By Lisa M. Goolik, J.D.
A case decided by the Court of Appeals of Iowa this week illustrates that an agreement is not necessarily an security agreement just because it purports to create a security interest. In reaching its conclusion that a lease agreement that contained a security agreement clause was, in fact, a lease, the court noted that whether a contract constitutes a lease or a security agreement does not depend on whether the parties call it a “lease” or a “security agreement,” but on the facts of the case. As a result, the lessor, Hard Hat Industries, Inc. (HHI), was entitled to repossess and sell leased equipment held by the lessee, CD Construction, LLC, in accordance with the lease’s terms (CD Construction, LLC v. Hard Hat Industries, Inc., Oct. 28, 2015, Doyle, P.J.).
Background. In 2010, CD Construction purchased a used excavator from HHI for $136,000 on a “rent-to-purchase” agreement. In 2013, the owner of CD Construction, Chris Doty, asked HHI’s owner, Donnie Baggs to borrow $35,000. Doty believed he asked Baggs for a loan secured by excavator; however, Baggs believed HHI was purchasing the excavator to lease back to CD Construction. HHI issued a check to CD Construction, and Doty provided HHI with a bill of sale for the excavator. The parties then entered into a “lease agreement” for the excavator, signed by HHI as lessor and Doty as lessee.
The agreement specified 17 monthly payments of $2,500 with a $7,500 balloon payment at the end of the term to “buy out” the excavator, which at that time, was valued between $85,000 and $100,000. After six months of the lease, Doty had an option to purchase the excavator for $50,000. The agreement also contained a security agreement clause, which purported to grant HHI a security interest in the excavator. In addition, the agreement provided that HHI keep the excavator in good condition, requiring HHI to complete more than $23,000 in repairs in the first few months of the term.
After CD Construction missed two monthly payments, HHI’s attorney sent a notice of termination of the lease to CD Construction. HHI subsequently repossessed and sold the excavator for $83,500.
CD Construction filed an action, alleging claims of conversion and breach of contract against HHI. CD Construction argued that the agreement was a security agreement rather than a lease, and as a result, HHI was not entitled to possession of the excavator.
Lease v. security agreement. The court began by noting that whether a contract constitutes a lease or a security agreement does not depend on whether the parties call it a “lease” or a “security agreement.” Rather, the facts of each case determine whether a transaction creates a lease or a sale with a security interest.
Under Iowa law, the court must apply a two-part analysis that begins with the bright-line test. According to the test, a transaction in the form of a lease creates a security interest if it: (1) prohibits the lessee from terminating the obligation to pay the lessor for the right to possess and use the equipment, and (2) meets one of the four independent criteria listed in section 1-203(d) of the Uniform Commercial Code:
- The original term of the lease is equal to or greater than the remaining economic life of the goods.
- The lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods.
- The lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement.
- The lessee has an option to become the owner of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement.
The court concluded the agreement did not meet the requirements of the bright-line test. As to the first requirement, the agreement provided CD Construction had the right to cancel the agreement 10 days after the first day of the lease term.
In addition, the agreement did not satisfy any of the four additional factors in the second requirement: the original term of the lease was not equal to or greater than the remaining economic life of the goods; there was no requirement or option to renew the lease, nor was there an option to renew the lease for nominal payment; and if CD Construction chose to purchase the excavator at the end of the lease, the $7,500 balloon payment plus the cost to reimburse HHI for the repairs was not “nominal.”
As a result, the transaction was not a sale with a security interest. Accordingly, when CD Construction defaulted on the lease agreement, HHI was entitled to possession of the excavator under the terms of agreement.
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