It is common for those in our industry to distinguish true leases from dollar-out leases or other leases intended as security, which result in nothing more than a secured loan (referred to throughout the remainder of this issue as an ALIAS). This edition goes a step further and discusses situations where a loan documented on a note and a security agreement (sometimes referred to as a straight loan) is preferable to a lease, and vice versa.
Distinctions are sometimes made below where an ALIAS merits different treatment than a straight loan or a true lease, as applicable. There are obviously tax and accounting situations that lead strongly towards structuring a transaction as either a true lease or, alternatively, an ALIAS or straight loan. However, for those transactions that are not driven by tax or accounting concerns, there are other considerations. This article focuses on the latter.
Differences Between True Leases and Loan Transactions (Provisions More Favorable In Notes)
In the following ways, straight loan transactions documented on a note and security agreement have advantages over transactions documented as either a true lease or an ALIAS.
When it comes to enforcing a payment obligation, a note is sometimes preferable because of its clarity, simplicity and familiarity to most judges. A note on its face speaks only of the payment obligation and is not convoluted by terms regarding the delivery of the equipment, lack of equipment warranties, use, maintenance, taxes and other issues. This clarity, coupled by the fact that Article 2A remedies available to lessees under true leases are clearly inapplicable, makes it easier generally to enforce payment obligations due under a note. The question is simply whether or not the borrower has paid.
When it comes to a lease, there are other questions that can be litigated such as whether the equipment has been delivered and accepted or whether certain other conditions have been satisfied. Under a properly documented three-party lease of the type most in our industry engage, where the lessor is the money source separate and distinct from the supplier, these issues should not pose any problems. However, leases have confused judges for quite some time and there is always a chance that courts will handle leases improperly. This is why provisions like the hell or high water clause, acceptance mechanism, disclaimer of warranties and nonagency language are so important in equipment leasing. By way of example, look at the “hell or high water clause” in a note. It is significantly shorter because a note is more hell or high water by its nature, although certain waivers of demand, diligence, presentment, protest, notice of dishonor and the like should be standard.
In addition, the risks of lessor liability are not present in the context of a note and security agreement. Vicarious liability laws are laws where owners of personal property are liable for injuries the property causes to third parties even if the owner did not behave improperly and was not negligent in any way. Although finance lessors are merely a money source, their presence as an “owner” in the documents can make them at risk for vicarious liability suits. This risk is greatest in the case of a true lease but is even present in an ALIAS.
Consider for example, Amba-An v. Arias-Turecious, 704 So. 2d 1093 (Fla. Ct. App. 1997), where a lessor under a dollar-out lease of a motor vehicle was held liable under Florida’s dangerous instrumentality doctrine for damages caused by the negligent operation of the leased equipment by the lessee even though the doctrine is supposed to apply only to owners of equipment and not secured lenders with merely a lien on it. The federal law called the Graves Amendment — codified at 49 U.S.C. §30106 — provides some comfort with respect to this issue but the overall impact of the Graves Amendment in Florida is not yet finalized.
See e.g., Garcia v. Vanguard Rental USA, Inc., 540 F.3d 1242 (11th Cir. 2008) when the court held that Graves Amendment preempted Florida statutes, but see Brookins v. Ford Credit Titling Trust, 2008 Fla. App. LEXIS 16968 (Fla. Dist. Ct. App. 4th Dist., Oct. 31, 2008)(en banc). Here the court decided case based on text of Florida statute as written without addressing the impact of the Graves Amendment.
Another area where a note and security agreement has an advantage over a lease is with respect to tax obligations. Quite simply, it is generally easier for operations personnel to manage a company’s tax obligations with respect to payments due under a promissory note as they are not clouded by the same type of sales, property and other tax issues that often plague lessors under equipment leases — or even lessors under ALIAS.
Differences Between True Leases and Loan Transactions (Areas Where Leases Are More Favorable)
In the following ways, true leases and more preferable than straight loan transactions. It should be noted that, for purposes of the following discussion, although an ALIAS should technically be treated identically to a transaction documented on a note and security agreement, an ALIAS may be of more practical benefit than a note and security agreement since it is sometimes confused with a true lease.
Usury laws in various states can operate to limit the amount of interest that can be charged with respect to money loaned. These laws are generally not applicable to true leases. On the contrary, usury is clearly an issue under promissory notes. Usury should technically apply to an ALIAS but are commonly ignored since the transaction is styled as a lease.
Landord’s Liens and Fixtures
Where an item of equipment is owned by the lessor and delivered to the lessee’s place of business, there is ample precedent in many states (although not all) that the lessor/owner’s position takes priority over that of a landlord or mortgagee, even if the equipment is affixed to the lessee’s building. Quite simply, the property is owned by the lessor and the lessee only has a leasehold interest to which a landlord’s/mortgagee’s security interest can attach.
