Ken P. Weinberg,
Shareholder,
Rimon

The recent deluge of state commercial financing disclosure laws designed to mimic consumer-style truth-in-lending statements raises interesting policy considerations as it relates to the inclusion or exclusion of equipment leasing and finance transactions.¹ In particular, of all the relevant laws enacted thus far, only California’s and New York’s fail to exclude purchase money obligation transactions from the disclosure laws. These two key jurisdictions appear to have fallen prey to a false dichotomy created between true leases and capital leases. To be sure, there are important economic and legal distinctions between UCC Article 2A and UCC Article 9 leases, which are discussed in considerable detail later in this article. But those distinctions have little to do with the apparent public policy driving the disclosure laws, i.e., providing small business customers with an interest rate equivalent they can use to comparison shop for the best deal.

In fact, where the primary purpose of many commercial financing transactions is to acquire equipment that a business will use to produce the goods and services it sells to commercial customers, the cost of credit is rarely, if ever, the only factor determining

which financing to pursue. Tax and accounting considerations tend to be primary motivators for equipment lessees, as do endof- term flexibility and vendor incentives. As a result, what purpose is served in providing an interest rate disclosure for equipment leasing and financing transactions that neither contemplate an actual interest rate nor serve as the critical determinative factor in which offer of financing to take? Sure, an interest rate could be deciphered based on, for example, rent factors and internal rates of return, but unlike consumer transactions in which the annual percentage rate may be the primary consideration for the customer seeking financing, the same is not necessarily true for commercial lessees.

With that background, a little history of equipment financings may help provide some context as to when similarities and differences between various types of lease financings are relevant. Over the years, many articles have focused on how to distinguish a true lease from a lease that is deemed to create nothing more than a security interest. In the first type of lease, referred to in this article as a true lease, the lessor owns the leased equipment, and the lessee has the right to possess and use the equipment in return for consideration. In the second type of transaction, referred to in this article as a security lease, the lessee owns the equipment, the lessor has a security interest in it and the primary purpose of the lien is to secure the lessee’s obligations to repay a loan made by the lessor in order to allow the lessee to acquire the equipment (which is often referred to as a purchase money obligation).²

As discussed in more detail in this article, there are times when true leases should be treated differently than security leases or any other equipment financing evidenced by documents that do not use leasing termination, such as a promissory note, security agreement or equipment finance agreement. Security leases and such other equipment financing arrangements that do not constitute true leases will be referred to in this article as equipment financings. This edition of Dispatches from the Trenches takes a closer look at the similarities and differences between true leases and equipment financings, with particular focus on key exceptions that are (or should be) recognized in interest rate disclosure laws that have been enacted or may be enacted in the future.

Security Leases, Article 2A Finance Leases, Saleleasebacks & Equipment Financings

Plenty of businesses offer short- to medium- term rentals for equipment. Consider, for example, the wide selection of various car rental companies and construction equipment rental companies available in the U.S. marketplace. However, many true leases are a special type of (longer-term) financing provided by banks, bank affiliates, captive finance companies and independent financing companies. The most common example of these transactions is a finance lease, which is a special kind of true lease governed by Article 2A of the UCC (sometimes referred to as an Article 2A finance lease). An Article 2A finance lease involves three or more parties: the lessee, the lessor and the equipment supplier( s) in a 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.³ Traditionally, lessors involved in these types of true leases have been thought of as passive lessors whose transactions remain functionally the equivalent of an extension of credit.4 In some cases, the lessee will have already acquired title to the equipment, and in that situation, the lessee and the lessor sometimes enter into what is commonly referred to as a “sale-leaseback transaction” pursuant to which the lessee sells the equipment to the funding source (i.e. the lessor) and then immediately leases it back.

The role of a lessor in an Article 2A finance lease, or in a sale-leaseback transaction entered into for similar purposes, is similar to the role of a lessor in a security lease. In both cases, 1) the lessor has provided the funds enabling the lessee to obtain possession and use of the equipment, and 2) if the lessee does not repay that initial cash outlay made by the lessor, with the profit reflected in the economic terms of the deal, the lessor can repossess the equipment and sell it to help the lessor receive the benefit of its originally contemplated bargain. The same is also true in other equipment financings that are not security leases regardless of whether the parties use more traditional lending nomenclature and terms to describe the transaction, including describing the lessor as a lender or secured party; describing the lessee as a borrower or debtor; and/or describing the documentation as a note, security agreement, equipment finance agreement or with other non-lease terminology.

