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Indiana Supreme Court Clarifies Indiana Law In Distinguishing A True Lease From A Sale Subject To A Security Interest

Today’s post supplements my February 11, 2011 post regarding Gibraltar Financial v. Prestige Equipment punch press case.  On June 21, 2011 (.pdf), the Indiana Supreme Court reversed the Court of Appeals’ decision that was the topic of my prior article.  At issue is the sometimes difficult question of whether a transaction constituted a lease or a sale subject to a security interest. 

UCC, generally.  Although the case involved Colorado law, the operative statutes are similar, if not identical, to those in Indiana.  The first is the UCC’s definition of a lease at Ind. Code § 26-1-2.1-103(j).  The “key thing to note” with regard to the definition is that lease and security interest-based transactions “are mutually exclusive.”  The second and more central statute is I.C. § 26-1-201(37), which sets forth rules for distinguishing the two transactions.  The provision is complex.  The Gibraltar opinion helps parties and their lawyers navigate through that statute.  (Colorado’s version is Colo.Rev.Stat. § 4-1-203.)

Security interest per se.  The Court first concluded that one component of Section 201(37) is to create a two-pronged “bright-line test” to decide the issue of whether the transaction has created a security interest.  If the facts meet the test, “no further inquiry is required.” 

    Prong 1.  The first prong is satisfied “if the consideration that the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease and is not subject to termination by the lessee.”  The Court in Gibraltar concluded that the lease was not subject to termination.  Thus the first prong of the bright-line test was met.

    Prong 2.  The second prong is satisfied if one or more of four “Residual Value Factors” identified in the statute are found to exist.  In Gibraltar, only one of the four factors were potentially at issue:  whether the lease provided the lessee with an option to become the owner of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease.  The Court (and the Court of Appeals) wrote at length about two different tests applicable to this prong:  the “Fair Market Value Test or Standard” and the “Option Price/Performance Cost Test.”  (Review the opinion for details.)  The Court held that prong 2 was not satisfied under either test, essentially because “compliance with the Lease required [lessee] to pay more than nominal consideration to become the owner of the press.” 

Because prong 2 of the bright-line test was not met, there was no security interest per se created by the lease.

Fall back.  If the transaction does not pass the two-pronged bright-line test, Indiana courts must turn to a consideration of “the economic reality of the transaction in order to determine . . . whether the transaction is more fairly recognized as a lease or as a secured financing agreement.”  The Court discussed the pertinent statutory provisions and described their complexity, as well as courts’ struggles with interpreting them.  The Court’s solution was to articulate the following rule:  the question is whether the economic realities of the transaction dictate that it is a lease, and the focus in answering the question should be on the operative “economic factors” that drove the transaction.  The Court’s opinion identified some of the factors to be considered, none of which alone controls.  Indeed there were factors supporting both sides in Gibraltar.  The bottom line is that a resolution of this issue is highly dependent upon the facts. 

No summary judgment.  The Gibraltar decision involved an appeal of the trial court’s summary judgment ruling, which was affirmed by the Court of Appeals.  Here’s how the Indiana Supreme Court left the case: 

the defendants had the burden of establishing the absence of any genuine issue of material fact as to the economic realities of the transaction dictating that it was a lease as a matter of law.  To do so required evidence of the expectations of [lessee] and [lessor] at the time the transaction was entered into as to such factors as the value of the punch press on the EBO and lease expiration dates, the discount rate, and whether the “only economically sensible course” for [lessee] would have been to exercise the EBO. 

The Court saw “no way of resolving this case without this evidence” and thus reversed the case.   

Gibraltar serves as a reminder that not all “lease” agreements will be treated as leases.  Lenders should be attentive to these rules and to structure their transactions accordingly, depending upon whether they desire the transactions to be true leases versus a secured loans.  This dense body of law plays an important role when asset-based lenders and their collection counsel are confronted with defaults on these transactions.  The nature of the underlying transaction will control the remedies available to the lender/lessor, as well as who owns the asset.