Destination: BLJOct2004

10/28/04 Buffalo Law Journal: Third party can complicate terms of finance leases

Third party can complicate terms of finance leases

Article 2-A of the UCC: Limited Defenses to Lessees Under "Hell or High Water" Leases

When Article 2A of the Uniform Commercial Code ("UCC") was promulgated in 1987, it was the first addition to the UCC since its promulgation in 1951 (and enactment in New York in 1963). Article 2A confines itself to leasing of personal property transactions. The Drafters of Article 2A did not have the benefit of much legal precedent in structuring the rules of leasing transactions and basically modeled it after Article 2 (its big brother). Financing acquisitions of capital goods through the vehicle of leasing is a relatively recent phenomenon but has increased in use and has become an effective financing tool. Yet there are issues that one should be aware when attempting such financing.

A financing lease is a lease in which the lessor does not supply the goods that are leased. The lessor acts instead as the financier for the acquisition of the goods. Under Article 2A (as revised in 1990 and amended in 2003), a lease qualifies as a finance lease if the lessor provides a statement of the terms of the supply contract or notifies the lessee where the information may be obtained from the supplier, as well as providing the supply contract itself. The expectation is that the lessor will pay the supplier the purchase price for the leased goods.

There are certain terms in the typical finance lease with which the lessor and lessee should be familiar because their consequences can be devastating. Section 2-A-407 of the UCC provides the benefits of the classic "hell or high water" term to non-consumer finance leases, which term, as recent case law demonstrates, could have a significant impact on remedies provided.

For finance leases, 2-A-207 makes a lessee’s promise to pay rent "irrevocable and independent" after the lessee has accepted the goods. The lessor’s role is essentially limited to obtaining the goods (by payment or the promise thereof) for the supplier. "Finance lease" contemplates a three party relationship where the lessee generally looks to the supplier (not the lessor) to perform the essential covenants and warranties. As a result, when lessee accepts the goods, then the lessee’s promise to pay the lessor (not the supplier) is rendered "irrevocable and independent," a promise, no matter how harsh the consequences, courts are willing to enforce, come "hell or high water."

Canon Financial Services, Inc. v. Medico Stationary, Inc., (300 A.D.2d 66, 751 N.Y.S.2d 194 [1st Dep’t Dec. 10, 2002]), illustrates an example of the possible incestuous enforceability of a hell or high water clause. In Canon, the Appellate Division found that the lease in question was a finance lease under section 2-A-103(1)(g). The First Department rejected defendant lessee’s argument that the hell or high water clause should be unenforceable because the lessor and supplier were wholly owned subsidiaries of the manufacturer. The court also rejected defendant lessee’s argument that "the 10-day period, measured from delivery, that they had under the lease to give written notice of rejection and thereby avoid the ‘hell or high water’ clause (UCC 2-A-407) was unreasonable." The court found these argument unavailing and enforced the hell or high water clause despite the close relationship between the lessor and supplier.

Because section 2-A-407 does not apply to consumer leases, a consumer is free to argue that he or she has a right to set off against the rent owed any damages as a result goods provided pursuant to a finance lease. In addition, the consumer is free to argue that the lease should be canceled due to breaches of warranties. Such arguments not available on a commercial lease. Nevertheless, there is nothing to prevent the lessor from including "hell or high water" provisions in the leases with consumers. Unless the provision is held to be unenforceable due to, for example, unconscionability pursuant to section 2-A-108, the consumer protection offered by section 2-A-402 can be eviscerated.

A string of recently decided cases involving Wells Fargo demonstrates the enforceability of (or, possibly, the lack thereof) hell or high water provisions. In Rhythm & Hues, Inc. v. The Terminal Marketing Company, Inc., (No. 01 CIV 4697 (AGS), 2002 WL 1343759 [S.D.N.Y. June 19, 2002]), the District Court questioned the enforceability of the hell or high water clause despite the merger clause contained in the lease. Indeed, the court looked to other contemporaneous documents to explore the true intent of the parties. Rhythm & Hues, Inc. ("R&H"), a film production studio, required various pieces of highly technical equipment from various suppliers. The parties disputed whether the assistance of Terminal Marketing Company ("Terminal") in financing R&H’s purchase of the equipment was a financing lease or a line of credit. Complicating the analysis was Terminal’s assignment of the purported leases to Well Fargo, which brought this action seeking damages for R&H’s non-payment of rent.

