This article discusses a unique issue and an additional credit risk related to usage-based leases and loans, more particularly in transactions with state and local governmental entities (collectively referred to as “SLGs” and singularly, as an “SLG”) when such entities must obtain various approvals to appropriate funds necessary to fulfill its obligations under a lease or loan.
Banks and commercial finance companies (collectively referred to herein as “lenders” and singularly as a “lender”) active in the equipment finance industry routinely extend financing to SLGs that use tax generated, governmental funds for lease payments. When documenting these types of transactions, a lender often will require the SLG to execute a municipal addendum, which outlines the SLG’s unique payment obligations to the lender. In executing the municipal addendum, the SLG acknowledges a number of items that include, but may not be limited to: (a) the availability of funds to repay obligations for the current fiscal year, as well as the reasonable belief that such funds will continue to be available throughout the duration of the finance term; (b) the essential use of the equipment to facilitate the SLG’s operation and ability to properly function; (c) the SLG’s compliance with any and all applicable bidding and signature requirements; and (d) compliance with a designated notice period and termination in the event funds fail to be appropriated by the SLG for a subsequent fiscal year.
In addition to the municipal addendum, many lenders also require an opinion of counsel letter from the SLG’s attorney. This letter serves to confirm the validity and enforceability of the transaction with the SLG along with express confirmation of salient terms. Of particular importance, the opinion of counsel letter contains a representation from counsel that the SLG has no authority (statutory or otherwise) to terminate the transaction prior to the end of its term for any reason other than the non-appropriation of funds.
Most transactions financed are structured with a fixed monthly payment (plus taxes, if applicable) because the SLG is only permitted to remit the amount of funds approved (i.e., appropriated) by its governing board. In some instances, if the lender extends financing for certain equipment, such as copiers or X-ray machines, the transaction may be structured with a usage-based billing component. In a usage-based structure, the SLG contractually agrees to remit a combined payment comprised of (i) the equipment rental with a specified threshold number of allotted copies or images processed on the equipment for the month (the “Base Monthly Amount”), plus (ii) a variable amount for copies or images processed on the equipment in excess of the predetermined allotment. With this type of arrangement, the SLG is free to process as many copies or images as it desires each month, but will be billed for each copy or image in excess of the Base Monthly Amount. Any additional overage charges are included on the monthly invoice. There is no cap on the amount that can be billed for such excess usage, and the funds collected for the excess usage are passed on to the equipment vendor. Consequently, the SLG may be required to remit funds greater than the fixed monthly payment because of copies or images processed in excess of the contractually permitted allotment.
This common, usage-based structure thus may present a unique problem for an SLG and its lender since the SLG can only agree to remit a designated amount of funds during each fiscal year in connection with the transaction. If the SLG agrees to a five-year term with a fixed payment plus potential overage charges, the lender assumes a risk that the SLG will “over use” the equipment and accumulate enough overage charges that all funds appropriated for the equipment financing are expended prior to the conclusion of the fiscal year. For example, what if a lender extends five-year financing for equipment subject to usage-based billing and the SLG exhausts all appropriated funds six months into year three due to overage charges? The lender assumes the risk of both credit and non-appropriation when financing these types of SLG transactions, but the aforementioned scenario is not what most lenders consider to be the standard non-appropriation risk. In the absence of an express agreement between the vendor and lender to account for the additional risk of non-appropriation, the lender may face a loss upon return of the equipment, particularly if returned prior to the scheduled maturity date. Although most municipal addenda provide for non-appropriation of funds only at the termination of a fiscal year, an attempt by the lender to enforce payment obligations for the duration of the fiscal year in which overages prematurely exhaust all of the SLG’s funds could be met with resistance or refusal by the vendor depending upon the contractual arrangements between the lender and vendor. Non-appropriation may be uncommon; however, the possibility of an occurrence increases when financing a transaction pursuant to a usage-based billing structure. Such additional risk should be considered by credit underwriters when they first analyze the transaction. Ideally, the SLG would have additional funds appropriated as insurance in the event that usage exceeds the monthly payment.
The lender could undertake an alternative approach to protect itself from the additional risk occasioned by usage-based transactions with SLGs. The lender may want to consider incorporating an indemnification or recourse clause into its agreement with the vendor to address the problems created by the usage-based transaction or require a separate transaction-specific indemnification or recourse agreement in order to ensure protection when financing usage-based transactions that are subject to non-appropriation.
A usage-based transaction creates additional risk for a lender when it has to consider the risk of non-appropriation by an SLG. As such, the lender should be keenly aware of all such risks when it negotiates the pricing and documents the transaction in order to avoid the risk of losing money in the transaction.
