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When is a Sale-Leaseback an Equitable Mortgage?

By Gregory A. Thorpe and John C. Murray

© 2005. All rights reserved.
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 recently decided, in the case of 1
85 North Wabash, LLC v. Lake Wabash, LLC, No. 1-03-0751 (Ill. App., 1st Dist. De
c. 24, 2003), that the answer is: "Yes." The Appellate Court found that the inte
nt 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 tha
t the parties intended a security arrangement, the court will not recharacterize
the transaction.
The facts of this case are complex. The dispute involved property at 185 North W
abash Street in Chicago ("Property"), consisting of six lots and a 23-story offi
ce building designed by the famous Chicago architect, Daniel Burnham. In the lat
e 1990s, Lake Wabash, LLC ("Lake Wabash") was formed and acquired ownership of t
he Property from two attorney-developers, who continued to serve as the managers
of Lake Wabash. Lake Wabash was interested in consolidating the Property with o
ther 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 s
avings bank to renovate the Property. The loan went into default in 1991. The Re
solution Trust Corporation ("Resolution Trust") acquired the loan after the savi
ngs bank failed. During the two years that Resolution Trust managed the Property
as a mortgagee in possession (and continuing through 1996) the real estate taxe
s 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 loa
n 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 Wabas
h entered into a Settlement Agreement with the tax buyers, which required Lake W
abash to pay $6 million into escrow by a certain date.
Lake Wabash was unable to obtain conventional financing, and approached an adjoi
ning property owner about obtaining a loan to pay off the tax debt. The adjoinin
g property owner was not willing to provide a loan, but the parties, who were re
presented by sophisticated and experienced counsel, agreed to enter into a Real
Estate Sale and Leaseback Agreement ("RESL Agreement") with respect to the Prope
rty. The RESL Agreement established a purchase price for the Property of $6.5 mi
llion, and provided that Lake Wabash would receive a one-year lease and would pa
y a nominal annual rental of $10.00.
The purchaser (the adjoining landowner) was not able to obtain sufficient financ
ing. One of the principals in Lake Wabash then contacted a real estate investor
about partnering with the adjoining landowner. The investor and the adjoining la
ndowner then formed 185 North Wabash, LLC ("185 North"), and acquired the purcha
ser's interest in the RESL Agreement. The RESL Agreement was amended to add a re
purchase option in favor of Lake Wabash, at a price equal to 185 North's acquisi
tion and development costs plus $500,000 (or $800,000, depending on when the tra
nsaction closed.). In order to exercise the option, Lake Wabash was required to
deliver written notice and $50,000 in earnest money at least 30 days before the
option expiration date of October 7, 2000. The provision also provided that if L
ake 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 L
ake Wabash "shall have no legal or equitable interest in the property".
Lake Wabash attempted to exercise the option in September 2000 by written notice
and the delivery of a check in the amount of $50,000, but the check was returne
d for insufficient funds. 185 North then notified Lake Wabash that it had not pr
operly exercised the option and its rights were terminated. Lake Wabash did not
attempt to do anything further and peacefully surrendered possession of the Prop
erty after an agreed order of possession was entered.
Thereafter -- in what in hindsight proved to be a costly maneuver -- 185 North f
iled a breach-of-lease action against Lake Wabash for failure to pay expenses an
d perform repair obligations while it was the tenant of the Property. Lake Wabas
h counterclaimed, seeking a declaration that the leaseback with option to repurc
hase constituted an equitable mortgage.
The Trial Court Decision
An eight-day bench trial ensued. The principals in Lake Wabash testified that th
ey believed the transaction was really a loan that had to be repaid, and that th
eir intention was to borrow the money needed to satisfy the tax buyers and then
develop the Property as a Holiday Inn Express hotel. But in early 2000 Holiday I
nn advised Lake Wabash that it would not receive a lease, which was necessary fo
r Lake Wabash to obtain financing on the Property. (Furthermore, the principals
in Lake Wabash acknowledged that they signed transfer tax declarations at the cl
osing, which stated that the transaction was a bona-fide sale.)
Contrary to the statements of the principals in Lake Wabash, both of the princip
als of 185 North testified that they were not in the business of making loans, a
nd 185 North in fact obtained its own mortgage loan on the Property from LaSalle
Bank. One of the principals in 185 North also testified that no one ever said t
hat Lake Wabash would own an equitable interest in the Property after the sale w
as closed, or that the transaction was intended to be a bridge loan to pay off t
he tax debt. The other principal testified that he was only interested in buying
the property and giving Lake Wabash a one-time right to repurchase.
