Eureka v. Wentworth: Further Erosion of the 'Hell or High Water' Principle

There was a problem, though. The trial court found that Wentworth, from the beginning, had neither the ability nor the intention of paying the vendors. Eureka made several rent payments to Wentworth, but the vendors were not paid. Because the vendors' requests to Wentworth went unanswered, the vendors soon turned to Eureka, demanding payment of their invoices. The vendors repeatedly dunned Eureka, and one of the vendors instituted litigation against Eureka. Eureka advised Wentworth that it would cease paying rent and separately settled with each of the vendors by returning the equipment and making specified payments. Eureka then brought suit against Wentworth in federal district court, demanding the return of all rent previously paid by it. Among other charges, Eureka asserted fraud. Wentworth counterclaimed that Eureka had breached its “hell or high water” promise to pay rents. The court ruled in favor of Eureka, but Wentworth appealed to the First Circuit Court of Appeals.

The appellate court reviewed Eureka's various claims against Wentworth, but focused on the issue of fraudulent misrepresentation. The court first considered Wentworth's defense that the Code effectively pre-empted an action for fraudulent misrepresentation. The court cited UCC Section 1-103, which provides that unless displaced by a particular provision of the Code, “the principles of law and equity, including … fraud [and] misrepresentation … shall supplement [the] provisions [of the UCC]” and noted that nowhere in the UCC is a claim of fraudulent misrepresentation explicitly pre-empted.

Next, the court considered the common law elements of fraudulent misrepresentation. Generally speaking, there must be a false representation of a material fact with the intention to induce the other person to act thereon, and such person must have relied to its detriment on the misrepresentation. Analyzing whether a misrepresentation had been made, the court introduced a novel concept. A finance lessor, the court decided, makes an “implicit representation” to the lessee that it has both the ability and the intention to make payment to the supplier for the goods. If the finance lessor entered into the lease knowing that it would not (or could not) pay the supplier, then the lessee may treat the agreement to lease as an actionable misrepresentation. By entering into the leases, Wentworth had made an implicit representation that it had the ability and the intent to pay the vendors of the equipment. Wentworth's inability to pay and its intention not to pay the vendors of the equipment constituted an actionable misrepresentation. The court then considered whether Wentworth's misrepresentation was material. “Yes,” answered the court, plainly so, since the acquisition of the equipment for lease to Eureka was central to the entire transaction.

Wentworth countered that Eureka, despite Wentworth's failure to pay, had continued to enjoy the use of the equipment, as contemplated by the leases. No one had deprived Eureka of the benefit of its bargain. Therefore, Eureka had not suffered any detriment. The court disagreed. To accept this argument, it reasoned, is “to blink reality.” The reality, it opined, is that Eureka was faced with harassment by the equipment vendors because of Wentworth's refusal and inability to pay the invoices. Eureka “never bargained for the headaches associated with defending itself against the adverse claims” of the vendors. Although the vendors might never have won a lawsuit against Eureka, because their claims were properly against Wentworth as their “buyer,” it was enough that their claims were “colorable” and that Eureka “incurred unavoidable costs.” Merely being forced to respond to the vendors' demands was detriment enough to Eureka. This, concluded the court, amounted to fraudulent misrepresentation.

The court then considered whether Eureka had rightfully canceled the lease and stopped paying rent. First, it cited UCC Section 2A-505(4), which the court read as permitting, in the case of fraud or material misrepresentation, the same remedies as are available in cases of default. Second, it reasoned that, since UCC Sections 2A-508(1)(a)-(b) permit a lessee to cancel a lease and recover rents after a lessor default, Eureka was entitled to take the same actions in this case. Withholding rental payments in response to a lessor's fraudulent misrepresentation, the court stated, is an appropriate remedy for a lessee.

Wentworth countered that the “hell or high water” doctrine made this result impermissible. The promise to pay rentals is separate and independent from any actions of the lessor, it asserted. True, in the majority of lessor breaches, replied the court, but there are a “few exceptions” to the “hell or high water” doctrine. It did not elaborate what these exceptions might be, except to affirm that fraud constitutes one such instance. And fraud, as the court repeated, is sufficient grounds for a lessee to cancel a lease.

