Equipment leases make up a significant portion of every business budget in the modern business world in which both the tax laws and the need for expensive computer and telecommunications hardware require large investments. Typically, a business will “invest” hundreds of thousands of dollars of its budget with telephonic systems, computerization, and, as technology increases in importance, security systems, remote offices, video conferencing equipment and wireless communications.
The lessors are often seemingly massive entities with complex names somehow mysteriously connected with “telephonic” sounding names and too often our client assumes that the lessor is a “baby bell” or a branch of some international computer company. While that is sometimes true, more often than not you are dealing with a small company with less assets than your own which finances its own access to equipment and is quite likely to cease to exist about the same time the lease runs out. Clearly the maintenance clauses are a key concern, but so is the reluctance to actually carefully read and negotiate those long and often boring lease agreements.
When the asset being leased is expensive and important for a prospective lessee, the lessee may spend the appropriate time reviewing every clause and negotiating all points of interest. However, thousands of equipment leases are signed every year that are quite routine and modest in size, such as for computers, copiers, furniture or construction, manufacturing or farming equipment. Such leases usually are prepared by the lessor and utilize a standard form of the lessor, usually in very small print. The lessor will often tell the lessee that the form is not negotiable, perhaps because the transaction is too small to justify such effort. In some cases, of course, this will be true and the lease is strictly a "take it or leave it" proposition. In other cases, there will be scope to negotiate at least a few provisions that the lessee finds objectionable.
This article shall give the basic review considerations that every business should consider before engaging in such leases. The reader is advised to also review our web articles on Contracts; Arbitration; Guaranties.
Basic Areas of Concern:
1. Economic Terms: Clearly the most important terms are how much is the rent, how often is it payable, what is the term of the lease and how much is payable by the lessee in the event the lease terminates early because of casualty to the equipment. These terms are the ones most usually open to negotiation and an intelligent business person will have “shopped around” to test the market long before sitting down to work out these details. It has been our experience that the average “opening offer’ is usually twenty percent higher than what the lessor will agree upon. Do not forget that the right to terminate early is often accompanied by a significant penalty and that should be negotiated with vigor.
2. Delivery Risk: It is often the case that a lessor's standard form provides that, as between the lessee and the lessor, the risk of the equipment being properly delivered and in good condition on delivery is entirely that of the lessee. The lessee could find itself required to pay rent for defective equipment (since the lessor paid for the equipment). This can be particularly offensive when the lessor is affiliated with the manufacturer who is selling the equipment to the lessee. Ideally the lessor should not pay until the equipment has been inspected and accepted by the lessee.
3. Collateral: Many standard forms require that a lessee pay one or more months of rent in advance, which in effect acts as collateral throughout the life of the lease term. This prepaid rent in some cases may be used to pay the last month's rent. Lessees often enter into leases because they believe leases provide 100% financing, but in transactions where such collateral is required, this is self-evidently not the case. Indeed, the cost of collateral may tip the economic balance and make it more economic for a lessee to buy equipment than to lease it. Of course, the lessee should attempt to obtain interest on any such collateral.
4. End of Term Options: It is always in the lessee's interest to have both a renewal option and a purchase option at the end of the lease term (including at the end of a renewal term), even if the price is at fair market value as then determined. Preferably, of course, the lessee should negotiate a fixed rate renewal or fixed price purchase option so it can in effect have the benefit of these options at the lower of the fixed rate or market value.
One very common error made by lessees is to forget about modest-sized leases and neglect to renew or purchase the equipment at the end. Many of the standard lessor forms provide that when this occurs, there is an automatic extension of the lease for a period, often as long as one year, at a not very favorable rent unless the lessee affirmatively notifies the lessor in advance that the lessee wishes for the lease to end when it is scheduled to end. Thus, a simple failure to act by the lessee can result in incurring a substantial additional obligation. Either this automatic renewal should be negotiated out, or the lessee should use a tickler system to remind itself of the need to send the appropriate notice.
5. Return of Equipment: Every lessee is obligated to return equipment in good condition at the end of a lease if the lessee has not purchased the equipment. The other details of the return obligation can be quite economically burdensome, however. For example, many leases will require that the equipment be returned anywhere the lessor specifies, sometimes disassembled and boxed, sometimes reassembled. Many leases require the lessee to store the equipment at its expense for a period of time and pay for its maintenance and insurance during this period. Some leases will require that the equipment must be in the same condition as when delivered to the lessee – and will not allow for "ordinary wear and tear". These requirements can be quite expensive, and may economically compel the lessee to purchase the equipment at the end of the lease even if it does not want to do so. Of course, at the end of some "leases" there is a $1 purchase option, in which case the return provision is not terribly relevant.
