Finance Leases - A Viable Equipment Financing Option Or A Trip To Hell

What is a Finance Lease?

Business owners, particularly small business owners, in acquiring expensive office equipment or other goods, often times look for an opportunity to lease the equipment rather than buy it. To be sure, leasing can be an advantageous and even an essential alternative to purchasing office equipment or other items to be used within a business. However, before entering into such an arrangement as the party that is going to be leasing the equipment, be sure you have carefully read, considered, and fully understand the nature of the terms that will commonly be found in the documents you will sign as part of that lease.

A finance lease will typically involve three parties. First, there is the business that wishes to lease equipment (the lessee). Typically, the lessee will have dealt with the party offering the goods to the lessee (the vendor). If the lessee is interested in leasing the goods rather than purchasing them, the vendor will often have one or more financing companies they work with that then serve as the "lessor". The lessor buys the equipment from the vendor, and the lessee has use of the equipment during the term of the lease in exchange for making lease payments to the lessor. Within that typical arrangement, there is a particular type of lease that will commonly arise, known as a finance lease.

Finance leases are defined by Article 2A of the Uniform Commercial Code (UCC). Iowa's version of the UCC as it relates to leases is found in Article 13 of Iowa Code Chapter 554 (554.13101 to 554.13532). A lease may qualify as a finance lease in two ways. First, the parties to the lease can agree in writing that the lease is a finance lease and is to be treated as such under the UCC. Even absent such an agreement, the UCC specifies that a lease will qualify as a finance lease where the lessor does not select manufacture or supply the goods, but rather merely provides financing to acquire possession of those goods, and gives the lessee certain written information as to the identity of the vendor and the rights the lessee has against the vendor. In Iowa those criteria are set out at Iowa Code Section 554.13103(g).

The determination that a lease is a finance lease is important because the lessee's promises under the lease to make the lease payments become irrevocable upon acceptance of the goods and the lessee has no rights of cancellation or essentially any other rights against the lessor. That language of unconditional obligation to pay contained in a finance lease is commonly known as a "hell or high water clause".

In summary, the lessor in a finance lease transaction seeks to position itself in the role essentially of a bank, asserting if the bank loans you money to purchase equipment and you are disappointed with the equipment, you are not relieved of the obligation to repay the bank.

A Word of Caution about Finance Leases.

As stated at the outset of this article, leases, including those qualifying as finance leases, may very well be an advantageous and necessary part of how you acquire the items needed for your business. Given the harsh and sometimes unexpected results that can arise from a finance lease however, it is particularly important that you carefully review and understand what you are getting into. The fact that finance leases have a payment clause described by the word hell, suggests you should proceed with caution and full information.

What is most important to understand, is that if anything goes wrong in the transaction, and the goods do not perform as you expected, your remedy will be likely limited to pursuing the vendor rather than the lessor.[1] That can be very problematic in a finance lease because your signed paperwork will often be limited to the lease, without a written agreement between you and the vendor. In addition, the finance lease will often have a forum selection clause that will specify that in the event of any litigation between you and the lessor, that litigation will be in a state different from yours and different from the one in which the vendor is located. That may make it difficult for you to bring in the vendor that sold you on the defective equipment, as a third-party defendant, in the event you are sued by the lessor.

Steps you can take to protect yourself are to ensure you are dealing with a well established vendor that will be in a position to stand responsible for any breaches of warranties or other defects in the goods, and ideally have a separate written agreement with the vendor in addition to the finance lease with the lessor, specifying your rights against the vendor in the event the goods are not as represented. Ideally, such an agreement would specify that the vendor is bound by the same forum selection clause as you are so that they can be combined in any suit brought by the vendor. Proceeding with caution will help prevent you from experiencing hell or high water.

[1] There may in fact be defenses and claims to pursue relative to the lessor that can be explored in the event of a dispute with your lessor. However, that potential is not meant to take away from the main message of this article which is to be fully informed and cautious before entering a finance lease.