LEGAL ASPECTS OF LEASING IN ENGLAND

By Alistair MacRae, Partner, Norton Rose

This article was prepared in October 2003 by Norton Rose, the international law firm and a market leader in the areas of structured and asset finance. For further information on Norton Rose, please click www.nortonrose.com or alternatively contact Alistair MacRae (Partner) in their London office (+44 207 283 6000)

Disclaimer: this publication is intended only to give guidance rather than definitive advice. Norton Rose accepts no liability for any errors or omissions in the information herein and accepts no responsibility for anyone who takes action and/or relies on any information that has been provided.

1 Introduction

The legal analysis of an equipment lease under English law is that it is a contract of bailment; that is, an agreement under which the lessor gives up possession of the asset to the lessee in return for payment. Title to the asset does not pass under a lease.

If provision is made for ultimate sale to the lessee, then the transaction is properly categorised for tax and legal purposes as one of hire-purchase or deferred sale.

The summary which follows deals with the typical clauses that are to be found in a lease agreement. These provisions may however vary depending upon whether the lease is a finance lease (where the lessor is repaid its investment in full over the lease period) or an operating lease (where the lessor will still have a significant part of its investment outstanding at the end of the lease period and will therefore be replying on a further period of leasing, or selling the equipment, in order to be repaid in full).

We also propose to look at some of the important common law and statutory provisions which are relevant when supplying movable assets on lease in England and Wales.

2 Typical clauses in a lease agreement

The following clauses are usually found in a lease agreement.

2.1 The basic terms of the lease
2.2 Rental and payment terms
2.3 Adjustment Provisions
2.4 Termination provisions
2.5 Provisions protecting the Lessor from liabilities associated with the Equipment
2.6 Provisions protecting the interest of the Lessor in the Equipment

2.1 The basic terms of a lease

2.1.1 The parties

It is important to establish the identity of the lessor. A number of documents can be quite misleading in that the name of a manufacturer or "intermediary" appears prominently at the top but, on closer reading, it appears that an unconnected lessor is to be introduced. This may not concern a lessee but should be pointed out

Even if an acceptable name is inserted as lessor this is not necessarily the end of the story. Many leases are entered into by lessor with a view to being transferred on. A lessee should look at the assignment/transfer rights of the lessor. Alternatively there may be a provision that the named "lessor" is acting as agent for a principal.

If the identity of the lessor is significant, the lessee should consider requiring consent for transfers and a representation that the "lessor" is not fronting for another party.

If transfer is to be permitted a provision should be included to the effect that the lessee is to be under no greater liability that it would have incurred in the absence of transfer. Detailed consideration of the working of any adjustment provisions which operate by reference to the tax position of the "owner" may be required.

2.1.2 Leasing

A basic operative clause covering the obligation to lease and take on lease should be inserted. It is unusual for a lessor to undertake anything other than the giving of quiet possession.

2.1.3 Period

The agreement should cover when and how the period of letting begin. It should also establish if there is a pre-lease period before delivery.

Usually there will be provision for a fixed period. This is often called the "Primary Period". Following the expiry of the Primary Period there may be provision for a “secondary” Period.

2.1.4 Equipment

The assets may be called "Equipment", "Goods", "Machines", "Items" or something similar.

They should be described with sufficient detail for the following purposes:

to ensure the contract does not fail for lack of certainty over the subject-matter;
to enable the lessor to identify the equipment in the event of repossession;
to provide a preliminary check that the equipment is likely to be "plant and machinery" for capital allowance purposes.

2.1.5 Acceptance

A deemed acceptance provision by the lessee is generally less satisfactory than a separate acceptance certificate. A " deemed acceptance" purporting to take place before the lessee has received the equipment is unreliable.

Rejection of equipment by a lessee after commencement of the lease is not easy to accommodate in a finance lease. Generally problems must be sorted out direct between the lessee and supplier, but there is often no direct contractual relationship between those parties (the equipment having been sold to the lessor). This area needs careful review when acting for a lessee.

The lessor is looking for unconditional acceptance by the lessee: if there are problems they must be sorted out direct between the supplier and the lessee.

2.2 Rental and payment terms

From both sides` points of view the rental provisions are the backbone of the lease. The lessor looks to the rentals over the fixed period to repay its funding costs on purchasing the equipment and to provide its return or profit on the transaction.

