Lease Portfolio Purchase Due Diligence

A New Trend

Of late, it is not uncommon for the finance company you represent to seek your advice about purchasing a stream of payments with no claim to, or purchase of, the equipment's residual value unless a default in the payment stream occurs. The equipment is the collateral that secures the lessee's faithful performance of its obligations under the lease, even if the finance company doesn't own the residual. Accordingly, since there is no back-end kicker through the disposition of residual, a due diligence investigation is a necessary ingredient to any successful portfolio purchase, where just the payment stream is being purchased.

Frequently, the business and credit professionals at lease finance companies are particularly focused on the credit underwriting aspects of due diligence when purchasing a portfolio. The finance company will carefully establish its credit criteria that each lease in the portfolio must meet. It will typically include a requirement that the lessee meet a certain minimum credit score, that there not be a first payment default, that the portfolio be appropriately aged, not have more than a certain number of late payments, if any, and of course, any prior lessee bankruptcy just to name a few.

Additionally, if the assignor of the portfolio is also providing the servicing, consideration will be given to the commingling of Servicer's funds or the funds of others with the proceeds derived from the lease stream belonging to the finance company from the portfolio it owns. A servicer bankruptcy will tie up the financing company's capital for a long time, perhaps forever when funds of the Servicer are commingled. Provisions in the Servicing Agreement between the portfolio purchaser and the Servicer will most likely address this and other issues.

The Servicing Standard

Among the other issues the Servicing Agreement should address is the negotiation of the servicing standard, which is the effort the Servicer will employ to maximize the timely recovery of the finance company's payment stream and the diligence with which it will seek to preserve all applicable remedies found in each of the leases comprising the portfolio. Typically, such provisions obligate the Servicer to enforce the finance company's rights in accordance with applicable law and prudent, usual and customary procedures of financial institutions in like situations charged with servicing a portfolio of leases for others or, to be more precise, the procedures that the Servicer uses on leases for which it receives payments on its own account. The due diligence investigation for your client should review this servicing standard modifying it where necessary to insure vigorous enforcement of your client's right to receive its payments.

Also typically encountered in most Servicing Agreements is the equipment value threshold above which the Servicer agrees to insure that all necessary or desirable action is taken to perfect and maintain continuous perfection and first lien priority of the security interests granted by the lessee in the equipment to assignor/servicer. The first lien security interest is thereupon assigned to the finance company during the term of the lease or until the payment stream is paid in full.

This raises yet another complication if the assignor/servicer has existing credit facilities with a lender(s) that has filed blanket liens. In representing the finance company, part of counsel's due diligence obligation is to perform a lien and judgment search to ascertain what liens and judgments have been filed against the assignor/servicer that could interfere with the finance company's ability to collect its payment stream in the event of a default and then to obtain a subordination from those prior or blanket lien holders or negotiate an appropriate Inter-creditor arrangement that protects the finance company's right to collect its payment stream and/or seize the collateral and monetize it.

Again, because the equipment serves as the collateral from the lessee to the finance company when a lease stream is purchased and to insure payment for as long as any obligations are owed by the lessee to the finance company, the finance company must expend time and effort to confirm and maintain insurance coverage on the collateral. Usually, the Servicing Agreement will require the Servicer to insist on evidence from the lessee showing appropriate coverage naming the Servicer and its assigns is continuously maintained and permitting the Servicer to force place coverage if it lapses. Counsel for the finance company's due diligence includes an insurance audit of all leases to establish there is insurance coverage in an appropriate amount for all equipment collateral and that such insurance is continually maintained through completion of the payment stream obligations.

Third Parties

In those situations where servicing is done by some third-party organization, the exercise of due diligence requires that you, as counsel for the financing agency, investigate the servicers success at collection of defaulted leases. Does the servicer maintain full-time professional collectors that possess the necessary skill and training to engage the lessee and secure the payments you purchased? Do they keep extensive notes of those contact calls? Do they make collection calls on a regular basis and utilize the most up-to-date software to assist in this effort? Do they provide meaningful monthly aging reports? Are there procedures in place to enforce collection? What is their success rate? These are all questions that a diligent lawyer would ask to insure that the selected servicer is doing its job to collect your client's payments.

Recourse Rights

What recourse rights, if any, does your client have against the assignor/servicer in the event of a default by a lessee? Most Program Agreements that accompany the execution of the Servicing Agreement provide little or no recourse rights. But is that fair? The assignor/servicer is in a better position than the finance company to manage the risks associated with equipment leasing. They are likely providing you with relatively standard representations and warranties dealing with the authority of the lessee to execute the lease agreement, the validity of the signatures of the lessee and all guarantors and the veracity of all financial information it has gathered in connection with closing the lease transaction, all of which you require to minimize fraud. Shouldn't the assignor/servicer stand behind those standard representations and warranties and provide a right of recourse in the event they prove untrue?

