Edward K. GrossEdward K. GrossOber, Kaler, Grimes & Ober, Kaler, Grimes & ShriverShriverekgrossekgross@@oberober.com.com

Principles of Lease Principles of Lease DocumentationDocumentation

A presentation made toA presentation made toThe 2003 ELA Lease Accountants The 2003 ELA Lease Accountants ConferenceConference

IntroductionIntroduction

Lessor’s MotivationsLessor’s Motivations

•• Maximize ProfitMaximize Profit–– Rent (portion of amount advanced, plus interest)Rent (portion of amount advanced, plus interest)

–– Tax/Depreciation BenefitsTax/Depreciation Benefits

–– Residual ValueResidual Value

•• Avoid LiabilityAvoid Liability

•• Avoid Administrative and Other Burdens of Avoid Administrative and Other Burdens of OwnershipOwnership

IntroductionIntroduction

Lessee’s MotivationsLessee’s Motivations

•• Obtain Use and Possession of Capital Obtain Use and Possession of Capital Equipment at Cheapest Cost to LesseeEquipment at Cheapest Cost to Lessee

•• Address Accounting, Regulatory, Contractual Address Accounting, Regulatory, Contractual and Other Considerations (if any)and Other Considerations (if any)

•• FlexibilityFlexibility–– UseUse

–– PurchasePurchase

The Law The Law –– GenerallyGenerally

•• CommercialCommercial

•• TortTort

•• TaxTax

•• User/Equipment SpecificUser/Equipment Specific

•• OtherOther

The LawThe Law

Uniform Commercial CodeUniform Commercial Code

•• Article 1 Article 1 –– GeneralGeneral

•• Article 2 Article 2 –– SalesSales

•• Article 2A Article 2A –– LeasesLeases

•• Article 9 Article 9 –– Secured TransactionsSecured Transactions

The LawThe Law

Uniform Commercial CodeUniform Commercial Code

Lease/Security Interest Lease/Security Interest (“Non(“Non--True Lease”)True Lease”)

LeaseLease(“True Lease”)(“True Lease”)UCC Sec. 2AUCC Sec. 2A--103(j)103(j)

Finance LeaseFinance Lease(“Finance Lease”)(“Finance Lease”)UCC Sec. 2AUCC Sec. 2A--103(g)103(g)

Article 2A Article 2A –– LeasesLeases

•• Freedom of ContractFreedom of Contract•• “Finance Lease” Concept“Finance Lease” Concept•• Covers Consumer LeasesCovers Consumer Leases•• Validates SaleValidates Sale--LeasebacksLeasebacks•• Implied Representations and WarrantiesImplied Representations and Warranties•• Enforceability and RemediesEnforceability and Remedies•• FixturesFixtures

Article 2A Article 2A –– LeasesLeases

True LeaseTrue LeaseUCC Sec. 1UCC Sec. 1--201(37)201(37)

What are the “economic realities” of the What are the “economic realities” of the transaction? Does the transaction? Does the Lessor Lessor have a reasonable expectation have a reasonable expectation that at lease expiration or that at lease expiration or termination it will either receive termination it will either receive more than nominalmore than nominalcompensation for the compensation for the equipment or recover equipment or recover equipment that has equipment that has more more than nominalthan nominal residual value?residual value?

Consider•Options

•Useful Life

Article 2A Article 2A –– LeasesLeases

Benefits and Detriments of Benefits and Detriments of CharacterizationCharacterization

True LeaseTrue Lease

•• LessorLessor is Owneris OwnerUCCUCC--2A2A

•• Bankruptcy Bankruptcy AdvantagesAdvantages

•• Tax AdvantagesTax Advantages

NonNon--True LeaseTrue Lease

•• Seller/Lender/ Seller/Lender/ Secured Party UCCSecured Party UCC--2/ 2/ UCCUCC--99

•• Liability AvoidanceLiability Avoidance

“Finance Lease”“Finance Lease”UCC Sec. 2AUCC Sec. 2A--103(g)103(g)

PrerequisitesPrerequisites

•• Lessor does not select, manufacture or Lessor does not select, manufacture or supply the goodssupply the goods

•• Lessor acquires the equipment to lease it Lessor acquires the equipment to lease it to Lessee under that leaseto Lessee under that lease

•• Prior to leasing, Lessee gets a copy of, or Prior to leasing, Lessee gets a copy of, or is otherwise made familiar with, “supplier” is otherwise made familiar with, “supplier” and “supply contract”and “supply contract”

