Developments, Risks and Advanced Structures in the Lease Syndication Market

Many practitioners agree that the better way to view the question of “recourse” in the context of lease syndications is as risk allocation. In a full recourse transaction, the originator retains the lion's share of risk. In a non-recourse transaction, all of the credit risk is allocated to the funder, and most other risks are allocated to the funder as well.

Historically, syndicated transactions have often been distinguishable from brokered arrangements in that an originator in a syndicated transaction made representations only as to matters within its own control: that it has executed all documents, has not previously assigned the lease, is not in default under the lease, etc. In a brokered transaction, the representations often extended to matters that may be beyond the originator's control, such as: due execution by the lessee, the absence of fraud, validity and enforceability of all documents, etc.

The distinction between these two types of transactions is sometimes difficult to justify. Brokered transactions are traditionally smaller and may need to be completed with faster turnaround. For this reason, funders may be less able to perform due diligence themselves. Originators in syndicated transactions are often funders in their own right and generally well-established entities whose policies and
procedures are respected and who have a strong bargaining position.

Changes in market dynamics and changes in the negotiating strength of the parties as well as the risks parties are willing to take may blur or change the line between syndication and brokered transactions and cause the parties to consider carefully the appropriate allocations of risk.

The primary risks involved in these transactions include the credit risk, the collateral risk, and the transactional risk. The credit risk is simply risk as to the ability of the lessee and its guarantors or co-obligors to perform. The collateral risk involves not only the continuing value of the leased equipment but also its potential for causing damage to third parties resulting in lessor liability, environmental concerns, and its eligibility for tax and other benefits of ownership. The transactional risk includes risk of fraud, improper or unenforceable documentation, improper signatures and forgery and other procedural issues that, if not covered by originator representations and warranties, are assumed by the funder in a non-recourse transaction.

The allocation of risk may be accomplished in several ways. Full recourse or limited recourse transactions, such as UNL structures, leave a portion of the risk with the originator. The inclusion of originator representations and warranties leaves transactional or other risks with the originator to the extent covered by the representations.

Representations and Warranties

It is beyond the scope of this article to include an in-depth analysis of all the various representations and warranties that may be requested or required of an originator. Instead, the authors recommend that the parties consider the purposes of the representations as a whole and whether such representations should be qualified as to the originator's knowledge. The following list includes examples of some representations that have been required or requested by funders:

• Representations within originator's control, such as that the originator has duly authorized, executed, and delivered all of the documents assigned by it, that there are no other agreements to which the originator is a party, that the copy of the lease delivered to the funder is the sole original chattel paper counterpart, that the originator has not received any deposit or prepaid rent, that the originator has not previously sold or assigned the lease to a third party, and that the originator is not in default of any of its obligations to the lessee, vendor, or another person.
• Representations as to the equipment, such as the equipment not having suffered a casualty, that the originator has good title or whatever title was received from the vendor, that the equipment was purchased from the vendor and not from a casual seller or the lessee, and that the equipment has been delivered to and accepted by the lessee.
• Representations as to the documentation, such as that all documents have been duly authorized, executed and delivered by the lessee, that all copies of lease documents delivered to the funder are true, correct and complete, that each of the lease documents is valid and enforceable against the lessee, that the lease is free of defenses, counterclaims or rights of setoff, and that all taxes relating to the originator's purchase or lease of the equipment have been paid or accounted for.
• Representations as to the validity of the transaction, such as that no fraud or forgery exists, that the equipment has been delivered to the lessee at the specified address, that no false or misleading information, such as financial statements, have been delivered to the funder. Many originators or sellers are hesitant to make representations as to these matters since they are out of their control.

Recognizing that the purpose of these representations is largely to allocate risk in the transaction, the parties should consider the extent to which the originator should assume or retain risk for matters beyond its knowledge or control and the extent to which the funder should assume such risk or can find an alternative means of protecting itself. For example, the representation that the equipment has been delivered and accepted is typically addressed by the delivery of a duly executed acceptance certificate or other language in the lease documents.

In some cases, risk allocation is accomplished by qualifying the originator's representations by its “knowledge.” Care must be taken in drafting these provisions to ensure that knowledge is properly defined as involving the appropriate originator's employees. In addition, recent disputes have made it clear that such language will be carefully scrutinized or interpreted differently than the parties' intentions. See Hitachi Credit America Corp. v. Signet Bank and Signet Leasing & Financial Corp., 166 F.3d 614 (4th Cir. 1999). Therefore, originators may seek to qualify knowledge representations to its “actual knowledge” or “without inquiry” in order to reduce the risk of an unexpected breach.

The parties should also consider factors that may affect how risk should be allocated. These include size of the transaction and the opportunity for the funder to conduct any form of due diligence, the familiarity of each of the parties with the lessee, the equipment type and the vendor, whether the transaction is a single financing or is sold as part of a portfolio of leases, and whether the transaction is sold with or without notice to the lessee.

The last of these, lessee notice and acknowledgement, is particularly important in light of the preference of many originators to sell or discount “blind” assignments. In most one-off assignments, the lessee is requested to execute an acknowledgement of notice of the assignment. The acknowledgement often confirms, among other things, the execution of the lease documents, the existence and acceptability of the equipment, that the lessee has no defenses or rights of set-off, the outstanding payments due, and that the lessee has not previously received notice of assignment of the transaction. These acknowledgements may actually give the funder a separate cause of action against the lessee should the acknowledgement prove untrue, as well as giving comfort.

Where a transaction is assigned on a blind basis, however, the lessee is not notified of the assignment, and the funder receives no additional assurances from the lessee at the time of the assignment and must rely solely on the originator's representations and the documentation as presented. In addition, the possibility exists that the lessee may not take kindly to the assignment, such as where the lessee believes it has a relationship with the originator or has received assurances (not contained in the lease documents) that the transaction would not be assigned or that the originator would always service the transaction. While both UCC '2A-303 and ”9-407/408 permit assignments without lessee notice and even in the face of contractual non-assignment clauses, there has been little if any judicial consideration of these provisions and claims by a lessee or borrower that it has been damaged by the assignment.

