A PRACTICAL LOOK AT LEASE DOCUMENTATION
By Barry S. Marks
[Barry S. Marks, esq., is a shareholder at Berkowitz, Lefkovits, Isom & Kushner, Professional Corporation, based in Birmingham, Alabama, USA. Barry has been associated with several committees of the Equipment Leasing Association and government bodies, and regularly contributes to journals and conferences. For a resume of Barry Marks, click here. To visit the home page of his Corporation, click here.]
Lease provisions (and I am including provisions in such ancillary documents as purchase orders, delivery and acceptance certificates, officers’ certificates and the like) do many things. One way to evaluate them from a business perspective is to categorize them according to their intended purpose. This exercise will allow you to determine whether it is reasonable for the lessee to ask you to vary standard language and whether alternative protection is necessary or available.
In many cases, a single lease provision will offer many forms of protection for the lessor all at once. Many provisions are “boilerplate” which is a much-abused term for provisions which are actually so universally important that they are commonly placed in leases and, paradoxically, often undervalued and overlooked.
Your equipment lease documents are designed to:
* Protect lease revenues — By this I mean provisions which are designed to give you the benefit of your bargain from the lease itself, chiefly the rent stream. Language in the lease providing rental terms and the “Hell-or High Water” clause obviously fall into this category. Language regarding the lessee’s continued ability to pay rent, such as cross default and certain other default provisions, also fall into this category. Guaranties and security deposit arrangements may also be considered as revenue-protection advice as may certain protective provisions in termination options and loss/property damage insurance clauses.
* Protect residual value — One easy way to determine the difference between an experienced equipment lessor and a novice is to listen to the importance he or she places on the residual. Since the halcyon days of ITC and the tax-lease fervor of the early ’70’s, more and more truly substantial leasing operations focus on residual value as a primary source of future revenue. Provisions which protect the equipment, or substitute a desired cash settlement, fall into this category. These include provisions regarding the return of equipment, but also its use and maintenance, property damage insurance, event of loss clauses and purchase or renewal options.
* Protect the lessor from liability — The only constant that I can cite during the 17 years I have been in practice is that our society has grown more litigious. At the same time, the horror stories have grown more horrifying. Well-drafted equipment leases include provisions requiring liability insurance, limiting the lessee’s use of the equipment and requiring the lessee to indemnify the lessor against a variety of potential lawsuits and other claims.
* Protect enforceability — With the increase in lessee bankruptcy and fraudulent transactions, we are more-and-more concerned with protection against claims that the lessee did not actually approve the lease as required by corporate law or that the deal is a sham. Most of this protection is found in officer’s certificates, opinions of counsel, corporate resolutions and other documentation outside the lease. This category also includes lease provisions which protect against legal technicalities such as usury “savings clauses” and severability provisions.
You will note that I have said nothing about default remedies. The listing above was by no means intended to be exclusive, but well-drafted remedies provisions, and the manner in which the lessor deals with a lessee default, address all of these desired protections.
Generally, the term of an equipment lease will begin on acceptance of the equipment, which sounds much more simple than we all know it actually is. This is one of many areas where the reliance on standard form documentation, without periodic review and a bit of thought in individual circumstances, can lead to disaster.
Coordination of the lease, the schedule (if a master lease is used), the delivery and acceptance certificate and the purchase order are key.
Beware of delays in acceptance where the lessee, for whatever reason, does not accept shortly after shipment (this is discussed more below). The date on which the term begins should be clear. Confirm commencement of the lease in writing if there is any question by a fax to the lessee.
Beware of loose language in lease schedules which varies the term of the printed document.
Bear in mind that a bankruptcy preference problem may exist if there is a delay in filing UCC-1 statements due to confusion about the commencement date of the lease.
Most leases clearly state whether the rent is intended to be paid in advance or in arrears. Be mindful of this in structuring casualty or termination value tables and in varying purchase or renewal option language.
Interim rent can often be a problem.
Far more common than problems about the term and rent provisions are problems regarding the lessee’s late payment of rent. Generally, this is not a usury problem in most states — penalty rent is not considered to be “interest” for usury purposes under most state laws. However, several types of problems can arise if the late charges are not consistently applied. If the lessee is going to be given grace for any reason, a written letter to the lessee should explain that the lessor reserves the right to reinstitute the penalty later on.
Late charges fall into several categories. Some leases require a single lump sum payment, which should be invoiced to the lessee as soon as it is due.
Other leases require a calculation of interest, usually from the date due until the date of payment.
While some leases will state that the reason for one or the other of the charges is loss of interest, documentation fees, etc., it is not a good idea to attempt to add this language in a letter to the lessee.
Compare grace period for late fee and late fee provision to cure rights in defaults section.
It is important that the lessor compare the late payment provisions of the lease to any loan document if the lease is to be leveraged. This is particularly crucial if the lessor intends to borrow against the lease in a recourse transaction.
Net Lease/Hell or High Water Clause/Warranty Disclaimer
There is a great deal of overlap in these concepts, which are actually intended to be separate and to deal with distinct, although similar, issues.
The net lease provision states that the lessee is responsible for paying operating costs, taxes and insurance. This effectively means that the rent payment is “net” to the lessor (except for the lessor’s income taxes and overhead).
The hell or high water clause is important to establish that the lessee must pay the full amount of rent whether or not the equipment functions and has no right of offset. If this clause is explained to the lessee, it should be pointed out that the lessee does not, in this clause alone, give up its right to sue the lessor if it feels that the lessor has breached any terms of the lease, including representations regarding the equipment. Such assurances, however, should never be put in writing unless the writing is reviewed by counsel.
