Consent and Waiver. Master Lease Agreement Number: (the Master Lease Agreement )

Transcription

1 Consent and Waiver LESSEE: ADDRESS: LESSOR: ADDRESS: XYZ Company 123 Main Street Anywhere, USA LESSEE CUSTOMER ADDRESS: Master Lease Agreement Number: (the Master Lease Agreement ) Lessee and the undersigned entity signing below as Lessee Customer ("Lessee Customer"), in connection with Lessee Customer's contractual relationship with Lessee, hereby request Lessor's consent to Lessee's grant of a temporary, revocable license to Lessee Customer to use that certain computer equipment now and hereafter subject to Master Lease Agreement Number from time to time, as such equipment is further described in Exhibit A attached hereto and incorporated by reference, as such Exhibit A may be supplemented in writing from time to time by written notice to Lessee Customer from Lessor substantially in the form of Exhibit B attached hereto (each, an Exhibit A Supplement ). The initial Exhibit A attached hereto, together any Exhibit A Supplements, are collectively referred to as Exhibit A. Any equipment described in Exhibit A, as supplemented from time to time, is hereinafter referred to as the Equipment. In consideration of Lessor s consent to Lessee s above-described grant, Lessee Customer hereby covenants, represents, and warrants to Lessor, its successors and assigns, as follows: 1. Lessee Customer expressly acknowledges and agrees that, upon its receipt of an Exhibit A Supplement, unless Lessee Customer delivers a written objection to Lessee and Lessor within two (2) business days, Lessee Customer shall be deemed to have accepted the Exhibit A Supplement and agreed that all equipment referenced thereon shall become a part of the term Equipment as originally defined in this Consent and Waiver ( Waiver ), and shall become subject to this Waiver, together with all other Equipment then subject to this Waiver. 2. Lessee Customer acknowledges and agrees that the Equipment is owned by Lessor and not by Lessee Customer or the Lessee and that the Equipment is and at all times will remain subject to the terms and conditions of the Master Lease Agreement. 3. Lessee Customer acknowledges that Lessor has disclaimed any representations or warranties whatsoever with respect to the Equipment, as further described in the Master Lease Agreement. 4. Lessee Customer hereby waives and disclaims any and all rights and interests that it now has, or may have in the Equipment and all proceeds thereof ( Proceeds ), including, but not limited to, any rights emanating from any agreement with Lessee, lien, encumbrance, security interest, or any applicable law. Lessee Customer hereby further waives and disclaims any rights it now or hereafter may have whatsoever against Lessor with respect to the Equipment or the Master Lease Agreement 5. Lessee Customer agrees not to assert any claim against or interest in the Equipment or Proceeds, and shall have no enforceable right to possession of the Equipment or Proceeds for any reason whatsoever.

2 6. As between Lessee Customer and Lessor, the Equipment is, and shall at all times be and remain, personal property and shall not be deemed to be affixed to, or a part of, any premises of Lessee Customer by reason of the manner of its installation or by reason of its being attached in any manner to premises occupied by Lessee Customer or Lessee. 7. The Equipment will at all times be located at the Equipment Location identified in the applicable Equipment Schedule to the Master Lease Agreement and in Exhibit A hereto and Lessee Customer agrees not to relocate or permit relocation of the Equipment from such Equipment Location except pursuant to Lessor exercise of rights in the Equipment or as otherwise advised in writing by Lessor. 8. Lessee Customer agrees that it will immediately execute and deliver to Lessor financing statements or any other documents reasonably requested by Lessor to evidence Lessor s rights and interests in the Equipment. 9. In the event of default by the Lessee under the Master Lease Agreement or any Equipment Schedule thereto, Lessee Customer shall permit Lessor, its agents or representatives, to enter the then Equipment Location during normal business hours, to exercise any rights Lessor may have under the Master Lease Agreement, including, but not limited to, the right to repossess or disable the Equipment and shall look only to the Lessee or its successors or assigns for any damage caused by the exercise of said rights. 10. All notices under this Waiver shall be sent via hand delivery, certified mail or nationally recognized overnight mail service, receipt required to the parties address shown in the first paragraph hereof, unless any party hereto has previously delivered to the other parties hereto written notice of an address change. Notwithstanding the foregoing, in the case of any notice of an Exhibit A Supplement or an objection by Lessee Customer to an Exhibit A Supplement, such notice or objection may be delivered as set forth in the previous sentence or via facsimile, with telephone confirmation of receipt, to: Lessee Facsimile No. Attn: Phone confirmation of fax receipt to: Lessee Customer Facsimile No. Attn: Phone confirmation of fax receipt to: Lessor: XYZ Company Facsimile No.: Attn: Phone confirmation of fax receipt to: 11. The Waiver shall be binding upon the heirs, administrators, executors, successors and assigns of Lessee Customer, and shall inure to the benefit of the successors and assigns of Lessor. Except as set forth in Section 1 above with respect to Exhibit A Supplements only, this Waiver may not be amended except by a writing signed by Lessee Customer, Lessor and Lessee. 12. Lessee Customer consents to Lessee s release of information to Lessor regarding Lessee Customer s use of the Equipment, including copies of contracts between Lessee Customer and Lessee. 2