Cross-Collateralization and Cross-Defaults

Although uncommon in true syndications, some participations, outright assignments, and discounting structures involve hotly contested issues regarding the effect of an originator's breach of representations and warranties or actual fraud. Should an entire portfolio of leases assigned at varying terms be impacted by an originator default on a single transaction? Some practitioners distinguish between isolated warranty breaches and more serious defaults that may indicate a weakness in the originator's entire portfolio.

Consequence of Breach

Without additional provisions, breach of a representation constitutes a contractual default giving rise to damages incurred by the funder as a result of the originator's breach. Where a representation is knowingly and deliberately violated (or, in some jurisdictions, negligently made) an action in fraud may be successful. As the elements of an action in fraud may be difficult to prove, and the rewards of an action for simple breach are uncertain, parties may create specific remedies through one of two types of arrangements.

Some assignments may provide that a breach of representation and warranty requires the originator to repurchase the assigned lease or pay off the note it issues for a discounted lease. Such repurchase arrangements can create accounting difficulties where “true sale” treatment is required by the originator. This is particularly true in the case of vendor captives. Moreover, a repurchase can be a draconian remedy as the discounted present value of the rents, after payment has been made to the vendor, far exceeds the originator's potential profit. Originators may also view repurchase obligations as draconian since any breach regardless of its materiality or magnitude could force an originator to repurchase the transaction. Where a repurchase is desired, the parties must carefully craft the arrangement to ensure that any remaining value in the lease passes to the originator. The determination of the discount factor to use is a potential pitfall for the originator if it is calculated to preserve the funder's potential profit at the expense of the originator.

Repurchase arrangements can also be used to address the credit risk, such as a first or first and second payment default repurchase requirement.

One major shortcoming for funders relying on repurchase arrangements is that repurchase may be the only recovery that the funder is likely to receive. Many repurchase arrangements state that the repurchase is the sole remedy of the funder, and this can leave the funder exposed where it suffers additional damages. Funders may be subject to third-party liability where, for example, the originator did not have good title to the equipment, has not paid the vendor, has not made provisions for the payment of taxes, or has otherwise breached representations or assumptions of the parties.

In addition, funders may expend considerable sums on enforcement actions prior to demanding repurchase, including the cost of repossession and refurbishment of equipment and legal costs. None of these are covered where the normal repurchase is the funder's exclusive remedy.

In order to give the funder additional protection, the parties may agree to an indemnification provision. Indemnifications do not generally involve the true sale issues that plague repurchase provisions (unless they provide substantial recourse to the originator or cover risks not customarily borne by an originator). The parties must carefully draft any indemnification provision so that it is consistent with the risks they are willing to accept or expect to be compensated for. In addition, the drafter may need to consider causation factors and what triggers the indemnification obligation. Other issues to be addressed in drafting and negotiating indemnity provisions include whether a “cap” or “floor” is appropriate to avoid the originator being obligated to pay more than the cost of the transaction, or cover minor expenses and at what point the originator should have the right to notice and the opportunity to take control of any legal action covered by the indemnity.

While indemnities have become increasingly preferred over repurchase obligations, draftsmen must be careful to ensure that the funder is fully covered. Traditional indemnification language focuses on third-party claims rather than compensation for lost value. Absent careful drafting, the funder may have a difficult time proving damages caused by a more serious misstatement that in fact goes to the value of the assigned transaction, such as incorrect payment histories or the existence of an undisclosed purchase or termination option granted to the lessee. The effect of a breach of each representation should be considered, along with limitation or deletion of boilerplate language waiving consequential damages and the inclusion of specific references to diminution of value.

Shortfalls

Funders should also make sure that the amounts payable by the lessee under the lease are at all times sufficient to cover in full the funder's investment and anticipated return on the lease. In addition to routine rent payments, funders must review the termination values, stipulated loss values, early purchase option amounts, early termination payments, and other amounts payable by the lessee under the lease and confirm that such amounts would make the funder whole at the time such payments are made. If the amount payable by the lessee may be less than the funder's net book investment, funders may request that the originator be responsible for any shortfall. This is often referred to as a “clawback” and is often calculated as an amount equal to the difference between the funder's then net book investment less the amount payable by the lessee under the terms of the lease. The parties should consider whether to specify the events that would give rise to a clawback and whether there should be any caps or limitations with respect to the clawback. Sometimes an originator can eliminate the need for a clawback by agreeing that the funder will pay the originator's fee in whole or in part by means of a “fee scrape” from the periodic rent payments. This alternative reduces the funder's original purchase price and therefore its net book investment.

Allocation of Taxes, Costs And Expenses

As is the case with so many other issues addressed in the syndication documents, the question of who is to bear the exposure to certain costs and expenses incurred in connection with the transaction is a matter of risk allocation. There are three general areas which must be considered in this regard, and the first is taxes.

We need to address sales and/or use taxes, both with respect to the acquisition of the leased equipment and also with respect to the rentals previously having been paid or becoming payable after the effective date of the assignment. Typically, the originator would be responsible for sales or use taxes: 1) in connection with the acquisition of the equipment (to the extent the equipment has already been acquired by the originator), and 2) for rents that were paid prior to the effective date of the assignment. The funder assumes responsibility for any sales or use taxes relating to the period from and after the effectiveness of the assignment. The parties can agree to cover these costs through mutual indemnities, reimbursement, or acknowledgements of rights.

Another tax concern to be addressed is the possibility that there could be transfer charges, expenses, or taxes in connection with the assignment itself. That is, is there a sales tax imposed with respect to the transfer of legal title to the leased equipment from the originator to the funder; or does the state impose a tax on the transfer of the interest of the lessor? At one time, North Carolina imposed just such a tax on the transfer of intangibles. That tax no longer is in effect.

