The ‘Ins + Outs’ of UCC Finance Leases & Co-Lessee Issues

Dispatches from the Trenches

This edition of Dispatches from the trenches: (a) provides some background information with respect to what the term “Finance Lease” means when used under the Uniform Commercial Code (the “UCC”)– which is a significantly different from how that term is commonly used by some in the leasing industry; and (b) discusses some of the risks related to Co-Lessees and potential solutions.

What is a UCC “Finance Lease”?

“Lease financing” has been described by one commentator as possibly “the most important single source of funds to support business expenditures for capital equipment” Amelia H. Boss, The History of Article 2A: A Lesson for Practitioner and Scholar Alike, 39 Ala. L.Rev. 575, 577 (1988). Lease financings involve three or more parties – the lessee, the lessor, and the equipment supplier(s). The lessee selects the equipment and negotiates particularized modifications with the equipment supplier. The lessor then purchases the selected equipment and leases it to the lessee. Traditionally, lessors involved in “lease financings” have been thought of as passive lessors, whose transactions remain functionally the equivalent of an extension of credit. See e.g. Nath v. Nat. Equipment Leasing Corp., 439 A.2d 633 (Pa. 1981)(noting that this type of lessor “is not in the business of selling or marketing merchandise [but rather, it is in] the business of circulating funds”). Given the limited function of the lessor, the lessee relies entirely on the supplier for representations, covenants and warranties. Edwin E. Huddleston III, Old Wine in New Bottles: UCC Article 2A – Leases, 39. Ala. L. Rev. 615, 616 Notes 1 (1998).

Lease financings can take various forms, one of which is a “Finance Lease” as defined under Article 2A of the Uniform Commercial Code (the “UCC”). Unfortunately, the terminology “finance lease” is sometimes a source of confusion. Many people in the leasing industry use that term to refer to a transaction which, although called a “lease”, is actually a loan from the lessor to the lessee with the “leased property” serving as collateral for the loan—such as a lease with a one dollar purchase option. Those people distinguish the finance leases from “true leases” which are also called “tax leases” or “operating leases.” To avoid any confusion we will use the term a “Lease Intended as Security” to refer to leases that are actual loans and the term “True Lease” to refer to leases which are not simply disguises security interests.

Under Article 2A of the Uniform Commercial Code (the “UCC”), the term “Finance Lease” is defined to be a true lease which “consists of an overall three-party transaction in which: (1) the lessor does not select, manufacture, or supply the goods, (2) the lessor did not own the goods before the lease was arranged, and (3) the lessee either approves the purchase contract or receives specified warranty and supplier information before signing the lease agreement.” Ian Shrank and Arnold G. Gough, Equipment Leasing-Leveraged Leasing (PLI 4th ed.,1999), Vol. 1, §3:1.5[C].

Due to the limited role that a lessor plays in a Finance Lease and the important role that such transactions play in our economy, Article 2A offers special statutory protection to lessors who lease goods in this manner. As noted in the comments to the UCC, the various sections of Article 2A operate to “substitute the supplier of the goods for the lessor as the party responsible for warranties and the like.” UCC §2A-101, comments (emphasis added). For example §2A-209 automatically extends the seller’s warranties (and their exclusions) to the lessee and automatically excludes any implied warranties of fitness or merchantability by the lessor. Shrank, supra at §3:1.5[B]. In addition, §§2A-516, 517 state that, once the lessee has accepted the property, it has no right to revoke that acceptance. Most importantly, §§2A-407 and 508 create a statutory “hell or high water” clause by making the lessee’s obligations (including payment obligations) irrevocable and independent of the lessor’s or supplier’ s obligations. Id. at §3:1.10[A]. In other words, once the lessee accepts property under a Finance Lease, that lessee is obligated by statute to perform under that lease “come hell or high water.” As Shrank explains, the interplay of these UCC provisions: “allows a computer lessor to promise vital services to the lessee, then to breach this promise entirely, yet requires the lessee to continue paying rent without set-off, all without any express clause in the lease agreement.” Id.

All of the aforementioned protections afforded lessors under Finance Leases can be obtained through contractual provisions. The Official Comments to the UCC state that “[i]f a transaction does not qualify as a finance lease, the parties may achieve the same result by agreement.” UCC §7-2A-103, comment (g). Indeed, the UCC “provisions are merely codifications of standard commercial leasing practices that previously were achieved by contract rather than by statute.” Shrank, supra at §3:1.10[A]. Well respected authorities therefore encourage lessors to “include express ‘hell or high water’ clauses if for no other reason than to avoid arguments about whether a ‘finance lease’ is involved.” Id. at §3:1.[D].

CO-LESSEES

Many people in the industry have heard that co-lessees do not provide the same protection as a guarantied lease but do not necessarily know why. Usually, the co-lessee issue is raised when the better credit does not want to (or can’t) sign a guaranty. In such cases, a proposal is made for “joint and several obligations”. However, this co-lessee resolution should be considered carefully as it raises a variety of risks, most of them resulting from the judicial system’s lack of familiarity with this issue.

Courts know what to do with guaranties. However, this author knows of no litigated cases involving co-lessees in which the lessor sought to compel one lessee to cover another’s obligations or joint obligations. As such, it is much more difficult to determine how a court would rule if one lessee defaults or goes into bankruptcy. Similarly, there is little (if any) precedent for how a court might rule if the lessees (in a true lease) or actual owner/borrowers (in a lease-purchase) squabble over the use and possession of the equipment or their respective obligations to pay taxes, remove liens, maintain, pay for return or pay rent.

Co-borrowers are not uncommon but a lease is a significantly different situation since a lease includes the right to use and possess equipment as well as the obligation to pay for it, while a loan document only covers repayment of a debt. Quite simply, co-borrowers cannot generally involve the lender in a dispute regarding the collateral in the same way that co-lessee’s may be able to do so. Clearly, a lease-purchase is less of a problem than a true lease, but judges have a penchant for ignoring the substance of a lease-purchase transaction when it suits them.

If a guaranty cannot be used, a lease-sublease structure may provide an appropriate work-a-round. In that case, the original lessee will become the “sublessor” and the documents should make clear that the original lessee/sublessor remains legally obligated for performance but has no rights to use the equipment, all of which rights are passed to the sublessee. The sublease can then be assigned as collateral to the original lessor. Of course, there are intricacies here and such documents must be drafted carefully to make sure the sublessee’s rights are fully subject and subordinate to the original lessor’s rights. In addition, this structure implicates a variety of UCC and other documentation issues.

Ken Weinberg has been involved in equipment leasing and finance transactions having an aggregate value well into the billions of dollars, including TRAC, First Amendment, FMV, service contract and other true lease structures; synthetic leases, leases intended as security, equipment finance agreements, and traditional loan transactions; progress payment, interim funding and construction financings; sublease and inventory structures; mixed goods and services transactions; vendor lease programs; assignments and syndications; warehouse and funding lines; and refinancings, back-leveraging, lease assignments, sales of interest and portfolio acquisitions.

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