Municipal Leasing: Favorite Son or Leasing's 'Red-Headed Stepchild'?

Leasing may be an attractive alternative to bond financing for the governmental entities. This is particularly true where specific items of equipment are being financed, where the dollar amount involved does not justify traditional bond closing costs and where the lessee/issuer already has a significant bond indebtedness outstanding. Leases (or lease-purchases, as they are called in some states) are allowed without voter approval.

This article addresses a few of the primary challenges for traditional leasing companies entering the municipal leasing market.

The Laws Are Not Uniform

Leases to non-governmental business entities benefit from the certainty provided by the Uniform Commercial Code (UCC). From state to state there are only minor variations in Article 2A (Leases) and Article 9 (Secured Transactions). Lessors save time and money by using standardized forms and procedures to document transactions and perfect security interests from state to state.

The law governing municipal transactions is less predictable. There are statutes addressed to the financing of specific categories of equipment. For example, Louisiana has rules related to leasing telecommunication equipment. Some states, such as Illinois, allow multiyear obligations in leases for personal property. Some states have programs through which municipalities finance certain equipment through the state. For example, counties in Delaware are required to lease vehicles from the Delaware Division of Support Services. See, Del. Code Ann. tit. 9 ' 6906(d).

While lessors can still generally use a standard municipal lease form, many state statutes require particular provisions in the lease agreements in order to be binding. For example, agreements with the State of Ohio require a certification that there is a balance in the budget that is not already appropriated, and that it is sufficient to pay the obligations coming due in the current fiscal year.

Lessee Attorney Opinions

For most lease transactions with governmental entities, lessor counsel frequently require an opinion from the lessee's lawyer that the lease transaction has been duly approved and the document appropriately executed.

An opinion of local counsel gives the lessor assurance that the lease has been properly approved by the governmental entity. For non-governmental borrowers, many lessors comfortably rely on corporate or member resolutions approving most small-ticket and middle-market transactions. Corporate procedures do not vary widely from state to state, and lessors can rely on the doctrine of “apparent authority,” under which corporate officers may be presumed to have certain powers, particularly when making purchases and borrowing money in the company's ordinary course of business.

By contrast, the approval process for governmental entities is less consistent, and the apparent authority doctrine does not apply to public officers. For example, personal property leases for parishes in Louisiana require the approval of the State Bond Commissioner pursuant to R.S. 39:1410.60 et.seq . The lessee's lawyer should be familiar with the state's laws related to such transactions, as well as the lessee's standard procedures for approval.

One cautionary note on this topic is in order: In many cases, the lessee's counsel, particularly in-house counsel, does not carry sufficient malpractice coverage to address damages resulting from an incorrect opinion. Moreover, the abilities and professionalism of counsel vary greatly and many city or county lawyers do not have experience in rendering opinions in major transactions, but will be under pressure to facilitate the desired financing.

Non-appropriation

One of the better-known idiosyncrasies of municipal leasing is the “non-appropriation” clause. Most cities and counties are prohibited from incurring debt without voter approval. Whether a transaction constitutes debt for a municipality is different from the question of whether a transaction is a secured loan or true lease for UCC, accounting or tax purposes. For municipal financing purposes generally, a debt is a payment obligation that extends beyond the current fiscal year of the municipality. Therefore, a true lease would be considered a municipal debt if it involved multiyear payments. But a lease intended as security would not necessarily be considered debt if it has a non-appropriation clause.

A non-appropriation clause basically provides that the municipality can stop making lease payments at the end of its fiscal year and have no further obligation under the contract if it does not appropriate funds (i.e., put money in its budget) to pay the lease payments in the next fiscal year. It merely returns the equipment to the lessor and walks away. Despite the non-appropriation clause, the lease payments for the transaction will be calculated based on the expected term of the transaction. However, the lessor cannot accelerate future fiscal year rents because the municipality has made no appropriation for these payments.

Often, the non-appropriation clause will provide that the lease will automatically renew for another fiscal year unless the municipality does not appropriate funds for the payments.

While municipalities are generally lower credit risks than private parties, non-appropriation adds a different risk for the government loans. Lessors can lessen this risk by leasing only essential equipment. The more essential the equipment, the less likely it will be that the municipality will walk away from the equipment before the end of the term. Additionally, certain clauses are included in most municipal leases that are designed to mitigate the non-appropriation risk.