What if the assignor/servicer fails to perfect its security interest in the collateral as a consequence of an incorrect indexing of the financing statement due to a negligent mistake in the recording of the name of the of the lessee?

What if the error in the name of the lessee was due to a purposeful concealment or fraud by the lessee? Has the assignor/servicer confirmed the identity of its lessee by the exercise of its own appropriate due diligence?

Regardless of the answer to these questions, you as counsel for the finance company, of course depending upon the practicality of doing so given the size of the portfolio, should consider examining the formation documents for each lessee in the portfolio without the need to rely on the assignor/servicer's representation.

Are there recourse rights against the servicer for a material failure in its duties? For example, the servicer is usually expected to bill and remit all sales and other required taxes due on the lease payments to the appropriate taxing authority. If the servicer fails or neglects in this duty is the servicer responsible for all late payments and penalties imposed by the taxing authority?

If these and other breaches occur, what are the rights of the finance company to terminate servicing and by what means is each lessee informed of the demand to discontinue making payments to the servicer and initiate future payments to the finance company.

An Example

Part of counsel's due diligence should include an examination of the servicer's prior history of compliance with its servicing obligations and should include a continuation of that monitoring to insure the servicer is doing what it contracted to do. We had a situation some years ago where a servicer mistakenly coded payments that were intended for another finance company, but landed in an account coded for our client. It could after all have been an innocent, albeit curious, mistake to make. The following month, however, sums due to our client under its perfect pay arrangement were not deposited to the client's account. It raised all sorts of red flags. The client, at our urging, began an intensive examination of just what was happening.

The under-the-microscope examination proved helpful and our instincts correct. One month later we encouraged the client to terminate the servicing arrangement when explanations from the servicer were less than satisfactory. Approximately six months later, and certainly outside any applicable preference period, the servicer filed for bankruptcy. Most other finance companies were not so lucky. The portfolios they purchased became mired in the bankruptcy because they ignored some fundamental warning signs. A request to the client to provide ongoing information about how the servicer was complying with its service obligations exposed this issue in time to allow the client to take steps to minimize its involvement in the bankruptcy.

Additionally, having a letter in advance on the servicer's letterhead and signed by the servicer to be sent to all lessees upon default and a termination of servicing arrangement certainly assisted in the quick substitution of the client as the new servicer. Keep in mind that even in the best of circumstances, not all lessees immediately discontinue payments to the servicer upon receipt of such a letter. In our experience, it can take as long as 90 days to educate all lessees as to where payments are now to be remitted. Nevertheless, the disruption caused by the sudden change in servicer proved to be nothing by comparison to the difficulties and delays that other finance companies suffered in the bankruptcy. To this day, our client recalls how a little bit of diligence on our part saved them hundreds of thousands in legal fees.

A Thorough Review

In addition to the above, good practice suggests that counsel representing the financing company also undertake a legal due diligence review of all leases in the proposed portfolio to be purchased while the client is simultaneously examining each lease in the portfolio from a credit perspective. In the typical portfolio our legal due diligence includes a review of the following:

• Fully signed Lease as well as all Amendments and Schedules where the equipment is properly described and with serial numbers (We also prefer a photograph depicting the serial number on the equipment which is no longer difficult given the ubiquitous camera phone);
• Company resolution approving the transaction with an incumbency certification attached;
• The Note;
• The Security Agreement;
• The Uniform Commercial Code filing, noting that it is correctly filed with the right lessee in the correct jurisdiction;
• The Delivery & Acceptance Certificate properly executed and dated at on after the equipment is delivered and set-up;
• Proper insurance certificates naming the client as a loss payee and additional insured with an obligation from the insurance company to notify the client prior to lapse due to non-payment of premium;
• Guaranty Agreements properly executed and dated that specifically state that it is a guaranty of payment and performance and not of collection. Entity guarantees must be accompanied by a resolution and incumbency certification as well;
• A properly executed Landlord's Waiver that permits the finance company sufficient time to remove the equipment, or conduct an on-site sale if it is too cumbersome to remove, in addition to landlord's agreement to subordinate its rights to the finance company;
• Flood certification;
• A proper and valid assignment letter to the financing company of the stream of payments for each lease plus collateral rights in the equipment;
• Good Standing certificates for lessee and all entity guarantors;
• For states that permit it like Pennsylvania, a valid and enforceable Confession of Judgment provision with separate accompanying explanation and waiver of rights;
• A jurisdiction and choice of law provision in the lease that is acceptable to the client;
• If there is a franchisor, a waiver and subordination by the franchisor along the lines of the waiver obtained from the landlord and a consent to assignment from the franchisor; and
• A copy of the lessee and guarantors' photo identification.

