Financial Leasing in the Context of Uniform Commercial Code of the United States - Essay Example

? Financial Leasing in the Context of Uniform Commercial of the United s Table of Contents Table of Contents Introduction 2 The Uniform Commercial Code of the United States 6 The Worldwide Economic Meltdown of 2000 8 Title 2A as a means to prevent another economic meltdown 11 Conclusion 13 Bibliography 17 Introduction Financial Leasing also called Capital Leasing is a purchasing strategy normally employed to acquire assets that allow purchasing organizations or parties to spread the cost of acquisition in the form of rental thereby expensing it at the onset. Although considered as an actual sale in normal accounting standards ownership of the asset in question is held by the lessor until the end of the term of the Financial Lease. Financial Leasing allows the lessee to reap the benefits of owning the asset by utilizing or maximizing its economic benefits within its viable and useful life1. Under the Uniform Commercial Code of the United States Financial Lease is a lease with respect to: (i) The lessor does not select, manufacture, or supply the goods; (ii) The lessor acquires the goods or the right to possession and use of the goods in connection with the lease; and of the following occurs: a. The lessee receives a copy of the contract by which the lessor acquired the goods or the right to possession and use of the goods before signing the lease contract; b. The lessee’s approval of the contract by which the lessor acquired the goods or the right to possession and use of the goods is a condition to effectiveness of the lease contract; c. The lessee, before signing the lease contract, receives an accurate and complete statement designating the promises and warranties, and any disclaimers of warranties, limitations or modifications of remedies, or liquidated damages, including those of a third party, such as the manufacture of the goods, provided to the lessor by the person supplying the goods in connection with or as part of the contract by which the lessor acquired the goods or the right to possession and use of the goods; or d.  if the lease is not a consumer lease, the lessor, before the lessee signs the lease contract, informs the lessee in writing (a) of the identity of the person supplying the goods to the lessor, unless the lessee has selected that person and directed the lessor to acquire the goods or the right to possession and use of the goods from that person, (b) that the lessee is entitled under this Article to the promises and warranties, including those of any third party, provided to the lessor by the person supplying the goods in connection with or as part of the contract by which the lessor acquired the goods or the right to possession and use of the goods, and (c) that the lessee may communicate with the person supplying the goods to the lessor and receive an accurate and complete statement of those promises and warranties, including any disclaimers and limitations of them or of remedies.2 For lessors the essential challenges in financial leasing are the length of time the financial institution’s investment is exposed which is the duration of the financial lease. Since the financial institution only holds the title of ownership of the asset in financial leases they do not have possession of the asset therefore the care, maintenance, state and condition of the asset is not within the control of the financial institution. This exposure is considered a risk by financial institution since in the event of a default or failure of the lessee to satisfy his part of the agreement the state and condition of the asset may not make it marketable or commercially viable for the financial institution or the lessor to recover his investment at the onset. Taking the above into consideration the lessor can exercise his right by virtue of Article 9 of the Uniform Commercial Code of the United States to secure his investment supported by Article 1 203 of the same Code which states that: A transaction in the form of a lease creates a security interest if the consideration that the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease and is not subject to termination by the lessee, and: (1) the original term of the lease is equal to or greater than the remaining economic life of the goods; (2) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods; (3) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement; or (4) the lessee has an option to become the owner of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement.3 In financial leasing the lessors absorbs all the financial risk while the lessee enjoys the economic benefit and possession of the asset. Although to repeat, lessors have legal rights and ownership of the asset he is not in possession of the asset. The lessee as far as the whole financial transaction is concerned has the sole responsibility of complying with the use and payment of the rental as a consequence of his use of the asset. This would include the care and maintenance of the asset since ideally the asset is considered his after the end of the financial lease agreement. The dynamic nature of the leasing market and the way the financial industry evolve to respond to these market forces at times exposes systemic flaws that previously was not taken into consideration as far as the law is concerned. It should be noted that a general failure amongst financial institutions to perfect its financial lease contracts can result to economic losses for