Braving Tempestuous Times

In a decade marked by credit crises and financial fraud, lenders, factors, securitization entities and other funding sources that, in good faith, provide lease and accounts receivable financing to leasing companies and vendors must increasingly rely on the absolute, unconditional “hell-or-high-water” nature of the obligations they choose to finance. Hell-or-high-water protection has long been considered a commercial necessity to ensure the free flow of equipment lease financing and now, bolstered by recent changes to the Uniform Commercial Code (UCC), it has been extended to accounts receivable financing of goods and services.

Through this crucible of a faltering economy, combined with the growth of financing scams and Ponzi schemes (such as the infamous “Matrix Box” in the NorVergence cases), courts have had a fresh opportunity to examine the limits of enforcing hell-or-high-water obligations. This article discusses several recent court decisions that suggest practical strategies to assure wary funding sources that hell-or-high-water obligations will remain a viable route for navigating treacherous economic seas.

What Are 'Hell-or-High Water' Obligations?

A “hell-or-high-water obligation” is one in which a lessee or buyer of goods or services (the Obligor) becomes absolutely and unconditionally obligated to pay its financial obligations to a third-party funding source to which its lease or sale (i.e., accounts receivable) obligations are assigned (the Assignee), notwithstanding any defense, setoff or counterclaim that the Obligor may have against the lessor or seller of the goods or services. Hell-or-high-water obligations are often set forth in the basic lease or sale agreement/invoice as a “hell-or-high water provision” with respect to the obligations owed directly to the seller or lessor of the goods or services. However, they are more frequently couched as third-party “waiver-of-defenses provisions” set forth in a lease, notice of assignment, or delivery and acceptance certificate (D&A), in which the Obligor agrees not to assert against an Assignee of its lease or accounts receivable obligations any defenses, setoffs or claims it may have against the lessor or seller of the goods or services leased or purchased by the Obligor.

Statutory recognition of hell-or-high water provisions, however, is limited to certain non-consumer equipment leases, where the lessor is not also the vendor of the equipment (i.e., “finance lease” obligations) under UCC Section 2A-407 (upon acceptance of the goods, the lessee's obligations are “irrevocable and independent” of the lessor's obligations under the lease), and UCC Section 2A-508(6) (restricting a lessee's rights of setoff in a finance lease). However, UCC Section 9-403 (enacted as part of Revised Article 9 of the UCC in 2001) now expressly gives effect to waiver-of-defenses provisions to Assignees of any non-consumer lease or sale obligations for any types of goods or services.

A valid waiver-of-defenses provision under UCC Section 9-403 provides the Assignee of the obligation with the rights of a “holder-in-due course” of a negotiable instrument under UCC Section 3-305(b), and similarly requires that the Assignee take the assignment for: 1) value; 2) in good faith; and 3) without notice of a claim or defense to the assigned obligation. A waiver-of-defenses provision is likewise only subject to so-called “real defenses” that may be asserted against a holder-in-due course, which are limited to: 1) infancy; 2) duress, lack of legal capacity or illegality that nullifies the obligation; 3) fraud in the inducement; and 4) discharge in insolvency proceedings. As with a holder-in-due course of a negotiable instrument, a valid waiver-of-defenses clause allows an Assignee the distinct advantage of obtaining summary judgment in an enforcement action against the Obligor, irrespective of any claims or defenses asserted by the Obligor against the lessor or seller of goods or services.

The NorVergence Cases: Fraudulent Promises to Supply Services Under a Lease

Liberty Bank F.S.B. v. Diamond Paint and Supply, Inc., 60 UCC Rep.Serv.2d 1334 (Iowa Ct. App. 2006): The lessor, NorVergence, Inc. (NorVergence), verbally promised to supply the lessee with certain telephone and data services with equipment (consisting of a so-called “Matrix Box”) under a lease that contained both hell-or-high-water and waiver-of-defenses clauses. When the lessor failed to provide the telecommunications services, the lessee refused to pay its lease obligations and was sued by the Assignee of the lease.

The lessee argued that the lease did not fall within the scope of Article 2A of the UCC because the agreement was “predominantly for services, not goods,” and thus did not qualify as a “finance lease.” The court noted that the lease, on its face, only covered equipment and that there was “no genuine dispute” that the lease covered goods and not services. The court also noted that the lease stated that it “will be considered a finance lease” under Article 2A, and held that the agreement of the parties that the lease was a “finance lease” under Article 2A would be given effect. The court then held that the protections provided by the hell-or-high-water provisions in the lease became effective upon the lessee's acceptance of the goods, as evidenced by a duly executed D&A, and affirmed summary judgment of the lower court in favor of the Assignee of the lease.