2.2.1 Rental obligation

This should appear in clear language. The amount of rental may be set out in a schedule.

2.2.2 Payment period

The clause should specify when the first rental is due and what triggers payment.

2.2.3 Time for payment

The due dates for rental payments should be stated. Time will normally be expressed to be of the essence (subject to agreed period of grace) to ensure that prompt payment is a condition of the contract (see 2.4.3 below).

If the due date is not a business day there should be a provision specifying an alternative date. Lessors who account on a cash basis will want to select the next following business day rather than the preceding business day in order to avoid the rent being received in the previous financial year.

2.2.4 Interest for late payment

It is a necessary provision but it should not be excessive so as to constitute a penalty.

2.2.5 VAT

Rental under an equipment lease should be paid together with VAT at the standard rate (as it is classed as the supply of a service). Under a hire- purchase agreement (a supply of goods for VAT purposes) VAT is paid on the capital cost on day one, with the finance charges being an exempt supply.

2.2.6 Exclusion of set-off

Rental should be received "whole" by the lessor. All rights of set-off should be expressly excluded

2.2.7 No deductions and grossing-up

No deductions should be made by the lessee. If deductions are required by law (e.g. withholding taxes) a grossing-up provision should be included to keep the lessor protected.

2.2.8 Method and place of payment

Payment should be made in cleared funds in sterling to a bank account or by another method acceptable to the lessor.

2.2.9 Payment due on condition of equipment

An express provision should provide that rent remains payable in all circumstances: a so-called "hell and high-water" provision.

2.3 Adjustment Provisions

Adjustment provisions in finance leases (where, for example, rentals adjust with reference to changes in tax or interest rates) can be very complex. A party considering the lease as securityshould note they may cause the rentals to decrease as well as increase, thus reducing the value of the anticipated cash flow.

2.3.1 Interest variation provisions

Rentals may be fixed or float by reference to interest rates in the same way as term loans. The base rentals often assume a fixed rate so that adjustments are only required to the extent that the reference rate moves against the fixed rate. There are a number of special points:

interest variations will be calculated on the amount of capital the lessor regards as invested in the lease at any time. In a tax-based lease the profile of this "capital balance outstanding" varies according to tax liabilities and tax payment dates and rental receipts and does not parallel the amortization profile of a loan. This can mean that a floating rate lease, taken as security for a floating rate loan, will not track the amount of the secured loan obligation even though they float off the same interest rate;
in certain cases the "capital balance outstanding" may be reduced to nil before the end of the fixed period. Indeed the lessor may, for a short period, hold surplus funds. In this case special interest variation provisions are required.

2.3.2 Tax variation clauses

It is normal to have provisions allowing for variation in rentals because of changes in certain assumptions relating to the taxation treatment of the transaction. The sophistication of such provisions varies enormously depending on the size of transactions and the market in which the lessor/lessee are operating

The adjustment provisions may be included in a clause in the body of the document or in a separate schedule (often called the " Financial Schedule").

The adjustment provisions should cover the following points:

the triggers for adjustment e.g. changes in the rate of corporation tax, capital allowances, other taxation changes
whether any of the triggers are unfair or unacceptable to the lessee. The purpose of adjustment provisions is to protect the lessor. However some "carve-outs" may be appropriate if they are matters which are the lessor’s fault or within the lessor’s reasonable control.
if an adjustment is triggered what is the procedure? Often the calculation will be made by the lessor. Consider requiring a check by the lessor’s auditors or independent accountants.
what the purpose of the adjustment is i.e. to maintain a stated after or pre tax return? Is the return disclosed? Is the method used to calculate the return fixed and disclosed?
what information is to be provided to the lessee? Full disclosure is clearly desirable.
if there is to be a tax contest clause. Can the lessee challenge a disallowance or other tax problem?
how long adjustments can be made for. A cut-off period should be considered

2.4 Termination provisions

If the Primary Period ends early the lessor will not receive all the anticipated primary period rentals. It is therefore vital to identify all the situations in which early termination may occur and, in each case, look for the provisions that state how the lessor is to be paid out in that event.

There are three normal early termination situations: voluntary, total loss and default.

2.4.1 Voluntary Termination

The period of notice should be checked by the lessor. The lessor may wish to restrict the right to terminate towards the end of its financial year. The lessee should be liable to pay a termination sum.

