Although loans to finance equipment leases are more complicated to document, require more time to administer, and have higher risks for losing a priority position on collateral than the normal commercial loan, such loans can provide a very profitable source of business to banks. This article briefly describes how to document a loan to a leasing company; however, it is not meant to be a checklist. Rather it points out some of the potential complications and difficulties associated with such loans to help assure that banks can minimize the risk of loss.
For the purposes of this article, assume the borrower leases equipment to third parties and wants the bank to provide financing taking the leases and the underlying equipment as collateral.
IS THE LEASE REALLY A LEASE?
An issue that faces every equipment lease company is whether the lease is truly a lease or simply a conditional sales contract (a sale that is conditioned on the completion of the payments). While this seems like it would be an easy thing to determine, courts have not found it so. True leases have been turned into conditional sales contracts simply by the addition of an option to purchase the leased equipment at the end of the lease term. Other true leases have been held to be conditional sales contracts as a result of purchase options contained in side agreements. These leases which are really sales contracts are known as "purchase" or "finance" leases. A bank needs to be protected regardless of whether the lease is a true lease or a purchase lease.
TREAT THE LEASE AS A PURCHASE LEASE
Begin the documentation process by treating the lease as a "purchase lease" even if it is a "true lease." The lender must take this step because of the effect of the Uniform Commercial Code (the "UCC"). If the equipment lease is a "true lease" and not a "purchase lease", the UCC does not cover the rights created by the lease. Unfortunately, as noted above, the line between a "true lease" and a "purchase lease" is often blurred and neither the bank or a leasing company may find out the lease was a "purchase lease" until a bankruptcy or other court rules that way after the fact. If the lease is found to be a "purchase lease", it is considered to be nothing more than a sales contract with a grant of a security interest back to the leasing company. If the leasing company has done nothing to perfect that security interest, it will lose in a priority fight with anyone else who does not have a perfected lien against the lessee and will lose as against a bankruptcy trustee.
In order to protect against this after-the-fact determination that a lease was a sales contract with a grant of a security interest, the leasing company files a financing statement just as it would if it had a security agreement instead of a lease.
Typically, this filing contains the statement that the lease is a "true lease" and the filing is made for "notice" purposes. The filing will be made in the appropriate place for that type of equipment. The filings for equipment used in farming, of course, are typically made in the county register of deeds office, while the filing for non-farm equipment is made in the Secretary of State's office. The appropriate filing office varies somewhat from state to state although the above locations are correct for Illinois, Minnesota and Wisconsin. The lessee is shown as the "debtor" on the financing statement, the leasing company is the "secured party" and the bank is the "assignee".
TREAT THE LEASE AS A TRUE LEASE
What if the lease turns out to be in fact a true lease? In that case, the lessee has no ownership rights in the equipment and cannot grant a security interest to the leasing company which in turn, therefore, cannot assign it to the bank. In that event, the leasing company rather than the lessee, is the owner of the equipment. However, as to the leasing company, the leased equipment is not "equipment", it is "inventory" and the bank must have a security agreement with the leasing company granting the bank a lien on the leasing company's inventory. The financing statement for the inventory will show the leasing company as "debtor" and the bank as "secured party". Usually one filing covers all inventory within a single state, but leased equipment maintained in a different state would require an inventory filing in that state as well.
ENSURE THAT THE BANK HAS A PURCHASE MONEY PRIORITY
Often the lessee will have other creditors with liens perfected prior to the leasing company's lien. The UCC gives priority to security interest taken by a person who by making advances enables the debtor to obtain the collateral - the purchase money priority. To take advantage of this provision, the lien must be perfected within twenty days after the collateral is received (the number in other states varies). One of the several challenges facing a lender to the leasing company is ensuring that the filings, whether for true leases or finance leases, are done in a timely fashion so that if necessary, so the bank will have the purchase money priority.
FILE ON THE CHATTEL PAPER
Many lenders stop at this point and do not take a perfected security interest in rentals. Note that the bank will not have a perfected security interest in the rental payments and therefore probably will not get the rentals if the leasing company gets in trouble, and the lender will not have any right to possession of the leased equipment until the end of the lease term when the equipment will have a much reduced value. To overcome this problem, the lender must go through the steps necessary to perfect a lien against the lease itself. The lease, whether a true lease or purchase lease, is "chattel paper" covered by the Uniform Commercial Code. Perfection is accomplished in the same manner as for inventory. That is, the lender files a financing statement naming the leasing company as debtor. In the case of the leasing company, the financing statement description of collateral will include both inventory and chattel paper.
PUT A LEDGEND ON THE LEASE SHOWING THE BANK'S LIEN
Simply filing a financing statement, however, still leaves a gap as to chattel paper. The gap results from the wording of the UCC. The UCC permits a third party purchaser of chattel paper to have a priority over a secured lender if the purchaser buys without knowledge that the "specific" chattel paper is subject to the lender's lien. This reference to "specific" chattel paper allows a purchasers to argue that a financing statement purporting to cover all chattel paper is not sufficient to create "knowledge" of the conflicting lien even if the wording of the lien seems to be all encompassing.
To prevent that argument, the bank must require each original lease agreement to be stamped with a legend showing that it is subject to the bank's lien. The bank should audit the leases to insure they are being stamped and be especially vigilant if the leasing company falls on hard times.
REVIEW THE LEASE PROVISIONS
Finally, the lease is a contract giving rights to the lessor and the lessee. The bank is taking a security interest in the lease so that if necessary the bank can collect the lease payments. The bank's ability to collect depends on the terms of the lease contract. For example, non-consumer leases should have a clause waiving defenses against an assignee, such as the Bank. Without that clause, the lessee might be able to raise warranty-type defenses and slow or stop the bank's collection efforts.
This is just one example. Inclusion or exclusion of other provisions may be equally important to the bank. Therefore, each lease form must be reviewed to determine what obligations may be required to be performed in order to obtain the lessee's lease payment.
Lending to a leasing company is complicated business requiring substantial attention to documentation and monitoring to protect the bank's collateral position.