THE BASIS OF A LESSOR’S LEGAL RIGHTS: A TRUE LEASE : By Vinod Kothari
The distinctive legal rights of an asset owner over a money-lender was the primary reason for the evolution of leasing and hire-purchase as modes of financing. While plain financing instruments gave only a right to money, both leasing and hire-purchase were cases of asset-based dealings and therefore, the lessor had right over and access to the asset.
The legal rights of a lessor over the asset have been well-understood by Courts in almost all jurisdictions. Unless the lease is a mere device to garb a secured lending transaction, Courts would generally honour the lease agreement and allow to the lessor the rights mentioned therein.
LESSOR’S PREDOMINANT OWNERSHIP INTERESTS:
In most countries, the lessor’s predominant legal interest over the leased asset has been recognised. This is one of the clauses in the UNIDROIT convention on international leases. No other creditor of the lessee, or a statutory authority having a claim against the lessee, can have a superior legal interest over the property to over-ride the lessor’s interest.
In a case dealing with hire-purchase, the Indian Supreme Court recently upheld the owner’s legal interest over the asset and his right of repossession even if a clause to this effect was not there in the agreement.[ K A Mathai alias Babu v. Kora Bibbikutti (1996) SCC (Cri) 281]. Being a generic right over property, it did not matter if such a clause was specifically there in the agreement.
There have been cases in India where the lessee became a sick undertaking, which is a pre-insolvency stage of an industrial unit. The Sick Industrial Companies Act contains an embargo on any proceeding against the sick company or against its property. However, as a repossession claim by the lessor was a claim against the lessor’s own property, there was no interference to be made such repossession.
The essence of the above is that any liquidation, Sick Companies, attachment or any other proceedings against the lessee would not affect the supreme interest of the lessor in the asset.
EXISTENCE OF A TRUE LEASE:
All the above rights are, however, conditional upon there existing a true lease or a true hire-purchase transaction. The essence of a true lease or true hire-purchase transaction is that it must be made out before the judicial authority that the parties actually intended buying and leasing, or buying and hiring out an asset and the transaction was not a de facto lending agreement, garbed as a lease or hire-purchase. The preferential rights of the lessor as asset-owner would not be available if the lease is not established to be a true lease.
A lease must be a true lease, not merely in form but also in substance.
As a general rule, Courts do not explore the substance of every transaction coming before them. If Courts were to explore substance at random, no commercial contract has a safe harbour, since a Court may examine the substance and conclude that the form of the agreement conflicts with the substance. Normally, agreements entered into by parties with open eyes, unless there is an intent to defraud any one, would be accepted as it is. Therefore, the form prevails, unless the question of substance is brought before the Court with enough of explanation as to why the substance could be different from the form.
A hire-purchase jurisdiction in India, one of the first cases of substance prevailing over form was the ruling of the Supreme Court in Sundaram Finance Ltd. v. State of Kerala AIR 1966 SC 1178. This was a sales-tax case, and the lessor himself argued that the substance of the transaction labelled and documented as a hire-purchase was a loan on security. The Supreme Court referred to a number of rulings in England dealing with the distinction between a hire-purchase and a Bill of Sale, a device prevailing in England to get over money-lending legislation. Examining the facts, the Supreme Court held that the case was indeed one of secured lending, and not a hire-purchase.
The decision in Sundaram Finance became the basis for the Madras High Court to deal with the issue of form and substance in case of hire-purchase transactions, at length, in Official Liquidator, Mansuba and Co. v. Commissioner of Police (1969) 1 CLJ 5. This was a case dealing with the ownership rights of HP owner. While the borrower went into liquidation and the HP owners sought to invoke their ownership over the assets claiming the assets to be theirs, the Madras High Court drew a distinction between assets which were truly owned by the hire-vendors, and the cases of mere secured lending. In the latter variety of cases, the so-called HP vendor was a mere money-lender, and had no better right than an unsecured lender.
There is, thus, a possibility, already tested in India, of a Court going into the substance of a lease or hire-purchase agreement and holding it to be a case of secured lending. This question has been seriously discussed in Courts in several other jurisdictions, significantly the countries where leasing as a mode of financing has existed for several decades. Notably, the tax angle in defining a true lease has not been the same as the legal angle. The legal angle is merely concerned with the intention of parties to vest ownership rights in the lessor.
For example, in India, the tax laws recognise a hirer as the owner. But the legal rights of an owner are recognised for enforcing ownership rights. Thus, the hire-vendor is the owner for the purpose of enforcing his claims, while the hirer is the owner for claiming ownership-based tax allowances. This dichotomy is easily understandable in India.
In a number of jurisdictions, however, even from the point of view of enforcing legal ownership rights, a hire-purchase transaction, or an agreement to transfer effective title to the lessee, would be regarded as a secured financing, and not asset-ownership.
