Recharacterization of Synthetic Leases How a Lease Becomes a Secured Claim

Recharacterization of Synthetic Leases How a Lease Becomes a Secured Claim

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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.

Recharacterization and Corresponding Claim Limitations

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. 11 U.S.C. §365(d)(4). If a debtor fails to affirmatively and timely assume a lease, however, the lease is deemed rejected. Id. A deemed rejection is the equivalent of lease termination, which logically leads to automatic stay termination. In re M & R Apparel Inc., 92 B.R. 565, 567 (Bankr. D. Conn. 1988); In re Escondido West Travel Lodge, 52 B.R. 376, 378 (Bankr. S.D. Cal. 1985).

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. 11 U.S.C. §502(b)(6); In re Steven Windsor Inc., 201 B.R. 133, 135 (Bankr. D. Md. 1996); In re Fifth Ave. Jewelers, 203 B.R. 372, 377 (Bankr. W.D. Pa. 1996); In re Gantos, 176 B.R. 793, 795 (Bankr. W.D. Mich. 1995).

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.

To assume a lease, however, a debtor must cure all existing defaults thereunder and provide adequate assurance of future lease obligations. 11 U.S.C. §365(b)(1). 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 11 U.S.C. §§365(b) 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. 11 U.S.C. §§506(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.

Applying the Appropriate Recharacterization Test

In determining whether a synthetic lease is actually a disguised mortgage, bankruptcy courts are divided on whether state or federal law is in control. In re Challa, 186 B.R. 750, 755-58 (Bankr. M.D. Fla. 1991); In re MCorp Financial Inc., 122 B.R. 49, 53 (Bankr. S.D. Texas 1990). Despite the potential differences of varying state law, the legislative history of 11 U.S.C. §101(51), 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. In re Kim, 232 B.R. 324, 328 (E.D. Pa. 1999); In re Homeplace Stores Inc., 228 B.R. 88, 92 (Bankr. D. Del. 1998); In re Continental Airlines Inc., 932 F.2d 282, 294 (3d Cir. 1991); In re Harris Pine Mills, 862 F.2d 217, 220 (9th Cir. 1988).

Contrary to legislative history, however, numerous other courts hold that federal law controls. See In re Barney's Inc., 206 B.R. 328, 332 (Bankr. S.D.N.Y. 1997); In re KAR Development Associates L.P., 180 B.R. 629, 638 (Bankr. D. Kan. 1995); In re Hotel Syracuse Inc., 155 B.R. 824, 838-39 (Bankr. N.D.N.Y. 1993); International Trade Admin. v. Rensselaer Polytechnic Institute, 936 F.2d 744, 750 (2d Cir. 1991). 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." Liona Corporation v. PCH Associates, 804 F.2d 193, 199 (2d Cir. 1986); In re Theatre Holding Corp., 22 B.R. 884, 886 (Bankr. S.D.N.Y. 1982); City of Olathe v. KAR Development Associates, 180 B.R. at 638. 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." Barney's Inc., 206 B.R. at 332; PCH Associates, 804 F.2d at 200.

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 In re Eagle Enterprises Inc., 237 B.R. 269, 274-75 (Bankr. E.D. Pa. 1999); In re Lunan Family Restaurants, 194 B.R. 429, 450-51 (Bankr. N.D. Ill. 1996); United States v. Colorado Invesco Inc., 902 F. Supp. 1339, 1342-43 (D. Colo. 1995); In re Village Import Enterprises Inc., 126 B.R. 307, 308-09 (Bankr. E.D. Tenn. 1991). 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:

[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."
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 Barney's, 206 B.R. at 334; KAR, 180 B.R. at 639; Hotel Syracuse, 155 B.R. at 838-39; Challa, 186 B.R. at 757.

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. In re Waldoff's Inc., 132 B.R. 325, 328 (Bankr. S.D. Miss. 1991). 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. Id.

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.


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.

Journal Date: 
Monday, November 1, 1999