Thinking Small: Creating a Small-Ticket Leasing Company

This article discusses both the creation of small-ticket leasing companies by existing leasing businesses and what is needed for startup operations. We begin with the assumption that the reader is well versed in general leasing principles and that by “small-ticket” we are talking about transactions that are under $250,000, in most cases under $100,000, and include leasing of most kinds of equipment to startups, high-risk credits, and other types of lessees that may not be attractive in other leasing operations.

What Is Special About Small Ticket?

The first distinction between small-ticket and middle-market or large-ticket operations is that small-ticket transactions are more likely to include weaker credits and equipment of dubious collateral value. Large-risk deals are likely to die in the credit review process, but there are many reasons why a lessor would accept additional risk in small-ticket financings. The risk on each individual transaction is smaller, and the small-ticket market features yields that are much higher than are generally required in larger transactions. In small-ticket leasing, the effort is to maintain a high volume of transactions so as to spread the risk among as many deals as possible.

This high-volume/high-risk/high-yield concept supports several observations: First, lessors familiar with larger transactions need to be prepared to move quickly and not fret over the details of smaller deals. Small-ticket transactions are highly form-driven, often assuming no negotiation at all by the lessee (who is unlikely to refer a small-ticket lease to counsel) and may often be presented on a “take it or leave it” basis. Small-ticket documentation is usually drafted by counsel familiar with a cost-benefit analysis as to the inclusion of any protection. Because the documents must be short and simple, usually a single two-sided page, the small-ticket lease does not include some of the protections lessors expect for larger transactions. This requires a judgment call by both lawyer and client.

Another feature of these transactions is that the salesman or broker must understand the forms that are being signed and not be required to call home or contact his or her lawyer every time a question is presented by an aggressive lessee.

In what might appear to be a daunting statement, small-ticket lessors must be prepared for charge-offs. Among other things, it rarely pays to enter into protracted litigation, and the risk of a counterclaim or class action if the company has been cutting corners on licensing, usury or other limitations (discussed below) makes it more attractive to simply walk away from some transactions.

Small-ticket lessors must balance the need for fast approvals and volume, which lend themselves to credit scoring, and the fact that many of the credits will have “stories” requiring intelligent and insightful evaluation.

High volumes also require clear and easily understood internal policies, such as when to require a landlord waiver (if ever) and how to proceed when a lessee begins to slow-pay.

Because most small-ticket transactions (about 75% according to an old ELFA study) are $1 purchase option leases and many transactions are today documented utilizing Equipment Finance Agreements, usury issues are much more important than they are in larger transactions, many of which will be true leases. This is because a true lease, in most jurisdictions, is not considered potentially usurious as no “interest” is charged. Payments under a lease intended to create security interest or an Equipment Finance Agreement are more clearly principal and stated or implicit interest.

Licensing and other state regulatory laws are also a potentially serious problem. In several states, extremely small transactions are lumped in with consumer transactions for licensing and other purposes. For example, in Kentucky, lenders making loans of $15,000 or less are required to obtain a license. KRS ' 286.4-420 et seq. This statute is found in a subtitle called “Consumer Loan Companies”; but, the licensing statute itself does not limit its application to consumer loans. Similarly, Rhode Island, Alaska, Florida and other states differentiate between loans over and under $25,000 for various legal purposes, including usury limits.

Credit v. Collateral

Small-ticket transactions are credit-driven rather than closed in reliance on the value of collateral in most instances. This is, in part, because the small amount of money involved rarely justifies repossession, refurbishment and resale of equipment. For this reason, some small-ticket lessors do not even bother filing UCC financing statements. It is also very common to rely on purchase money interest protection and never check for existing liens. Many middle-market and large-ticket lessors, particularly banks, would be shocked by this practice, at least where the date of delivery and other aspects of the transaction are not clear.

