introduction to governmental leasing: differences … of constitutions and statues • very...

Introduction to Governmental Leasing: Differences between

Federal Leasing, State and Local Government Leasing and

Commercial LeasingGeorge M. Mardikes

Davis Wright Tremaine LLP

Overview to Approach

• To understand governmental leasing, whether to the federal government or to a state or local government, one needs to understand the differences between commercial leasing, federal leasing and state and local leasing

• For convenience, we will refer to state and local government leasing as Municipal Leasing

Commercial Leasing

• It is easy to bind the lessee, whether an individual, a corporation, an LLC, or partnership. For example, there is apparent authority, estopple, unjust enrichment and other theories to bind the lessee

• The big issues are (i) the credit quality of the lessee, (ii) the value of the asset financed and (iii) the security interest in the asset.

Commercial Leasing, cont.

• Documentation is pretty standard and it is an easy document package

• Contracts are binding on the lessee for the full term of the lease

• Credit quality of the vendor and quality of the asset financed is not of primary importance since the lessee is bound for the full term

Commercial Leasing, cont.

• Usually lessee has no right to set-off if the asset does not perform

• Tax considerations are to make sure the lessor is the tax owner for a fair market value lease and the lessee is the tax owner for a lease-purchase agreement

• Interest under a lease-purchase is taxable• Assets are usually subject to property

taxation, if the jurisdiction levies one

Municipal Leasing• The lessee is a state or local government, a

creature of constitutions and statues• Very difficult to bind the lessee• To protect taxpayers, apparent authority,

estopple, unjust enrichment, ratification and such other theories to bind the lessee are not available or if available, very limited

• Constitutions and statutes establish limitations and procedures for entering into the agreements

Municipal Leasing, cont.

• The result if one fails to follow legal requirements to bind the lessee are harsh -- the contract is void contract

• For lease-purchase agreements, the asset is usually not subject to property taxes

• Because of this, lease-purchase agreements are predominately used, occasionally we see fair market value leases for technology equipment


• Municipal Leases almost always need a nonappropriation clause

• It allows the lessee to terminate the lease, if the governing body of the lessee does not appropriate funds to pay the rental payments for the subsequent fiscal year

• The ability of the lessee to annually terminate the lease makes the lease a one year obligation and not a debt that would require voter approval

Municipal Lease, cont.

• The ability of the governmental lessee to terminate annually needs to be absolute and not subject to limitations that hinder such right to terminate

• For example, having a provision that does not allow the substitution of the terminated asset by the governmental lessee with another asset would likely cause the lease to be void

Municipal Lease, cont.• Nonappropriation: If sufficient funds are not appropriated to make Rental

Payments required under the Lease, the Lease shall terminate and Lessee shall not be obligated to make Rental Payments under the Lease beyond the then current fiscal year for which funds have been appropriated. Upon the occurrence of such nonappropriation (an "Event of Nonappropriation") Lessee shall, no later than the end of the fiscal year for which Rental Payments have been appropriated, deliver possession of the Property under the Lease to Lessor. If Lessee fails to deliver possession of the Property, the termination shall nevertheless be effective but Lessee shall be responsible for the payment of damages in an amount equal to the portion of Rental Payments thereafter coming due that is attributable to the number of days after the termination during which the Lessee fails to deliver possession and for any other loss suffered by Lessor as a result of Lessee's failure to deliver possession as required. Lessee shall notify Lessor in writing within seven (7) days after the failure of the Lessee to appropriate funds sufficient for the payment of the Rental Payments, but failure to provide such notice shall not operate to extend the Lease Term or result in any liability to Lessee.


• Like Commercial Leasing, the transactions usually provide that the lessee cannot terminate, set-off or abate payments due to problems with the performance of the asset or the performance of the vendor of the asset or the manufacturer of the asset

• Therefore, the credit for the transaction is the governmental lessee


• The annual termination right due to nonappropriation however creates its own credit concerns

• Is the asset essential? The less essential the asset, the greater the risk of nonappropriation

• Is the asset and its manufacturer of decent quality? Historically, on small transactions, there is an increase in nonappropriation, if the asset does not perform, especially copiers

Municipal Leasing, cont.• The ability to terminate the lease annually is

often used by the lessee to get out of a lease of an asset that is not performing. In essence, the nonappropriation clause is used by the lessee as a means to cancel a lease, if the property does not work. The nonappropriation is simple, unlike suing the manufacturer for a default or warranty claim.