For ease of reference moving forward, this article will refer to the money source playing the role of lessor, lender or secured party as the purchase money funder and the party playing the role of lessee, borrower or debtor as the customer.

True Leases V. Other Equipment Financings — Different Treatment

Different treatment should apply in other areas depending on whether the purchase money funder or the customer is the party who owns the leased equipment. For example, the party who owns the equipment may be more properly viewed as the party who should receive the tax benefits of ownership (including investment tax credits and depreciation deductions) and pay personal property or other taxes assessed by taxing authorities with respect to such equipment.

Another example of a circumstance in which different treatment may be appropriate can be found by focusing on the purchase money funder’s exercise of its rights in the applicable equipment if the customer fails to perform its obligations under the applicable contracts. If the equipment is actually owned by the customer (as is the case with equipment financings), the customer should have rights during the foreclosure process to help preserve any equity the customer may have in the equipment. If the purchase money funder owns the equipment outright (as is the case under a true lease), the customer should not receive the same protections.

True Leases V. Other Equipment Financings — Similarities

The examples presented in the previous section when true leases should be treated differently than equipment financings both stem from the ownership of the equipment. Although the ownership issue is a core difference, and something to be considered, it is important to understand that the types of true leases discussed in this article have much more in common with equipment financings than they do differences. One way to understand the similarities is to view the products from the perspective of the customer and focus on why customers like equipment leasing and finance products.

First, true leases and equipment financings free up credit lines and other traditional finance avenues by providing customers with an alternative to borrowing under bank credit lines, keeping lending availability under such lines open. Indeed, many credit facilities permit exceptions for true leases and for purchase money obligations. This carefully synchronized capital stack allows customers an avenue to easy, efficient financing for the equipment necessary to run their businesses while simultaneously allowing other assets to be used as collateral for other lending arrangements that provide liquidity for other types of investments and business expenses the customers may find prudent.

Second, equipment leasing and finance products generally result in 100% financing, unlike other lending arrangements which typically have a loan-to-value ratio, borrower base or other restrictions.

Third, because true leases and equipment financings focus on the equipment as collateral, the documentation used by purchase money funders is not typically as intrusive to the customer’s overall business activities as more traditional finance documents. For example, compared to traditional financings, true leases and equipment financings are less likely to impose financial covenants and, when included, such covenants tend to be less finely tuned. Similarly, customers who are party to true leases and equipment financings are likely to have more flexibility in operating their businesses day to day because purchase money funders are focused more on protecting the value of the leased or financed equipment, and therefore, often have less restrictive covenants in other areas than are present in more traditional loan agreements.

Fourth, there is a large, well-developed body of law governing the rights and obligations of parties to true leases and equipment financings. Consider, for example, Article 2A of the UCC (applicable to true leases) and Article 9 of the UCC (applicable to equipment financings, including security leases), both of which are quite uniform in 49 of the 50 states.⁵ These laws address various aspects of these specialized transactions. For example, the laws address the customer’s interest in the equipment, including, for equipment financings, requiring any repossessed equipment to be sold in a commercially reasonable matter, the proceeds of the sale to be used to satisfy any of the customer’s obligations to the purchase money funder, and requiring any leftover excess proceeds go to the customer or other of its creditors with liens on such equipment. This is a critical protection and an important difference to note from any other type of financing subject to licensing and disclosure laws.

Lastly, in large part due to many of the factors listed previously, purchase money funders offering true leases and equipment financings tend to move quickly and in a more cost effective manner than in typical lending arrangements. For example, equipment leasing and finance transactions often rely on forms, including using schedules for discrete transactions that incorporate by reference standard terms and conditions in a master agreement. Purchase money funders also often rely on special purchase money priority rules in Article 9 of the UCC to increase the speed and efficiency in which the purchase money funder can obtain the priority rights it needs in the financed equipment.⁶ Similarly, purchase money funders often proceed without the cost, formality and delays that would be caused if opinions of counsel were required, taking comfort from the fact that the customer’s obligations to the purchase money funder are incurred in connection with the customer’s acquisition of equipment used in its ordinary course of business. As a result, many customers find that dealing with some equipment leasing and finance companies is simpler and faster than working through traditional bank lenders.

