What are the essential provisions of a Modern Financial Leasing Law?

May 16 2021

The Essential Provisions of a Modern Financial Leasing Law

There are certain foundational elements to a successful modern financial leasing law.  They differ from the typical provisions of a traditional rental law. They include the following:

Freedom of Contract

Recognition of the Three-Party Structure of the Modern Financial Lease

Duties Consistent with a Party's Role in the Transaction

Lessee's Absolute Duty to Pay After Acceptance

Lessor's Lack of Equipment Responsibilities     

Lessee's Recourse Against the Supplier

Equipment Not Liable to Other Creditors

Assignability Freedom and Restraint
        

Lessor's Right to Accelerate Remaining Lease Payments Upon Lessee      

Default Expedient Repossession

Any proposed financial leasing law should contain all of these elements. 

Freedom of Contract.  A good leasing law is strong on basic rules and skimpy on details.  Without doubt, the hallmark of the modern leasing industry throughout the world in its half-century of existence, has been its creativity and innovation.  Even in mature leasing markets, new products are still developed.  A detailed leasing law can seriously stifle and smother this inventiveness. Detailed legislation is also rarely necessary.  Leasing is first and foremost a commercial matter between contracting parties that only in unusual instances requires state oversight.  What a good leasing law can do is to set forth a basic structure within which the parties can negotiate according to their own economic interest with such some reliance that third parties will understand and respect what they have done. There need not and should not be a fine-point coverage of leasing transactions.  A leasing law should aim to provide an overall framework conducive to leasing and not try to micro-manage the financial leasing industry.  The rest is left for the parties to address in the specific, negotiated terms and conditions of their contract.

Law Limited to Finance Leases.  A good financial leasing law limits is application to finance leases.  While a number of countries have enacted financial leasing laws--and the rate of enactment is increasing--very few countries have enacted leasing laws that encompass operating leases.  Most traditional rental or hire laws are viewed as adequate for that task.  For those and many other good reasons, a financial leasing law should cover only finance leases as so defined within it.

Recognition of the Three Party Structure of the Modern Financial Lease
A modern financial lease transaction has three principal parties--the lessor, lessee and supplier—each of whom has a specific role and who should have rights and obligations consistent with that role.  A lot of the confusion that exists in the legal environment of many countries occurs because it is not acknowledged that the role of the parties in a finance lease is different than that of their role in a traditional rental.  A good leasing law can clarify what those rights and responsibilities are in accordance with their development in the marketplace.  A good financial leasing law has sections that address the rights and obligations of each of these three parties, as well as third parties that might be affected by the finance lease contract.


Duties Consistent with a Party's Role in the Transaction

In the simplest terms, it is the supplier's duty to provide the equipment and make sure that it performs as promised, it is the lessor's duty to pay the supplier for the cost of the equipment, and it is the lessee's duty to pay the lessor the periodic rental payments, use the equipment properly, keep it safe during the lease term, and return it to the lessor at the end of the lease (unless another arrangement has been made).  All other duties and responsibilities of the parties should be consistent with these basic ones.

Lessee's Absolute Duty to Pay After Acceptance

From a lessor’s perspective, the most important duty a lessee has is to pay the periodic lease payment.  From a finance lessor’s perspective, that duty cannot be excused in any circumstance, including the occurrence of equipment problems or defects, casualties to the equipment, government seizure or any other reason whatsoever.  Accordingly, most financial lease contracts throughout the world have a “hell or high water” provision that obligates the lessee to pay the periodic lease payment without excuse of any kind whatsoever.  These provisions are generally accepted as fair because the lessee chose the equipment and the supplier and the lessor would not have purchased the equipment but for the lessee’s request.


Lessor's Lack of Equipment Responsibilities

The payment of the supplier for the leased asset is the primary obligation that the lessor has under a finance lease.  In fact, once that payment has been made, the finance lessor has typically performed all of its obligations under the finance lease except to warrant the lessee's quiet use and possession of the asset during the lease term.

The lessor should not be liable for any problems with the equipment once the lessee has accepted it.  After all, the lessee selected both the equipment and the supplier.  In fact, the lessee will most likely know more about the equipment than the lessor.  Additionally, the equipment is usually delivered directly to the lessee, inspected by the lessee and accepted by the lessee without the lessor ever having seen it. The lessee is the one in the best position to determine whether the equipment is as ordered and working properly for its intended uses.  To make the lessor responsible for equipment defects in such a situation is unfair. 

