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Bank Leasing: Different from Bank Lending 

By:  Barry Marks 

A few weeks ago, The American Banker included an article on the attractiveness of equipment finance to banks who have been hit by the decline in real estate investments. As more and more banks enter the equipment finance/leasing business, counsel will be called upon to explain and manage some differences in what may seem to be just two forms of lending. This article discusses some of the ways in which lending and equipment finance differ.

Documentation.  A side-by-side comparison between documentation used in bank lending and equipment finance operations often reveals a stark contrast. Loan documentation, having literally evolved over centuries, tends to be more complicated on its face, often consisting of separate loan agreements, security agreements, promissory notes and supporting documents such as guarantees, electronic funds transfer authorizations and the like. 

Bank leasing and equipment finance documentation, on the other hand, is relatively new and often generated in competition with commercial leasing operations.  This may result in the equipment finance forms being more sales-oriented and compact. For example, an equipment finance agreement generally combines the loan agreement, security agreement and promissory note. It is not uncommon for customers to express a preference for the simplified lease/equipment finance practices, such as documenting multiple transactions with one master agreement to be incorporated into short schedules containing specific transaction terms.   

Equipment finance documentation is also more specialized, sometimes incorporating terms of art and industry-standard language that may be baffling to loan officers and their customers alike. Equipment finance personnel must be prepared to address this confusion.

Inevitably, someone will ask why it is necessary to add any equipment finance language to loan documentation that has been used by the bank (and its lawyer) for years. A few observations:

Disclaimers of warranties and agency relationship with vendor.   It is unusual for loan agreements to include these provisions, which are  standard in equipment finance documents. This is because equipment finance often involves a closer relationship between lessor/lender and vendor than a bank loan.  Where there is any possibility that the borrower might argue that the lender is in league with the equipment vendor, the additional language is advisable.

Use, Maintenance and, Location language. This language is rarely as detailed in loan agreements as it is in leases and equipment finance agreements.

Casualty and insurance requirements. Many loan agreements require insurance for collateral but do not require full or partial prepayment if the collateral is lost or destroyed, much less provide a mechanism for prepayment.

Reporting or other administrative requirements if different from loan department. These provisions may be the tip of a very dangerous iceberg. Internal policies regarding everything from late fees and financial reporting to notice requirements and inspection rights must be coordinated.

Equipment-specific defaults and remedies. As with general administrative matters, different bank departments may have developed specific and different language regarding the relative importance of general defaults (such as failure to satisfy reporting requirements and cross-defaults with other indebtedness) and protection of collateral (such as maintenance of insurance and removal of liens). These priorities may be expressed in different cure rights and thresholds.

Financial Covenants. As discussed in an article appearing in The Journal in 2010 (Vol 28 No. 1), equipment finance companies, including bank affiliates, do not traditionally include net worth ratios and other financial covenants in form documentation.

Coordinating loan and equipment finance documentation faces another challenge: what to do when a single transaction entails both bank-administered loans such as receivables financings and equipment-secured loans or leases?

The first stumbling block will be the fact that most equipment finance operations use standard documents to hold down legal costs and streamline administration. While some bank loan departments utilize commercial loan packages such as Lazer Pro, many rely on local counsel for individual transactions, especially in the case of larger transactions. This means that crafting documentation to complement bank loan papers will mean shooting at a moving target.

In this context, it is essential to manage the expectations of executives on both sides. Where bank documentation will not be standard, the use of a legal counsel from either the bank or equipment finance side will be required. Either the bank's lawyer or the equipment finance unit's lawyer should create documentation to (1) add equipment finance language into the loan documents, (2) adjust the equipment finance agreement or lease documentation to avoid overlap with the bank documents, or (3) create a document that will bridge two sets of documents while avoiding alienating the customer.

Operations. As noted above, ancillary and closing documentation such as incumbency certificate forms, must be coordinated to minimize administrative confusion and avoid duplication. Operations personnel who will be charged with closing and administering transactions must also be versed in the differing terminology that may be employed by loan and equipment finance departments and clear lines of responsibility and communication are essential.

Certain policy matters may also differ, particularly with respect to Uniform Commercial Code (UCC) issues. These may require input from legal counsel and prioritization by management:

Sensitivity to inventory issues. Equipment held for sale or rental, including items leased by an equipment management subsidiary to affiliates, may be deemed inventory for UCC purposes. Different departments may be more or less knowledgeable about these issues and place them in higher or lower priority.

Requirements for landlord or mortgagee waivers. Extensions of credit relying on equipment collateral are more likely to require these documents, although the process is often difficult and frustrating.

Asset inspection and tracking. Again, equipment finance departments are more likely to place some priority on this sometimes expensive and time consuming process. Prefunding inspection by third party providers is much more often a requirement in the case of equipment finance operations, possibly due to the higher incidence of fraud.

Many of these issues would seem to be "common sense" to leasing practitioners and many bankers. Experience dictates, however, that they are real-world stumbling blocks for bankers and those who would like to do business with them.

In upcoming issues, we will examine the different programs banks, leasing company originators, vendors and others should consider when embarking on bank-funded equipment finance programs.

