1. An FMV-Option And Even A No-Option Lease Might Not Be A Lease.
No! Really?
Posted February 2010
Every lessor knows that a lease having a “nominal” purchase option is not a true lease but rather a loan (if the originating lessor is not the equipment supplier) or a conditional sale (if the originating lessor is the supplier). The test for what constitutes a true lease, and the concept of nominality, are set forth in UCC 1-203, and at first glance, it seems simple enough.
The difficulty comes in understanding the many nuances of the concept of nominality and being able to imagine the myriad of transaction structures that will not meet the UCC true-lease test. Is it possible for a lease with a 10% purchase option to fail the test? A lease with a fair market value (“FMV”) purchase option? A lease with no option—one whose end-of-term provision simply requires the lessee to return the equipment?
If you answered ‘No’ to any of those questions, then you’re wrong. Even a transaction with no purchase option might not be a true lease, as we will examine further below. For those readers who might not fully appreciate why a deep understanding of UCC 1-203 is so important in good risk management, then be aware that, for example, if a transaction fails to pass the true-lease test, then it could be subject to state loan-licensing requirements, retail-installment statutes, usury restrictions, and other state laws that do not apply to true leases. (Some of these state laws would apply to loans but not conditional sales, and vice-versa.) To take another example, if the transaction is not a true lease, then Section 365 of the Bankruptcy Code (“Unexpired Leases and Executory Contracts”) will not apply; and if the lessee files for bankruptcy and the lessor failed to file a UCC financing statement, then the lessor, who will not be deemed the owner of the equipment, could lose it to another creditor who filed a blanket lien on the lessee’s assets.
One of the often neglected provisions of 1-203 comes out of the first sentence of subsection (d), which provides: “Additional consideration is nominal if it is less than the lessee’s reasonably predictable cost of performing under the lease agreement if the option is not exercised.” If, for example, a lease requires the lessee to return the equipment at the end of the term at the lessee’s expense and the predictable (at the time the lease is written) cost to return is greater than the amount of the purchase option, then the transaction would not be a true lease no matter how high the option amount might be.
To have a fuller appreciation of how the cost to return the equipment might destroy true-lease status, read In re Gateway Ethanol, L.L.C., 415 B.R. 486 (2009), which involved a lease having a $3.6 million equipment cost and a $600,000 (approximately 17%) purchase option. The court held that the transaction was a true lease, but only after discussing the return cost at length and rejecting testimony (as not credible) that the cost to return was greater than the purchase option amount.
So how could an FMV-option lease fail the true-lease test? Compare, for example, a hypothetical $25,000 five-year tractor-trailer lease having an FMV purchase option to a hypothetical $25,000 five-year lease of a prefabricated metal utility shed having an FMV purchase option. Clearly the fair market value of the trailer at the end of that lease will be a substantial percentage of its original $25,000 cost, and the cost to prepare it for shipment back to the lessor, plus the actual shipping costs, would be small in relation to its fair market value. One court has said that the concept of nominality essentially boils down to this: “If only a fool would fail to exercise the option,” then the option will be deemed nominal. In re Taylor, 209 B.R. 482, 486 (1997). In our trailer lease hypothetical, it is fair to say that both an intelligent lessee and a fool alike could go either way on exercising the option at the end. Therefore the trailer lease would almost certainly be adjudged a true lease under 1-203.
The utility shed lease, by comparison, has very different characteristics. Much of the original $25,000 cost of the shed would have been for construction costs. Unlike the trailer, its original value in its pre-constructed state would have been substantially less than $25,000, and to return it to the lessor at the end of the term would require the lessee to incur substantial deconstruction expenses. (And remember, its “fair market value” at the end, for purposes of 1-203 analysis, would not be what its value is to the lessee in its still fully-constructed state, but its value to a potential buyer or lessee in the market, i.e., its value as a deconstructed pile of metal panels, nuts and bolts. Therefore its deconstructed value would the value that would dictate the amount of the purchase option.) Under these circumstances, “only a fool” would plan, at the time the transaction is written, to decline the purchase option at the end. The transaction therefore would almost certainly be adjudged a loan or a sale.
The point is simply that the trailer lease and the utility shed lease, which at first blush might look like they have virtually identical financial characteristics, have polar opposite legal characteristics under 1-203 (not to mention different accounting characteristics under FAS 13 and different tax characteristics under IRS guidelines—but those are topics for another day).