What the court did assert, interestingly, is that a “simple breach of warranty” is not sufficient. For example, Wentworth's breach of its covenant of quiet enjoyment, by bringing Eureka into a situation whereby it was subject to the repeated dunning of the vendors, may give rise to a separate action by the lessee. It does not, on the other hand, “defeat the 'hell or high water' clause.”

In any case, the court continued, it does not matter whether Eureka's response of settling directly with the vendors was “letter perfect.” Wentworth's “deplorable course of conduct” forced Eureka's hand. Wentworth acted “entirely contrary to [the] obligations of good faith and fair dealing” set forth in the UCC. The court seems to imply that when a lessor behaves so outrageously, it cannot be allowed to get away with it based on a “hypertechnical” defense, eg, that the lessee was never actually deprived of the use of its goods. Under the circumstances, the court found, Eureka's actions were “reasonable.” The court affirmed the trial court's judgment against Wentworth.

This case is troublesome for several reasons. The court fabricated out of thin air an “implicit representation” by all finance lessors of their ability and intention to pay. This reasoning is incongruous with the ability of a lessor to disclaim all implied warranties under the UCC, so long as such disclaimer is in writing and conspicuous. UCC '2A-214(2). The court also set the bar low for the level of detrimental reliance that the lessee must suffer in order to invoke a claim of fraudulent misrepresentation. It was surely an irritant that the vendors turned to Eureka when Wentworth became unresponsive. But, contrary to the court's scoffing, Eureka did continue to have the benefit of the equipment each month, and it was paying the monthly amount of rent it had bargained for. Surely the proper measure of material harm in this context is the actual deprivation of the use of the goods?

The Eureka opinion alters the relationship between a lessee and its finance lessor. The “hell or high water” principle is meant to recognize that a finance lessor is merely supplying the money in a financing transaction pursuant to which the lessee has already identified the equipment, instructed the lessor to purchase it, and ultimately accepted it. The lessee always has the right to bring a separate and independent cause of action against the lessor if the lessor breaches the lease or commits fraud, but the “hell or high water” concept is intended to prevent a lessee from exercising undue leverage over a lessor by withholding rent. By carving out fraud from the “hell or high water” protections and setting the bar low for the determination of damages, the court eroded a lessor's protections and opened the door to a lessee exercising its “nuclear option.” A consequence of the Eureka decision is that a lessee need only assert that the lessor broke an “implicit” representation that caused some de minimis “colorable” harm, and a lessee may stop paying rent ' even though the lessee may be in full possession and use of the equipment. The lessee would thereby enjoy its primary aim under the lease ' the use and possession of the equipment, while the lessor is deprived of its primary aim ' the receipt of rent.

The Eureka decision, if followed, would not only have a deleterious effect on lessors in a lease transaction, but also on the willingness of third-party financing companies to purchase such leases from lessors. If traditional “hell or high water” protection is not afforded to a lessor, then neither will it be extended to a lessor's assignees. A result will be the chilling of lease syndications and, with the shrinking of the secondary market, increased difficulty for small firms that rely on leases to obtain the use of equipment otherwise unavailable to them via traditional lending (ie, non-leasing) transactions.

An example of the harmful ramifications that can result from the erosion of the “hell or high water” standard appears in the current NorVergence fiasco. NorVergence, Inc. was a telecommunications company that packaged both equipment and services in a single transaction. It sold low-cost Internet and other long-distance services to its customers, which services it previously had purchased wholesale from national telecommunications carriers. In addition to a service contract, NorVergence and the customer concurrently entered into an equipment rental agreement, pursuant to which NorVergence leased a “Matrix” box. The “Matrix” box was represented by NorVergence as being essential to the telecommunications services afforded under the service contract. The pricing under both agreements was such that the amounts allocated to the payments due under the “rental” agreement far exceeded the relative value of the “Matrix” box. NorVergence syndicated dozens of these transactions to third-party leasing companies. As NorVergence became increasingly unable to pay the long-distance carriers, an involuntary bankruptcy petition was filed against NorVergence in the summer of 2004. At the same time, the customers found that their telecommunications services were terminated. Actions are pending against the third-party leasing companies by various lessees, and governmental agencies have brought their own investigations, in some instances resulting in costly settlements to the leasing companies. Although the proceedings of the cases are generally not publicly available, it is clear that a primary charge is that NorVergence committed fraud against its lessees, and because of the fraudulent behavior, NorVergence and its assignees should not be entitled to rely on “hell or high water” protections to force the continued payment of rent.