Most states permit a purchase for resale/re-lease exemption, but it is problematic if one is dealing with an “upfront” tax state, such as New Jersey or Illinois, where the tax for the full lease term has already been paid.

In addition to transfer taxes, there may also be excise taxes or transfer expenses in connection with the re-titling of certificate of title motor vehicles.

The parties must determine which party should be responsible for any such transfer taxes or expenses and the impact, if any, such taxes or expenses have on the consideration to be paid in connection with the assignment. While many major players in the syndication market have imposed such risk on the funder, it is imperative that the parties fully understand the sales tax laws relating to each transaction and structure.

Another exposure typically addressed by the use of indemnification is breaches by one of the parties. If it turns out that one of the representations made by the originator is incorrect, then the funder should be entitled to indemnification for any damages actually incurred by it.

Servicing

Many syndication transactions involve the creation of a servicing or fiscal agency relationship, pursuant to which the originator or seller of the participation interest will continue to service the transaction on behalf of the other party. To avoid issues after the sale, it is important to carefully document: 1) the specific responsibilities being assumed by the fiscal agent; 2) the time frames within which those responsibilities are to be performed; and 3) the standard of care to be satisfied in the performance of those obligations.

Almost all fiscal agencies involve the billing and collecting of the rents. The sensitive issues are: the time frame within which the collected rents are to be remitted; the responsibility of the fiscal agent for payment of interest if the rents are received but not remitted in a timely fashion; and whether the parties intend to utilize a “perfect pay” arrangement.

Under a “perfect pay” arrangement, the fiscal agent agrees to remit amounts becoming due on or by a certain date, regardless of whether those payments have actually been received by the fiscal agent. Essentially, the fiscal agent is making an advance to the funder with respect to any payments that it has not yet then received. A fiscal agent is willing to do this on the assumption that it is entitled to recover these servicer advances either by receiving payment from the lessee or, after a certain period of non-payment has occurred, from the funder itself. Other issues to be addressed are: 1) whether the servicer advances are mandatory or discretionary; 2) whether the fiscal agent must notify the funder each time it makes a servicer advance; and 3) who is entitled to the late charges associated with an overdue rental payment as to which a servicer advance has been made. Logically, the fiscal agent should be entitled to recover that late charge if it has made a servicer advance.

It is not as customary for the fiscal agent automatically to assume responsibility with regard to all of the different types of taxes becoming due and payable with respect to the lease transaction. Generally, a fiscal agent may agree to collect and remit the sales or use tax, but it may be more problematic for a fiscal agent to agree to report and pay personal property taxes. In some transactions, the responsibility for reporting and paying property taxes is allocated to the lessee, and all that the originator/fiscal agent must do is to confirm that the lessee is performing its obligation to remit those taxes. However, where the lessee is not obligated or permitted to file the personal property tax returns and pay the personal property taxes, such responsibility falls upon either the fiscal agent or the funder. Except in the context of small-ticket transactions or blind assignments, it is becoming much more common today for the fiscal agent to avoid any responsibility with respect to those taxes, so the funder is obligated to prepare and file the returns and pay the personal property taxes that it collects from the lessee. In the event the funder assumes such responsibility, then the fiscal agent should agree to remit to the funder any personal property taxes that it receives from the lessee, but it has no obligation to advance those funds.

Most fiscal agency agreements acknowledge that, if the lease transaction goes into default, the funder wants to be in a position to enforce the transaction directly and the fiscal agency is or can be terminated upon the occurrence of the default. However, in some transactions, the fiscal agent may have more experience in enforcing lease transactions or in disposing of the type of equipment involved in the transaction, and the parties may impose that burden on the fiscal agent. In that context, one of the important questions is whether any discretion is left to the fiscal agent or whether it can act solely in response to instructions received or consents provided by the funder. Also, if the fiscal agent is permitted to incur expenses in connection with enforcement of a transaction, it is customary to have a cap on those expenses that may be incurred without the express consent of the funder, and the funder is also obligated to reimburse the fiscal agent for the permitted expenses that are incurred.

The standard of care of the fiscal agent is also a hot button. There are any number of standards that may be thrown out for consideration: 1) customary industry practices; 2) adherence by the fiscal agent to its own policies and procedures in connection with transactions retained for its own account; and 3) gross negligence/willful misconduct.

Since many originators will service syndicated accounts in accordance with their own policies and procedures, it is important that the funder understands how the originator services its own accounts. For instance, we have seen differences between the way some originators follow-up for insurance certificates and financial statements and conduct UCC searches and file UCC financing statements and what some funders expect. How the parties come down on this issue is often a matter of their bargaining power.

Finally, the parties must consider the circumstances under which servicing may be terminated, including bankruptcy, willful breach, or culpable conduct by the fiscal agent, “innocent” breach of representations or simple negligence, and general performance of the portfolio. The varying interests of originators and funders in who services may require practical consideration of each transaction.

Blind Assignments

One additional option created by a fiscal agency, at least where the transaction is closed by the originator before assignment to the funder, is the “blind assignment.” In these transactions, the lessee is not notified of the assignment and continues to make payments to the originator, often to a lockbox or other secured account.

Blind assignments are popular with originators who insist on maintaining their relationship with the lessee and/or vendor and may facilitate better lessee performance. Among other things, the funder takes the risk that the originator may misuse funds, cease to do business, or take action in violation of the terms of the assignment, such as accepting a payout or altering the terms of the lease without the consent of the funder.

One common misconception is that the use of a lockbox is a panacea for the funder's exposure. Many lockbox arrangements permit the originator to “sweep” the account monthly so that it can deduct taxes and its own fees, if any, before remitting payments to the funder. In these arrangements, the funder is at least exposed to one or more misdirections of the assigned rentals and may find itself in a difficult position if the originator files for Chapter 11 protection before its right to service the lockbox is terminated by the funder.

Another exposure often overlooked by funders is that if the originator closes its operations or becomes uncooperative, the lessees will not begin remitting payments or other performance to the funder. Many funders wisely require execution by the originator of notices addressed to each lessee in advance, to be held in escrow by the funder until originator default or other agreed circumstances.

