When is a Sale-Leaseback an Equitable Mortgage?By Gregory A. Thorpe and John C. MurrayÂ© 2005. All rights reserved.IntroductionWhen two sets of sophisticated real estate investors represented by experiencedcounsel say something is a duck -- and it quacks and swims with its webbed feet-- is it a duck? The Illinois Appellate Court recently 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 withan option to repurchase is an equitable mortgage, and held that when the partyseeking to recharacterize the transaction cannot satisfy its burden of proof that the parties intended a security arrangement, the court will not recharacterizethe transaction.BackgroundThe facts of this case are complex. The dispute involved property at 185 North Wabash Street in Chicago ("Property"), consisting of six lots and a 23-story office building designed by the famous Chicago architect, Daniel Burnham. In the late 1990s, Lake Wabash, LLC ("Lake Wabash") was formed and acquired ownership of the Property from two attorney-developers, who continued to serve as the managersof Lake Wabash. Lake Wabash was interested in consolidating the Property with other property and then developing it for use as a Holiday Inn.The prior owners had obtained a $15 million mortgage loan from an Ohio federal savings bank to renovate the Property. The loan went into default in 1991. The Resolution Trust Corporation ("Resolution Trust") acquired the loan after the savings bank failed. During the two years that Resolution Trust managed the Propertyas a mortgagee in possession (and continuing through 1996) the real estate taxes were not paid and the tax buyers at the tax sale filed a Petition for Tax Deed. (Interestingly, Resolution Trust eventually forgave the entire $15 million loan because the original loan documentation could not be found by Resolution Trust, resulting in a total windfall to the prior owners of the Property.) Lake Wabash entered into a Settlement Agreement with the tax buyers, which required Lake Wabash to pay $6 million into escrow by a certain date.Lake Wabash was unable to obtain conventional financing, and approached an adjoining property owner about obtaining a loan to pay off the tax debt. The adjoining property owner was not willing to provide a loan, but the parties, who were represented by sophisticated and experienced counsel, agreed to enter into a RealEstate Sale and Leaseback Agreement ("RESL Agreement") with respect to the Property. The RESL Agreement established a purchase price for the Property of $6.5 million, and provided that Lake Wabash would receive a one-year lease and would pay a nominal annual rental of $10.00.The purchaser (the adjoining landowner) was not able to obtain sufficient financing. One of the principals in Lake Wabash then contacted a real estate investorabout partnering with the adjoining landowner. The investor and the adjoining landowner then formed 185 North Wabash, LLC ("185 North"), and acquired the purchaser's interest in the RESL Agreement. The RESL Agreement was amended to add a repurchase option in favor of Lake Wabash, at a price equal to 185 North's acquisition and development costs plus $500,000 (or $800,000, depending on when the transaction closed.). In order to exercise the option, Lake Wabash was required todeliver written notice and $50,000 in earnest money at least 30 days before theoption expiration date of October 7, 2000. The provision also provided that if Lake Wabash failed to timely exercise the purchase option and deliver the earnest

money, the purchase option would terminate and be null and void ab initio and Lake Wabash "shall have no legal or equitable interest in the property".Lake Wabash attempted to exercise the option in September 2000 by written noticeand the delivery of a check in the amount of $50,000, but the check was returned for insufficient funds. 185 North then notified Lake Wabash that it had not properly exercised the option and its rights were terminated. Lake Wabash did notattempt to do anything further and peacefully surrendered possession of the Property after an agreed order of possession was entered.Thereafter -- in what in hindsight proved to be a costly maneuver -- 185 North filed a breach-of-lease action against Lake Wabash for failure to pay expenses and perform repair obligations while it was the tenant of the Property. Lake Wabash counterclaimed, seeking a declaration that the leaseback with option to repurchase constituted an equitable mortgage.The Trial Court DecisionAn eight-day bench trial ensued. The principals in Lake Wabash testified that they believed the transaction was really a loan that had to be repaid, and that their intention was to borrow the money needed to satisfy the tax buyers and thendevelop the Property as a Holiday Inn Express hotel. But in early 2000 Holiday Inn advised Lake Wabash that it would not receive a lease, which was necessary for Lake Wabash to obtain financing on the Property. (Furthermore, the principalsin Lake Wabash acknowledged that they signed transfer tax declarations at the closing, which stated that the transaction was a bona-fide sale.)Contrary to the statements of the principals in Lake