Presto Change-Oops: Unexpected Challenges in Converting a Lease into an Equipment Finance Agreement

The rise of the Equipment Finance Agreement or EFA has been nothing short of meteoric. Fueled by concerns about lessor liability, confusion among state revenue agents regarding application of sales taxes and concerns regarding the reputation of equipment leasing, the EFA may soon eclipse the familiar “buck-out” lease intended as security.

On its face, using an existing equipment lease form to document an EFA transaction would seem fairly simple. The economics of an EFA should be similar to those of a lease intended as security: full payout with implicit interest and either a mandatory balloon payment or no additional payment at the end, with the borrower/lessee owning the equipment subject to a security interest for the lender/lessor. As many practitioners have found, however, taking a client's standard-form equipment lease and creating an equipment finance agreement is more complicated than it appears.

An EFA may be described as a Loan and Security Agreement and Promissory Note rolled into one document with several key provisions not normally found in standard Security Agreements. These provisions are commonly relied upon in the equipment financing and leasing industry to protect the equipment collateral. Their absence impacts both the lender's security and the marketability of an EFA on the secondary finance (syndication) market.

Before even beginning the conversion process, two fundamental questions must be answered: First, does the lessor want the EFA to look like a loan agreement or like a lease? Some lessors want to keep the transactions they offer as far from those presented by competing banks as possible. Others want the transaction to clearly be a loan so as to approach customers who are afraid of leasing. Second, what are the priorities? Does the lessor want the agreement to be as consistent as possible with existing lease documentation? What consistency must be preserved? Is length an issue, or may language be added to protect against legal risks inherent in lending?

This article examines these and other issues that arise in converting lease forms into equipment finance agreements.

An Equipment Finance Agreement Is a Loan Document

There are many reasons to base an EFA form on an existing lease document. Among other things, consistency between the forms will facilitate administration and maintain branding. Working from an existing form is generally less time-consuming for the draftsman (which may be read as “less expensive for the client”). Consistency will also minimize operational confusion and facilitate the use of existing ancillary documents such as secretary's certificates and insurance forms.

Against this consistency, however, is a simple fact clear to most lawyers but sometimes lost on their clients: An equipment finance agreement is a loan document. It is an entirely different animal from the true lease documentation on which most, if not all, leases intended as security are based. Many of the issues raised by this difference require counsel to be versed in lending as well as leasing, particularly if the EFA is to be sold to a bank represented by counsel familiar with traditional lending.

What is really happening is that documentation based on equipment rental agreements is being transformed into loan documentation. While rental agreements address commercial transactions, loan documentation is based on many years of secured lending. Some loan document concepts have always been incorporated into leases intended as security, but others rarely come up in any type of leasing.

One of the fundamental differences between a lease and an EFA is that EFAs involve the collection of interest. This is true whether the EFA breaks down monthly payments between principal and interest, or combines them as a single payment. Because interest is charged, lenders should expect that laws regarding the collection of interest, most notably usury laws, will apply in EFA transactions.

Interest is generally defined for purposes of state usury laws as a charge for the use of money or forbearance in collecting a debt. Many states have civil or criminal usury statutes, or both, applicable to commercial lending as well as loans to consumers. While lessors sometimes ignore these laws, even for leases intended as security, EFA lenders must take them into account. A particular concern is that many leases include high late fees and additional charges for tax service, inspections or other services rendered by the lessor. These charges, in some cases, can be reinterpreted as additional interest, causing a seemingly safe transaction to exceed usury rates.

In contrast, most courts acknowledge that true leases are not subject to usury laws as interest is not collected. See, e.g., Performance Systems, Inc. v. First American Nat. Bank, 554 S.W.2d 616 (Tenn.); Orix Credit Alliance, Inc. v. Northeastern Tech Excavating Corp., 222 A.D.2d 796, 634 N.Y.S.2d 841 (3d Dep't 1995); Citipostal, Inc. v. Unistar Leasing, 283 A.D.2d 916, 724 N.Y.S.2d 555 (4th Dep't 2001).

