Today I want to talk about sale leaseback transactions. Let’s say that Sherry owns a small manufacturing company. Her company went through a down cycle and experienced cash flow problems.
Her bank was unwilling to provide any financing. As an alternative she met with Eric, who owned a capital leasing company. He offered to buy her manufacturing equipment for cash and lease it back to Sherry’s company for a lease term of 5 years, but at a rent that is substantially higher than fair market rent.
The lease provided Sherry with an option to purchase the equipment at the end of the lease for a purchase price that is significantly less than the estimated fair market value of the equipment in 5 years. Alternatively, Sherry’s company could continue to lease the equipment for a rental that is significantly less than the fair market rental value of the equipment in 5 years.
Sherry’s cash flow problems continued, and she was faced with the prospect of defaulting on her sale/leaseback deal with Eric’s company. Sherry’s accountant looked at her deal with Eric as a loan and said that the interest rate she was paying Eric was more than the current 10% California usury rate.
The accountant also said that if her deal with Eric is a loan and not a sales and leaseback, then she does not have to pay the “interest” component of the rent and would be entitled to collect from Eric’s company three times the amount of “interest” she has paid it over the last year.
Is the accountant right? In this case the answer is yes. California law looks at the substance of Sherry’s deal not the label put on the paperwork.
In this case, the courts would find that the deal was a loan and not a sale leaseback because the economic substance of the deal was a loan. The court would look at Sherry’s right to buy back the equipment at the end of the lease as having no economic substance because the option price is nominal compared to a fair market value option price.
Plus, the courts would find the deal in substance not a true lease because the rent during the 5 year lease term is substantially higher than fair market rental value. Also, the rent upon extension is substantially lower than fair market rental value.
A discussion by the California Appeals Court on this subject is found in the case of Blodgett v. Rheinschild, 56 Cal.App. 728 (Cal. Ct. App. 1922) and can be found at: https://casetext.com/case/blodgett-v-rheinschild; and Rochester Capital Leasing Corp. v. K & L Litho Corp., 91 Cal. Rptr. 827 (Cal. Ct. App. 1970) and can be found at: http://caselaw.findlaw.com/ca-court-of-appeal/1826018.html
Comment. California courts looking at whether a transaction is a loan in substance (generally subject to the usury law) or a lease in substance (not subject to usury law), are guided by California Commercial Code Section 1203. http://codes.findlaw.com/ca/commercial-code/com-sect-1203.html
By John McCauley: I help people start, grow, buy and sell their businesses.
Email: jmccauley@mk-law.com
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