the financial institution. Default of the debtor not only will bring economic difficulties if not collapse due to the losses incurred by the lessor it will also bring the complication in possessing the asset. Legal restriction and governance is designed to protect the general public, the contracting parties and even the financial industry against itself. However, free market even in the global financial leasing industry should be allowed to prosper if not mature by itself. Too much restriction in the conduct of financial leasing agreements through the operation of legislated laws can arrest its growth if not eventually kill Financial Leasing. This thesis will conduct a critical and analytical analysis of the Uniform Commercial Code of the United States in an attempt to relate the financial collapse that recently happened worldwide. This thesis shall attempt to present a critical analysis of the deficiency if not the flaws of the laws that allowed the crises to take its course. It is the hypothesis of this thesis that the laws relate only to the conduct of individual financial leasing contract agreements. Another hypothesis of this thesis is that the governance of the financial institutions and its exposure to the securitized financial leasing market was not taken into consideration by the spirit of the laws. In critically analyzing the spirit of the law, this thesis shall attempt to seek the balance of how much regulation is needed to balance the requirements of free enterprise and free market with the protection of the industry against itself and the protection of the public. It should be noted that the financial industry provide a critical service to the public and allowing it free reign in the spirit of free market may be counter-productive as experienced during the worldwide financial collapse from 2000 to 2009. In Zions Credit Corporation v. Rebel Rents, Inc4 in an attempt to raise more capital to operate its business Rebel Rents Inc. entered into a sale/leaseback deal with Zion Credit Corporation. Zion purchased fifty five construction vehicles from Rebel Rents. However, the vehicle is essential in the operation of Rebel Rents thus the finance leasing agreement between the two companies stipulated that Rebel Rents, rent back the vehicles for a total of three million five hundred thousand over the duration of the finance leasing. Finance Leasing was opted by Zion Credit Corporation and Rebel Rents because an outright loan agreement would require only that Zion put a lien on the vehicles but not actually owning it. Analyzing the situation it would seem that Zion needed more security to ensure that its investment is not only covered but secured. The Uniform Commercial Code of the United States The Uniform Commercial Code of the United States or UCC for brevity tackle financial leasing as a process of sale rather than actual leasing. Although ownership of the item remains with the lessor its actual possession remains with the lessee. Possession translate to the consumption of the economic benefits of possession of the asset by the lessee however, it also entails the payment of rental that covers the economic value of the asset over a period that covers the economic life of the asset to the lessor by the lessee. By agreement and as stipulated by the Financial Leasing agreement and the very nature of Financial Leasing the ownership of the Asset or subject of the Financial Leasing agreement will be transferred to the lessee at the end of the agreement. Article 2A defines leasing in its entirety including financial leasing and the conduct of the lessor and the lessee including their responsibilities to satisfy the provisions of their financial leasing contract in accordance with the provision of existing laws that includes the UCC. Article 1 – 203 defines the difference between a lease and security interest including financial leases and their respective natures in the normal course of business. Article 9 governs the conduct of security interest and its normal process of securing assets that would include negotiable instruments. Article 9 110 stipulate that: A security interest arising under Section 2-401, 2-505, 2-711(3), or 2A-508(5) is subject to this article. However, until the debtor obtains possession of the goods: (1) the security interest is enforceable, even if Section 9-203(b)(3) has not been satisfied; (2) filing is not required to perfect the security interest; (3) the rights of the secured party after default by the debtor are governed by Article 2 or 2A; and (4) the security interest has priority over a conflicting security interest created by the debtor.5 UCC 2004 Article 9 - 110 It should be noted that the United States Uniform Commercial Code Article 1 Section 203 states that: Whether a transaction in the form of a lease creates a lease of security interest is determined by the facts of each case.6 Lessees and Lessors could draw a finance lease contract that could include provisons that will allow for security interests that can be traded for the added protection of the lessor aside from additional revenue. Finance Institution can now pool these securitized instruments and sell it either as bonds or trade it. The Worldwide Economic Meltdown of 2000 The official assessment of the United States National Bureau of Economic Research is that the recession began in December 20077. According to the US NBER, contributory to the recession are the lending practices of financial institution and the securitization of real estate mortgages in the United