Improving Lease Flexibility Through Covenant Analysis: Part 2

(TMA International Headquarters)

In the previous issue of the Journal, we reviewed the covenant differences between leases and loans. We indicated that leasing is generally represented as having fewer restrictions (read covenants) than debt financing, but also alerted the reader to provisions in leases that can be quite limiting. We proposed how restric­tive lease covenants could be softened to the benefit of the lessee while not placing the lessor at risk.

Part 2 of this discussion continues by offering four additional illustrations of lease provisions that may require contrac­tual surgery to bend them to the needs of the lessee. These provisions relate to the lessee’s rights to modify, return, sublease and purchase leased equipment.

Issue: Modifications to Leased Equipment

Standard lease language prohibits the lessee from modifying the leased equip­ment. This concept does not appear unrea­sonable on its face. However, when dealing with technology equipment or other equip­ment, which may require periodic modifi­cation to suit the lessee’s needs, such lan­guage can be unduly restrictive. Consider the following representative wording:

Lessee will not make alteration to or modification of the equipment lessor’s prior written consent. Any item attached to the equipment shall immediately become the property of the lessor.

Where the lessee wishes to finance a modification, a whole Pandora’s box of issues opens. Even where the lessee simply wants to add additional memory to a com­puter, a hydraulic lift onto a truck or to make other minor modifications, the process of obtaining lessor consent can be cumbersome. There is no legal require­ment (absent appropriate language) for the lessor to be "reasonable" in giving or withholding its consent, only that the lessor act "in good faith," a much more subjective and uncertain concept.

For this reason, the lessee should request that modifications which are (1) readily removable or which (2) do not impair the value or utility of the equipment be permit­ted. The lessee should also request that any modification which is removed at the end of the lease term be the property of the lessee, so long as the lessee repairs any damage caused by the modification or its removal.

Issue: Right to Return Leased Equipment

A downright predatory lease being used by several lessors currently provides for the following:

At the expiration of the term, lessee shall: (1) purchase the property for a mutually agreeable price; (2) return all of the property and lease replacement property from lessor which has a cost greater that the original cost of the prop­erty; or (3) extend the schedule for a period of one additional year at the rate delineated herein.

The one thing the lessee cannot do in this case is simply return the equipment at the end of the lease term! The best the lessee can hope for in this lease is to pay an additional year’s rent at the same rate it has been paying throughout the lease term. This provision has zero flexibility as to financial requirements or in being able to extricate oneself from the lease. Of course, this provision can be "fixed" if caught prior to signing the lease by adding a fourth option: or, (4) lessee may return the equipment to lessor at the end of the lease term.

Issue: Assignment or Sublease

Virtually every equipment lease states that the lessee may not sublease the equip­ment, assign its obligations under the lease to a third party or terminate the lease dur­ing its term, without at least securing the lessor’s consent. A particularly onerous lease covenant provides:

An event of default shall occur if...(d) lessee attempts to...sublet the equipment.

Where the lessee is one of several affili­ated corporations, it is often important that the lessee have the right to transfer the equipment to a brother-sister corporation or its corporate parent. This is particularly important where the initial lessee might be sold or its operations closed. Such assign­ment or subleases between affiliated com­panies should be permitted.

If there is a likelihood that the lessee will not need to use the equipment at some time in the future (which is particularly true where the lessee leases computers and other technology equipment but is unable to negotiate satisfactory upgrade rights or other flexibility), the lessee should attempt to arrange for one of the following rights:

1. An early termination right, in which case the lessee has the right to require the lessor to sell the equipment during the lease term. The lessee will usually be obligated to guarantee a minimum purchase price, mak­ing up the difference. This amount should be quantified in the lease documentation and calculations checked to ensure that the lessor receives no more that its originally anticipated lease revenues, discounted to present value.
2. An early buyout right, under which the lessee has the right to buy the equip­ment from the lessor for a stated amount at some time during the lease term. Usually, this buyout is not permitted until after the lessor has taken all MACRS deductions and early buyout rights are not common in short-term leases. Ideally, the lessee should be permitted to purchase for fair market value, but the lessee will usual­ly be required to agree to a minimum pur­chase price, which approximates the lessor’s anticipated revenues, discounted to present value.
3. Broad sublease rights, under which the lessee has the right to sublease the equipment, remaining financially responsi­ble for performance by the sublessee. Where the initial lessee is creditworthy, many lessors, including technology lessors, are willing to grant the lessee the right to sell the lease to domestic companies which have good overall credit and the ability to main­tain the equipment properly (themselves or through a maintenance organization).

Issue: Lessee’s Right to Purchase the Leased Equipment

Purchase option rights are written in a variety of ways. However, there are many contracts that are silent on the purchase issue. The following citation, when present in a lease contract, is common:

Lessee shall have the option to purchase all but not less than all the equipment in a schedule at the end of the term. The pur­chase option shall be fair market value to be determined by lessor.

Many lessees choose lease financing because it affords acquisition of equipment with a smaller initial cash flow obligation than other financing sources. However, a number of these same organizations have equipment needs that run well past the lease term. In these cases, favorable pur­chase option language is important.

In the provision cited above, there are at least two potential problems. First, the lessee does not have the right to selectively purchase items of equipment listed on a schedule—the lessee must purchase all equipment on a schedule or none. Second, the lessor, in its sole discretion, can decide fair market value. Since this contract (which is typical) does not offer a dispute resolution mechanism, the lessee will be required to either pay the lessor’s fair market value or acquire the needed equipment elsewhere.

If this in an important option to the lessee, there are several ways to renegotiate the language governing purchase. The con­tract could indicate, for instance, that the lessor and lessee will mutually determine fair market value, and if that is not possible, then the American Arbitration Association will select an appraiser that will determine a value that will be binding on all parties.

Summary and Conclusions

Leasing can be a highly flexible financ­ing vehicle and should be considered a valuable addition to the turnaround pro­fessional’s toolkit. However, it is vital to remember that ultimate flexibility is de­pendent upon the terms and conditions specified in the lease agreement. Leases differ significantly from lessor to lessor, and there are literally hundreds of lease contracts being used in the marketplace at anyone time. To ensure that the lease con­tains the rights, obligations and options of importance, each lease contract must be examined in detail, with appropriate alter­native wording proposed where needed. The ad we have all seen in airline maga­zines has it right: "you don’t get what you deserve, you get what you negotiate."