruptcy Code does not require a debtor to comply with a secured claim's operative
documents.

Instead, the Code reads to allow great variance from such terms and conditions. The danger lies
in this differing treatment. Specifically, a recharacterized synthetic lease that does include the
typical secured financing safeguards may find itself being an unsecured claim, subject to
corresponding treatment. Accordingly, although bankruptcy courts are divided on whether to
apply state or federal law to the recharacterization issue, beware of the consequences of the
Bankruptcy Code's treatment of leases vs. secured claims.

<h3>Applying the Appropriate Recharacterization Test</h3>

In determining whether a synthetic lease is actually a disguised mortgage, bankruptcy courts
are divided on whether state or federal law is in control. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Challa, 186 B.R. 750, 755-58
(Bankr. M.D. Fla. 1991)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re MCorp Financial Inc., 122 B.R. 49, 53 (Bankr. S.D. Texas
1990)</a>. Despite the potential differences of varying state law, the legislative history of <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §101(51)</a>, which defines "security interest," states, "[w]hether...a lease constitutes a
security interest under the Bankruptcy Code will depend on whether it constitutes a security
interest under applicable state or local law." H.R. Rep. No. 95-595, at 314 (1978), reprinted
in 1978 U.S.C.C.A.N. 5963, 6271. Thus, the legislative history clearly contemplates the
application of state law. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Kim, 232 B.R. 324, 328 (E.D. Pa. 1999)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Homeplace
Stores Inc., 228 B.R. 88, 92 (Bankr. D. Del. 1998)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Continental Airlines Inc., 932 F.2d
282, 294 (3d Cir. 1991)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Harris Pine Mills, 862 F.2d 217, 220 (9th Cir. 1988)</a>.

Contrary to legislative history, however, numerous other courts hold that federal law controls.
See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Barney's Inc., 206 B.R. 328, 332 (Bankr. S.D.N.Y. 1997)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re KAR Development
Associates L.P., 180 B.R. 629, 638 (Bankr. D. Kan. 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Hotel Syracuse Inc., 155 B.R.
824, 838-39 (Bankr. N.D.N.Y. 1993)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Trade Admin. v. Rensselaer Polytechnic
Institute, 936 F.2d 744, 750 (2d Cir. 1991)</a>. As the Second Circuit stated, "[w]e have no
difficulty applying the §502(b)(6) requirement of a bona fide lease to §§365(d)(3) and (4)
because these sections, when read together, are part of a total scheme designed to set forth the
rights and obligations of landlords and tenants involved in bankruptcy proceedings." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
Corporation v. PCH Associates, 804 F.2d 193, 199 (2d Cir. 1986)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Theatre Holding
Corp., 22 B.R. 884, 886 (Bankr. S.D.N.Y. 1982)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Olathe v. KAR Development
Associates, 180 B.R. at 638</a>. These courts, as opposed to varying state law standards, apply the
"economic realities" test, which disregards labels and examines whether "the parties intended
to impose obligations and confer rights significantly different from those arising from the
ordinary landlord/tenant relationship." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Inc., 206 B.R. at 332</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Associates, 804
F.2d at 200</a>.

In applying the economic realities test, bankruptcy courts closely examine the substance of the
transaction to determine whether a lease is actually a financing transaction, and if a lessee is
actually a beneficial owner. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Eagle Enterprises Inc., 237 B.R. 269, 274-75 (Bankr.
E.D. Pa. 1999)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Lunan Family Restaurants, 194 B.R. 429, 450-51 (Bankr. N.D. Ill.
1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States v. Colorado Invesco Inc., 902 F. Supp. 1339, 1342-43 (D. Colo. 1995)</a>;
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Village Import Enterprises Inc., 126 B.R. 307, 308-09 (Bankr. E.D. Tenn. 1991)</a>. These
courts partially base their examinations on §502(b)(6)'s legislative history.

Section 502(b)(6), which limits a lessor's claim for damages, does not define "lease of real
property," but its legislative history makes clear that:

<blockquote>
[W]hether a "lease" is a true or bona fide lease or, in the alternative, a financing "lease"
or a lease intended as security, depends upon the circumstances of each case. The
distinction between a true lease and a financing transaction is based upon the economic
substance of the transaction and not, for example, upon the locus of title, the form of the
transaction or the fact that the transaction is denominated as a "lease."</blockquote>
S. Rep. No. 95-989, at 64 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5850.

Consequently, in applying the language of §502(b)(6)'s legislative history, bankruptcy courts
commonly consider whether (1) the rental payments compensated the lessor for the use of the
land, or was structured for some other purpose, such as ensuring a particular investment
return; (2) the purchase price is related to the fair market value of the property, or as the
amount necessary to finance the transaction; (3) the property was purchased by the lessor
specifically for the lessee's use; (4) the lease structured the transaction to secure certain tax
advantages; (5) the lessee assumed obligations associated with financing, including taxes and
insurance; and (6) the lessees may purchase the property, at lease end, for nominal
consideration. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 206 B.R. at 334</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 180 B.R. at 639</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Syracuse, 155 B.R.
at 838-39</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 186 B.R. at 757</a>.

For example, a Mississippi bankruptcy court applied the economic realities test, thereby
examining the parties' intent, and found that the agreement at issue was a secured financing
agreement. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Waldoff's Inc., 132 B.R. 325, 328 (Bankr. S.D. Miss. 1991)</a>. In its
determination, the court considered the lessee's obligation for all repairs and replacements of
the equipment and parts; payment of all taxes, insurance, license, registration fees and other
charges; and the fact that the debtor/lessee's accountant treated the transaction as a financing
transaction for tax purposes, thereby finding that the lease was actually secured financing, but
secured only to the extent of the value of the collateral and unsecured for the claim's balance. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

Accordingly, the synthetic lessor in Waldoff's discovered that the application of the federal
economic realities test can result in recharacterization of a synthetic lease, with unintended and
disappointing results. Similarly, state law, depending on the particular state, can have the same
result. This is not to say that all synthetic leases in every bankruptcy case, under all applicable
law, will result in a secured claim. However, the potential exists for those who do not otherwise
foresee this contingency.

<h3>Conclusion</h3>

Despite the intentions of parties to a synthetic lease, a subsequent bankruptcy case may result
in the recharacterization of a synthetic lease as a security agreement. Accordingly, documents
evidencing a synthetic lease should contain typical mortgage provisions to protect the synthetic
lessor's interests. For further protection, if only the "lease" describes the loan provisions as
opposed to a separate mortgage document, the "lessor" should record a memorandum of the
lease.

Additionally, this document should recite, inter alia, that the lessee grants a lien on the real
property, and should contain enforcement rights and remedies provisions as well as proper
state statutory references. Furthermore, the lease and any recorded memorandum should state
the parties' intention that for all purposes other than financial accounting, including state, real
estate, commercial law, bankruptcy, and federal, state and local income tax purposes, the
transaction contemplated in the document is a financing arrangement, thereby preserving the
lessee's ownership in the property. Although these steps may seem redundant when drafting,
they may later prove a saving grace in bankruptcy.

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Journal Authors

Bruce H. White

John C. Murray

William L. Medford

Journal Date

Monday, November 1, 1999 - 12:00