What every equipment lessor needs to know about rent-to-own agreements and lease/rental purchase options

A True Story. An equipment owner/lessor in North Carolina leases equip­ment under a master lease agreement to a local business in two segments. In the first, the lessee (customer) leases approximately $25,000 worth of equipment (identified on Schedule 1 attached to the master lease) on a two-year term.

Schedule 1 sets forth a buyout option price equal to the anticipated fair market value of the equipment at the end of the lease term. Later, the owner leases an additional $155,000 worth of equipment to the same customer. The additional equip­ment is identified on a new schedule (Schedule 2), which provides for payments over a five-year period, and a buyout option price of one dollar.

The master lease states that the attached schedules create “operating leases” (not “capital leases”) and are “noncancelable” until their terms expire. In case the second lease is somehow viewed as a “disguised loan,” however, the owner files a UCC-1 Financing Statement with the Secretary of State 23 days after the customer takes posses­sion of the additional (Schedule 2) equipment.

Two years later, the customer files bankruptcy. The owner files a “Motion for Relief From Stay” with the bankruptcy court seeking to repossess its equipment. The customer’s lender (bank), which had previously taken a blanket security interest in all of the customer’s property, disputes the owner’s claim with respect to Sched­ule 2. The bank claims that its interest is superior to the owner’s with respect. to the $155,000 worth of equipment. Who won?

Answer: The bank! The owner cannot repossess its $155,000 worth of equipment; that equipment is now part of the bankruptcy estate, to be administered in favor of the customer’s creditors, which may or may not ultimately allow the owner to recover some portion of its $155,000 loss.

If you’re like most people, the first question that comes to mind is: How did that happen? Didn’t the owner still “own” its equipment? The answer, at least under the Uniform Commercial Code, is: No.

How Can This Be?

  • Transforming an Apparent Lease into a Loan. The answer can be found in the Uniform Commercial Code (“UCC”). As the bankruptcy court noted, UCC § 2-103 provides that a [putative! lease will be deemed a “disguised security agreement” (in effect, a “loan secured by collateral”) if, among other things, it is not subject to termination by the lessee (customer), and the lessee has an option to become the owner of the goods for no additional consideration or for nominal additional consid­eration [for example, a $1.00 buyout] upon compliance with the lease agreement (remember, this issue did not exist with respect to Schedule 1 because It called for a “fair market value” buyout).
  • Determining Whose Loan is Superior. After the court determined Schedule 2 was really a “disguised loan” rather than a lease, It had to decide whose loan (the owner’s or the bank’s) took priority. Ordinarily, a “purchase money security interest” in specific equipment (like the interest of the owner) would be superior to the bank’s more general “blanket lien” interest. But, unfortunately for the owner, UCC Article 9 required the owner to file its UCC-1 Financing Statement of public record within 20 days after the customer took possession. Failing that (the owner didn’t file its UCC-1 until the 23rd day), the interest of a “prior perfected security interest holder” (i.e., the bank) wins. (Remember, the bank had previously filed its “blanket lien” on all of the customer’s property).
If you’re like most people, the first question that comes to mind is: How did that happen? Didn’t the owner still “own” its equipment?

What’s To Be Learned Moving Forward? Buyout options and rent-to-own arrangements are becoming much more common in the equipment industry, as sellers and customers continue to look for the most attractive financing alternatives. But, as the above story highlights, offering buyout options of any kind can be perilous for equipment owners. Here are a few things equipment owners/lessors should bear in mind before entering into these agreements:

1. Dollar Buyouts. A lease with a dollar buyout option will virtually always be deemed a “disguised financ­ing” (meaning the customer will be considered the owner from the date of taking possession). This isn’t necessarily always a bad thing, but it likely won’t be viewed as a true “operating” lease from either a legal or a tax perspective. If you do offer dollar (or other nominal consideration) buyout options, take the necessary precautions, and always file a properly completed UCC-1 Financing Statement immediately (typically, at your Secre­tary of State’s office).