Popular Leasing USA, Inc. v. Mortgage Sense, Inc., 66 UCC Rep.Serv.2d 719 (Cal. Ct. App. 2008): the lessee executed a lease with NorVergence containing both a hell-or-high-water clause and a waiver-of-defenses clause on terms similar to the Diamond Paint case (above), and executed a D&A that certified that it had received and accepted all of the equipment covered by the lease. After failing to make rental payments and being sued by the Assignee of the lease, the lessee claimed that the Assignee could not enforce the lease because the equipment had never been installed or accepted, and that the D&A had been procured by the lessor's fraud.

The court first held that the Assignee had the rights of a holder-in-due course under the hell-or-high water provisions of the lease. Although it found that the lease did not require acceptance of the goods as a pre-condition to its commencement, the court examined whether any fraud in connection with the execution of the D&A might constitute a defense to the Assignee as a holder-in-due course.

The lessee stated that the lessor had told it to sign certain forms (which were attached together on a clipboard) solely to confirm that the leased equipment had been delivered “and for no other purpose.” The lessee further stated that the forms bearing the heading “Delivery and Acceptance Certificate” were partially obscured by other papers on the same clipboard, and that these headings were not visible at the time the lessee signed the forms.

The court held that if these facts were to be evidence of fraud, they did not show the type of fraud that would constitute a defense to a claim by a holder-in-due-course. The court stated that “the only type of fraud available as a defense against a holder-in-due-course [i.e., known as "fraud in the inducement"] is 'fraud that induced the Obligor to sign the instrument with neither knowledge nor reasonable opportunity to learn its of its character or its essential terms',” as provided in UCC Section 3-305(a)(1)(iii). The court held that, when the lessee's representatives executed the D&A, they had an opportunity to learn what it was they were signing and, if they chose not to do so, any fraud by the lessor in connection therewith did not meet the requirements to constitute a defense to a holder-in-due course under UCC Section 3-305, as incorporated by UCC Section 9-403.

IFC Credit Corporation v. Specialty Optical Systems, Inc., 252 S.W.3d 761 (Tex. Ct. App. 2008): IFC Credit Corporation (IFC) began to purchase leases from NorVergence in October 2003. In January 2004, at about the time it was scheduled to start receiving payments from the first group of leases it purchased from NorVergence, IFC began to receive letters and calls from unhappy NorVergence customers, complaining that they were getting billed but not receiving telecommunications services or the promised savings from their Matrix Boxes. In March 2004, IFC and NorVergence amended their master lease purchase agreement to provide IFC with greater financial protections, including a 25% holdback from the amount it paid for the leases. When lessees refused to pay because they were not receiving the promised telecommunications services, IFC was not obligated to pay the amounts withheld.

IFC continued to receive a steady stream of customer complaints about NorVergence, and experienced a high rate of default on NorVergence's leases. Accordingly, by late April or early May 2004, IFC planned to terminate its relationship with NorVergence, but changed its mind, and amended the master lease purchase agreement a second time to provide for steeper discounts on the purchase price of the leases and increasing the holdbacks from 25% to 50%.

In April 2004, Specialty Optical Systems, Inc. (Specialty) entered into a lease for a Matrix Box, after a representative had convinced it to cancel its existing telephone services contract. On May 18, 2004, NorVergence countersigned the lease and an IFC representative contacted Specialty as part of a “verbal audit” to confirm that the Box had been received and that Specialty had signed the D&A, and to assure Specialty that it would receive the savings promised by NorVergence. Shortly thereafter, IFC took assignment of the lease.

Because the Box had no value other than to enable delivery of telecommunications services, Specialty firmly believed that the monthly payments under the lease included the Box as well as the promised telephone service and internet access. Despite the lessee's belief, the lease contained both hell-or-high-water and waiver-of-defenses provisions that obligated it to make payments to IFC even if Specialty never received the services it thought it was purchasing, as long as the Box was delivered in outwardly good condition.

Specialty never received the telecommunications services, and at some point prior to June 30, 2004, NorVergence defaulted on its contracts with common carriers (with which it had contracted to provide telecommunications services to lessees), and was forced into involuntary bankruptcy. Specialty then attempted to cancel the lease due to its failure to receive the services, returned the Box to IFC, and ceased making payments under the lease. In an action by IFC to enforce the lease, the trial court declared the lease unenforceable and void ab initio.

