Ubi Sunt Equipment Finance?
A Pirate Looks at...over 65
Back, WAY back, when yours truly was in college, we had a course in ye olde English literature (you know, Beowulf and all that jazz ending with Chaucer (the Miller's Tale was everybody's favorite). There was a convention that began
meaning "where has gone." The speaker stands before a roaring fire with his cup of mead, lamenting "Ubi Sunt my gold-friend, who rode the wine-dark seas?" and like poetic stuff.
I mentioned all this academic blah-blah several years ago but it is too good an attention-getter to pass up. This little piece is about "where is gone, equipment finance?" meaning another foray into a sententious old lawyer blabbering about where the industry has gone and where it appears to be going. You might want to read on as there is some free legal advice here and also an opportunity to use the other side of your overtaxed brains in a little creative (gasp) thinking.
Big changes are afoot, there are bad signs from the East, the drums and smoke signals...I mean I don't like the look of this, Luke...The industry is changing and some of us will and others won't make the transition.
Perhaps the biggest change. With the demise of the old operating lease rules, the days of financing equipment acquisitions without burdening the balance sheet with "debt" are pretty much at an end. Not totally, and the alternative may work out to many customers' advantage, but a paradigm shift is clearly taking place.
At the same time, vendors are facing new limitations on their ability to recognize revenue in "completed sale transactions." This will present significant challenges for vendors who enter into leases and installment sales and assign the documents to leasing companies...and their accountants. The concept of retaining an interest in the equipment has morphed under ASC's 860 and 606 to one of retaining "control" over either inventory sold to a lessor or a financial asset assigned to a lender. This will require rethinking (and probably amending) Vendor Program Agreements. It will also put pressure on our vendor clients, who will pass that pressure along to their financers.
The vendors were already putting pressure on lessors and their counsel to address the 21
Century's shift from hard assets to a service industry.
Why own it when you can rent it?
Fueled a lot of the growth in our business since the 1950's (albeit largely applied in form and mindset more than substance).
What I really want is the result.
Seems to be what we will see for the next 75 years or so.
Managed Equipment Services. Bundled Transactions. Service Contracts. Maintenance Agreements. Subscriptions. Software Financing. All these and more are leading us away from the template of a lease or secured loan transaction (or are they? more on this below). We lawyers grew (somewhat) comfortable with the
lease versus loan
issues. We understood many equipment financings were really the same as what we prepare for bank clients, but with buck-out leases and equipment finance agreements replacing promissory notes and security agreements.
In truth, except for a couple of aspects of true lease financing, what we have been doing is just asset-based secured lending, focusing more on collateral value than creditworthiness of the borrower...or at least elevating the importance of collateral to shore up weak credits and/or (or...sometimes) drop rates. No big surprise there. The industry actually moved closer to traditional lending after the Great Recession with requirements for financial covenants (purists gasp!) and additional collateral.
The new paradigm sees customers uninterested in owning hardware and much more interested in the bottom line: they want to know that they will have the benefit of ___ hours of production, uninterrupted by equipment failures; they want to have the benefit of high technology grade technology and be assured their competitors will never steal a march on them over the www mountain. Blame it on the spread of technology, the software-based economy or the ascension of Millennials and their younger counterparts.
I remember clients who either were or dreamed of being publicly-held spurning leases in favor of anything that put hard assets on their balance sheet. Then Silicon Valley made millionaires of people who invested in intellectual property rather than balance sheet assets. Wall Street is looking less to the balance sheet and more to the financial statement, or potential financial statement.
In short, the world, at least on this side of the two big water parks, is looking to soft cost financing and that is 180 degrees from asset-based financing, secured lending...and equipment leasing and finance.
Every ELFA Legal Forum and most issues of any legal publication offers guidance on how to structure transactions that are partially, or totally, financing air and promises. The best we lawyers seem able to do is to grab our clients (sorry y'all) by your virtual lapels and stare through the internet at your virtual eyes and say "THIS IS NOT WHAT YOU DO FOR A LIVING. THERE IS NO COLLATERAL HERE!"