3 IN WITNESS WHEREOF, the undersigned have executed this Waiver as of.. LESSEE CUSTOMER: By: (Lessee Customer Authorized Signature) (Type/Print Name) (Type/Print Title) (Date) LESSEE: By: (Lessee Authorized Signature) (Type/Print Name) (Type/Print Title) (Date) Consented to by: LESSOR: XYZ COMPANY By: Lessor Authorized signature (Type/Print Name) (Type/Print Title) (Date) 3

4 EXHIBIT A EQUIPMENT DESCRIPTION AND LOCATION 4

5 Date: EXHIBIT B Via facsimile no. Attn: Re: Notice of EXHIBIT A SUPPLEMENT to Waiver dated Dear : This letter shall constitute notice by ( Customer ) and XYZ Company ( Lessor ), pursuant to that certain Consent and Waiver dated (the Waiver ) by and among ( Lessee ), Lessor and ( Lessee Customer ), that: 1. Lessee has entered or will enter into lease agreements with Lessor whereby Lessee will lease from Lessor certain equipment described below, all or part of which is currently or may be located upon or affixed to the Equipment Location; and 2. Lessee and Lessor hereby supplement Exhibit A to said Waiver by adding such equipment listed below to Exhibit A, (any such equipment described below, to become a part of the term Equipment as originally defined in said Waiver, together with all other Equipment now subject to such Waiver): EQUIPMENT LIST Equipment Location: See attached invoices for Equipment description. [OR specifically list] Unless within two business days of receipt of this notice, Lessee and Lessor receive a written objection from Lessee Customer, delivered pursuant to Section 10 of the Waiver, Lessee Customer shall be deemed to have accepted this Exhibit A Supplement and agreed that all equipment referenced hereon shall become a part of the term Equipment as originally defined in said Waiver and subject to said Waiver, together with all other Equipment then subject to such Waiver. All terms and conditions of the Waiver shall apply to the above-described equipment. Except as expressly modified above, all original terms and conditions of the Waiver shall remain in full force and effect. 5

6 This Notice of Exhibit A Supplement to Waiver shall be effective as of this day of,. Lessee Lessor XYZ Company By: Title: Date: By: Title: Date: 6

7 I. Article 2A Framework Glen J. DuMont A. True Lease vs. Security Interest Commercial lessors increasingly have been plagued by claims of bankrupt lessees that the leases they have entered into with such lessees are not leases, but rather disguised security interests; such claims adversely impact lessors rights to receive post-petition lease payments from a debtor lessee following a Chapter 11 filing pursuant to 365(d)(10) of the U.S. Bankruptcy Code. In many recent cases, debtor lessees have challenged the true lease status of transactions, claiming the transactions are merely disguised security agreements ; in these cases, courts have stayed debtor lessees obligations to make payments under leases pending determination of whether the transaction in question is a lease or a loan. i. Uniform Commercial Code Provisions The Uniform Commercial Code ( U.C.C. ) defines lessor as a person who transfers the right to possession and use of goods under a lease, 1 and lessee as a person who acquires the right to possession and use of goods under a lease. 2 There must be a lease in order to create and govern the relationship between the parties. The U.C.C. defines the term lease as a transfer of the right to possession and use of goods for a term in return for consideration, but a sale... or retention or creation of a security interest is not a lease. 3 It is worth noting that the definition of lease expressly excludes security interests. The General Provisions of the U.C.C. provide that a security interest is an interest in personal property or fixtures which secures payment or performance of an obligation....[t]he right of a... lessor of goods under Article... 2A to retain or acquire possession of the goods is not a security interest, but a... lessor may also acquire a security interest by complying with Article 9. 4 Section 1-201(37) goes on to set forth a test for determining whether a transaction creates a lease or a security interest. Courts should determine whether a transaction creates a lease or security interest based on the facts of each case by applying the following bright line test: a transaction creates a security interest if the consideration the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease not subject to termination by the lessee, and a. the original term of the lease is equal to or greater than the remaining economic life of the goods, b. the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods, 1 2A-103(1)(p). 2 2A-103(1)(n). 3 2A-103(1)(j) (emphasis added) (37).