Non-Substitution Clause

One of the most common protections is a non-substitution clause. This clause provides that the lessee may not acquire equipment similar to the leased equipment within a stated period of time after termination due to non-appropriation. Such a clause could keep the municipality from returning the lessor's equipment before the end of the intended term and quickly replacing it with better equipment or merely a better lease deal. However, some state courts have found that such clauses are unenforceable because they render a non-appropriations clause useless. If the equipment is essential equipment and cannot be replaced for a given period of time, then the municipality cannot, as a practical matter, non-appropriate. Therefore, the transaction is really debt because the contract compels the expenditure beyond one year. See. e.g., Frankenmuth v. Magaha 769 So.2d 1012 (Fla. 2000).

Good Faith

Another commonly used provision requires the lessee to use reasonable efforts in good faith to secure appropriations. These clauses are of dubious enforceability because they may interfere with the sovereignty of the municipality. Such clauses could also negate the value of the non-appropriation clause under some state laws. For example, the Texas Court of Appeals in City-County Waste Control Board v. Capital City Leasing, 813 S.W.2d 705, 1991 Tex. App. LEXIS 1869, held that a requirement that the municipality seek in good faith to obtain appropriations for the lease for the entire term actually constitutes an obligation extending beyond one year. Consequently, the lease transaction was considered an unconstitutional debt.

Some states go so far as to require something more than a non-appropriation termination right, such as a lessee's right to terminate the lease for convenience. Under these laws, not only can the lease be terminated in the event the lessee's governing body does not appropriate sufficient funds, the lessee has a right, for any reason, to terminate the lease and return the leased equipment. The wording in these laws leaves a substantial question as to whether they are satisfied by a simple non-appropriation clause or if something more is required. See the following excerpt from a Georgia statute:

O.C.G.A. ' 36-60-13 (2014)

' 36-60-13. Multiyear lease, purchase, or lease-purchase contracts

(a) Each county or municipality in this state shall be authorized to enter into multiyear lease, purchase, or lease-purchase contracts of all kinds for the acquisition of goods, materials, real and personal property, services, and supplies, provided that any such contract shall contain provisions for the following:

(1) The contract shall terminate absolutely and without further obligation on the part of the county or municipality at the close of the calendar or fiscal year in which it was executed and at the close of each succeeding calendar or fiscal year for which it may be renewed as provided in this Code section; (emphasis added)

This Georgia statute clearly eliminates any requirement for the municipality to act in good faith to seek appropriations regardless of what the lease contract provides.

Another question that arises and is largely left unanswered is whether the lessor retains any rights against the lessee following non-appropriation. Presumably, if the lessee fails to return the leased equipment as required by the lease, the lessor would have a cause of action, but even this remains somewhat unclear given the wording of some statutes and the manner in which the clause is drafted by some counsel. At least one court has held that a municipality that refused to return property after the end of a lease term committed an unconstitutional “taking” of the property and was required to return it to the lessor. See Summer Street Associates v. State Department of Adult Probation, 40 Conn. Supp. 171, 1984 Conn. Super. LEXIS 181; 484 A.2d 947.

A more troubling real-world issue is whether the lessee remains obligated for any indemnification or reimbursement in the event a claim is filed or a loss is incurred after termination due to events occurring prior to the non-appropriation.

Indemnification and Insurance

Lessors providing financing for ambulances, fire trucks, helicopters and other potentially dangerous equipment might well keep in mind state prohibitions on lessee indemnification. In several states, an indemnity for third party claims may be unenforceable. Some lessee counsel will refuse to allow such a provision to be included in the lease while others gloss over it and issue their opinion without taking into account that in a lease, unlike a traditional bond financing, the lessor may face a real-world exposure.

Even worse, there are states in which statutory or judicial limitations on the ability to purchase insurance severely restrict the lessee's flexibility and leave the lessor further exposed.

Who Is the Lessee?

The lessee may be a state, county, municipality, fire or hospital district, university or other government entity. Not all of these entities are separate political subdivisions of a particular state and eligible for tax exempt borrowing. For example, all property and debts of counties in Connecticut actually belong to the state. Conn. Gen. Stat. ' 6-2a . Cities in Hawaii do not have separate local governments. The local governments of Hawaii consist of the four counties in the state.