The failure to adequately anticipate end-of-term practical realities happens most often in the small-ticket market, where profitability depends heavily (and understandably) on speed and “low human touch” transaction origination. These are lessors who typically offer only “vanilla, chocolate and strawberry” (“dollar buyout, 10% buyout and Fair-Market-Value buyout”); and they often have bright-line policies that do not adequately take into account the finer points of 1-203(d).
We sometimes hear a small-ticket lessor say, for example, “We offer only FMV buyout leases in such-and-such a state because of the loan licensing and usury laws.” Or, “We don’t go to the expense of filing precautionary UCC statements on our MFV leases for deals under $X because, after all, they’re all true leases.” It is clear, though, that these lessors should reexamine their bright-line policies, because 1-203 sets out anything but a bright-line test.
Another hidden trap in 1-203(d) lays waiting for the lessor who writes what could be called a “giveaway residual” lease, meaning a lease with a fairly high yield on the stream but no purchase option and the lessor plans, at the time the lease is written, to offer the lessee an end-of-term sale price that is below fair market value. The lessor leaves open the possibly that she will change her mind in the end, but it is her usual practice to quickly dispose of the equipment at the end by making the lessee an offer he can hardly refuse. This is the very design of the product. This lessor wants the transaction to be construed as a true lease, and she believes it is. But in fact it is not.
See In re Bailey, 326 B.R. 156 (2005), for example. There, the lessor’s standard product was a “no-purchase-option lease” in which the yield on the stream was fairly high and then, at the end of the term, the lessor would automatically and mechanically offer to sell the equipment to the lessee for 10% regardless of what the equipment was worth on the open market. In the particular lease at issue, the equipment (over-the-road trailers) had an end-of-term projected fair market value of $27,000 but the lessor, as part of its standard program, was planning to offer it to the lessee at the end of the term for only $4,310. Under these circumstances, the court held that the transaction was a sale and security agreement. The decision turned on the lessor’s own testimony. When asked why he would plan to give away so much value at the end, the lessor testified simply, “Because … that’s the program we use.”
The In re Bailey court’s ultimate conclusion was that the lessee’s “reasonably predictable cost of performing under the lease agreement” (by returning the equipment to the lessor, which was his only contractual option) would be greater than the cost of accepting the lessor’s pre-planned, non-contractual purchase offer. The court was saying, in other words, that the phrase “cost of performing” in the statute does not always mean “out-of-pocket cost of performing,” but can also mean loss of economic benefit to the lessee.
To sum up, a transaction that might at first glance look, feel and smell like a lease because it has either no purchase option, an FMV option or an option that does not otherwise “feel” nominal might, in the final analysis, not be a lease at all. Good risk management requires lessors and their counsel to know all the nuances of the concept of nominality in UCC 1-203 and to understand all of the different possibilities coming out of the phrase “cost of performing under the lease agreement” in subsection (d). There are too many unexpected and potentially adverse financial, legal and state regulatory consequences that could result otherwise.
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2. Know the Difference Between Late Fees and Late-Payment Interest
Posted February 2010
This article comes out of a conversation I had with a lessor a few weeks ago – an experienced lessor who was under the mistaken belief that late fees and late-payment interest are two versions of the same thing, and therefore that his lease form could provide for one but not the other. The fact is, they are two entirely different things, with different legal considerations applying to each. A well-written lease intended for general use should contain both if the lessor wants to reserve all opportunities to minimize losses arising out of late payments.
A late fee is, or at least should be, a one-time “flat” charge that is intended to allow the lessor to recoup some or all of her internal expenses relating to the collection of late payments. It should not be called, or treated as, a “penalty” because contract law, generally, does not permit one party to charge the other party a penalty for the other’s non-performance. The non-breaching party can only charge for her losses.
Late-fee provisions are governed by the law of liquidated damages. “Liquidated damages” simply means a damages amount that is pre-determined by the parties at the time the contract is entered into because actual damages, if and when the time comes, would be too difficult to calculate with precision. Late fees are a perfect example. If a lease did not provide for a pre-determined (or “liquidated”) late-fee amount or percentage but instead stated simply that the lessor has the right to charge the lessee for its actual collection costs, it would be extremely difficult, if not impossible, to calculate with exactitude. For example, the lessor would have to keep detailed track of individual telephone and postage expenses, collection-employee labor costs, collection infrastructure expenses, etc. Therefore the law permits the lessor to charge a pre-determined flat fee.