8 c. the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement, or d. the lessee has an option to become the owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement. 5 ii. Pillowtex and Edison Brothers In a decision last fall, the United States Court of Appeals for the Third Circuit added to the body of case law addressing the bright line test or per se rule for determining whether a transaction is a true lease or a disguised security agreement. In the matter of In re: Pillowtex, Inc., the court upheld a lower court decision that a Master Energy Services Agreement ( the MESA ) between the parties was not a true lease, but a secured financing agreement, and, therefore, the debtor, Pillowtex, was not required to make lease payments despite the fact that the parties intended to structure the transaction as a lease. 6 After determining that the MESA was not a disguised security agreement under the bright line test of New York U.C.C (37), the Pillowtex court agreed with the bankruptcy court decision that, based on the economic realities of the underlying transaction (as memorialized in the MESA), the MESA was a secured financing arrangement. Since none of the four residual value factors of New York U.C.C (37) were present, the court examined the economic realities of the transaction, applying the test enunciated in an earlier Delaware bankruptcy case, In re: Edison Brothers Stores, Inc. 7 The factors to be reviewed in evaluating the economic realities in order to determine whether there has been a sale or a true lease include the following: (a) whether the purchase option is nominal; (b) whether the lessee is required to make aggregate rental payments having a present value equaling or exceeding the original cost of the leased property; and (c) whether the lease term covers the total useful life of the equipment; in evaluating the economic reality of the transaction, courts are required to examine the intent of the parties and the facts and circumstances that existed at the time the parties entered into the transaction. 8 In particular, the Pillowtex court focused on the second Edison Brothers factor and determined that the aggregate rental payments owing by Pillowtex under the MESA had a present value equal to or exceeding the cost of the energy-saving equipment. In light of Pillowtex, if a transaction is not a disguised security agreement per se, courts then may examine the specific facts of the case to determine whether the economics of the transaction suggest that it is a security agreement. Going forward, lessors should draft their lease agreements keeping in mind the bright line test for a security agreement and the economic realities factors applied in Edison Brothers and Pillowtex; given these decisions, however, prudent lessors may wish to further protect their rights by making precautionary filings of U.C.C (37). 6 In re: Pillowtex, Inc., 349 F.3d 711 (3rd Cir. 2003) B.R. 801 (Bankr. D. Del. 1997). 8 Edison Bros., 207 B.R. at

9 financing statements (in those cases where a security interest in the assets may be perfected by filing). B. Safety Net or Minefield Potential Unexpected Outcomes under Article 2A Since U.C.C. Article 2A codifies legal principles applicable to personal property leasing, its provisions are used as default provisions to fill in gaps by curing uncertainties or omissions in the lease agreement between the parties. Therefore, lessors should be mindful of the safety net provisions of Article 2A that could produce unintended results for them if their lease is silent, inadequate or lacking on certain terms. i. Warranties Many lessees request product and other warranties from lessors. Unless the lessor is the manufacturer or supplier of the goods to be leased, the lessor should distance itself from any such warranties by expressly and conspicuously disclaiming any warranties, express or implied, including warranties of merchantability and fitness for a particular purpose. 9 A lessor can resist lessee warranty requests by taking an assignment from a lessee of all of lessee s purchase rights to take title to and buy the goods that will become the subject of a particular lease. To the extent the lessor is permitted (since it cannot guaranty that those rights are available or transferable), it can then assign all warranties relating to those goods provided by the manufacturer or seller thereof to the lessee for the entire term of the lease. The lessee would be free to enforce the warranties in its name and at its expense. In the event that the lessee is precluded from enforcing any such warranty in its name, upon lessee s request, the lessor should be willing to take reasonable steps to enforce such warranty; the lessee should be required to reimburse the lessor for any out-of-pocket expenses incurred in enforcing the particular warranty. a. Manufacturer/Seller vs. Finance Lessor While commercial sale documents provide fairly standard types of warranties provided by a manufacturer or seller, the warranties provided by a lessor will vary depending upon whether the lessor is the manufacturer or seller of the leased items or a finance lessor (i.e., a captive leasing company established as a separate legal entity or an independent leasing company). A finance lessor has the ability to enter into finance leases with lessees. Article 2A defines a finance lease as a lease with respect to which: (i) the lessor does not select, manufacture, or supply the goods; (ii) the lessor acquires the goods or the right to possession and use of the goods in connection with the lease; and (iii) one of the following occurs: (a) the lessee receives a copy of the contract by which the lessor acquired the goods or the right to 9 See 2A

10 possession and use of the goods before signing the lease contract; (b) the lessee s approval of the contract by which the lessor acquired the goods or the right to possession and use of the goods is a condition of effectiveness of the lease contract; (c) the lessee, before signing the lease contract, receives an accurate and complete statement designating the promises and warranties, and any disclaimers of warranties, limitation or modification of remedies, or liquidated damages, including those of a third party, such as the manufacturer of the goods, provided to the lessor by the person supplying the goods in connection with or as part of the contract by which the lessor acquired the goods or the right to possession and use of the goods; or (d) if the lease is not a consumer lease, the lessor, before the lessee signs the lease contract, informs the lessee in writing (1) of the identity of the person supplying the goods to the lessor, unless the lessee has selected that person and directed the lessor to acquire the goods or the right to possession and use of the goods from that person, (2) that the lessee is entitled under this Article to the promises and warranties, including those of any third party, provided to the lessor by the person supplying the goods in connection with or as part of the contract by which the lessor acquired the goods or the right to possession and use of the goods, and (3) that the lessee may communicate with the person supplying the goods to the lessor and receive an accurate and complete statement of those promises and warranties, including any disclaimers and limitations of them or of remedies. 10 b. Manufacturer/Lessor and Seller/Lessor Warranties In addition to any express warranties it may provide, in those instances where the lessor of goods is the manufacturer or seller of those goods, the lessor is expected to warrant that 10 2A-103(1)(g). 4