Take US Uniform Commercial Code as an example. By definition, a lease is regarded as a secured financing, if (a) the lease term is more than or equal to the remaining economic life of the asset; b) the lease transfers title to the lessee or obliges the lessee to renew the lease for the remaining economic life; or (c) the lease allows the lessee right to renew the lease on payment of token rentals, or to be owner on payment of a nominal amount. Clearly therefore, hire-purchase is taken as a case of secured financing under the US laws.
In Re Marhoefer Packing Co., 674 F. 2d 1139, 33 UCC Rep. Serv. 370, the Court stated: “An essential characteristic of a true lease is that there be something of value to return to the lessor after the term”. This principle has been accepted in England also, though in English law, as in India, a lessor’s right to an asset is not disputed merely because it is a case of hire-purchase.
FEATURES OF A TRUE LEASE:
4. Intention to redeliver: It must be exhibit in a lease that the parties have intended a lease, not a sale. Therefore, the intent of redelivery is necessary. This is not merely from the point of tax benefits, but even from the essential ownership rights of a lessor. If it is apparent that the lessor has agreed to a sale right in the beginning, he puts himself in the position of an unpaid seller, or a mere secured financier.
5. Intent to invest in asset value, not merely a right to rentals: In essence, the requisites above stress on the need for the lessor to look at a lease as an investment in the value of an asset, and not merely as a creation of right to rentals. If all that the lessor sees is the rentals created by the lease, the lease is bound to be regarded as a plain financing agreement. The conduct of the parties must make it evident that the lessor is investing in asset value. For example, the basic instinct of a buyer in examining the value of an asset, getting him satisfied about the quality and the worth of the asset, etc. That apart, the lessor must be looking at the residuary interest in the asset and must attach significance to it. Peter Coogan and others in Secured Transactions have pointed out that “the lessor must retain the right to regain possession at a time and in a manner that the residual is a thing of not unsubstantial value.”
Association of Leasing and Financial Services Cos. attempted to educate Indian lessors on the concept of a true lease and brought out a self-regulatory note on true lease transactions. A true lease has been defined therein as an “investment by a lessor in the value of an asset, with the intent of exploiting its value by renting the asset out on lease, and without an intent to create an owner’s equity in favour of any other person.”
Like in case of lease, the true bailment features apply in case of hire-purchase too. Each of the requisites above in case of lease is equally applicable to hire-purchase.
What, then, is the significance of option to buy? The common knowledge is that a hire-purchase transaction would make it obvious that the goods will be bought by the hirer, since the hirer will be given an option to buy the goods. It is also clear that the option to buy will be given at a nominal value as per an accepted practice in the country. So, is it at all necessary for the lessor to establish having a right to claim redelivery of the asset, or the residuary interest in the asset? In other words, if assets on hire-purchase, by fact or by contract, is one which would never be delivered, or is not even capable of redelivery, is it a case of true hire-purchase?
Courts have understood the distinction between hire-purchase and conditional sale based on whether the transaction implied an option to buy, or an obligation to buy. If the setting of the transaction is such that the hirer has agreed to buy, or will be obliged to buy, a hire-purchase is regarded as a conditional sale. For example, if a hire-purchase contract is non-cancellable for its entire tenure, after which the hirer is given an option of buying at a token value, it is a as good as a sale having been forced on the hirer. It has been held in several cases in India that the option to buy, in order to be meaningful, must be a real option, and not just a fiction.
The English version of hire-purchase has a significant difference from a conditional sale. The option to buy includes an option not to buy, that is, an option to return the goods. This option is not applicable at the end of the hiring tenure alone: it is available during the hiring tenure even. Thus, during the tenure, the owner carries the risks of an asset owner.
US law clearly regards a lease carrying a nominal option to buy as a case of secured financing.
Thus, in order to be regarded as a true hire-purchase, a hire-purchase contract must carry a right of the hirer to return the goods at a point of time during the hiring tenure where the value outstanding to the owner is not insubstantial.
ASSET-BASED FINANCING: ONLY SOLUTION TO TRUE LEASES
The question of truth of a lease will continue to affect lessors and hire-purchase financiers. In India, the issue of whether the parties intended a lease or a secured financing has so far not been faced in Courts. No doubt, as lessee- defaults increase, the issue will be faced. Courts cannot close their eyes to reality and look at the mere contents of the agreement. At the same time, Courts cannot tear apart every agreement and explore its substance. But in most cases, the setting of the transaction itself will go against the time-tested features of a true lease. Today in India, most lessors would be shuddering the idea of filing an asset-recovery suit since doing that would expose the fragility of the transaction. But that does not prevent a lessee from taking such a stand when a suit to recover rentals is made.
In many cases, assets leased may not have existed. In many cases, asset values have been engineered. Leasing of assets which are integral part of the lessee’s real estate has been common.
In sum lessors have looked at leasing as a mode of financing. The pre-obsession with the financial attributes has kept the lessor’s eyes off the asset-requisites.