A common theme in Eureka and NorVergence is the undermining of the “hell or high water” nature of finance leases. In both cases, fraudulent behavior by the lessor provided the opening to attack this principle. It remains to be seen whether courts will expand upon this exception, further undercutting the “hell or high water” protection of the Code or whether they will reassert the traditional principles that have enabled the leasing industry to flourish. In any case, the developments signaled in these cases are ominous and must be resisted.

A fundamental tenet of equipment leasing has been the concept of “hell or high water” rental payments. Once the lease is signed and the lessee accepts the goods, then the lessee's promises under the lease become irrevocable, especially the promise to pay rent. The draftsmen of UCC Article 2A recognized this critical element and codified it with respect to a finance lease in UCC '2A-407(1)-(2) (all citations herein refer to Uniform Commercial Code Article 2A pre-2003 revisions). A finance lease is a particular type of “true” equipment lease in which the lessee itself selects the item of equipment it wants and instructs the lessor to acquire it for lease to the lessee. UCC '2A-103(g). A finance lessor is neither the manufacturer nor supplier of the item of equipment; it is merely providing the money. Article 2A of the Uniform Commercial Code (the “Code” or the “UCC”) extends certain benefits to finance lessors, one of the most important of which is that the lessee's promises are not subject to termination, modification or repudiation; in other words, the lessee must comply with them come “hell or high water.” UCC '2A-407(2)(b).

The “hell or high water” protection of the Code is meant to ensure that the rental payments due to a finance lessor will not be held hostage by the lessee because of a defect in the equipment being financed or a claim by the lessee that the lessor breached a provision of the lease or otherwise. Traditionally, courts have viewed a lessor's “hell or high water” protection as inviolate. Under what circumstances, then, could a lessee cancel the lease and cease making rental payments, and are there any exceptions to the “hell or high water” nature of lessee's obligations? A recent case, Eureka Broadband Corporation v. Wentworth Leasing Corporation , 400 F.3d 62 (1st Cir. 2005), suggests that fraud may be such an exception.

Eureka Broadband Corporation, the lessee, was engaged in the business of installing fiber optics systems in commercial office buildings and, once installed, selling access to companies providing telecommunications services to the buildings' tenants. Eureka wished to acquire certain equipment necessary to its business and negotiated two leases, each for a term of 2 years, with Wentworth Leasing Corporation. The terms of the leases were substantially identical. As is typical in a finance lease, Eureka identified the equipment it needed and instructed Wentworth to purchase the equipment from the vendors. Eureka accepted delivery of the equipment and forwarded executed delivery and acceptance acknowledgments to Wentworth. In the meantime, the primary vendor sent its invoices directly to Wentworth (but, for an unexplained reason, the other vendor sent its invoice to Eureka).

There was a problem, though. The trial court found that Wentworth, from the beginning, had neither the ability nor the intention of paying the vendors. Eureka made several rent payments to Wentworth, but the vendors were not paid. Because the vendors' requests to Wentworth went unanswered, the vendors soon turned to Eureka, demanding payment of their invoices. The vendors repeatedly dunned Eureka, and one of the vendors instituted litigation against Eureka. Eureka advised Wentworth that it would cease paying rent and separately settled with each of the vendors by returning the equipment and making specified payments. Eureka then brought suit against Wentworth in federal district court, demanding the return of all rent previously paid by it. Among other charges, Eureka asserted fraud. Wentworth counterclaimed that Eureka had breached its “hell or high water” promise to pay rents. The court ruled in favor of Eureka, but Wentworth appealed to the First Circuit Court of Appeals.