States. The practice led to a speculative bubble in real estate and equities which fed itself due to the lucrative profit that can be earned from them by financial institutions and speculators. To illustrate in the context of real estate mortgages: When a mortgage agreement between a debtor and a financial institution is executed for a purchase of a particular property the financial institution will hold the lien on the title of the property. The lien on the title of the asset being held in trust by the lessor would have for its exposure the asset and the debt of the debtor. It should be noted that during the pendency of the mortgage agreement the bank ideally will only get as its return from the huge investment the regular amortization from the loan agreement while the asset that is not even in the financial institution’s name sits idly in the vault. In order to minimize this exposure and at the same time earn from the sleeping asset in its vault, the financial institution acting within his legal right can pool all these assets in a form of negotiable instruments and sell it as bonds. This is the first bubble that is created, these bonds can again be sold if not traded for another negotiable instrument that will feed the bubble further and the cycle continues. The financial institution considering the second transaction (bond trading) as another revenue stream will feed more loan agreements into the revenue stream for conversion to bonds. The practice led to the artificial increase in the value of real estate assets and the ballooning financial transaction created over the same asset. The precarious house of cards to collapse on to it-self would only require a single financial institution to experience defaults in the payment of its real estate mortgages that would trigger foreclosure proceedings by the financial institutions. As the need of financial institutions to convert into liquid asset mounts so that it can cover its maturing bonds now do not have any choice but to lower the value of the asset it holds so that it can be sold much faster and be converted into cash. This in turn contributed to the reduction of the value of the assets being held by other company that further led to losses. Translating the above to financial leases where the financial institution actually holds the title of ownership of the asset instead of a simple lien. The securitization of financial leases not only makes financial sense for the financial institution since it is a means for the financial institution to recover its investment in case of default by the lessee. The lucrative value of the rentals from financial leases on the short term makes the bonds that represent these leases attractive to speculators. However this can only be done if the financial lease includes security agreement similar to an equipment trust certificate in airline purchase which would then allow financial institutions to trade the financial lease as a negotiable instrument. This will secure the financial institution’s investment most especially if the lessee defaults or the probability of default is high. Please note that Financial Leases do not necessarily translate to secured interest transactions it has to be included in the provisions of the contract. A peripheral analysis of the turn of events that contributed to the 2000 recession is the ability of financial institution to negotiate the asset it holds. The actions of the financial institution do not affect nor infringe on the rights of the asset owner, since in principle the asset owner still have remedial options available to him through replevin8 or even through Chapter 11 proceedings. However, the action of financial institutions should be considered as against public policy since the widespread practices of securitization amongst the financial institutions have led to the 2000 recession. The securitization of leases is actually legal and was consummated in the spirit of free trade and open market thus no specific party or individual can be considered as culpable for the recession however, the financial industry as a whole driven by profit have taken advantage of the scheme. BASEL I to III was held in an effort by the global financial industry to self-regulate and police itself. The conference provided guidelines and recommended legislation for policy making bodies in charge of financial institution in participating countries to govern and monitor the financial institutions within its borders. The conference also provided a timeline wherein participating countries need to completely adopt the recommended legislation and guidelines. One of the significant guideline of the conference is the guideline in risk assessment and the ratio of the financial institutions liquid capital and what it is allowed to trade in the open market. As for the recommendation on governance BASEL I to III introduced new tools and concept that can be used by governments to govern financial institutions. Another significant guideline of the BASEL accord is the limitations imposed in the use of secured interest to capitalize ventures most specially to increase the capital requirements of banks. The economic recession was a result of a series of events that culminated in the snowballing of economic indicators with each barrage feeding the growing downward trend of the economy. Title 2A as a means to prevent another economic meltdown Title 2A unto itself protects the interest and rights of both the lessor and the lessee in the execution, operation and perfection of financial lease