THE LESSEE’S ACCEPTANCE OF EQUIPMENT is not merely a documentation formality from your Legal Department. It is a critical step to achieving “hell or high water” treatment (i.e., when the lessee’s obligations under a lease become absolute and unconditional irrespective of any equipment or service issues). This article will explore the key aspects of equipment acceptance and several options available to lessors.
Under the Uniform Commercial Code (“UCC”) (UCC Section 2A-407), “hell or high water” treatment for UCC 2A commercial leases is triggered by the lessee’s acceptance of the equipment following delivery and a reasonable opportunity to inspect the equipment. Knowing when the applicable equipment has been accepted and the ability to demonstrate this for a court is important. Acceptance is also important because it confirms that the equipment, which represents collateral and potentially residual value for the lessor, has been delivered in good condition.
Template lease forms typically require that the lessee agree to sign and return to the lessor a delivery and acceptance certificate (“D&A”) following delivery. Lessors generally will not provide funding until the signed D&A is received by the lessor.
This seems straightforward. However, a number of issues are becoming more common in the industry. One issue is that lessees are not always quick to sign and return D&A’s. Some (possibly many) small ticket lessors seek to avoid the delay by including a D&A on the face of the lease. When the lessee signs the lease, it may also be asked to sign the D&A at the same time. If the equipment has been delivered and is “plug and play,” this may well be an acceptable time period in which to inspect and accept the equipment. In many cases, however, the equipment will not have been delivered at lease signing and therefore the lessee will not have had a reasonable (or possibly any) opportunity to inspect the equipment. A lessor then runs the risk that a court will view the acceptance as not meaningful and not effective under the circumstances. To address this, once the equipment has been delivered and a reasonable inspection period has elapsed, a prudent lessor will either request a follow-up signed D&A or conduct a telephone verification call confirming lessee acceptance.
Another issue is that in some industry segments vendors desire to accelerate their recognition of sales revenue rather than waiting for the equipment to be accepted, and in some cases they want this recognition to occur before the equipment has even been delivered. Such vendors prefer to “finalize” the sale at a point prior to lessee acceptance by requiring the lessor to unconditionally commit to the vendor that it will fund at such point. This is often motivated by the need to meet monthly, quarterly or yearly financial targets, especially in publicly traded entities. The scope of this article is not intended to encompass such accounting issues. However, suffice it to say that the real issue is not that the industry standard practice of waiting for a D&A prior to funding will PREVENT revenue recognition by the vendor. Instead the issue is that this industry practice will simply DELAY revenue recognition until acceptance has actually occurred.
The rationale for hell or high water treatment is that a finance lessor is merely providing funding for the equipment without being involved with the equipment’s manufacturing, performance, servicing or selection, and that the lessee has received the equipment and has had reasonable opportunity to inspect and accept it. Thereafter, by signing the D&A and authorizing the lessor to fund the vendor, the lessee is acknowledging and agreeing that it is fully and unconditionally obligated for all of its obligations under the lease.
What happens when a vendor asks a lessor to “jump the gun” and fund prior to receipt of a D&A? Many (possibly most) lessors will simply say “no” given the importance under the UCC of acceptance with regards to hell or high water treatment. However, there are several approaches that some lessors are willing to use for the right vendors and end-users.
One approach is for a lessor to accept “deemed acceptance” in lieu of express acceptance via a D&A, especially in the small ticket context. Under this approach, the lease provides the lessee with a specified number of days after delivery to inspect and implicitly accept the equipment. If the lessee has not expressly notified the lessor of any issues within such period, the lessee agrees up front in the lease that it shall be deemed to have accepted the equipment for all purposes under the lease. A prudent lessor will likely ask for vendor repurchase in the event that the lessee raises any equipment issues within some identified period of time. However, if the prime motivation for the vendor is to be able to achieve revenue recognition at such deemed acceptance point rather than merely access to cash, this approach probably will not achieve the vendor’s goals. Such a repurchase obligation would likely delay the vendor’s revenue recognition until the specified repurchase period has expired.