The appellate court reviewed Eureka's various claims against Wentworth, but focused on the issue of fraudulent misrepresentation. The court first considered Wentworth's defense that the Code effectively pre-empted an action for fraudulent misrepresentation. The court cited UCC Section 1-103, which provides that unless displaced by a particular provision of the Code, “the principles of law and equity, including … fraud [and] misrepresentation … shall supplement [the] provisions [of the UCC]” and noted that nowhere in the UCC is a claim of fraudulent misrepresentation explicitly pre-empted.

Next, the court considered the common law elements of fraudulent misrepresentation. Generally speaking, there must be a false representation of a material fact with the intention to induce the other person to act thereon, and such person must have relied to its detriment on the misrepresentation. Analyzing whether a misrepresentation had been made, the court introduced a novel concept. A finance lessor, the court decided, makes an “implicit representation” to the lessee that it has both the ability and the intention to make payment to the supplier for the goods. If the finance lessor entered into the lease knowing that it would not (or could not) pay the supplier, then the lessee may treat the agreement to lease as an actionable misrepresentation. By entering into the leases, Wentworth had made an implicit representation that it had the ability and the intent to pay the vendors of the equipment. Wentworth's inability to pay and its intention not to pay the vendors of the equipment constituted an actionable misrepresentation. The court then considered whether Wentworth's misrepresentation was material. “Yes,” answered the court, plainly so, since the acquisition of the equipment for lease to Eureka was central to the entire transaction.

Wentworth countered that Eureka, despite Wentworth's failure to pay, had continued to enjoy the use of the equipment, as contemplated by the leases. No one had deprived Eureka of the benefit of its bargain. Therefore, Eureka had not suffered any detriment. The court disagreed. To accept this argument, it reasoned, is “to blink reality.” The reality, it opined, is that Eureka was faced with harassment by the equipment vendors because of Wentworth's refusal and inability to pay the invoices. Eureka “never bargained for the headaches associated with defending itself against the adverse claims” of the vendors. Although the vendors might never have won a lawsuit against Eureka, because their claims were properly against Wentworth as their “buyer,” it was enough that their claims were “colorable” and that Eureka “incurred unavoidable costs.” Merely being forced to respond to the vendors' demands was detriment enough to Eureka. This, concluded the court, amounted to fraudulent misrepresentation.

The court then considered whether Eureka had rightfully canceled the lease and stopped paying rent. First, it cited UCC Section 2A-505(4), which the court read as permitting, in the case of fraud or material misrepresentation, the same remedies as are available in cases of default. Second, it reasoned that, since UCC Sections 2A-508(1)(a)-(b) permit a lessee to cancel a lease and recover rents after a lessor default, Eureka was entitled to take the same actions in this case. Withholding rental payments in response to a lessor's fraudulent misrepresentation, the court stated, is an appropriate remedy for a lessee.

Wentworth countered that the “hell or high water” doctrine made this result impermissible. The promise to pay rentals is separate and independent from any actions of the lessor, it asserted. True, in the majority of lessor breaches, replied the court, but there are a “few exceptions” to the “hell or high water” doctrine. It did not elaborate what these exceptions might be, except to affirm that fraud constitutes one such instance. And fraud, as the court repeated, is sufficient grounds for a lessee to cancel a lease.

What the court did assert, interestingly, is that a “simple breach of warranty” is not sufficient. For example, Wentworth's breach of its covenant of quiet enjoyment, by bringing Eureka into a situation whereby it was subject to the repeated dunning of the vendors, may give rise to a separate action by the lessee. It does not, on the other hand, “defeat the 'hell or high water' clause.”

In any case, the court continued, it does not matter whether Eureka's response of settling directly with the vendors was “letter perfect.” Wentworth's “deplorable course of conduct” forced Eureka's hand. Wentworth acted “entirely contrary to [the] obligations of good faith and fair dealing” set forth in the UCC. The court seems to imply that when a lessor behaves so outrageously, it cannot be allowed to get away with it based on a “hypertechnical” defense, eg, that the lessee was never actually deprived of the use of its goods. Under the circumstances, the court found, Eureka's actions were “reasonable.” The court affirmed the trial court's judgment against Wentworth.

