An equipment lease is more than an agreement to make monthly payments. Businesses should understand the full legal, financial, and operational implications of an equipment transaction before signing, including the lease terms, the nature of the transaction, ownership and financing arrangements, potential claims by third parties, and the consequences if the lessor defaults or becomes insolvent. This article highlights key issues businesses should consider before entering into an equipment lease and throughout the equipment’s lifecycle, from delivery and acceptance through maintenance, termination, and return of the equipment.

Businesses considering equipment leases often focus on the obvious questions: What is the monthly payment? How long is the lease? Is there a purchase option? Those questions are important, but they do not tell the whole story. An equipment lease can create significant legal, operational, and financial risks that may not become apparent until the equipment is damaged, the lease is terminated, the lessor fails, or the lessor’s financing source asserts rights in the equipment.

A prospective lessee therefore should approach an equipment transaction as more than a financing decision. Before signing, the lessee should understand the lease terms, the legal character of the transaction, the lessor’s ownership and financing arrangements, the potential consequences of a lessor default or insolvency, and the obligations associated with using and ultimately returning the equipment.

Read Beyond the Rental Rate

The first step is to understand the lessor’s form of lease and its standard terms and conditions, including schedules, riders, and exhibits. The stated rental rate and term may be the most visible provisions, but other provisions can have a substantially greater economic impact.

A prospective lessee should carefully consider provisions concerning default, acceleration, early termination, indemnification, insurance, taxes, maintenance, casualty, relocation, equipment modifications, assignment, quiet enjoyment, and end-of-term return requirements. The lessee also should understand what remedies the lessor has if the lessee defaults and whether the lease limits the lessee’s remedies if the lessor fails to perform.

The lessee should pay particular attention to provisions that may appear routine but can materially affect the transaction. For example, a broad indemnification provision, an expansive definition of default, an obligation to pay substantial early-termination charges, or stringent equipment-return requirements can significantly increase the cost of a lease. The lessee also should consider whether the lease adequately addresses the rights of assignees, secured parties, and other persons claiming through the lessor.

The important point is to evaluate the entire economic and legal commitment, rather than focusing primarily on the monthly payment.

Determine What Kind of Transaction You Are Entering Into

The lessee also should determine the legal character of the transaction. A document labeled a “lease” does not necessarily determine whether the transaction is a lease or, instead, creates a security interest.

Under UCC § 1-203, whether a transaction in the form of a lease creates a lease or a security interest is determined by the facts and circumstances. Among other things, the statute identifies circumstances in which an arrangement creates a security interest, while also making clear that certain features—such as the lessee’s assumption of risk of loss, payment of taxes and insurance, or an option to purchase—do not by themselves convert a lease into a security interest.

A finance lease is a different concept. Article 2A specifically defines a finance lease as a type of lease involving, generally, a lessor that (i) does not select, manufacture, or supply the goods, (ii) acquires the goods in connection with the lease, and (iii) satisfies specified requirements concerning the supplier’s contract and warranties.

The distinction matters. In a finance lease, for example, the lessee’s promises generally become irrevocable and independent upon acceptance of the goods in a nonconsumer transaction. UCC § 2A-407 provides that those promises are enforceable between the parties and by or against third parties, including assignees.

Accordingly, before signing—and particularly before accepting the equipment—the lessee should understand whether it is entering into a conventional lease, a finance lease, or a transaction that may be characterized as a secured financing, and what that characterization means for its rights, obligations, remedies, and exposure to third-party claims.

Understand the Lessor’s Ownership and Financing

The lessee also should determine who owns the equipment and what ownership or security interests third parties may have in it.

A lessor may purchase equipment with its own funds, but equipment lessors also may finance acquisitions through banks or other secured lenders, including warehouse or asset-based credit facilities. Those facilities may be secured by the lessor’s equipment, lease receivables, chattel paper, proceeds, or other assets.

The prospective lessee therefore should ask: Who owns the equipment, and what interests do third parties have in it?

The answer can matter if the lessor defaults on its financing. Article 9 contains rules governing the relative rights of lessees and secured creditors, and those rules can depend upon such matters as the nature of the lease, the lessee’s status, the timing and perfection of the lender’s security interest, and the circumstances under which the lessee acquired possession. In particular, Article 9 provides specific protections for lessees in ordinary course.

The lessee should not assume, however, that the existence of a warehouse lender automatically creates a problem. Warehouse financing is a common way for leasing companies to finance their businesses. The relevant question is whether the lender’s rights could interfere with the lessee’s rights under the particular transaction.