For these reasons, and because so many startups and weak credit lessees are involved, small-ticket leases are much more likely than other types of equipment finance transactions to require guarantors or the posting of other collateral. This puts a great deal of emphasis on the Guaranty Agreement, not only in terms of its form and enforceability, but in making sure that the document is properly signed and is not a forgery. For obvious reasons, a Guaranty is more likely to be improperly executed than the lease documentation itself.

Where other collateral is involved, a cost/benefit analysis is required as to whether a second mortgage, interest in other (used) equipment or other collateral is worth the cost of documentation.

Parties

Given the emphasis on high volume, small-ticket leasing often utilizes brokers either arranging for transactions to be documented by the lessor or for the broker to act as a lease originator, signing documents in its own name and selling the deal to the lessor. This process reduces overhead by limiting the number of salesmen required and can rapidly expand volume. It carries its own risks:

Most significantly, broker transactions are more likely to be fraudulent than those originated in-house. While established brokers are unlikely to participate in fraudulent transactions, the lessor must take care to ensure that the broker is well educated in the indicia of fraud and is committed to ferreting it out.

One of the most common mistakes in this area is that the lessor fails to include proper penalties for breach of broker representations. A clear buy-back provision or strongly worded indemnity prevents arguments over the nature and extent of damages, among other things.

Many small-ticket programs rely on vendor relationships to bring in higher volumes of business. As with brokers, the use of third-party originators can be risky. Again, the accent on high volume and willingness to accept risk can lead to one of two things: sloppy practice or the enforcement of a few strict anti-fraud policies. As with brokered transactions, the program agreement with the vendor must be clear and complete.

Documentation and Policy Issues

As noted above, small-ticket leasing requires a cost/benefit analysis and rethinking of many common policies. The above discussion of changes in UCC-filing and search policy is one example. Other changes in documentation and policy generally involve streamlining documents and procedures:

Economies do not favor negotiating each lease, much less involving counsel. For this reason, small-ticket forms are more likely to be written in “plain English” using terms such as “you” and “we” rather than “lessee” and “lessor” so that the customer can understand at least its basic obligations and risks and not feel it necessary to call his lawyer.

As the lease itself will be short, it is often just as well to abandon the Master and Schedule format and simply use a one-off lease form for each transaction.

Acceptance procedures are simplified, but it is important to allow the lessee the opportunity to inspect and reject equipment. The common practice among small-ticket lessors of allowing the lessee to sign an Acceptance Certificate in advance of delivery has led to lawsuits, often with chilling results. The dangers of this practice are indicated in cases such as JAZ, Inc. v. Foley, 104 Hawaii 148, 85 P.3d 1099 (2004), Colonial Pacific Leasing Corp. v. J.W.C.J.R. Corp., 199 P.2d 541 (Utah App. 1999); and Tri-Continental Leasing Corp. v. Law Office of Richard W. Burns, 710 S.W.2d 604 (Tex. App. 1985).

Language regarding use and maintenance of the equipment is generally simplified, relying on the somewhat unclear industry-standard language of “reasonable wear and tear.” Likewise, language regarding loss and damage to the equipment is simplified, and a formula may be added in lieu of actually preparing a casualty value table.

The specifics of insurance language may be pared down in the small-ticket lease, but this requires the leasing company to be even more vigilant in insisting on proper certificates. Bear in mind that where liability is concerned, even an inexpensive piece of equipment can result in millions of dollars of loss.

Events of default and remedies are usually reduced to a single paragraph, which, among other things, removes cure periods and other lessee-favorable language. Likewise, the language of indemnities is removed in large part, leaving only the basic requirement of indemnification by the lessee against losses, claims and taxes, penalties and interest. The lessee should remain obligated, however, either to file tax returns or reimburse the lessor for property and other taxes, and it should be clear that the lessee's indemnity is not only with respect to the equipment or its particular usage, but as to the transaction as a whole.