Even The Differences are Just Options on the Smorgasbord

All of the factors noted previously make equipment leasing and finance an attractive option for many customers. Purchase money funders can often further customize the products to address tax and accounting considerations. Both parties can benefit from the fact that different end-of-term options can impact who is deemed to own the equipment for both tax and accounting purposes. For example, some customers are unable to take advantage of the depreciation deductions or other credit incentives that come from ownership of the equipment. The result is more common in capital intensive industries (more capital/equipment means more depreciation) and when various incentives encouraging companies to invest in new equipment are available (such as “bonus depreciation” or tax credits sometimes available to encourage the development of certain industries or technologies, like clean energy). True leases can enable those tax benefits to be efficiently used, allowing customers to receive some of the benefit from these incentives in the form of lower rental payments from purchase money funders who use the benefits as tax owners of the equipment.

Of course, whether a transaction is a true lease (with the purchase money funder being the owner of the equipment) or an equipment financing (with the customer being the owner) depends on whether you are looking at the issue through the lens of federal tax rules or through some other lens, like accounting rules, commercial law rules (like the UCC, which also applies in the bankruptcy context) or local tax rules. Indeed, the exact same fact pattern and structure can yield different conclusions when looked at through the different lenses. For example, although they are very similar, not all transactions that are true leases for federal tax purposes qualify as true leases for accounting purposes and vice versa. Transactions that are inconsistent in this respect are often referred to as “synthetic leases,” such as a transaction which is a true lease for accounting purposes but not for federal income tax purposes.

It is important to understand that the lease-versus-loan, synthetic lease, tax benefit and accounting treatment considerations listed above are only some of the options available to customers when considering the smorgasbord offered by equipment leasing and finance companies.

Should True Leases and Other Equipment Financings be Treated Differently from Each Other Under Interest Rate Disclosure Laws?

With a clear understanding of some of the differences and similarities between true leases and equipment financings, the question arises as to how the distinction should be applied (if at all) in the various laws that have been or may be enacted in various states to require lenders providing all sorts of financing to disclose the applicable interest rate and various other fees and expenses in a standardized way so as to allow customers to shop on price.

Such laws, referred to as interest rate disclosure laws, may make sense in certain contexts, including in more traditional finance. However, for reasons to be noted in this article, the negative impact on customers of applying such laws to the equipment leasing and finance industry outweigh the benefits. In particular, although the interest rate is a relevant consideration for some customers, the ultimate decision is based on many other factors that are unique to the industry. Matters are further complicated by the plethora of end-of-term options, the presence of tax benefits, vendor finance incentives and other factors that make it harder to draw a standard comparison matrix for customers considering various equipment leasing and finance products. In some situations, the information targeted by the interest rate disclosure laws does not even exist. After all, there is not any interest rate applicable to a true lease since the lessee’s payment obligations serve to compensate a lessor for a lessee’s use of the equipment owned by the lessor rather than payment of principal and interest for a loan.⁷

Indeed, interest rate disclosure laws routinely exclude true leases from their scope, as should be the case. What about equipment financings? As noted at the outset, many jurisdictions also exempt purchase money obligations. Although such transactions evidence loans, and an interest rate could theoretically be calculated, these jurisdictions wisely acknowledge that the role of the purchase money funder in these transactions is the same as the purchase money funder’s role under Article 2A finance leases (and sale-leaseback transactions entered into by purchase money funders and customers for similar purposes). At the end of the day, customers are choosing equipment leasing and finance products for a variety of reasons and have been blessed with the wide variety of options available to solve various needs. Depending on the existing facts and circumstances, many customers use multiple types of products, even switching back and forth between true leases and equipment financings when the need arises.

In light of the foregoing, it would be incongruous to require purchase money funders to comply with a complex regulatory structure solely when customers do not request the optionality/ treatment of a true lease. After all, each customer drives the decision to use an Article 2A finance lease (or sale-leaseback equivalent) or an equipment financing resulting in a purchase money obligation — a decision which is largely a function of the customer’s particular circumstances and goals. For a variety of reasons, requiring disclosures for equipment financings ultimately hurts the very customers whom the legislation was designed to protect. First, requiring such disclosures would increase the administrative burden on and costs incurred by the purchase money funders, which would be passed along to the customers. Second, requiring disclosures for equipment financings will cause some purchase money funders to offer fewer options to lessen these burdens. Indeed, some purchase money funders have already indicated they will only offer true lease products in states that do not have a purchase money obligation exemption.