This case is troublesome for several reasons. The court fabricated out of thin air an “implicit representation” by all finance lessors of their ability and intention to pay. This reasoning is incongruous with the ability of a lessor to disclaim all implied warranties under the UCC, so long as such disclaimer is in writing and conspicuous. UCC '2A-214(2). The court also set the bar low for the level of detrimental reliance that the lessee must suffer in order to invoke a claim of fraudulent misrepresentation. It was surely an irritant that the vendors turned to Eureka when Wentworth became unresponsive. But, contrary to the court's scoffing, Eureka did continue to have the benefit of the equipment each month, and it was paying the monthly amount of rent it had bargained for. Surely the proper measure of material harm in this context is the actual deprivation of the use of the goods?

The Eureka opinion alters the relationship between a lessee and its finance lessor. The “hell or high water” principle is meant to recognize that a finance lessor is merely supplying the money in a financing transaction pursuant to which the lessee has already identified the equipment, instructed the lessor to purchase it, and ultimately accepted it. The lessee always has the right to bring a separate and independent cause of action against the lessor if the lessor breaches the lease or commits fraud, but the “hell or high water” concept is intended to prevent a lessee from exercising undue leverage over a lessor by withholding rent. By carving out fraud from the “hell or high water” protections and setting the bar low for the determination of damages, the court eroded a lessor's protections and opened the door to a lessee exercising its “nuclear option.” A consequence of the Eureka decision is that a lessee need only assert that the lessor broke an “implicit” representation that caused some de minimis “colorable” harm, and a lessee may stop paying rent ' even though the lessee may be in full possession and use of the equipment. The lessee would thereby enjoy its primary aim under the lease ' the use and possession of the equipment, while the lessor is deprived of its primary aim ' the receipt of rent.

The Eureka decision, if followed, would not only have a deleterious effect on lessors in a lease transaction, but also on the willingness of third-party financing companies to purchase such leases from lessors. If traditional “hell or high water” protection is not afforded to a lessor, then neither will it be extended to a lessor's assignees. A result will be the chilling of lease syndications and, with the shrinking of the secondary market, increased difficulty for small firms that rely on leases to obtain the use of equipment otherwise unavailable to them via traditional lending (ie, non-leasing) transactions.

An example of the harmful ramifications that can result from the erosion of the “hell or high water” standard appears in the current NorVergence fiasco. NorVergence, Inc. was a telecommunications company that packaged both equipment and services in a single transaction. It sold low-cost Internet and other long-distance services to its customers, which services it previously had purchased wholesale from national telecommunications carriers. In addition to a service contract, NorVergence and the customer concurrently entered into an equipment rental agreement, pursuant to which NorVergence leased a “Matrix” box. The “Matrix” box was represented by NorVergence as being essential to the telecommunications services afforded under the service contract. The pricing under both agreements was such that the amounts allocated to the payments due under the “rental” agreement far exceeded the relative value of the “Matrix” box. NorVergence syndicated dozens of these transactions to third-party leasing companies. As NorVergence became increasingly unable to pay the long-distance carriers, an involuntary bankruptcy petition was filed against NorVergence in the summer of 2004. At the same time, the customers found that their telecommunications services were terminated. Actions are pending against the third-party leasing companies by various lessees, and governmental agencies have brought their own investigations, in some instances resulting in costly settlements to the leasing companies. Although the proceedings of the cases are generally not publicly available, it is clear that a primary charge is that NorVergence committed fraud against its lessees, and because of the fraudulent behavior, NorVergence and its assignees should not be entitled to rely on “hell or high water” protections to force the continued payment of rent.

A common theme in Eureka and NorVergence is the undermining of the “hell or high water” nature of finance leases. In both cases, fraudulent behavior by the lessor provided the opening to attack this principle. It remains to be seen whether courts will expand upon this exception, further undercutting the “hell or high water” protection of the Code or whether they will reassert the traditional principles that have enabled the leasing industry to flourish. In any case, the developments signaled in these cases are ominous and must be resisted.