Important Differences Between Commercial and Municipal Equipment Lease Documents
by Toni I. Stegeman September/October 2008
A veteran commercial leasing professional can quickly become “a fish out of water” when attempting to dive into the murky waters of municipal leasing. Nearly everyone knows that a municipal lease must include something referred to as a “nonappropriation clause,” but beyond that, do you know the legal risks of failing to include certain provisions that are specific to municipal leasing transactions? Do you know the provisions that should not be included?
The authority of states and local governments to enter into lease purchase agreements is governed by vastly different laws than the very general laws that apply to nongovernmental entities. A failure to recognize and respect this difference could greatly increase your risk of entering into an invalid municipal lease. Further risk is added by the complexity of the federal income tax laws that govern tax-exemption of the interest payments under a municipal lease.
In addition to having one of the nation’s largest tax-exempt bond counsel practices, Gilmore & Bell, P.C. has a long history of serving as legal counsel to leasing companies, banks and other lending institutions, in connection with their municipal leasing businesses. Through this representation, we often see municipal leases submitted to our clients for purchase that appear to be in the form of commercial lease purchase agreements, with the mere addition of nonappropriation clauses.
This article is intended to highlight those provisions that should, or should not, be included in your municipal leases. Developing a better understanding of the legal differences between commercial and municipal lease purchase documents will help your transactions proceed to a closing more quickly and efficiently, enable you to better serve your customers and, perhaps, provide access to a broader range of funding sources. Please note that, for ease of reading, the term “municipal” is used throughout this article to apply to state and local governments, generically. Also, just to clarify, even though the term “municipal lease” is used, this entire discussion relates to municipal lease-purchase agreements that are financing leases, not operating leases (or true leases).
Nonappropriation Clause It is common knowledge in the municipal leasing industry that, in most cases, a municipal lease must include what is referred to as a “nonappropriation clause” to avoid being considered unlawful indebtedness under state law.
With few exceptions, municipalities are prohibited by state law from incurring indebtedness without requiring voter approval or satisfaction of constitutional or statutory debt limitations. Most states’ laws consider “debt” to include any obligation to pay money in a future fiscal period. A nonappropriation clause removes the legal obligation to make payments in a future fiscal period. One version of a nonappropriation clause permits the municipality to cancel the lease, without penalty, at the end of a fiscal period if its governing body elects not to include in the budget an appropriation for the rent payments coming due in the next fiscal period.
Another version of the nonappropriation clause provides that the initial term of the lease expires at the end of the fiscal period for which an appropriation has been made, and is automatically renewed for the next fiscal period by the appropriation of funds sufficient to pay the rent payments coming due in that period. The particular version used depends upon the applicable state law. State law may also require that the lease renewal be affirmatively approved by the municipality’s governing body, rather than allowing an automatic renewal absent an affirmative termination.
There can be no penalty to the municipal lessee for the exercise of its right to nonappropriate and terminate the lease. The lessee can only be obligated to pay rent payments due during the last fiscal period for which an appropriation was made. There can be no acceleration of the remaining rent payments that would otherwise be payable until the expiration of the maximum term of the lease. The lessor may require the lessee to uninstall or remove the equipment, and return it to the lessor.
Beyond adding a nonappropriation clause, all requirements under the lease that would require the municipality to pay money in future years, must also be made “subject to appropriation of sufficient funds.”
In California, an “abatement clause” may be used instead of a nonappropriation clause. With an abatement clause, the municipality is required to appropriate moneys sufficient to pay rent payments so long as the equipment is “available for use” by the municipality. Abatement leases usually require increased attention to property and casualty insurance requirements because of the “available for use” condition to payment. Lessors will very often also require rental interruption insurance on these transactions.