agreements. During the pendency of the Financial Agreement the financial institution is not allowed to transfer to a third party the ownership of the asset through the title or instrument conveying ownership of the asset unless the lessee have failed in its obligation. However, the law is silent with regards to the conduct of financial institution or the lessor in the administration of the loan agreement that covers the asset of the lessee. By definition under UCC 9 203 (a), the asset is the property of the financial institution until such time the lessee obtains ownership as stipulated in the finance lease agrement. Thus, if the financial institutions convey the asset to secure its interest to a third party this thesis posits that the financial institution is not violating any laws. However, to satisfy the requirements of the UCC an actual security agreement to cover the finance lease agreement should be drawn between the financial institution and the lessee. In fine an analysis of the provisions of the UCC financial institutions would generally prefer financial lease rather than direct mortgage since in mortgage the financial institution only holds a lien over the asset instead of actual ownership provided for by financial leases. Thus for the financial institution finance leasing is much more secure and less risky and less expensive as far as litigation cost is concerned since by virtue of the finance lease agreement itself the title of ownership has actually been conveyed to the lessor at the onset. However, without express provision stipulated in the financial lease agreement stating the securitization of the financial lease agreement the finance lease will not be considered a secure interest. The UCC in itself do not bar financial institution to secure its financial leases therefore financial institution can in principle secure their loans. However, it should be within the provision of the financial lease agreement therefore with the full knowledge and understanding of the lessee. This will ensure that the lessee has full knowledge of the consequence of a default. An analysis of the process taking into consideration the limitations and restriction provided for by the UCC for finance lease agreements. The securitization of finance leasing as mentioned do not infringe on the rights of the lessee and the lessor. It only provides an additional layer of security of the investment of the financial institution. If the lessee becomes religious and have actually met his obligation, the property will eventually be transferred in his name as stipulated in the finance lease agreements. The residual interest of the financial institution will be covered by the financial lease agreement as stipulated by the agreement that could be through another financial leasing agreement or actual transfer of ownership from the lessor to the lessee. The UCC refers to individual transactions and relationships of parties whose relationship is governed by the provisions and articles of the Uniform Commercial Code of the United States. The code does not and will not govern the actions and policies of the financial institution. The regulatory and governance of financial institutions is under the Financial Institutions Regulatory and Interest Rate Control Act of 1978 in the United States. The recession was the result of the natural reaction of financial institutions to events or difficulties they are facing. However the widespread reaction of financial institutions fed and exacerbated the situation further. The operation of the provisions of the UCC that is meant to protect the rights of parties involved in commercial transaction fed the recession further. Conclusion The conduct of financial institution is governed by the Financial Institutions Regulatory and Interest Rate Control Act of 1978 in the United States. The law established the Federal Financial Institutions Examination Council9 that prescribed uniform principles, standards and report form for federal examination of financial institutions. The operation of this law should have set the limits and exposure of financial institutions that ideally could have prevented the worldwide economic slowdown in 2008. However the law in itself or even the FIEC could not have prevented the endemic failure of borrowers to pay their amortizations or the personal bankruptcies that happened during the period. The financial institution for its part did not engaged in any illegal activities but they have in fact under the normal course of business acted regularly and without malice. For starters, FIRIRC should abide by the recommendation of BASEL I to III that prescribed restrictions in the commercial trade and use of negotiable instruments as capital. This pertains to Tier 2 capital using negotiable instruments. This will limit the use of instruments with variable value. The BASEL accord has also set the ratio of available funds for investments with that of its total liquidity coverage. This is in effect will prevent banks from over exposing itself into loans and borrowings to cover these loans without taking into consideration its own liquidity to cover the loans10. The operational policies of financial institution are beyond the reach and ambit of the Unified Commercial Code of the United States. The recession happened with the widespread of attempt of financial institution to recover the losses of banks because of the impending losses due to the defaults. It was the market forces reacting to the direction the market are heading to protect revenue