6. Tax Indemnity: It is normal in most net leases that the lessee will indemnify the lessor and its assigns for property, use, sales and other miscellaneous taxes that may be imposed on the transaction. Except in very small leases, the lessee should investigate whether there is any unexpected tax of this sort that would not exist if the lessee had merely purchased the equipment and borrowed the money to pay for it. Some states have taxes on rentals, or gross income taxes, that can make leasing quite burdensome, and might indicate purchasing is preferable to leasing. If the lessor is not based in the U.S., the lessee must be sure no withholding taxes will apply to the rent payments.
In addition, lessees will sometimes put into form leases indemnification to protect the lessor from loss of its tax depreciation deductions for the equipment. The short version of these clauses often takes the form of an "all events" indemnity, which says that the lessee protects the lessor from this risk in all events. To fine tune these indemnities can become quite complex and a small lease will not justify such detail and the accompanying negotiation. However, at a minimum the lessee should attempt to have the indemnity only apply if the actions, breaches or misrepresentations of the lessee cause the loss of depreciation deductions to the lessor.
7. Assignment by the Lessor: Virtually every lease will give the lessor the ability to assign the lease to others. These assignments are basically of two types - a collateral assignment to a lender or an outright assignment to a new lessor. In the case of the collateral assignment to a lender which occurs after the lease is entered into, the lessee need not be overly concerned because the lender will take subject to the lessee's rights under the lease. However, normally the lease will require the lessee to expressly acknowledge such a collateral assignment. This should always be subject to the lender acknowledging the quiet enjoyment rights of the lessee. If the lessee also indemnifies the lender to the same extent as the lessor, the lessee should attempt to avoid incurring any withholding tax risk if the lender is outside the U.S. and any prepayment premium or breakage risk in the event the transaction ends early.
In the case of an assignment to another lessor, however, the lessee would find itself doing business with a stranger. In many cases, this may not matter. However, if the lessor is obligated to perform any sort of services in connection with the lease, the lessee may want to assure that the original lessor remains responsible for doing this. In particular, if the lessor is holding advance rent or other collateral of the lessee, the lessee wants to be comfortable that it will get this back at the end of the lease (assuming the lessee has performed in full). Ideally, the lease would provide that the lessee must consent to any assignment to another lessor, but in smaller leases such a provision would rarely be agreed by the lessor.
8. Events of Defaults: Remedies: Although some people spend an inordinate amount of time negotiating grace periods and cure periods in events of default, in the real world lessors and lenders are loathe to quickly foreclose because of the cost of that process and the risk of lender liability. A more important issue may be the remedies. Although general applicable law (Article 2A of the Uniform Commercial Code) provides a set of remedies to lessors, most leases will contain their own set of remedies. The one that a lessee must watch out for is the ability of the lessor to collect all future rent either without discounting, and/or without an offset for the value of the equipment returned to the lessor. This will normally result in a double recovery for the lessor. The appropriate remedy would be to present value the remaining rents and subtract from this either the present value of the fair market rent for that equipment for the balance of the lease term, or the fair market sales value of the equipment.
9. Termination Value: In larger leases, the lessor will put into the lease a schedule of Termination Values, which the lessee must pay in the event of the destruction of the equipment, event of default by the lessee or any other early termination by lessee of the lease. Typically these sums are calculated by computer and may be difficult to verify. The goal is normally to return to the lessor its investment, plus a yield on that investment plus the present value of what the fair value of the equipment was expected to be at the scheduled end of the lease term, all calculated on an after-tax basis. As the lessee will not normally have access to the tax position of the lessor, the lessee can only guess at this calculation. However, it is common for lessor's to add in a "premium" to the Termination Value calculation, in effect giving the lessor a greater all-in, after-tax yield if the lease ends early than if it had gone to term as planned. Lessees should try to resist this.
This writer once represented a very successful business man who made his living with leasing equipment, in this particular case tools and construction equipment. We often worked long hours on the various lease remedies and one of my personal goals in drafting is to make business contracts concise and clear. In my opinion, confusion leads to ambiguity in obligations which leads to foolish disputes. Clients almost always agree to that outlook but this client made a point relevant here. He insisted that the lease contain as many “thereofs,” “herewiths,” and “as described above in section 2.01,…” as we could put in to make it as complex and incomprehensible as possible. “Make them bored,” he told me, “Make them want to glance over it quickly since they’d rather be reading a phone book. Looking over these things is the worst job in the office given to someone who’d rather be eating razors. We don’t care if they look at it carefully now…we only care that we have the rights if we need them.”
He made a lot of money with that approach and as far as I know, never lost a case enforcing a lease.
Keep that in mind when the next small novel entitled, “Equipment Lease” arrives on your desk. Read it carefully, take the time, use the lawyer and the CPA…and you may be very happy you did when the time comes at the end of the lease!