A late-fee provision will only be enforceable, however, if the amount can be said to be a “reasonable estimate” (as of the time the lease is entered into) of what the lessor’s actual costs will be if payments are made late. The industry has seen a few class actions in recent years attacking late-fee provisions as being allegedly excessive. One of these lessors successfully defended the action, settling out early for a small “nuisance” amount, by setting forth detailed evidence of its internal collection overhead and showing that the company was actually spending more to collect late payments than it was receiving in late fees. Any good risk management plan would have the lessor run through that kind of financial analysis every few years and be prepared to justify its late-fee provision by showing cold, hard costs.
A late-payment interest provision, by contrast, is not viewed by the law as a means of recouping internal collection expenses, but only as a tool for compensating the lessor for the lost time-value of the money that is paid late. A lease (including dollar-buyouts and other “nominal” leases, which are considered loans or time-sales, and not true leases, under the law) is not an interest-bearing instrument. The periodic payments are priced to bring the lessor a pre-determined return of some or all of its investment (depending on the residual), and if installments are paid late, there is no “running interest” and therefore the lessor will not receive its bargained-for return. This is why the law allows for late-payment interest in addition to late fees.
It is beyond the scope of this column to delve into all the factors that should be considered by a lessor in establishing a precise late-payment interest rate. As a very general rule of thumb, a simple interest rate of 1.5% per month (or 18% per year), accruing from the due date to the date paid, is probably safe in most states as long the provision contains a “safety net” clause stating that the actual rate to be charged will always be the lesser of the stated rate or the maximum rate allowed by applicable law. (And of course, the law varies from state to state, so it is always wise to check with your counsel before adding or amending contract language.)
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3. Death, Taxes and Purchase Options
Posted January 2010
A small-ticket lessor (let’s call it John Doe Leasing Co.) asked me the other day whether there are any legal risks involved in stating in an advertising brochure or website that monthly lease payments under its FMV or 10% purchase option leases “may be fully deductible as an operating expense.” He stressed the word “may” because he knows enough that it’s dangerous to state absolutes.
This was about the thousandth time I had been asked this question over the years. It’s a question more about the law of false advertising than tax law. But when I gave my answer this time, I added something that I had never said the previous nine hundred and ninety-nine times.
A little background first. For lease payments to be fully deductible as an operating expense, the lease structure must have certain “true lease” characteristics established by the IRS and various tax court rulings. If it doesn’t meet the test, the “lease” will be deemed a conditional sale and the lessee will only be entitled to the tax benefits associated with depreciating the equipment. (There is no single, “bright line” test established by the IRS, but if you take a look at IRS Revenue Ruling 55-540, you’ll probably get sufficient guidance.)
It is beyond the scope of this article to pore through the details of that ruling; for our purposes here, I merely want to point out that one of the things that will usually destroy true lease treatment is if “the total of the rental payments and any option price payable in addition thereto approximates the price at which the equipment could have been acquired by purchase at the time of entering into the agreement, plus interest and/or carrying charges.” (See 55-540 section 4.05.) The IRS will impute a “reasonable” rate of interest in its analysis.
Now back to John Doe Leasing Co. Before I answered Mr. Doe’s question, I went to his company’s website and found something interesting. Using the site’s “Lease Rate Calculator,” I found, for example, that a three-year FMV- or 10%-buyout lease having an original equipment cost of $20,000 would have 36 monthly payments totaling a little more than $25,000. 10% on top of that (which is also what this lessor generally quotes in its FMV-option transactions also) makes a total of payments of about $27,000, which carries an implicit interest rate of about 21%. (Doe Leasing writes deals up to $250,000 only, which is not atypical amongst its small-ticket competitors. A $250,000 five-year FMV or 10% lease, to take another Doe Leasing example, would have 60 payments totaling almost $290,000. 10% on top of that gives a total of $340,000, which carries an implicit interest rate of about 12%.)