Significant Advantages ofSignificant Advantages of“Finance Lease”“Finance Lease”

•• Automatically “Hell or High Water”Automatically “Hell or High Water”

•• Implied Warranties automatically Implied Warranties automatically disclaimeddisclaimed

•• Risk of loss automatically passes to Risk of loss automatically passes to LesseeLessee

•• Lessee gets automatic passLessee gets automatic pass--through of through of Supplier’s warrantiesSupplier’s warranties

Assignment of LeasesAssignment of LeasesUnder Article 2AUnder Article 2A(UCC Sec. 2A(UCC Sec. 2A--303)303)

•• Restrictions on transfers may not be Restrictions on transfers may not be enforceableenforceable

•• NonNon--breaching party may have other remediesbreaching party may have other remedies–– If by Lessee, is it transferring use and possession?If by Lessee, is it transferring use and possession?

–– If by If by LessorLessor, is it materially increasing Lessee’s , is it materially increasing Lessee’s burdens or risks?burdens or risks?

UCC Article 9UCC Article 9Secured TransactionsSecured Transactions

Security Interest in EquipmentSecurity Interest in Equipment

•• Creation and attachment of the Creation and attachment of the security interestsecurity interest

•• PerfectionPerfection

•• Priority of the security interestPriority of the security interest

BankruptcyBankruptcy

Basic Elements of a Basic Elements of a Bankruptcy ProceedingBankruptcy Proceeding

•• Automatic Stay/ReliefAutomatic Stay/Relief

•• Proof of ClaimProof of Claim

•• Lease Assumption or RejectionLease Assumption or Rejection

•• Plan (Chapter 11)Plan (Chapter 11)

•• “Ipso Facto” Clauses“Ipso Facto” Clauses

BankruptcyBankruptcy

Basic Elements of a Basic Elements of a Bankruptcy ProceedingBankruptcy ProceedingAutomatic Stay, 11 U.S.C. Sec. 362(a)Automatic Stay, 11 U.S.C. Sec. 362(a)•• Essentially an Injunction Against Debtor or Essentially an Injunction Against Debtor or

Property of Its EstateProperty of Its Estate•• So Lessor CannotSo Lessor Cannot

–– Cancel LeaseCancel Lease–– Send Demand Letters (or call)Send Demand Letters (or call)–– File Suit to Collect MoneyFile Suit to Collect Money–– Repossess the EquipmentRepossess the Equipment–– Dispose of the EquipmentDispose of the Equipment

BankruptcyBankruptcy

Proof of ClaimProof of Claim11 U.S.C. Sec. 50111 U.S.C. Sec. 501

•• Must file within courtMust file within court--determined determined deadlinedeadline

•• If Chapter 11, only have to file if claim If Chapter 11, only have to file if claim is described in Debtor’s schedules as is described in Debtor’s schedules as disputed, contingent or unliquidated or disputed, contingent or unliquidated or is inaccurately scheduledis inaccurately scheduled

•• Most Most LessorsLessors file as a matter of course file as a matter of course

BankruptcyBankruptcy

Relief from StayRelief from Stay11 U.S.C. Sec. 362(d)11 U.S.C. Sec. 362(d)

•• Lessor may seek an order vacating Lessor may seek an order vacating the stay, for “cause,” including:the stay, for “cause,” including:–– failure to provide failure to provide LessorLessor with “adequate with “adequate

protection”protection”

–– absence of equity in leased equipment absence of equity in leased equipment (non(non--true leases)true leases)

BankruptcyBankruptcy

Assumption or RejectionAssumption or Rejection11 U.S.C. Sec. 365 (only true leases)11 U.S.C. Sec. 365 (only true leases)

•• Lessee Required to Assume or RejectLessee Required to Assume or Reject

–– Within 60 Days of Filing if Chapter 7Within 60 Days of Filing if Chapter 7

–– Not Later Than Confirmation of Plan if Chapter 11Not Later Than Confirmation of Plan if Chapter 11

•• Right to Compel assumption or rejection of Right to Compel assumption or rejection of leaselease11 U.S.C. Sec. 365(d)(2)11 U.S.C. Sec. 365(d)(2)

BankruptcyBankruptcy

Assumption or RejectionAssumption or Rejection(continued)(continued)

•• AssumptionAssumption–– Cure or Provide Adequate Assurance of Prompt Cure or Provide Adequate Assurance of Prompt