We would add to this list a Progress Payment Agreement on the appropriate occasions when it is required as well as our continued plea for telephone verification from the lessee of delivery and acceptance in addition to reliance on the written Delivery and Acceptance Certificate.

Having a due diligence list handy and performing a due-diligence review of each lease in any portfolio has always resulted in the discovery of missing documents that are then either found or replicated, making such legal due diligence examination worthwhile and justifying its nominal expense. Many of our clients have returned leases in a portfolio that lacked some or all of the necessary documentation prior to closing the portfolio purchase, thus enhancing the value of the entire portfolio.

Conclusion

Performing the necessary due diligence that any accomplished leasing lawyer should undertake is not time-consuming, and now with this article, hopefully not difficult. Given how successful this has been in our practice, those clients that have asked us to complete a legal due diligence investigation of all of the proposed leases in the portfolio will never again seek to purchase a lease portfolio without asking us to do a legal due diligence investigation first.

Anthony L. Lamm and Stephen Levin are partners in The Lamm Group with offices in Philadelphia and Cherry Hill, NJ. Lamm, the firm's managing partner and a member of this newsletter's Board of Editors, is admitted in Pennsylvania. Levin is admitted in Pennsylvania and New York. They may be reached at [email protected] and [email protected], respectively.'

Editor's Note: This article is the third in a continuing series on sophisticated leasing issues.'

This article examines the due diligence steps that every lawyer must address when advising a client about the merits of purchasing an equipment lease portfolio. Years of legal due diligence reviews of clients' proposed portfolio purchases, a great deal of common sense, a well-developed checklist and a number of war stories from experience have taught us not only the importance of conducting a legal due diligence review, but also the steps to take to ensure that an educated decision can be made concerning the risks inherent in purchasing a particular portfolio.

Performing due diligence investigations is far more important and far more far-reaching than only ferreting out fraud. We are not minimizing the extreme care that a lease finance company must take to prevent loss due to fraud, but this article addresses what steps a lease finance company must take to improve the portfolio purchase realization rate along with minimizing fraud, and servicing issues concerning default, late payment, or no payment, plus many other concerns, through an effective due diligence investigation. No effort is made to discuss the negotiation of business and legal points of a portfolio purchase agreement unless it relates to accompanying due diligence investigations that could assist in a mutually successful arrangement. We can leave the negotiation of business and legal provisions of a portfolio purchase to a future article.

A New Trend

Of late, it is not uncommon for the finance company you represent to seek your advice about purchasing a stream of payments with no claim to, or purchase of, the equipment's residual value unless a default in the payment stream occurs. The equipment is the collateral that secures the lessee's faithful performance of its obligations under the lease, even if the finance company doesn't own the residual. Accordingly, since there is no back-end kicker through the disposition of residual, a due diligence investigation is a necessary ingredient to any successful portfolio purchase, where just the payment stream is being purchased.

Frequently, the business and credit professionals at lease finance companies are particularly focused on the credit underwriting aspects of due diligence when purchasing a portfolio. The finance company will carefully establish its credit criteria that each lease in the portfolio must meet. It will typically include a requirement that the lessee meet a certain minimum credit score, that there not be a first payment default, that the portfolio be appropriately aged, not have more than a certain number of late payments, if any, and of course, any prior lessee bankruptcy just to name a few.

Additionally, if the assignor of the portfolio is also providing the servicing, consideration will be given to the commingling of Servicer's funds or the funds of others with the proceeds derived from the lease stream belonging to the finance company from the portfolio it owns. A servicer bankruptcy will tie up the financing company's capital for a long time, perhaps forever when funds of the Servicer are commingled. Provisions in the Servicing Agreement between the portfolio purchaser and the Servicer will most likely address this and other issues.

The Servicing Standard

Among the other issues the Servicing Agreement should address is the negotiation of the servicing standard, which is the effort the Servicer will employ to maximize the timely recovery of the finance company's payment stream and the diligence with which it will seek to preserve all applicable remedies found in each of the leases comprising the portfolio. Typically, such provisions obligate the Servicer to enforce the finance company's rights in accordance with applicable law and prudent, usual and customary procedures of financial institutions in like situations charged with servicing a portfolio of leases for others or, to be more precise, the procedures that the Servicer uses on leases for which it receives payments on its own account. The due diligence investigation for your client should review this servicing standard modifying it where necessary to insure vigorous enforcement of your client's right to receive its payments.

