Assuring the Lessors' Protections Afforded By the Finance Lease

Article 2A of the UCC embodies these expectations by excluding finance leases from its provisions instituting the implied warranties of merchantability and fitness for a particular purpose. See UCC ”2A-212(1) and 2A-213. Furthermore, in order to protect the finance lessor's expectation of payment, Section 2A-407 of the UCC (commonly referred to as the “hell or high water” provision) provides that a lessee's promises under a finance lease “become irrevocable and independent upon the lessee's acceptance of the goods.” UCC '2A-407(1). Once those promises become “irrevocable and independent,” they are “not subject to cancellation, termination, modification, repudiation, excuse or substitution without the consent of the party to whom the promise runs.” UCC '2A-401(2)(b).

In order to take advantage of these protections preserving the right to payment and to insulate against any breach of warranty claims that a lessee may assert against an ordinary lessor, equipment lessors entering into finance leases need to take appropriate steps to assure that the lease at issue does in fact qualify as a finance lease. There are two means to accomplish this: 1) by agreement and 2) through satisfaction of Article 2A's statutory criteria.

Finance Lease By Agreement

In the first instance, a lessor can assure that its lease is treated as a finance lease under Article 2A by bargaining for a provision in the lease wherein the parties agree that the lease is a “finance lease.” When the parties have expressly agreed to create a finance lease, the law will treat the lease as a finance lease irrespective of whether the transaction actually qualifies as a finance lease under Section 2A-103(1)(g) of the UCC (defining “finance lease”). As the Official Comment to UCC '2A-103(1)(g) states, “[i]f a transaction does not qualify as a finance lease, the parties may achieve the same result by agreement; no negative implications are to be drawn if the transaction does not qualify.” Additionally, Section 2A-103(4) incorporates the general provisions of Article 1 of the UCC into Article 2A, including Section 1-302(a), which specifies that “the effect of provisions of [the Uniform Commercial Code] may be varied by agreement.” Indeed, the rule allowing lease parties to create a finance lease by agreement is consistent with Article 2A's endorsement of warranty disclaimers in Section 2A-214 and Section 2A-301's statement that “a lease contract is effective and enforceable according to its terms between the parties.” See 2 White & Summers, Uniform Commercial Code '13-3 (4th ed. 2005).

Based upon the aforementioned UCC Sections and Comments, courts addressing the issue have looked with favor upon the parties' ability to make a finance lease by agreement ' even where the lease does not qualify as a finance lease under the statutory definition. For instance, in General Elec. Capital Corp. v. Nat'l. Tractor Trailer School, Inc., 667 N.Y.S.2d 614, 619 (Supr. Ct. N.Y. 1997), the Supreme Court of New York concluded that the lease in question satisfied the statutory definition of a finance lease, and subsequently went on to find that:

Even if the Lease did not meet the N.Y. UCC statutory definition of a finance lease, the parties can still achieve the same result by agreement. N.Y. UCC '2-A-103, Official Comment “g”; 2 White & Summers, ['13.3 (4th ed. 1995)]. The code explicitly invites the parties to make their own law by agreement, encouraging the exercise of freedom of contract. … Paragraphs (3) and (4) of the Lease explicitly disclaim all warranties and state that the Lease “IS A 'FINANCE LEASE' AS DEFINED IN ARTICLE 2A OF THE UNIFORM COMMERCIAL CODE.” This is the equivalent effect of the statutory finance lease under Article 2-A.

Additionally, in the recent decision of De Lage Landen Fin. Servs., Inc. v. M.B. Mgmt. Co., Inc., A.2d, 2005 WL 3376813, *5 (Pa. Super. Ct. Dec. 13, 2005), the Superior Court of Pennsylvania examined this same issue with similar results. In De Lage, it was apparent that the lease in question did not qualify as a finance lease under the statutory definition set forth in Article 2A. After a trial, the Court of Common Pleas concluded that, because there was no evidence that the lessee had directed the lessor to acquire the goods from the supplier, the statutory test for a finance lease had not been satisfied. Id. at *4. Therefore, the lower court held that the protections afforded to finance leases did not apply to the specific lease at issue. On appeal, the Superior Court vacated the trial court's judgment, stating that:

The trial court overlooked the fact that section (g) of the Comment to 13 Pa.C.S. '2A103 provides, 'If a transaction does not qualify as a finance lease, the parties may achieve the same result by agreement; no negative implications are to be drawn if the transaction does not qualify.' … [w]e find that the parties in the case sub judice are bound by the language contained in paragraph twenty of the lease agreement, wherein [the lessee] agreed that the lease was a finance lease as defined in article 2A. As noted, the Comment to 13 Pa.C.S. '2A103 expressly provides that the parties can agree that a transaction which otherwise would not qualify as a finance lease does in fact constitute such a lease. Id.

Thus, based upon the text of Article 2A and its Official Comments, as well as case law addressing the issue, it is clear that the parties to a lease can create a finance lease by agreement. See also Netrix Leasing, LLC v. K.S. Telecom, Inc., 2001 WL 228362, *5 (S.D.N.Y. March 7, 2001) (“Comment g to UCC '2A-103(1)(g) clearly states that if a transaction does not qualify as a third-party finance agreement, then the parties may still achieve the same result by contractual agreement. Based on the plain language of the contract, the Court finds that the parties have such an agreement.”). Incorporating a provision into the lease wherein the parties expressly agree that the lease is a finance lease as defined in Article 2A of the UCC ensures that the lessor will realize the benefits which Article 2A affords to finance lessors, including protection against breach of warranty claims and incorporation of the statutory “hell or high water provision” set forth in UCC '2A-407. Such a provision is easily incorporated into a lease agreement and should be used in addition to provisions disclaiming express and implied warranties under UCC '2A-214.

Statutory Finance Lease

Where the parties have not expressly agreed that the lease constitutes a finance lease, a finance lease may nonetheless exist if it meets the statutory definition set forth in Section 2A-103(1)(g) of the UCC. That Section defines a finance lease as:

[A] lease with respect to which:

(i) the lessor does not select, manufacture or supply the goods;

(ii) the lessor acquires the goods or the right to possession and use of the goods in connection with the lease; and

(iii) [the lessee has received sufficient notice or information regarding the manufacturer's and/or supplier's promises and warranties contained within the contract between the manufacturer or supplier and the lessor prior to signing the lease]. (abridged); See full text of Section 2A-103(1)(g)(iii) for all provisions.

In a typical finance lease transaction, the lessor acquires the goods or the rights to possession and use of the subject goods and provides the lessee with sufficient notice and information regarding the promises and warranties of the manufacturer and supplier with respect to the goods in order to satisfy Section 2A-103(1)(g)(2-3). Thus, where the parties have not expressly agreed to a finance lease, the dispute over whether a finance lease was created generally turns upon whether the lessor selected, manufactured or supplied the goods.

In a situation where the lessor acquires the goods from an unrelated entity upon the lessee's direction, it is usually apparent that the lessor did “not select, manufacture or supply the goods” for purposes of UCC '2A-103(1)(g)(1). However, it is a cloudier case where the lessor is a financing subsidiary of the manufacturer or supplier. Courts have typically looked to the Official Comment to UCC '2A-103(1)(g) when confronted with this issue, which provides that “this Article creates no special rule where the lessor is an affiliate of the supplier; whether the transaction qualifies as a finance lease will be determined by the facts of each case.” See e.g., Siemens Credit Corp. v. Newlands, 905 F.Supp. 757, 763 (N.D.Cal. 1994) (“Official comment (g) to UCC section 2A-103 plainly states, 'this article creates no special rule where the lessor is an affiliate of the supplier; whether the transaction qualifies as a finance lease will be determined by the facts of each case.'” See also AT&T Credit Corp. v. Transglobal Telecom Alliance, Inc., 966 F.Supp. 299, 303-04 (D.N.J. 1997). The “facts of each case” inquiry generally means litigation and the costs associated therewith. To avoid this, it is prudent in these circumstances to bargain for a finance lease by agreement.