2.4.2 Total loss

Total loss may be defined as not only total destruction of the asset, but also damage beyond economic repair and, sometimes, requisition or other compulsory loss of the asset. Depending on the equipment there may also need to be provision for a total loss of part of the equipment e.g. if 10 out of 100 containers are lost overboard.

A procedure for notifying insurers and for payment of insurance proceeds should be included in the agreement.

There should be an obligation on the lessee to pay a termination sum at a specified date. This date may be somewhat deferred to allow for receipt of insurance proceeds. If such proceeds are received they may be applied to reduce the termination sum due. However any shortfall must be the contractual liability of the lessee.

If insurance proceeds are received after the lessor has been paid out or if they exceed the termination sum, then they (or the surplus) will be rebated to the lessee.

If the termination sum does not fall due until after a rental payment date then the provision will usually stipulate for the rental payment to be paid (and the termination sum reduced accordingly), notwithstanding the goods have already become a total loss. Although possibly open to theoretical debate such provisions appear to be acceptable from a tax point of view.

Total loss may have significant credit risk implications for the lessee if the equipment is central to its business. Any deferral of the termination sum, while convenient, should therefore be considered carefully by the lessor.

2.4.3 Default

There should be a list of events of default similar to that in a loan agreement, but including acts which imperil the value of the assets leased.

Termination of a finance lease for default raises complicated issues of law relating to penalties. In summary look for the following:

a list of events which distinguish major breaches of contract from minor breaches (e.g. by including suitable grace periods for remedy); in particular a provision that time of payment of rent is to be of the essence of the contract;
language which supports the argument that the lessee has repudiated the lease
agreement if one of the events occurs;
the right for the lessor to accept the repudiation by notice (automatic termination is to be avoided);
a right to repossess the equipment;
the right to recover a termination sum as liquidated damages;
a provision which will give credit to the lessee if the lessor realises value from the repossessed equipment (see 2.4.5 below)

The main points to bear in mind are that the termination sum may be unenforceable as a penalty unless (i) the lessor can demonstrate that the lessee repudiated the lease i.e. that the breach complained of was a breach of condition and (ii) the termination sum is a genuine pre-estimate of loss and not a penalty.

2.4.4 The Termination Sum

The sum which the lessor will need to receive on an early termination for any reason will comprise:

any arrears of rent plus interest accrued on the same;
costs and expenses associated with the termination e.g. repossession, storage or insurance charges;
costs of reinstating the goods, if necessary, to the condition required by the lease (probably good working condition fair wear and tear excepted);
consequential expenses e.g. costs of breaking fixed funding or unwinding funding arrangements if relevant;
loss of future rentals: It is this head of loss which causes most problems and is most vulnerable to attack as a penalty. The lessor’s requirement is to receive a sum equal, at the date of payment, to the then present value of the future rent stream. There are at least two ways of calculating this sum which are in common use:

(a) The discount method: each rental is discounted at a specified rate from the date on which it would have fallen due to the date of payment of the termination sum. The discount rate is for agreement between the parties.

(b) The stipulated loss table: the lessor calculates a table of termination values using a method similar to that for calculating the rentals, and based on various taxation assumptions.

In each type of termination (voluntary, total loss, default) the lessor will need to receive a termination sum. Note that the problem of penalties only applies on default termination.

Certain leases, mainly designed for computer equipment, contain complicated up-grading or exchange provisions. These require very careful review. The purpose is to allow the lessee to return some or all of the old equipment (without paying a termination sum) providing the lessee at the same time enters into a fresh lease agreement for new equipment of greater value (and presumably greater performance). If the same lessor is involved in both old and new leases it is reasonably straightforward for the lessor to evaluate the financial consequences of permitting an exchange. However if the original lessor is not to be involved in the new lease the question arises how the lessor is to receive the termination sum it needs.

Various methods of providing apparent flexibility to lessees are currently and all need to be treated with caution to determine exactly what rights are conferred on each party.

2.4.5 Sales Agency

Under a finance lease, the lessee will (upon payment in full of the termination sum) have the right to act as the sales agent of the lessor in order to sell the equipment. The lessee will then be entitled to retain, by way of sales commission, a substantial part of the net sales proceeds (perhaps as much as 98%). The sale should not be to any party “connected” to the lessee.

