Equipment Leases in Bankruptcy: 5 Tests for Whether It Is Really a Lease or a Loan

To a businessman, a lease means you can leave, and if you can’t leave, it’s a loan. In bankruptcy, it’s not that simple. The label on the contract doesn’t decide it. A lease is really a loan if you cannot cancel the payments for the full term and one of four other tests is met. How you pay the debt may be far different than if the equipment were a lease. True leases let you keep equipment if you cure any arrears and pay in full under the contract. Disguised loans, on the other hand, get cut down to value in a plan.

Automatic-loan Tests

The four automatic-loan tests only matter if you cannot walk away without paying for the full term. If you can, it’s probably not a loan. That’s the fundamental test. If not, it might be. Go on to the second test.

The second test is to see if the lease term is as long as the equipment’s remaining useful life. If it is, or if you must renew for the rest of that life, or if you must end up owning the equipment, then it’s a loan. That covers a lot.

If the lease term is less than the equipment’s life, it can still be a loan if you can renew for the rest of that life for a token sum, or if the contract lets you buy the equipment for little or nothing.

”Below what you’d pay not to buy the equipment” is the best rule to decide if the price to buy the equipment after the lease is up is only nominal. To get this right, think about the day you signed the contract, not the day you file. A buyout set at the market value when you buy is not nominal. A “lease” for two years on a five-year-old CNC machine with a $1 buyout at the end of the term is a loan, usually. A “lease” for five years on new kitchen equipment, where the lease lets you buy out for a fair market value with the lessor expecting to get its equipment back, is usually a lease.

The things that don’t decide it, by themselves, are if the lease payments are about the same as the equipment’s value over time, or you carry risk of loss, or you pay taxes, insurance, or upkeep. A buy option at fair market value later doesn’t change things by itself, either. Some courts don’t stop at the five tests. They may call it a loan if buying is the only way it would ever make economic sense. Courts all over the country differ on this.

A lessor often files something called a precautionary UCC financing statement to protect its lien rights in case a court decides its contract is a disguised loan. The filing alone doesn’t make it a loan.

Assume or Reject Leases

With a true lease, you have a choice: you can keep the equipment by bringing the lease current and keeping up the payments from there on. To assume a lease, you must pay all money past due on the filing date. After that you pay according to the terms of the lease from the time you assume. If you decide to keep it, you are stuck with the full lease term. Or you can reject it and the equipment goes back to the lessor.

If the court calls it a loan, your lender may be secured only up to what the equipment is worth today. Whatever balance is left becomes unsecured debt, and you keep the equipment and pay that value through the plan. Older equipment financed on a loan that made sense when it was new may now be worth only a fraction of what you owe, which can leave the lender badly undersecured.

Rejecting a true lease lets the lessor repossess the equipment and maybe seek a damages claim that’s usually unsecured.

A North Carolina bankruptcy court found in In re Price that the debtors had loans, not leases. Their contracts gave no right to cancel, and they’d only have to pay $1 each to buy the trailers later. $92,000 of more than $132,000 of loans could be treated as unsecured, leaving them with trailers worth about $40,000.

If you file a Chapter 11, there’s a strict rule for what happens to true leases and the payments that come due after filing. You must keep paying bills that come due, on time, from day 60 after filing until the court approves an assumption or rejection, or says otherwise. This rule just applies to bills that come due from day 60 on. In Chapter 7, if the trustee does not assume or reject an equipment lease within 60 days, it is treated as rejected unless the court extends it first. Then the equipment leaves the estate and the stay over it ends on its own.

In Chapter 13, you assume or reject leases. For true leases, you cure any missed payments and change nothing else in the contract. How you catch up with the lessor may be over time under the plan, not right away. If the lease is a disguised loan, you don’t have to cure the defaults right away.

Check the Actual Lease Terms

You need to be careful about vendor financing that looks like a lease. Some companies price their deals as a sale, just paper them as leases.

Go over your equipment leases to make sure your lawyer knows which equipment is leased and which was bought and paid for. Have a copy of all the contracts and every written change or renewal. Bring a list of payments made so far. If you can cancel a lease, give a copy of the cancellation clause to your lawyer. Think about having each machine valued right now, to see if it’s worth more than you owe on it. Have your lawyer check the actual lease terms against the five-test rule.