There should be a clear grant of a security interest by the lessee to the lessor whether the financing is an EFA, a $1-out lease or a true lease (in the last case, reciting that the grant is in case the lease is deemed a financing despite the party's intention). Prohibitions on the lessees' sublease or assignment and language specifically permitting the lessor to assign are essential and should not be excised.

“Miscellaneous” sections are generally greatly reduced, but here a cost-benefit decision may be very important with regard to the following language:

The integration (no other agreements) clause and statement that the agreement may not be amended except in writing should be maintained. Likewise, choice of law and consent to jurisdiction in the place selected by the lessor should not be removed, and in most jurisdictions, the waiver of jury trial is a good idea.

There are a few other bits of language that find their way into small-ticket leases because they are so rarely negotiated. These should be considered carefully as some may lead to trouble. For example, forced-place insurance clauses have been a subject of class action litigation in recent years and must be carefully drafted. Automatic renewals are prohibited in some states and abuse of these rights, both in documentation and practice, is a troubling issue for the industry.

Small Ticket: Opportunities and Risks

The recent unpleasantness in the equipment finance industry has resulted in many small-ticket players exiting the market. This creates both an opportunity and an object lesson in the risks in this segment. It should be no surprise that a lawyer advises that proper documentation and procedures are every bit as important as good credit analysis in getting those high yields from the paper to the pocket, instead of into the paper shredder.

Barry Marks, a member of this newsletter's Board of Editors, is a founding shareholder with Marks & Weinberg, P.C., whose practice centers on equipment leasing and finance. He has more than 30 years of experience including a wide range of financing structures. He is the author of books available at www.leasingpress.com and a poetry collection available at www.brickroadpoetrypress.com.

There are many reasons why small-ticket leasing has become attractive. Banks large and small are looking for alternatives to residential and commercial real estate loans, and the good yields in small-ticket leasing are enticing. The emphasis put on obtaining depositors and maintaining relationships has made banks hesitant to refer any business away, even small transactions that might not lead to bigger deals.

Independent leasing companies have also begun to rethink their longtime preference for the larger transactions. Small-ticket leasing may offer higher yields, keep good customers coming back for larger transactions and if nothing else, employ underutilized staff and equipment.

Small-ticket leasing is also an easy entry into the leasing business for former leasing company and bank employees looking to set up broker or small independent shops, and vendors are finding that any means of promoting sales are worthy of consideration, even if the per-unit sales involve small numbers.

This article discusses both the creation of small-ticket leasing companies by existing leasing businesses and what is needed for startup operations. We begin with the assumption that the reader is well versed in general leasing principles and that by “small-ticket” we are talking about transactions that are under $250,000, in most cases under $100,000, and include leasing of most kinds of equipment to startups, high-risk credits, and other types of lessees that may not be attractive in other leasing operations.

What Is Special About Small Ticket?

The first distinction between small-ticket and middle-market or large-ticket operations is that small-ticket transactions are more likely to include weaker credits and equipment of dubious collateral value. Large-risk deals are likely to die in the credit review process, but there are many reasons why a lessor would accept additional risk in small-ticket financings. The risk on each individual transaction is smaller, and the small-ticket market features yields that are much higher than are generally required in larger transactions. In small-ticket leasing, the effort is to maintain a high volume of transactions so as to spread the risk among as many deals as possible.

This high-volume/high-risk/high-yield concept supports several observations: First, lessors familiar with larger transactions need to be prepared to move quickly and not fret over the details of smaller deals. Small-ticket transactions are highly form-driven, often assuming no negotiation at all by the lessee (who is unlikely to refer a small-ticket lease to counsel) and may often be presented on a “take it or leave it” basis. Small-ticket documentation is usually drafted by counsel familiar with a cost-benefit analysis as to the inclusion of any protection. Because the documents must be short and simple, usually a single two-sided page, the small-ticket lease does not include some of the protections lessors expect for larger transactions. This requires a judgment call by both lawyer and client.