In short, there is no such thing as a hell or high water services agreement. Or better said, the HHW is an umbrella full of holes. Put yourself in a judge's place: The defendant swears he thought he was merely contracting for three years of maintenance on his gizmo. The contract, all 40 pages of it, had some blather about being noncancellable if assigned to a bank, but he couldn't imagine having to pay when the vendor went bankrupt and no one was servicing the gizmo. The gizmo is worthless. But the nasty banker says he has to pay, not only for the worthless gizmo but the cost of maintaining it when there would be no maintenance service.
Feel free to color, amend or supplement the above hypothetical. A subscription to an internet portal that no longer exists or doesn't do what it was designed to do. Software that doesn't work because it is no longer "supported."
No, this is
the same as buying a forklift and agreeing you will pay the lessor or lender whether or not it works. Among other things, the UCC has not yet caught up with the world (there is some comfort in Article 9 on
waiver of defenses
, and some other good-but-not -finance lease-good stuff).
So what do we do? A couple of thoughts. Call it free legal advice or an attempt to avoid an hour of haranguing you over the phone.
1. Know what you have. Stop thinking this is all Same-O Same-O stuff. Have a
moment and think about what the deal truly is before you tell your lawyer you are leasing services and subscriptions and intellectual property. ("Naked lunch" means looking at what is at the end of your fork before you put the whatever in your mouth. Often a good idea.) Is there
really collateral here? Are you financing promises by the vendor, and if so how much are you willing to risk that the vendor will be able to perform? If you were the customer, would you
agree to pay in advance for the services, subscriptions or for hardware that will be worthless without the services?
2. There is a decision matrix here: The risk is greatest where the vendor insists on bundling all goods and services into a single agreement, without payments being divided or identified in any way between hardware rent and services, and merely wants to assign that to the lender/lessor on a blind or private label basis. Everything we can do to move off of that, to full disclosure and a customer expressly saying "I will pay come hell or high water for $____ rent and, separately, for $____ services (which I recognize I may never receive and I accept the risk of prepaid services) the safer you will be. And the less the vendor will like it.
3. Walk away from the idea of equipment finance altogether if that is not really what you are doing. Instead of starting from a lease or EFA, with a vendor program agreement offering repurchase support, start from a promissory note and guaranty. Is the vendor financially capable of guarantying the transaction, at least insofar as defaults caused by its failure to honor its agreements with the customer? A promissory note is as strong a legal document as we can draft. It is an absolute, unconditional promise to pay (sound familiar?). We turn loan and security agreements into Equipment Finance Agreements. Deals without real collateral might as well be unsecured notes, with the nomenclature changed to be
Installment Payment Agreements
Unconditional Payment Agreements
that don't even mention, or only tangentially mention the vendor and its products and services.
4. Consider that, while the vendor may not recognize it, putting more of the risk on the vendor makes a world of sense. If a customer defaults for any reason (including a bad credit decision), why should the vendor have a windfall? If the vendor does not have to provide services or if the subscription is cancelled, the vendor is either doing better than expected or at least not losing anything. It is entirely reasonable to call upon the vendor to refund the unearned portion of the prepaid service or subscription fees. That is, if the vendor is still around to do so.
5. Above all, don't kill your messenger. Your lawyer, be she in-house or other, should be concerned on your behalf when you bring in the cat-gift (you know, dead bird or shrew) of a $5,000,000 ten-year bundled service and software contract. If your lawyer isn't concerned....well, hand her this.
Above all, don't panic about all this. It may well be the future, but with a little creativity, you can structure any of a dozen variations on the familiar structures that will minimize the risk. Unfortunately, it is probably true that no services-type deal will be as safe as a UCC financing lease unless you have a guaranty from an AAA credit vendor. Still, we will be in business for a long time to come. It may just be a different business.