The Texas Court of Appeals analyzed the waiver-of-defenses and hell-or-high water provisions set forth in the lease, under a standard good-faith holder-in-due course analysis. The court noted that the test for “good faith” is whether the purchaser had actual knowledge of facts and circumstances amounting to bad faith, and that a person has “notice of a fact” includes when, from all of the facts and circumstances, he has reason to know it exists. It noted that the more a holder knows about the underlying transaction and controls or participates in it, the less the need for giving him “the tension free rights [of a holder-in-due-course] considered necessary in a fast moving, credit-extending commercial world.”

The court found that IFC was fully aware that NorVergence's failure to provide services had resulted in a high default rate and was sufficiently concerned about NorVergence's deteriorating financial condition that it amended the master program agreement twice to enhance its level of protection through considerable holdbacks. Although the leases referenced the Matrix Box only, the court found that IFC knew that NorVergence was marketing the leases by promising services and savings in conjunction with the leasing of the Matrix Box, and that in the absence of T-1 service or telephone service the Box had no value whatsoever. The court found that, despite IFC's awareness that customers were not receiving the promised services, IFC continued to reassure new customers like Specialty (by means of its “verbal audits”) that the services would be forthcoming. Accordingly, the court held that IFC's level of participation in the underlying transaction moved the transaction beyond the realm of innocent acquisition of commercial paper. IFC was thus not entitled to the protections of a holder-in-due-course, and upheld the trial court's verdict that IFC took the lease subject to the lessee's defenses and therefore could not enforce the lease.

Conclusion

Next month, we will discuss the effect of several other recent cases on the financing of hell-or-high-water lease obligations and accounts receivable obligations, and suggest some techniques to help ensure that the enforceability of hell-or-high-water obligations can continue to be relied upon by funding sources.

Raymond W. Dusch is a senior attorney with the law firm of Schulte Roth & Zabel LLP, in New York City. A member of this Newsletter's Board of Editors, he has been involved in equipment leasing and financing for more than 30 years. He can be reached at [email protected]. The Author wishes to thank Tania Mazumdar for her research assistance in connection with this Article.

In a decade marked by credit crises and financial fraud, lenders, factors, securitization entities and other funding sources that, in good faith, provide lease and accounts receivable financing to leasing companies and vendors must increasingly rely on the absolute, unconditional “hell-or-high-water” nature of the obligations they choose to finance. Hell-or-high-water protection has long been considered a commercial necessity to ensure the free flow of equipment lease financing and now, bolstered by recent changes to the Uniform Commercial Code (UCC), it has been extended to accounts receivable financing of goods and services.

Through this crucible of a faltering economy, combined with the growth of financing scams and Ponzi schemes (such as the infamous “Matrix Box” in the NorVergence cases), courts have had a fresh opportunity to examine the limits of enforcing hell-or-high-water obligations. This article discusses several recent court decisions that suggest practical strategies to assure wary funding sources that hell-or-high-water obligations will remain a viable route for navigating treacherous economic seas.

What Are 'Hell-or-High Water' Obligations?

A “hell-or-high-water obligation” is one in which a lessee or buyer of goods or services (the Obligor) becomes absolutely and unconditionally obligated to pay its financial obligations to a third-party funding source to which its lease or sale (i.e., accounts receivable) obligations are assigned (the Assignee), notwithstanding any defense, setoff or counterclaim that the Obligor may have against the lessor or seller of the goods or services. Hell-or-high-water obligations are often set forth in the basic lease or sale agreement/invoice as a “hell-or-high water provision” with respect to the obligations owed directly to the seller or lessor of the goods or services. However, they are more frequently couched as third-party “waiver-of-defenses provisions” set forth in a lease, notice of assignment, or delivery and acceptance certificate (D&A), in which the Obligor agrees not to assert against an Assignee of its lease or accounts receivable obligations any defenses, setoffs or claims it may have against the lessor or seller of the goods or services leased or purchased by the Obligor.

Statutory recognition of hell-or-high water provisions, however, is limited to certain non-consumer equipment leases, where the lessor is not also the vendor of the equipment (i.e., “finance lease” obligations) under UCC Section 2A-407 (upon acceptance of the goods, the lessee's obligations are “irrevocable and independent” of the lessor's obligations under the lease), and UCC Section 2A-508(6) (restricting a lessee's rights of setoff in a finance lease). However, UCC Section 9-403 (enacted as part of Revised Article 9 of the UCC in 2001) now expressly gives effect to waiver-of-defenses provisions to Assignees of any non-consumer lease or sale obligations for any types of goods or services.