Where the underlying transaction is a loan rather than a true lease, however, the landlord or mortgagee may raise issues of priority. This is particularly problematic when the loan occurs and the security interest is granted after personal property has been delivered to the premises. Under the laws of many states, a landlord’s lien for rent or a mortgagee’s interest in a fixture will take priority over items of personal property or fixtures that are located at the premises prior to the personal property lender’s interest attaching (with the exception that there is a 20-day purchase-money-security-interest window that trumps prior liens).
One of the main areas where leases differ from loans is in the context of remedies. This difference stems from a couple of things. First, under a true lease the lessor owns the equipment and therefore should have greater rights with respect to the equipment. Second, even in the case of a ALIAS, the various issues addressed by leases, the presence of a purchase option (even if a bargain or mandatory) and the lack of a disclosed interest rate, result in a more complex structure. As such, case law in this area is more varied and there is generally less of an understanding of leasing remedies.
As a result, the baseline for default damages under a note is generally the principal balance of the note. Strong notes sometimes add a prepayment premium but borrowers frequently negotiate that point.
On the contrary, under a lease (whether a true lease or an ALIAS), there usually is not a principal balance stated within the textual provisions of the document. Instead, the amount due upon default is usually obtained by attaching a stipulated loss value or casualty value table or by discounting future rentals and any residual to present value by using a discount rate that is less than the “implicit rate.” As a result, lessors frequently benefit from what amounts to a prepayment premium. However, lessees negotiate this point less than in notes and there may be more room for profit after a lease default than a note default.
In addition, because a borrower under a loan (including a lessee under an ALIAS) technically owns the equipment/collateral and therefore has some “equity” to be preserved, there are usually more stringent enforcement standards placed on lenders that foreclose on such collateral. In particular, Article 9 of the Uniform Commercial Code requires secured parties wishing to foreclose to “jump through hoops” including providing certain notices, selling the collateral in a commercially reasonable manner, and refunding any surplus to the borrower (or other secured creditors).
Technically, these provisions are inapplicable to true leases. However, due to the difficulty of distinguishing between true leases and loans and the fact that courts often analyze the issue inconsistently and improperly, most leasing companies treat all of their transactions as if they were simply loans with respect to this issue. As such, prudent lessors and lenders would often not see a marked difference between a lease and a note and security agreement with respect to their actions when foreclosing on collateral. The practical difference is that if a true lessor missteps, it may be able to save itself under a true lease situation by arguing that the Article 9 rules are not applicable to it but would have no such defense in a case of a straight note transaction.
Lastly, as a practical matter, it is sometimes easier to repossess equipment under a lease since landlords, local law enforcement officers and others are more likely to let a true owner pick up its equipment. Regardless of whether the transaction is an ALIAS or true lease, law enforcement agencies and other third parties may be less knowledgeable about distinguishing the two and an ALIAS is likely to result in similar treatment for the lessor. In some states, for example Alabama, a lessor can even declare property to be stolen after a lessor terminates the lease due a default and a lessee fails to return it.
Another notable area where leases differ from loans is in the context of a lessee/borrower bankruptcy. It should be noted that, for purposes of this discussion, an ALIAS should technically be treated identically to a transaction documented on a note and security agreement and there is not any legal distinction between the two. However, as discussed before in certain other areas, an ALIAS may be of more practical benefit than a note and security agreement since there can sometimes be an argument as to whether the underlying lease transaction is an ALIAS or a true lease.
Some true lease benefits under Bankruptcy Law are: a.) lessee holds only a “leasehold interest” and, if a true lease is terminated and the lessee’s leasehold interest therefore extinguished immediately before the time the lessee declares bankruptcy, the lessor has an argument that there is no longer any lessee-interest in the equipment that can be part of the lessee’s bankruptcy estate; b.) although there is a gray “equitable” area within the rules that sometimes allows a lessee greater rights, lessees under a true lease usually have only 60 days to either assume or reject a true lease, thereby allowing a true lessor to “move on” quicker than a secured lender; and c.) true leases are also not subject to the “cram down” actions, which can be used by a bankrupt lessee or its trustee with respect to loan transactions — where the borrower’s obligations are bifurcated into a secured claim (the portion of the obligations, which are equal to the value of the collateral) and the unsecured claim (the portion of the obligations that exceeds the value of the collateral).
Licensing and Doing Business Issues
Several states have laws requiring licensing for personal property lenders. Prime examples are the California Finance Lenders License and §340 of the New York Banking Code (the New York provision applies to business loans of only $50K or less). These laws are generally thought to exclude personal property lessors. It can, and is, argued that a lessor under an ALIAS is entitled to the same exemption but that is not necessarily the case.
Kenneth P. Weinberg is a founding partner of Marks & Weinberg. Weinberg has significant experience in dealing with virtually every type of equipment and facility lease financing. He has penned Dispatches From the Trenches since 2002, and routinely publishes articles in a variety of equipment leasing and financing journals. Weinberg graduated cum laude from the University of Georgia School of Law, J.D., and was executive articles editor of Journal of Intellectual Property Law. If you have any questions or comments about this column or other industry-related legal issues, contact Weinberg at 205-251-8307 or visit www.leaselawyer.com.