We warned you. Not just us, many of the other lawyers and the wise old mentor/shamans/business leaders who kept warning that
Pigs Git Fat 'N Hogs Git Slaughtered.
(Sorry, couldn't resist). The more "aggressive" (MY lawyer says I cannot name names or say "crooked") of our peers have burdened their customers with automatic renewal and interim rent provisions that are designed to add to the bottom line while penalizing customers for not being forensic accountants or leasing lawyers. They have
hidden the ball
on the actual cost of financing and gone to Procrustean lengths to get rich while...cheating people.
No, there is nothing wrong with interim rent, automatic renewals, not disclosing rates (which can be calculated 100 ways, anyway) or not treating the customer like he's a brain-damaged ward of the state (translation: consumer). The thought here, and I am proud of it, is if Bozo can't or won't read, Bozo should not be in business. Period.
But don't complain if you haven't had the experience of:
- listening to a grown man cry on the phone saying he is losing his job because he did not understand the deliberately opaque language someone paid a lawyer to draft, cross-referencing the renewal "option" through half a dozen sections of a master lease and schedule;
- trying to explain to a hospital's lawyer that her client is paying for equipment that was worn out and used up ten years ago because the automatic renewal re-started a seven-year lease and the only way out of it is to enter into a new seven-year lease of new equipment on whatever terms the lessor is offering...at the end of the current seven-year renewal, and, yes, it took you 20 minutes to figure out how that language actually reads;
- explaining to an angry client that an automatic renewal provision on a dollar-out lease, or interim "rent" in an equipment finance agreement was...odd;
- reading how a lease term didn't begin for years (five if I recall) because the language of the lease kept extending the interim rent period and, somehow, the vendor didn't quite finish delivering and installing that last little piece until the term should have ended for the first-delivered equipment;
- arguing to a judge that a long-term lease of kitchen equipment that, by design, had to be completely rebuilt during its first four years was really a financing despite having a fair market value purchase option (we won that one);
It is small wonders states are lining up to address various lease and loan language that, I will say forever, is PERFECTLY REASONABLE and require disclosures that are PERFECTLY RIDICULOUS. Yes, the California DBO and the legislature of that state are going way overboard. (BTW, they are being very helpful, reasonable and responsible in working with industry lawyers and listening to reason on all this - despite what some irresponsible commentators have alleged). But that is how government works. If a fool sits on a hot stove because he...well, because he does, the state legislature is likely to require all stoves to be sold with warning labels ("DO NOT SIT HERE IF IN OPERATION") and automatic cut off gadgets that will turn off the machine and spray aloe all over the place if a pressure of more than 2 pounds is sensed....Lawmakers and bureaucrats cut with axes whether or not a scalpel makes more sense.
Whether we brought it on ourselves or not, we need to support ELFA and anyone else who is, in a responsible fashion, trying to limit the reach of Big Brother. Look for new legislation "addressing" all sorts of industry practices that opens the box and kills Schrodinger's cat in order to prevent animal cruelty.
You ain't seen nothing yet.
Usury and Licensing. We have been doing 50-state surveys for the last ten years and if there is one clear message it is that there are many unclear laws and regulations in many, many states. We can give clients a lot of information and avoid most issues, but there are judgment calls to be made. We have never seen an off-the-shelf book that is very helpful. Are you aware that these laws often apply to out-of-state lessors and lenders and that:
- Over a dozen states limit the rate of interest that can be charged on commercial financings, probably including $1-purchase option leases?
- Several states require motor vehicle lessors to be licensed?
- Some states restrict sales of off-lease vehicles by motor vehicle lessors, even to their own lessees?
- Most lease forms do not have clauses protecting against usury laws. These clauses are not bulletproof but are a good idea in most instances.
- Choosing the law of a "friendly" state may not protect against usury, particularly criminal usury, or against licensing requirements and may be negated by lack of relationship between the parties or transaction and the named state? There are ways to make this protection stronger.
It certainly is an issue for our business. The one political factor that is sure to hurt us is uncertainty. Liberal (sorry,
) or conservative, equipment finance has shown that we can adjust for almost any approach that is predictable. Who could have possibly predicted what we now face?
