"Lease" Held To Be A Lease, Not Seller Financing

This follows-up my 11-5-09 post Indiana Court of Appeals Tackles True Lease Vs. Secured Loan Question.  Last year, the Court of Appeals addressed the same issue in a different context in Gibralter Financial v. Prestige Equipment, 2010 Ind. App. LEXIS 626 (Ind. Ct. App. 2010) (.pdf).  If you're an asset-based lender struggling with understanding your rights under a written agreement named a "lease," which may have been intended to be a secured loan, Gibralter is a nice Indiana opinion that outlines some of the key issues for consideration. 

Big picture.  The dispute in Gibralter boiled down to whether the subject transaction was a financed sale or a lease.  At stake was ownership of a quarter million dollar punch press.  If the Court deemed the transaction to be a lease, as opposed to a sale, then the lessor/alleged seller retained ownership of the punch press. 

Legal test.  The case actually involved Colorado law, but it appears Indiana's UCC provisions are similar to Colorado's, so the legal analysis essentially is the same.  The key statute is Ind. Code 26-1-1-210(37), including specifically subsection (b).  These cases involve a two-pronged test:

1. whether the right to possession and use is subject to termination by the lessee;
2. whether the lessee had an option to become the owner for "nominal additional consideration" once the lease was paid.

If the answer to question 1 is "yes," then the analysis ends because the subject document will be considered a lease.  If the answer is "no," then question 2 must also be answered.  If the answer to question 2 is "yes," then the document/transaction will be considered a security agreement/sale.  On the other hand, if the answer to question 2 is "no," then the document will be considered a lease. 

Test results.  Reading a legal test is one thing, but understanding it is another.  Illustrations help, which is why I always attach .pdf's of the legal opinions to my posts.  Gibralter explains in detail why the lessor (alleged seller) prevailed on its contention that this was a lease transaction.  As to question 1, the Court stated that, for a lease to be terminable, "the lessee must have the right to cease payments and walk away from the lease without further future financial responsibility to the lessor."  In Gibralter, no such right existed, so the Court turned to question 2.  The Court's discussion of question 2 was quite involved and dealt with an examination of such things as the lessee's costs and payments, as well as the value of the punch press.  There are a couple of sub-tests that deal with this issue, including the "FMV Standard" and the "Option Price/Performance Cost Test."  Read the decision for more.  In the end, the Court concluded that, given all the facts and circumstances, "Key retained a meaningful residuary interest and that the Lease was merely a lease." 

In the final analysis, the Court held that Key (the lessor/ alleged seller) was the owner of the punch press.  Any lenders reading this post should remain mindful of these tests and to structure their transactions accordingly, depending upon whether they intend for them to be a true lease versus a secured loan.    

Note:  The Indiana Supreme Court has reversed the Court of Appeals, as outlined in my July 1, 2011 post.