Another feature of these transactions is that the salesman or broker must understand the forms that are being signed and not be required to call home or contact his or her lawyer every time a question is presented by an aggressive lessee.

In what might appear to be a daunting statement, small-ticket lessors must be prepared for charge-offs. Among other things, it rarely pays to enter into protracted litigation, and the risk of a counterclaim or class action if the company has been cutting corners on licensing, usury or other limitations (discussed below) makes it more attractive to simply walk away from some transactions.

Small-ticket lessors must balance the need for fast approvals and volume, which lend themselves to credit scoring, and the fact that many of the credits will have “stories” requiring intelligent and insightful evaluation.

High volumes also require clear and easily understood internal policies, such as when to require a landlord waiver (if ever) and how to proceed when a lessee begins to slow-pay.

Because most small-ticket transactions (about 75% according to an old ELFA study) are $1 purchase option leases and many transactions are today documented utilizing Equipment Finance Agreements, usury issues are much more important than they are in larger transactions, many of which will be true leases. This is because a true lease, in most jurisdictions, is not considered potentially usurious as no “interest” is charged. Payments under a lease intended to create security interest or an Equipment Finance Agreement are more clearly principal and stated or implicit interest.

Licensing and other state regulatory laws are also a potentially serious problem. In several states, extremely small transactions are lumped in with consumer transactions for licensing and other purposes. For example, in Kentucky, lenders making loans of $15,000 or less are required to obtain a license. KRS ' 286.4-420 et seq. This statute is found in a subtitle called “Consumer Loan Companies”; but, the licensing statute itself does not limit its application to consumer loans. Similarly, Rhode Island, Alaska, Florida and other states differentiate between loans over and under $25,000 for various legal purposes, including usury limits.

Credit v. Collateral

Small-ticket transactions are credit-driven rather than closed in reliance on the value of collateral in most instances. This is, in part, because the small amount of money involved rarely justifies repossession, refurbishment and resale of equipment. For this reason, some small-ticket lessors do not even bother filing UCC financing statements. It is also very common to rely on purchase money interest protection and never check for existing liens. Many middle-market and large-ticket lessors, particularly banks, would be shocked by this practice, at least where the date of delivery and other aspects of the transaction are not clear.

For these reasons, and because so many startups and weak credit lessees are involved, small-ticket leases are much more likely than other types of equipment finance transactions to require guarantors or the posting of other collateral. This puts a great deal of emphasis on the Guaranty Agreement, not only in terms of its form and enforceability, but in making sure that the document is properly signed and is not a forgery. For obvious reasons, a Guaranty is more likely to be improperly executed than the lease documentation itself.

Where other collateral is involved, a cost/benefit analysis is required as to whether a second mortgage, interest in other (used) equipment or other collateral is worth the cost of documentation.

Parties

Given the emphasis on high volume, small-ticket leasing often utilizes brokers either arranging for transactions to be documented by the lessor or for the broker to act as a lease originator, signing documents in its own name and selling the deal to the lessor. This process reduces overhead by limiting the number of salesmen required and can rapidly expand volume. It carries its own risks:

Most significantly, broker transactions are more likely to be fraudulent than those originated in-house. While established brokers are unlikely to participate in fraudulent transactions, the lessor must take care to ensure that the broker is well educated in the indicia of fraud and is committed to ferreting it out.

One of the most common mistakes in this area is that the lessor fails to include proper penalties for breach of broker representations. A clear buy-back provision or strongly worded indemnity prevents arguments over the nature and extent of damages, among other things.

Many small-ticket programs rely on vendor relationships to bring in higher volumes of business. As with brokers, the use of third-party originators can be risky. Again, the accent on high volume and willingness to accept risk can lead to one of two things: sloppy practice or the enforcement of a few strict anti-fraud policies. As with brokered transactions, the program agreement with the vendor must be clear and complete.