Maybe it's the echo-chamber effect of being able to find a site and pundit who tells you you were right all along on the internet.
Maybe it's eight years of a progressive administration rankling the sleeping majority.
Maybe it's because the world is moving too fast for some of our friends and family to understand and their response is to get angry.
Whatever the reason, right, left,, crazy or sane,
is bad for the world, bad for the intelligent minority and bad...VERY bad for business. When did we stop talking and start yelling at each other? When did we start asking first
Who's side are you on?
and then deciding whether to listen?
Adams and Jefferson hated each other's politics. The Continental Congress included ministers of religions that had persecuted one another in Europe. They all recognized that the young republic they were creating would never stand if they did not let the other guy be....well, wrong.
Now the personal part (I won't blame you if you skip this paragraph): I have spent most of my adult life wishing for economically conservative, pro-business, small-government leadership. I am a hawk. I believe in live-and-let live separation of church and state (which used to be what we called conservatism). Now I see one party lying down when it should be rising up and another running for the far side when it should be looking for an acceptable middle ground. Folks, if we don't moderate and start talking and LISTENING to each other, we are going to kill this golden goose we call capitalism. Vote your head as well as your heart, but please consider at the same time whether we will ever get anywhere if we elect people who do not have the integrity, selfless patriotism, ethics and common sense we demand of our children.
Now is the time for all good women and men to come to the aid of our industry. Join. Contribute. If you are old and experienced enough, mentor. If you are young or new to the industry - like all y'all who jumped in to finance over the road vehicles and other equipment post-2009- listen and learn before you get hurt and hurt others.
On the Lighter Side.
Will someone please come up with a replacement for "Gentlemen" or "Dear Sirs"? "Ladies and Gentlemen" sounds like we are going to introduce a dancing elephant or something.
Privacy and Information Protection.
Matt can speak to this better than I, but new laws and soon-to-be laws are going to affect more and more of our industry. Bear in mind that identity theft and all that isn't just about the internet or your computer files. Can a disgruntled employee steal confidential information from your computers or from your paper files? Do you know what your responsibility is when there is a breach?
Merchant Cash Advance and Loans.
We do this sort of work; we have for years. A recent piece in a law school publication attacked merchant cash advance contracts as disguised loans. Loans are often subject to usury limitations and there may be licensing issues (see above). Cases, and there are precious few of them, go both ways on what is a "loan" and on whether a bank affiliation will protect a lender from usury issues. We have our own ideas as to how to avoid a high yield working capital loan running afoul of state law, but the message here is that if this were as easy as some people are thinking...well, it isn't.
The Law versus Reality.
The Uniform Commercial Code is a wonderful set of laws. It helps immensely. Unfortunately (you knew this was coming, huh?), it is slow to develop and slower to be understood. We have some very good laws about chattel paper, including electronic chattel paper, but they are not finding their ways into many older lease forms. This will cause problems in the courts very soon. You heard it here.
Years ago there was a case that, rightly, held that the funder with the chattel paper original of a lease had a first perfected security interest in that lease. The funder who only had a financing statement filed came in second. Then there was a case in which there were, arguably, two or more "chattel paper" counterparts because the broker was defrauding his funders. The financing statement-filer who was first in time won.
Now we have more and more documents being sent out, signed, and returned electronically. Or being funded based on pdf's or faxes (you will be explaining what a
is to new hires in a couple of years. Tell them to look up
Many years ago, Nicholas Negroponte, one of the original computer guys, wrote that the one thing we could say about the digital age was that it would progress faster than we could predict. He is being proven true. Do you really understand the rules regarding electronic documents and signatures? Are you sure your documents reflect the current law?
Thanks to those of y'all who read all the way to the bottom and please feel free to email back your thoughts. We sincerely hope all of you will be among those who prosper in the new economy or whatever we to call the months and years ahead, and we hope to do our part to help.