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Did you know that eight out of 10 American companies lease some or all of
their business equipment? Put another way, nearly one-third of all business
investment in equipment is financed with some form of equipment lease. Despite
changes in tax laws and economic conditions, equipment leasing remains one of
the most popular means of financing business-equipment acquisitions in this
country.

Like many types of financing, equipment leasing is form-driven. Counsel
unfamiliar with key legal, tax and business considerations important to this
type of financing often fail to spot problem language in some of the forms.

This article will focus on some of the more common “gotcha’s” in lessor-generated
form documents. Although the article will deal chiefly with financing provided
by third-party lessors (as opposed to equipment vendors), most of the
considerations listed below are applicable to a wide variety of equipment
leases, including third-party and vendor leases, true leases and leases intended
as secured transactions, short-term and “full payout” leases, leases of various
types of equipment and leases of various sizes. Although advice will generally
be given to lessee counsel, counsel for lessors should consider lessee
priorities and options in tailoring forms to specific transactions.

Before looking at the terms of the typical lease, a few words about the role of
lessee counsel are appropriate. Counsel, particularly in-house counsel
representing lessees, need to be aware that equipment leasing is a specialty
having a limited overlap with other types of financing. Form documents are
prepared, and usually negotiated, by experienced lawyers who specialize in
equipment-lease financing. It is rare that the negotiations are conducted on a
level playing field.

Adding to the problem is the danger that the client will actually work against
its own counsel. If the client has selected the leasing company prior to
initiating negotiations on documentation, the leasing company has an immediate
advantage and a strong disincentive where negotiating is concerned.

Finally, lessee counsel needs to assemble information about the circumstances of
the negotiations before proceeding. The correct response to lessor demands often
requires an understanding of the lessor’s and lessee’s respective priorities:

- Know your lessor – Leasing companies come in many varieties, including banks,
brokers, equipment specialists, captives, independents and companies of all
sizes. Each has a different level of flexibility as to various matters, such as
the ability to provide future funding for upgrades or equipment additions,
regulatory and practical limitations on the acceptable amount of end-of-term
exposure (the “residual assumption”), and the ability to fund the transaction
should a change occur in prevailing interest rates or other circumstances
between execution and delivery.

- Know your equipment – Will the equipment require special maintenance and does
the lessee want to provide this maintenance in-house? Is it likely that the
equipment will require upgrades or modifications during the lease term? Is it
likely that the equipment will become obsolete or otherwise undesirable during
the lease term? Is it likely that the equipment will become essential to the
lessee’s business so that the lessee will want the right to purchase the
equipment at the end of the term for a pre-agreed purchase price?

- Know your client – Is the lessee likely to merge or undergo another change of
circumstances during the lease term? Is the lessee particularly rate-sensitive?
Does the lessee have other means of financing equipment? Is it likely to be
necessary to move the equipment during the term or to make other arrangements?

Some of the most serious problems with equipment leases come at the very outset.
Most leases provide that the lease term does not start until the acceptance date
(or commencement date), which is the date on which the lessee signs an
acceptance certificate indicating that it has inspected the leased equipment and
found it to be in acceptable condition.

Once the acceptance certificate is signed, the lease become irrevocable and is
an absolute obligation of the lessee. Virtually all equipment leases contain a
hell or high water clause stating that the lessee must make payments in all
events, even if the equipment fails to function properly. The hell or high water
clause is never negotiable. Lessor counsel usually responds by comparing the
lease to a loan financing, in which the borrower is not permitted to cease
making payments to the bank should the collateral fail to function as desired.

With this in mind, it is crucial that the lease provides that the lessee has the
absolute right to reject equipment that does not properly function. Consider the
two following provisions regarding commencement of the lease term:

The lessee shall be deemed to accept the equipment upon its delivery and
installation by the supplier and shall evidence such acceptance by execution of
an acceptance certificate.

Upon delivery, the lessee shall inspect the equipment and, if the lessee
determines in its sole discretion that the equipment functions properly, the
lessee shall execute an acceptance certificate.

A second, related issue is whether the term of the lease begins prior to the
date the lessor makes payment to the vendor. Should the lessor be entitled to a
30-, 60- or 90-day “float” while the lessee is paying lease rentals? Is there a
danger (given the size and nature of the leasing company) that the lessor will
go out of business and be unable to make the required payment to the vendor
after the lessee has signed an irrevocable lease?

A third issue that often escapes attention at the outset of a lease is the
matter of interim rent. Most leasing companies, and many lessees, prefer to pay
rent on the first or fifteenth day of the month. Because the lease term starts
on execution of the acceptance certificate, it is unlikely that the actual lease
commencement date will fall on the first or fifteenth day.

Most leases provide that the lessee pays interim rent during the period from
actual acceptance to the pre-agreed first rental payment date. On its face, it
seems perfectly logical to calculate this rental as 1/30th of a monthly rent
payment (or 1/90th of a quarterly payment).