Despite the apparent convenience of having the originator service the account, a blind assignment requires even more diligence by the funder than other servicing arrangements. Funders should anticipate a potential delay or disruption in payments if the lessee is notified of the change of ownership late into the lease term and failure to require and review frequent reports as to defaults, lapses in insurance coverage, equipment movement, disputes and other lessee issues can leave the funder with potential holes in its portfolio.

Finally, before agreeing to accept a blind assignment, the funder should carefully consider why it is proposed. Despite the pro-assignment provisions of UCC ”2A-303 and 9-407, language prohibiting or restricting assignment by the originator should be taken seriously, as should the possibility that the lessee expects additional performance from the originator. Enforceable or not, addressing these concerns early and dealing with a reputable originator can save headaches and dollars later.

Remarketing and Residual Support

With respect to certain syndications where the originator has some special or strong expertise in equipment remarketing and residual valuations or the funder has less experience or comfort with equipment remarketing and residual valuations, the originator may agree to remarket or provide residual support with respect to the leased equipment for the funder. Where an originator “supports” or guarantees the residual, the originator agrees to pay the funder an amount equal to the difference (if any) or a portion of the difference between some agreed-upon residual and the actual value or net proceeds of a disposition of the equipment. The most common method of remarketing or residual support offered by originators is where the originator agrees to remarket or provide residual support in the event the lessee returns the equipment at the expiration of the term in the condition required by the lease. However, originators can also agree to provide remarketing services and residual support upon early termination events during the term or the return of the equipment in the event of a default.

While this arrangement is commonly referred to as a “residual guaranty” or “residual support,” these arrangements are often documented in the form of a remarketing agreement. The originator, who is agreeing to “support” or guaranty a certain residual value, will want to handle the remarketing itself. The parties should carefully document how much authority the originator will have with respect to the remarketing services and what types of events require the prior written consent of the funder. For instance, it is common that no disposition of the equipment can occur without the prior consent of the funder. However, an originator may argue that it should have the right to sell the equipment without the prior written consent of the funder as long as the originator is able to sell the equipment for an amount where the net proceeds are equal to or greater than the funder's assumed residual. The parties should also consider addressing the types of remarketing permitted to the originator (i.e., sale, lease, scrap, month-to-month rent, etc.), whether or not the originator should be the exclusive remarketer, and whether the originator has a final date to complete its remarketing efforts before the funder can begin remarketing. Funders should make sure that any taxes and expenses are paid first before the proceeds are applied against its assumed residual, and oftentimes funders will want to limit the amount of remarketing expenses an originator can incur without obtaining the funder's consent. Finally, an often-difficult point to negotiate will be what happens if the equipment is not returned in the condition required by the lease? In such event, should the originator have no further obligation to remarket or support the residual or should the amount of its support just be reduced by the harm to the value of the equipment?

Originators will usually be compensated for providing remarketing or residual support by either receiving a set fee agreed to by the parties and/or by sharing in any net proceeds in excess of the assumed residual. While the fee arrangements can be structured in myriad ways, oftentimes an originator will be entitled to receive from any “upside” the amount of the residual “downside” it supported and perhaps some percentage share of any excess proceeds above that. Whatever the fee arrangement is, it is important that the parties consult their tax and accounting advisers to make sure that the amount of support and the amount of sharing are not inconsistent with the way the parties want to treat the transaction from both a tax and an accounting standpoint. For instance, under both FAS 140 and FAS 13, an originator may not be able to recognize sale treatment if the amount of the residual support it provides is in excess of 10% of the fair value of the equipment in an operating lease or 10% of the residual value of the equipment in a capital lease.

Securities Laws Issues

Many practitioners in the equipment finance industry believe that the syndication of an equipment lease transaction is either not impacted by the securities laws or just impacted on a peripheral basis. Even though the definition of a “security” under the Securities Act of 1933 does not specifically refer to a lease, the definition of a “security” does expressly include any note, evidence of indebtedness, participation, investment contract and interest or instrument commonly known as a security. Though the authors are not aware of any specific case law directly on point, it is possible that non-true leases, participation interests sold in leases, or certain syndication structures that contemplate the originator sharing in proceeds or offering certain kind of services or support could affect the way one analyzes the characterization of a syndication of an equipment lease under the securities laws. If one determines that a syndication of an equipment lease or a pool of leases should be treated as the sale of a security, then such sale must be registered with the applicable securities agencies unless the syndication qualifies under an exemption from registration under the securities laws. The most common exemptions that would be available to the parties in an equipment lease syndication would be under '4(2) of the Securities Act of 1933, the safe harbor for private offerings under Rule 506 of Regulation D or the so-called Rule 4(1') exemption. These “private placement” exemptions cover private offerings to sophisticated investors or a limited number of sophisticated investors and generally impose restrictions on transferability and resale.

Conclusion

In this article, the authors have addressed some common issues in the lease syndication market. It is important that these issues be addressed on a deal-by-deal basis. The appropriate treatment of certain issues will vary depending upon the specifics of the particular transaction. A general approach to an issue that is appropriate in one transaction may not satisfactorily address the issue in another transaction. Also, as the lease syndication market continues to grow, we expect more variations on these structures will develop, and the approach to these issues will continue to evolve.

Mark D. Kohler is General Counsel Syndications at GE Capital, Americas. He may be reached at [email protected]. Barry S. Marks, a member of this newsletter's Board of Editors, is a founding shareholder of Marks & Weinberg, P.C. Marks may be reached at [email protected] or through the firm's Web site www.leaselawyer.com. Alan J. Mogol, a member of this newsletter's Board of Editors, is a principal of Ober, Kaler, Grimes & Shriver in Baltimore. He may be reached at [email protected].