Another approach is for the lessor to forego acceptance and have the lessee pre-authorize the lessor to fund the purchase price of the equipment at some point prior to lessee’s acceptance or possibly even delivery. The lessee in this case will effectively already have agreed via the lease that it will be fully obligated for all lease payments (and also that, as between lessor and lessee, risk of loss will have passed to the lessee) even if the equipment is defective, not timely delivered or even never delivered. Note that this is distinct from the “deemed acceptance” approach described above in that the funding occurs, and the lease begins, without any acceptance whatsoever, be it deemed or actual. Many end-user lessees may not be willing to agree to this precisely because they do not want to be unconditionally obligated unless and until the equipment has been delivered and they have had the chance to fully “kick the tires.” However, in many respects, this approach is not fundamentally different from a loan structure where the obligor agrees to be fully obligated as soon as the loan closes. As long as the lease language is abundantly clear and unambiguous, and the lessee agrees to it by signing the lease, this should not be viewed as fundamentally unfair to the lessee under general freedom to contract principles. It is important to note, however, that the lessor would then be relying on the contractual language in the lease rather than the UCC’s hell or high water provisions.
Many lessors who utilize this “pre-authorization” approach also require vendor repurchase for some agreed upon period in the event that the lessee makes any claims relating to delivery and acceptance of the equipment. Again, though, this would likely raise the revenue recognition considerations described above for the vendor.
It is worth noting that for any of the above alternate approaches, the lessor’s risk should be self-mitigating at some point. For instance, following some period of months after the lease has commenced, the lessee will have used (and made payments for) the equipment for so long that it will be viewed as functionally having accepted same. Consider, in such a case, how much sympathy a court might have for a lessee seeking to assert that it did not accept the equipment after using and paying for it for many months or even years.
Given the significance of acceptance under the UCC, D&As are a standard requirement in the industry. The above alternate approaches clearly entail heightened lessor risk and thus should only be considered for vendors and end-users with strong risk profiles. Many conservative lessors may struggle with accepting this additional risk.
Under the Uniform Commercial Code (“UCC”) (UCC Section 2A-407), “hell or high water” treatment for UCC 2A commercial leases is triggered by the lessee’s acceptance of the equipment following delivery and a reasonable opportunity to inspect the equipment. Knowing when the applicable equipment has been accepted and the ability to demonstrate this for a court is important. Acceptance is also important because it confirms that the equipment, which represents collateral and potentially residual value for the lessor, has been delivered in good condition.
Template lease forms typically require that the lessee agree to sign and return to the lessor a delivery and acceptance certificate (“D&A”) following delivery. Lessors generally will not provide funding until the signed D&A is received by the lessor.
This seems straightforward. However, a number of issues are becoming more common in the industry. One issue is that lessees are not always quick to sign and return D&A’s. Some (possibly many) small ticket lessors seek to avoid the delay by including a D&A on the face of the lease. When the lessee signs the lease, it may also be asked to sign the D&A at the same time. If the equipment has been delivered and is “plug and play,” this may well be an acceptable time period in which to inspect and accept the equipment. In many cases, however, the equipment will not have been delivered at lease signing and therefore the lessee will not have had a reasonable (or possibly any) opportunity to inspect the equipment. A lessor then runs the risk that a court will view the acceptance as not meaningful and not effective under the circumstances. To address this, once the equipment has been delivered and a reasonable inspection period has elapsed, a prudent lessor will either request a follow-up signed D&A or conduct a telephone verification call confirming lessee acceptance.
