To determine whether a “lease” is actually a disguised secured purchase, the bankruptcy court looks at the deal’s economic substance.
In our last blog post we showed how in bankruptcy a lease isn’t always a lease. A transaction labeled as a lease of personal property may actually be a secured purchase for bankruptcy purposes. We showed that when a so-called “lease” is not a true lease, through “cramdown” you can often keep the property being “leased” for much less than you’d pay otherwise.
Today our blog post is about the factors that the bankruptcy courts look at in distinguishing a true lease from a disguised secured purchase.
Federal Bankruptcy Law or State Laws Govern?
Generally, under the U.S. Constitution federal law governs what happens in bankruptcy. (See Article I, Section 8.) However, the U.S. Bankruptcy Code does not define the term “lease.” It doesn’t say how to distinguish between a lease and secured purchase.
The Bankruptcy Code does definitely treats “unexpired leases” very differently than secured purchases. It dedicates a major detailed and lengthy section to this distinction. (See Section 365.)
Without a definition of “lease” in the Bankruptcy Code, bankruptcy courts have to look to state laws. This means that whether something called a lease is treated that way in bankruptcy may differ from state to state.
Substance Governs over Form
In looking at state laws, bankruptcy courts have uniformly said it’s not very important what the transaction is called. Instead what counts is its substance—the transaction’s actual terms.
The following easily manipulable circumstances are not usually very important:
- whether the written agreement is called a lease or a purchase
- who holds the title to the leased/purchased goods
All of the states, with the exception of Louisiana, have adopted the Uniform Commercial Code’s provisions on sales and leases. The UCC says that “[w]hether a transaction creates a lease or a [secured purchase] is determined by the facts of each case.” In other words, look to the economic substance of the transaction.
The Main Factors
Bankruptcy courts look at all relevant factors when determining the economic substance of a lease/loan agreement. No single factor determines it.
1) One very important factor is how the monthly payments are calculated. Lease and purchase payments are calculated differently. True lease payments are based on “current consumption” prices. That’s the market rate price for the continued use of the thing being leased. Otherwise, if the payments are larger, then may be construed as interest and principal payments for purchasing the property.
2) Is there an option to buy the property at any point for a relatively small amount? If so, that “lease” sounds more like a secured purchase.
3) Are you required to buy the property when a certain event occurs? If so, again that indicates a secured purchase.
4) Do you own the property when you finish making the required “lease” payments? This is common with furniture leases and such, which are indeed sometimes advertised as “rent-to-own.” If you are supposedly renting to own, there’s a good chance that the “lease” is not a true lease but rather a disguised secured purchase.
If your so-called lease is not a true lease, you would not be stuck with either “assuming” the lease and all of its terms or else “rejecting” it and surrendering the “leased” property. Instead under Chapter 13 you could likely do a “cramdown” and keep the property, often for much less money.