Part One of this article provided an overview of the three common structures typically used in connection with syndication of equipment finance transactions, as well as addressed UCC issues and syndication of motor vehicle leases. This second installment discusses types of recourse to the seller; allocation of taxes, costs, and expenses; servicing; remarketing and residual support; and securities laws issues.

Types of Recourse to Seller

Risk Allocation

Many practitioners agree that the better way to view the question of “recourse” in the context of lease syndications is as risk allocation. In a full recourse transaction, the originator retains the lion's share of risk. In a non-recourse transaction, all of the credit risk is allocated to the funder, and most other risks are allocated to the funder as well.

Historically, syndicated transactions have often been distinguishable from brokered arrangements in that an originator in a syndicated transaction made representations only as to matters within its own control: that it has executed all documents, has not previously assigned the lease, is not in default under the lease, etc. In a brokered transaction, the representations often extended to matters that may be beyond the originator's control, such as: due execution by the lessee, the absence of fraud, validity and enforceability of all documents, etc.

The distinction between these two types of transactions is sometimes difficult to justify. Brokered transactions are traditionally smaller and may need to be completed with faster turnaround. For this reason, funders may be less able to perform due diligence themselves. Originators in syndicated transactions are often funders in their own right and generally well-established entities whose policies and
procedures are respected and who have a strong bargaining position.

Changes in market dynamics and changes in the negotiating strength of the parties as well as the risks parties are willing to take may blur or change the line between syndication and brokered transactions and cause the parties to consider carefully the appropriate allocations of risk.

The primary risks involved in these transactions include the credit risk, the collateral risk, and the transactional risk. The credit risk is simply risk as to the ability of the lessee and its guarantors or co-obligors to perform. The collateral risk involves not only the continuing value of the leased equipment but also its potential for causing damage to third parties resulting in lessor liability, environmental concerns, and its eligibility for tax and other benefits of ownership. The transactional risk includes risk of fraud, improper or unenforceable documentation, improper signatures and forgery and other procedural issues that, if not covered by originator representations and warranties, are assumed by the funder in a non-recourse transaction.

The allocation of risk may be accomplished in several ways. Full recourse or limited recourse transactions, such as UNL structures, leave a portion of the risk with the originator. The inclusion of originator representations and warranties leaves transactional or other risks with the originator to the extent covered by the representations.

Representations and Warranties

It is beyond the scope of this article to include an in-depth analysis of all the various representations and warranties that may be requested or required of an originator. Instead, the authors recommend that the parties consider the purposes of the representations as a whole and whether such representations should be qualified as to the originator's knowledge. The following list includes examples of some representations that have been required or requested by funders:

• Representations within originator's control, such as that the originator has duly authorized, executed, and delivered all of the documents assigned by it, that there are no other agreements to which the originator is a party, that the copy of the lease delivered to the funder is the sole original chattel paper counterpart, that the originator has not received any deposit or prepaid rent, that the originator has not previously sold or assigned the lease to a third party, and that the originator is not in default of any of its obligations to the lessee, vendor, or another person.
• Representations as to the equipment, such as the equipment not having suffered a casualty, that the originator has good title or whatever title was received from the vendor, that the equipment was purchased from the vendor and not from a casual seller or the lessee, and that the equipment has been delivered to and accepted by the lessee.
• Representations as to the documentation, such as that all documents have been duly authorized, executed and delivered by the lessee, that all copies of lease documents delivered to the funder are true, correct and complete, that each of the lease documents is valid and enforceable against the lessee, that the lease is free of defenses, counterclaims or rights of setoff, and that all taxes relating to the originator's purchase or lease of the equipment have been paid or accounted for.
• Representations as to the validity of the transaction, such as that no fraud or forgery exists, that the equipment has been delivered to the lessee at the specified address, that no false or misleading information, such as financial statements, have been delivered to the funder. Many originators or sellers are hesitant to make representations as to these matters since they are out of their control.

Recognizing that the purpose of these representations is largely to allocate risk in the transaction, the parties should consider the extent to which the originator should assume or retain risk for matters beyond its knowledge or control and the extent to which the funder should assume such risk or can find an alternative means of protecting itself. For example, the representation that the equipment has been delivered and accepted is typically addressed by the delivery of a duly executed acceptance certificate or other language in the lease documents.

In some cases, risk allocation is accomplished by qualifying the originator's representations by its “knowledge.” Care must be taken in drafting these provisions to ensure that knowledge is properly defined as involving the appropriate originator's employees. In addition, recent disputes have made it clear that such language will be carefully scrutinized or interpreted differently than the parties' intentions. See Hitachi Credit America Corp. v. Signet Bank and Signet Leasing & Financial Corp., 166 F.3d 614 (4th Cir. 1999). Therefore, originators may seek to qualify knowledge representations to its “actual knowledge” or “without inquiry” in order to reduce the risk of an unexpected breach.

The parties should also consider factors that may affect how risk should be allocated. These include size of the transaction and the opportunity for the funder to conduct any form of due diligence, the familiarity of each of the parties with the lessee, the equipment type and the vendor, whether the transaction is a single financing or is sold as part of a portfolio of leases, and whether the transaction is sold with or without notice to the lessee.

The last of these, lessee notice and acknowledgement, is particularly important in light of the preference of many originators to sell or discount “blind” assignments. In most one-off assignments, the lessee is requested to execute an acknowledgement of notice of the assignment. The acknowledgement often confirms, among other things, the execution of the lease documents, the existence and acceptability of the equipment, that the lessee has no defenses or rights of set-off, the outstanding payments due, and that the lessee has not previously received notice of assignment of the transaction. These acknowledgements may actually give the funder a separate cause of action against the lessee should the acknowledgement prove untrue, as well as giving comfort.

Where a transaction is assigned on a blind basis, however, the lessee is not notified of the assignment, and the funder receives no additional assurances from the lessee at the time of the assignment and must rely solely on the originator's representations and the documentation as presented. In addition, the possibility exists that the lessee may not take kindly to the assignment, such as where the lessee believes it has a relationship with the originator or has received assurances (not contained in the lease documents) that the transaction would not be assigned or that the originator would always service the transaction. While both UCC '2A-303 and ”9-407/408 permit assignments without lessee notice and even in the face of contractual non-assignment clauses, there has been little if any judicial consideration of these provisions and claims by a lessee or borrower that it has been damaged by the assignment.