The removal of lessor responsibility for equipment defects does not leave the lessee without recourse—it simply has to seek redress for those problems from the supplier, the proper party for dealing with them and the one in the best position to effect a solution.

If the lessor has chosen the supplier and the equipment, then it might have some such responsibilities.  This does not preclude the lessee from nominating the lessor as its agent to act in its stead.  In that instance, the actual lessor responsibility would depend on the scope and provisions of the agency agreement.

Lessee's Recourse Against the Supplier

Ultimately, the supply agreement will be between the lessor and supplier directly, without the lessee being a party to it.  This can happen because (1) the lessee, not already having entered into the supply agreement, asks the lessor to “please go buy this asset and then lease it to me,” or (2) the lessee has already entered into a purchase contract with the supplier, which the lessee will then just transfer to the lessor.  In each of these cases, the lessee will not have or no longer have a direct contractual relationship with the supplier and, therefor, a problem in making claims, such as for asset defects, directly against the supplier.  A good financial leasing law provides for the possibility of direct lessee action against the supplier, thereby avoiding these problems.

Equipment Not Liable to Other Creditors

Property leased pursuant to a financial lease should not be subject to the claims of lessee’s other creditors.  Because a financial lease serves a function similar to that of a loan, courts have sometimes failed to recognize the financial lease as a truly separate and distinct form of transaction with true ownership rights in the lessor.  This has often been the case when the consequence of such a failure is to make the leased property available to satisfy the claims of lessee’s general creditors.  This situation can be deterred if the leasing law is clear that the ownership right to the property vests solely in the lessor.

Assignability Freedom and Restraint

A good financial leasing law should provide that the lessor may transfer or otherwise deal with all or any of its rights in the leased asset or under the lease agreement without the consent of the lessee, but such a transfer shall not relieve the lessor of any of its obligations under the lease agreement or alter the nature of the lease agreement.  However, the lessee should be allowed to transfer the right to the possession or use of the leased asset or any other rights under the lease agreement only with the consent of the lessor and subject to the rights of third parties.

The difference in treatment between lessor and lessee is necessitated by the needs of the market.  The lessor has to have the ability to pledge the lease and leased equipment in order to obtain funding to acquire it in the first place.  The lessee’s disposition of the lease needs to be restrained because the decision to acquire the equipment is one based upon the lessee’s creditworthiness.  A substituted lessee would mostly likely have a different credit profile and present a risk very different than the one the lessor bargained for.

Lessor's Right to Accelerate Remaining Lease Payments Upon Lessee Default

A good financial leasing law should also provide a rights and remedies scheme for leases that fall into default.  This is not to say that the legislative scheme should supplant the one provided by the parties in their contract.  Rather, as a practical matter it can provide a reference for judges and other dispute adjudicators as to what is appropriate and acceptable in the case of financial leases.  Without such a reference, judges have been known to apply traditional rental default remedies--regardless of what the contract says--which simply are inappropriate and inadequate for financial leases.  Almost every country has experienced this problem as its leasing market has developed.

A good financial leasing law allows for acceleration of the remaining lease payments. The ability to accelerate the remaining lease payments is important because the lessor would not have acquired the leased property but for the lessee’s request.  Because there may not be any secondary market for the equipment, repossession of the equipment and a generalized calculation of damages is often a wholly inadequate remedy.  A lessor will suffer significant losses in such circumstances.  This is very often the case in emerging economies where there are minimal or no secondary markets for almost all types of assets.  The more appropriate remedy in such circumstance would be to allow the lessor to recover the whole of the lease payments.  Such a remedy would be allowed in the case of a loan, and as a financial lease serves a similar financing purpose, such a remedy is appropriate in the case of a financial lease as well.  The acceleration of all remaining payments into a currently due lump sum is made fair by its discount to present value.  When discounting to present value for purposes of calculating damages from a breach of contract, the inflation rate is the most appropriate discount rate.

Expedient Repossession
One of the important motivations for creditors to offer lease products is the strength of their interest in the asset financed arising from the creditor’s ownership of it. In most every country, the ownership right is a stronger right than the rights a creditor would have from a security interest, chattel mortgage or other type of lien interest.  However, if the lessor cannot repose the asset in an efficient and cost-effective manner, the major value of that right is lost.  A good leasing law must allow for quick and effective repossession of the leased asset upon default of the lease by the lessee.  Sometimes, the creation of such a repossession mechanism can be done in the financial leasing law itself.  Other times, the civil procedure law of the country may have to be amended.