Wabash, both of the principals of 185 North testified that they were not in the business of making loans, and 185 North in fact obtained its own mortgage loan on the Property from LaSalleBank. One of the principals in 185 North also testified that no one ever said that Lake Wabash would own an equitable interest in the Property after the sale was closed, or that the transaction was intended to be a bridge loan to pay off the tax debt. The other principal testified that he was only interested in buyingthe property and giving Lake Wabash a one-time right to repurchase.LaSalle Bank's attorney also testified that LaSalle would not have made the mortgage loan to 185 North if it believed that Lake Wabash retained any interest inthe Property. Various appraisers also testified as to the value of the Property.The trial court found that 185 North's appraiser was the most credible with respect to the value of the Property, and accepted his "fair market" valuation of the Property -- which considered the impact of the sale-leaseback and repurchaseoption on the Property's value -- at between $6.5 million to $7 million. The court found that Lake Wabash had failed to establish by clear and convincing evidence that the price paid by 185 North was below market value or that there was anywritten evidence of a debt.The trial court noted that 185 North had entered into a contract to sell the Property, shortly after the option expired, for $11.5 million - but this offer fellthrough, and the transaction never closed. One of the principals of 185 North testified that the arrangement with Lake Wabash, i.e., the sale-leaseback with anoption to repurchase, affected the Property's purchase price and distinguishedit from the proposed subsequent sale to a third party, which did not grant 185 North, as the seller, the right to repurchase the Property or to occupy the Property for one year at a nominal rental.The Appellate Court DecisionOn appeal, Lake Wabash raised the following issues: (1) the correctness of the trial court's ruling that the RESL Agreement was intended as a sale and not as an

equitable mortgage; (2) whether the trial court erred in not admitting the testimony of Lake Wabash's appraiser; (3) whether the evidence should be reopened toadmit a "newly discovered" news story describing the conversion of the Propertyinto a 200-unit multi-family rental building; and (3) "whether the trial courterred in finding that LW [Lake Wabash] was obligated to prove by clear and convincing evidence all thirteen factors annunciated in Robinson vs. Builders Supply& Lumber, Co., 223 Ill. App. 3rd 1007 (1991)" ("Robinson Case"). The Robinson Case recognized thirteen factors which have been considered in determining whethera deed is actually an equitable mortgage. The factors are:The existence of an indebtedness;The close relationship of the parties;Prior unsuccessful attempts for loans;The circumstances surrounding the transaction;The disparity of the situation of the parties;The lack of legal assistance;The unusual type of sale;The inadequacy of consideration;The way the consideration was paid;The retention of written evidence of the debt;The belief that the debt remains unpaid;An agreement to repurchase; andThe continued exercise of ownership privileges and responsibilities by the Seller. Robinson vs. Builders Supply & Lumber, Co., supra, 223 Ill. App. 3rd at 1014. Lake Wabash argued that the trial court erred as a matter of law when it held that all 13 factors enunciated in the Robinson Case (as set forth above) were required elements of proof and that Lake Wabash was required to establish all the elements by clear and convincing evidence. But the Appellate Court found that thetrial court's Order actually contradicted that contention and that the trial court merely considered -- correctly -- the Robinson Case factors as an aid in ascertaining the true intent of the parties when they entered into the transaction.The Appellate Court noted that a deed absolute on its face may, under certain circumstances, be found to constitute an equitable mortgage. In fact, Section 5 ofthe Illinois Mortgage Act codifies this concept and provides that, "every deedconveying real estate, which shall appear to have been intended only as a security in the nature of a mortgage, though it be an absolute conveyance in terms, shall be considered a mortgage." 765 ILCS 905/5. The Court also noted that the Robinson Case held that courts routinely consider the adequacy of the considerationto determine intent and, hence, this was why the appraisal testimony was so important in the trial court's decision.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 thatfailure to exercise the option would result in Lake Wabash having "no legal or equitable" interest in the Property, and reasoned that the fact that Lake Wabashattempted 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 also noted (asmentioned earlier) 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 further that ifthe parties had intended the transaction to be a loan, the RESL Agreement wouldhave indicated the terms of repayment if Lake Wabash chose not to timely exercise its repurchase option.