2.5 Provisions protecting the Lessor from liabilities associated with the Equipment

2.5.1 As between the lessor and the lessee there should be a provision excluding all liability for the
condition of the equipment, implied warranties and any other obligation other than that of
giving quiet possession.

Even the quiet possession obligation needs qualification to ensure that defects in the title received by the owner from the supplier could not result in the owner being in breach of contract. It is normal for the lessee to take this risk.

This is subject to the application of the Unfair Contract Terms Act 1977 and the Supply of Goods and Services Act 1982 to the hiring or leasing of equipment (see below).

2.5.2 Claims by third parties who have suffered injury or loss by reason of the equipment cannot,
obviously, be excluded or avoided by any contract term in the lease. Instead the owner will
expect the following tiers of protection:

indemnities from the lessee covering every type of claim for every type of loss;
the benefit of third party liability insurance taken out by the lessee at its own expense; the owner, its directors and employees may require to be named as co-insured under the policy. This would be usual practice for aircraft, but is less common for other types of equipment. If the equipment appears hazardous specialist insurance advice will be needed by the owner;
provisions as to the safe and proper use of equipment.

The potential for claims against the lessor increases significantly if any maintenance or support service is provided.

2.6 Provisions protecting the interest of the Lessor in the Equipment

2.6.1 The first step is to check the purchase arrangements in order to ensure that the lessor will
obtain good title to the equipment, free of all liens charges and encumbrances. (N.B. This
assumes the lessor is to be the ultimate owner of the equipment.)

2.6.2 The lease should contain a blanket prohibition on the lessee from dealing in, altering, moving, or
neglecting the equipment or creating adverse interests over it or purporting to do so. There are,
however, certain exceptions which should be noted and which may be requested by lessees:

liens arising in the ordinary course of repair, providing they are promptly discharged;
sub-leasing: it is a commercial matter whether this is permitted and if so on what terms;
a sales agency appointment taking effect at the end of the fixed period or earlier voluntary termination will usually be granted;
alterations which are required to keep the equipment in good working order or which do not reduce its value may be permitted as may be attachments which can be removed without damage;
an obligation to keep the equipment at a fixed site is usual but must be relaxed for essential repair and, obviously, if the equipment is of its nature moveable.

2.6.3 Rights should be reserved to enable the lessor to publicise its interest in the equipment to
various third parties:

to place name-plates on the equipment (if not done at the start of the letting);
to notify mortgagees and landlords and to receive acknowledgements from such parties (this is relevant during the whole of the lease period, not just at the start);
to receive notice from the lessee of new mortgagees/landlords;
to have its interest noted on any insurance policy covering loss of or damage to the equipment and (or be named as loss payee).

2.6.4 The Lessee should be obliged to pay all outgoings relating to the equipment and/or the
premises where it is located (rent, rates, taxes etc).

2.6.5 The lessee should assume the risk of loss of or damage to the equipment. The only exception
is loss or damage resulting from the owner`s negligence. The lease should cover:

on total loss a termination sum should be due (see above).
on damage falling short of total loss the lessee should be liable to reinstate the equipment at its own expense.

The lessor will normally require the lessee to carry insurance cover (all risks) for loss or damage to the equipment. The terms of such insurance should be acceptable to the owner. The detail will depend on the nature of the equipment involved. Exceptionally the owner may be prepared to allow the lessor to "self-insure" i.e. carry the risk without back-up insurance.

Rent should be expressed to be payable during any period the equipment is unusable.

2.6.6 The lessor will require the right to repossess the equipment on default, and it is common to
provide an express right to entry on to the lessee’s premises for this purpose.

2.6.7 A right to inspect the equipment at periodic intervals should be reserved.

2.6.8 The lessee should, subject to the terms of any sales agency, be obliged to redeliver the
   equipment to the owner at the end of the letting in a stated condition (usually good working
   condition, fair wear and tear excepted): any expense incurred by the owner in putting the
   equipment into the redelivery condition should be for the account of the lessee.

Note: This article was prepared in October 2003 by Norton Rose, the international law firm and a market leader in the areas of structured and asset finance. For further information on Norton Rose, please click here www.nortonrose.com or alternatively contact Alistair MacRae (partner) in their London office (+44 207 283 6000

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LEGAL ASPECTS OF LEASING IN ENGLAND