Cross-Collateralization and Cross-Defaults

Although uncommon in true syndications, some participations, outright assignments, and discounting structures involve hotly contested issues regarding the effect of an originator's breach of representations and warranties or actual fraud. Should an entire portfolio of leases assigned at varying terms be impacted by an originator default on a single transaction? Some practitioners distinguish between isolated warranty breaches and more serious defaults that may indicate a weakness in the originator's entire portfolio.

Consequence of Breach

Without additional provisions, breach of a representation constitutes a contractual default giving rise to damages incurred by the funder as a result of the originator's breach. Where a representation is knowingly and deliberately violated (or, in some jurisdictions, negligently made) an action in fraud may be successful. As the elements of an action in fraud may be difficult to prove, and the rewards of an action for simple breach are uncertain, parties may create specific remedies through one of two types of arrangements.

Some assignments may provide that a breach of representation and warranty requires the originator to repurchase the assigned lease or pay off the note it issues for a discounted lease. Such repurchase arrangements can create accounting difficulties where “true sale” treatment is required by the originator. This is particularly true in the case of vendor captives. Moreover, a repurchase can be a draconian remedy as the discounted present value of the rents, after payment has been made to the vendor, far exceeds the originator's potential profit. Originators may also view repurchase obligations as draconian since any breach regardless of its materiality or magnitude could force an originator to repurchase the transaction. Where a repurchase is desired, the parties must carefully craft the arrangement to ensure that any remaining value in the lease passes to the originator. The determination of the discount factor to use is a potential pitfall for the originator if it is calculated to preserve the funder's potential profit at the expense of the originator.

Repurchase arrangements can also be used to address the credit risk, such as a first or first and second payment default repurchase requirement.

One major shortcoming for funders relying on repurchase arrangements is that repurchase may be the only recovery that the funder is likely to receive. Many repurchase arrangements state that the repurchase is the sole remedy of the funder, and this can leave the funder exposed where it suffers additional damages. Funders may be subject to third-party liability where, for example, the originator did not have good title to the equipment, has not paid the vendor, has not made provisions for the payment of taxes, or has otherwise breached representations or assumptions of the parties.

In addition, funders may expend considerable sums on enforcement actions prior to demanding repurchase, including the cost of repossession and refurbishment of equipment and legal costs. None of these are covered where the normal repurchase is the funder's exclusive remedy.

In order to give the funder additional protection, the parties may agree to an indemnification provision. Indemnifications do not generally involve the true sale issues that plague repurchase provisions (unless they provide substantial recourse to the originator or cover risks not customarily borne by an originator). The parties must carefully draft any indemnification provision so that it is consistent with the risks they are willing to accept or expect to be compensated for. In addition, the drafter may need to consider causation factors and what triggers the indemnification obligation. Other issues to be addressed in drafting and negotiating indemnity provisions include whether a “cap” or “floor” is appropriate to avoid the originator being obligated to pay more than the cost of the transaction, or cover minor expenses and at what point the originator should have the right to notice and the opportunity to take control of any legal action covered by the indemnity.

While indemnities have become increasingly preferred over repurchase obligations, draftsmen must be careful to ensure that the funder is fully covered. Traditional indemnification language focuses on third-party claims rather than compensation for lost value. Absent careful drafting, the funder may have a difficult time proving damages caused by a more serious misstatement that in fact goes to the value of the assigned transaction, such as incorrect payment histories or the existence of an undisclosed purchase or termination option granted to the lessee. The effect of a breach of each representation should be considered, along with limitation or deletion of boilerplate language waiving consequential damages and the inclusion of specific references to diminution of value.

Shortfalls

Funders should also make sure that the amounts payable by the lessee under the lease are at all times sufficient to cover in full the funder's investment and anticipated return on the lease. In addition to routine rent payments, funders must review the termination values, stipulated loss values, early purchase option amounts, early termination payments, and other amounts payable by the lessee under the lease and confirm that such amounts would make the funder whole at the time such payments are made. If the amount payable by the lessee may be less than the funder's net book investment, funders may request that the originator be responsible for any shortfall. This is often referred to as a “clawback” and is often calculated as an amount equal to the difference between the funder's then net book investment less the amount payable by the lessee under the terms of the lease. The parties should consider whether to specify the events that would give rise to a clawback and whether there should be any caps or limitations with respect to the clawback. Sometimes an originator can eliminate the need for a clawback by agreeing that the funder will pay the originator's fee in whole or in part by means of a “fee scrape” from the periodic rent payments. This alternative reduces the funder's original purchase price and therefore its net book investment.

Allocation of Taxes, Costs And Expenses

As is the case with so many other issues addressed in the syndication documents, the question of who is to bear the exposure to certain costs and expenses incurred in connection with the transaction is a matter of risk allocation. There are three general areas which must be considered in this regard, and the first is taxes.

We need to address sales and/or use taxes, both with respect to the acquisition of the leased equipment and also with respect to the rentals previously having been paid or becoming payable after the effective date of the assignment. Typically, the originator would be responsible for sales or use taxes: 1) in connection with the acquisition of the equipment (to the extent the equipment has already been acquired by the originator), and 2) for rents that were paid prior to the effective date of the assignment. The funder assumes responsibility for any sales or use taxes relating to the period from and after the effectiveness of the assignment. The parties can agree to cover these costs through mutual indemnities, reimbursement, or acknowledgements of rights.

Another tax concern to be addressed is the possibility that there could be transfer charges, expenses, or taxes in connection with the assignment itself. That is, is there a sales tax imposed with respect to the transfer of legal title to the leased equipment from the originator to the funder; or does the state impose a tax on the transfer of the interest of the lessor? At one time, North Carolina imposed just such a tax on the transfer of intangibles. That tax no longer is in effect.

