Indiana Court Of Appeals Tackles True Lease Vs. Secured Loan Question

When commercial asset-based lenders and their collection counsel are confronted with defaults under agreements labeled a “lease,” such as an equipment lease, often there is a question of whether the transaction was a true lease as opposed to a secured loan.  A detailed discussion of the differences between the two transactions goes beyond the scope of this post, but generally the nature of the underlying transaction will affect, among other things, the remedies available to the lender/lessor upon a default.  My focus here simply is to outline how Indiana courts might evaluate whether the underlying deal is a lease or a secured loan in the first place.  The recent Indiana Court of Appeals opinion in Gangloff Industries v. Generic Financing, 2009 Ind. App. LEXIS 897 (Ind. Ct. App. 2009) (.pdf) is informative.

The circumstances.  Generic Financing entered into a “Lease Agreement” with Robert Bougher concerning a semi-truck.  The Court outlined portions of the agreement on pages 2-4 of the opinion.  Bougher’s wife and Gangloff entered into a separate “Owner Operator Service Contract” by which the wife agreed to operate the semi-truck and to haul goods for Gangloff.  A couple years later, the semi-truck broke down and required $6,000 in repairs.  Gangloff paid for the repairs.  Bougher was to re-pay Gangloff, but Bougher died before he could do so.  Gangloff took possession of the semi-truck pending the wife’s payment of recovery and storage expenses. 

The litigation.  While Gangloff had the semi-truck in storage, Generic filed a lawsuit.  There were multiple causes of action and legal theories asserted between Gangloff and Generic concerning who was entitled to possession of the semi-truck and who owed damages to whom.  In order to resolve the damages and possession issues, the Court of Appeals had to address the question of whether the “Lease Agreement” between Generic and Bougher was a true lease or a security interest (a loan secured by the semi-truck).   

The test.  The Court initially turned to Indiana’s UCC, specifically Ind. Code § 26-1-1-201(37), which defines a security interest as “an interest in personal property or fixtures which secures payment or performance of an obligation.”  The Court next noted that “the primary issue to be decided in determining whether a lease is ‘intended as security’ is whether it is in effect a conditional sale in which the ‘lessor’ retains an interest in the ‘leased’ goods as security for the purchase price.”  The UCC refuses to recognize form over substance, which is why Indiana’s UCC includes a lease intended as security in the statutory definition of security interest. 

The Court in Gangloff explained that I.C. § 26-1-1-201(37) “unequivocally” states that a lease will be deemed a security interest if:

(1) the consideration the lessee is to pay the lessor is an obligation for the term of the lease and the lessee may not terminate the obligation; and
(2) one of four enumerated conditions [a-d outlined in the statutory  subsection] apply.

Here is a .pdf of the portion of the statute quoted by the Court, including subsections (a)-(d).  In Gangloff, the “only potentially relevant condition” was subsection (d), which involves the lessee’s option to become the owner of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease. 

The application of the test.  The Generic/Bougher agreement obligated Bougher to pay Generic monthly installments totaling $43,051.95 over a period of thirty-eight months.  This consideration was loosely based upon the price of the semi-truck plus interest.  Furthermore, Generic alone had the option to terminate the “Lease” before the fixed term.  As such, the written agreement met part (1) of the statutory test. 

Regarding part (2), specifically subsection (d) under the statute, the Court cited case law for the following proposition:

The courts are clear upon one thing, which is that where the terms of the lease and option purchase are such that the only sensible course of action for the lessee at the end of the term is to exercise the option to purchase and become the owner of the goods, then the lease is one intended to create a security interest.

Bougher had the option to purchase the semi-truck for $3,190.00, which was 10% of the financed amount.  Had Bougher fully complied with the agreement for three years use of the semi-truck, he would have paid, including the down payment, a total of $45,762.00.  The Court held that subsection (d) was satisfied because “the only sensible course of action would have been to exercise the option and purchase the truck for a fraction of the total rent price.”  Thus, the “Lease Agreement” created a security interest rather than a true lease.   

The consequences.  The Court’s conclusion that the Generic/Bougher “lease” created a security interest (like a loan secured by the semi-truck) clarified all sorts of issues regarding the relative rights of the parties.  Next week’s follow-up post will address the second part of the Gangloff opinion concerning a lien priority dispute between Gangloff and Generic.  The objective of today’s post was to highlight the importance of recognizing that not all “lease” agreements will be treated as leases.