Here are the factors for determining whether a business lease is treated as a true lease in bankruptcy or rather as a secured purchase.
A couple days ago we ended our blog post saying that we would next “get into the special business-oriented factors the bankruptcy courts use to determine whether a lease is a true lease.” We described the benefits that a true lease gives to the lessor. And we showed the ways that recharacterizing a lease as a secured purchase can greatly benefit the business debtor.
When a Business Lease is Not a True Lease
Some initial principles:
- Federal bankruptcy law often works closely with state laws. This includes state laws determining whether a lease is a true lease. Bankruptcy law does not define a lease, and yet makes significant consequences arise from labeling a transaction a lease. So we look to state laws for making this determination.
- Especially in the context of business asset leases, in interpreting state lease law bankruptcy courts look to the substance of the transaction not at the name given to it. Look to the economic substance of a transaction instead of whether or not it’s called a lease.
- The courts do not put weight on the subjective intent of the parties—whether they think it’s a lease or not. Instead they look to the objective factors found within the lease agreement and in the parties’ economic relationship.
Factors Relevant to Business Leases
Consider the following questions, in the context of an equipment lease, to get at the substance of a lease vs. secured purchase:
- What is the total amount of the lease payments compared to the value of the equipment? Do the “lease” payments compensate the lessor for the lessee’s ongoing use of the lessor’s property? Or do they pencil out more like payments of principal and interest?
- Did the lessor manufacture or purchase the equipment specifically for the lessee’s use? Was it specifically designed for the lessee, so that its continued business operations depend on its use of the equipment?
- Did the lessee assume the typical risks and obligations of ownership instead of the lessor? Which one is contractually responsibility for paying insurance, taxes, maintenance and upkeep?
- How does the term of the lease compare to the useful economic life of the goods? Is the lessee required to renew the lease for the equipment’s full economic life?
- What happens to the equipment at the end of the lease term? Is the lessee allowed or required to buy the equipment at the end of the lease at a modest payoff? Is the lessee required to purchase it under certain conditions?
Overall, if the equipment has little or no value at the end of the lease, the transaction is more likely a purchase. If the lessee is able to buy the equipment cheaply, the economic substance of the deal is less likely a true lease than a purchase.
Whether an agreement is a true lease or a disguised secured financing arrangement can be hugely important when you, the lessee, file bankruptcy. Be aware that economic substance—not the agreement’s title or your subjective understandings—is the determinative factor.