'Creative' State Leasing

The laws of some states seek to create their own form of equipment finance vehicles. In some cases, these laws actually restrict the ability of the state and its political subdivisions to arrange lease financing. In others, the language creates uncertainty as to exactly what the lessor will have in its portfolio when the deal closes. See New York's Deferred Payment Plan program.

States sometimes lump together personal property and real estate leasing, which can result in more limitations on leasing options. The lease-purchase transaction is considered an exception to the general requirement of voter approval for municipal debt. In South Carolina, for example, there were several reported court cases where school boards used creative leasing structures to accomplish long-term financing of school improvement projects that otherwise may not have been approved by voters (and in at least one case a voter referendum for bond financing for the project at issue failed). After the South Carolina Supreme Court held in several cases that such lease financing did not constitute debt under the state constitution, the legislature passed a law that further tightened the ability of municipalities to do lease financing (S. C. Code Ann. ' 11-27-110).

Conclusion

The good news for the leasing industry is that, unlike secured loans, leases (even in some cases leases intended as security) are compatible with the non-appropriation provisions required by most states. The challenge, though, for the leasing company wishing to offer municipal leases in multiple states is that the applicable laws can differ significantly from state to state.

Of course, the very nature of the subject matter invites the reader to counter with the laws of his or her own state and contrary experience. This makes for good conversation. It also underscores the problem. Both the leasing industry and local governments across the United States would benefit from uniform laws for municipal leasing. Such a change would open new markets for many leasing companies and local governments would benefit from greater competition.

The industry may want to push for uniform laws. But in the meantime, we encourage leasing companies to explore the municipal leasing market because of the size of this market and the high-quality credits.

Barry Marks is a founding shareholder and William L. Phillips III is an associate with Marks & Associates, P. C. Marks, a member of this newsletter's Board of Editors, centers his practice on equipment leasing and finance. The authors can be reached at [email protected] and [email protected].

There is some dispute as to the origin of the term “red-headed step child,” but its usage since the early 20th century has been to denote a child who is unwanted, neglected and misunderstood by his or her parents. For many banks and other lessors, the limited competition, strong credits and tax benefits of “muni leasing” make it a favorite. In many respects, however, municipal leasing (which term we will use for equipment financing and leasing for state, county and city governments and agencies generally) is equipment finance's red-headed stepchild.

Municipal leasing is different. Credit risk is replaced by risk of “non-appropriation.” The documentation is a little (in some cases a lot) different. Operating in 50 states is more challenging. However, for the leasing company willing to put in the effort, there are significant opportunities for growth.

State laws are generally designed to prohibit the municipalities from incurring any significant amount of debt without voter approval. This can have a chilling effect on financing equipment acquisitions through public or private borrowing. It is impractical for cities and counties to seek voter approval of bond financing for routine equipment purchases and the fees associated with bond financing are cost-prohibitive for such transactions.

Leasing may be an attractive alternative to bond financing for the governmental entities. This is particularly true where specific items of equipment are being financed, where the dollar amount involved does not justify traditional bond closing costs and where the lessee/issuer already has a significant bond indebtedness outstanding. Leases (or lease-purchases, as they are called in some states) are allowed without voter approval.

This article addresses a few of the primary challenges for traditional leasing companies entering the municipal leasing market.

The Laws Are Not Uniform

Leases to non-governmental business entities benefit from the certainty provided by the Uniform Commercial Code (UCC). From state to state there are only minor variations in Article 2A (Leases) and Article 9 (Secured Transactions). Lessors save time and money by using standardized forms and procedures to document transactions and perfect security interests from state to state.

The law governing municipal transactions is less predictable. There are statutes addressed to the financing of specific categories of equipment. For example, Louisiana has rules related to leasing telecommunication equipment. Some states, such as Illinois, allow multiyear obligations in leases for personal property. Some states have programs through which municipalities finance certain equipment through the state. For example, counties in Delaware are required to lease vehicles from the Delaware Division of Support Services. See, Del. Code Ann. tit. 9 ' 6906(d).

While lessors can still generally use a standard municipal lease form, many state statutes require particular provisions in the lease agreements in order to be binding. For example, agreements with the State of Ohio require a certification that there is a balance in the budget that is not already appropriated, and that it is sufficient to pay the obligations coming due in the current fiscal year.

Lessee Attorney Opinions

For most lease transactions with governmental entities, lessor counsel frequently require an opinion from the lessee's lawyer that the lease transaction has been duly approved and the document appropriately executed.