Banks and commercial finance companies (collectively referred to herein as “lenders” and singularly as a “lender”) active in the equipment finance industry routinely extend financing to SLGs that use tax generated, governmental funds for lease payments. When documenting these types of transactions, a lender often will require the SLG to execute a municipal addendum, which outlines the SLG’s unique payment obligations to the lender. In executing the municipal addendum, the SLG acknowledges a number of items that include, but may not be limited to: (a) the availability of funds to repay obligations for the current fiscal year, as well as the reasonable belief that such funds will continue to be available throughout the duration of the finance term; (b) the essential use of the equipment to facilitate the SLG’s operation and ability to properly function; (c) the SLG’s compliance with any and all applicable bidding and signature requirements; and (d) compliance with a designated notice period and termination in the event funds fail to be appropriated by the SLG for a subsequent fiscal year.
In addition to the municipal addendum, many lenders also require an opinion of counsel letter from the SLG’s attorney. This letter serves to confirm the validity and enforceability of the transaction with the SLG along with express confirmation of salient terms. Of particular importance, the opinion of counsel letter contains a representation from counsel that the SLG has no authority (statutory or otherwise) to terminate the transaction prior to the end of its term for any reason other than the non-appropriation of funds.
Beware the risks of these usage-based leases and loans.
Most transactions financed are structured with a fixed monthly payment (plus taxes, if applicable) because the SLG is only permitted to remit the amount of funds approved (i.e., appropriated) by its governing board. In some instances, if the lender extends financing for certain equipment, such as copiers or X-ray machines, the transaction may be structured with a usage-based billing component. In a usage-based structure, the SLG contractually agrees to remit a combined payment comprised of (i) the equipment rental with a specified threshold number of allotted copies or images processed on the equipment for the month (the “Base Monthly Amount”), plus (ii) a variable amount for copies or images processed on the equipment in excess of the predetermined allotment. With this type of arrangement, the SLG is free to process as many copies or images as it desires each month, but will be billed for each copy or image in excess of the Base Monthly Amount. Any additional overage charges are included on the monthly invoice. There is no cap on the amount that can be billed for such excess usage, and the funds collected for the excess usage are passed on to the equipment vendor. Consequently, the SLG may be required to remit funds greater than the fixed monthly payment because of copies or images processed in excess of the contractually permitted allotment.
This common, usage-based structure thus may present a unique problem for an SLG and its lender since the SLG can only agree to remit a designated amount of funds during each fiscal year in connection with the transaction. If the SLG agrees to a five-year term with a fixed payment plus potential overage charges, the lender assumes a risk that the SLG will “over use” the equipment and accumulate enough overage charges that all funds appropriated for the equipment financing are expended prior to the conclusion of the fiscal year. For example, what if a lender extends five-year financing for equipment subject to usage-based billing and the SLG exhausts all appropriated funds six months into year three due to overage charges? The lender assumes the risk of both credit and non-appropriation when financing these types of SLG transactions, but the aforementioned scenario is not what most lenders consider to be the standard non-appropriation risk. In the absence of an express agreement between the vendor and lender to account for the additional risk of non-appropriation, the lender may face a loss upon return of the equipment, particularly if returned prior to the scheduled maturity date. Although most municipal addenda provide for non-appropriation of funds only at the termination of a fiscal year, an attempt by the lender to enforce payment obligations for the duration of the fiscal year in which overages prematurely exhaust all of the SLG’s funds could be met with resistance or refusal by the vendor depending upon the contractual arrangements between the lender and vendor. Non-appropriation may be uncommon; however, the possibility of an occurrence increases when financing a transaction pursuant to a usage-based billing structure. Such additional risk should be considered by credit underwriters when they first analyze the transaction. Ideally, the SLG would have additional funds appropriated as insurance in the event that usage exceeds the monthly payment.
The lender could undertake an alternative approach to protect itself from the additional risk occasioned by usage-based transactions with SLGs. The lender may want to consider incorporating an indemnification or recourse clause into its agreement with the vendor to address the problems created by the usage-based transaction or require a separate transaction-specific indemnification or recourse agreement in order to ensure protection when financing usage-based transactions that are subject to non-appropriation.
A usage-based transaction creates additional risk for a lender when it has to consider the risk of non-appropriation by an SLG. As such, the lender should be keenly aware of all such risks when it negotiates the pricing and documents the transaction in order to avoid the risk of losing money in the transaction.
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LEGAL RESOURCES
Leasing Law
Column
2018