When two sets of sophisticated real estate investors represented by experienced counsel say something is a duck -- and it quacks and swims with its webbed feet -- is it a duck?

The Illinois Appellate Court decided, in the case of 185 North Wabash, LLC v. Lake Wabash, LLC, No. 1-03-0751 (Ill. App., 1st Dist. Dec. 24, 2003), that the answer is "yes." The appellate court found that the intent of the parties is a prime factor in determining whether a sale-leaseback with an option to repurchase is an equitable mortgage, and held that when the party seeking to recharacterize the transaction cannot satisfy its burden of proof that the parties intended a security arrangement, the court will not recharacterize the transaction. The appellate court referred to an earlier Illinois appellate court decision, Robinson v. Builders Supply & Lumber, Co., 223 Ill. App. 3rd 1007, 1014 (1991), which recognized the following 13 factors in determining whether a transaction designated as a sale-leaseback is actually an equitable mortgage:

1. The existence of an indebtedness;
2. The close relationship of the parties;
3. Prior unsuccessful attempts for loans;
4. The circumstances surrounding the transaction;
5. The disparity of the situation of the parties;
6. The lack of legal assistance;
7. The unusual type of sale;
8. The inadequacy of consideration;
9. The way the consideration was paid;
10. The retention of written evidence of the debt;
11. The belief that the debt remains unpaid;
12. An agreement to repurchase; and
13. The continued exercise of ownership privileges and responsibilities by the Seller. 

In the 185 North Wabash case, supra, the Illinois appellate court found that the trial court correctly considered the above Robinson factors as an aid in ascertaining the true intent of the parties when they entered into the transaction. The appellate court determined that proof of the existence of an equitable mortgage must be "clear, satisfactory, and convincing." The court noted the parties' sophistication in real estate matters and found that the documents negotiated and executed by the parties reflected the parties' intention to treat the transaction as a sale. The court also noted that the documents specifically stated that failure to exercise the option would result in the defendant, Lake Wabash, having "no legal or equitable" interest in the subject property, and reasoned that the fact that Lake Wabash attempted to exercise the option on the last day it could do so indicated that it treated the transaction as a sale and not a mortgage. The court further noted that Lake Wabash had filed transfer tax declarations that required the payment of transfer taxes at the closing and that the transfer tax declarations indicated that the transaction was a sale; and noted that if the parties had intended the transaction to be a loan, the documents would have indicated the terms of repayment.

So what lessons and morals can be gleaned from the Illinois appellate court's decision in 185 N. Wabash? The following are observations on the court's ruling:

1. This case involved sophisticated and experienced real estate investors and sophisticated legal counsel, as pointed out by both the trial court and the appellate court. The documents negotiated and drafted by the parties and their respective counsel (and their actions and conversations in connection therewith) specifically referred to the transaction as a sale-leaseback and made no mention, express or implied, of any other characterization. Also, Lake Wabash signed transfer-tax declarations stating that the transaction was in fact a sale. Clearly the facts, and the burden of proof, were in 185 North Wabash’s favor and Lake Wabash faced an uphill battle in attempting to prove the existence of a sufficient number of the Robinsonfactors to establish that the intention of the parties was other than as stated in their documents.
2. Appraisal testimony can be crucial in determining the value of the property in these types of cases, which in turn is crucial to the issue of whether the consideration for the transaction is fair and sufficient to prevent recharacterization. The credibility of the appraisers was critical to the appellate court's decision in 185 North Wabash, and it appears that 185 North was shrewd in retaining a highly reputable, experienced, and believable appraiser who stood up well under direct- and cross-examination in court. (Query: Would it not be the case that whenever a sale-leaseback transaction involving commercial property contains a repurchase option, the value of the property will be negatively impacted?)
3. It likely would have been even helpful if the sale-leaseback agreement contained specific language (perhaps bold and in caps) negating and disclaiming any construction of the transaction as a security arrangement or equitable mortgage, or any intention to create any relationship between the parties, either express or implied, other than as expressly stated in the sale-leaseback agreement.
4. Recharacterization is always an uphill battle, i.e., trying to argue that something is not what the parties said it is. Courts are not particularly fond of these cases; they are equitable proceedings and courts generally will hold the party seeking to recharacterize a document or transaction to a high standard of proof. As demonstrated by the appellate court's holding in 185 North Wabash, the question of valuation is often crucial. Sale/leaseback transactions may be recharacterized as either equitable mortgages or, possibly as joint ventures -- although to date there does not appear to be any final court decision that has recharacterized a sale/leaseback transaction as a joint venture.
5. The recharacterization tests applied by bankruptcy courts often serve as a useful guideline when analyzing the risks of a sale-leaseback transaction. See, e.g., Barneys, Inc. v. Isetan Co.(In reBarney's, Inc.), 206 B.R. 328, 332-33 (Bankr. S.D.N.Y. 1997) (stating that "[t]he appropriate inquiry is whether the parties intended to impose obligations and confer rights significantly different from those arising from the ordinary landlord/tenant relationship;" the court also noted that where the purported "lease" involves rental payments that are actually payments of principal and interest on a real estate loan, there is no "true" or "bona fide" lease)…. [T]he economic substance of the transaction, and not its label, will ultimately determine whether it is a “true” lease or a financing transaction.