Nonsubstitution Clause A “nonsubstitution clause” is intended to reduce the risk of nonappropriation by restricting the ability of the municipal lessee to appropriate funds for substitute equipment. The nonsubstitution clause, however, is generally thought to be unenforceable, and could even result in the lease being declared invalid. Nonetheless, many lessors continue to include these clauses in their standard municipal lease forms. An example of a nonsubstitution clause is as follows:
If the Lease Term for any Equipment is terminated as a result of a failure to appropriate sufficient funds for the Rental Payments coming due in the next succeeding fiscal year, Lessee agrees, to the extent permitted by law, that Lessee will not expend funds for the purchase or use of equipment performing functions similar to those performed by the Equipment for a period of 90 days following the termination of the Lease Term.
In 2000, the Florida Supreme Court held that a nonsubstitution clause in an Escambia County computer lease purchase agreement violated the Florida Constitution. Frankenmuth Mut. Ins. Co. v. Magaha, 769 So 2d 1012 (Fla. 2000). The Florida Supreme Court stated:
[A] non-substitution clause denies the county “full budgetary flexibility” because it renders the non-appropriation clause illusory by compelling the municipality to make the lease payments or suffer a penalty. The Attorney General of at least one State has opined a non-substitution clause compels lease payments and creates debt.
The U.S. District Court, in its opinion involving the same parties, further stated the following:
The court also finds that the non-substitution clause violates public policy. As a general rule, a municipality “cannot surrender, by contract or otherwise, any of its legislative and governmental functions and powers.” 2A McQuillin §10.38 at 425. “The principle is fundamental and rests on policies the soundness of which has never seriously been questioned.” Id. By agreeing to the non-substitution clause in this lease, Flowers and/or the County Commission effectively contracted away the taxpayers’ right to a central data processing system for up to two years. Given the essential function central data processing plays in running a county government, Flowers and/or the County Commission had no right to agree to this provision. The clause is void and unenforceable for this reason as well.
The U.S. District Court held that the nonsubstitution clause was severable, therefore, the Escambia County lease was not invalidated. This decision was upheld by the U.S. Court of Appeals, Eleventh Circuit.
Since the Escambia County case, we have seen a declining number of municipal equipment lessors require nonsubstitution clauses. It appears that most of the leading originators and funding sources of municipal leases have now removed nonsubstitution clauses from their governmental lease forms. There are, however, still many municipal leasing companies that continue to include nonsubstitution clauses, while admitting considerable doubt as to the enforceability of the clause. These leases must be examined carefully to ensure that they include well-drafted severability clauses.
Best Efforts Clause Another contractual clause that is intended to lessen the risk of nonappropriation, the “best efforts clause,” is intended to require the appropriate governmental officers to exercise their best efforts to obtain the appropriations needed to make rent payments under the lease. A well-drafted best efforts clause will include language such as the following:
The responsible financial officer of Lessee shall do all things lawfully within his or her power to obtain and maintain funds from which the Rental Payments may be made, including making provision for such Rental Payments to the extent necessary in each proposed annual budget submitted for approval in accordance with applicable procedures of Lessee and to exhaust all available reviews and appeals in the event such portion of the budget is not approved. Notwithstanding the foregoing, the decision whether or not to budget or appropriate funds or to extend this Agreement for any Renewal Term is solely within the discretion of the then current governing body of Lessee.
It’s important to recognize the difference between a best efforts clause that places the best efforts obligation on the lessee’s budget officer, rather than on the lessee, as an entity, or its governing body. Some courts have found that imposing the best efforts obligation on the lessee, as an entity, or on its governing body, is contrary to the principle that the municipality must have the option to cancel the lease at the end of each fiscal term in order to avoid applicable debt restrictions.
Additional Representations by the Lessee As a further attempt to reduce the risk of nonappropriation, the lease purchase agreement for a municipality will usually include representations that the equipment is essential to the lessee’s governmental purposes, that the lessee currently intends to make rent payments for the maximum term of the lease if funds are legally available therefor, and that the lessee has no reason to believe that sufficient funds for rent payments for the maximum term of the lease would not be available.