Documentation and Policy Issues

As noted above, small-ticket leasing requires a cost/benefit analysis and rethinking of many common policies. The above discussion of changes in UCC-filing and search policy is one example. Other changes in documentation and policy generally involve streamlining documents and procedures:

Economies do not favor negotiating each lease, much less involving counsel. For this reason, small-ticket forms are more likely to be written in “plain English” using terms such as “you” and “we” rather than “lessee” and “lessor” so that the customer can understand at least its basic obligations and risks and not feel it necessary to call his lawyer.

As the lease itself will be short, it is often just as well to abandon the Master and Schedule format and simply use a one-off lease form for each transaction.

Acceptance procedures are simplified, but it is important to allow the lessee the opportunity to inspect and reject equipment. The common practice among small-ticket lessors of allowing the lessee to sign an Acceptance Certificate in advance of delivery has led to lawsuits, often with chilling results. The dangers of this practice are indicated in cases such as JAZ, Inc. v. Foley , 104 Hawaii 148, 85 P.3d 1099 (2004), Colonial Pacific Leasing Corp. v. J.W.C.J.R. Corp. , 199 P.2d 541 (Utah App. 1999); and Tri-Continental Leasing Corp. v. Law Office of Richard W. Burns , 710 S.W.2d 604 (Tex. App. 1985).

Language regarding use and maintenance of the equipment is generally simplified, relying on the somewhat unclear industry-standard language of “reasonable wear and tear.” Likewise, language regarding loss and damage to the equipment is simplified, and a formula may be added in lieu of actually preparing a casualty value table.

The specifics of insurance language may be pared down in the small-ticket lease, but this requires the leasing company to be even more vigilant in insisting on proper certificates. Bear in mind that where liability is concerned, even an inexpensive piece of equipment can result in millions of dollars of loss.

Events of default and remedies are usually reduced to a single paragraph, which, among other things, removes cure periods and other lessee-favorable language. Likewise, the language of indemnities is removed in large part, leaving only the basic requirement of indemnification by the lessee against losses, claims and taxes, penalties and interest. The lessee should remain obligated, however, either to file tax returns or reimburse the lessor for property and other taxes, and it should be clear that the lessee's indemnity is not only with respect to the equipment or its particular usage, but as to the transaction as a whole.

There should be a clear grant of a security interest by the lessee to the lessor whether the financing is an EFA, a $1-out lease or a true lease (in the last case, reciting that the grant is in case the lease is deemed a financing despite the party's intention). Prohibitions on the lessees' sublease or assignment and language specifically permitting the lessor to assign are essential and should not be excised.

“Miscellaneous” sections are generally greatly reduced, but here a cost-benefit decision may be very important with regard to the following language:

The integration (no other agreements) clause and statement that the agreement may not be amended except in writing should be maintained. Likewise, choice of law and consent to jurisdiction in the place selected by the lessor should not be removed, and in most jurisdictions, the waiver of jury trial is a good idea.

There are a few other bits of language that find their way into small-ticket leases because they are so rarely negotiated. These should be considered carefully as some may lead to trouble. For example, forced-place insurance clauses have been a subject of class action litigation in recent years and must be carefully drafted. Automatic renewals are prohibited in some states and abuse of these rights, both in documentation and practice, is a troubling issue for the industry.

Small Ticket: Opportunities and Risks

The recent unpleasantness in the equipment finance industry has resulted in many small-ticket players exiting the market. This creates both an opportunity and an object lesson in the risks in this segment. It should be no surprise that a lawyer advises that proper documentation and procedures are every bit as important as good credit analysis in getting those high yields from the paper to the pocket, instead of into the paper shredder.

Barry Marks, a member of this newsletter's Board of Editors, is a founding shareholder with Marks & Weinberg, P.C., whose practice centers on equipment leasing and finance. He has more than 30 years of experience including a wide range of financing structures. He is the author of books available at www.leasingpress.com and a poetry collection available at www.brickroadpoetrypress.com.