• For sophisticated lessees, the risk of nonappropriation is low due to the need to maintain access to this form of financing in the capital markets


• Because of the nonappropriation risk, in addition to the credit of the lessee and the essential use of the asset, the quality of the vendor, including the quality of the product of that vendor and their services and the financial viability of the vendor to support the product, are important


• Documentation for Municipal Lease is very specific to the state of the lessee and the type of entity within the state

• AGLF has a Fifty State Survey of the authority of counties, cities and school districts to lease-purchase. I served as original author and continue as the project manager to the bi-annual update by our firm

Municipal Leasing, cont.• Sometimes the law requires something foolish,

like the inclusion of a note with the lease or installment purchase documents. If required, you must do it

• The law may restrict the term of the transactions, say to 3 years, failure to comply renders the lease void

• If there is a limitation on the dollar amount of the financing to avoid public bidding, then the dollar limit must be complied with

• The interest rate may also be restricted by law

• Oregon requires a statement that the lease rentals reflect the savings from exemption from property taxes for the asset, if does not so state, then the asset is not exempt from property taxes

• If state law requires a super majority of the governing body to approve the lease, then without it, the lease is invalid

• Is state law requires approval by a higher governmental entity with oversight, the compliance is required


• Federal Tax-Exemption of the interest on Municipal Leases is usually desired since it results in lower interest payments

• Fair market value leases are not tax-exempt, which is another reason they are not often used

• If the lease-purchase agreement is void under state law, the interest is taxable, another harsh result


• There are many special rules under federal tax law for a lease-purchase agreement to be tax-exempt

• The lessee must either be a state, or a political subdivision with substantial powers of taxation, condemnation or police powers

• The interest component of the lease payments must be separately stated from principal

Municipal Leasing, cont.• Use of the property by the federal government or

a private business usually causes the loss of the tax-exemption on the interest

• A special form, Form 8038-G (or GC) has to be filed with the Internal Revenue Code within a certain time period of closing

• The Federal Lease must be in registered form• Special representations and covenants are in

the documents to address the federal tax-exemption and to assure it remains tax-exempt


• Quality control for state law compliance for Municipal Leases is accomplished with an opinion of counsel to the lessee that the lease is legal, valid and binding

• Quality control related to the lessee’s financial ability to pay is handled with financial statements and normal due diligence

• Essential use is accomplished with a certificate provided by the lessee and lessor due diligence


• Quality control of federal tax issues is accomplished by either a tax opinion by competent tax counsel, or on small transactions, by having the forms reviewed by competent tax counsel with clear instructions to those documenting the transaction

• Quality control with respect to vendor risk is accomplished by lessor by reviewing their financials and their performance with respect to product and services

Federal Leasing

• With Federal Leasing, the lessee is some part of the federal government. It can be a federal agency, Congress, VA, NASA, GSA, many types of entities

• Often, private entities or municipal lessees have the right to use GSA (General Services Administration) pricing and terms. We treat these as commercial transactions and do not actually use the documentation for federal leases, for reasons discussed below

Federal Leasing, cont.

• The Federal Lease does not look like a conventional lease document package

• It is a bundle of sticks and one has to make sure everything is covered in the various papers provided

• Most often, the leasing is pursuant to a GSA schedule, but one has to make sure that the GSA schedule has leasing terms and conditions, since often they do not

Federal Leasing, cont.• One also has to make sure that for transactions

pursuant to a master agreement or a GSA schedule, that the party contracting with the federal government is the same legal entity that has entered into the master agreement or GSA schedule, and that that entity is the entity credit approved for the transaction by the party taking assignment

• Most Federal Leasing is pursuant to delivery orders or purchase orders issued pursuant to a master agreement or GSA schedules, but stand alone transactions also exist

Federal Leasing, cont.• Fair market value leasing (usually called Lease

with Option to Purchase, LWOP) and lease-purchase leasing (usually called Lease to Ownership Program, LTOP) is provided

• The interest on LTOP is always taxable, unlike Municipal Leasing

• Property taxes tend to be a concern only with LWOPs, since the federal government is usually exempt from state and local taxes, if it is the owner of the asset


• The body of law controlling Federal Leasing is federal legislation, federal entity regulation, and more often than not the Federal Acquisition Regulations (the FARs), as amended by various federal agencies, such as the Department of Defense

• Many terms, conditions, rights and remedies are incorporated by reference with inclusion of certain FAR provisions


• Similar to Municipal Leasing, the federal lessee has the right to terminate due to nonrenewal or nonappropriation

• Like a Municipal Lease, essential use is important

• In addition, the federal lessee has the right to terminate for convenience at any time

• Termination for convenience is often mitigated by a termination schedule


• Termination for Convenience of the Government (Fixed-Price) (Short Form) (Apr 1984): The Contracting Officer, by written notice, may terminate this contract, in whole or in part, when it is in the Government’s interest. If this contract is terminated, the rights, duties, and obligations of the parties, including compensation to the Contractor, shall be in accordance with Part 49 of the Federal Acquisition Regulation in effect on the date of this contract.