A valid waiver-of-defenses provision under UCC Section 9-403 provides the Assignee of the obligation with the rights of a “holder-in-due course” of a negotiable instrument under UCC Section 3-305(b), and similarly requires that the Assignee take the assignment for: 1) value; 2) in good faith; and 3) without notice of a claim or defense to the assigned obligation. A waiver-of-defenses provision is likewise only subject to so-called “real defenses” that may be asserted against a holder-in-due course, which are limited to: 1) infancy; 2) duress, lack of legal capacity or illegality that nullifies the obligation; 3) fraud in the inducement; and 4) discharge in insolvency proceedings. As with a holder-in-due course of a negotiable instrument, a valid waiver-of-defenses clause allows an Assignee the distinct advantage of obtaining summary judgment in an enforcement action against the Obligor, irrespective of any claims or defenses asserted by the Obligor against the lessor or seller of goods or services.

The NorVergence Cases: Fraudulent Promises to Supply Services Under a Lease

Liberty Bank F.S.B. v. Diamond Paint and Supply, Inc. , 60 UCC Rep.Serv.2d 1334 (Iowa Ct. App. 2006): The lessor, NorVergence, Inc. (NorVergence), verbally promised to supply the lessee with certain telephone and data services with equipment (consisting of a so-called “Matrix Box”) under a lease that contained both hell-or-high-water and waiver-of-defenses clauses. When the lessor failed to provide the telecommunications services, the lessee refused to pay its lease obligations and was sued by the Assignee of the lease.

The lessee argued that the lease did not fall within the scope of Article 2A of the UCC because the agreement was “predominantly for services, not goods,” and thus did not qualify as a “finance lease.” The court noted that the lease, on its face, only covered equipment and that there was “no genuine dispute” that the lease covered goods and not services. The court also noted that the lease stated that it “will be considered a finance lease” under Article 2A, and held that the agreement of the parties that the lease was a “finance lease” under Article 2A would be given effect. The court then held that the protections provided by the hell-or-high-water provisions in the lease became effective upon the lessee's acceptance of the goods, as evidenced by a duly executed D&A, and affirmed summary judgment of the lower court in favor of the Assignee of the lease.

Popular Leasing USA, Inc. v. Mortgage Sense, Inc. , 66 UCC Rep.Serv.2d 719 (Cal. Ct. App. 2008): the lessee executed a lease with NorVergence containing both a hell-or-high-water clause and a waiver-of-defenses clause on terms similar to the Diamond Pain t case (above), and executed a D&A that certified that it had received and accepted all of the equipment covered by the lease. After failing to make rental payments and being sued by the Assignee of the lease, the lessee claimed that the Assignee could not enforce the lease because the equipment had never been installed or accepted, and that the D&A had been procured by the lessor's fraud.

The court first held that the Assignee had the rights of a holder-in-due course under the hell-or-high water provisions of the lease. Although it found that the lease did not require acceptance of the goods as a pre-condition to its commencement, the court examined whether any fraud in connection with the execution of the D&A might constitute a defense to the Assignee as a holder-in-due course.

The lessee stated that the lessor had told it to sign certain forms (which were attached together on a clipboard) solely to confirm that the leased equipment had been delivered “and for no other purpose.” The lessee further stated that the forms bearing the heading “Delivery and Acceptance Certificate” were partially obscured by other papers on the same clipboard, and that these headings were not visible at the time the lessee signed the forms.

The court held that if these facts were to be evidence of fraud, they did not show the type of fraud that would constitute a defense to a claim by a holder-in-due-course. The court stated that “the only type of fraud available as a defense against a holder-in-due-course [i.e., known as "fraud in the inducement"] is 'fraud that induced the Obligor to sign the instrument with neither knowledge nor reasonable opportunity to learn its of its character or its essential terms',” as provided in UCC Section 3-305(a)(1)(iii). The court held that, when the lessee's representatives executed the D&A, they had an opportunity to learn what it was they were signing and, if they chose not to do so, any fraud by the lessor in connection therewith did not meet the requirements to constitute a defense to a holder-in-due course under UCC Section 3-305, as incorporated by UCC Section 9-403.