 PART II: MOTOR VEHICLES AND FEDERAL TAX LIENS

By:  Matthew Evans & Bill Phillips

Federal tax liens automatically attach to a taxpayer's property, including motor vehicles, upon demand and assessment from the IRS.  To perfect and have priority over subsequent lienholders, a Notice of Tax Lien must be filed.  Where to file such notice is left to state law. The filing requirements provide a place where an interested party can search to see if federal tax liens exist.  Consequently, if the government files in the wrong place its interest will not be perfected.

Most states have adopted the Uniform Tax Lien Registration Act ("UTLRA"). UTLRA states that a federal tax lien filed for most business entities shall be filed in the Office of the Secretary of State (or similarly situated office depending on the state) where the organization's principal executive offices are located. Generally, this is where the crux of the decision making power resides. Note that this is different from the state of filing for financing statements under the Uniform Commercial Code. Financing statements are filed in the state of incorporation for the entity.   

A creditor with a security interest in a motor vehicle would not be perfected if it only filed a financing statement in the state central filing office. It would have to be notated on the certificate of title to the motor vehicle to obtain perfection. However, UTLRA provides that the federal tax lien is perfected against motor vehicles as well as other personal property by the central office filing.  If the federal tax lien is to have any effect on motor vehicles such a centralized filing is necessary since it is impractical to expect the IRS to compel taxpayers or lienholders in possession of the certificate of title to surrender the title to the IRS to obtain notation as a lienholder. On the other hand, this method of perfection could lead to unjust results for purchasers or creditors that see only the certificate of title.

II.                  Special Protection for Motor Vehicles

The Internal Revenue Code provides special protection when financing motor vehicles. The purchase money security interest ("PMSI") and purchasers at retail sale under certain situations can prime preexisting federal tax liens. These are discussed generally in the Part I of our Newsletter on Federal Tax Liens.

SCENARIO 1: Imagine, as a lender or finance company, your client ABC CORPORATION, wants to purchase a large number of motor vehicles from a dealer.  The dealer is subject to federal tax liens, which reach all of the motor vehicles. The dealer presents clean certificates of title to your borrower. Should this be of any concern?

Even though federal tax liens touch the dealer's motor vehicles, the purchase at retail sale will likely be free and clear of the federal tax lien. The critical inquiry is that the sale is one that is made in the ordinary course of the seller's business, such as a car dealer selling cars. Even if you are aware of the dealership's federal tax liens, as long as you do not posses intent to evade or hinder the payment of the dealership's federal tax liens and the sale is made in the ordinary course of business you will still likely take priority.

 A different result may be reached if  the number of motor vehicles purchased exceed customary quantities sold by the seller, such as a bulk sale or if purchased at an auction. This can defeat the ability of your interest to prime the federal tax lien. Additional inquiry is required in these situations to determine your ability to prime the federal tax lien.

NEVER, we repeat NEVER do a sale-leaseback transaction with a customer subject to a federal tax lien - even if the certificate of title is otherwise clear. Doing so will draw unfavorable treatment by the IRS and likely leave your interest worthless if you do not fall under another special protection category.   

SCENARIO 2: Imagine, as a lender or finance company, your client ABC CORPORATION, wants to finance a purchase of a motor vehicle. ABC CORPORATION tells you that it is subject to federal tax liens. What should you do?

First, remember that a federal tax lien does not take priority over a valid security interest under state law unless the Notice of Federal Tax Lien is "first in time."  Check the applicable state office, generally the Secretary of State, to determine if the Notice has been filed. If no Notice of Federal Tax Lien is filed, your security interest if valid and perfected under state law will take priority.

If a Notice of Federal Tax Lien has been filed then special protection is needed for your interest to prime the federal tax lien. As we all know, purchase money security interests ("PMSI") give a lender or finance company priority over an already existing security interest to the extent new money is used to purchase the collateral if properly perfected. In IRS Rev. Ruling 68-57, the IRS cleaned up a history of indecision regarding the PMSI and the federal tax lien. If a PMSI is perfected under state law, then a PMSI will prime a federal tax lien.  Of critical concern is the time period allowed for perfecting the PMSI after delivery of the vehicle. This time period varies from state to state. Check out this information before closing the transaction.

As a word of caution, even though your PMSI can prime a federal tax lien, the federal tax lien will attach to any equity in the collateral that your borrower has. As a best practice, it is recommended to incur the minimal cost in searching for federal tax liens on your borrower and analyze if the transaction still makes "sense."  Additionally, the IRS could bring "good faith" arguments that exist under the UCC to defeat your PMSI.  If a party knows of a federal tax lien, and possesses intent to evade the payment of such tax arguments rooted in lack of "good faith" could possibly defeat your PMSI over a federal tax lien.    

ALWAYS BE CAUTIOUS IF YOU KNOW OR SUSPECT THAT YOUR BORROWER IS SUBJECT TO FEDERAL TAX LIENS, THE MINIMAL COST IN SEARCHING OFTEN OUTWEIGHS ANY BENEFIT IN RELYING UPON THE SPECIAL PROTECTIONS AFFORDED UNDER THE INTERNAL REVENUE CODE.