2. Market Value Purchase Options. A lease with a market value buyout option stands a better chance of being viewed as a true operating lease, but remember, the UCC includes several other factors (such as a lease term that extends through the remain­ing economic life of the equipment) that could transform an apparent operating lease into a “disguised financing” (loan) arrangement.

3. Short-Term Lease/Option Models. Using an ordinary short-term (e.g., hourly, daily, weekly or monthly) rental agreement and simply offering to apply a percentage of the rent paid to the ultimate purchase price has become a popular model for many dealers and rental operators. A fair amount of caution is still warranted here, however, as we’ve encountered a wide range of issues, including:

  • If the customer rents the same piece of equipment five times, is the customer entitled to apply some or all of the prior rentals (and if so, how far back?) to the purchase price, or just the current rental?
  • What happens if the customer fails to pay timely rent for a portion of the rental term and then claims the right to apply its prior rentals to a purchase (For example, does a breach nullify the option, and if so, permanently? Or, does curing the breach revive the option?)
  • What if the customer actually pays more in rent than the original value of the equipment (and then remembers the purchase option). Is the customer entitled to a refund upon exercise?
  • What if the customer claims to have notified the owner of the customer’s exercise of the verbal (but not written) option?
  • If the option is properly exercised, is.the customer required to pay the balance of the
    purchase price immediately, or is the customer entitled to some form of delayed payment plan/financing?
  • Do the same protections for the owner/lessor that were included in the lease document apply to a sale (remember­ing that UCC Article 2 covers sales, while Article 2A covers leases)?

4. Business-Only Customers. Equipment owners/ lessors are usually well-advised to offer purchase options only to business customers, and refrain from offering them to individual (non-business) consumers. Lengthy federal and state disclosure requirements, and potential penal- ties for noncompliance, make consumer lease/purchase transactions too burdensome for most equipment rental operators. To that end, lessors are generally wise to include the following statement in any lease/purchase agreement: “The equipment is being obtained by the lessee solely for business purposes, and not for any personal, family or household use.”

5. Other Possible Effects. Finally, as one might guess, purchase options can give rise to a number of other legal and financial issues, including:

  • Lenders: If rented equipment is sold, particularly from a dedicated rental fleet, will the owner’s lender object? Will the lender willingly provide the necessary lien release(s)? A quick review of your loan agreements (if any) should reveal whether your lender has agreed to permit periodic sales of equipment and provide lien releases (Note: Be sure to check both specific purchase money financing documents as well as any “blanket lien” documents)
  • Insurance: Requiring the lessee to maintain general liability, property damage (at full replacement value) and workers’ compensation insurance is the usual starting point. Sophisticated customers may want to negotiate some of the more important details such as deductibles, coverage limits or even a self-insured retention. Some may also demand that they be responsible for insuring only the actual value or buyout price of the equipment as of the date of any loss (Note: The latter is most often the case when the buyer has negotiated a specific early buyout price).
  • Taxes: Both sales/use tax and income tax considerations should also be carefully considered.
    • Obviously, including a provision in your rental contract requiring the lessee/customer to pay all sales, use, transfer, import/export, value added (particularly if equipment
      is going overseas), environmental and other taxes, fees, fines, imposts, duties and related charges is generally a good idea.
    • Separately, with respect to income tax effects, char­acterization and “dual-use” issues (based on whether the equipment was purchased with the intention of renting or selling it) are still being worked out by the IRS, but the tax effects of characterizing equipment as either “inventory for sale” or “rental fleet” can be substantial (among other things, rental property is generally depreciable and eligible for 1031 exchanges, while inventory is not), making good planning in this area critical. One suggestion commonly being considered is using different entities (a “sales” entity, and a “rental” entity) to clarify the distinction.

Conclusion: To sum it up, what seems like a simple transaction (a sale of leased equipment) turns out to be laden with very real and potentially expensive risks. Fortunately, once identified, most are relatively easy to deal with (but much more so before purchase options are granted to customers) If you offer purchase options on leased equipment, or plan to do so in the near future, now would be a good time to seek both legal and tax advice. Rent-to-own agreements and purchase options can be excellent selling tools, but don’t let their apparent simplicity fool you.