Pressure to upgrade medical equipment has not abated while banks tightened credit requirements. The answer for many hospitals is to lease rather than buy new equipment, but this option carries its own pitfalls. Unlike common loan document forms, equipment leases contain traps for the unwary and even the most experienced corporate lawyers rarely have experience in identifying and avoiding these issues.

This article will highlight a few of the many negotiating points and traps common to lessor-drafted lease documents.

The "Hell or High Water" Clause 
Virtually all leases contain a provision similar to the following:

"This is a non-cancellable net lease and the Lessee shall not be entitled to any abatement or reduction of payments due hereunder for any reason.  The Lessee agrees to make the payments due hereunder to the Lessor or its assignee regardless of any existing or future set-off or claim which may be asserted by the Lessee."

Courts routinely uphold these provisions, meaning that the lease cannot be cancelled because the equipment does not function properly. This language is designed to protect third party banks and other finance companies on the theory that the lessor is essentially in the same position as a lender taking a security interest in equipment to finance its purchase. The clause is generally enforceable, however, even in cases where the lessor is affiliated with the equipment vendor or manufacturer.

Experience dictates that any attempt to substantially revise or delete the clause is likely to be a waste of time. Lessors, including the vendors themselves, are likely to borrow against the lease from third parties who rely on the clause to ensure they will receive rents. As discussed below, this inability to stop paying rent places increased emphasis on pre-acceptance inspections and other rights.

The lessee can suffer even where the vendor has provided warranties, because most warranties only provide for repurchase at the original equipment cost, which may actually be less than the amount necessary to pay off the lease. Added to this is the fact that the lessor is under no obligation to accept replacement equipment or permit the lessee to payoff the lease early. The lessee should coordinate the lease and purchase agreement so that if the equipment does not function as warranty, (1) the lessor must agree to sell the equipment to the vendor and (2) the vendor must repurchase the equipment from the lessor for an amount sufficient to release the lessee from further liability.

Lease Commencement. 
A lease should only commence when the lessee determines that the equipment is in acceptable condition and working order.  Many leases provide that the lease commences when the lessor or the vendor determines that the equipment is installed and operable. Once the lease commences, the "hell or high water clause" takes effect, meaning that the lessee can be forced to continue to lease equipment that does not function properly or does not meet the specifications stated in the purchase order.

Lessees should preserve their right to inspect and reject unsatisfactory equipment and should never sign an “acceptance certificate” before inspection and testing are completed. 

End of Term.
Consider this language:

“At the end of the initial term or any extended term, the Lessee shall have the option to (1) return the Equipment as provided herein, (2) extend the term of this Lease for an additional period of one year, or (3) purchase the Equipment at its fair market value, as determined by the Lessor. The Lessee shall notify the Lessor in writing of its election to return, renew or purchase as permitted by this Section not more than 210 nor less than 180 days prior to the end of the initial term and if it fails to notify the Lessor of its election, it shall be deemed to have selected to extend term of this Lease as provided in clause (2) of the immediately-preceding sentence.”

This language, on its face seems reasonable enough. On closer examination, it appears that

·       The lessee has only a 30 day window, occurring more than 6 months before the end of the term to terminate the lease at what it thought would be the normal end of term. If it fails to make the election in time, the lease continues for an additional year at the original rent (without taking depreciation into account).

·       If the lessee wishes to purchase the equipment at the end of the lease, it is at the lessor’s mercy to determine the price of the equipment. The lessor can easily force the lessee to pay a premium or extend the term if the lessee needs the equipment or cannot, for any reason, return it on time.

·       In many cases, the cost of simply returning the equipment will be prohibitive, as discussed below. The availability of the purchase option may also be limited by conditions such as that the lessee is not “in default” meaning that it is not even a day late on any required financial reporting or other duty at the time of exercise.

·       The time expended to de-install, recertify, crate and ship the equipment comes out of the lessee’s use – the lessee will pay rent during the weeks or months it takes to ensure that the equipment is shipped “at the end of the term.”

Similar language is sometimes included in leases designed to finance the entire cost of the equipment with the lessee owning the equipment at the end of the term. Essentially, the lessee will have paid the entire cost of the equipment but will continue to be billed after it believed the lease term ended.

In some leases, the ability to return the equipment is actually omitted or conditioned on the lessee’s entering into a lease of replacement equipment, essentially locking the lessee into a perpetual lease relationship with the lessor.

Return of Equipment.
Sophisticated lessors know that their ability to realize on the residual value of equipment is largely dependent on the terms of the return provision.  Draconian return requirements can be used to force the lessee to exercise its purchase “option” and buy obsolete or depreciated equipment at a premium. The lease may provide that the lessee must

·       have the equipment certified by the manufacturer or another party unless this can be pre-arranged so that the manufacturer will continue to maintain it in the hands of the new owner or second lessee,

·       have the equipment already fully de-installed, crated and prepared for shipping on the last day of the lease,

·       pay the costs of movement of the equipment to any location chosen by the lessor, and/or

·       satisfy vague or subjective condition and maintenance standards on return.

Leasing is good business for many equipment users. It provides a source of funds for acquisition of up-to-date technology and equipment that may not be otherwise available. Careful review of the lease document, however, is a prerequisite to making use of this availability.