Also, many companies that regularly engage in lease transactions also typically build an inventory of residual equipment relating to expired or defaulted leases. Upon the re-lease of this equipment, the issue of lessor as supplier may be difficult to overcome. The facts of the matter will generally control, and the lessor will be left with the burden of proving that it did not select, manufacture or “supply” the equipment. In addition to disclaiming any warranties as to the subject equipment, such lessors should make every effort to bargain for a provision in the lease specifying the parties' express agreement that the lease is a finance lease as defined in Article 2A of the UCC to avoid this situation.

To summarize, Article 2A of the UCC provides valuable protections to the finance lessor that can be easily secured by a bargained-for agreement contained within the lease. This is accomplished by simply specifying that the lease is a finance lease for purposes of Article 2A. Absent such a provision, lessors may be exposed to claims for breach of implied warranties where the equipment is unsuitable or defective. They may also lose the lessor's right to payment under the statutory “hell or high water clause” under UCC '2A-407. Furthermore, when faced with situations where the finance lessor is affiliated with the manufacturer or supplier or where an inventory of equipment is created for re-letting, incorporation of such a provision will, in most instances, avoid the need for fact-intensive litigation on whether a lease constitutes a finance lease.

Generally, the lessor/lessee relationship is governed by Article 2A of the Uniform Commercial Code (the “UCC”). In many respects, Article 2A mirrors Article 2, treating ordinary lessors like sellers. 2 James J. White & Robert S. Summers, Uniform Commercial Code '13-3 (4th ed. 2005). For example, under UCC '2A-210 the ordinary lessor has express warranty liability similar to that incurred by a seller under UCC '2-313. Additionally, Sections 2A-212 and 2A-213 impose the familiar warranties of merchantability and fitness for a particular purpose on ordinary lessors. A lessee can assert the lessor's breach of these warranties by effectuating setoff, by suit for damages or by withholding performance. Id. Furthermore, where the lessee has filed a petition for relief under Title 11 of the United States Code (the “Bankruptcy Code”), the debtor-lessee may object to the allowance of the creditor-lessor's claim for rejection damages by asserting that the leased equipment was defective or unsuitable for the lessee's particular business.

Despite the similarities between the UCC's treatment of Sales and Leases, Article 2A affords special rights to the “finance lessor.” This article examines these rights and the impact of the relevant legal decisions upon them in order to provide finance lessors some insight as to what needs to be done to safeguard these rights.

The UCC's specialized treatment of finance lessors is based upon the reasonable expectations of the parties in these types of transactions. A traditional finance lessor purchases equipment at the lessee's direction for the sole purpose of “leasing” it to the lessee purely as a method of financing. Thus, the lessee has no reason to expect that the finance lessor would assume responsibility if the equipment is unsuitable or defective. Rather, the parties would expect the manufacturer and/or supplier of the equipment to be held accountable in this respect. This expectation of the parties is codified at UCC '2A-209, which provides that the supplier's promises and warranties pass through the finance lessor and extend to the finance lessee. UCC '2A-209(a). Moreover, since the finance lessor has no control over the manufacture or supply of the equipment, the normal expectations of the parties are that the finance lessor will be entitled to payment for its extension of the financing, regardless of the defectiveness or unsuitability of the equipment.

Article 2A of the UCC embodies these expectations by excluding finance leases from its provisions instituting the implied warranties of merchantability and fitness for a particular purpose. See UCC ”2A-212(1) and 2A-213. Furthermore, in order to protect the finance lessor's expectation of payment, Section 2A-407 of the UCC (commonly referred to as the “hell or high water” provision) provides that a lessee's promises under a finance lease “become irrevocable and independent upon the lessee's acceptance of the goods.” UCC '2A-407(1). Once those promises become “irrevocable and independent,” they are “not subject to cancellation, termination, modification, repudiation, excuse or substitution without the consent of the party to whom the promise runs.” UCC '2A-401(2)(b).

In order to take advantage of these protections preserving the right to payment and to insulate against any breach of warranty claims that a lessee may assert against an ordinary lessor, equipment lessors entering into finance leases need to take appropriate steps to assure that the lease at issue does in fact qualify as a finance lease. There are two means to accomplish this: 1) by agreement and 2) through satisfaction of Article 2A's statutory criteria.

