Converting a Lease into an Equipment Finance Agreement
The rise of the Equipment Finance Agreement or EFA has been nothing short of meteoric. Fueled by concerns about lessor liability, confusion among state revenue agents regarding application of sales taxes and concerns regarding the reputation of equipment leasing, the EFA may soon eclipse the familiar "buck-out" lease intended as security.
On its face, using an existing equipment lease form to document an EFA transaction would seem fairly simple. The economics of an EFA should be similar to those of a lease intended as security: full payout with implicit interest and either a mandatory balloon payment or no additional payment at the end, with the borrower/lessee owning the equipment subject to a security interest for the lender/lessor . As many practitioners have found, however, taking a client's standard-form equipment lease and creating an equipment finance agreement is more complicated than it appears.
An EFA may be described as a Loan and Security Agreement and Promissory Note rolled into one document with several key provisions not normally found in standard Security Agreements. These provisions are commonly relied upon in the equipment financing and leasing industry to protect the equipment collateral. Their absence impacts both the lender’s security and the marketability of an EFA on the secondary finance (syndication) market.
Before even beginning the conversion process, two fundamental questions must be answered: First, Does the lessor want the EFA to look like a loan agreement or like a lease? Some lessors want to keep the transactions it offers as far from those presented by competing banks as possible. Others want the transaction to clearly be a loan so as to approach customers who are afraid of leasing. Second, what are the priorities? Does the lessor want the agreement to be as consistent as possible with existing lease documentation? What consistency must be preserved? Is length an issue or may language be added to protect against legal risks inherent in lending?
This article will examine these and other issues that arise in converting lease forms into equipment finance agreements.
An Equipment Finance Agreement is a Loan Document
There are many reasons to base an EFA form on an existing lease document. Among other things, consistency between the forms will facilitate administration and maintain branding. Working from an existing form is generally less time-consuming for the draftsman (which may be read as “less expensive for the client”). Consistency will also minimize operational confusion and facilitate the use of existing ancillary documents such as secretary’s certificates and insurance forms.
Against this consistency, however, is a simple fact clear to most lawyers but sometimes lost on their clients: an equipment finance agreement is a loan document. It is an entirely different animal from the true lease documentation on which most, if not all, leases intended as security are based. Many of the issues raised by this difference require counsel to be versed in lending as well as leasing, particularly if the EFA is to be sold to a bank represented by counsel familiar with traditional lending.
What is really happening is that documentation based on equipment rental agreements is being transformed into loan documentation. While rental agreements address commercial transactions, loan documentation based on many years of secured lending. Some loan document concepts have always been incorporated into leases intended as security but others rarely come up in any type of leasing.
One of the fundamental differences between a lease and an EFA is that EFAs involve the collection of interest. This is true whether the EFA breaks down monthly payments between principal and interest or combines them as a single payment. Because interest is charged, lenders should expect that laws regarding the collection of interest, most notably usury laws, will apply in EFA transactions.
Interest is generally defined for purposes of state usury laws as a charge for the use of money or forbearance in collecting a debt. Many states have civil or criminal usury statutes, or both, applicable to commercial lending as well as loans to consumers. While lessors sometimes ignore these laws, even for leases intended as security, EFA lenders must take them into account. A particular concern is that many leases include high late fees and additional charges for tax service, inspections or other services rendered by the lessor. These charges, in some cases, can be reinterpreted as additional interest, causing a seemingly safe transaction to exceed usury rates.
In contrast, most courts acknowledge that true leases are not subject to usury laws as interest is not collected. See e.g. Performance Systems, Inc. v. First American Nat. Bank, 554 S.W.2d 616 (Tenn.); Orix Credit Alliance, Inc. v. Northeastern Tech Excavating Corp., 222 A.D.2d 796, 634 N.Y.S.2d 841 (3d Dep't 1995); Citipostal, Inc. v. Unistar Leasing, 283 A.D.2d 916, 724 N.Y.S.2d 555 (4th Dep't 2001).
