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Florida Court Misses the Boat…Of Wrong Conclusions, Mutual Mistakes & More

Dispatches from the Trenches

This edition of Dispatches from the Trenches discusses: (1) a new way in which a Florida court has reached the wrong conclusion in its true lease analysis; (2) guarantors escaping their obligations under a "mutual mistake" theory due to mistakes made by the lessor/guaranteed party; and (3) the difference between termination and expiration and its impact on when a lessee can exercise a purchase option.

In re Shores, 2005 WL 1212591 (E.D. Fla. 2005)

Courts continue to find new ways to erroneously apply the UCC true lease test. In this case, the Court finds a lease that is terminable by the lessee at any time to create a security interest (i.e., a loan) rather than a true lease.

Lessee entered into a lease agreement with Lessor covering a portable warehouse. Lessee subsequently filed for bankruptcy under Chapter 13 and the standard battle over whether the underlying transaction was a true lease or a loan began.

The court cited the UCC 1-201(37) definition of a security interest and properly noted the bright line rule, which requires the court to hold that a "lease" actually constitutes a loan in the event: (1) the lease cannot be terminated by the lessee without further obligation; and (2) one of four other facts is present. The court correctly held that, since Lessee had the option to terminate the lease without penalty, the bright line test did not require the court to find the transaction to be a loan as a matter of law.

However, the court then began the facts and circumstances test provided for in Section 1-201(37), which states "[w]hether a transaction creates a lease or security interest is determined by the facts of each case." During this analysis, the court noted that "[i]n determining whether a lease is a 'true lease' courts have traditionally focused on whether or not the lease contains an option to purchase [and that] if the lease contains an option to purchase for a nominal sum at the end of the lease term, then it is argued that the lessee has been purchasing the item over the term of the lease and, thus, it is a financing arrangement and not a true lease." Based on this logic and the fact that the lease in question had a nominal purchase option, the court held that the transaction constituted a loan rather than a true lease.

In making this holding, the court missed the boat by failing to realize that the presence of a nominal purchase option only assures that the lessee (and not the lessor) will retain the equipment and that it will never be returned to lessor possession if the lessee cannot terminate early without penalty. If, however, as is the case here, the lessee has the option to terminate the lease early without penalty, it could reasonably decide to terminate the lease early and return the equipment to lessor. For example, if the lessee decided three months into the lease term that it no longer wanted the leased equipment, it would likely return the equipment to lessor rather than continue making payments throughout the lease term. In that case, the presence of the nominal purchase option is irrelevant. Obviously, the facts and circumstances test still has a role to play even when the terms of the lease allow the lessee to terminate early without penalty. See e.g., In re Triplex Marine Maintenance, Inc, 45 UCC Rep. Serv.2d 977 (Bankruptcy Ct., Texas, 2000)(court determined that a "lease" constituted a loan under the “sensible person test” solely because the lease covered all of the lessee’s assets and the court felt that the lessee’s only sensible choice was therefore to exercise its purchase option). However, the court in this case applied the facts and circumstances test inappropriately.

C & J Leasing Corp. v. Island Sun Enterprises, 2005 WL 975544 (Iowa App., April 28, 2005)

Lessee incorporated as "Island Sun Enterprises, Inc." but adopted the fictitious name "Island Sun Tan" for its salon tanning business and subsequently amended its articles of incorporation to change its name to "ISE, Inc."

Lessee and Lessor agreed to engage in a sale-leaseback transaction whereby certain tanning equipment would be sold to Lessor and immediately leased back. Guaranties were executed by co-owners (the Guarantors) as additional credit enhancement. Unbeknownst to Lessor, Lessee borrowed additional money from another bank (the Competing Secured Party) a week before the sale-leaseback was finalized and pledged the same tanning equipment to the Competing Secured Party as collateral.

Although Lessor filed its UCC covering the equipment before the Competing Secured Party, Lessor filed under the Lessee's old name and the Competing Secured Party filed under Lessee’s correct name and, as such, had a prior position.