Indian lessors are possibly waiting to learn , though that is a hard way of learning, that the business of leasing and hire-purchase, in law, spirit and in business prudence, demands circumspection of asset values. Borrower-based financing may be good money-lending, but bad leasing. The financing World in general realises that asset-based financing is far safer and reliable than entity-based financing. but this principle becomes unavoidably strong in case of lease or hire-purchase transactions, which, by their very technical nature, are drawn up as asset-financing transactions.
Does asset-based financing necessarily mean financing of utilities? Does it cut the scope of leasing only to readily realisable assets such as commercial vehicles or earthmoving equipments? Not really. Leasing as a medium of corporate finance will have to support acquisition of capital assets by corporates, which in more cases than not will be esoteric and tailored. Asset-based financing requires only a change of approach: a lessor taking a decision to invest should not only be looking at the entity but also, and with greater stress, at the asset. He may not rely on the value of the asset alone. But he must make sure that there is an asset to back up the investment at all times.
Often, we confuse assets values to mean the realisable value of an asset. That is not the intent. The market value of an asset matters only when the asset has to be stripped and converted into cash. The value of an asset is the value to its user. Asset-based financing approach does not, therefore, intend limiting the lessor’s involvement to assets which have a ready market. It only involves the lessor taking a few steps beyond the balance sheet evaluation of the asset and satisfying himself on the value of the asset to the lessee, the impact the asset is making on his cash flows, and the loss of value the lessee is likely to suffer by not having the asset.
From prudential viewpoint as well, a lessor’s investment is secured not by the value he can get by encashing the asset, but the value the asset has to the lessee. Where the value of the asset to the client comes down, vis-a-vis the lessor’s outstanding investment, the lessor becomes unsecured. From technical viewpoint also, problems begin, as noted below.
LESSOR’S RIGHTS IN TRUE LEASES/HIRE-PURCHASE:
One key question is: what the essence of the lessor being the owner of the asset? What is the privilege a lessor obtains as an asset owner? Obviously, the lessor’s distinctive advantage is that the lessor is able to stake a claim to the asset in the event of default.
This privilege, that is, the right to claim the asset, is as much a privilege as a source of a likely problem. Imagine a lessor having leased an asset, where the lessee defaults. The lessor seeks to repossess the asset terminating the lease contract. If the value of the asset does not recover the investment outstanding, can the lessor still have any claim against the lessee?
Put simply, the point is, can there be any right to rentals after the lease has been pre-closed on account of a default? Technically, between the lessor and the lessee, the contract is one of a lease, that is, renting. As long as the lessee has the asset on rent, the lessee is obliged to pay the rentals. A lessor may terminate the lessee’s right to use in the event of default. If that has been done, can the lessor have any right to future rentals?
Most agreements incorporate a clause that in the event of default, all rentals payable in future will fall due immediately. The underlying principle is that if a default of the lease is taken as a default of the whole of the lease agreement, then there is a basis to claim the rentals which have not even fallen due. In Lombard Tricity Finance Limited case, recently, an English Court had to examine whether a clause in the agreement providing for acceleration of all rentals on the date of default was a valid clause. The Court deviated from the rule pronounced years ago in the case of Financings Limited v. Baldock and held that if the agreement included a clause to the effect that a default of any one rental will be taken to be a default going to the root of the contract giving to the lessor a right to claim all rentals as due immediately, then such a clause is valid.
In India, a clause on such minimum payments has not come for legal scrutiny. But it is quite doubtful if a Court would honour a lessor’s claim to rentals even though the rentals have not fallen due. A hire-purchase agreement stands on a slightly different footing, since Courts have understood it to be carrying a semi-financial character. A lease agreement is viewed as a rental agreement. Unless the rentals over accrued, they may not become payable.
This once again emphasises that the value of the asset finally becomes significant. Therefore, in the event of contractual default, the ownership of an asset may turn out to be a risk too.
RISKS IN ASSET-BASED FINANCING:
As noted above, inspite of the non-cancellability of the agreement and the minimum payments clause therein, there may be a reflection of the asset value on the lessor’s rights. Therefore, the value of the asset form an essential pre-disbursal evaluation.
Not only that, it is also necessary to evaluate the asset from time to time.
As the asset is in exclusive possession of the lessee, and the lessor being technically disqualified to keep a tab on the asset values, it is advisable to keep an assured value clause in the agreement. This clause is premised on the fact that being an exclusive user of the asset, the lessee may use or abuse the asset. Abuse of the asset is an abuse of the powers granted by the lessor: hence, as a precaution, the lessor would seek to control the lessee’s right of use by stipulation as to values. Hence, the lessee is empowered to use the asset, but not to render it worthless. The lessor may charge the lessee for having misused the asset if the value, at any point of time, or at the end of the lease , is less than a guaranteed value in the beginning.
So, the lease agreement will contain a residual value schedule, giving the minimum values which the lessee, based on his estimate of the current value and estimated depreciation on proper use condition, guarantees.
This may effectively cover the lessor against the asset ownership turning into risk rather than reward.