of the banks. The Unified Commercial Code’s reach only includes the agreements between the lessors and the lessee or parties covered by the UCC. As posited by this thesis at the onset. Revisiting the second hypothesis: the US FFIEC is the body responsible for the governance of financial institution to ensure that their rights as well the rights of their clients are protected at all times. This means that FFIEC is the one responsible for implementing or spearheading reforms in the banking sectors as recommended by the BASEL accords. The BASEL accords have been charged by the banking industry worldwide to come up with restrictions in an effort to police its ranks. Financial Leasing is an important innovation in the financing industry to ensure that even the small players or emerging players would be able to compete with large corporations. Financial Leasing enables small companies with a good business model to start purchasing much needed equipment to start its operation at once. Financial Leasing also provide a way for small companies in the brink of collapse to refinance itself with the use of its current equipment via Lease/buy back scheme. Financial Leasing is an important aspect of local and international finance that services a vast majority of the companies in the United States. These are the companies’ set-up by entrepreneurs that do not have enough capital to finance its operation and Financial Leasing is the only option that it has in order for them to get started in their business. The UCC provides the process and restriction that will protect the leasing industry and the financial industry through spurious contracts or provisions thereof that is not in accord with the law. The unfortunate financial collapse experienced worldwide is not a consequence of disparities or imbalance in the protection of interest of both lessors and lessees as far as the UCC is concerned. The financial collapse was brought about by financial institution capitalizing on the negotiable instruments that it is holding to secure its interest, reduce its risk and for a small profit. The actions of the financial institution does not infringe on the rights of the lessee since towards the perfection of the financial lease and through the operation of the financial lease contract or agreement the lessee can and will still be able to exercise his ownership over the asset. In cases only of default will problems be encountered by both the lessee and the lessor, however, given the nature of financial leases the ownership of the asset is not an issue anymore. However, given the nature and the restriction provided by the law to financial institution with regards to Financial Leases, Financial Institutions are not allowed to mark-up the actual cost of the asset. Even though the financial institution is allowed to charge a modest service fee and the cost of money in the form of interest its profitability remains modest. Considering the risk the financial institution is in and the possible losses he will incur incase the lessee defaults in his payments it would make sense for financial institution to securitized the financial leases and include the provision in the contract. As prescribed by UCC, the financial institution does not have any responsibility to ensure that the asset it has financed is maintained or taken cared off or operated properly. It is the responsibility of the lessee to ensure that the maintenance and wellbeing of the equipment financed through financial leasing done. Equipment that is not well maintained would have a drastic reduction in its value that is not or may not be included in the contract for financial lease. Considering that defaults do happen in leases or rentals the financial institution in order to recover its loss has the following cost: It will be responsible for the transport of the asset to an area where the financial institution has total control and supervision. The financial institution will likewise be responsible for the refurbishing of the assets if it can be refurbished for it to be marketable. Finally in order for financial institution to recover its losses from the purchase of the asset, the financial institution will be responsible for locating its new owner if not new lessees. The exposure of the financial institution as described above will not only warrant securitization of the financial lease but also justify the increase or the levy of premium to the amount that will be charged by the financial institution against the lessee. Bibliography Basel Committee on Banking Supervision. (2009). Strengthening the Resiliency of the Banking Sector. BASEL III (pp. 15-18). BASEL: Bank for International Settlements. Black, H. C., Garner, B., & West Publishing Company. (2000). Black's Law Dictionary 7th Edition. New York: West Group. Congress of the United States of America. (2003, January 23). UCC: Uniform Commercial Code. Retrieved from law cornell: http://www.law.cornell.edu/ucc/ucc.table.html NBER Makes it Official: Recession Started in December 2007, The Wall Street Journal. 2008-12-01 http://blogs.wsj.com/economics/2008/12/01/nber-makes-it-official-recession-started-in-december-2007/ Proposal 1 of the Basel Committee on Banking Supervision September 12, 2010. United States Federal Law (Pub L 95-630) under Title X of the act. White, J., & Summers, R. S. (2000). White and Summers Hornbook on the Uniform Commercial Code, 5th (Hornbooks). New York: West Publishing. Zions Credit Corporation v Rebel Rents Inc 291 B.R. 520, 526 (Bankr. C. D. Cal 2003) Read More