IFC Credit Corporation v. Specialty Optical Systems, Inc. , 252 S.W.3d 761 (Tex. Ct. App. 2008): IFC Credit Corporation (IFC) began to purchase leases from NorVergence in October 2003. In January 2004, at about the time it was scheduled to start receiving payments from the first group of leases it purchased from NorVergence, IFC began to receive letters and calls from unhappy NorVergence customers, complaining that they were getting billed but not receiving telecommunications services or the promised savings from their Matrix Boxes. In March 2004, IFC and NorVergence amended their master lease purchase agreement to provide IFC with greater financial protections, including a 25% holdback from the amount it paid for the leases. When lessees refused to pay because they were not receiving the promised telecommunications services, IFC was not obligated to pay the amounts withheld.

IFC continued to receive a steady stream of customer complaints about NorVergence, and experienced a high rate of default on NorVergence's leases. Accordingly, by late April or early May 2004, IFC planned to terminate its relationship with NorVergence, but changed its mind, and amended the master lease purchase agreement a second time to provide for steeper discounts on the purchase price of the leases and increasing the holdbacks from 25% to 50%.

In April 2004, Specialty Optical Systems, Inc. (Specialty) entered into a lease for a Matrix Box, after a representative had convinced it to cancel its existing telephone services contract. On May 18, 2004, NorVergence countersigned the lease and an IFC representative contacted Specialty as part of a “verbal audit” to confirm that the Box had been received and that Specialty had signed the D&A, and to assure Specialty that it would receive the savings promised by NorVergence. Shortly thereafter, IFC took assignment of the lease.

Because the Box had no value other than to enable delivery of telecommunications services, Specialty firmly believed that the monthly payments under the lease included the Box as well as the promised telephone service and internet access. Despite the lessee's belief, the lease contained both hell-or-high-water and waiver-of-defenses provisions that obligated it to make payments to IFC even if Specialty never received the services it thought it was purchasing, as long as the Box was delivered in outwardly good condition.

Specialty never received the telecommunications services, and at some point prior to June 30, 2004, NorVergence defaulted on its contracts with common carriers (with which it had contracted to provide telecommunications services to lessees), and was forced into involuntary bankruptcy. Specialty then attempted to cancel the lease due to its failure to receive the services, returned the Box to IFC, and ceased making payments under the lease. In an action by IFC to enforce the lease, the trial court declared the lease unenforceable and void ab initio.

The Texas Court of Appeals analyzed the waiver-of-defenses and hell-or-high water provisions set forth in the lease, under a standard good-faith holder-in-due course analysis. The court noted that the test for “good faith” is whether the purchaser had actual knowledge of facts and circumstances amounting to bad faith, and that a person has “notice of a fact” includes when, from all of the facts and circumstances, he has reason to know it exists. It noted that the more a holder knows about the underlying transaction and controls or participates in it, the less the need for giving him “the tension free rights [of a holder-in-due-course] considered necessary in a fast moving, credit-extending commercial world.”

The court found that IFC was fully aware that NorVergence's failure to provide services had resulted in a high default rate and was sufficiently concerned about NorVergence's deteriorating financial condition that it amended the master program agreement twice to enhance its level of protection through considerable holdbacks. Although the leases referenced the Matrix Box only, the court found that IFC knew that NorVergence was marketing the leases by promising services and savings in conjunction with the leasing of the Matrix Box, and that in the absence of T-1 service or telephone service the Box had no value whatsoever. The court found that, despite IFC's awareness that customers were not receiving the promised services, IFC continued to reassure new customers like Specialty (by means of its “verbal audits”) that the services would be forthcoming. Accordingly, the court held that IFC's level of participation in the underlying transaction moved the transaction beyond the realm of innocent acquisition of commercial paper. IFC was thus not entitled to the protections of a holder-in-due-course, and upheld the trial court's verdict that IFC took the lease subject to the lessee's defenses and therefore could not enforce the lease.

Conclusion

Next month, we will discuss the effect of several other recent cases on the financing of hell-or-high-water lease obligations and accounts receivable obligations, and suggest some techniques to help ensure that the enforceability of hell-or-high-water obligations can continue to be relied upon by funding sources.

Raymond W. Dusch is a senior attorney with the law firm of Schulte Roth & Zabel LLP, in New York City. A member of this Newsletter's Board of Editors, he has been involved in equipment leasing and financing for more than 30 years. He can be reached at [email protected]. The Author wishes to thank Tania Mazumdar for her research assistance in connection with this Article.