Consider, however, that the lessee generally calculates the amount of rent it
will be paying over the agreed term of the lease: 36, 48, 60 months, etc. Paying
a full interim rent can increase the lease term by as much as 29 days (89 days
in a quarterly rent lease).

In some circumstances, this does not present a problem for the lessee. Often,
however, the lease is a full payout lease, in which the lessee is aware that it
is repaying the full initial purchase price of the equipment with implicit
interest over the lease term. If so, by paying interim rent, the lessee is
paying more than the entire purchase price of the equipment. Even in a
shorter-term lease, the additional payment is something for which the lessee has
not bargained.

Standard responses often acceptable to the lessor include shortening the lease
term by the number of days during the interim rent period or requiring the
lessee to pay only an interest factor between acceptance and the first day of
the rental term. Many lessors, especially those who will delay actually paying
the vendor for the equipment, are willing to forego interim rent altogether.

From an equipment-use perspective, leases are generally more restrictive than
secured loans. Most form leases prohibit movement of the equipment to a new
location without “lessor’s prior written consent.” If the lessee desires to move
the equipment, it should negotiate the right to do so by simply giving the
lessor advance notice.

The issue of modifications and upgrades is key to many types of equipment,
particularly technology equipment. Absent strong language in the lease, and a
lessor with the ability to do so, the lessee has no right to obtain additional
financing for equipment upgrades.

Moreover, many leases contain language prohibiting any alterations or
modifications of leased equipment without prior written consent of the lessor.
Many leasing companies are willing to permit at least readily removable
alterations if the lessee requests this right during the documentation
negotiations.

Consider also the effect of the following language on the lessee’s ability to
obtain financing for any modification or upgrade:

Any item of equipment attached to the equipment shall become an accession and
deemed owned by the lessor upon attachment.

This language, which can subject the lessor (and the lessee through
indemnification obligations) to additional income taxes, can prevent the lessee
financing a desired upgrade or addition through a third-party institution or
bank. Again, where the modification can be removed without substantial damage to
the leased equipment, the lessee should have the right to do so.

Equipment leases are designed to run for a specified term and then, absent a
purchase option, obligate the lessee to return the equipment to the lessor.
Often, however, the lessee will need flexibility in dealing with the equipment.
This is particularly true in the case of technology equipment and where the
lessee’s circumstances may change because of the availability of more productive
technology.

Many lessors are willing to allow the lessee an early termination option (ETO).
If a lease is silent with regard to an ETO, the default cost to the lessee will
normally be all (undiscounted) remaining lease payments – a highly unattractive
option. Under an ETO, the lessee may terminate the lease by either returning the
equipment to the lessor or arranging for its sale to a third party. In either
event, the lessee is responsible to pay a termination value, calculated as an
amount to preserve the yield the lessor originally anticipated earning over the
full lease term.

A termination value schedule may be incorporated into a lease, which specifies
the termination value to be paid during any month of the lease. Such values are
typically expressed as a percentage of the original cost of the equipment under
lease. A termination value as of a particular month is generally equal to the
present value of remaining lease payments (that would have been paid had the
lease run its full course) plus the present value of the residual value
originally booked by the lessor, adjusted for tax effects.

Many lessors inflate residual assumptions when calculating termination value to
protect potential windfall profits on the equipment. Savvy lessees, however,
understand that termination values so calculated leave a lessor better off than
had the lease run full term because (1) the lessor’s yield is preserved; (2) any
sales proceeds obtained for the returned equipment is pure “upside,” and (3)
equipment returned prior to the end of the lease term is typically more valuable
than the end-of-term residual value assumed by the lessor in agreeing to the
lease. Termination values can be lessened by astute negotiation focusing on the
lessor’s actually anticipated residual value.

Other lessees may prefer an early buy-out option (EBO). An EBO gives the lessee
the right to purchase the equipment from the lessor for a pre-agreed amount.
Again, this purchase price covers the lessor’s anticipated return.

The difference between the two is fairly obvious: Under an ETO, the lessee parts
with the equipment for an agreed-upon cost to cancel. Under an EBO, the lessee
purchases the equipment during the lease term. As such, the EBO really protects
only the lessee’s initial cost-of-funds assumption; if interest rates fall or
lessee acquires additional funding ability, an EBO may be preferable. On the
other hand, the cost of exercising an EBO will normally be significantly higher
than an ETO. This is because the lessor’s hoped-for residual upside must be
recovered, as well as the conservative residual estimate the lessor originally
assumed. Further, the lessee will in all likelihood be required to pay sales tax
on exercising the EBO, since title will pass to the lessee – a cost not relevant
to the ETO case.

A third, often overlooked, alternative is the sublease right. Subleasing is
often available where the lessor is not in the position to offer an ETO or an
EBO, or the lessee cannot negotiate either of those two options on acceptable
terms. In order to avail itself of the sublease option, however, the lessee must
be in a position to market equipment to similarly situated lessees who may be
better able to use the leased equipment. In a large organization, prospective
lessees could be sister companies, which might make the search for a potential
user less daunting.