The same may not be true for “rent” charged in leases intended as security is sometimes re-characterized as principal and (implicit) interest, although some would argue that the implicit rate is not interest at all. The lender under an EFA does not even have this form over substance argument that interest is not being charged and collected.
This brings about two important defenses used by lenders traditionally as a means of avoiding usury restrictions. First, a usury savings clause, stating that the parties do not intend to violate applicable law and that payments will be reduced as necessary to avoid the collection of excessive interest is generally advisable. These clauses are rarely found in equipment leases and it is understandable that many lessors prefer not to see anything that implies that their rent may be "too high" or that any payment should be reduced. There are cases in which courts have refused to reduce interest charged below the usury limit by applying a usury savings clause. In re Venture Mortgage Fund, L.P., 282 F.3d 185 (2nd Cir. 2002); Swindell v. Fannie Mae, 330 N.C. 153 (1991); Federal Home Loan Mortgage Corporation v. 333 Neptune Avenue Limited Partnership, 201 F.3d 431 (2nd Cir. 1999). There may be reason for concern that the presence of the clause indicates an intention to violate usury laws. Henson v. Columbus Bank & Trust Company, 770 F.2d 1566 (11th Cir. 1985) (“When [other elements of usury] are express on the face of the contract, usurious intent may be presumed.”) Nevertheless, many courts have held that the presence of a usury savings clause protects against usury penalties. E.g., Continental Mortgage Investors v. Sailboat Key, Inc., 395 So.2d 507 (Fla.1981).
Second, choice of law becomes even more important where interest at a high rate will be collected. Avoiding application of the laws of a state with a low usury ceiling, particularly a criminal rate, is highly advisable. Including a consent to jurisdiction or forum selection clause designating the location in which the parties will litigate disputes strengthens the choice of law.
The collection of interest brings about other issues. While lessors rarely disclose implicit rates, disclosure of interest rates may be required in EFAs, either by law or market pressures. In Georgia, the requirement of a “stated” rate of interest is generally regarded as a requirement that interest rates be disclosed in order to avoid the state’s restrictive usury laws. O.C.G.A. §7-4-2. Customers who recognize that the EFA is a loan document may want to see interest expressed in familiar terms. This will particularly be true where the EFA is offered as an alternative to traditional loan financing, as where the EFA lender is competing with a bank lender.
Specific Drafting Considerations
Briefly touching on a few of the many issues that are likely to arise:
Replacing "lessor" and "lessee" with "lender" and "borrower" may be easy enough but raises the question of how much like a bank loan agreement the parties want the EFA to appear. Likewise, the decision whether to replace "rent" with "payment" or a similar word or with an expression of "principal and interest" involves both the question of whether to disclose the implicit interest rate and whether to distinguish the EFA transaction from a competing bank loan.
Loan payments are generally collected in arrears whereas rentals are usually collected in advance. This is not an iron-clad rule and there is no reason why level EFA payments cannot be collected in advance, but a potential customer comparing loan and EFA proposals may ask.
It should be clear that the borrower owns the equipment from day one and is granting a first priority security interest to the lender. This sort of language, if included in a lease form at all, is often an after thought. Unlike a lease intended as security, the EFA can clearly identify the equipment as collateral, which can carry benefits. For example, in granting a security interest, it is not uncommon to include interests in proceeds such as receivables if the equipment is rented (whether or not permitted) and insurance proceeds.
The security interest should, if possible, be perfected as a purchase money security interest meaning, among other things, that the purchase price of the equipment is paid to the vendor and not as reimbursement to the borrower and that a UCC-1 Financing Statement is filed within 20 days after delivery of the equipment to the borrower.
Hell or High Water.
One of the few comforting aspects of EFA transactions as opposed to leases is that loans are in inherently "hell or high water" obligations. Warranty disclaimers, unconditional obligation language and prohibitions on setoffs rarely appear in traditional loan documents. On the other hand, one lessor protection lost in an EFA is “finance lease” status under UCC Article 2A. It is probably a good idea to leave in at least a bare bones disclaimer of UCC warranties and statement that the transaction is free from rights of set-off and the like, particularly in the case of an equipment financing by a vendor captive, or any time that the EFA is to be based on a lease agreement form,.