Also typically encountered in most Servicing Agreements is the equipment value threshold above which the Servicer agrees to insure that all necessary or desirable action is taken to perfect and maintain continuous perfection and first lien priority of the security interests granted by the lessee in the equipment to assignor/servicer. The first lien security interest is thereupon assigned to the finance company during the term of the lease or until the payment stream is paid in full.

This raises yet another complication if the assignor/servicer has existing credit facilities with a lender(s) that has filed blanket liens. In representing the finance company, part of counsel's due diligence obligation is to perform a lien and judgment search to ascertain what liens and judgments have been filed against the assignor/servicer that could interfere with the finance company's ability to collect its payment stream in the event of a default and then to obtain a subordination from those prior or blanket lien holders or negotiate an appropriate Inter-creditor arrangement that protects the finance company's right to collect its payment stream and/or seize the collateral and monetize it.

Again, because the equipment serves as the collateral from the lessee to the finance company when a lease stream is purchased and to insure payment for as long as any obligations are owed by the lessee to the finance company, the finance company must expend time and effort to confirm and maintain insurance coverage on the collateral. Usually, the Servicing Agreement will require the Servicer to insist on evidence from the lessee showing appropriate coverage naming the Servicer and its assigns is continuously maintained and permitting the Servicer to force place coverage if it lapses. Counsel for the finance company's due diligence includes an insurance audit of all leases to establish there is insurance coverage in an appropriate amount for all equipment collateral and that such insurance is continually maintained through completion of the payment stream obligations.

Third Parties

In those situations where servicing is done by some third-party organization, the exercise of due diligence requires that you, as counsel for the financing agency, investigate the servicers success at collection of defaulted leases. Does the servicer maintain full-time professional collectors that possess the necessary skill and training to engage the lessee and secure the payments you purchased? Do they keep extensive notes of those contact calls? Do they make collection calls on a regular basis and utilize the most up-to-date software to assist in this effort? Do they provide meaningful monthly aging reports? Are there procedures in place to enforce collection? What is their success rate? These are all questions that a diligent lawyer would ask to insure that the selected servicer is doing its job to collect your client's payments.

Recourse Rights

What recourse rights, if any, does your client have against the assignor/servicer in the event of a default by a lessee? Most Program Agreements that accompany the execution of the Servicing Agreement provide little or no recourse rights. But is that fair? The assignor/servicer is in a better position than the finance company to manage the risks associated with equipment leasing. They are likely providing you with relatively standard representations and warranties dealing with the authority of the lessee to execute the lease agreement, the validity of the signatures of the lessee and all guarantors and the veracity of all financial information it has gathered in connection with closing the lease transaction, all of which you require to minimize fraud. Shouldn't the assignor/servicer stand behind those standard representations and warranties and provide a right of recourse in the event they prove untrue?

What if the assignor/servicer fails to perfect its security interest in the collateral as a consequence of an incorrect indexing of the financing statement due to a negligent mistake in the recording of the name of the of the lessee?

What if the error in the name of the lessee was due to a purposeful concealment or fraud by the lessee? Has the assignor/servicer confirmed the identity of its lessee by the exercise of its own appropriate due diligence?

Regardless of the answer to these questions, you as counsel for the finance company, of course depending upon the practicality of doing so given the size of the portfolio, should consider examining the formation documents for each lessee in the portfolio without the need to rely on the assignor/servicer's representation.

Are there recourse rights against the servicer for a material failure in its duties? For example, the servicer is usually expected to bill and remit all sales and other required taxes due on the lease payments to the appropriate taxing authority. If the servicer fails or neglects in this duty is the servicer responsible for all late payments and penalties imposed by the taxing authority?

If these and other breaches occur, what are the rights of the finance company to terminate servicing and by what means is each lessee informed of the demand to discontinue making payments to the servicer and initiate future payments to the finance company.

An Example

Part of counsel's due diligence should include an examination of the servicer's prior history of compliance with its servicing obligations and should include a continuation of that monitoring to insure the servicer is doing what it contracted to do. We had a situation some years ago where a servicer mistakenly coded payments that were intended for another finance company, but landed in an account coded for our client. It could after all have been an innocent, albeit curious, mistake to make. The following month, however, sums due to our client under its perfect pay arrangement were not deposited to the client's account. It raised all sorts of red flags. The client, at our urging, began an intensive examination of just what was happening.

