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Equipment Leasing: Basic Contract Drafting Issues

By Lawrence Hsieh

GC New York

September 13, 2012

If you're a junior associate, chances are you'll soon be summoned on a Friday afternoon to work on a business combination that has to close on Monday. If you're a bit lost, you can at least take comfort knowing that there are good resources you can access to learn about how deals are structured.1 Once you understand the structure of the deal (including the "how" and the "why"), you can access a variety of good resources to help you to draft, benchmark and negotiate the transaction documents.

Now fast forward a few years, and once again you get the dreaded Friday afternoon call. But this time, you take the call sitting in a cubicle in a suburban corporate park, and it's the GC instead of a partner on the other end of the line. You've got dozens of acquisitions under your belt, but the GC tells you that you'll be negotiating an equipment lease.

You dig around a bit, and soon realize that "standard" equipment lease forms are hard to come by (even if you represent a lessor). And the ones out there vary dramatically in form and substance.2 That's partly because lease classification depends on a combination of economic, state law, bankruptcy, tax and accounting considerations. Just because you call it a "lease" doesn't necessarily make it so, even if you draft the most internally consistent, unambiguous, dreck-free contract in all of legal history. "Substance trumps form" almost every time.

This article will focus on basic drafting issues that impact what is one of the most important (and overlooked) legal issues in equipment lease practice—true lease status under Article 2A of the Uniform Commercial Code. Keep in mind that the parties need also to determine whether the lease is a true tax lease under the federal income tax guidelines and an operating or capital lease under the accounting rules. Many of the determining factors overlap, but an analysis of tax and accounting issues is beyond the scope of this article.

Lease or Sale

Let's start with the fundamentals. Under the UCC, there are two basic ways to transfer equipment to somebody who needs to use it. You can sell it under Article 2 or lease it under Article 2A. If you sell the equipment, you're going to convey both ownership and possession of the equipment to the buyer. If you're a lessor, you're going to convey the exclusive right to use the equipment to the lessee, but retain ownership of the equipment.

If the lessor structures the lease improperly, it makes the lease vulnerable to a UCC true lease attack. This occurs when the lessee attempts to re-characterize the putative lease as a "disguised security interest" (i.e., an Article 2 sale, subject to an Article 9 security interest to secure the purchase price). If the lessee prevails, this significantly reduces the lessor's rights in the equipment.

• First, the "lessee" becomes the owner of the equipment. The "lessor" becomes the proud owner of a security interest in the equipment.

• To add insult to injury, the lessor's security interest is unperfected if it neglected to file a precautionary UCC-1 financing statement.

• Since the transaction is now a sale, rather than a lease, the lessor is deemed to have given (unless disclaimed) the Article 2 rather than Article 2A implied product warranties. This can impact the lessor's warranty disclaimers. For example, the lessor in a UCC finance lease (a special kind of UCC true lease)3 is entitled to an automatic disclaimer of the implied warranty of merchantability. In other words, UCC finance lease lessors don't need to make the disclaimer because Article 2A doesn't impute the warranty to the lessor in the first place. Unfortunately, if the transaction turns out to have been a sale, then the finance lessor (now a seller) will likely be deemed to have given a seller's Article 2 implied warranty of merchantability because it probably never occurred to the lessor to make the disclaimer.

• Since the transaction is now a sale, whose deferred purchase price is deemed a loan, the lessor (as lender) is subject to the usury laws.

• If the lessee goes bankrupt, the equipment becomes part of the lessee's (rather than the lessor's) bankruptcy estate. Among other negative consequences, the lessor may find itself impacted by a cramdown. A cramdown is a bankruptcy procedure where the court confirms the lessee's plan of reorganization of its estate (including the equipment) over the lessor's objection, as long as the plan is fair to each impaired class.

Legal Requirements

Courts have considerable discretion to determine whether the lease is actually a disguised security interest.

Lessee's Non-Terminable Obligation. An equipment lease typically contains the lessee's non-terminable "hell or high water" financial obligation to make lease payments. This includes the lessee's obligation to make the lessor whole by making a present value liquidated payment if the lessee exercises any early termination option. The lessee's non-terminable obligation jeopardizes UCC true lease status because it is akin to a borrower's "non-terminable" obligation to make loan payments, whether at stated maturity or prepaid.

If the lessee has a non-terminable obligation to make lease payments AND the lessor has a weak residual interest in the equipment (see below), this makes the lease vulnerable to a UCC true lease attack, even if the parties call the transaction a "lease."