Cure of PreCure of Pre-- and Postand Post--Petition Defaults (Except Petition Defaults (Except Penalties and/or NonPenalties and/or Non--Monetary Defaults . . . Monetary Defaults . . . Maybe)Maybe)

–– Administrative Claim for PreAdministrative Claim for Pre-- and Postand Post--Damages Damages if Breached or Rejectedif Breached or Rejected

–– Assume and AssignAssume and Assign

•• RejectionRejection–– Business Judgment Rule (case law)Business Judgment Rule (case law)–– Unsecured Claim for DamagesUnsecured Claim for Damages

BankruptcyBankruptcy

“No Free Ride” Rule“No Free Ride” Rule11 U.S.C. Sec. 365(d)(10)11 U.S.C. Sec. 365(d)(10)

•• True Leases OnlyTrue Leases Only

•• Lessee Must Perform All Obligations Lessee Must Perform All Obligations Arising From or After 60 Days After Filing Arising From or After 60 Days After Filing (Other Than Penalties)(Other Than Penalties)

•• Unless Court Orders Otherwise, Based on Unless Court Orders Otherwise, Based on “Equities” of Case“Equities” of Case

•• Administrative Claim for Damages Due to Administrative Claim for Damages Due to BreachBreach

BankruptcyBankruptcy

Plan of ReorganizationPlan of Reorganization11 U.S.C. Sec. 112311 U.S.C. Sec. 1123

•• Will Finally Address Assumption or Will Finally Address Assumption or Rejection (if not Already Addressed)Rejection (if not Already Addressed)

•• Will Finally Address Treatment and Will Finally Address Treatment and Manner of Distribution with Respect to Manner of Distribution with Respect to ClaimClaim

BankruptcyBankruptcy

“Ipso Facto” Claims“Ipso Facto” Claims11 U.S.C. Sec. 365(b)(2)11 U.S.C. Sec. 365(b)(2)

Cannot enforce clauses that are Cannot enforce clauses that are

triggered by insolvency.triggered by insolvency.

BankruptcyBankruptcy

Treatment in Bankruptcy Treatment in Bankruptcy (Chapter 11)(Chapter 11)

True LeaseTrue Lease

•• Assumption (and/or Assumption (and/or Assignment) or Assignment) or RejectionRejection

•• No Free RideNo Free Ride

•• Ownership Ownership –– Return Return of Equipment or of Equipment or Assumption of Lease/ Assumption of Lease/ Administrative ClaimAdministrative Claim

NonNon--True LeaseTrue Lease

•• Relief from StayRelief from Stay

•• Adequate ProtectionAdequate Protection

•• Collateral Issues:Collateral Issues:–– Secured Claim: Lower Secured Claim: Lower

of Amount of Debt or of Amount of Debt or Value of CollateralValue of Collateral

–– Unsecured Claim for Unsecured Claim for Deficiency Deficiency

Basic Lease DocumentationBasic Lease Documentation

Generally, Substance Similar Generally, Substance Similar butbut Form Form DifferentDifferent

•• Small ticketSmall ticket

•• Middle MarketMiddle Market

•• Big TicketBig Ticket

Basic Lease DocumentationBasic Lease DocumentationProposal and Commitment LetterProposal and Commitment Letter

•• ProposalProposal–– Proposes Financing Under Proposed Terms Proposes Financing Under Proposed Terms

and Conditionsand Conditions

–– Not bindingNot binding

Basic Lease DocumentationBasic Lease DocumentationProposal and Commitment LetterProposal and Commitment Letter

•• Commitment LetterCommitment Letter–– Both Parties Commit to Enter into Financing Both Parties Commit to Enter into Financing

TransactionTransaction

–– After Credit Approval and Before After Credit Approval and Before DocumentationDocumentation

–– BindingBinding

–– Should Address All Credit Committee Should Address All Credit Committee RequirementsRequirements

Basic Lease DocumentationBasic Lease DocumentationMaster Lease AgreementMaster Lease Agreement

•• Basic Terms and ConditionsBasic Terms and Conditions

•• Negotiate OnceNegotiate Once

•• Contemplates “takedowns” by Lease Contemplates “takedowns” by Lease Schedule(s)Schedule(s)

Basic Lease DocumentationBasic Lease DocumentationMaster Equipment LeaseMaster Equipment Lease

Basic Provisions Include:Basic Provisions Include:•• Rent and Manner of Rent and Manner of