The same may not be true for “rent” charged in leases intended as security is sometimes re-characterized as principal and (implicit) interest, although some would argue that the implicit rate is not interest at all. The lender under an EFA does not even have this form-over-substance argument that interest is not being charged and collected.

This brings about two important defenses used by lenders traditionally as a means of avoiding usury restrictions. First, a usury savings clause, stating that the parties do not intend to violate applicable law and that payments will be reduced as necessary to avoid the collection of excessive interest is generally advisable. These clauses are rarely found in equipment leases, and it is understandable that many lessors prefer not to see anything that implies that their rent may be “too high” or that any payment should be reduced. There are cases in which courts have refused to reduce interest charged below the usury limit by applying a usury savings clause. In re Venture Mortgage Fund, L.P., 282 F.3d 185 (2nd Cir. 2002); Swindell v. Fannie Mae, 330 N.C. 153 (1991); Federal Home Loan Mortgage Corporation v. 333 Neptune Avenue Limited Partnership, 201 F.3d 431 (2nd Cir. 1999). There may be reason for concern that the presence of the clause indicates an intention to violate usury laws. Henson v. Columbus Bank & Trust Company, 770 F.2d 1566 (11th Cir. 1985) (“When [other elements of usury] are express on the face of the contract, usurious intent may be presumed.”) Nevertheless, many courts have held that the presence of a usury savings clause protects against usury penalties. E.g., Continental Mortgage Investors v. Sailboat Key, Inc., 395 So.2d 507 (Fla. 1981).

Second, choice of law becomes even more important where interest at a high rate will be collected. Avoiding application of the laws of a state with a low usury ceiling, particularly a criminal rate, is highly advisable. Including a consent to jurisdiction or forum selection clause designating the location in which the parties will litigate disputes strengthens the choice of law.

The collection of interest brings about other issues. While lessors rarely disclose implicit rates, disclosure of interest rates may be required in EFAs, either by law or market pressures. In Georgia, the requirement of a “stated” rate of interest is generally regarded as a requirement that interest rates be disclosed in order to avoid the state's restrictive usury laws. O.C.G.A. ' 7-4-2.' Customers who recognize that the EFA is a loan document may want to see interest expressed in familiar terms. This will particularly be true where the EFA is offered as an alternative to traditional loan financing, as where the EFA lender is competing with a bank lender.

Specific Drafting Considerations

Briefly touching on a few of the many issues that are likely to arise:

Definitions

Replacing “lessor” and “lessee” with “lender” and “borrower” may be easy enough but raises the question of how much like a bank loan agreement the parties want the EFA to appear. Likewise, the decision whether to replace “rent” with “payment” or a similar word or with an expression of “principal and interest” involves both the questions of whether to disclose the implicit interest rate and whether to distinguish the EFA transaction from a competing bank loan.

Loan payments are generally collected in arrears, whereas rentals are usually collected in advance. This is not an iron-clad rule and there is no reason why level EFA payments cannot be collected in advance, but a potential customer comparing loan and EFA proposals may ask.

Security Interest

It should be clear that the borrower owns the equipment from day one and is granting a first priority security interest to the lender. This sort of language, if included in a lease form at all, is often an afterthought. Unlike a lease intended as security, the EFA can clearly identify the equipment as collateral, which can carry benefits. For example, in granting a security interest, it is not uncommon to include interests in proceeds such as receivables if the equipment is rented (whether or not permitted) and insurance proceeds.

The security interest should, if possible, be perfected as a purchase money security interest, meaning, among other things, that the purchase price of the equipment is paid to the vendor and not as reimbursement to the borrower and that a UCC-1 Financing Statement is filed within 20 days after delivery of the equipment to the borrower.

Hell or High Water

One of the few comforting aspects of EFA transactions as opposed to leases is that loans are in inherently “hell or high water” obligations. Warranty disclaimers, unconditional obligation language and prohibitions on setoffs rarely appear in traditional loan documents. On the other hand, one lessor protection lost in an EFA is “finance lease” status under UCC Article 2A. It is probably a good idea to leave in at least a bare bones disclaimer of UCC warranties and statement that the transaction is free from rights of setoff and the like, particularly in the case of an equipment financing by a vendor captive, or any time that the EFA is to be based on a lease agreement form.