The under-the-microscope examination proved helpful and our instincts correct. One month later we encouraged the client to terminate the servicing arrangement when explanations from the servicer were less than satisfactory. Approximately six months later, and certainly outside any applicable preference period, the servicer filed for bankruptcy. Most other finance companies were not so lucky. The portfolios they purchased became mired in the bankruptcy because they ignored some fundamental warning signs. A request to the client to provide ongoing information about how the servicer was complying with its service obligations exposed this issue in time to allow the client to take steps to minimize its involvement in the bankruptcy.

Additionally, having a letter in advance on the servicer's letterhead and signed by the servicer to be sent to all lessees upon default and a termination of servicing arrangement certainly assisted in the quick substitution of the client as the new servicer. Keep in mind that even in the best of circumstances, not all lessees immediately discontinue payments to the servicer upon receipt of such a letter. In our experience, it can take as long as 90 days to educate all lessees as to where payments are now to be remitted. Nevertheless, the disruption caused by the sudden change in servicer proved to be nothing by comparison to the difficulties and delays that other finance companies suffered in the bankruptcy. To this day, our client recalls how a little bit of diligence on our part saved them hundreds of thousands in legal fees.

A Thorough Review

In addition to the above, good practice suggests that counsel representing the financing company also undertake a legal due diligence review of all leases in the proposed portfolio to be purchased while the client is simultaneously examining each lease in the portfolio from a credit perspective. In the typical portfolio our legal due diligence includes a review of the following:

• Fully signed Lease as well as all Amendments and Schedules where the equipment is properly described and with serial numbers (We also prefer a photograph depicting the serial number on the equipment which is no longer difficult given the ubiquitous camera phone);
• Company resolution approving the transaction with an incumbency certification attached;
• The Note;
• The Security Agreement;
• The Uniform Commercial Code filing, noting that it is correctly filed with the right lessee in the correct jurisdiction;
• The Delivery & Acceptance Certificate properly executed and dated at on after the equipment is delivered and set-up;
• Proper insurance certificates naming the client as a loss payee and additional insured with an obligation from the insurance company to notify the client prior to lapse due to non-payment of premium;
• Guaranty Agreements properly executed and dated that specifically state that it is a guaranty of payment and performance and not of collection. Entity guarantees must be accompanied by a resolution and incumbency certification as well;
• A properly executed Landlord's Waiver that permits the finance company sufficient time to remove the equipment, or conduct an on-site sale if it is too cumbersome to remove, in addition to landlord's agreement to subordinate its rights to the finance company;
• Flood certification;
• A proper and valid assignment letter to the financing company of the stream of payments for each lease plus collateral rights in the equipment;
• Good Standing certificates for lessee and all entity guarantors;
• For states that permit it like Pennsylvania, a valid and enforceable Confession of Judgment provision with separate accompanying explanation and waiver of rights;
• A jurisdiction and choice of law provision in the lease that is acceptable to the client;
• If there is a franchisor, a waiver and subordination by the franchisor along the lines of the waiver obtained from the landlord and a consent to assignment from the franchisor; and
• A copy of the lessee and guarantors' photo identification.

We would add to this list a Progress Payment Agreement on the appropriate occasions when it is required as well as our continued plea for telephone verification from the lessee of delivery and acceptance in addition to reliance on the written Delivery and Acceptance Certificate.

Having a due diligence list handy and performing a due-diligence review of each lease in any portfolio has always resulted in the discovery of missing documents that are then either found or replicated, making such legal due diligence examination worthwhile and justifying its nominal expense. Many of our clients have returned leases in a portfolio that lacked some or all of the necessary documentation prior to closing the portfolio purchase, thus enhancing the value of the entire portfolio.

Conclusion

Performing the necessary due diligence that any accomplished leasing lawyer should undertake is not time-consuming, and now with this article, hopefully not difficult. Given how successful this has been in our practice, those clients that have asked us to complete a legal due diligence investigation of all of the proposed leases in the portfolio will never again seek to purchase a lease portfolio without asking us to do a legal due diligence investigation first.

Anthony L. Lamm and Stephen Levin are partners in The Lamm Group with offices in Philadelphia and Cherry Hill, NJ. Lamm, the firm's managing partner and a member of this newsletter's Board of Editors, is admitted in Pennsylvania. Levin is admitted in Pennsylvania and New York. They may be reached at [email protected] and [email protected], respectively.'