Another issue is that in some industry segments vendors desire to accelerate their recognition of sales revenue rather than waiting for the equipment to be accepted, and in some cases they want this recognition to occur before the equipment has even been delivered. Such vendors prefer to “finalize” the sale at a point prior to lessee acceptance by requiring the lessor to unconditionally commit to the vendor that it will fund at such point. This is often motivated by the need to meet monthly, quarterly or yearly financial targets, especially in publicly traded entities. The scope of this article is not intended to encompass such accounting issues. However, suffice it to say that the real issue is not that the industry standard practice of waiting for a D&A prior to funding will PREVENT revenue recognition by the vendor. Instead the issue is that this industry practice will simply DELAY revenue recognition until acceptance has actually occurred.
The rationale for hell or high water treatment is that a finance lessor is merely providing funding for the equipment without being involved with the equipment’s manufacturing, performance, servicing or selection, and that the lessee has received the equipment and has had reasonable opportunity to inspect and accept it. Thereafter, by signing the D&A and authorizing the lessor to fund the vendor, the lessee is acknowledging and agreeing that it is fully and unconditionally obligated for all of its obligations under the lease.
What happens when a vendor asks a lessor to “jump the gun” and fund prior to receipt of a D&A? Many (possibly most) lessors will simply say “no” given the importance under the UCC of acceptance with regards to hell or high water treatment. However, there are several approaches that some lessors are willing to use for the right vendors and end-users.
One approach is for a lessor to accept “deemed acceptance” in lieu of express acceptance via a D&A, especially in the small ticket context. Under this approach, the lease provides the lessee with a specified number of days after delivery to inspect and implicitly accept the equipment. If the lessee has not expressly notified the lessor of any issues within such period, the lessee agrees up front in the lease that it shall be deemed to have accepted the equipment for all purposes under the lease. A prudent lessor will likely ask for vendor repurchase in the event that the lessee raises any equipment issues within some identified period of time. However, if the prime motivation for the vendor is to be able to achieve revenue recognition at such deemed acceptance point rather than merely access to cash, this approach probably will not achieve the vendor’s goals. Such a repurchase obligation would likely delay the vendor’s revenue recognition until the specified repurchase period has expired.
Another approach is for the lessor to forego acceptance and have the lessee pre-authorize the lessor to fund the purchase price of the equipment at some point prior to lessee’s acceptance or possibly even delivery. The lessee in this case will effectively already have agreed via the lease that it will be fully obligated for all lease payments (and also that, as between lessor and lessee, risk of loss will have passed to the lessee) even if the equipment is defective, not timely delivered or even never delivered. Note that this is distinct from the “deemed acceptance” approach described above in that the funding occurs, and the lease begins, without any acceptance whatsoever, be it deemed or actual. Many end-user lessees may not be willing to agree to this precisely because they do not want to be unconditionally obligated unless and until the equipment has been delivered and they have had the chance to fully “kick the tires.” However, in many respects, this approach is not fundamentally different from a loan structure where the obligor agrees to be fully obligated as soon as the loan closes. As long as the lease language is abundantly clear and unambiguous, and the lessee agrees to it by signing the lease, this should not be viewed as fundamentally unfair to the lessee under general freedom to contract principles. It is important to note, however, that the lessor would then be relying on the contractual language in the lease rather than the UCC’s hell or high water provisions.
Many lessors who utilize this “pre-authorization” approach also require vendor repurchase for some agreed upon period in the event that the lessee makes any claims relating to delivery and acceptance of the equipment. Again, though, this would likely raise the revenue recognition considerations described above for the vendor.
It is worth noting that for any of the above alternate approaches, the lessor’s risk should be self-mitigating at some point. For instance, following some period of months after the lease has commenced, the lessee will have used (and made payments for) the equipment for so long that it will be viewed as functionally having accepted same. Consider, in such a case, how much sympathy a court might have for a lessee seeking to assert that it did not accept the equipment after using and paying for it for many months or even years.
Given the significance of acceptance under the UCC, D&As are a standard requirement in the industry. The above alternate approaches clearly entail heightened lessor risk and thus should only be considered for vendors and end-users with strong risk profiles. Many conservative lessors may struggle with accepting this additional risk.
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2020