One of the more controversial topics in leasing is the enforcement of an automatic renewal, or evergreen, clause in a document entitled “Lease Agreement.” The typical automatic renewal clause will state something like the following: “If no default exists under this lease, you [the lessee] will have the option at the end of the initial or any renewal term to purchase all (but not less than all) of the equipment at the purchase option price shown at the front of this lease, plus any applicable taxes. Unless the purchase option price is $1.00, you must give us [the lessor] at least 60 days written notice before the end of the initial term that you will purchase equipment or that you will return the equipment to us. If you do not give us such written notice, or if you do not purchase or deliver the equipment in accordance with the terms and conditions of the lease, this lease will automatically renew for an additional 12 month term and thereafter renew for successive one month terms until you deliver the equipment to us. During such renewal(s) the lease payment will remain the same. We may cancel an automatic renewal term by sending you written notice ten days prior to such renewal term. . .Upon payment of the purchase option price, we shall transfer our interest in the equipment to you ‘as is,’ ‘where is’ without any representation or warranty whatsoever and the lease will terminate.”

Automatic renewal, or evergreen, clauses have been the subject of many recent bills in an attempt to regulate the use and abuse of such clauses not only in documents purporting to be leases but in other types of contracts as well. Most of the legislation is to assure consumers that they will receive notice prior to the end of the base lease term that the lease will renew if the lessee or obligor does not notify the lessee or creditor within a certain time frame how it will exercise its end of term rights. The latest two states introducing legislation dealing with automatic renewal clauses are Maine and Pennsylvania. Louisiana, Wisconsin, New York and Rhode Island have automatic renewal laws that affect commercial equipment leases. Other states have renewal clauses which affect consumer leases and transactions. Therefore, this subject can be a hot button for legislatures around the country.

There are a number of cases which have upheld the enforceability of automatic renewal clauses . However, when it is manifestly unfair to enforce an automatic renewal clause in a lease or other contract when there is a nominal purchase option, despite the clear contractual language of a contract a court may not enforce such an agreement contending it is unconscionable, an unenforceable adhesion contract or based on equitable grounds.

In a recent case, a court in Ohio enforced an automatic renewal clause without properly discussing the ramifications of such enforcement in the opinion. This brings us to the recent case of Pacific Space Design Corp. v. PNC Equipment Finance, LLC. In this case, the lease agreement included the automatic renewal clause set forth in the first paragraph of this article. The lessee never gave the required end of term 60 day notice to the lessor of its intent to return the equipment, purchase the equipment or renew the lease. The lease automatically renewed. The purchase option in the lease was fixed at $17,022, which was 10% of the original purchase price for the equipment. The lessee contended that it did not know that the lease automatically renewed because payments were made through an automatic clearing house debit and the lessor received an additional 34 monthly renewal payments totaling $100,076.98 after the base term had concluded. Once the lessee reviewed a bank statement and realized it had made 34 more payments, it brought a lawsuit against the lessor contending the lessee was not entitled to this sum given that the purchase option was only $17,022 and the lessor was, among other things, unjustly enriched.

The Ohio court stated that because the terms of the lease were clear and unambiguous, the lessee’s inadvertence was no defense to recover the 34 renewal payments. The lessee contended that the lease was not actually a lease but considered a “conditional sale” under the Uniform Commercial Code (or as we know it, a lease intended as security). However, the court refused to deal with that issue, stating that it was irrelevant whether or not the lease was a conditional sale contract due to the terms of the contract. The Ohio court held that it was not going to rewrite the terms of the agreement to remedy a perceived imbalance, and therefore upheld and enforced the terms of the contract to the detriment of the lessee.

Although this case will be used by lessors in the future to demonstrate that the automatic renewal clause is valid and enforceable, it is somewhat troubling. First, when the lessor and lessee enter into a contract, they have certain expectations. The lessor expects that the lease will be paid as agreed, meaning that the lessor will receive its monthly payments plus payment of taxes, other costs and fees incurred by the lessee throughout the term of the lease, and—if it is not a full payout lease—either the return of the equipment or the receipt of the purchase option price for the equipment at the end of the lease term. Most leases do not voluntarily renew because the lessee would prefer to get newer and better equipment, if possible, and return the equipment or purchase it. If a lessee breaches a lease in mid-term, the lessor is entitled to its damages comprised of all unpaid past due lease payments, all future lease payments discounted to present value, all accrued and unpaid late charges, all taxes and the residual value of the equipment discounted to present value. The measure of damages assumes that the lessor has not taken possession of the leased equipment, caused it to be sold and created a deficiency balance . Therefore, assuming all payments have been made as agreed through the base term of the lease and the only outstanding amounts are the residual value for the equipment, for the lessor to realize on the “benefit of its bargain” under the lease agreement, it should be entitled to the residual value plus interest thereon as either set forth in the contract or by statute in the particular state, and any attorneys fees and costs incurred in connection with enforcing its claim to the right to the residual. Thus, in the Pacific Space Design case, the true benefit of the bargain was the residual value of the equipment which was $17,022 plus interest on that sum through date of trial. Assuming that trial occurred four years after the end of the term of the lease and also assuming that a rate of interest is at 10% for four years the total sum due at the time of trial would have been $23,830.80 (plus attorney’s fees and costs) and not $100,076.98 (plus attorney’s fees and costs).

The second issue that the court did not consider was whether or not the transaction could have been considered to be a lease intended as security (or disguised loan) or a true lease. Although there is a two prong test to determine whether a lease is a true lease or lease intended as security, Courts generally focus on whether the purchase option at the end of the lease term is nominal to make the determination whether the lease is a true lease or a lease intended as security . If the lease is not a true lease and instead is simply a loan creating a security interest in the equipment, the lessee is the owner of the equipment and is in effect paying off a secured loan from the lessor. In such event, the lessor, who is nothing more than a lender, has no right to any further payments after the secured loan is paid in full. Whether a 10% purchase option is considered nominal and creates a lease intended as security or a true lease was irrelevant in the court’s opinion. Instead, the court focused on the fact that because the lease stated “unless the purchase option price is $. . .” it was irrelevant whether the lease was a true lease or lease intended as security. What if the purchase option was 1% of the original cost of the equipment rather than 10%? What if the purchase option was $101 rather than $1? Would it be fair to the lessee under those circumstances to be required to pay $100,076.98 for something it could have acquired for $101? Since such a lease would have all of the profit the lessor required paid throughout the term of the lease, receiving renewal payments in that circumstance is a massive windfall. Moreover, if the lease had a $101 purchase option, then the lease clearly was a lease intended as security under anyone’s laws and the lessee was the owner of the equipment.

Thus, while lessors can embrace this decision as enforcing the terms of the lease contract, the decision is badly flawed because its reasoning did not take into account either the benefit of the bargain analysis with respect to the transaction or whether or not the lessee was truly the owner of the equipment and the transaction was a secured loan and not a true lease.

Court decisions which do not strike a balance between law and equity cause legislators to continue their attempts to further regulate the leasing industry through legislation such as automatic renewal legislation. Therefore, lessors should recognize that they should not continue to collect rent after the end of the term of the lease when the transaction is actually a lease intended as security or—as otherwise stated—a loan with a security interest. This practice is simply not the right way to treat customers and it is not worth the risk to a lessor’s reputation and the chance of further regulation in the industry.

Andrew K. Alper is a partner with the law firm of Frandzel Robbins Bloom & Csato, L.C. in Los Angeles.