Hell or High Water Clause Comes Under Attack

by Andrew K. Alper March/April 2008
Columnist Andrew Alper discusses the common missteps taken by both lessors and lessees when drafting a hell or high water provision in equipment lease agreements. He also provides recent examples of the courts’ uneven decisions regarding the matter.

The “hell or high water” provision in an equipment lease agreement is a provision that makes a lessee’s obligation to pay rent irrevocable and independent upon the acceptance of the leased equipment. (See Uniform Commercial Code (UCC) Article 2A-407)

Many cases have, in the past, enforced hell or high water clauses despite the attack of a lessee. [See e.g., Wells Fargo Inc. Minnesota, N.A., Indenture Trustee, Plaintiff v. Brooks America Mortgage Corporation and Michael Wayne Brooks (2004) WL 2072358 (U.S. Dist. Ct. S.D. N.Y. September 14, 2004); Wells Fargo Bank Minnesota, N.A. v. Nassau Broadcasting Partners, L.P. (2003) WL 22339299, 52 UCC Rep. Serv. 2d 249 (S.D. N.Y. October 10, 2003); Wells Fargo Bank, N.W. N.A. v. Taca Int’l. Airlines, S.A. 247 F.Supp.2d 352, 361 (S.D. N.Y. 2002); Leasetec Corp. v. Orient Systems Inc., 85 F.Supp. 1310, 1316-1317 (S.D. Fla. 1999); Unistar Leasing v. Lipkin (2004) WL 2650825 (N.Y. App. Div. November, 2004); Preferred Capital, Inc. v. Sturgil (2004) WL 1882865 (Ohio App. 9 Dist. August 25, 2004); Harte-Hanks Direct Marketing/Baltimore v. Varilease Technology, 299 F.Supp.2d 505 (D. Md. 2004)].

However, what lessors sometimes forget is that the hell or high water clause is only enforceable — and the promise to pay under the equipment lease agreement becomes irrevocable and independent — after the lessee accepts the goods. Consequently, some of the more recent cases where a court would not enforce a hell or high water clause include Eureka Broadband Corp. v. Wentworth Leasing Corp., 400 F.3d 62 (1st Cir. 2005) Jaz, Inc. v. First Hawaiian Leasing, 104 Haw. 148; 85 P.3d 1099 (2004) and Relational Funding Corporation v. TCIM Services Inc. (2004) U.S. Dist. Lexus 3945 (D. Del. February 24, 2004).

This brings us to a couple of recent decisions, which deal with equipment acceptance issues and the hell or high water clause, and could have been decided the other way.

In the case, In re Rafter 362 B.R. 25 (10th Cir. B.A.P. 2007), the lessee needed irrigation systems for its Kansas farm property. The lessee executed four equipment leases, one for each of the four sprinkler systems, each with a five-year term. The payments were to be made on a semi-annual basis. The leases approved payment to the supplier and the money was paid by the lessor. The parties were aware that the sprinkler systems were needed for the May 2001, corn planting season.

In July 2001, one system was delivered and installed but the lessee contended that it did not conform to any of the leases in terms of serial numbers or equipment characteristics. Nevertheless, the lessee used it. Two additional non-conforming units were delivered between mid-August and mid-September 2001. After examination, the lessee directed that they not be installed. The equipment was left standing in the fields. It was never completely assembled nor was it made operational. The fourth sprinkler system was never delivered.

On November 1, 2001, the lessee sent a letter to the lessor stating that the sprinklers did not work and they were rejected and the lessee would not make the lease payments. The lessor responded and advised the lessee that the lessor had no responsibility for breach of warranties and that the payments were due on the leases. The lessee then made demand on the supplier to make the payments and the demand was ignored.

Payments were not made on the leases, the lessor commenced litigation and the lessee ultimately filed a Chapter 12 bankruptcy. The lessee objected to the lessor’s claim in bankruptcy. At trial on the claims objection, the Bankruptcy Court ruled that the lessee was liable on three of the four leases (there was no liability on the lease where no equipment was delivered) and after a motion for reconsideration filed by the lessee was denied, the lessee appealed.

The case turned on whether the equipment was accepted as a matter of law so that the hell or high water provisions of 2A-407 made the payment obligation irrevocable. The parties agreed that the leases were “finance leases” under Article 2A (although there was never any discussion in the case as to whether there was a purchase option, or whether the transaction was actually a true lease or a lease intended as security so as to be governed by Article 2 rather than Article 2A).