LaSalle Bank's attorney also testified that LaSalle would not have made the mort
gage loan to 185 North if it believed that Lake Wabash retained any interest in
the 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 res
pect to the value of the Property, and accepted his "fair market" valuation of t
he Property -- which considered the impact of the sale-leaseback and repurchase
option on the Property's value -- at between $6.5 million to $7 million. The cou
rt found that Lake Wabash had failed to establish by clear and convincing eviden
ce that the price paid by 185 North was below market value or that there was any
written evidence of a debt.
The trial court noted that 185 North had entered into a contract to sell the Pro
perty, shortly after the option expired, for $11.5 million - but this offer fell
through, and the transaction never closed. One of the principals of 185 North t
estified that the arrangement with Lake Wabash, i.e., the sale-leaseback with an
option to repurchase, affected the Property's purchase price and distinguished
it from the proposed subsequent sale to a third party, which did not grant 185 N
orth, as the seller, the right to repurchase the Property or to occupy the Prope
rty for one year at a nominal rental.
The Appellate Court Decision
On appeal, Lake Wabash raised the following issues: (1) the correctness of the t
rial 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 test
imony of Lake Wabash's appraiser; (3) whether the evidence should be reopened to
admit a "newly discovered" news story describing the conversion of the Property
into a 200-unit multi-family rental building; and (3) "whether the trial court
erred in finding that LW [Lake Wabash] was obligated to prove by clear and convi
ncing evidence all thirteen factors annunciated in Robinson vs. Builders Supply
& Lumber, Co., 223 Ill. App. 3rd 1007 (1991)" ("Robinson Case"). The Robinson Ca
se recognized thirteen factors which have been considered in determining whether
a 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; and
The continued exercise of ownership privileges and responsibilities by the Selle
r. 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 th
at all 13 factors enunciated in the Robinson Case (as set forth above) were requ
ired elements of proof and that Lake Wabash was required to establish all the el
ements by clear and convincing evidence. But the Appellate Court found that the
trial court's Order actually contradicted that contention and that the trial cou
rt merely considered -- correctly -- the Robinson Case factors as an aid in asce
rtaining 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 ci
rcumstances, be found to constitute an equitable mortgage. In fact, Section 5 of
the Illinois Mortgage Act codifies this concept and provides that, "every deed
conveying real estate, which shall appear to have been intended only as a securi
ty in the nature of a mortgage, though it be an absolute conveyance in terms, sh
all be considered a mortgage." 765 ILCS 905/5. The Court also noted that the Rob
inson Case held that courts routinely consider the adequacy of the consideration
to determine intent and, hence, this was why the appraisal testimony was so imp
ortant in the trial court's decision.
The Appellate Court determined that proof of the existence of an equitable mortg
age must be "clear, satisfactory, and convincing." The Court noted the parties'
sophistication in real estate matters and found that the documents negotiated an
d executed by the parties reflected the parties' intention to treat the transact
ion as a sale. The Court also noted that the documents specifically stated that
failure to exercise the option would result in Lake Wabash having "no legal or e
quitable" interest in the Property, and reasoned that the fact that Lake Wabash
attempted to exercise the option on the last day it could do so indicated that i
t treated the transaction as a sale and not a mortgage. The Court also noted (as
mentioned earlier) that Lake Wabash had filed transfer tax declarations that re
quired the payment of transfer taxes at the closing, and that the transfer tax d
eclarations indicated that the transaction was a sale, and noted further that if
the parties had intended the transaction to be a loan, the RESL Agreement would
have indicated the terms of repayment if Lake Wabash chose not to timely exerci
se its repurchase option.
Lake Wabash also argued that the trial court should not have relied upon the app
raisal testimony by 185 North's appraiser that $6.5 million constituted the fair
market value of the Property. But the court found that the valuation establishe
d by 185 North's appraiser -- who had more than 30 years of appraisal experience
-- was "not against the manifest weight of the evidence." The Court also found
that the trial court's exclusion of the appraisal prepared by North Wabash's app
raiser (and the court's striking of the testimony in connection therewith) did n
ot constitute reversible error in any event, because sufficient independent evid
ence existed to support the trial court's ruling in favor of 185 North Wabash.
Lake Wabash further argued that it received nothing from the sale because the $6
million in proceeds went to the tax buyers and there was no reason for it to do
the transaction if it was not a loan, because otherwise it could have just allo
wed the Property to be transferred to the tax buyers. But the Court noted that L
ake Wabash, by virtue of the repurchase option, obtained a one-year reprieve fro
m certain loss of the Property and gained the opportunity to obtain financing on
the Property or secure a development partner.
