Assuming or Rejecting Unexpired Leases

Bankruptcy and Unexpired Leases: What are the Rules?

The principal question applied to leases in bankruptcy proceedings is this: is the lease in question an actual long-term rental agreement, or is it a financial instrument that has been utilized for favorable taxation, depreciation, or other business advantages?

The Congress addressed this issue in 1984 when it rewrote sections of the Bankruptcy code and made major changes concerning the “nonresidential real property lease.” The issue came to the fore due to the long delays in bankruptcy courts over the resolution of lease agreements.

While most of the complaints originally concerned small businesses with shopping center leases, subsequent legal interpretations of Congress’ action that have been made in court decisions have narrowed the scope of the term “lease.” Other agreements reached under this heading, such as equipment leases in business and certain types of real property leases that might be characterized as “rent to own” arrangements have been found to be financial transactions in nature, and have been treated as such in Bankruptcy Court.

Acquisition of Equipment

The use of lease arrangements for the acquisition of equipment is a standard business arrangement these days, and is defined by the Uniform Commercial Code as a secured financial transaction rather than a true lease. In this situation, if at the end of the lease the lessor holds little or no equity in the property and if the lessee has taken the depreciation and been charged with the obligations and risks ordinarily reserved to the property owner, then the agreement is treated as a financing document rather than a true lease. These standards can apply to leases for real property as well as equipment.

Financial Instrument vs. Executory Contract

Case law has generally held that leases of this type also do not qualify as executory contracts, which may be assumed or rejected by the trustee, and limits the lessor’s claim under bankruptcy law. Lessors are not eligible for assumption or rejection of their lease terms by the bankruptcy court or trustee, as would be the case with an executory contract. Case law can be found to be contradictory at times, however, as there is no precise method of differentiating between a finance lease and a true lease. In like fashion although to a lesser extent, there is no clear cut line between the lease employed as financial instrument and as an executory contract.

When a lease is determined to be a financial instrument the lessor is also ineligible for the special provisions for claims under bankruptcy as provided for in the case of bona fide leases. These allowable claims are explained in detail in Section 502 (b) (6) of the Bankruptcy Code. The Code section also provides for limits to the claims a lessor may assert when his lease has been rejected by the bankruptcy trustee. The lessor is prevented from claiming the maximum value of any liquidated damages (as defined in his lease) as the benchmark for his allowable claim. In this fashion, the lessor is prevented from circumventing the debate over what is a financial transaction and what is a lease in trying to maximize his claim.