Lessor's Residual Interest. Most leases contain the lessee's "hell or high water" obligation to make lease payments. Therefore, to overcome a UCC true lease attack, the lessor needs to make sure that it expects to have a significant residual interest in the equipment. A lessor has a strong residual interest if it expects to be able to exploit meaningful economic value in the equipment after the lease is done, for example, sell or re-lease the equipment or even use it for itself. The thinking here is that a lessor that does not retain a significant residual interest has basically sold the equipment to the lessee.

Let's talk about how some of the key lease provisions impact UCC true lease status.

UCC True Lease Provision

Some lessors like to include a provision in the lease specifically stating that the lease is a UCC true lease. Keep in mind that while this is evidence of intent, courts have discretion to look beyond the lease language at what the courts like to call the "economic realities" of the transaction.

Term. One way the lessor can try to maximize its residual value in the equipment is to structure the initial (or "basic") term of the lease to be significantly shorter than the economic life of the equipment. The lessor cannot exploit the equipment at the end of the lease if the parties peg the initial term to match the economic life of the equipment because the lessee will have sapped all the value out of the equipment by lease-end.

Furthermore, the lessor should not allow the lessee to drain the economic life of the equipment by giving the lessee the evergreen right to renew the lease. These are called chameleon leases because they may look like UCC true leases during the initial term, but they change into a disguised security interest during the renewal phase.

A lease with a term as long as the economic life of the equipment is more like a sale. You can think of it this way—rather than making lease payments, the "lessee" is deemed to be making deferred installment payments of the purchase price, secured by the "lessor's" security interest in the equipment.

Payment Terms. Lessors can also jeopardize UCC true lease status by structuring payment and related terms that are too loan-like, for example, by requiring the lessee to furnish a promissory note or notes to evidence the lease payments, or to require the lessee to make loan-like financial covenants.

Lessors also invite trouble if they are overly aggressive in structuring interim term lease payments. Interim terms synchronize the lease terms of the various items of equipment in a master lease that are delivered on separate dates. The interim term for each item of equipment begins on the date the lessee accepts the item, and the initial or basic term for ALL the items begins on the same date, like the beginning of the month. Interim payments should do no more than to fairly compensate the lessor for the prorated use of the equipment during the interim term. Overaggressive interim pricing may be deemed too loan-like.

End of Lease Terms. Equipment leases typically include either the lessee's obligation or option to purchase the equipment or to renew the lease at the end of the initial term. If the lessor obligates the lessee to purchase at the end of the initial term, this leaves the lessor with no residual value. If the lessor obligates the lessee to renew the lease at the end of the initial term, it risks that there may be no residual value left for the lessor at the end of the renewal term.

Options are less risky, but only if the lessor does not offer economic terms that are so enticing to the lessee that exercising the option is too good to pass up (e.g., dollar purchase option on equipment that has thousands of dollars of useful life left). Courts often treat a bargain option in substance as an obligation to purchase, leaving no expectation of residual value for the lessor.

The lessor shouldn't overlook the parties' end-of-lease logistical obligations. For example, the parties must negotiate whether the lessee has the burden of returning the equipment, and if so where to. Or the parties might negotiate that the lessor has the obligation to retrieve the equipment. The lessor's cost of retrieval offsets the lessor's anticipated residual interest. This may jeopardize UCC true lease status if the cost is so prohibitive that the lessor has no incentive to retrieve the equipment even though the equipment has quite a few years of useful life left.

Maintenance, Use, Upgrade and Insurance Provisions. The lessee's failure to maintain, properly use or upgrade the equipment jeopardizes the lessor's residual interest and therefore UCC true lease status. Lessors typically require the lessee to take steps to maintain and properly use the equipment, as well as the obligation to make specified upgrades. In addition, the lessee typically covenants to maintain insurance, including property insurance, to reimburse the lessor (as loss payee) for any loss to the equipment, including material impairment and government condemnation.


Lawrence Hsieh is an attorney at the Practical Law Company and the author of the 'Corporate Transactions Handbook' (Data Trace Publishing Company, 2011). Lisa Sciallo, an attorney at the Practical Law Company, assisted in the preparation of this article.

Endnotes:

1. For example, Hsieh, Corporate Transactions Handbook: A Deal Structure Primer, Data Trace Publishing Company, 2011

2. For an annotated pro-lessor UCC true lease form, go to www.PracticalLaw.com and search "equipment lease."

3. A UCC finance lease is a special kind of "three party" UCC true lease where the lessor provides just the financing to enable the lessee to lease equipment provided by the third-party supplier.