11 the goods are delivered free of the rightful claim of any person by way of infringement or the like, and provide implied warranties of merchantability and fitness for particular purpose. 11 c. Finance Lessor Warranties Captive lessors and independent leasing company lessors acting as finance lessors are not expected to provide the same warranties as a manufacturer or seller of those goods. In fact, Article 2A excepts finance leases from provisions regarding lessor warranties that the goods are delivered free of the rightful claim of any person by way of infringement or the like, and implied warranties of merchantability and fitness for particular purpose. 12 ii. Lessee Remedies for Lessor Default The lessor s remedies in an equipment lease agreement should be more comprehensive than those afforded to lessees; lessees should be reminded that the lessor s role is primarily that of passive money source with the majority of the contract performance residing with the lessee. Therefore, lessors should attempt to limit their duties, liabilities and obligations under a lease agreement. While Article 2A addresses lessor default fairly extensively, 13 lessors should be able to avoid these provisions by drafting their lease agreements to exclude lessor defaults or narrowly limit the events or occurrences that would constitute a lessor default. Limited lessor events of default would include lessor s breach of its covenant of quiet enjoyment followed by a failure or inability to cure such breach within a reasonable period of time following written notice of the breach by lessee; lessor failure to pay the seller, manufacturer or licensor for any products(s) within a specified period of time (generally not less than 30 days) after lessor has received all documentation necessary to establish lessee s acceptance followed by continued failure to pay beyond some reasonable period after written notice from lessee; a lessor assignment for the benefit of creditors or the filing of a proceeding under any bankruptcy, reorganization, arrangement of debt, insolvency or receivership law by or against lessor (and, if such proceeding is involuntary, it is not dismissed within some reasonable period (generally days) after the filing date). The remedy for breach of lessor default provisions should be money damages: a lessee s sole and exclusive remedy for a lessor default should be to bring an action against the lessor seeking direct damages suffered by the lessee and any reasonable and necessary expenses (including court costs and reasonable legal fees) incurred by the lessee in connection with the lessor breach. Termination should not be offered as a lessee remedy since such a remedy defeats the hell-or-high water nature of the lease, can make syndication or securitization of the lease difficult, and could result in additional loss to the lessor. 11 2A A See 2A

12 II. Lessor Assignments Jeffrey T. Veber A. Outright Assignments and Lessor s Need for Flexibility A lessor s ability to assign or otherwise transfer its rights in a lease remains one of the most heavily negotiated issues in a lease financing. From the lessor s perspective, it is important to maintain maximum flexibility without limits on its rights to assign its interest in a leased asset (or the rent streams under a lease). A lessee, on the other hand, often selects a particular lessor for a particular reason (i.e., as the result of an existing relationship or the lessor s creditworthiness) and, therefore, a lessee does not want to have a new lessor foisted upon it without its consent. Although some lessors ultimately are successful in maintaining absolute flexibility, most leases will contain some objective criteria to evaluate assignment to potential assignees. In this regard, typical criteria include net-worth and solvency tests, specified jurisdictions, and entity types. i. U.C.C. Amendments to Increase Availability of Credit As a general matter, the Articles 2A and 9 invalidate certain contractual provisions which prohibit or inhibit the ability of a lessor to assign or to grant a security interest in its rights to receive future rent payments. Comment 4 to Article 2A-303 provides an explanation that granting such a security interest does not generally prejudice a lessee. Furthermore, a lessor s ability to perform its duties under a lease may be enhanced by its ability to obtain relief from an antecedent debt. Thus, the underlying policy of the U.C.C. in this regard is to increase the availability of credit to a lessor where the lessor s only responsibility under a lease is to receive rent payments. ii. Article 2A-303 With certain exceptions, Article 2A-303(2) restricts the alienability of a lessee s ability to interfere with a lessor s right to transfer its interest under a lease contract. A transfer of interest in this context includes a sale as well as the creation and enforcement of a security interest in a lessor s interest as well as a lessor s residual interest in the financed assets. As a result, a contractual provision which purportedly prohibits a lessor from selling or assigning its interest in a lease rental stream or from granting a security interest in a lease rental stream is ineffective. Article 2A-303 provides for certain exceptions to this general rule. First, if the transfer of a lessor s rights is an event of default pursuant to the terms of the lease and a lessor has some remaining obligations under a lease (such as maintenance) then a lessee has certain rights to obtain damages pursuant to Article 2A-501(2). Furthermore, if the transfer of a lessor s rights is not an event of default pursuant to the terms of the lease and the transfer materially changes a lessee s duties or materially increases the burden or risk imposed upon a lessee, a court may award damages to a lessee or award relief such as canceling the lease or issuing an injunction to prevent the transfer. 6

