“True Lease” Versus “Disguised Security Interest”

"A transaction in the form of a lease creates a security interest if the consideration that the lessee is to pay the lessor is an obligation for the term of the lease and is not subject to termination by the lessee, and:

(1) The original term of the lease is equal to or greater than the remaining economic life of the goods;

(2) 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;

(3) 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; or

(4) 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. ORC § 1301.203(B)

A lease does not create a security interest merely because conditions enumerated in ORC § 1301.203(C) exist."

The party claiming that a lease is a disguised security interest as opposed to a true lease bears the burden of proof. In re QDS Components, Inc., 292 B.R. 313 (Bankr. S.D. Ohio 2002). The characterization fixed by the parties to the agreement is not necessarily controlling in distinguishing between a true lease and a disguised security agreement. In re Vital Products Co., 210 B.R. 109 (Bankr. N.D. Ohio 1997); In re Bevis Co., Inc., 201 B.R. 923 (Bankr. S.D. Ohio 1996); Telmark, Inc. v. Schierloh, 102 Ohio App.3d 801, 658 N.E.2d 43 (3rd Dist. 1995). Calling a transaction a lease, when its intention is to create a security interest, will not preclude application of Article 9. Telmark, Inc. v. Schierloh, 102 Ohio App.3d 801, 658 N.E.2d 43(3rd Dist. 1995). The paramount factor in determining whether there is a lease or a security agreement is the existence of an option to purchase the leased property for little or no consideration. In re Estep, 173 B.R. 126 (Bankr. N.D. Ohio 1994). The hallmark of a lease, as opposed to a disguised security agreement, is that a lease grants the lessee the right to use the property for a period less than its economic life, with the obligation to return the property to the lessor while it retains some substantial economic life. In re QDS Components, Inc., 292 B.R. 313 (Bankr. S.D. Ohio 2002). When the term of the agreement, conversely, provides for the consumption of the majority of the useful life of the goods in question, there is a purchase contract or financing agreement, rather than a lease. In re Nationwise Auto, Inc., 250 B.R. 900 (Bankr. S.D. Ohio 2000). 

 

Ohio courts have held that a so-called equipment lease was not a true lease but a disguised security agreement, which the lessor could not recover from the lessee’s Chapter 11 estate on the theory that the lease term had expired, where the so-called lease obligated the lessee to make a stream of payments for the entire term of the lease with no obligation to terminate and enabled the lessee to acquire the leased property at the end of the lease term for a payment that was less than a single lease payment and considerably less than the equipment’s anticipated remaining fair market value. In re Vital Products Co., 210 B.R. 109 (Bankr. N.D. Ohio 1997) citing former ORC § 1301.01(KK). Again, an alleged equipment lease which the debtor/lessee could not cancel without immediately incurring liability for the total outstanding balance owing on the lease, and which gave the debtor the option of purchasing the equipment at the end of the lease term for a nominal sum is not a true lease, but an installment sales contract with a disguised security interest. In re Fox, 229 B.R. 160 (Bankr. N.D. Ohio 1998).

Original Author: Jay J. Lah, Esq.

Update Review: Shannon D. Lawson, Esq.