Most states permit a purchase for resale/re-lease exemption, but it is problematic if one is dealing with an “upfront” tax state, such as New Jersey or Illinois, where the tax for the full lease term has already been paid.

In addition to transfer taxes, there may also be excise taxes or transfer expenses in connection with the re-titling of certificate of title motor vehicles.

The parties must determine which party should be responsible for any such transfer taxes or expenses and the impact, if any, such taxes or expenses have on the consideration to be paid in connection with the assignment. While many major players in the syndication market have imposed such risk on the funder, it is imperative that the parties fully understand the sales tax laws relating to each transaction and structure.

Another exposure typically addressed by the use of indemnification is breaches by one of the parties. If it turns out that one of the representations made by the originator is incorrect, then the funder should be entitled to indemnification for any damages actually incurred by it.

Servicing

Many syndication transactions involve the creation of a servicing or fiscal agency relationship, pursuant to which the originator or seller of the participation interest will continue to service the transaction on behalf of the other party. To avoid issues after the sale, it is important to carefully document: 1) the specific responsibilities being assumed by the fiscal agent; 2) the time frames within which those responsibilities are to be performed; and 3) the standard of care to be satisfied in the performance of those obligations.

Almost all fiscal agencies involve the billing and collecting of the rents. The sensitive issues are: the time frame within which the collected rents are to be remitted; the responsibility of the fiscal agent for payment of interest if the rents are received but not remitted in a timely fashion; and whether the parties intend to utilize a “perfect pay” arrangement.

Under a “perfect pay” arrangement, the fiscal agent agrees to remit amounts becoming due on or by a certain date, regardless of whether those payments have actually been received by the fiscal agent. Essentially, the fiscal agent is making an advance to the funder with respect to any payments that it has not yet then received. A fiscal agent is willing to do this on the assumption that it is entitled to recover these servicer advances either by receiving payment from the lessee or, after a certain period of non-payment has occurred, from the funder itself. Other issues to be addressed are: 1) whether the servicer advances are mandatory or discretionary; 2) whether the fiscal agent must notify the funder each time it makes a servicer advance; and 3) who is entitled to the late charges associated with an overdue rental payment as to which a servicer advance has been made. Logically, the fiscal agent should be entitled to recover that late charge if it has made a servicer advance.

It is not as customary for the fiscal agent automatically to assume responsibility with regard to all of the different types of taxes becoming due and payable with respect to the lease transaction. Generally, a fiscal agent may agree to collect and remit the sales or use tax, but it may be more problematic for a fiscal agent to agree to report and pay personal property taxes. In some transactions, the responsibility for reporting and paying property taxes is allocated to the lessee, and all that the originator/fiscal agent must do is to confirm that the lessee is performing its obligation to remit those taxes. However, where the lessee is not obligated or permitted to file the personal property tax returns and pay the personal property taxes, such responsibility falls upon either the fiscal agent or the funder. Except in the context of small-ticket transactions or blind assignments, it is becoming much more common today for the fiscal agent to avoid any responsibility with respect to those taxes, so the funder is obligated to prepare and file the returns and pay the personal property taxes that it collects from the lessee. In the event the funder assumes such responsibility, then the fiscal agent should agree to remit to the funder any personal property taxes that it receives from the lessee, but it has no obligation to advance those funds.

Most fiscal agency agreements acknowledge that, if the lease transaction goes into default, the funder wants to be in a position to enforce the transaction directly and the fiscal agency is or can be terminated upon the occurrence of the default. However, in some transactions, the fiscal agent may have more experience in enforcing lease transactions or in disposing of the type of equipment involved in the transaction, and the parties may impose that burden on the fiscal agent. In that context, one of the important questions is whether any discretion is left to the fiscal agent or whether it can act solely in response to instructions received or consents provided by the funder. Also, if the fiscal agent is permitted to incur expenses in connection with enforcement of a transaction, it is customary to have a cap on those expenses that may be incurred without the express consent of the funder, and the funder is also obligated to reimburse the fiscal agent for the permitted expenses that are incurred.

The standard of care of the fiscal agent is also a hot button. There are any number of standards that may be thrown out for consideration: 1) customary industry practices; 2) adherence by the fiscal agent to its own policies and procedures in connection with transactions retained for its own account; and 3) gross negligence/willful misconduct.

Since many originators will service syndicated accounts in accordance with their own policies and procedures, it is important that the funder understands how the originator services its own accounts. For instance, we have seen differences between the way some originators follow-up for insurance certificates and financial statements and conduct UCC searches and file UCC financing statements and what some funders expect. How the parties come down on this issue is often a matter of their bargaining power.

Finally, the parties must consider the circumstances under which servicing may be terminated, including bankruptcy, willful breach, or culpable conduct by the fiscal agent, “innocent” breach of representations or simple negligence, and general performance of the portfolio. The varying interests of originators and funders in who services may require practical consideration of each transaction.

Blind Assignments

One additional option created by a fiscal agency, at least where the transaction is closed by the originator before assignment to the funder, is the “blind assignment.” In these transactions, the lessee is not notified of the assignment and continues to make payments to the originator, often to a lockbox or other secured account.

Blind assignments are popular with originators who insist on maintaining their relationship with the lessee and/or vendor and may facilitate better lessee performance. Among other things, the funder takes the risk that the originator may misuse funds, cease to do business, or take action in violation of the terms of the assignment, such as accepting a payout or altering the terms of the lease without the consent of the funder.

One common misconception is that the use of a lockbox is a panacea for the funder's exposure. Many lockbox arrangements permit the originator to “sweep” the account monthly so that it can deduct taxes and its own fees, if any, before remitting payments to the funder. In these arrangements, the funder is at least exposed to one or more misdirections of the assigned rentals and may find itself in a difficult position if the originator files for Chapter 11 protection before its right to service the lockbox is terminated by the funder.