13 a. Assignment of Rental Streams As a general matter, the assignment of a lease rental stream does not materially change the obligations of a lessee under a lease. In particular, as with most leases, where a lessor s main responsibility after delivery of the leased asset is to collect payment, restrictions upon a lessor s ability to transfer its interest are ineffective. Transfers which receive this treatment include a sale by a lessor of a lease rental stream in connection with a securitization as well as a grant of a security interest in a lease rental stream in connection with a back-leveraging of the lease. In these cases, unless the lease provides such a transfer to be an event of default, a lessee may not prevent the transfer and has no recourse against its lessor. b. Assignment of Residual Interests An analysis of the assignment of a lessor s residual interest in leased assets yields substantially the same results as an analysis of the assignment of a lease rental stream, i.e., Article 2A encourages the creation of a security interest in, or the sale of, a lessor s residual interest as long as such transfer does not materially change the lessee s obligations under a lease. iii. Lessee s Approval Rights Article 2A does not grant a lessee the right to approve a change in the party that receives rental payments. Furthermore, under general principles of contract law, if a lessee is notified of an assignment of a lease rental stream and makes payment of rent to the original lessor then the lessee remains obligated to pay rent in a timely manner to the new lessor and seek reimbursement from the original lessor. 14 Article 2A distinguishes between a lessor s ability to grant a security interest in its right to receive payments and a delegation of its obligation of performance under a lease. 15 If a lessor has obligations under the lease to maintain or upgrade the leased asset or otherwise to perform certain obligations, then a lessee has the right to object to an assignment. B. Collateral Assignments Oftentimes a lessor is more concerned with possessing the ability to make a collateral assignment of a lease (i.e., assigning the lease (including the lease rental stream) to a financier to secure an antecedent debt) rather than the ability to make an outright assignment. From the perspectives of the lessor and the lender, the most important issues with respect to a collateral assignment are (i) how to perfect a security interest in a lease following the assignment, (ii) how to deal with certain shared rights, and (iii) how to effect back leveraging Am. Jur. 2d Assignments 142 (2000). 15 William D. Hawkland, Uniform Commercial Code Series (West 1992 and Supp. 2002) 2A-303:02. 7

14 i. Perfection of Security Interest As a general matter, leases are classified as chattel paper under Article 9-102(11). Assuming a lease is tangible chattel paper, 16 the security interest may be perfected by filing or by taking possession ( 9-312). Revised Article generally requires the filing of a UCC-1 financing statement in a central office in the jurisdiction where the debtor is incorporated, thus eliminating the need for dual local and state filings that were previously required, except in certain enumerated exceptions. Perfection also may be achieved by taking and maintaining physical possession of the original chattel paper copy of a lease although, as a practical matter, with the multitude of originals it always is prudent to file. ii. Shared Rights between Lessor and Lender Once a lessor makes a collateral assignment of a lease to its lender, the lender may exercise all of the rights of the lessor under the lease in the lessor s name. For this reason, a lessor needs to negotiate with its lender a bundle of shared rights which defines those certain rights that a lessor can exercise in its own name. Typical shared rights include the right to receive notices from a lessee, to demand performance of certain covenants by a lessee, and to perform inspections of the leased asset. iii. Back Leveraging In many cases a lessor will not leverage a lease transaction at the outset, but in an effort to use the value of the lease rental stream and underlying leased asset to raise financing, the lessor may opt to leverage the transaction at a later date. This process, referred to as back leveraging, simply refers to the situations in which a lessor borrows funds from a lender using the lease and the leased asset as collateral for the loan, and the lease rental stream as the means to service the debt. The assignment of the rental stream raises separate issues from the collateral assignment: while an assignment of a lease rental stream to a lender generally is permitted, a collateral assignment of a lease usually requires a lessee s consent and raises the issues more fully discussed above. For this reason, a lessor will want to document its rights to back leverage a lease at the outset of the lease transaction. Generally, provisions which protect the rights to back leverage provide for the level of assistance which a lessee will provide to a lessor in a back leveraging and the terms of a lessee s consent. All lenders will want a lessee to indemnify them and to provide insurance for them in the same manner as the lessor is covered. As a result, a lessor should obtain a lessee s agreement to these requirements at the outset of the lease transaction while it still has some degree of leverage. In addition, a lessor should advise its lender that the lender will need to provide its lessee with some comfort regarding the lessee s right to quiet enjoyment. 16 Under Revised Article 9, electronic chattel paper must be perfected by filing or control (as opposed to possession) pursuant to 9-313(a) and 9-314(a). 8

15 III. General Indemnity Audrey Sung A. Theory of Indemnity The basic purpose of the indemnity provisions of a lease agreement is to preserve for the lessor the benefit of the net lease concept. Along with the hell-or-high water rent payment clauses, the waivers and disclaimers of warranties and the affirmative operational covenants by the lessee to maintain and insure the equipment, the indemnity provisions shift the obligations, risks and liabilities that relate to or arise from the equipment to the lessee. By allowing the lessor (and by extension, lenders to the lessor) to rely on the stated rental and other payments to be made by the lessee, these provisions permit the lessor to obtain financing secured by the lease rentals, presumably at lower cost than financing without such security. However, even in the context of a triple net lease, there are limitations on the scope of the indemnity and procedural rights of the lessee that any sophisticated and well-represented lessee will insist upon, and lessors would do themselves a service by understanding the competing concerns that need to be accommodated in the indemnity clauses, so that they can adequately protect their own interests and also meet the needs of their customers. B. Scope of Coverage The indemnity provisions basically provide a contractual mechanism for the allocation of risk between the lessor and lessee. Almost by definition, the indemnity is designed to deal with the unknown - the future claims, the third party claims and other unforeseen liabilities. The structure of the typical general indemnity clause in any equipment lease consists of a lead-in clause that establishes the general scope of the indemnity, which is generally drafted as broadly and sweepingly as possible, which is followed by (at least in fully negotiated leases) a series of specific exclusions. This structure is at least in part designed to deal with the general principle of contract interpretation which holds that indemnity clauses are disfavored and therefore are to be construed narrowly, against the drafter since the lessor is almost always the party responsible for drafting and is also the primary beneficiary of the indemnity. Nonetheless, care must still be taken with the drafting of the lead-in clause, as claims that are found to fall outside the initial sweep of that clause simply are not covered regardless of whether they are otherwise excluded pursuant to any of the subsequent carve-outs. i. Third Party Liability Claims Under general principles of tort law, the lessor, as the owner of the equipment, may be held liable to third parties for property damage, personal injury and death caused by, arising out of or otherwise relating to the equipment under theories of strict liability and/or imputed negligence. 17 In order to effect the basic economic bargain of the triple net lease, in which the lessee assumes all risks relating to and arising out of the equipment, the general 17 See, e.g., Merton Price v. Shell Oil Company, 2 Cal. 3d 245; 466 P.2d 722; 85 Cal. Rptr. 178; 1970 Cal. LEXIS 270 (1970) (lessor subject to strict liability in tort). 9