Federal Leasing, cont.• The party that is the contractor with the federal

government, basically the role of the lessor, is consider the prime contractor and is the party with privity of contract with the federal government

• The federal government usually reserves the right to set-off and abate rental payments against the prime contractor and any assignee of the prime contractor

• The federal government has a detailed and specific way to waive its rights to set-off and abate, but seldom does so

Federal Leasing, cont.• The Assignment of Claims Act provides that unless the

federal government has waived it right to set-off, then an assignee of the prime contractor (the lessor) shall take subject to all rights outstanding that the federal government has against the prime contractor at the time of assignment, as well as all rights that arise after the date of assignment that arise against the prime contractor related to the contract assigned

• The federal government also only recognizes the right to assign the payments under the federal lease, not the right to assign the whole contract

Federal Leasing, cont.• The prime contractor remains the party with privity of

contract with the federal government and the federal government reserves the right to withhold payment of the lease payments, if the prime contractor does not perform under the terms of the contract. What this means is that if the asset does not comply with the terms, conditions and warranties provided by the prime contractor or if required services or upgrades are not provided by the prime contractor, the federal government has the legal right to set-off against payment of the lease payments for such breach by the prime contractor, as well as take other remedies, such as termination for default

Federal Leasing, cont.• The result of these rights in the federal

government is that the vendor/prime contractor is the weakest link in the transaction

• In addition, they are in the chain of title and any entity taking assignment of the rentals has to take assignment from the vendor/prime contractor and subject to their performance

• Assignment can be made only to a bank, trust company, or other financing institution, including any federal lending agency


• Given the nature of Federal Leasing, a major focus of the documentation is with the assignment of rights from the lessor/prime contractor to the assignee

• The assignee needs (i) assurance of contract performance by the vendor, (ii) remedies against the vendor due to abatement or other breach of the contract with the federal government, and (iii) the ability to put the transaction back to the vendor or other sufficient remedy

Federal Leasing, cont.• Another important requirement is the cooperation and

legal obligation of the lessor/prime contractor to provide the necessary interaction with the federal lessee and the enforcement of the contract provisions against the federal lessee, since the assignee does not have privity of contract with the federal government

• This includes assistance with billing and collecting, as well as assistance with enforcement of rights in the event of a termination for convenience for collection of any termination charges due and owing from the federal government


• One assumes in taking assignment of a Federal Lease that the federal government will not recognize the assignee and will deal solely with the vendor/prime contractor

• The assignment between the vendor/prime contractor is basically documenting an ongoing relationship between the vendor/prime contractor and assignee over the life of the Federal Lease, comfort with the vendor/prime contractor becomes of paramount importance

• Quality control with respect to Federal Leasing tends to focus on the Vendor/Prime Contractor, their credit quality, the quality of their product and services and the quality of the organization

• Also, some risk is minimized by assuring the installation and performance of the asset with acceptance of the asset by the federal government at the outset

• There does not exist an opinion practice of getting opinions on the legal, valid and binding nature of a Federal Lease on the federal government due mainly to the existence of experienced contracting officers assigned to the transactions

Conclusions• Commercial Leasing tends to focus on the credit quality

of the lessee, their ability to pay, regardless of whether the lessee needs the asset or whether the asset performs

• Municipal Leasing, where the credit quality is not that much of a concern due to the infrequency of bankruptcy and legislation requiring balance budgets and a certain degree of fiscal responsibility, tends to focus on the essential use of an asset because of the right of the governmental lessee to nonappropriate annually. In addition, but less of concern is the quality of the vendor, since a problem vender might lead to a reason for nonappropriation

• Federal Leasing, with the superb credit quality of the United States government, focuses some on the essential use of the asset to the federal government due to the federal government’s right annually not to renew or to nonappropriate. But often more importantly the vendor/prime contractor is the focus and concern, since its performance under the contract with the federal government remains a risk to the assignee throughout the term of the Federal Lease

Presented by

George MardikesDavis Wright Tremaine LLP

1300 SW 5th Avenue, Suite 2300Portland, Oregon 97201

503-778-5323Fax: 503-276-5623

[email protected]

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