Leased or Fleeced?

The invisible side of Leasing

The North American equipment leasing market exceeds $250 billion in annual sales. Canada contributes $60 billion of this rapidly expanding total. Hundreds of leasing transactions are finalized daily, featuring a multitude of rates, terms, conditions and transactional structures. Interestingly, in spite of the profound impact that such financing has, few managers fully understand all of the aspects and implications of a lease contract.

Consequently, thousands of dollars are lost or unnecessarily pass into the hands of lessors due to overpayments, missed cut-off dates, or incorrect tax classifications, to name a few. A lessor who does not fully disclose pertinent information, or manipulates a transaction, can do so with a high degree of skill. Takeovers or mergers encumber the acquiring party with predecessor lease contracts and in instances where downsizing or reengineering affects institutions or companies, it is much easier for items to "fall through the cracks."

The onus is on the lessee to represent its best interests in each lease contract, as it is the lessor's mandate to maximize profits. Lease agreements can be tricky, complex and difficult to understand, and allowing a lessor control of the contract virtually assures the lessee a less-than-optimum deal.

When it comes to today's lease consultants proposing opinions to lessees, it is significant to note that they are most likely biased in their advice, in that either the equipment vendor or leasing company remunerates them.

Just when you thought it was safe to go back into the water, the foregoing might lead you to conclude that there are sharks circling in the pools of lease finance. In fact, the Wall Street Journal devoted a front-page article describing the unknown and hidden side of leasing. The story pointed to the widespread jeopardy of leasing, and the fact that it was not just the little guy that was being bitten, but major U.S. and Canadian corporations too.

So, what's so complex about leasing? After all, the definition of leasing isn't so difficult: the lessor provides the equipment for use by the lessee, while the lessee agrees to pay a specific series of payments over a set term. Lessees have two basic types of leases from which to choose: capital and operating. A capital lease (akin to a conditional sales contract) is when the lessee will own the equipment at end of term with the last payment or nominal payment (usually $1 or $10). An operating lease is signed when the equipment ownership issue is unclear, or if the lessee is intent on returning the equipment at the end of the lease term. In this case, a future value ("residual") is structured into the contract. If ownership is unsure, or if the lessee considers upgrades prior to the end of lease term, an operating lease with a capped residual of a certain percentage of the equipment cost should be used.

In operating leases the fun begins where the residual is designated as "fair market value" (FMV). FMV is commonly taken to mean what a "willing buyer" would pay a "willing seller" in a normal marketplace. But in the world of leasing, without written evidence to the contrary, FMV means whatever the lessor wants it to mean. FMV could be "far more vague" than is in the lessee's best interests, and therefore the lessee now becomes "far more vulnerable." Considering the multitude of delights upon which a leasing shark may feast, the FMV issue is probably number-one. Lessors grant themselves the opportunity to make up for the apparent low rates offered at the beginning with the FMV end of term buy-out.

If the residual is capped, there can be no dispute about the payment due at lease end. In this respect, the lessee may pay a slightly higher monthly rate, with the comfort of knowing that there will be no surprises at the end of the lease. Consider this example: Leased equipment became integral to a client's operation, unlikely to be sent back following the last payment. The original purchase price of the equipment was $380,000. It was agreed that the funder was to receive four, annual payments in advance of $111,000, over a period of 48 months to a FMV end. The interest rate was quoted at 10.5%.

In a case where a capital or capped operating lease should have been written, the client was either led into an FMV lease or not given full disclosure of the end-of-term options available. At lease end, the lessor requested a FMV buy-out of $ 116,000, for which the lessee was duly and legally bound to pay if they wanted to keep the equipment. Had this payment been made in full, the interest rate for this lease would have more than doubled to approximately 23%!

In another FMV example, a company had leased $1.5 million worth of computer equipment, which it decided to keep nearing lease end. Over the phone, the vice-president of finance was told by the leasing company salesperson that at the end of the lease the buyout would cost up to about $200,000. But as the lease approached expiration, the leasing company pointed to language in the written contract saying the price had to be "mutually agreeable." Then the lessor issued an invoice agreeable to the leasing company for $500,000.

When cases like this go to court, the leasing company, supported by a written contract, invariably wins. Unfortunately, stories of this nature are commonplace. So, in the face of all of this, what is a CFO, controller or a purchasing manager supposed to do? The following serves as useful guidelines in helping managers confronted with leasing challenges:

* A capital lease is the choice if you want to own the asset at lease end.

* Weigh all of your options before signing an FMV agreement. "Cap" the residual in writing if you are not absolutely sure.

* If you plan on writing off the payments, make sure that the contract still satisfies the technical requirements of a true operating lease.

* Are there any other end-of-term obligations or exposures such as automatic renewal?

* Make monthly payments only. If you prefer to pay quarterly or annually, obtain written verification that the payment structure is properly reflected in the interest rate.

* Demand to know the interest rate in writing. Can you confirm the true interest rate? Variables that must be taken into consideration include advance payments, security deposits and residuals.

* Do some checking to ensure that the rate is the best that's available to you.

* If you have given a security deposit, will you be getting it back?

* Check the vendor's invoice against the leasing company's. Make sure that no "extras" have been added. (For example, insurance that you are already paying)

* Ensure that you have actually received all the equipment you are paying for.

* Detailed copies of each and every document that pertains to the deal should be on your premises.

* Know and manage each and every option and/or notification date. An accountability tracking system will manage your leases if you do not have a system of your own.

* Have you received full and honest disclosure?

* Get everything in writing!

Not all leasing companies are the same -- differences in priority and responsibility exist between lessors and lessees. As the economy evolves, and trends such as cost cutting and consolidation continue, efficient cash management and control continue to gain importance. And where leasing is concerned, there should be no surprises.

Ty Bakti is the president of Nettec, a lease management and audit firm.