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Explaining What We Do Finance Leases 101

Among the challenges we face in selling leasing to business executives who are unfamiliar with sophisticated equipment financings is the task of explaining that an equipment lease is not the same thing as a vendor-financed installment sale financing or a short term rental agreement. This article will touch on some of the aspects of third party equipment financings and some of the explanations and arguments that might be presented to the uninitiated and his or her lawyers. It is intended to be shared with prospective lessees, which is why it may seem a bit basic to experienced lessors and counsel..

Birds of Different Feathers: Finance Leases v. Vendor Rental Agreements

When we say “equipment lease” we are generally speaking of a finance lease as defined under Uniform Commercial Code Section 2A-103.  A finance lease is a lease in which the lessor is not the manufacturer or vendor of the equipment and is only acquiring the equipment for purposes of leasing it to the lessee.  Another requirement of the legal definition is that the lessee must have access to the warranty information under the purchase contract with the vendor or be furnished with the description of that contract.  In other words, the lessor in a finance lease is acting in the same capacity as a lender making a loan in which the equipment is collateral:  the lessee selects the equipment and determines that it is appropriate for its use and that the vendor is reliable, the lessor provides money only.  

Under the statutory scheme, the lessee in a finance lease is required to make rental payments and otherwise perform under the lease whether or not the equipment works as intended. The lessor assigns all of its rights against the vendor to the lessee.  The lessor is not deemed to make any “implied warranties” and the lessee has no power to revoke acceptance after it has taken acceptance of the equipment.  In order to insure there is no implication that these rights are waived, and to make clear the parties’ intentions so there could be no question, a well-drafted commercial finance lease goes to great pains to include a disclaimer of warranties by the lessor and an acknowledgment by the lessee that it is solely responsible for losses to itself or third parties caused by the equipment.  

A finance lease is therefore clearly distinguishable from a rental agreement under which a rental company maintains an inventory of equipment, keeps it in good repair and provides it to the lessee for use on a specific project or, usually, a period of less than a year.  These rental agreements often include language under which the lessor, and not the lessee is responsible for the maintenance and care of the equipment and also for its performance.  

Similarly, some vendors are willing to accept payments over time either through an installment sales contract secured by the equipment or a lease transaction.  In the case of a vendor lease, it is not uncommon for the vendor to agree to terms that favor the lessee, recognizing that the vendor is not only a lessor but the party who should be responsible for the performance of the equipment and any damage it may cause. 1  

Walking Like a Duck: The Distinctive Features of Finance Leases

In light of this distinction, and keeping in mind that the position of a finance “lessor” is essentially the same as a secured lender, the following common issues should be easily resolved:  

1.There should be no limitations on the warranty disclaimer.  It should be clear that the lessee, as the party who has selected the equipment, is solely responsible for any failure of the equipment to operate as warranted and that the lessee will look directly to the vendor, rather than the lessor, if there is a problem.  For this reason, the lessor assigns any rights it may have to the warranty warranties to the lessee, at least so long as the lessee is not in default under the lease and during the duration of the lease term.  The lessee should not sue the lessor for damage to the lessee’s business caused by the failure of the equipment, meaning that the lessee should have no rights to consequential damages and the like.

1. It is interesting that a vendor captive, which is a corporation or other entity owned by the vendor or part of the vendors corporate family may also be a lessor under a finance lease as the courts recognize that such entities do not fall within the specific definition of finance lease and because it is common for these entities to assign the lease to a more traditional finance lessor. See, e.g., Siemens Credit Corp.v.Newlands, 905 F. Supp. 757 (N.D. Cal. 1994).

2.The lessee should agree to make rental payments whether or not the equipment operates and whether or not it has some claim against the lessor.  It often requires some explanation to the lessee, but the lessor must be in a position to assign the lease to a third party and give assurances to that party that the lessee will continue to pay rent and render other performance (such as insurance and maintenance obligations) even if the lessee has a claim against the lessor and irrespective of whether the equipment works properly.  Just as the lessor is not deemed to make any warranties with regard to the equipment, the lessor has the right to expect the lessee to make all payments “come hell or high water” (hence this language is often referred to as the “hell or high water” clause).  

Note that this does not mean that the lessee waives all rights to sue the lessor, whether or not the lease is assigned.  The lessor should remain legally liable if it has made promises to the lessee outside of the lease transaction, such as a promise to provide future financing.  The lease itself, however, should not be affected by any of these claims.  Just as the lessee must continue to make payments on a promissory note for a loan to finance its purchase of equipment whether or not the lessee believes it has a claim against the lender, rent payments under the lease are absolute and unconditional and not subject to deduction or set-off.  

3. The lessee should be responsible for damage caused by the equipment to third parties.  Some lessees argue that the lessor should not be indemnified against its own negligence and that any lessee indemnity should not include the lessor’s negligence or negligent conduct. This is entirely understandable, but the lessor must insist that it only be responsible for its willful misconduct, and, if it is willing to say so, its gross negligence.