This raises the question of whether there is any downside to the EFA being interpreted as a lease. In most instances, lessors engaging in true leasing go to great lengths to avoid their transactions being interpreted by bankruptcy courts and tax agents as disguised loans. The reverse is rarely true but not inconceivable, as when a funder is concerned about possible bankruptcy of the originating lessor, or a plaintiff whose client has been injured by equipment collateral seeks to establish ownership in the lender in order to sue for negligence or vicarious liability.

From a more practical perspective, some funders' counsel who have more experience in lending than leasing may be uncomfortable with including traditional lease language in what is acknowledged to be a loan document. If so, the belt-and-suspenders benefits of stating that the EFA obligations are absolute and unconditional may be outweighed by the need to appease a banker.

Use and Maintenance

Lease documentation traditionally focuses on the equipment collateral as much as the creditworthiness of the lessee, and it might be argued that language requiring specific maintenance and applying restrictions on use is unnecessary. While this language may be confusing to some bank counsel, careful consideration should be given to the effects of reducing the borrower's obligations from those of a lessee.

Insurance

A major policy decision for some lessors is whether to require liability insurance coverage in an EFA. The lender under an EFA is significantly less likely to be successfully sued for damage caused by the equipment collateral than the owner of equipment under a true lease. Nevertheless, dropping the requirement for liability coverage may not come easy to many lessors or their banks. Similar drafting issues arise in the general indemnity section, which might be shortened if space is a concern.

Default and Remedy Language

With particular regard to the use of remedies under Article 9 of the UCC, this language must be reconsidered as it relates to loan foreclosures as opposed to lease repossessions. One particular concern is whether damages are calculated with reference to Casualty Value, as discussed below. If Casualty Value results in charges in excess of the outstanding principal, the calculation might be deemed to create a penalty, which might not be enforceable. In addition, rules regarding “commercially reasonable” sales and other limitations are even more important in an EFA than a traditional lease.

Casualty

Many lease casualty or stipulated loss value totals include protection from the loss of the lessor's bargain or additional charges to make the lessor whole should interest rates change since the inception of the lease. This calculation may not be enforceable in the case of an EFA because the lessor's loss is calculated with regard to equipment, while a lender's loss is calculated with regard to the loss of principal. A make-whole provision or stated prepayment premium, if those protections are desired, should be expressly stated rather than being added into the casualty value table calculation without disclosure.

Other Provisions

Language regarding the payment of taxes, particularly property taxes, must be examined as the equipment will clearly be owned by the borrower. Language describing subleases and assignments by the borrower must be revised so equipment is not subleased in the case of a loan agreement, and unlike lease obligations, loans are not traditionally assignable. In some states, the right to prepay a loan, as opposed to the right to return equipment prior to the end of the lease term, may be implied unless specifically waived.

One Final Note

We might fairly observe that the popularity of equipment finance agreements is indicative of the general shift from leasing to equipment finance. This subtle, but increasingly pronounced shift raises many issues for the industry. It is accompanied by pressure from some banks to include equipment finance in their product line and a blurring of the boundaries between bank lending and equipment finance departments.

At the same time, entering the world of equipment-collateralized loans involves more than some leasing professionals expect. There is much law governing commercial lending, as opposed to lease financing. Lending is highly regulated, while leasing long flew under state regulatory radar. Loans include such foreign provisions as financial covenants and revolving lending/repayment arrangements, and lenders do not limit collateral to equipment alone but look to receivables and other assets that may or may not be associated with the equipment collateral.

There is more involved here than a few tweaks to form documents. Now that our baby steps into the lending world are becoming a competitive sprint, it may be wise to think about just what equipment finance means and what we are doing in both the near-term and distant future.

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Barry Marks 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. Patricia T. Reid is an associate at Marks & Weinberg. Her transactional work is concentrated in equipment leases, contract negotiation and documentation. Her clients include national and regional banks, equipment leasing and finance companies.