Those wanting to apply the legislation to the equipment leasing and finance community may be saying, “You cannot make an omelet without breaking eggs.” However, as is often the case, the benefits and burdens must be weighed carefully. Here, the benefit would be the ability to shop interest rates more easily as it relates to equipment financings. Given that the interest rate is merely one factor of many considered by customers availing themselves of the diverse, cost-effective, quick and efficient products currently offered by equipment leasing and finance companies, the interest rate disclosures do not benefit customers as much in the equipment leasing and finance industry as they would when selecting a different form of financing. In short, equipment financing — which focuses on acquiring equipment necessary to run a business — is different than other types of lending transactions like merchant cash advances, factoring and revolving lines of credit, which focus strictly on obtaining money and repaying it with interest.

To ensure parity for all equipment leasing and finance companies and a full suite of financing options for customers going forward, the exemptions from disclosure should be uniform across Article 2A and purchase money obligations for banks, bank affiliates, captive finance companies and independent financing companies that are providing vital funds for businesses to acquire equipment and foster continued economic growth across the U.S.

¹To date, 15 states have considered commercial financing disclosure laws. California, New York, Utah and Virginia passed their laws prior to 2023. The legislatures in Connecticut, Missouri, Georgia and Florida passed laws in 2023 that either have or are expected to be signed into law by each state’s respective governors this year. New Jersey, Illinois, Maryland, Texas, North Carolina, Kansas and Mississippi have proposed legislation that are still under consideration by the respective legislative bodies.

²UCC §9-103(a)(2) (defining a purchase money obligation as “an obligation of an obligor incurred as all or part of the price of the collateral or for value given to enable the debtor to acquire rights in or use of the collateral if the value is in fact so used.”)

³Shrank, Ian and Gough, Arnold G., Equipment Leasing-Leveraged Leasing (PLI 4th ed.,1999), Vol. 1, §3:1.5[C]. See also, UCC §2A-103(1)(g) (defining “finance lease”).

⁴See e.g., Nath vs. Nat. Equipment Leasing, 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.”)

⁵Louisiana’s laws are somewhat different in this area, but similar in many respects, given its historic roots in the Napoleonic code.

⁶See UCC §9-324 (allowing purchase money funders providing equipment financings to obtain a first priority security interest in the financed equipment as collateral for the purchase money obligation without having to search the UCC records and obtain subordinations or releases so long as certain conditions are satisfied).

⁷Some jurisdictions state the obvious by statute. See e.g. Fla. Stat. §§687.02 and 687.03. Other jurisdictions contain case law generally providing that usury is not a defense in an action to enforce provisions of a true lease. See e.g. Performance Systems v. First American Nat. Bank, 554 S.W.2d 616 (Tenn.); Orix Credit Alliance v. Northeastern Tech Excavating, 222 A.D.2d 796, 634 N.Y.S.2d 841 (3d Dep’t 1995) (holding that a defaulting equipment lessee’s defense of criminal usury was negated by the fact that a lease does not constitute a loan or forbearance and did not, therefore, fall within the definition of usury); Citipostal v. Unistar Leasing, 283 A.D.2d 916, 724 N.Y.S.2d 555 (4th Dep’t 2001)(neither a lease nor a sale on credit constitutes a loan or forbearance)(citing Orix Credit).

ABOUT THE AUTHORS:

Kenneth P. Weinberg is a shareholder at Rimon, P.C. and practices in the area of commercial finance, focusing on equipment leasing, equipment finance and renewable energy project finance. He has penned Dispatches from the Trenches since 2002.

Moorari K. Shah is partner in the Orange County and San Francisco offices of Sheppard Mullin. He represents banks, equipment finance companies, fintechs, mortgage companies, auto lenders and other non-bank financial institutions in transactional, licensing, regulatory compliance and government enforcement matters covering mergers and acquisitions, consumer and commercial lending and leasing, and supervisory examinations and enforcement actions involving state and federal agencies.