So what I told Mr. Doe was essentially this: An interest rate of 21% on a three-year $20,000 deal, and a 12% rate on a five-year $250,000 deal, are probably not less than “reasonable,” at least to the IRS – especially given the present rate environment. Therefore, although your 10% and FMV lease products are probably true lease structures for legal and bankruptcy purposes under UCC Section 1-203, it doesn’t appear that you’ve got those products priced in a way that would qualify them for true lease treatment for tax purposes. So, I concluded, if your company never writes true tax leases, you probably shouldn’t say anything in your advertising or website about deducting a hundred percent of the payments. It could imply that you offer tax leases when you really don't.
The reason I think this is important is that, over the years, I’ve seen an abundance of small-ticket advertising literature containing this kind of “soft” tax advice. It’s always found in the “Advantages of Leasing” section. The more well-written pieces say, essentially, that “payments under a true lease may be fully tax deductible, but you should consult your tax advisor to be certain.” This is a perfectly good thing for a lessor to say in his ads – but probably only if he has a true tax lease product to sell.
Because in the final analysis, taxes aren’t always as certain as …. well, the other thing.
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4. Lease Assignments: Don’t Forget to Address the Security Deposit.
Posted January 2010
In lease assignments, security deposits are sometimes the neglected, stray dog. Too often, in smaller assignment transactions, we see buy-sell documentation that carefully spells out the pricing and the treatment of residuals, and about a hundred other points, but neglects to state specifically how the lessee’s security deposit is to be handled at the end of the lease term. A security deposit is both an asset and liability of the holder, and if the treatment of it is not properly covered in the assignment document, the assignor (seller) or the assignee (buyer) could both end up with frustrated expectations, or worse. Haste and waste.
If the assignor either doesn’t want to sell the residual or otherwise wants to control the lease termination (or renewal) process, then she almost certainly will want to retain the security deposit – in other words, the present value of the deposit won’t be netted out of the assignment price. The assignee, on the other hand, generally, will usually want to take the security deposit. Doing so lowers the assignment price and gives the assignee an additional collection tool. Moreover, what if the assignor who retained the deposit is insolvent or out of business by the time the lease ends? Surely the lessee is going to look to the assignee for the refund, and as a practical matter, the assignee will have a problem to deal with and might even have legal exposure (not to mention a reputation risk), regardless of what the lease and the assignment documents might state on the subject.
To avoid these potential pitfalls, a lease should have a short, simple (and bolded or italicized) clause similar to this: “Lessee agrees that an assignee is not liable for any of Lessor’s obligations or liabilities under this lease, and Lessee further agrees not to assert against an assignee any claim or defense that Lessee may have against Lessor.” And the assignment document should contain a clause similar to this: “This assignment does not include an assumption by the assignee of any of the assignor’s obligations or liabilities under, or related to, the lease” [either “except for” or “including but not limited to” the assignor’s obligations with respect to the security deposit]. (Be aware, though, that correct phraseology may depend on the other language in your documents and on the applicable law in your particular state and other factors.)
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5. A Good Lesson on "Overblown" Liquidated Damages Clauses.
Posted January 2010
Here’s a reported court decision the wise lessor and its counsel will want to read and heed: National City Healthcare Finance v. Refine 360, LLC, 607 F. Supp. 2d 881 (N.D. Ill. 2009). It's a good lesson in humility.
There, the lessor sued its lessee for failure to make payments. Unfortunately for the lessor, the remedies provision in the lease agreement was a little too “overblown” for the judge’s comfort. That provision stated that, in addition to suing for past-due rent, the lessor could sue for the full, undiscounted amount of future rent plus the undiscounted estimated value of the equipment as of the date of the suit. In other words, the lease attempted to give the lessor the right to receive much more than its true, actual damages.
The judge was clearly irritated by what he perceived as “hucksterism” on the part of the lessor’s lease drafter. Writing in a subtle cynical style, he rebuffed the lessor’s over-reaching and denied its damages request (while giving the lessor permission to go “back the drawing board to prepare and present a revised submission that is not infected with the taints that attach to its current version”).
As this particular judge clearly knew – but what many lease drafters apparently hope judges will forget – “it takes no more than a rudimentary understanding of the concept of damages" that a lessor cannot recover undiscounted future value, because to allow otherwise would permit the lessor to recover an unfair windfall. The lease provision in question here is known as a “liquidated damages” clause, and such a clause is unenforceable unless it can be said to reflect a reasonable estimation of the lessor’s true, actual damages determined as of the time the contract is made.
