It happens all the time. You finance a customer’s acquisition of equipment and the customer subleases the equipment. While there is nothing inherently wrong with such arrangements, several potential issues arise which, if not carefully addressed, could expose a finance company to significant legal risk, including the loss of the equipment. This article identifies several issues and makes general suggestions for addressing the risks.

For ease of reference, we will describe documentation with the customer as a lease and the customer’s documentation with its affiliates or unaffiliated third parties as a sublease, but the same general concerns apply if your transaction with the customer is a loan.

Do You Have a Priority Issue? 

Even if you believe your transaction is a true lease for Uniform Commercial Code (UCC) purposes, it is still advisable to ensure a first priority lien in the equipment in case a court later determines that the transaction is, in fact, a secured loan. Of course, if your transaction with the customer is pursuant to an EFA or other document clearly evidencing a loan, or a lease with a mandatory or a nominal purchase option (like the classic dollar-out lease), perfecting a first priority security interest is crucial.

To obtain a first priority security interest, you can always conduct UCC searches and obtain waivers.1 However, you can avoid this more labor-intensive and time-consuming process by relying on a purchase money security interest (PMSI). If you rely on a PMSI, your customers’ subleasing of the equipment raises unique priority issues. What constitutes “inventory” for UCC purposes is a topic in and of itself. Simply put, if your customer subleases the equipment to an affiliate operating company or “bare rents” the equipment to its customers (i.e., without an operator), the prudent approach is to assume that the equipment is inventory in your customer’s hands.2

With “inventory,” the following must occur before or at the time your customer first possesses the equipment: 1) the security agreement must be signed and the lien must be granted; 2) a financing statement must be filed and 3) any conflicting security interest holders with earlier filings of record must have received a notification of your intent to acquire a PMSI within five years before the customer receives possession of the equipment.3 In the fast-moving world of equipment finance, it is not always an easy task to comply with these requirements. Documents must be considered as well. For example, if the grant of the security interest in the equipment is not effective until after the customer obtains possession and accepts it, you are not complying with the first requirement listed previously.

The rules are different if the equipment is a “titled vehicle.” In most cases, rather than filing a financing statement, you record your lien on the vehicle’s title.4 However, if your customer is in the business of selling goods of that kind, you must perfect by filing financing statements subject to the same issues discussed previously for non-titled equipment.5 Notably, non-uniform states such as Idaho, Illinois, Louisiana and Rhode Island require financing statements (and ignore the certificates of title, although it is advisable to comply with the certificate of title laws, too) even if your customer is only in the business of leasing (but not selling) goods like your equipment.

The Sublessee’s Right of “Quiet Enjoyment”

If your customer leases equipment in the ordinary course of its business, the sublessees have a right of “quiet enjoyment.”6 That means, absent special precautions, if your customer defaults under your transaction, you will not have recourse to the equipment for the term of the sublease.

If the subleases tend to be short-term rentals and the equipment will be returned to your customer on a monthly or other acceptable basis, you may be less concerned with the sublessees’ rights of quiet enjoyment because you could “grab” the equipment after a short-term rental ends and before another begins. If, however, your customer tends to have longer-term rentals, the inability to repossess the equipment can be more problematic.

The safest way to address this problem is for the sublessee to sign a writing that waives these rights and acknowledges the superiority of your interest. Care should be taken to show the sublessee received adequate consideration to make the waiver binding. It should be sufficient if you are willing to consent to your customer’s leasing of the equipment to the sublessee only upon receipt of such a waiver, and if you detrimentally relied on the waiver by funding.

Of course, actually obtaining such waivers may simply be too impractical, especially for volume businesses. In such instances, it is common to use a “trust but verify” approach in which your customer covenants that all subleases will include a waiver of quiet enjoyment in a form you have approved. The form sublease must have appropriate language and should be reviewed by counsel for the proper covenants. Also, periodic audits should be considered because if it turns out your customer does not use the proper form, you will still encounter problems repossessing the equipment while out on lease/rental. Such audits also may be impractical for various reasons, including cost, available resources, deal size and portfolio volume.

Finally, a third way to address quiet enjoyment is to obtain a collateral assignment of, and first priority security interest in, the sublease and the rental payments. This way, you would at least collect the rental payments while you wait for recourse to the equipment. While making sure your interest is a first priority interest is a topic itself, things to consider include whether you are 1) relying on the “super-priority” rule found in UCC §9-330 by taking possession of the only original sublease (and, if so, whether you are “giving value” and otherwise complying with Section 9-330) and/or 2) filing a financing statement, conducting UCC searches and obtaining lien waivers (and, if so, what steps you take to otherwise comply with UCC §9-330 and ensure nobody else primes your interest by taking possession of the sole original). Other issues can further complicate matters, including the presence of “split leases,” which may include some of your equipment but also equipment financed by another creditor. For all of these reasons, this particular method of addressing the quiet enjoyment issue is the most complex, time-consuming and costly.

Can the Equipment be Sold Free and Clear? 

What happens if the customer turns around and sells the equipment? Well, it’s possible the equipment could be sold “free and clear” of your interest, regardless of whether you have a secured loan or a true lease.7 The full details of these provisions are beyond the scope of this article, but the key issue is whether your customer regularly sells equipment of this type in the ordinary course of business. Selling this type of equipment from time to time (e.g., when it becomes worn or obsolete) does not necessarily mean that your customer is in the business of selling such equipment.8 It is all a matter of degree — how often your customer sells this type of equipment and the methods used are all important considerations.

The truth is there’s not much to be done about a bonafide buyer in the ordinary course taking your rights fear and clear. Certainly, you could conduct regular audits to ensure your equipment hasn’t been sold, but as mentioned previously, there are practical limitations to conducting such audits. Of course, you would have a claim against your customer for selling out of trust, but you would no longer have recourse to the equipment. Ultimately, when it comes to the risk of free and clear sales, lending to such customers is less about legal risk mitigation than it is about risk tolerance and careful underwriting.

Transactions in which your customer subleases equipment to third parties are fairly common in our industry, especially in certain market segments, but the situation raises unique legal and practical issues that require additional expertise, consideration and diligence. Prudent finance companies will therefore go into these transactions mindful of these risks and take the necessary precautions.•

1. UCC. §9-322(a)(1).

2. Some may argue that even when it’s an operator rental or if your customer is merely providing a service, not specific equipment, that too qualifies as inventory since the definition of “inventory” includes goods that are furnished by the customer to others under a contract of service or held by the customer for such purposes.

3. UCC §9-324(b).

4. UCC §9-311(a)(2).

5. UCC §9-311(d).

6. UCC §9-321(c) (for loans); §2A-305(2) (for leases).

7. UCC §9-320 (loans); UCC §2-403 (For the entrustment provisions applicable to leases which provides that (“[a]ny entrusting of possession of goods to a merchant who deals in goods of that kind gives him power to transfer all rights of the entruster to a buyer in ordinary course of business); UCC §9-102, Official Comment 4a.

8. UCC §9-102, Official Comment 4a.

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. Scott D. Chait is an attorney with Sumitomo Mitsui Banking Corporation, with a primary role of supporting equipment finance and leasing activity as well as other related transactional matters.

The views expressed in this article belong solely to the authors and do not necessarily represent the views or position of their employers or any other person.