Finance Lease By Agreement

In the first instance, a lessor can assure that its lease is treated as a finance lease under Article 2A by bargaining for a provision in the lease wherein the parties agree that the lease is a “finance lease.” When the parties have expressly agreed to create a finance lease, the law will treat the lease as a finance lease irrespective of whether the transaction actually qualifies as a finance lease under Section 2A-103(1)(g) of the UCC (defining “finance lease”). As the Official Comment to UCC '2A-103(1)(g) states, “[i]f a transaction does not qualify as a finance lease, the parties may achieve the same result by agreement; no negative implications are to be drawn if the transaction does not qualify.” Additionally, Section 2A-103(4) incorporates the general provisions of Article 1 of the UCC into Article 2A, including Section 1-302(a), which specifies that “the effect of provisions of [the Uniform Commercial Code] may be varied by agreement.” Indeed, the rule allowing lease parties to create a finance lease by agreement is consistent with Article 2A's endorsement of warranty disclaimers in Section 2A-214 and Section 2A-301's statement that “a lease contract is effective and enforceable according to its terms between the parties.” See 2 White & Summers, Uniform Commercial Code '13-3 (4th ed. 2005).

Based upon the aforementioned UCC Sections and Comments, courts addressing the issue have looked with favor upon the parties' ability to make a finance lease by agreement ' even where the lease does not qualify as a finance lease under the statutory definition. For instance, in General Elec. Capital Corp. v. Nat'l. Tractor Trailer School, Inc ., 667 N.Y.S.2d 614, 619 (Supr. Ct. N.Y. 1997), the Supreme Court of New York concluded that the lease in question satisfied the statutory definition of a finance lease, and subsequently went on to find that:

Even if the Lease did not meet the N.Y. UCC statutory definition of a finance lease, the parties can still achieve the same result by agreement. N.Y. UCC '2-A-103, Official Comment “g”; 2 White & Summers, ['13.3 (4th ed. 1995)]. The code explicitly invites the parties to make their own law by agreement, encouraging the exercise of freedom of contract. … Paragraphs (3) and (4) of the Lease explicitly disclaim all warranties and state that the Lease “IS A 'FINANCE LEASE' AS DEFINED IN ARTICLE 2A OF THE UNIFORM COMMERCIAL CODE.” This is the equivalent effect of the statutory finance lease under Article 2-A.

Additionally, in the recent decision of De Lage Landen Fin. Servs., Inc. v. M.B. Mgmt. Co., Inc., A.2d, 2005 WL 3376813, *5 (Pa. Super. Ct. Dec. 13, 2005), the Superior Court of Pennsylvania examined this same issue with similar results. In De Lage, it was apparent that the lease in question did not qualify as a finance lease under the statutory definition set forth in Article 2A. After a trial, the Court of Common Pleas concluded that, because there was no evidence that the lessee had directed the lessor to acquire the goods from the supplier, the statutory test for a finance lease had not been satisfied. Id. at *4. Therefore, the lower court held that the protections afforded to finance leases did not apply to the specific lease at issue. On appeal, the Superior Court vacated the trial court's judgment, stating that:

The trial court overlooked the fact that section (g) of the Comment to 13 Pa.C.S. '2A103 provides, 'If a transaction does not qualify as a finance lease, the parties may achieve the same result by agreement; no negative implications are to be drawn if the transaction does not qualify.' … [w]e find that the parties in the case sub judice are bound by the language contained in paragraph twenty of the lease agreement, wherein [the lessee] agreed that the lease was a finance lease as defined in article 2A. As noted, the Comment to 13 Pa.C.S. '2A103 expressly provides that the parties can agree that a transaction which otherwise would not qualify as a finance lease does in fact constitute such a lease. Id.