Finally, the Appellate Court rejected Lake Wabash's argument that a news story i
t found on the Internet (three years after the execution of the RESL Agreement),
regarding the planned $45 million conversion of the Property into a multi-famil
y rental project, was relevant with respect to the value of the Property at the
time the parties entered into the RESL Agreement.
So what lessons and morals can be gleaned from the Appellate Court's decision in
185 N. Wabash? The authors have the following observations on the Court's rulin
This case involved sophisticated and experienced real estate investors and sophi
sticated legal counsel, as pointed out by both the trial court and the Appellate
Court. The documents negotiated and drafted by these parties (and their actions
and conversations in connection therewith) specifically referred to the transac
tion as a sale-leaseback and made no mention, express or implied, of any other c
haracterization. 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's favor and Lake Wabash faced an uphill battle in attempting
to prove the existence of a sufficient number of the Robinson Case factors (beyo
nd its argument that it had previously unsuccessfully attempted to obtain a loan
and the documents contained a repurchase right and provided for a lease at a no
minal rental amount) to establish that the intention of the parties was other th
an as stated in their documents.
If you know you are dealing with extremely litigious parties (apparently the cas
e in this matter), think long and hard before you drag them into court and give
them an opportunity to make a claim of an equitable mortgage -- especially when
you have already obtained title to and possession of the property and the proper
ty is worth at least the amount of the original sale price (which apparently, wa
s the case in 185 North Wabash based on the appraisal testimony accepted by the
Appellate Court).
Appraisal testimony can be crucial in determining the value of the property in t
hese types of cases, which in turn is crucial to the issue of whether the consid
eration for the transaction is fair and sufficient to prevent recharacterization
. The credibility of the appraisers certainly was critical to the Appellate Cour
t's decision in 185 North Wabash, and it appears that 185 North was shrewd in re
taining a highly reputable, experienced, and believable appraiser who stood up w
ell under direct- and cross-examination in court. (Query: Would it not be the ca
se that whenever commercial property is encumbered with a lease containing a rep
urchase option, the value of the property will be negatively impacted?)
The language in the option provision of the RESL Agreement, stating that failure
to timely exercise the purchase option and deliver the earnest money would term
inate the option right and nullify it ab initio -- and that Lake Wabash would th
ereafter have no legal or equitable interest in the Property -- certainly was he
lpful to 185 North. But it likely would have been even more helpful if the RESL
Agreement had contained specific language (perhaps bolded 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 par
ties, either express or implied, other than as expressly stated in the RESL Agre
Recharacterization is always an uphill battle -- you are trying to argue that so
mething 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 p
arty seeking to recharacterize a document or transaction to a high standard of p
roof. As demonstrated by the Appellate Court's holding in 185 North Wabash, the
question of valuation is often crucial. Sale/leaseback transactions may be recha
racterized as either equitable mortgages or joint ventures (although to date no
final court decision has ever recharacterized a sale/leaseback transaction as a
joint venture). See Thomas C. Homburger and Brian P. Gallagher, To Pay or Not to
Pay: Claiming Damages for Recharacterization of Sale Leaseback Transactions Und
er Owner's Title Insurance Policies, 30 Real Prop. Prob. and Tr. J. 443, 488-489
(Fall 1995); Thomas C. Homburger and Gregory Andre, Real Estate Sale and Leaseb
ack Transactions and the Risk of Recharacterization in Bankruptcy Proceedings, 2
4 Real Prop. Prob. and Tr. J. 95 (Spring 1995). In a sale/leaseback transaction,
the seller/lessee may attempt to have the sale and leaseback recharacterized as
an equitable mortgage in order, among other things, to provide it with an oppor
tunity to "redeem" the property at a foreclosure sale. The recharacterization te
sts applied by bankruptcy courts often serve as a useful guideline when analyzin
g the risks of the transaction. See, e.g., Barneys, Inc. v. Isetan Co. (In re Ba
rney's, Inc.), 206 B.R. 328, 332-33 (Bankr. S.D.N.Y. 1997) (stating that the "[t
]he appropriate inquiry is whether the parties intended to impose obligations an
d confer rights significantly different from those arising from the ordinary lan
dlord/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). The courts have
applied a fact-based analysis to determine whether the substance of the transac
tion is in accord with its form and the expressed intent of the parties. Althoug
h the issue of whether a transaction is characterized as a sale or a mortgage de
pends to a great extent on the expressed intention of the parties, the economic
substance of the transaction -- and not its label -- will ultimately determine w
hether it is a true sale/leaseback or a financing transaction.