Another exposure often overlooked by funders is that if the originator closes its operations or becomes uncooperative, the lessees will not begin remitting payments or other performance to the funder. Many funders wisely require execution by the originator of notices addressed to each lessee in advance, to be held in escrow by the funder until originator default or other agreed circumstances.

Despite the apparent convenience of having the originator service the account, a blind assignment requires even more diligence by the funder than other servicing arrangements. Funders should anticipate a potential delay or disruption in payments if the lessee is notified of the change of ownership late into the lease term and failure to require and review frequent reports as to defaults, lapses in insurance coverage, equipment movement, disputes and other lessee issues can leave the funder with potential holes in its portfolio.

Finally, before agreeing to accept a blind assignment, the funder should carefully consider why it is proposed. Despite the pro-assignment provisions of UCC ”2A-303 and 9-407, language prohibiting or restricting assignment by the originator should be taken seriously, as should the possibility that the lessee expects additional performance from the originator. Enforceable or not, addressing these concerns early and dealing with a reputable originator can save headaches and dollars later.

Remarketing and Residual Support

With respect to certain syndications where the originator has some special or strong expertise in equipment remarketing and residual valuations or the funder has less experience or comfort with equipment remarketing and residual valuations, the originator may agree to remarket or provide residual support with respect to the leased equipment for the funder. Where an originator “supports” or guarantees the residual, the originator agrees to pay the funder an amount equal to the difference (if any) or a portion of the difference between some agreed-upon residual and the actual value or net proceeds of a disposition of the equipment. The most common method of remarketing or residual support offered by originators is where the originator agrees to remarket or provide residual support in the event the lessee returns the equipment at the expiration of the term in the condition required by the lease. However, originators can also agree to provide remarketing services and residual support upon early termination events during the term or the return of the equipment in the event of a default.

While this arrangement is commonly referred to as a “residual guaranty” or “residual support,” these arrangements are often documented in the form of a remarketing agreement. The originator, who is agreeing to “support” or guaranty a certain residual value, will want to handle the remarketing itself. The parties should carefully document how much authority the originator will have with respect to the remarketing services and what types of events require the prior written consent of the funder. For instance, it is common that no disposition of the equipment can occur without the prior consent of the funder. However, an originator may argue that it should have the right to sell the equipment without the prior written consent of the funder as long as the originator is able to sell the equipment for an amount where the net proceeds are equal to or greater than the funder's assumed residual. The parties should also consider addressing the types of remarketing permitted to the originator (i.e., sale, lease, scrap, month-to-month rent, etc.), whether or not the originator should be the exclusive remarketer, and whether the originator has a final date to complete its remarketing efforts before the funder can begin remarketing. Funders should make sure that any taxes and expenses are paid first before the proceeds are applied against its assumed residual, and oftentimes funders will want to limit the amount of remarketing expenses an originator can incur without obtaining the funder's consent. Finally, an often-difficult point to negotiate will be what happens if the equipment is not returned in the condition required by the lease? In such event, should the originator have no further obligation to remarket or support the residual or should the amount of its support just be reduced by the harm to the value of the equipment?

Originators will usually be compensated for providing remarketing or residual support by either receiving a set fee agreed to by the parties and/or by sharing in any net proceeds in excess of the assumed residual. While the fee arrangements can be structured in myriad ways, oftentimes an originator will be entitled to receive from any “upside” the amount of the residual “downside” it supported and perhaps some percentage share of any excess proceeds above that. Whatever the fee arrangement is, it is important that the parties consult their tax and accounting advisers to make sure that the amount of support and the amount of sharing are not inconsistent with the way the parties want to treat the transaction from both a tax and an accounting standpoint. For instance, under both FAS 140 and FAS 13, an originator may not be able to recognize sale treatment if the amount of the residual support it provides is in excess of 10% of the fair value of the equipment in an operating lease or 10% of the residual value of the equipment in a capital lease.

Securities Laws Issues

Many practitioners in the equipment finance industry believe that the syndication of an equipment lease transaction is either not impacted by the securities laws or just impacted on a peripheral basis. Even though the definition of a “security” under the Securities Act of 1933 does not specifically refer to a lease, the definition of a “security” does expressly include any note, evidence of indebtedness, participation, investment contract and interest or instrument commonly known as a security. Though the authors are not aware of any specific case law directly on point, it is possible that non-true leases, participation interests sold in leases, or certain syndication structures that contemplate the originator sharing in proceeds or offering certain kind of services or support could affect the way one analyzes the characterization of a syndication of an equipment lease under the securities laws. If one determines that a syndication of an equipment lease or a pool of leases should be treated as the sale of a security, then such sale must be registered with the applicable securities agencies unless the syndication qualifies under an exemption from registration under the securities laws. The most common exemptions that would be available to the parties in an equipment lease syndication would be under '4(2) of the Securities Act of 1933, the safe harbor for private offerings under Rule 506 of Regulation D or the so-called Rule 4(1') exemption. These “private placement” exemptions cover private offerings to sophisticated investors or a limited number of sophisticated investors and generally impose restrictions on transferability and resale.

Conclusion

In this article, the authors have addressed some common issues in the lease syndication market. It is important that these issues be addressed on a deal-by-deal basis. The appropriate treatment of certain issues will vary depending upon the specifics of the particular transaction. A general approach to an issue that is appropriate in one transaction may not satisfactorily address the issue in another transaction. Also, as the lease syndication market continues to grow, we expect more variations on these structures will develop, and the approach to these issues will continue to evolve.

Mark D. Kohler is General Counsel Syndications at GE Capital, Americas. He may be reached at [email protected]. Barry S. Marks, a member of this newsletter's Board of Editors, is a founding shareholder of Marks & Weinberg, P.C. Marks may be reached at [email protected] or through the firm's Web site www.leaselawyer.com. Alan J. Mogol, a member of this newsletter's Board of Editors, is a principal of Ober, Kaler, Grimes & Shriver in Baltimore. He may be reached at [email protected].