PaymentPayment•• Late ChargesLate Charges•• Term of Lease and Any Term of Lease and Any

OptionsOptions•• Net Lease/“Hell or High Net Lease/“Hell or High

Water”Water”•• OwnershipOwnership•• Conditions Precedent to Conditions Precedent to

FundingFunding•• Delivery and AcceptanceDelivery and Acceptance

•• Maintenance/Return and Maintenance/Return and InspectionInspection

•• InsuranceInsurance•• IndemnificationIndemnification

–– Tax (General and Income)Tax (General and Income)–– GeneralGeneral

•• DisclaimersDisclaimers•• Lessee’s RepresentationsLessee’s Representations•• Default and RemediesDefault and Remedies•• Financials, etc.Financials, etc.•• Governing Law and Choice Governing Law and Choice

of Forumof Forum•• BoilerplateBoilerplate

Basic Lease DocumentationBasic Lease DocumentationLease ScheduleLease Schedule•• Each a Separate “Instrument of Lease”Each a Separate “Instrument of Lease”•• Incorporates Master Lease ProvisionsIncorporates Master Lease Provisions•• Chattel PaperChattel Paper•• Economic TermsEconomic Terms

–– Equipment DescriptionEquipment Description–– Term of Lease Term of Lease –– Commencement and ExpirationCommencement and Expiration–– Rent Amounts and PeriodicityRent Amounts and Periodicity–– Acceptance AcknowledgementsAcceptance Acknowledgements–– Riders as to Options or Flexibility PointsRiders as to Options or Flexibility Points

Basic Lease DocumentationBasic Lease DocumentationAcceptance CertificatesAcceptance Certificates

•• Signed by Lessee After Inspecting Signed by Lessee After Inspecting EquipmentEquipment

•• Acknowledge Final AcceptanceAcknowledge Final Acceptance

•• Establish Effective Date of Lease Establish Effective Date of Lease Schedule/Commencement Date of LeaseSchedule/Commencement Date of Lease

•• Absolute Condition Precedent to FundingAbsolute Condition Precedent to Funding

Basic Lease DocumentationBasic Lease DocumentationOptionsOptions•• End of Term End of Term

–– PurchasePurchase–– RenewalRenewal–– ReturnReturn

•• During TermDuring Term–– TerminateTerminate–– PurchasePurchase

(Rider or in Lease)(Rider or in Lease)

Basic Lease DocumentationBasic Lease DocumentationOptionsOptionsEnd of Term Purchase OptionEnd of Term Purchase Option

•• Price Stipulated Price Stipulated –– Fixed and/or Fair Fixed and/or Fair Market Sales ValueMarket Sales Value

•• ConditionsConditions–– NoticeNotice

–– No DefaultNo Default

–– All or Designated Units of EquipmentAll or Designated Units of Equipment

Basic Lease DocumentationBasic Lease DocumentationOptionsOptionsEnd of Term Renewal OptionEnd of Term Renewal Option•• Length of Term(s)Length of Term(s)•• Maximum Number of Term(s)Maximum Number of Term(s)•• Rent Stipulated Rent Stipulated –– Fixed and/or Fair Fixed and/or Fair

Market Rental ValueMarket Rental Value•• ConditionsConditions

–– NoticeNotice–– CreditCredit–– All or Designated Units of EquipmentAll or Designated Units of Equipment

Basic Lease DocumentationBasic Lease DocumentationOptionsOptions

Terminal Rent Adjustment Clause (TRAC)Terminal Rent Adjustment Clause (TRAC)

IRC IRC §§ 7701(h) 7701(h)

•• Lessee Risk/CompensationLessee Risk/Compensation

•• Split RiskSplit Risk

Basic Lease DocumentationBasic Lease DocumentationOptionsOptionsDuring Term OptionsDuring Term Options•• Early Termination or Purchase OptionEarly Termination or Purchase Option•• When ExercisableWhen Exercisable•• Stipulated AmountStipulated Amount

–– if EBO, Fixed and/or Fair Market Sales Valueif EBO, Fixed and/or Fair Market Sales Value

•• ConditionsConditions–– NoticeNotice–– No DefaultNo Default–– All or Designated Units of EquipmentAll or Designated Units of Equipment

Basic Lease DocumentationBasic Lease DocumentationGuarantyGuaranty

•• Unconditional, Primary and AbsoluteUnconditional, Primary and Absolute

•• Payment and Not CollectionPayment and Not Collection

•• Waiver of Suretyship DefensesWaiver of Suretyship Defenses

•• Ability to AssumeAbility to Assume

•• Choice of Law, etc.Choice of Law, etc.