Common to virtually all leases is a requirement that the lessee insure the
leased equipment and be responsible in the event the equipment is damaged or
destroyed. Among the key issues to be considered in this portion of the lease
are whether the lessee desires the right to apply insurance proceeds to replace
leased equipment (preserving the financing and expediting acquisition of
replacement equipment) and how the lessee’s obligation with respect to loss or
destruction is calculated.

Most leases provide that the lessee must pay (through insurance proceeds or
otherwise) the stipulated loss value (SLV) or casualty value of the equipment.
In theory, the SLV simply compensates the lessor for its anticipated return on
the lease at the end of the term.

SLV and EBO values are very much the same, since the lessor is disposing of its
interests in the leased equipment under either scenario. An SLV value for any
month during the lease should equal the present value of remaining lease
payments and originally booked residual value (as in the ETO case), adjusted for
tax effects. The lessor often increases the residual value component to cover
its potential upside on disposition of leased equipment. In fact, SLVs typically
are significantly higher than their theoretical value because of aggressive
residual value components (and lack of lessee understanding). Significant
improvement (reduction) in the cost of SLVs can be achieved by vigorous
negotiation.

Before leaving this area, counsel should be careful as to the wording of any
replacement “option.” Many lease forms currently require the lessee to replace
equipment that has been destroyed. The option to replace should always rest in
the lessee because that company should be fully compensated through payment of
SLV. Also, care must be taken as to the precise wording of what is permissible
as replacement equipment. Standard language often requires identical replacement
equipment, or equipment from the same manufacturer. Greater flexibility in
substitutable equipment is desirable in most cases.

At the end of the lease term, most leases state that the lessee must return the
equipment to: “a location designated by the lessor within the continental United
States.” Return is to be at the lessee’s own cost and exposure, but often by a
common carrier or other means selected by the lessor.

Many consultants urge that the lessee not agree to pay the cost of return of the
equipment as the purchase price usually includes the cost of freight-in. The
lessee should be aware, however, that refusing to pay for return delivery
usually results in higher lease rates because it affects the lessor’s assumed
end-of-term residual-value recovery.

A better negotiating position is often to limit the areas to which the equipment
must be returned, such as return within a 100-mile radius of the lessee’s place
of business, or to negotiate a cap as to the financial obligation to be incurred
by the lessee.

Another common pitfall is language reading as follows:

At the end of the term, the lessee shall deliver the equipment to a location
within the continental United States specified by the lessor, fully de-installed
and crated and recertified by the manufacturer for future use.

This language would require the lessee to cease using the equipment, de-install
it and have it checked by the manufacturer for recertification during the lease
term. Better language requires the lessee to begin these procedures at the end
of the term, assuring the lessee full use of the equipment during the entire
lease term.

As to purchase and renewal options, the best advice is for the lessee’s counsel
to read carefully the printed form. Many draftsman insert in “standard” language
terms such as the following:

So long as the lessee is not in default hereunder, the lessee shall have the
option to purchase the equipment at its fair market value (as determined by the
lessor)”; or “at the greater of fair market value or 10 percent of the original
equipment costs …”; or “… at the fair market value as determined by mutual
agreement or, if the parties cannot agree, by an appraiser selected by lessor ….

Many of the problems with these types of language are readily apparent. What is
not so apparent is the use of the term “in default.” Unless otherwise defined,
this would deny the lessee the right to exercise its purchase option (or, if
used elsewhere, its early termination, early buy-out, replacement or renewal
option) if the lessee is one day late in providing annual financial statements,
paying a property tax or taking any other action. Better language reads “so long
as no event of default has occurred and is continuing hereunder,” giving the
lessee the benefit of any grace period.

In the case where options to renew the lease or purchase the equipment at lease
end are important, it is important to have a more objectively determined fair
market value process than the standard provisions summarized above. Many leases
are silent altogether regarding such options.

Also, the stated language requires the lessee to purchase the “equipment,” which
is likely to be read as “all but not less than all equipment.” If the lessee
desires the right to purchase only selected portions of the equipment, the
language should so state. The language is particularly onerous if the lease
covers many types of equipment, such as a computer, telephone system and fleet
of delivery vans.

Because of its popularity, equipment leasing has emerged as a distinct form of
financing. Counsel faced with lessor-generated documents should be aware that it
is not merely negotiating another loan-type arrangement, but attempting to work
in a field dominated by full-time specialists. Careful reading and education
will go far in leveling the playing field.

By Barry S. Marks and James M. Johnson

Marks is a shareholder with Berkowitz, Lefkovits, Isom & Kushner in Birmingham,
Ala. Johnson is a professor of finance in the Graduate School at Northern
Illinois University in Dekalb, Ill.

Source: American Bar
Association

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