Basic Legal Structure of Asset Finance
In a series of six bi-monthly articles during 2010 Bermans’ Partner Peter Sinnett sets out a basic introduction to some of the legal issues arising from cradle to grave in a typical Leasing/HP transaction.
This first article looks at basic legal structures and the Lessor’s various legal relationships.
When a customer (“the Lessee”) wants to acquire an asset without the inconvenience of having to pay for it upfront there are a number of options of deferring payment using a Funder set up to provide finance for that purpose, but there are relatively few distinct legal structures as opposed to products with different names based on one of those few structures.
Basic Legal Structures
The most obvious way to defer payment is for the Lessee to take out a loan and itself pay the Supplier in full for the acquisition of the asset. From a purely legal point of view this has many advantages for the Funder – there is no need for it to make sure that it obtains title to the asset, no room for non-payment by the Lessee on grounds of misrepresentations by the Supplier or defective performance of the asset, and no need to worry about residual values. However, on the downside the Funder does not have the security of owning the asset, though a similar effect can be achieved by security devices such as a chattel mortgage.
However, the problem with loans is that they are often not perceived as appropriate by Lessees and they lack many of the tax and accounting advantages (real or perceived) of other forms of asset finance.
If the Lessee wants to acquire title to the asset at the end of the deferment period this is often achieved by the Hire Purchase route – the Funder buys the asset from the Supplier and provides it to the Lessee in return for periodical payments during a fixed term, at the end of which the Lessee has the option to take title either for a nominal payment or a balloon payment. In Hire Purchase VAT is payable at the outset.
Another legal mechanism used where title is to pass to the Lessee is conditional sale – an outright sale of goods in which the passing of title to the Lessee is deferred until instalment payments have been completed over a fixed period.
However, the most common legal structure used in asset finance is the Lease or Hire Agreement – the Funder buys the asset from the Supplier and lets it on hire in return for periodical payments normally equalised across a minimum period of hire. There may be the possibility of a secondary period of hire, and although tax rules prevent a prior agreement to pass title to the Lessee, this is sometimes achieved by a separate agreement made after the Lease has expired.
Perhaps the main distinction between different types of Lease is that between a finance Lease and an operating Lease. There are accounting standards which address this issue but the basic distinction is between a finance Lease where the economic value of the asset is effectively substantially paid by the Lessee over the life of the Agreement, as opposed to an operating Lease where the asset is expected to have a residual value at the end of the term and may then be the subject of a further Lease to a different Lessee or a sale with proceeds of somewhere above 10% of its initial value.
Of course the above is only a whirlwind tour of the various alternatives, and there is a myriad of tax and accounting issues involved in choosing the right transaction structure.
Structures Used by Lessor Funders
Assuming a Lessor has written business on Lease or HP, it is common for a series of such deals to be backed off to a larger Funder or Funders. In bigger transactions this may involve Head Lessors or syndicates. In small and middle ticket business a number of Lessor Funders operate under 3 basic legal structures.
Firstly, there may be a sale of the asset and receivables under which the Lessor is required to give extensive warranties as to the performance of the asset and the enforceability of the underlying Agreement, though the credit risk of non-payment by the Lessee is normally taken by the Lessor Funder.
If the Lessee has a valid complaint against the original Lessor this will normally be capable of being set-off as a defence against the Lessor Funder’s claim to the receivables, but there is no question of a positive claim by the Lessee against the Lessor Funder.
In this structure the Lessor Funder has the added benefit of the residual value of the asset when it is repossessed or returned.
Secondly, there may be a sale of receivables only without title to the asset, so unless the Lessor Funder takes security over the asset such as by a chattel mortgage it is not entitled to repossess it on early termination or to its return at the end of Lease, so in a very real sense it has less security than in the first structure.
Thirdly, there may be an undisclosed agency arrangement between the original Lessor and the Lessor Funder, so the latter buys the asset from the Supplier and as a matter of law is the real contracting party with the Lessee. In this structure any proven complaints available to the Lessee against the original Lessor (who was acting only as agent) can be used against the Lessor Funder, and in theory there may be a claim for damages brought against the Lessor Funder if for example the asset was defective causing loss and relevant exclusion clauses were not upheld by the Court.
Key Legal Relationships
Prior to its contact with the Lessee, the Lessor’s most important legal relationship is with the Supplier of the asset. It is essential for the Lessor to ensure that it obtains title to the asset, and that it has legal redress against the Supplier if the asset is defective or the Agreement is incapable of being enforced for reasons which can properly be laid at the Supplier’s door. This is best achieved by a Trading Agreement, but for many Lessors this is still something more honoured in the breach that the observance.
Another key relationship is between the Lessor and brokers in all their guises. Some brokers enter into the title chain and are easier to deal with in the sense that they undertake the obligations of a Supplier, but many brokers who act as pure introducers and simply take a commission have limited obligations to the Lessor unless they are subject to a Broker Agreement.
In recent years the growth of independent brokers engaged not by Suppliers but by Lessees has become of increasing significance. The Hurstanger case a couple of years ago applied long-established legal principles of agency to such a broker at the bottom end of the market, pointing out that if the broker is paid by the Lessee to look after his interests then he can’t in good conscience also take commission from the Lessor without the informed consent of the Lessee. There remains a difference of opinion between lawyers as to the precise reach of this decision into different types of the asset finance market, but Lessors at least need to be alive to future challenges from Lessees on the basis of failure to inform them of commission payments in circumstances where they thought the broker was acting for them.
In the March edition we will look at a number of legal issues arising pre-agreement, including sale and leaseback, landlords’ waivers and data protection.