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The rise of the Equipment Finance Agreement or EFA has been nothing short of meteoric. Fueled by concerns about lessor liability, confusion among state revenue agents regarding application of sales taxes and concerns regarding the reputation of equipment leasing, the EFA may soon eclipse the familiar “buck-out” lease intended as security.

On its face, using an existing equipment lease form to document an EFA transaction would seem fairly simple. The economics of an EFA should be similar to those of a lease intended as security: full payout with implicit interest and either a mandatory balloon payment or no additional payment at the end, with the borrower/lessee owning the equipment subject to a security interest for the lender/lessor. As many practitioners have found, however, taking a client's standard-form equipment lease and creating an equipment finance agreement is more complicated than it appears.

An EFA may be described as a Loan and Security Agreement and Promissory Note rolled into one document with several key provisions not normally found in standard Security Agreements. These provisions are commonly relied upon in the equipment financing and leasing industry to protect the equipment collateral. Their absence impacts both the lender's security and the marketability of an EFA on the secondary finance (syndication) market.

Before even beginning the conversion process, two fundamental questions must be answered: First, does the lessor want the EFA to look like a loan agreement or like a lease? Some lessors want to keep the transactions they offer as far from those presented by competing banks as possible. Others want the transaction to clearly be a loan so as to approach customers who are afraid of leasing. Second, what are the priorities? Does the lessor want the agreement to be as consistent as possible with existing lease documentation? What consistency must be preserved? Is length an issue, or may language be added to protect against legal risks inherent in lending?

This article examines these and other issues that arise in converting lease forms into equipment finance agreements.

An Equipment Finance Agreement Is a Loan Document

There are many reasons to base an EFA form on an existing lease document. Among other things, consistency between the forms will facilitate administration and maintain branding. Working from an existing form is generally less time-consuming for the draftsman (which may be read as “less expensive for the client”). Consistency will also minimize operational confusion and facilitate the use of existing ancillary documents such as secretary's certificates and insurance forms.

Against this consistency, however, is a simple fact clear to most lawyers but sometimes lost on their clients: An equipment finance agreement is a loan document. It is an entirely different animal from the true lease documentation on which most, if not all, leases intended as security are based. Many of the issues raised by this difference require counsel to be versed in lending as well as leasing, particularly if the EFA is to be sold to a bank represented by counsel familiar with traditional lending.

What is really happening is that documentation based on equipment rental agreements is being transformed into loan documentation. While rental agreements address commercial transactions, loan documentation is based on many years of secured lending. Some loan document concepts have always been incorporated into leases intended as security, but others rarely come up in any type of leasing.

One of the fundamental differences between a lease and an EFA is that EFAs involve the collection of interest. This is true whether the EFA breaks down monthly payments between principal and interest, or combines them as a single payment. Because interest is charged, lenders should expect that laws regarding the collection of interest, most notably usury laws, will apply in EFA transactions.

Interest is generally defined for purposes of state usury laws as a charge for the use of money or forbearance in collecting a debt. Many states have civil or criminal usury statutes, or both, applicable to commercial lending as well as loans to consumers. While lessors sometimes ignore these laws, even for leases intended as security, EFA lenders must take them into account. A particular concern is that many leases include high late fees and additional charges for tax service, inspections or other services rendered by the lessor. These charges, in some cases, can be reinterpreted as additional interest, causing a seemingly safe transaction to exceed usury rates.

In contrast, most courts acknowledge that true leases are not subject to usury laws as interest is not collected. See, e.g., Performance Systems, Inc. v. First American Nat. Bank , 554 S.W.2d 616 (Tenn.); Orix Credit Alliance, Inc. v. Northeastern Tech Excavating Corp. , 222 A.D.2d 796, 634 N.Y.S.2d 841 (3d Dep't 1995); Citipostal, Inc. v. Unistar Leasing , 283 A.D.2d 916, 724 N.Y.S.2d 555 (4th Dep't 2001).