Several months later, Lessee was unable to pay its bills (with its principal filing for bankruptcy). Competing Secured Party provided a notice of disposition of collateral, stating that it intended to repossess the equipment and sell it at private sale. Competing Secured Party was not only able to satisfy its debt by selling part of the collateral, it was also able to collect a surplus. Competing Secured Party then notified Lessor it was holding the surplus proceeds for Lessor as junior lienholder. Competing Secured Party also left the remaining equipment on the premises of the former tanning salon business for repossession by Lessor.

The next month, Lessor filed suit against the Guarantors to collect on the guarantees. For nearly 15 months after filing the suit, Lessor did not attempt to repossess the remaining equipment nor collect the remaining proceeds held by Competing Secured Party.

Guarantors sought to escape their obligations under the guaranties by using a variety of theories and both the district court and appellate court agreed. Perhaps the courts were motivated by Lessor's sloppiness in closing the transaction and/or its total disregard for the concept of mitigating damages. In any event, the Court used the theory of "mutual mistake" to rescind the guaranties, holding that: (a) Guarantors and Lessor where mutually mistaken as to whether Lessor would have a first priority security interest in the leased equipment; (b) Guarantors would not have guaranteed the Lessee’s obligations had they known there would be no collateral; and (c) Lessor should bear the risk of this mistake since it was in the best position to discover this mistake and failed to list the correct name of the Lessee on the UCC financing statement. It should be noted that strong Guaranty forms often address this issue by having Guarantor acknowledge that its obligations are not conditioned on any acts by the Guaranteed Party, explicitly stating that Guaranteed Party is under no obligation to proceed against or exhaust any security granted to it by any party.

Frost National Bank v. L&F Distributors, 2005 WL 1252269 (Tex. May 27, 2005)

Frost National Bank (Lessor) purchased 14 delivery vehicles for the purpose of leasing them to Williams Distributors (Lessee). The terminal rental adjustment clause (TRAC) gave the lessee the right to purchase the vehicles by giving 90 day written notice and provided for payment "on the last day of [the lease’s] expiration in an amount in cash equal to the then Fair Market Value…" The standard TRAC also provided that Lessor would be guaranteed a payment of 20% of the invoice price of the vehicles when they were sold.

While the trial court had found that the clause unambiguously provided that Assignee had the right to exercise the option at any time with due notice, and that Lessor was in breach by refusing to sell the vehicles, the Texas Supreme Court reached the opposite conclusion.

Approximately a year into the lease term, Lessee assigned the lease to another company (Assignee). Assignee notified Lessor of its intent to exercise to purchase option at that time, and promptly sued Lessor for a declaratory judgment, adding a claim for specific performance.

The court first considered the rules of construction of agreements in determining whether the TRAC had an unambiguous meaning. While the trial court had found that the clause unambiguously provided that Assignee had the right to exercise the option at any time with due notice, and that Lessor was in breach by refusing to sell the vehicles, the Texas Supreme Court reached the opposite conclusion. The court first pointed to the language of the contract as a whole, finding that, based on the definition of the term "expiration" within the contract, the TRAC unambiguously allows Assignee to purchase the vehicles only at the end of the lease term. Specifically, the court noted that the court of appeals failed to distinguish between the terms "expiration" and "termination." The latter, rather than the former, refers to premature termination of the lease period, as would be required for exercise of the purchase option before the lease term was up. Finally, the court held that application of the TRAC in the manner advocated by Assignee would be "unreasonable, inequitable, and oppressive." Such construction would require Lessor to sell the vehicles at the lessee’s discretion at 20% percent of their original value, foregoing a potentially great proportion of their rental value. Accordingly, the court reversed and rendered judgment on the declaratory judgment action, remanding the other claim for trial proceedings.

Article appeared in the April, 2006 issue of the Monitor.
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