An opinion of local counsel gives the lessor assurance that the lease has been properly approved by the governmental entity. For non-governmental borrowers, many lessors comfortably rely on corporate or member resolutions approving most small-ticket and middle-market transactions. Corporate procedures do not vary widely from state to state, and lessors can rely on the doctrine of “apparent authority,” under which corporate officers may be presumed to have certain powers, particularly when making purchases and borrowing money in the company's ordinary course of business.

By contrast, the approval process for governmental entities is less consistent, and the apparent authority doctrine does not apply to public officers. For example, personal property leases for parishes in Louisiana require the approval of the State Bond Commissioner pursuant to R.S. 39:1410.60 et.seq . The lessee's lawyer should be familiar with the state's laws related to such transactions, as well as the lessee's standard procedures for approval.

One cautionary note on this topic is in order: In many cases, the lessee's counsel, particularly in-house counsel, does not carry sufficient malpractice coverage to address damages resulting from an incorrect opinion. Moreover, the abilities and professionalism of counsel vary greatly and many city or county lawyers do not have experience in rendering opinions in major transactions, but will be under pressure to facilitate the desired financing.

Non-appropriation

One of the better-known idiosyncrasies of municipal leasing is the “non-appropriation” clause. Most cities and counties are prohibited from incurring debt without voter approval. Whether a transaction constitutes debt for a municipality is different from the question of whether a transaction is a secured loan or true lease for UCC, accounting or tax purposes. For municipal financing purposes generally, a debt is a payment obligation that extends beyond the current fiscal year of the municipality. Therefore, a true lease would be considered a municipal debt if it involved multiyear payments. But a lease intended as security would not necessarily be considered debt if it has a non-appropriation clause.

A non-appropriation clause basically provides that the municipality can stop making lease payments at the end of its fiscal year and have no further obligation under the contract if it does not appropriate funds (i.e., put money in its budget) to pay the lease payments in the next fiscal year. It merely returns the equipment to the lessor and walks away. Despite the non-appropriation clause, the lease payments for the transaction will be calculated based on the expected term of the transaction. However, the lessor cannot accelerate future fiscal year rents because the municipality has made no appropriation for these payments.

Often, the non-appropriation clause will provide that the lease will automatically renew for another fiscal year unless the municipality does not appropriate funds for the payments.

While municipalities are generally lower credit risks than private parties, non-appropriation adds a different risk for the government loans. Lessors can lessen this risk by leasing only essential equipment. The more essential the equipment, the less likely it will be that the municipality will walk away from the equipment before the end of the term. Additionally, certain clauses are included in most municipal leases that are designed to mitigate the non-appropriation risk.

Non-Substitution Clause

One of the most common protections is a non-substitution clause. This clause provides that the lessee may not acquire equipment similar to the leased equipment within a stated period of time after termination due to non-appropriation. Such a clause could keep the municipality from returning the lessor's equipment before the end of the intended term and quickly replacing it with better equipment or merely a better lease deal. However, some state courts have found that such clauses are unenforceable because they render a non-appropriations clause useless. If the equipment is essential equipment and cannot be replaced for a given period of time, then the municipality cannot, as a practical matter, non-appropriate. Therefore, the transaction is really debt because the contract compels the expenditure beyond one year. See. e.g. , Frankenmuth v. Magaha 769 So.2d 1012 (Fla. 2000).

Good Faith

Another commonly used provision requires the lessee to use reasonable efforts in good faith to secure appropriations. These clauses are of dubious enforceability because they may interfere with the sovereignty of the municipality. Such clauses could also negate the value of the non-appropriation clause under some state laws. For example, the Texas Court of Appeals in City-County Waste Control Board v. Capital City Leasing , 813 S.W.2d 705, 1991 Tex. App. LEXIS 1869, held that a requirement that the municipality seek in good faith to obtain appropriations for the lease for the entire term actually constitutes an obligation extending beyond one year. Consequently, the lease transaction was considered an unconstitutional debt.