16 indemnity must shift this background tort liability from the lessor to the lessee. In order to achieve this result, the indemnity clause should expressly include ownership (of the equipment) in the litany of activities for which the lessee provides indemnity (e.g., manufacture, purchase, acceptance, ownership, delivery, non-delivery, inspection, lease, sublease, possession, use or non-use, etc. of the equipment), and also expressly include coverage for claims based on or arising out of the negligence of the lessor, whether active, passive or imputed. These particular clauses in the affirmative scope of the indemnity frequently elicit objections from the lessee (particularly less sophisticated lessees), but it is critical for the lessor to stand firm on these clauses though, as discussed below, there is room to address certain concerns of the lessee on these issues in the carve-outs or exclusions from the indemnity. ii. Indemnity for Breach by Lessee In addition to the indemnity against liability for third party claims (and the related costs of defense, etc.), a lessor may also look to a lessee to keep the lessor whole in respect of the lessor s own property and interests. These interests include the lessor s interest in the equipment leased to the lessee, specifically, the value and condition of that equipment, as well as obligations that the lessor may have under financing arrangements that it enters into in reliance upon (and often secured by) the lessee s obligations to pay rent under the lease. These items are generally covered by including an indemnity for breach of the lease within the affirmative scope of the indemnity. The lessee may object to the indemnity for breach of the lease on several grounds, including (i) it is a back door to the remedies provision which deprives the lessee of the grace periods specifically agreed in the events of default, (ii) similarly, if the parties have agreed to exclude the lessor s break funding and other unwind costs under its financing arrangements from the measure of damages in the remedies provision, the indemnity for breach would effectively nullify that agreement by allowing the lessor to claim those expenses under the indemnity, and (iii) fundamentally, the lessor s remedies for breach of the lease should be governed by the remedies provision, and not by the indemnity, which serves a different purpose. The lessor s response should include whatever adjustment may be appropriate to make the indemnity consistent with the agreed measure of damages under the remedies, but will note that the lessee is not harmed by overlap between the provisions as the lessor would not entitled to duplicate recovery in any event. Clearly the indemnity provides the lessor with greater flexibility for making claim on the lessee than the exercise of remedies, which is desirable for the lessor. C. Exclusions As noted above, the initial clause of the general indemnity sweeps broadly, and a number of exclusions are customarily agreed in order to cut back on the scope to match the expectations of the parties. i. Ownership and Value of Equipment First, to the extent that ownership of the equipment is specifically included within the indemnity for tort liability purposes, the lessee will generally seek to include an express carve-out or acknowledgment that it does not have any obligation to indemnify the lessor 10

17 for matters relating to lessor s title to the equipment, which should not be objectionable to the lessor. In addition, a lessee may seek to exclude reduction in the residual value of the equipment, which highlights the tension between a lessee s legitimate concern to avoid serving as a residual value guarantor or otherwise assuming market risk for the value of the equipment and the lessor s need to have the lessee indemnity cover damage to the residual value of the equipment to the extent attributable to the lessee s actions or inactions. One possible approach is to provide that the lessee has no obligation to indemnify for the residual value so long as the lessee is in full compliance with its obligations under the lease. ii. Acts of the Lessor In addition, several exclusions for matters attributable to the lessor are generally agreed. Having agreed (reluctantly) to include the lessor s negligence within the scope of the indemnity, a lessee will generally be anxious to have a carve-out for actual bad acts of the lessor, whether defined as willful misconduct or gross negligence. Lessors may seek to include a contractual definition of gross negligence as an intentional or conscious action or decision which is taken with reckless disregard for the consequences of such action or decision. In any event, the carve-out should not include negligence, gross or otherwise, that is imputed to the lessor by virtue of its interest in the equipment or the lease. Lessor liens, breach by lessor of its obligations under the lease, and voluntary transfers by the lessor of its interests in the equipment and/or the lease (other than in connection with the exercise of remedies following an event of default) are all commonly excluded without much controversy. iii. Temporal Exclusions Because the lessee basically has possession and control of the equipment during the lease term, the lessee should, in some sense, be obligated to assume liability for the equipment risk only for the period of the lease term. Thus, the lessee s indemnity should exclude losses, claims, etc. arising out of events that occur (i) prior to commencement of the lease term (but the carve-out should not include claims due to defects in the equipment, even if such defects are the result of manufacture or repair or overhaul of the equipment), and (ii) after redelivery of the equipment to lessor, in full compliance with the return conditions and other requirements of the lease (but matters attributable to acts or omissions of the lessee need to be carved out of the exclusion and back into the indemnity). iv. Other Miscellaneous Exclusions Finally, several housekeeping exclusions ensure that the indemnity does not inadvertently supersede other specifically negotiated provisions of the lease and related documents. Thus, the taxes are generally carved out of the general indemnity because they are specifically governed by the tax indemnity provisions, and similarly, a carve-out is generally agreed for expenses, if any, that the lessor has expressly agreed to bear elsewhere in the documentation. 11