The Bankruptcy Appellate Panel agreed with the Bankruptcy Court holding that the lessee had accepted the three sprinkler systems as a matter of law because the lessee acted in a way indicating its intent to retain the goods despite their nonconformity by not making an effective and timely rejection. Pursuant to Article 2A-515, acceptance of goods may be made by affirmatively signifying acceptance (i.e., executing a Delivery and Acceptance Receipt — the opinion never discussed whether a Delivery and Acceptance Receipt was executed and it is presumed that it was not executed), acting with respect to the goods as though they are accepted, or by failing to make an effective rejection of the goods in accordance with 2A-509.

A rejection of the goods is ineffective unless it is made within a reasonable time after tender of the delivery of the goods or delivery of the goods and the lessee seasonably notifies the lessor. If no time is specified in the lease, then UCC §1-204 provides that a reasonable time depends on the nature, purpose and circumstances of such action, and that an action is taken seasonably when it is taken within a reasonable time.

Since the lessee used the first sprinkler system when it was delivered and installed in July 2001, even if the goods were nonconforming, the lessee acted in such a manner as to indicate intent to retain the goods despite their alleged nonconformity. The court also held that the second and third sprinkler systems were deemed to be accepted despite the fact that even though the lessee never used or installed them, the rejection letters the lessee wrote to the lessor and the supplier in November 2001, some 2-3 months later were, as this court saw it, not an unequivocal rejection and also written too late.

The lessee later tried to argue on reconsideration that the lessee’s duty to accept or reject the sprinklers did not arise until the sprinklers were completely delivered and installed so they could be properly tested. Because the lease provided that the lessor was not responsible for delivery and installation or servicing of the equipment and the lessee’s obligation commenced on receipt of the equipment, it rejected the lessee’s argument.

In addition, Article 2A-515 acceptance is conditioned on the opportunity to inspect the goods, not based on the opportunity to test the goods. Therefore, the Bankruptcy Appellate Panel upheld enforcement of the three leases against the lessee.

Certainly, this is a case where the court could have reasonably found that there was no intent to accept the second and third sprinkler systems but instead chose to enforce the lease.

In a strange case where a court would not enforce an equipment lease, the court went to great lengths to use facts and law that appear to be inapplicable to the case to make the determination that the lease would not be enforced. In CN Funding LLC v. The Ensig Group, Ltd. 18 Misc. 3d 214; 846 N.Y.S. 2d 555, decided in the Supreme Court of New York on October 31, 2007, the plaintiff/lessor sought summary judgment against the lessee to collect sums due on an equipment lease agreement whereby the lessee was to lease printing equipment. The lessee had executed the Equipment Lease Agreement, and a Delivery and Acceptance Certificate confirming acceptance of the equipment, and a document called an Acceptance of Equipment and Amendment to Lease.

Schedule A to the lease set forth the name of the supplier of the equipment who, of course, had been selected by the lessee. However, the equipment was never delivered to the lessee because, at the time the equipment lease was entered into, the supplier was in bankruptcy. Nevertheless, the lessee had executed the amendment, which stated, in pertinent part, that the lessor would advance funds for the purchase of the equipment and the lessee would commence its payments despite not having the equipment delivered. The amendment further stated that nondelivery of any item of the equipment shall not relieve the lessee from making its payments under the equipment lease.

The lessee contended that despite the fact that it executed the Delivery and Acceptance Certificate and the amendment, since it never received any of the equipment, there was no consideration for the lease and the lessee should not have any liability under the equipment lease.

In dealing with this case, the court first looked to what the definition of “finance lease” was in Article 2A-103 (g) in New York and focused on subsection (D) of the definition of a finance lease. In pertinent part, to be a finance lease under that section, the lessor a.) must inform the lessee in writing of the identity of the person supplying the goods to the lessor unless the lessee selected that person and requested the lessor to acquire the goods from that person, b.) that the lessee is entitled to promises and warranties provided to the lessor from the person supplying the goods to the lessor, and c.) that the lessee may communicate with the person supplying the goods to the lessor and receive an accurate statement of those promises and warranties, including any disclaimers and limitations on those warranties.