Wells Fargo argued that "[a]ccording to both leases, the ‘assignee’s rights or the rights of the holder of a security interest in this lease shall be free from all defenses, setoffs or counterclaims which lessee may be entitled to assert.’" To determine whether the instrument was a hell or high water lease, Wells Fargo argued that the District Court need only consider the express language of the lease. The court found, however, that the lease documents were not the only documents construing the agreements. "R&H argues that documents signed around the time of Lease No. 3855 reveal that the purported lease document was undertaken in the context of a line of credit." Judge Schwartz denied Wells Fargo summary judgment because the various documents purporting to constitute the lease were ambiguous.

Regarding the other lease at issue, Lease No. 3989, summary judgment was defeated by R&H’s allegations of fraud in the inducement by Terminal. Lease No. 3989 also stated that "assignee’s rights or the rights of the holder of a security interest in this lease shall be free from all defenses, setoffs or counterclaims which lessee may be entitled to assert." However, R&H was permitted to conduct additional discovery to determine whether "Wells Fargo was complicit in any fraud," because such complicity would invalidate the "hell or high water" clause of Lease No. 3989. Therefore, despite the strong merger clause of the two leases at issue and the express language constituting a hell or high water clause, the District Court was unwilling to enforce the terms without further discovery.

In Wells Fargo Bank Minnesota N.A. v. Nassau Broadcasting Partners, L.P.( No. 01 CIV 11255(HB), 2003 WL 22339299 [S.D.N.Y. Oct. 10, 2003]), the District Court found that the assignment was valid and the hell or high water clause, enforceable. Nassau, a radio operator, entered into a leaseback agreement with Terminal (same entity as in Rhythm & Hues) where Nassau purchased over $621,000.00 worth of equipment and Terminal would then purchase that same equipment from Nassau for what Nassau paid and would lease it back to Nassau. The problem was that Terminal paid Nassau $100,000 but not the full amount of the equipment’s purchase price. Terminal, as in Rhythm & Hues, assigned the lease to Wells Fargo, which demanded that Nassau pay the monthly rental price to Wells Fargo. When Nassau refused because Terminal failed to pay Nassau the full purchase price as promised, Wells Fargo sued. The District Court found that to relieve Nassau of its obligations to pay rent would require the court to rewrite the agreement. A hell or high water clause, "[a]n unconditional agreement in a non-consumer lease to pay rent on equipment[,] is ordinarily enforceable even if such term is harsh and one-sided."

Confirming lessor’s reliance on hell or high water clauses, the District Court in Wells Fargo Bank Northwest, N.A. v. TACA International Airlines, S.A. and JHM Cargo Express, S.A.(247 F. Supp. 2d 352 [S.D.N.Y. 2002]) ("TACA I"), the court ruled that the hell or high water clause in a lease with unequivocal disclaimer of representations was enforceable notwithstanding misrepresentations made by lessor. The court in TACA I refused to give effect to a letter agreement entered into between the lessor and lessee after the lease was signed, which letter agreement, lessee argued, modified the terms of the lease. Finding the letter agreement did not modify the provisions of the hell or high water clause, the District Court in the companion case, Wells Fargo Bank Northwest, N.A. v. TACA International Airlines, S.A. and JHM Cargo Express, S.A. (No. 01 CIV 11484 (GEL), 2003 WL 21180415 [S.D.N.Y. May 20, 2003]) ("TACA II"), permitted enforcement of a liquidated damages formula. After calculation, the present value of the remaining rent due, however, exceeded the fair market rental value determined, as provided in the lease, by an appraiser chosen by the lessor. The damage was therefore limited to such appraisal. In TACA II the court granted Wells Fargo’s summary judgment motion on damages for $31,084,462.00.

In Andin International, Inc. v. Matrix Funding Corporation, (194 Misc.2d 719, 756 N.Y.S.2d 724 [Sup. Ct. N.Y. Co. Feb. 10, 2003]), the Supreme Court applied New York law to a lease stated to be governed by Utah law, which, if Utah law applied to the terms of the lease, would have violated fundamental public policy of New York. In Andin, the court ruled that the lessor violated New York General Obligations Law, section 5-901, which requires the lessor to provides notice to the lessee to remind the lessee that the lease will renew unless the lessee provide notice of termination. The lessor’s motion to have the lessee’s complaint dismissed was denied. The court found that the lessor failed to abide by section 5-901 and that, even if the court were to apply Utah law, the lease agreement would most likely be unenforceable due to unconscionability as one-sided for the lessor, which could unilaterally set the price lessee would have to pay to terminate the lease.