18 D. Procedural Matters Relating to Indemnities i. Control of Defense and Subrogation Rights In many lease agreements, the indemnity clause simply ends after defining the scope of the indemnity. Yet, many procedural issues should be considered and addressed expressly in the lease agreement in order to avoid confusion and disappointment in the event of litigation of claims covered by the indemnity. As the party obligated to provide the indemnity, the lessee clearly has a strong interest in controlling the defense of any third party claims and will also want to be subrogated to the rights of lessor with respect to claims that it pays under the indemnity. At the same time, however, the lessor generally will not wish to cede control over the proceedings to the lessee unless the lessee acknowledges that the claim or claims at issue are covered by the indemnity, and even then the lessor, and even then, the lessor generally will seek to retain some right of approval over counsel chosen for the defense as well as the right to retain separate counsel, whether at lessee s expense or at lessor s expense, if it deems prudent. Frequently, the degree of control ceded to the lessee is a function of the creditworthiness of the lessee the more creditworthy the lessee, the more confidence the lessor can have that the lessee will ultimately perform under its indemnity obligation, and therefore the more willing the lessor would be to allow the lessee to control the proceedings. Similarly, a lessor may have concerns that a lessee may, in pursuing subrogated claims, do things that the lessor may not choose to do for itself as a business matter, such as pursue certain parties for certain types of claims. In light of the conflicting interests at stake, it is generally prudent for the parties to address their respective rights in terms of control of litigation, choice of counsel, right to settle, etc. in the lease agreement, including, for example, any obligation by the lessee to post a bond or set aside reserves. ii. After-Tax Basis and Survival of Indemnities To round out the discussion of procedural issues, it should b noted that, in order to make a lessor whole with respect to indemnified claims, the lessee s indemnity payment must be made on an after-tax basis, so that the lessor receives the whole amount of the claim. In addition, a key characteristic of the general indemnity in an equipment lease agreement is that it must survive the expiration, termination or cancellation of the lease and the return of the equipment to the lessor. Therefore, the lease itself must expressly provide for such survival, and, to the extent that a lessor customarily signs a redelivery receipt or other similar document acknowledging the return of the equipment, it would be prudent practice to have the parties mutually acknowledge the survival of the indemnities beyond the return of the equipment documented. Similarly, with respect to aircraft registered at the Federal Aviation Administration, many lessors have adopted the practice of drafting their lease termination certificates so as to specify the survival of indemnities. 12

19 IV. Waivers Glen J. DuMont A prudent lessor will seek limitations on its own liability under a lease and waivers of a lessee s rights and remedies created by common law and Article 2A that impact the terms and conditions of a lease. Obtaining third party waivers to claims against the lessor and its leased asset(s) provides additional protection to the lessor. A. Limitations on Lessor Liability Since lessors are acting in the capacity of a bank or financing source, their lease agreements should include a section conspicuously disclaiming equipment warranties and responsibility for any product defects. Furthermore, a lessor acting as a passive financing source should have no liability to the lessee, the lessee s customers and any third parties for any incidental, indirect, special or consequential damages arising out of the lease or concerning the products being leased. However, lessors should ensure that the provisions of their agreements do not deprive lessees of any rights they may have against parties other than the lessor. B. Lessee Waivers Lessors should ensure that their lease agreements contain lessee waivers of defenses to payment and rights and remedies under Article 2A. i. Waiver of Defenses to Payment The typical hell-or-high water clause contained in a master lease agreement provides that each lease thereunder is non-cancelable; a net lease (i.e., in addition to rent the lessee bears the expense of taxes, insurance and maintenance charges); the obligation to pay rent and any other amounts when due is absolute and unconditional; and the lessee may not abate or reduce rent or any other amounts due to lessor or set off any charge against any such amounts. Better clauses add provisions whereby the lessee waives any defenses it may have to payment (e.g., recoupment, cross-claim, counterclaim) and agrees to pursue product installation, integration and warranty claims against the manufacturer of the product (while continuing to make all required payments to lessor). ii. Article 2A waiver Lessees are afforded certain statutory rights and remedies against a lessor conferred by Article 2A. A prudent lessor will include an Article 2A waiver in its lease agreement in an effort to limit the lessee s rights and remedies to the four corners of the lease agreement between the parties. These waivers may take a broader form (waiving all lessee rights and remedies under Article 2A) or a narrower form (waiving all lessee rights and remedies under Article 2A to the extent inconsistent with the lease agreement). 13