But what makes this otherwise plain-Jane case so interesting is how the judge ends his written opinion. After pointing out what courts usually do in collection litigation cases like this – that a party guilty of having an unenforceable liquidated damages clause will nevertheless be allowed to recover its actual damages – the judge goes on to suggest that in this particular case a little punishment might be in order:
"In candor, that [usual outcome] seems an inadequate outcome . . . [because] if a lessor . . . has the prerogative to insert a clearly overblown damages provision, comfortable in the knowledge that its invalidation will simply put the lessor back in the situation that it would have occupied in the absence of that provision, every incentive for a lessor to prepare a reasonable contractual provision vanishes. That would leave the lessor free to recover the contractually prescribed excessive amounts from unsuspecting lessees or, where lessees are in default, to obtain such unwarranted amounts through courts that have not thought about the problem—an intolerable no-lose and possible-win situation for the lessor." (607 F. Supp. at 884.)
More specifically, the judge wrote that if the lessor chooses to re-file its damages submission, the court might decide not to enforce the separate clause in the lease (outside the liquidated damages clause) providing for the lessee to pay the lessor’s enforcement costs, including reasonable attorney's fees.
Clearly there is a lesson to be taken from this opinion – and it applies to your entire contract, not merely your damages provisions: Don't get too greedy in writing your contract forms, because if you raise a judge's ire, he might just throw out generally accepted legal principles and give you less than what the technical law of contracts would otherwise provide.
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6. Automatic Renewal: A Different Perspective
Posted January 2010
The inclusion of automatic renewal (or “evergreen”) clauses in true leases has been a fairly common practice from time immemorial. There is no question that these clauses provide important protections to the lessor. If the lessee has no intent to renew, the lessor has in interest in knowing it before the end of the term so that he can start planning for remarketing or some other disposition of the equipment.
However, the question of whether a lessee should be reminded by the lessor of the notice deadline in plenty of time for the lessee to react is an entirely different question. As most of us know, some states (namely, New York and Rhode Island) have statutes requiring commercial equipment lessors to provide a written notice – a fair warning – before the notice deadline date arrives. Bills are pending in other states (e.g., Kentucky and New Hampshire). The issue is definitely heating up in the industry.
The rule of “caveat emptor” – or “buyer beware” – began eroding in the consumer finance business in the early twentieth century, and the erosion process started in the commercial finance business not too many decades later. Yet I still hear some lessors say things like, “A contract is a contract. Unless the lessee asked for a prior-notice clause to be included in the lease, he shouldn’t complain if he forgot to mark his calendar and give the required notice. Having a notice statute is ridiculous. We’re already over-regulated in this country!”
Most of the abuses occur in the small-ticket world. Larger lessees have sophisticated “tickler” systems. Consider the corner dry-cleaner, though. He signs up for a three-year lease in 2010. Is he supposed to go to Office Depot and try to find a 2013 calendar and mark the notice deadline date? And the more apt question is: What possible interest does a lessor have in not voluntarily reminding its customer of the notice deadline – unless it’s to create a chance that the lessee will slip up and get trapped in a renewal it does not want?
The stance of the Equipment Leasing and Finance Association (ELFA) on the pending legislation is simple and straight-forward (and I’m paraphrasing here): We, the Association, have a code of ethics for our members, and it says that lease contracts should be easy to understand and absolutely transparent. However, we do not really think that statutory regulation should be forced on the industry. We can police ourselves.
Okay, fair enough. ELFA’s job is to be a fierce advocate, and it shouldn’t be faulted for doing its job. But notwithstanding the official stance of ELFA, every lessor who writes auto-renew contracts and does not have a voluntarily-imposed notice policy should ask itself: By forcing auto renewal on my customer, am I risking my vendor relationship? Is there a chance this customer might repeat with me some day? And given the slowly creeping legislative trend, will the plantiff’s bar start coming up with more effective arguments that auto-renewal is a legally-actionable unfair business practice? (This author, in a past in-house corporate life, was given the task of helping to defend his employer in such a suit. A half a million dollars later, the employer squeaked out a win.)
But those are not the only questions a lessor might want to ask himself. They all grow out of simple pragmatism – what the German philosopher Emmanuel Kant called the “hypothetical imperative” – and nothing more. But Kant’s “categorical imperative” – the “Do Unto Others” question – would be: Would I want that to happen to me? This author represents lessors, not lessees, and so it’s not my purpose to moralize here. It’s simply a question I pose for the thinking lessor.
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