Some states go so far as to require something more than a non-appropriation termination right, such as a lessee's right to terminate the lease for convenience. Under these laws, not only can the lease be terminated in the event the lessee's governing body does not appropriate sufficient funds, the lessee has a right, for any reason, to terminate the lease and return the leased equipment. The wording in these laws leaves a substantial question as to whether they are satisfied by a simple non-appropriation clause or if something more is required. See the following excerpt from a Georgia statute:

O.C.G.A. ' 36-60-13 (2014)

' 36-60-13. Multiyear lease, purchase, or lease-purchase contracts

(a) Each county or municipality in this state shall be authorized to enter into multiyear lease, purchase, or lease-purchase contracts of all kinds for the acquisition of goods, materials, real and personal property, services, and supplies, provided that any such contract shall contain provisions for the following:

(1) The contract shall terminate absolutely and without further obligation on the part of the county or municipality at the close of the calendar or fiscal year in which it was executed and at the close of each succeeding calendar or fiscal year for which it may be renewed as provided in this Code section; (emphasis added)

This Georgia statute clearly eliminates any requirement for the municipality to act in good faith to seek appropriations regardless of what the lease contract provides.

Another question that arises and is largely left unanswered is whether the lessor retains any rights against the lessee following non-appropriation. Presumably, if the lessee fails to return the leased equipment as required by the lease, the lessor would have a cause of action, but even this remains somewhat unclear given the wording of some statutes and the manner in which the clause is drafted by some counsel. At least one court has held that a municipality that refused to return property after the end of a lease term committed an unconstitutional “taking” of the property and was required to return it to the lessor. See Summer Street Associates v. State Department of Adult Probation , 40 Conn. Supp. 171, 1984 Conn. Super. LEXIS 181; 484 A.2d 947.

A more troubling real-world issue is whether the lessee remains obligated for any indemnification or reimbursement in the event a claim is filed or a loss is incurred after termination due to events occurring prior to the non-appropriation.

Indemnification and Insurance

Lessors providing financing for ambulances, fire trucks, helicopters and other potentially dangerous equipment might well keep in mind state prohibitions on lessee indemnification. In several states, an indemnity for third party claims may be unenforceable. Some lessee counsel will refuse to allow such a provision to be included in the lease while others gloss over it and issue their opinion without taking into account that in a lease, unlike a traditional bond financing, the lessor may face a real-world exposure.

Even worse, there are states in which statutory or judicial limitations on the ability to purchase insurance severely restrict the lessee's flexibility and leave the lessor further exposed.

Who Is the Lessee?

The lessee may be a state, county, municipality, fire or hospital district, university or other government entity. Not all of these entities are separate political subdivisions of a particular state and eligible for tax exempt borrowing. For example, all property and debts of counties in Connecticut actually belong to the state. Conn. Gen. Stat. ' 6-2a . Cities in Hawaii do not have separate local governments. The local governments of Hawaii consist of the four counties in the state.

'Creative' State Leasing

The laws of some states seek to create their own form of equipment finance vehicles. In some cases, these laws actually restrict the ability of the state and its political subdivisions to arrange lease financing. In others, the language creates uncertainty as to exactly what the lessor will have in its portfolio when the deal closes. See New York's Deferred Payment Plan program.

States sometimes lump together personal property and real estate leasing, which can result in more limitations on leasing options. The lease-purchase transaction is considered an exception to the general requirement of voter approval for municipal debt. In South Carolina, for example, there were several reported court cases where school boards used creative leasing structures to accomplish long-term financing of school improvement projects that otherwise may not have been approved by voters (and in at least one case a voter referendum for bond financing for the project at issue failed). After the South Carolina Supreme Court held in several cases that such lease financing did not constitute debt under the state constitution, the legislature passed a law that further tightened the ability of municipalities to do lease financing (S. C. Code Ann. ' 11-27-110).

Conclusion

The good news for the leasing industry is that, unlike secured loans, leases (even in some cases leases intended as security) are compatible with the non-appropriation provisions required by most states. The challenge, though, for the leasing company wishing to offer municipal leases in multiple states is that the applicable laws can differ significantly from state to state.

Of course, the very nature of the subject matter invites the reader to counter with the laws of his or her own state and contrary experience. This makes for good conversation. It also underscores the problem. Both the leasing industry and local governments across the United States would benefit from uniform laws for municipal leasing. Such a change would open new markets for many leasing companies and local governments would benefit from greater competition.

The industry may want to push for uniform laws. But in the meantime, we encourage leasing companies to explore the municipal leasing market because of the size of this market and the high-quality credits.

Barry Marks is a founding shareholder and William L. Phillips III is an associate with Marks & Associates, P. C. Marks, a member of this newsletter's Board of Editors, centers his practice on equipment leasing and finance. The authors can be reached at [email protected] and [email protected].