Thus, based upon the text of Article 2A and its Official Comments, as well as case law addressing the issue, it is clear that the parties to a lease can create a finance lease by agreement. See also Netrix Leasing, LLC v. K.S. Telecom, Inc., 2001 WL 228362, *5 (S.D.N.Y. March 7, 2001) (“Comment g to UCC '2A-103(1)(g) clearly states that if a transaction does not qualify as a third-party finance agreement, then the parties may still achieve the same result by contractual agreement. Based on the plain language of the contract, the Court finds that the parties have such an agreement.”). Incorporating a provision into the lease wherein the parties expressly agree that the lease is a finance lease as defined in Article 2A of the UCC ensures that the lessor will realize the benefits which Article 2A affords to finance lessors, including protection against breach of warranty claims and incorporation of the statutory “hell or high water provision” set forth in UCC '2A-407. Such a provision is easily incorporated into a lease agreement and should be used in addition to provisions disclaiming express and implied warranties under UCC '2A-214.

Statutory Finance Lease

Where the parties have not expressly agreed that the lease constitutes a finance lease, a finance lease may nonetheless exist if it meets the statutory definition set forth in Section 2A-103(1)(g) of the UCC. That Section defines a finance lease as:

[A] lease with respect to which:

(i) the lessor does not select, manufacture or supply the goods;

(ii) the lessor acquires the goods or the right to possession and use of the goods in connection with the lease; and

(iii) [the lessee has received sufficient notice or information regarding the manufacturer's and/or supplier's promises and warranties contained within the contract between the manufacturer or supplier and the lessor prior to signing the lease]. (abridged); See full text of Section 2A-103(1)(g)(iii) for all provisions.

In a typical finance lease transaction, the lessor acquires the goods or the rights to possession and use of the subject goods and provides the lessee with sufficient notice and information regarding the promises and warranties of the manufacturer and supplier with respect to the goods in order to satisfy Section 2A-103(1)(g)(2-3). Thus, where the parties have not expressly agreed to a finance lease, the dispute over whether a finance lease was created generally turns upon whether the lessor selected, manufactured or supplied the goods.

In a situation where the lessor acquires the goods from an unrelated entity upon the lessee's direction, it is usually apparent that the lessor did “not select, manufacture or supply the goods” for purposes of UCC '2A-103(1)(g)(1). However, it is a cloudier case where the lessor is a financing subsidiary of the manufacturer or supplier. Courts have typically looked to the Official Comment to UCC '2A-103(1)(g) when confronted with this issue, which provides that “this Article creates no special rule where the lessor is an affiliate of the supplier; whether the transaction qualifies as a finance lease will be determined by the facts of each case.” See e.g., Siemens Credit Corp. v. Newlands , 905 F.Supp. 757, 763 (N.D.Cal. 1994) (“Official comment (g) to UCC section 2A-103 plainly states, 'this article creates no special rule where the lessor is an affiliate of the supplier; whether the transaction qualifies as a finance lease will be determined by the facts of each case.'” See also AT&T Credit Corp. v. Transglobal Telecom Alliance, Inc ., 966 F.Supp. 299, 303-04 (D.N.J. 1997). The “facts of each case” inquiry generally means litigation and the costs associated therewith. To avoid this, it is prudent in these circumstances to bargain for a finance lease by agreement.

Also, many companies that regularly engage in lease transactions also typically build an inventory of residual equipment relating to expired or defaulted leases. Upon the re-lease of this equipment, the issue of lessor as supplier may be difficult to overcome. The facts of the matter will generally control, and the lessor will be left with the burden of proving that it did not select, manufacture or “supply” the equipment. In addition to disclaiming any warranties as to the subject equipment, such lessors should make every effort to bargain for a provision in the lease specifying the parties' express agreement that the lease is a finance lease as defined in Article 2A of the UCC to avoid this situation.

To summarize, Article 2A of the UCC provides valuable protections to the finance lessor that can be easily secured by a bargained-for agreement contained within the lease. This is accomplished by simply specifying that the lease is a finance lease for purposes of Article 2A. Absent such a provision, lessors may be exposed to claims for breach of implied warranties where the equipment is unsuitable or defective. They may also lose the lessor's right to payment under the statutory “hell or high water clause” under UCC '2A-407. Furthermore, when faced with situations where the finance lessor is affiliated with the manufacturer or supplier or where an inventory of equipment is created for re-letting, incorporation of such a provision will, in most instances, avoid the need for fact-intensive litigation on whether a lease constitutes a finance lease.