The warranty disclaimer language is fairly standard because it is based on statutory requirements. Under Article 2A, a warranty is implied by the lessor whether the equipment is leased under a true lease or a disguised security arrangement. In other words, you are all deemed to be making an implied warranty that the equipment is “merchantable” and “fit” for the lessee’s intended use UNLESS THE WARRANTY DISCLAIMER LANGUAGE IS PRESENT IN YOUR LEASE.
The bad news is that this language can be varied by written (or, under unusual circumstances, oral) representations to the lessee. These include representations made by your salesmen or loose language in any written communications.
The good news is that Article 2A automatically establishes hell or high water clause protection, even if the lease language is defective, if the lease is a “finance lease.” (Note that even this protection might be waived if care is not taken in communications with the lessee.)
Delivery & Acceptance/Purchase Orders
At this point, we step into an area which really goes beyond the documentation itself. Some of the most serious problems which arise with regard to leases in their early stages involve how, when and whether the equipment has been properly delivered to the lessee and accepted by it. As a general rule, virtually all of the lessee’s obligations to the lessor, including the obligation to pay rent and to indemnify the lessor, arise only when the equipment has been accepted. Likewise, the lessor’s obligation to make payment to the vendor of the equipment arises on the lessee’s acceptance. Fumbling this opening kick-off can result in the lessor finding itself between vendor and lessee with no protection.
From a paperwork standpoint, the lessor will rely on the delivery and acceptance certificate, which should properly refer to the lease and should require the lessee to acknowledge that the equipment is fully operational. There is no good reason to confuse or delude the lessee in any regard in this part of the process — he is your agent.
The purchase order is one of the least-reviewed documents most lessors use. It should be absolutely clear that:
* The lessor’s obligation to purchase is contingent on acceptance by the lessee AND completion of all lessee/lessor documentation to lessor’s satisfaction.
* The lessee is under no authorization to vary the terms of the equipment order or to order additional equipment to be placed under the lease without lessor’s consent.
* Time limits should be specified, a reasonable testing period referenced.
* The Lessor should receive some notice of the date of delivery of the equipment (this may impact perfection under the Uniform Commercial Code).
It is a good idea to consider using different types of purchase orders for special types of equipment, such as equipment involving special tests (computer equipment) and equipment licensed under the Federal Aviation Administration, maritime or other rules.
Sale/leasebacks require special attention, ensuring that the lessee has good title (a UCC check is a must), avoiding potential fraudulent transfer problems (which is addressed by Article 2A) and including a bill of sale.
One of the provisions which addresses directly the lessor’s anticipated residual value realization is the return provision of the lease. These provisions include provisions addressing the condition in which the equipment must be on the date of return, the allocation of the costs of redelivery and what additional charges the lessee may be required to pay.
If there is any doubt as to the lessee’s obligation, the lessor should notify it in advance as to what the obligations are assumed to be. In many cases, a given type of equipment will require a special return provision, such as a requirement that the equipment is in adequate condition to receive government certification or to be maintained by a proper service organization in the future.
Consider: what liability does the lessee have if it fails to return promptly? Can it be argued that the lease is renewed by the lessor’s acceptance of continued rent payments?
On their face, few things are as simple as the concept of a renewal or purchase option. In fact, few provisions cause more problems. It is essential that the Lessor be fully familiar with the terms of the renewal or purchase option provision as it relates to the particular lessee and equipment. “Fair market value” may be a difficult concept.
If the lessee desires to exercise a renewal or purchase option, check to ensure that no default exists, that no liabilities are outstanding and that the lessee has complied with all notice and other requirements.
In addition, a provision describing how fair market value should be in your lease form. Be sure you are comfortable with its workings and the potential cost in dollars and time. Contact potential appraisers in advance and be sure that they are familiar not only with the type of equipment but the concept of a fair market value determination for equipment lease purposes.
Events of Default/Remedies
Before discussing the provisions found in most of your leases describing lessee defaults and preserving your remedies, let me note a couple of changes in this area which have been made by UCC Article 2A:
* Mitigation of damages is required under the laws of most states. In some cases, this is a change from prior law. Under mitigation concepts, the lessor is required to attempt to sell or release the equipment and give the benefit from the sale or release to the lessee calculating damages.
* The concept of “unconscionability” is now incorporated into leasing law. This concept, which previously existed in some states under common law, gives lessees the opportunity to claim that lease provisions are so onerous that they should not be enforced by the court.
On the subject of remedies, UCC Article 2A has again made significant changes. First, Article 2A recognizes the right of the lessor to insist on liquidated damages, which may vary the terms otherwise provided under Article 2A. Liquidated damages may be expressed as a formula which reasonably estimates the damages the lessor will incur by reason of the lessee’s default. The requirement under prior law (as interpreted in most states) that the damages be difficult to determine without use of the liquidated damages clause has been replaced.
Where the lease is silent as to damages or where the provisions of the lease are held to be unconscionable or otherwise unenforceable, UCC Article 2A provides its own damages formula. Basically, this formula will permit the lessor to recover the following: the sum of present value of all future rentals and the estimated residual value of the equipment at the expiration of the lease term, less the amount obtained by the lessor upon the sale or release of the equipment. In the event that the lessor does not sell or release the equipment, the fair market value of the equipment will instead be used as the deduction.
We will discuss in some detail, time permitting, remedies permitted under UCC Article 2A. In any event, it is very important that you review your equipment lease with regard to the default and remedies section and compare it to those rights remaining under UCC Article 2A. As a practical matter, a liquidated damages clause, setting out a formula by which the lessor’s damages following a default by the lessee may be calculated, is extremely important.