20 C. Consent and Waiver; Landlord Waiver In the post-dot-com era, the landscape is dotted with many information technology ( IT ) hosting facilities. Many lessees opt to lease IT equipment in their name and locate it at a hosting facility. In those instances, a lessor should obtain a consent and waiver with regard to the IT equipment being located at the host s site; the lessor consents to the equipment location and the host waives any rights in the equipment and claims of any kind against the lessor (e.g., indemnification rights and the right to sue for damages, including consequential damages). The consent and waiver agreement is a more specific form of the traditional landlord waiver. V. Lessor Damages Audrey Sung A. Basic Contract Theory The basic contract theory of damages is to put the non-breaching party in as good a position as he would have been in had the other party fully performed its obligations under the contract, but not in any better position. In the leasing context, however, courts have had great difficulty applying the principle in practice: some have reached results that might be fairly characterized as windfalls for the lessor while others have reached results that seem to fall far short of making the lessor whole. At its core, the economic bargain struck by a lessor and a lessee in a true lease includes two basic elements: (i) the lessee acquires the right to possession and use of the equipment for period of time in exchange for the payment of rent, and (ii) at the end of the agreed period (lease term), the equipment is returned to the lessor, who is then free to re-let to another lessee, to sell the equipment (free of any claim or interest by the lessee) or simply to hold the equipment idle. With this basic bargain in mind, we will examine the following concepts in turn: (a) the various types of losses incurred by a lessor when the lessee breaches the lease and which must be taken into account in determining the gross amount of damages that must be recovered by a lessor in order to be made whole, (b) the concept of mitigation as a limit on the lessor s recovery, and (c) liquidated damage formulas commonly used in equipment leases and potential pitfalls. B. Elements of Damages i. Benefit of the Bargain Damages 18 a. Past Due Amounts 18 Such damages are generally the damages that a breaching party to a contract must pay to the aggrieved party, equal to the amounts that the aggrieved party would have received, including profits, if the contract had been fully performed. Black s Law Dictionary (7 th ed. 1999). 14

21 First, and perhaps least controversial, the lessor must be entitled to recover for all amounts that have become due but remain unpaid under the lease, including, but not limited to, basic rent. In addition, the lessor needs to receive interest on past due amounts in order to account for the time value of money. 19 b. Future Rents In addition, for the lessor to recover the benefit of its bargain under the lease, rent for the unexpired portion of the lease must certainly be included as an element of damages. Certainly these amounts must be discounted to present value in order to avoid compensating the lessor. Under Article 2A-103(1)(u), the discount rate agreed by the parties in the contract would be upheld unless it is manifestly unreasonable. If the lease does not expressly provide for discounting (and therefore does not specify a discount rate), it is likely that a court in litigation will nonetheless require discounting as a condition to enforcement, and may choose a rate that is substantially different from what the parties would have chosen between themselves. 20 c. Damage to Lessor s Residual Interest Under Article 2A-532, a lessor is entitled, in addition to other recoveries permitted by Article 2A or other applicable law, to recover an amount that will fully compensate the lessor any loss of or damage too the lessor s residual interest in the goods caused by the default of the lessee. Thus, if a lessor does not receive the return of the equipment, or if the equipment upon return does not comply with the return condition requirements set forth in the lease, the lessor should be entitled to recover the value of the equipment, or the difference between the value of the equipment in the condition as returned and the value of the equipment in the condition specified in the lease. 21 However, in practice the difference in value is likely to be quite difficult to calculate, and to the extent the cost of repair or refurbishment is used as a proxy for this element of damages, depending on the type of equipment, certain difficult questions may be raised. For example, for some types of equipment, the cost of overhaul may exceed the value of the equipment as overhauled, and for other types of equipment, such as 19 None of the damage formulas in Article 2A specifies interest on past due amounts as an element of damages. See 2A-527, 528 and 529. Thus, it is important for the lease to expressly include interest on past due amounts as an element of damages. In addition, if a lease provides for liquidated damages, but the amount or the formula is found to be unenforceable (see discussion below), then recovery may be awarded as provided in Article 2A itself, which may not include interest. See 2A-504(2). 20 See, Kedziora the City Corp National Services, Inc., 7780 F. Supp (N.D. Ill. 1991) (holding undiscounted rent acceleration clause unenforceable as a windfall); CHR Equipment Financing, Inc. v. C.&K Transport, Inc., 448 N.W. 2d 693 (Iowa Ct. App. 1989); Heller Financial, Inc. v. Brian Burry, 633 F. Supp. 706 (N.D. Ill. 1986); and In re: Bruce Daly, 167 B.R. 932 D.C. Mont. 1994) (discounting future rents by the interest rate applicable to late payments under the lease). But see, Emlee Equipment Leasing Corp. v. Waterbury Transmission, Inc., 626 A.2d 307 (Conn. App. Ct. 1993) (upholding an undiscounted rent acceleration clause). 21 As quoted in the text, Article 2A clearly recognizes the lessor s right to recover the equipment (or the value thereof) in addition to other damages arising from a lessee s breach. Some courts, however, have failed to recognize this right in the lessor and have reached results that not only deprive lessor of this element of recovery, but have sometimes even used the value of the equipment as an offset against accelerated rents. See, e.g., Telmark, Inc. v. Liff, 1998 WL (Ohio App. 1998) (reducing lessor s recovery of accelerated rents (plus costs) by value of the equipment on the theory that lessor failed to mitigate damages by failing to sell the equipment). 15