Mr. Johnson is a professor of finance at the Graduate School of Business at Northern Illinois University. He has been a leasing adviser and educator for over 20 years. You can reach Mr. Johnson at Mark Financial Services in Elburn, Illinois. His phone number is 630-365-9004. This article appeared in Volume 7 Issue 1 of Tools and Tactics published by International Computer Negotiations, Inc. (ICN). Mr. Johnson granted us permission to use this article on our Web site because we share his viewpoint that lessees need to educate themselves on some of the unethical leases that are in the industry. If you have any questions or comments please feel free to send us an email at email@example.com.
There is a lease in use today by a handful of leasing companies that would no doubt please the Emperor in Star Wars. It truly represents the dark side of corporate finance. Once the workings of this lease are laid out and explained, the reader may be skeptical that it exists in the real world. It's easy to think this lease is illegal, unenforceable or merely the author's imagination working overtime. None of these, unfortunately, is the case.
To indelibly imprint this lease on the mind of the reader, we dub it the Death-Grip Lease. Although this may seem a bit dramatic, from the perspective of the lessee, it is the worst lease the author has seen in his twenty years of working in the leasing industry. And it has altered the career path of more than one professional who signed it.
The objectives of this article are threefold. First, the particulars of the Death-Grip Lease are described. Second, the implications and perils of its provisions are explained. Third, the importance of carefully analyzing the provisions of any lease (or avoiding lessor lease contracts altogether) is stressed.
The Essence of the Death-Grip LeaseIt is difficult to generalize about many of the aspects of equipment leasing, mainly due to its largely unregulated nature. There are few conventions, with tax law and lease accounting as notable exceptions. The same word or phrase often means something very different to professionals representing a variety of disciplines. For starters, ask a financier, an accountant, a tax professional and a lawyer what a lease is!
Because of this lack of standardization, a description of the Death-Grip Lease is necessarily generalized. Death-Grip Leases vary from lessor to lessor in their menu of particulars but they all have one features in common: their end-of-lease language. Let's highlight the end-of-lease trait of a Death-Grip Lease by first describing what happens in a "normal" lease.
A lease is normally thought of as providing the lessee with the temporary possession and use of someone else's property for a contractually agreed upon period of time. At the end of the contract term, subject to standard notification provisions, the user can do one of three things: (1) return the leased property to lessor; (2) attempt to negotiate an extension of the lease; or (3) attempt to negotiate the purchase of the property. These end-of-lease (hereafter EOL) actions have one very important feature in common: What happens at EOL is entirely up to the lessee. At EOL, the lessee has no additional financial obligations beyond returning the property (with reasonable wear and tear) unless the lessee wants to extend or buy. Let's say that again. In a standard lease, at EOL the lessee has no further financial obligation to the lessor except at the lessee's sole election.
With a Death-Grip Lease, however, the lessee's financial obligations are not concluded upon making all required payments during the lease term. In fact, a number of unsuspecting (or uninitiated) lessees only begin to realize the full implications of the Death-Grip Lease when they attempt to return the leased property at the end of the lease term.
When a Death-Grip lessee attempts to return the leased property at lease expiration, even when it does so within the prescribed notification period, it is informed that simply returning the leased property is not one of the choices. At this point in the deliberations, the lessee generally pulls out the lease contract and begins (perhaps, unfortunately, for the first time) to examine the EOL requirements of the lease (yes, requirements).
There it is ...in black and white. The contract specifies that at the end of the lease term, the lessee must make one of three elections: (1) purchase the property under lease at a mutually agreed upon price; (2) extend the lease for one year at the same lease rate; or (3) enter into a new lease for property of equal or greater value to that currently under lease.
The Cost of the Death-Grip EOL OptionsThe main thing to keep in mind about this lease is that the lessee must select one of the EOL choices - giving the leased property back is not a choice!
(2) Renewing the lease for one year. Is this a costly option? Generally, yes. If the lease is for high-technology equipment, then paying the base term rental rate for an additional year is much more than could be negotiated in advance - when the lessee is bargaining from strength. Not only is the renewal rate - which is the same as the initial term rate - higher than could be easily negotiated in advance, but the renewal term is very long. All in all, the cost of this option is a minimum of 50 percent higher than one would expect to prenegotiate in a standard lease.
(3) Negotiate a new lease for property of equal or greater value. This option permits the lessee to end the original lease if a new lease is entered into for new property. Although this may sound reasonable, the problem is that the new lease terms and conditions are not required to be the same as the original lease. Thus, this option should be read as follows: "The lessee may enter into a new lease for property of equal or greater value than the original lease at terms and conditions yet to be determined." Does this sound like the same problem as option (1) with "mutually agreeable" language? Yes. Does this mean that option (3) terms can be unreasonable or at rates higher than fair market value? Yes.
Recap of the Death-Grip LeaseThe upshot of the Death-Grip Lease is that the lessee is not finished paying for the leased property merely by making timely payments throughout the lease term. This is where the financial obligations of most leases end but it's only the end of phase one in a Death-Grip Lease. Think of the T.V. commercial that talked about the perils of putting off needed car repairs. The spokesperson said, "You can pay me now or pay me later." The new spin with the Death-Grip Lease is that "you can pay me now and pay me later". Should the lessee try to negotiate purchase of the property, the price is not required to be reasonable (and usually is not). If a new lease for new property is negotiated, the terms and conditions are generally much less favorable than the first lease (ignoring the very unreasonable EOL options). Thus, the minimum one should expect to pay as a penalty in this lease is an extra year's rent. Further, even if rent is paid for an additional year, it is not clear that the lessee can then walk away - the lessee may be caught in a perpetual do-loop. Remember, the one thing the lessee cannot do is simply return the property at EOL.
How to Avoid Death-Grip LeasesThe existence of this lease, more than any other, is motivation enough to carefully read any lease agreement before signing it. Unfortunately, finance and legal personnel cannot always be depended upon to catch such language if they are not experienced in leasing transactions. Many types of contracting have their own subtleties. Leasing is no exception. Thus, the burden often falls upon the equipment user who must assess the business purposes behind the asset acquisition and determine which provisions need renegotiation.
What else can be done? The lessee can, in concert with other personnel, attempt to pre-negotiate general lease terms and conditions with several major lessors before there is any deal on the table. Since there is no time urgency, it is difficult for a lessor to get the upper hand using this method. Alternatively, the lessee's firm can develop its own form lease documents and pre-negotiate terms and conditions with a number of lessors using the lessee contract as the starting point. Either of these strategies helps the lessee get better control of the deal. This will pay dividends in many transactions over time, and free up valuable time formerly spent wading through contractual land mines.
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February 27, 2006