Structured Finance and Revenue Streams: Not Absolute and Unconditional
by Kenneth P. Weinberg November/December 2015
In the first installment of a two part series, Attorney Kenneth Weinberg explores the unique nature of bundled and PPA transactions, and outlines how these transactions differ from more traditional equipment leasing and finance structures. Additionally, he provides a list of questions that will inevitably arise when equipment leasing and finance companies decide to invest in these situations.
As is the case with many mature and sophisticated forms of finance, the equipment leasing and finance industry frequently uses structured finance concepts. Securitizations, leveraged leases and one-off, non-recourse syndications are only a few examples. Our industry has also proven over the years to be very creative, adapting many times to the types of equipment customers desire to lease or finance.
The world continues to change at a rapid pace because of globalization, technological advances and the increased networking and integration capabilities sometimes described as the “internet of things” whereby objects are embedded with electronics, software, sensors and connectivity in order to allow them to provide greater value and services. The result is transactions that used to relate solely to equipment are increasingly involving services, licenses or other products (referred to as “bundled transactions”). Customers or endusers involved in these transactions sometimes refuse to agree to pay for the equipment “come hell or high-water” unless key services, licenses or products that are integral to the equipment’s value are also properly provided.
Many equipment leasing and finance companies are also carefully watching the energy industry as it continues to become an increasingly important area of investment and growth given the perfect storm brewing between the increasing types of fuel sources that can be used to generate power (such as wind, energy and biomass) and the way energy can be delivered on a bottom-up basis through distributed generation and microgrids rather than solely from the old top-down utility infrastructure model. In many power transactions, end-users agree only to purchase energy or other outputs such that the revenue supporting repayment of the financing party’s investment is derived from a power purchase agreement or other similar documentation (referred to in this column as “PPA transactions”), raising similar issues around the lack of hell-or-high-water obligations that are present in the types of bundled transactions noted above.
Although many believe these two areas offer increasing opportunity for future growth, the lack of hell-or-high-water obligations means a significant portion of the associated opportunities do not fit squarely into the cradle created by the statutes, common law and structures most commonly used in equipment leasing and finance transactions.
The next two editions of Dispatches from the Trenches will explore the unique nature of bundled transactions and PPA transactions. This edition focuses on how these transactions differ from more traditional equipment leasing and finance structures. The next edition will draw upon lessons learned through the use of other structures, with particular focus on project finance transactions.
The vast majority of transactions in the equipment leasing and finance industry have always stood on the secure foundation provided by the basic building block of a hell-or-high-water payment obligation. Not only do “market” documents contain provisions making the obligations of lessee or borrower (the “Obligor”) absolute and unconditional, there is also a well-developed body of statutory law allowing outright or collateral assignment of such transactions, thereby allowing securitizations, syndications and otherwise providing the liquidity and comfort financing parties need to fund such transactions.
Lessee Obligations Under the Lease Itself
Both statutory law and case law have generally been very supportive of the enforceability of a hell-or-high-water clause against an obligor in equipment leases or financings whenever the lender/lessor is viewed only as a money source. Courts generally understand the absolute and unconditional nature of payment obligations due under promissory notes or other documents evidencing a straight loan. There may, however, be more room for debate when the lessee is paying the lessor rent for use of the equipment, rather than the repayment of a principal balance plus interest. To protect lessors who are merely money sources, Article 2A of the Uniform Commercial Code (UCC) introduces a concept of a finance lease.1 This term refers to a true lease that “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.”
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.” In particular, the statutory scheme of Article 2A of the UCC provides the following key mechanics: (a) once the lessee has accepted the property, it has no right to revoke that acceptance; (b) once accepted, the lessee in a finance lease is required to make rental payments and otherwise perform under the lease whether or not the equipment works as intended; (c) the lessor assigns all of its rights against the vendor to the lessee and (d) the lessor is deemed to have excluded any “implied warranties” such as the implied warranty of merchantability or of fitness of a particular purposes. In order to ensure these important lessor protections, and to make clear the parties’ intentions, a well-drafted commercial finance lease generally includes the foregoing concepts as a contractual matter (rather than relying on the statutory framework). The Official Comments to the UCC expressly recognized this practice, stating that “[i]f a transaction does not qualify as a finance lease, the parties may achieve the same result by agreement.”