Hell or High Water Clause The “hell or high water clause” that is typically included in a commercial lease would also be included in a municipal lease, with one small but very significant change. A hell or high water clause essentially provides that the lessee’s obligations under the lease are absolute and unconditional. The only difference is that, in the municipal lease, that clause needs to be made subject to the municipality’s right to terminate upon an event of nonappropriation. Again, this is needed to avoid possible characterization of the lease as debt for state law purposes.
Acceleration of Payments If the municipal lessee defaults or fails to appropriate funds sufficient to renew the lease, there can be no acceleration of rent payments that would have otherwise been payable through the end of the maximum lease term. Any acceleration is limited to payments due during the current fiscal period, for which an appropriation has been made.
Lessee Indemnifications With limited exceptions, municipalities are prohibited from indemnifying other parties. In some states, merely including a requirement for indemnification by the municipality in the lease purchase agreement will invalidate the entire agreement. Any lessee indemnification provisions in a municipal lease must be stated to apply only “to the extent permitted by law.”
Federal Tax Matters for Tax-Exempt Leases The requirements for the municipal lease to qualify as a tax-exempt obligation are complex and beyond the scope of this article. Threshold requirements for tax-exemption that must be addressed in the municipal lease, though, include the following:
Principal and interest portions of rent payments must be stated separately.
The lessee must have the right to acquire the property at the end of the lease for a nominal purchase price.
The lease must be in “registered form,” which requires that the lessee (or its agent) maintain records of the identity of the lessor and any assignees of the lessor.
The lessee must be a state or political subdivision (must have a substantial amount of at least one of the following “sovereign” powers: taxing power, police power, condemnation power).
Agree that not more than 10% of the equipment will be used by a nongovernmental entity.
File IRS Form 8038-G or 8038-GC (lessee must sign and is responsible for filing, but tax-exemption depends upon filing, so the lessor commonly assumes responsibility for filing the lessee’s completed and signed form).
Other Matters Not all municipalities have the power under state law to enter into an equipment lease purchase agreement. Some states require that the agreement be in some other form, like an installment sale contract. Municipalities have limited authority to delegate powers, so municipal leases should be approved by the governing body of the municipality at a public meeting that has been properly called and held. The governing body should designate the official who is authorized to sign the lease documents. Remember that municipal lessees will usually be subject to lower interest rate limitations than those that are applicable to commercial leases.
In some situations, state or local laws will require public bidding for purchasing the equipment and/or entering into the municipal lease. Some states have statutes declaring certain contracts to be void unless specific language is included. These are among the reasons why it is important to require the municipal lessee’s attorney to provide a legal opinion that the municipal lease 1.) has been duly authorized, executed and delivered by the lessee, 2.) constitutes a valid, legal, binding and enforceable obligation of the lessee, and 3.) all public bidding requirements applicable to the equipment or the lease have been complied with. If the municipal lease is intended to be a tax-exempt obligation, the municipal lessee’s attorney will also need to give an opinion that the lessee is a state or political subdivision for purposes of federal tax law, as discussed above.
Toni I. Stegeman is a shareholder and director in the law firm of Gilmore & Bell, P.C. She has 23 years of experience in municipal finance, 14 of which she has practiced law exclusively in that area. Stegeman received a B.B.A. from West Texas State University and her law degree from the University of Houston. She is licensed to practice law in Missouri, Illinois and Texas. She has spoken on subjects relating to tax-exempt leasing at various seminars and before various organizations. She is a member of the AGL&F, and currently sits on the board of directors. Stegeman can be contacted at 816-218-7515, or at email@example.com.
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Brokerage, like many financial and professional services, has changed over the years, with the rise of digital innovations, ease-of-use communications and new products on offer through the leasing industry. But for those just starting out, sometimes the old-fashioned way of growing a business is still best, as Bob Bell explains.