This raises the question of whether there is any downside to the EFA being interpreted as a lease. In most instances, lessors engaging in true leasing go to great lengths to avoid their transactions being interpreted by bankruptcy courts and tax agents as disguised loans. The reverse is rarely true but not inconceivable, as when a funder is concerned about possible bankruptcy of the originating lessor or a plaintiff whose client has been injured by equipment collateral seeks to establish ownership in the lender in order to sue for negligence or vicarious liability.
From a more practical perspective, some funder’s counsel who have more experience is lending than leasing may be uncomfortable with including traditional lease language in what is acknowledged to be a loan document. If so, the belt-and-suspenders benefits of stating that the EFA obligations are absolute and unconditional may be outweighed by the need to appease a banker.
Use and Maintenance.
Lease documentation traditionally focuses on the equipment collateral as much as the creditworthiness of the lessee and it might be argued that language requiring specific maintenance and applying restrictions on use is unnecessary. While this language may be confusing to some bank counsel, careful consideration should be given to the effects of reducing the borrower's obligations from those of a lessee.
A major policy decision for some lessors is whether to require liability insurance coverage in an EFA. The lender under an EFA is significantly less likely to be successfully sued for damage caused by the equipment collateral than the owner of equipment under a true lease. Nevertheless, dropping the requirement for liability coverage may not come easy to many lessors or their banks. Similar drafting issues arise in the general indemnity section, which might be shortened if space is a concern.
Default and Remedy Language.
With particular regard to the use of remedies under Article 9 of the UCC, this language must be reconsidered as it relates to loan foreclosures as opposed to lease repossessions. One particular concern is whether damages are calculated with reference to Casualty Value, as discussed below. If Casualty Value results in charges in excess of the outstanding principal, the calculation might be deemed to create a penalty, which might not be enforceable. In addition, rules regarding "commercially reasonable" sales and other limitations are even more important in an EFA than a traditional lease.
Many lease casualty or stipulated loss value totals include protection from the loss of the lessor's bargain or additional charges to make the lessor whole should interest rates change since the inception of the lease. This calculation may not be enforceable in the case of an EFA because the lessor's loss is calculated with regard to equipment while a lender's loss is calculated with regard to the loss of principal. A make-whole provision or stated prepayment premium, if those protections are desired, should be a expressly stated rather than being added into the casualty value table calculation without disclosure.
Language regarding the payment of taxes, particularly property taxes, must be examined as the equipment will clearly be owned by the borrower. Language describing subleases and assignments by the borrower must be revised so equipment is not subleased in the case of a loan agreement and unlike lease obligations, loans are not traditionally assignable. In some states, the right to prepay a loan, as opposed to the right to return equipment prior to the end of the lease term, may be implied unless specifically waived.
One Final Note
We might fairly observe that the popularity of equipment finance agreements is indicative of the general shift from leasing to equipment finance. This subtle, but increasingly pronounced shift raises many issues for the industry. It is accompanied by pressure from some banks to include equipment finance in their product line and a blurring of the boundaries between bank lending and equipment finance departments.
At the same time, entering the world of equipment-collateralized loans involves more than some leasing professionals expect. There is much law governing commercial lending, as opposed to lease financing. Lending is highly regulated while leasing long flew under state regulatory radar. Loans include such foreign provisions as financial covenants and revolving lending/repayment arrangements and lenders do not limit collateral to equipment alone but look to receivables and other assets that may or may not be associated with the equipment collateral.
There is more involved here than a few tweaks to form documents. Now that our baby steps into the lending world are becoming a competitive sprint, it may be wise to think about just what equipment finance means and what we are doing in both the near term and distant future.