One of the unfortunate results of labeling a finance lease a “lease” rather than a “loan” is that the lessor is the nominal owner of the equipment. As such, the lessor may be confused with a short term rental operation and may find itself the target under a line of cases holding that renters are responsible for damage caused by the equipment.  This liability includes “vicarious liability” under which negligence by the lessee is imputed to the lessor as a matter of law.  There are also “products liability” cases in which due to the nature of the equipment and its function or simply because the equipment is placed in the stream of commerce by the owner/renter, the lessor may be held legally liable for damage caused by the equipment whether or not the lessor has been negligent.  

Even if proof of lessor negligence is required, lessors have good reason to fear that a confused and often biased jury holding that the lessor should be responsible for damage caused by “its own” equipment.  Also, the lessor may actually be sued on the basis that it was negligent in trusting the lessee to operate the equipment and not oversee trusting the lessee to operate the equipment or in not overseeing the operation closely and inspecting both the equipment and the qualifications of its operator.  

The presumption must always be that any lawsuit or other third party claim is the responsibility of the lessee.  This is because the lessee has the right to use the equipment with minimal restrictions and the lessee is responsible for the equipment itself.  For this reason, arguments that the lessee should only indemnify the lessor for damage caused due to the lessee’s negligence are unreasonable.  The lessor should know that it will not be the subject of any lawsuit or other claim and that should such a situation arise, the lessor will be indemnified and the lessee will maintain the defense litigation.  

Lessors are sometimes willing to agree to be responsible for their own “gross negligence and willful misconduct”, essentially meaning they are responsible if they or their employees and agents deliberately commit an act resulting in a third party claim or commit such an act with a conscious and voluntary disregard of the need to use reasonable care.  

Moreover, one of the most important aspects of indemnification is that the lessee will be responsible for maintaining defense, meaning that it (or its insurance) will provide legal representation and whatever work is necessary to provide for the lessor to be dismissed as a defendant.  If the lessee is in a position to argue that the lessor might be negligent, the lessee may not provide this defense.  It is important to bear in mind that any obligation of the lessee’s insurer to provide legal defense or make payments is limited to the terms of the contract so even if the lessee is acting in good faith, its insurer may take any avenue available to avoid providing protection.  

4.    The Lessee should be responsible for delivering the equipment to the Lessor or the next owner or lessee. In order for the lessor to offer the lessee the benefits of an assumed residual value, meaning that the lessor does not have to collect 100% of its investment with interest at a high rate through the rentals alone, the lessor needs to know that the equipment will be returned in saleable condition and that the lessee will bear the costs of return, returning promptly as required under the lease.  This will require the lessee to redeliver the equipment to a location specified by the lessor and to do so promptly.  

Very often, vendors are willing to make concessions at the end of the lease term in part because they are in the used equipment business and often because they are in a unique position to control end of term valuations.  These considerations are not available to lessors under a finance lease because finance lease lessors do not have ready access to the after market for equipment and are most often banks and other financiers for whom remarketing is more expensive and difficult.  

5.    The Lessee should be prepared to waive certain UCC rights. Because UCC Article 2A is designed to cover both short term rental agreements and finance leases, it contains certain rights and remedies only equipment renters need or should expect from their lessors. For example, UCC Section 2A-518 deals with “cover”, an Article 2 (Sales) concept applicable to the relationship between buyer and seller, not borrower and lender. The lessee can preserve its rights under this and other Sections of Article 2A in its contract with the vendor and, if desired, can arrange complementary rights under the lease so that the vendor, and not the lessee or lessor, bears certain burdens. Otherwise, rights under Sections 2A-508 through 518 should be waived in order to be clear as to the parties’ intent.

6.     The Lessee is obligated for Full Payout. Some lessees think that they should be able to terminate the lease and walk away without “penalty.” In a finance lease, the lessor does not have an inventory of similar equipment to market and the early termination and return of the equipment both denies it the benefit of its bargain and leaves it with equipment to market. For this reason, early termination options require that the lessee either find a buyer to cover the remaining investment (discounted present value of rents and assumed residual) or makes payment of that amount itself. As with a loan being paid early, the lessor expects the return of its investment at a minimum and in most cases demands some form of premium for the early payoff.

Ugly Duckling, Beautiful Swan

At the end of the day, a finance lease is not much different from a traditional bank loan in concept. Traditionally, a company borrows from a bank or other lender, signs a note and uses the money to buy equipment which it pledges to the bank as collateral. If the equipment does not work, the company may have a claim against the vendor, but it cannot withhold payment on the note or sue the lender. If the equipment injures someone, the lender faces little or no risk of liability; only the borrower/user will be liable for damage caused by equipment it operates.

A finance lease lessor expects essentially the same transaction, while often offering its customers terms that are not available in a straight loan. All this may sound unreasonable to customers and counsel thinking they are “just renting equipment”. Once they understand that they must approach the financing on the basis that the lessor is providing money, not equipment, the path is easier.  

The bottom line is that a finance lease must be freely assignable among banks and other financers as an absolute, unconditional payment obligation similar in virtually every way to a secured promissory note. If it does, it will glide through the stream of commerce, affording the lessee the available credit, attractive rates and minimal restrictions on its business that have made leasing popular for over 50 years. If not, it will be an outcast, an unmarketable obligation that has little value to any financer. That is simply not the business of finance lessors and it is in everyone’s best interest to understand this at the outset.