Basic Lease DocumentationBasic Lease DocumentationCertificates of InsuranceCertificates of Insurance

•• Types of CoverageTypes of Coverage–– Liability Liability –– Additional InsuredAdditional Insured–– Casualty Casualty –– Loss PayeeLoss Payee

•• Minimum Levels of CoverageMinimum Levels of Coverage•• Maximum Deductibles or Levels of SelfMaximum Deductibles or Levels of Self--

InsuranceInsurance•• Exclusions from CoverageExclusions from Coverage•• EndorsementsEndorsements

–– Breach of Warranty ClauseBreach of Warranty Clause–– Written Notice 30 Days Prior to Cancellation or ChargeWritten Notice 30 Days Prior to Cancellation or Charge–– Expiration DatesExpiration Dates

Basic Lease DocumentationBasic Lease DocumentationOther Credit SupportOther Credit Support•• Security DepositSecurity Deposit

–– CollateralCollateral–– Economic EnforcementEconomic Enforcement

•• Letter of CreditLetter of Credit–– ThirdThird--Party Obligation (Bankruptcy Proof)Party Obligation (Bankruptcy Proof)–– Lessor’s FormLessor’s Form–– Limited, Clear Drawing RightsLimited, Clear Drawing Rights

•• BreachBreach•• BankruptcyBankruptcy•• Failure to Replace LCFailure to Replace LC

–– Replacement Prior to Expiration or DefaultsReplacement Prior to Expiration or Defaults

Basic Lease DocumentationBasic Lease DocumentationOther Credit SupportOther Credit Support

•• Additional CollateralAdditional Collateral–– WarrantsWarrants–– Blanket LienBlanket Lien

•• Vendor SupportVendor Support

Basic Lease DocumentationBasic Lease DocumentationUCCUCC--1 Financing Statements1 Financing Statements

•• UCC Sec. 9UCC Sec. 9--505 for True Leases505 for True Leases

•• Correct Legal Name of DebtorCorrect Legal Name of Debtor

•• Appropriate Locations for FilingAppropriate Locations for Filing

•• Adequate Description of EquipmentAdequate Description of Equipment

•• Timely FilingTimely Filing

Basic Lease DocumentationBasic Lease DocumentationOther Closing DocumentsOther Closing Documents•• Lessee and any Guarantor or Other ObligorLessee and any Guarantor or Other Obligor•• Corporate CertificateCorporate Certificate

–– Certified ResolutionsCertified Resolutions–– IncumbencyIncumbency

•• OpinionsOpinions–– Corporate or Other Legal Status/AuthorityCorporate or Other Legal Status/Authority–– Compliance with Legal and Contractual RequirementsCompliance with Legal and Contractual Requirements–– EnforceabilityEnforceability–– LitigationLitigation–– OtherOther

Basic Lease DocumentationBasic Lease DocumentationPurchase DocumentsPurchase Documents•• Who is the Purchaser?Who is the Purchaser?

–– Purchase OrderPurchase Order

–– Purchase AgreementPurchase Agreement

–– InvoiceInvoice

•• ThirdThird--Party AgreementsParty Agreements–– Purchase Order/Agreement AssignmentPurchase Order/Agreement Assignment

–– Assignment of WarrantiesAssignment of Warranties

Basic Lease DocumentationBasic Lease DocumentationPurchase DocumentsPurchase Documents(continued)(continued)

•• Bills of SaleBills of Sale

•• Title Title –– Who Holds Title?Who Holds Title?–– Has Equipment Been Delivered?Has Equipment Been Delivered?

Basic Lease DocumentationBasic Lease DocumentationVendor Support DocumentsVendor Support Documents

•• RemarketingRemarketing

•• Put to Vendor (full or limited)Put to Vendor (full or limited)

•• Credit SupportCredit Support

Basic Lease DocumentationBasic Lease DocumentationIntercreditor AgreementsIntercreditor Agreements

•• Subordination Agreement Subordination Agreement –– How Deep?How Deep?

•• Assignment of Subleases Assignment of Subleases –– Who gets Who gets rent? How soon?rent? How soon?

•• Real Property WaiversReal Property Waivers–– LandlordLandlord

–– MortgageeMortgagee

–– OwnerOwner