The court stated that because the equipment lease failed to inform the lessee that it was entitled to any promises or warranties provided to the lessee by the supplier in connection with or as part of the contract by which the lessor acquired the goods, and because the lessee was not informed in writing that they may communicate with the person supplying the goods to the plaintiff and receive a complete and accurate statement of those promises and warranties, including any disclaimers, the equipment lease was not a finance lease. In addition, the court stated that the equipment lease did not state how the lessor derived its ownership interest in the equipment and therefore the court questioned the lessor’s ownership of the equipment (apparently the court was looking for a Bill of Sale in the equipment lease).

The court then held that because of these problems with the language in the equipment lease it must fail for lack of consideration. It is hard to imagine that even if the equipment lease was not a finance lease why this is determinative in this case. The holding of this case ignores the fact that principles of contract law still apply (See e.g., Article 1-302). However, the court never discussed why the inapplicability of finance lease status defeated the contract between the parties.

Without going into detail, this court appeared to look for ways not to enforce the lease. For example, the court a.) discussed facts, which the court believed would defeat the lessor’s status as a holder in due course (However, holder in due course status was not an issue in this case because the lessor did not assign the lease to a third party), and b.) the court stated that because there was no contract between the supplier and the lessee for the purchase of the equipment, the lessee could not assert claims against the supplier for nondelivery of the equipment and therefore there was no privity of contract for the lessee to assert claims against the supplier (since most leases assign the lessor’s rights against the supplier to the lessee to pursue the supplier for breach of warranty it appears that the court could have been off on another red herring, but there was no discussion about whether the equipment lease had such a provision or not).

In addition, because the equipment lease had disclaimers of warranties by the lessor this further evidenced a lack of consideration (what happened to Article 2-316 and the ability of a lessor to disclaim warranties in a lease?). Finally, the court pointed to the fact that the lessor withheld payment of the last $14,000 to the supplier only after the lessee advised the lessor that the equipment was not in fact delivered despite the execution of the various agreements by the lessee and the lessee’s request to the lessor not to pay the supplier.

Despite everything else, the court stated in its opinion that the lessor should have made the last payment to the supplier citing Wells Fargo Bank Minnesota. Nat. Ass’n v. CD Video, Inc. (22 AD3d 351, 802 N.Y.S. 2d 423 (1st Dept 2005) where that court enforced the lease because the delivery and acceptance certificate was signed by the lessee and the lessor made payment to the supplier to acquire the equipment.

Interestingly, the court also cited Master Lease Corp. v. Manhattan Limousine, Ltd. 177 AD2d 85, 91 580 N.Y.S. 61 (1st Dept. 2006) standing for the proposition that evidence that the lessee signed an equipment acceptance receipt acknowledging the acceptance of the equipment is normally conclusive on that issue. Didn’t the lessee sign an acceptance notice in this case? In fact, the lessee went a step beyond and executed the amendment where the lessee acknowledged that payments would be made by the lessor to the supplier even though the equipment may not have been received and the lessee would still be liable to make its equipment lease payments.

In any event, the court denied the lessor’s motion for summary judgment and granted summary judgment for the lessee and dismissed the case in favor of the lessee based on a lack of consideration to enforce the lease agreement.

The court in CN Funding was everywhere but where it should have been. The issue was the applicability of the hell or high water clause in the lease not whether the transaction was or was not a finance lease. No one was contending that the equipment did not operate as represented. The issue was not defective equipment, it was no equipment.

Instead, the court should have discussed the applicability of Article 2A-407 and whether the lessee has liability because of its execution of the Delivery and Acceptance Receipt and the amendment or whether the lessee was estopped by its own conduct to make the contention there was no consideration given its execution of those documents and the fact that its conduct led the lessor to pay the supplier for the equipment.

The lessons again to be learned from these cases are that the lessor must not only have well written documents but must be prudent in their transactions because once the lessor is in court, it takes its chances that the court may not necessarily follow what the lessor believes is the correct application of the law.

Andrew K. Alper is a partner with the law firm of Frandzel Robins Bloom & Csato, LC in Los Angeles. Alper has been representing equipment lessors, funding sources and other financial institutions since 1978. Alper obtained his Bachelor of Arts degree in Political Science, magna cum laude, from the University of California at Santa Barbara, and received his Juris Doctor from Loyola Marymount University School of Law making the Dean’s List.

Alper’s practice emphasizes the representation of equipment lessors and funding sources in all aspects of equipment leasing including litigation, documentation, bankruptcy and transactional matters. Besides representing equipment lessors and funding sources, Alper represents banks and other financial institutions in the area of commercial litigation, insolvency, secured transactions, banking law, real estate and business litigation.

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