If the original lessee’s credit is in rough enough shape, the amount of due diligence conducted by the lessor with respect to the new lessee is often fairly limited. This is particularly the case if the assignment and assumption are structured in such a manner as to keep the original lessee “on the hook” for the obligations under the lease even after assignment to the new lessee. Quite frankly, many lessors view such a transaction as simply adding another obligor and thereby increasing their chance of recovery without much risk. As long as the new lessee is in better financial health than the original lessee, lessors also receive some comfort in having the collateral transferred out of what may eventually become the bankruptcy estate of the original lessee to a company, which theoretically is less likely, due to its increased financial health, to file for bankruptcy protection.
However, in situations where the leased or financed equipment has value as collateral, lessors should take precautions to assure that the assignment and assumption does not negatively affect the lessor’s security interest in the collateral in the event a court determines that the underlying lease is really a secured loan.
This issue of Dispatches from the Trenches discusses additional due diligence that should be conducted for lessee assignments and assumptions. The remainder of this edition refers to the original lessee as “OldCo” and the new lessee as “NewCo.” Although this edition uses terms like lease, lessor and lessee, the discussion is equally applicable to an equipment finance agreement or other loan in which a lender is granted a security interest in equipment or other collateral as security for the borrower’s obligations to the lender.
Several provisions within Article 9 of the Uniform Commercial Code (UCC) are applicable to this situation and they draw a distinction between two different classes of collateral. The first group of collateral is existing collateral that is transferred. This group includes the leased or financed equipment that is transferred from OldCo to NewCo. The second group of collateral is hereinafter acquired or arising collateral. This group includes all collateral not existing at the time of the transfer such as, for example, accounts receivable or rentals to be received after the transfer as a result of OldCo’s or NewCo’s sublease of the equipment.
With respect to existing collateral that was owned by OldCo and sold or otherwise assigned to NewCo, the lessor generally retains its security interest. Section 9-315(a)(1) of the UCC states that, “a security interest or agricultural lien continues in collateral notwithstanding sale, lease, license, exchange or other disposition thereof unless the secured party authorizes the disposition free of the security interest or agricultural lien.” Assignment and Assumption Agreements by their terms satisfy this criteria by providing that the sale from OldCo to NewCo is subject to the same security interest and other rights in the leased or financed equipment that the lessor had against OldCo.
Lessors need to be mindful, however, that the retention of a security interest against NewCo does not necessarily mean that the security interest remains superior to those of other lenders, good faith purchasers for value or a trustee in bankruptcy. The priority status of the lessor’s security interest, or the lack thereof, depends upon whether the lessor remains “perfected” in the leased or financed equipment. The UCC provides that, unless NewCo is “located” in a different state than OldCo, the lessor remains perfected with respect to the collateral even if it does not file a new financing statement. Section 9-507(a) of the Uniform Commercial Code addresses this issue, stating that, “a filed financing statement remains effective with respect to collateral that is sold, exchanged, leased, licensed or otherwise disposed of and in which a security interest or agricultural lien continues, even if the secured party knows of or consents to disposition.”
The risk with respect to this existing collateral occurs when NewCo is located in a different jurisdiction than OldCo. Recall that, under Article 9 of the UCC, the location of the registered entity is where it is incorporated or otherwise formed. The example in Official Comment No. 3 to §9-507 is helpful:
Because of this risk, if NewCo is located in a different state than OldCo, the lessor must file a new financing statement against NewCo in the state where NewCo is located within one year or it will become partially unperfected with respect to the collateral that has been transferred against all purchasers for value (which includes a secured party). The lessor would still beat a trustee in bankruptcy.
It should be noted that the lessor is specifically authorized to file against NewCo with respect to the existing collateral. This authorization can be found in §9-509(c), which states that “by acquiring collateral in which security interest or agricultural liens continues under §9-315(a)(1), the debtor authorizes the filing of an initial financing statement, and an amendment, covering the collateral.”
The foregoing analysis applies only to existing collateral that was transferred by OldCo to NewCo. To the extent the security interest granted to the lessor covers other property, the rules discussed above do not apply. Other property would include, for example: a.) assets that NewCo has immediately prior to its acquiring of the existing collateral from OldCo; and b.) accounts, equipment, fixtures and other tangible property or intangible property acquired by NewCo after the existing collateral was transferred to it.
