IS IT A LEASE OR A LOAN? WHY THE DIFFERENCE…
By: Anthony L. Lamm and Thomas P. Stevens
In recent years, the Equipment Finance Agreement (a “loan”) has displaced the more traditional Operating Lease (a “lease”). There are a number of pitfalls, however, when it comes to how bankruptcy courts treat loans versus leases. This article explains how the two documents differ from a legal standpoint and how bankruptcy courts decide whether a given transaction is a loan or a lease (most often described in the bankruptcy setting as the difference between a “disguised security agreement” and a “true lease”). We also explain why the difference may matter to you if your borrower or lessee files for bankruptcy. As a result, there may be very good reasons to reconsider using the lease over the loan to better protect your rights as a secured creditor in bankruptcy cases.
When is a Transaction a “Security Agreement” versus a “True Lease”?
When it comes to a bankruptcy judge’s review of a document, the title is never the final word. Instead, bankruptcy courts focus on a number of key features of the transaction and the language in the document. In fact, the first legal issue a secured creditor often faces after its borrower or lessee has filed bankruptcy is whether the transaction is a “security agreement” or a “disguised finance agreement” (i.e., a loan) or a “true lease” (i.e., a lease). There is no hard and fast rule that dictates the result. Instead, bankruptcy courts examine a host of factors in the analysis and, if enough of these factors are present, then a court’s conclusion will likely to be that the transaction is a loan and not a lease. Here are a few of the many factors weighed by bankruptcy courts posed as questions:
- Is there an option to purchase the goods for a nominal sum?
- Is the total amount paid for “rent” equal to or does it exceed the value of the goods or, stated differently, is the rent equal to the reasonable equivalent of the value of the goods, plus interest?
- Is there a provision in the document granting the lessee an equity interest (ownership) in the goods or, in other words, who has title to the goods over the life of the lease, the lessor or the lessee?
- Does the agreement give the lessor the option to accelerate payment of rent upon a default?
- Did the lessee authorize the lessor to file a UCC-1 financing statement creating a security interest in the goods?
Why the Distinction Matters In Bankruptcy
The treatment of leases is often far more advantageous to a secured creditor than if its document is determined to be a loan. If a document is found to be a security agreement, then, at best, the lender has a “secured claim” that is only “allowable” up to the fair market value (“FMV”) of the collateral as of the date bankruptcy was filed. For example, in a Chapter 11 case (reorganization) where the FMV of the collateral is less than the amount owed, the debtor often stops making monthly payments under the agreement until a plan of reorganization is submitted and confirmed. Therefore, to get paid, a secured creditor has to force the issue and file a motion “lift the automatic stay” and recover its collateral or seek “adequate protection payments” (or “APP”) until a plan is confirmed. A motion to lift the automatic stay may not be cost effective when the FMV of the collateral is far less than the outstanding debt or hard to value without costly live testimony from an expert witness (usually an appraiser). APP is not always the best option either because the amount of the monthly payment is supposed to represent actual depreciation rather than what is due under the agreement. As a result, the monthly APP can be just a fraction of the monthly payment required under the document. Finally, even after a plan is confirmed, the secured creditor’s “allowed claim” (i.e., the amount actually paid by the debtor to the secured creditor over the life of the plan on the amount owed) is limited to the FMV of the collateral at the date the bankruptcy was filed. Thus, it is not uncommon for a secured creditor holding a security agreement to receive far less than the amount of the outstanding debt.
In contrast, if the documentation supports the conclusion that it is a lease then the “lessor” has better options in a bankruptcy court. The holder of an “unexpired lease” can force a bankruptcy debtor to “accept” or “reject” the lease including by filing a motion to force the issue.
If a lease is “accepted,” then the debtor has to “cure” all past defaults in payment (including paying accrued interest, late charges, etc.) and start paying the full monthly rental amount specified in the lease regardless of the FMV value of the collateral. If the lease is “rejected” then the debtor has to surrender the collateral (usually in short order which makes recovery easier and speeds up the opportunity to sell the leased goods and apply the proceeds against the amount owed). Importantly, with an unexpired lease there is no requirement to file a motion to lift the stay and pursue the often tedious and costly process of employing “state law remedies” to actually repossess the collateral.
The clear benefit to having a lease versus a loan comes into play when the debtor needs the leased equipment or goods to continue its business (during and after the bankruptcy), then the lessor will be paid all amounts in arrears as a “cure” and the debtor must start paying the full monthly rent due under the terms of the lease. Even better, the amount of the monthly payment is not reduced just because the value of the leased goods has depreciated.
Takeaways from This Analysis
Our conclusion after all this analysis is clear – it is often better to have a “true lease” than a “disguised security agreement” when your lessee files for bankruptcy. As always, the devil is in the details and this article does not address the different tax, accounting, or financial treatment of a given lease versus a loan. Therefore, the reader has to decide if a lease will serve better than a loan for a particular transaction or portfolio of leases or loans held. Understanding the precise factors bankruptcy courts consider in deciding whether a transaction is a lease versus a loan is half the battle and, if a lease is the best option for you, at least there is some guidance when it comes to what types of features, clauses, and concepts can sway a bankruptcy judge in your favor.