Over the years, armed with the statutory law referenced above and with contractual provisions hammering home these rights, equipment lessors have generally been successful enforcing hell-or-high-water provisions as long as the leased equipment is first accepted by the lessee.
Lessee Obligations to the Lease Assignee
When considering the assignment of leases, it is important to understand that key statutory law provides strong protections to the assignee in these transactions regardless of whether: (1) the underlying leases being assigned are “true leases” (whereby the assignor/lessor owns the equipment) or secured transactions (whereby the lessee owns the equipment and the assignor/lessor merely has the rights to receive payments for a financing secured by that equipment); or (2) whether the assignment is an outright assignment/sale (as is the case when leases are assigned to an special purpose entities (SPEs) in connection with securitizations) or a collateral assignment (as is the case when leases are assigned to loan participants, indenture trustees or security trustees, in connection with leveraged lease transactions).
In particular, Section 9-406 of the UCC provides that the lessee may discharge its obligation by paying the original party entitled to payment (e.g. the lessor/assignor) until the lessee receives proper notification that a different party (e.g. the SPE) should be paid. Notification is ineffective if it fails to reasonably identify the rights being enforced by the new party. The lessee also has the right to request proof of the assignee’s interest. However, once notice and proof of the assignee’s rights have been provided to the underlying lessee, such person “may discharge its obligation by paying the [assignee] and may not discharge the obligation by paying the [originator].” The statutory provisions are so strong that clauses in the leases that would otherwise restrict assignment without the lessee’s consent are invalid and, even if a lease expressly provides that the assignment of the lessor’s rights in the lease to a third party constitutes an event of default under the lease, such provision is ineffective. As explained in the official commentary, the policies underlying the ineffectiveness of contractual restrictions under this section build on common-law developments that essentially have eliminated legal restrictions on assignments of rights to payment as security.
Due to the nature of the lessee’s hell-or-high-water payment obligation, and the protection afforded to an assignee of the lessor’s rights in the lease, companies who take assignment of leases from reputable, well-known lessor/originators sometimes do not require any notice, acknowledgment or consent from the lessees under the assigned leases. Even when documentation is required from a lessee in connection with an assignment, such as a “Lessee Notice and Acknowledgment,” the agreements usually only request the lessee to acknowledge straight-forward, non-controversial matters such the number of remaining payments, the amount of any purchase option and whether the lessee should begin paying the assignee directly and, if so, when and where. As will be discussed in more detail in the next edition of Dispatches from the Trenches, consents used in various project finance transactions, including PPA transactions, differ substantially in this respect, and address a variety of issues stemming from the lack of hell-or-high water payment obligations.
How to Move Forward
The question arises: how do equipment leasing and finance companies invest in bundled transactions and PPA transactions? One approach is to insist on participating only in transactions that included solely hell-or-high-water obligations. That approach, which results in a smaller pool of financeable transactions, has been the topic of much debate within our industry during the last several years. Many additional questions arise, including:
To what extent can the familiar unconditional payment obligation related to specific equipment be separated from the overall payment stream owed by an end-user, lessee, licensee or account debtor for bundled services?
To what extent can and will an assignor/originator owing the performance of those other services stand behind those services and what impact would such recourse have on the assignor’s/originator’s ability to leverage its portfolio/pool of revenue streams?
To what extent will the legal concepts surrounding hell-or-high-water clauses or waiver of defense clauses be honored by courts in commercial transactions, under the theory of freedom of contract, in the context of transactions which do not relate solely to the leasing or financing of goods?
To what extent will such clauses be accepted in bundled transactions within the market-place even if honored by the courts?
Many (the author included) believe this area is continuing to develop, and that the questions above are still being answered. The next edition of Dispatches of the Trenches will focus on a mature industry that has dealt with non-hell-or-high-water obligations for many, many years — project finance. Although the techniques used in project finance may be suited only for larger and more structured transactions, a close look at the methods that have developed over time in that industry is useful and can help clarify the types of risks inherent in such deals. Stay tuned…
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