In most equipment leasing transactions, this other collateral is present only in the form of proceeds of the leased of financed equipment or additions, accessions or enhancements to it. If the equipment is subleased by lessee to third parties or furnished to third parties under a contract of service, it is common to obtain a security interest in rentals or other payments due from such third parties as well as the subleases or other contracts evidencing those payment obligations. This type of collateral is also the type of after-acquired collateral for which this second set of rules applies. Although less standard, lessors dealing in certain markets with weaker and less sophisticated credits may also obtain a security interest in additional collateral, which falls in this category, sometimes even an “all assets” security interest.
With respect to this second set of collateral, Article 9 does not focus on whether the security interest survives the transfer of assets from OldCo to NewCo. Rather, it focuses on whether and the extent to which NewCo became bound by the lease or other security agreement entered into by OldCo. Under §9-203(d), “the person becomes bound as debtor by a secured agreement entered into by another person only if by operation of law other than this article or by contract 1.) the security agreement becomes effective to create a security interest in the person’s property; or 2.) the person becomes personally obligated for the obligations for the other person, including the obligations secured under the security agreement, and acquires or succeeds to all or substantially all of the assets of the other person.”
If an Assignment and Assumption Agreement is executed by NewCo, it clearly becomes bound by contract to the original lease. It is worth noting that these provisions can also apply and be useful to lessors in situations where NewCo acquires all assets of OldCo (by merger or otherwise).
Under §9-508 of the UCC, the original financing statement is effective with respect to all property of NewCo in existence at the time of the transfer and all after-acquired property of NewCo if the financing statement would have been effective had OldCo been in possession of, or acquired possession of, such collateral. Because the financing statement is only effective if it has been filed in the state where NewCo is “located,” this rule of continued perfection will only apply if NewCo is located in the same state as OldCo. See §9-316 of the UCC, Official Comment 2; example 5.
Even if NewCo is located in the same state as OldCo, however, the continued perfection discussed above with respect to after-acquired property lasts for only four months if the difference between the name of NewCo and the name of OldCo is such that the filing is “seriously misleading” unless the secured party files an initial financing statement against NewCo before the expiration of the four-month period. See §9-508(b) of the UCC. The difference would be seriously misleading “if a search of the records of the filing office, under the [new] name, using the filing office’s standard search logic, if any, [fails to] disclose [the] financing statement.” See §9-506(b) and (c) of the UCC.
It should be noted, however, that any secured party of NewCo with a previously filed financing statement would have priority over this after acquired collateral. It should also be noted that it is possible for a lessor to avoid the complications noted with respect to after acquired collateral consisting of insurance proceeds by being loss payee on the insurance policy and having the insurance company pay lessor directly for any such loss.
The lesson here with respect to both types of collateral is that the lessor must conduct lien due diligence with respect to NewCo anytime the leased equipment or other collateral has value to the lessor.
With respect to the existing collateral that is transferred, such as the leased or financed equipment, this due diligence consists of verifying the correct legal name and jurisdiction of organization of NewCo and filing a financing statement against NewCo covering such collateral. Although it is not technically necessary to file the financing statement if NewCo is organized/located in the same jurisdiction as OldCo, it is good practice to do so and also serves the practical purpose of putting creditors of NewCo on notice of the lessor’s interest.
In situations where after acquired collateral is of significant value, for example rentals due under subleases of the equipment, lessors should conduct the same steps as set forth above for existing collateral and should also obtain necessary subordinations or releases from creditors of NewCo who have filings, which also cover the same after acquired collateral.
Kenneth P. Weinberg is a founding partner of Marks & Weinberg. Weinberg has significant experience in dealing with virtually every type of equipment and facility lease financing. He has penned Dispatches From the Trenches since 2002, and routinely publishes articles in a variety of equipment leasing and financing journals. Weinberg graduated cum laude from the University of Georgia School of Law, J.D., and was executive articles editor of Journal of Intellectual Property Law. If you have any questions or comments about this column or other industry-related legal issues, contact Weinberg at 205-251-8307 or visit www.leaselawyer.com.