The same may not be true for “rent” charged in leases intended as security is sometimes re-characterized as principal and (implicit) interest, although some would argue that the implicit rate is not interest at all. The lender under an EFA does not even have this form-over-substance argument that interest is not being charged and collected.

This brings about two important defenses used by lenders traditionally as a means of avoiding usury restrictions. First, a usury savings clause, stating that the parties do not intend to violate applicable law and that payments will be reduced as necessary to avoid the collection of excessive interest is generally advisable. These clauses are rarely found in equipment leases, and it is understandable that many lessors prefer not to see anything that implies that their rent may be “too high” or that any payment should be reduced. There are cases in which courts have refused to reduce interest charged below the usury limit by applying a usury savings clause. In re Venture Mortgage Fund, L.P., 282 F.3d 185 (2nd Cir. 2002); Swindell v. Fannie Mae , 330 N.C. 153 (1991); Federal Home Loan Mortgage Corporation v. 333 Neptune Avenue Limited Partnership, 201 F.3d 431 (2nd Cir. 1999). There may be reason for concern that the presence of the clause indicates an intention to violate usury laws. Henson v. Columbus Bank & Trust Company , 770 F.2d 1566 (11th Cir. 1985) (“When [other elements of usury] are express on the face of the contract, usurious intent may be presumed.”) Nevertheless, many courts have held that the presence of a usury savings clause protects against usury penalties. E.g., Continental Mortgage Investors v. Sailboat Key, Inc. , 395 So.2d 507 (Fla. 1981).

Second, choice of law becomes even more important where interest at a high rate will be collected. Avoiding application of the laws of a state with a low usury ceiling, particularly a criminal rate, is highly advisable. Including a consent to jurisdiction or forum selection clause designating the location in which the parties will litigate disputes strengthens the choice of law.

The collection of interest brings about other issues. While lessors rarely disclose implicit rates, disclosure of interest rates may be required in EFAs, either by law or market pressures. In Georgia, the requirement of a “stated” rate of interest is generally regarded as a requirement that interest rates be disclosed in order to avoid the state's restrictive usury laws. O.C.G.A. ' 7-4-2.' Customers who recognize that the EFA is a loan document may want to see interest expressed in familiar terms. This will particularly be true where the EFA is offered as an alternative to traditional loan financing, as where the EFA lender is competing with a bank lender.

Specific Drafting Considerations

Briefly touching on a few of the many issues that are likely to arise:

Definitions

Replacing “lessor” and “lessee” with “lender” and “borrower” may be easy enough but raises the question of how much like a bank loan agreement the parties want the EFA to appear. Likewise, the decision whether to replace “rent” with “payment” or a similar word or with an expression of “principal and interest” involves both the questions of whether to disclose the implicit interest rate and whether to distinguish the EFA transaction from a competing bank loan.

Loan payments are generally collected in arrears, whereas rentals are usually collected in advance. This is not an iron-clad rule and there is no reason why level EFA payments cannot be collected in advance, but a potential customer comparing loan and EFA proposals may ask.

Security Interest

It should be clear that the borrower owns the equipment from day one and is granting a first priority security interest to the lender. This sort of language, if included in a lease form at all, is often an afterthought. Unlike a lease intended as security, the EFA can clearly identify the equipment as collateral, which can carry benefits. For example, in granting a security interest, it is not uncommon to include interests in proceeds such as receivables if the equipment is rented (whether or not permitted) and insurance proceeds.

The security interest should, if possible, be perfected as a purchase money security interest, meaning, among other things, that the purchase price of the equipment is paid to the vendor and not as reimbursement to the borrower and that a UCC-1 Financing Statement is filed within 20 days after delivery of the equipment to the borrower.

Hell or High Water

One of the few comforting aspects of EFA transactions as opposed to leases is that loans are in inherently “hell or high water” obligations. Warranty disclaimers, unconditional obligation language and prohibitions on setoffs rarely appear in traditional loan documents. On the other hand, one lessor protection lost in an EFA is “finance lease” status under UCC Article 2A. It is probably a good idea to leave in at least a bare bones disclaimer of UCC warranties and statement that the transaction is free from rights of setoff and the like, particularly in the case of an equipment financing by a vendor captive, or any time that the EFA is to be based on a lease agreement form.