Consider the Warehouse Lender Before a Problem Arises

A lessee in ordinary course that is performing its obligations under the lease generally should not lose possession of leased equipment merely because the lessor defaults on its warehouse or other financing facility. UCC § 9-321(c) generally provides that a lessee in ordinary course takes its leasehold interest free of a security interest in the goods created by the lessor, even if the security interest is perfected and the lessee knows about it.

That protection, however, is not a reason to ignore the issue. Questions can arise concerning whether the transaction is a true lease, whether the lessee qualifies as a lessee in ordinary course, and the scope and priority of the lender’s security interest. The circumstances also can become more complicated when equipment is installed as an accession to other property or when other creditors have competing interests.

There also is a practical consideration. Even if a lender ultimately lacks the right to repossess equipment from a lessee that is performing under its lease, a dispute over possession can disrupt the lessee’s operations—particularly when the equipment is specialized, expensive, or essential to production.

A separate lender acknowledgment, lien waiver, or non-disturbance agreement is not necessarily standard in every equipment transaction. It may nevertheless be worth considering when the equipment is critical to the lessee’s business, the transaction is substantial or long-term, or the lessor’s financing arrangements create particular uncertainty. Such an agreement can provide additional contractual certainty that the lender recognizes the lessee’s rights and will not interfere with its possession so long as the lessee is performing its obligations.

The objective is not to assume that the warehouse lender necessarily has superior rights or, conversely, that the lessee is automatically protected from any interference. Rather, it is to understand the financing structure and determine whether additional contractual protection is warranted.

Plan for Lessor Insolvency, Failure, or Assignment

The lessee should consider the lessor’s financial stability and reputation. Is the lessor financially stable, reputable, and experienced in the equipment-leasing business? What happens if the lessor becomes insolvent or files bankruptcy, recognizing that bankruptcy can introduce additional statutory and procedural issues beyond the UCC. The lessee should also understand what happens to the lessor’s and lessee’s continuing rights and obligations after an assignment, including lease servicing, warranties, and payment instructions, among other items.

Manage the Equipment Throughout Its Lifecycle

The lessee should consider the full life cycle of the equipment—not simply the period between signing the lease and making the first payment. The lessee should resolve significant issues involving delivery, acceptance, equipment condition, supplier performance, and applicable warranties before accepting the equipment. The lessee also should consider the practical consequences of losing access to critical equipment because of a dispute involving the lessor. Business continuity may be more important than the legal ability to assert a claim after the fact.

The lease may impose detailed requirements concerning maintenance, insurance, permitted uses, relocation, alterations, upgrades, casualty, condemnation, and compliance with applicable laws. These requirements should be compared with the lessee’s actual business practices. A provision that appears reasonable when the lease is signed may become burdensome if the business moves, modifies the equipment, changes its operations, or needs to replace or upgrade the equipment.

The lessee also should understand its end-of-term obligations. What condition must the equipment be in when returned? Who pays for transportation and removal? What repairs or restoration may be required? What happens if the lessee wants to purchase the equipment or renew the lease? What are the consequences of early termination?

The most useful approach is to calculate the total potential cost of the transaction, not merely the scheduled rent. A favorable rental rate can be offset by substantial termination, restoration, removal, insurance, maintenance, or return-condition costs.

How Counsel Can Help

The prospective lessee ultimately must decide whether the business and legal risks and obligations of an equipment transaction are acceptable. Experienced counsel, however, can help identify and manage those risks by reviewing and negotiating the lessor’s forms, identifying unusually one-sided provisions, analyzing the legal character of the transaction, conducting appropriate UCC searches, and assisting with organizational documents, consents, and other transaction documents.

Look Before You Lease

An equipment lease should not be viewed simply as an agreement to make monthly payments. Before signing, a prospective lessee should understand what it is acquiring, who owns the equipment, how the lessor financed it, what rights third parties may have, what happens if the lessor fails, and what obligations the lessee will have throughout the equipment’s useful life.

Taking the time to address those questions before signing—and, where appropriate, before accepting the equipment—can help prevent a routine equipment transaction from becoming a significant operational, legal, or financial problem.

If you have any questions about this article, please contact: Samuel L. Pappas, Esq.

The foregoing is intended to be marketing material. Information is contained in this article is for general education and knowledge. It is not designed to be and should not be substituted for legal advice. This information is not intended to create an attorney-client relationship.