The rise of the Equipment Finance Agreement or EFA has been nothing short of meteoric. Fueled by concerns about lessor liability, confusion among state revenue agents regarding application of sales taxes and concerns regarding the reputation of equipment leasing, the EFA may soon eclipse the familiar "buck-out" lease intended as security.
On its face, using an existing equipment lease form to document an EFA transaction would seem fairly simple. The economics of an EFA should be similar to those of a lease intended as security: full payout with implicit interest and either a mandatory balloon payment or no additional payment at the end, with the borrower/lessee owning the equipment subject to a security interest for the lender/lessor . As many practitioners have found, however, taking a client's standard-form equipment lease and creating an equipment finance agreement is more complicated than it appears.
Basically, an EFA is a Security Agreement and Promissory Note rolled into one document with several key provisions not normally found in standard Security Agreements. These provisions commonly relied upon in the equipment financing and leasing industry, satisfy several important aspects which relate to the equipment and the commercial acceptance of an agreement in the marketplace.
Before even beginning the conversion process of an equipment lease form to an EFA, two fundamental questions must be answered: First, Does the lessor want the EFA to look like a loan agreement or like a lease? Some lessors want to keep the transactions it offers as far from those presented by competing banks as possible. Others want the transaction to clearly be a loan so as to approach customers who are afraid of leasing. What about the disclosure of interest rates or other common loan agreement terms?
Second, what are the priorities? Does the lessor want the agreement to be as consistent as possible with existing lease documentation? What consistency must be preserved? Is length an issue or may language be added to protect against legal risks inherent in lending?
This article will examine these and other issues that arise in converting lease forms into equipment finance agreements.
An Equipment Finance Agreement is a Loan Document
There are many reasons to begin to create an EFA from an existing lease document. Among other things, consistency between the forms will facilitate administration and maintain branding. Working from an existing form is generally less time-consuming for the draftsman (which may be read as "less expensive for the client").
Against this consistency, however, is a simple fact clear to most lawyers but sometimes lost on their clients: an equipment finance agreement is a loan document. It is an entirely different animal from the true lease documentation on which most, if not all, leases intended as security are based. Many of the issues raised by this difference require counsel to be versed in lending as well as leasing, particularly if the EFA is to be sold to a bank represented by counsel familiar with traditional lending.
What is really happening is that documentation based on equipment rental agreements is being transformed into documentation based on many years of secured lending. Some of the concepts have always been a part of leases intended as security but others rarely come up in any type of lending.
One of the fundamental differences between a lease and an EFA is that EFAs always involve the collection of interest. This is true whether the EFA breaks down monthly payments between principal and interest or collects both as a single level payment. While "rent" charged in leases intended as security is often recharacterized as principal and (implicit) interest, the lender under an EFA does not even have a form over substance argument that interest is collected. This means that laws regarding the collection of interest, most notably usury laws, will apply to EFAs.
For usury purposes, interest is generally defined as a fee collected for the use of money or forbearance in collecting a debt. Many states have either or both civil and criminal usury statutes applicable to commercial lending as well as loans to consumers. While many lessors have ignored these laws, even for leases intended as security, EFA lenders must take them into account. A particular concern is that many leases include high late fees and additional charges for tax service, inspections or other services rendered by the lessor. These charges, in some cases, can be reinterpreted as additional interest, causing a seemingly safe transaction to exceed usury rates.
This brings about two important defenses used by lenders traditionally as a means of avoiding usury restrictions. First, a usury savings clause, stating that the parties do not intend to violate applicable law and that payments will be reduced as necessary to avoid the collection of excessive interest is generally advisable. These clauses are rarely found in equipment leases and it is understandable that many lessors prefer not to see anything that implies that their rent may be "too high" or that any payment should be reduced. Nevertheless, many courts have held that the presence of a usury savings clause protects against usury penalties.
Second, choice of law becomes even more important where interest at a high rate will be collected. Avoiding application of the laws of a state with a low usury ceiling, particularly a criminal rate, is highly advisable. Including a consent to jurisdiction designating the state whose laws are chosen to apply to the EFA strengthens the application of the preferred state's laws.
The collection of interest brings about other issues. While lessors rarely disclose implicit rates, disclosure of interest rates may be required in EFAs, either by law or market pressures. In Georgia, the requirement of a "stated" rate of interest is generally regarded as a requirement that interest rates be disclosed in order to avoid the state's restrictive usury laws. Customers who recognize that the EFA is a loan document may want to see interest expressed in familiar terms. This will particularly be true where the EFA is offered as an alternative to traditional loan financing, as where the lessor is competing with a bank lender.
Specific Drafting Considerations
Briefly touching on a few of the many issues that are likely to arise:
Definitions.
Replacing "lessor" and "lessee" with "lender" and "borrower" may be easy enough but raises the question of how much like a bank loan agreement the parties want the EFA to appear. Likewise, the decision whether to replace "rent" with "payment" or a similar word or with an expression of "principal and interest" involves both the question of whether to disclose the implicit interest rate and whether to distinguish the EFA transaction from a competing bank loan.
Loan payments are generally collected in arrears whereas rentals are usually collected in advance. This is not an iron-clad rule and there is no reason why level EFA payments cannot be collected in advance, but a potential customer comparing loan and EFA proposals may ask.
Security Interest.
It should be clear that the borrower owns the equipment from day one and is granting a first priority security interest to the lender. This sort of language, if included in a lease form at all, is often an afterthought. Unlike a lease intended as security, the EFA can clearly identify the equipment as collateral, which can carry benefits. For example, in granting a security interest, it is not uncommon to include interests in proceeds such as receivables if the equipment is rented (whether or not permitted) and insurance proceeds.
The security interest should, if possible, be perfected as a purchase money security interest meaning, among other things, that the purchase price of the equipment is paid to the vendor and not as reimbursement to the borrower and that a UCC-1 Financing Statement is filed within 20 days after delivery of the equipment to the borrower. [Originally published in the LJN Leasing Newsletter]
To be continued in next issue....