This raises the question of whether there is any downside to the EFA being interpreted as a lease. In most instances, lessors engaging in true leasing go to great lengths to avoid their transactions being interpreted by bankruptcy courts and tax agents as disguised loans. The reverse is rarely true but not inconceivable, as when a funder is concerned about possible bankruptcy of the originating lessor, or a plaintiff whose client has been injured by equipment collateral seeks to establish ownership in the lender in order to sue for negligence or vicarious liability.

From a more practical perspective, some funders' counsel who have more experience in lending than leasing may be uncomfortable with including traditional lease language in what is acknowledged to be a loan document. If so, the belt-and-suspenders benefits of stating that the EFA obligations are absolute and unconditional may be outweighed by the need to appease a banker.

Use and Maintenance

Lease documentation traditionally focuses on the equipment collateral as much as the creditworthiness of the lessee, and it might be argued that language requiring specific maintenance and applying restrictions on use is unnecessary. While this language may be confusing to some bank counsel, careful consideration should be given to the effects of reducing the borrower's obligations from those of a lessee.

Insurance

A major policy decision for some lessors is whether to require liability insurance coverage in an EFA. The lender under an EFA is significantly less likely to be successfully sued for damage caused by the equipment collateral than the owner of equipment under a true lease. Nevertheless, dropping the requirement for liability coverage may not come easy to many lessors or their banks. Similar drafting issues arise in the general indemnity section, which might be shortened if space is a concern.

Default and Remedy Language

With particular regard to the use of remedies under Article 9 of the UCC, this language must be reconsidered as it relates to loan foreclosures as opposed to lease repossessions. One particular concern is whether damages are calculated with reference to Casualty Value, as discussed below. If Casualty Value results in charges in excess of the outstanding principal, the calculation might be deemed to create a penalty, which might not be enforceable. In addition, rules regarding “commercially reasonable” sales and other limitations are even more important in an EFA than a traditional lease.

Casualty

Many lease casualty or stipulated loss value totals include protection from the loss of the lessor's bargain or additional charges to make the lessor whole should interest rates change since the inception of the lease. This calculation may not be enforceable in the case of an EFA because the lessor's loss is calculated with regard to equipment, while a lender's loss is calculated with regard to the loss of principal. A make-whole provision or stated prepayment premium, if those protections are desired, should be expressly stated rather than being added into the casualty value table calculation without disclosure.

Other Provisions

Language regarding the payment of taxes, particularly property taxes, must be examined as the equipment will clearly be owned by the borrower. Language describing subleases and assignments by the borrower must be revised so equipment is not subleased in the case of a loan agreement, and unlike lease obligations, loans are not traditionally assignable. In some states, the right to prepay a loan, as opposed to the right to return equipment prior to the end of the lease term, may be implied unless specifically waived.

One Final Note

We might fairly observe that the popularity of equipment finance agreements is indicative of the general shift from leasing to equipment finance. This subtle, but increasingly pronounced shift raises many issues for the industry. It is accompanied by pressure from some banks to include equipment finance in their product line and a blurring of the boundaries between bank lending and equipment finance departments.

At the same time, entering the world of equipment-collateralized loans involves more than some leasing professionals expect. There is much law governing commercial lending, as opposed to lease financing. Lending is highly regulated, while leasing long flew under state regulatory radar. Loans include such foreign provisions as financial covenants and revolving lending/repayment arrangements, and lenders do not limit collateral to equipment alone but look to receivables and other assets that may or may not be associated with the equipment collateral.

There is more involved here than a few tweaks to form documents. Now that our baby steps into the lending world are becoming a competitive sprint, it may be wise to think about just what equipment finance means and what we are doing in both the near-term and distant future.

'

Barry Marks 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. Patricia T. Reid is an associate at Marks & Weinberg. Her transactional work is concentrated in equipment leases, contract negotiation and documentation. Her clients include national and regional banks, equipment leasing and finance companies.

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