Lease Finance

INDEX

SR NO.

TOPIC

PAGE NO.

1

Introduction & Definition

8

2

Finance Lease

9

3

Importance Of Lease Financing

10

5

Essential Elements Of Leasing

11

5

Types Of Lease Agreement

13

a) Finance Lease

14

b) Operating Lease

15

c) Sale & Lease Back

18

d)Leveraged Lease

20

e) Direct Lease

21

6

Features Of Financials Service

24

7

Advantages & Dis-advantages Of Leasing

25

8

Factors affecting Leasing Decisions

26

9

Difficulties Faced by Leasing Companies in India

27

10

LEASING IN INDIA

28

11

Difference Between Lease Financing & Hire Purchase

29

12

Evolution of Leasing

30

13

Evolution of Hire-purchase

33

14

Leasing and Hire-purchase: A vanishing distinction

34

15

Lessors

36 1

16

Specialized leasing companies

37

17

Banks and bank-subsidiaries

38

18

Specialized Financial institutions

39

19

One-off lessors

40

20

Manufacturer-lessors

41

21

The lessees

42

22

Sources of Law on leasing and hire-purchase

44

23

Leasing and Hire-purchase

45

24

Requirements of a valid lease or hire-purchase

46

25

Durability & Movability and severability

47

26

Identifiability

48

27

Obligations relating to the goods

49

28

What Is the Concept of Leveraged Leasing?

50

29

Underwriting

52

30

A Practical Look At Lease Document

54

31

Some Terms

60

32

History

63

33

Summary

64

34

Glossary

65

35

Reference

66

2

3

Introduction

In order to start and sustain a business one needs finance. In the unit one on feasibility study, you have already seen the process of estimating financial requirements. The process involved (a) making a list of all the assets iNTRODUCTION(b) identifying the sources of supply (c) estimating the cost of acquisition when the assets are to be acquired on outright basis. Then investment requirements as well as entrepreneur‘s fear will increase. To scare away the entrepreneur‘s fear, the emphasis should be given to resources and not to the ownership. In this unit we intend to familiarize you with some important financial innovations i.e., leasing, hire purchase and factoring.

Definition:  Leasing is a contractual arrangement , where  The owner (Lessor) of the Asset(Equipment)  Transfers the possession / right to use the Asset(Equipment) to another(Lessee)  For an agreed period of time in return for rental.

4

\

Finance Lease A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer conveys to the equipment user the right to use the equipment in return for a rental. In other words, lease is a contract between the owner of an asset (the lessor) and its user (the lessee) for the right to use the asset during a specified period in return for a mutually agreed periodic payment (the lease rentals). The important feature of a lease contract is separation of the ownership of the asset from its usage.Lease financing is based on the observation made by Donald B. Grant: ―Why own a cow when the milk is so cheap? All you really need is milk and not the cow.‖  Long-term, non-cancellable lease contracts are known as financial leases.  To record a lease as a capital lease, the lease must be noncancelable.  One or more of four criteria must be met: 1. Transfers ownership to the lessee. 2. Contains a bargain-purchase option. 3. Lease term is equal to or greater than 75 percent of the estimated economic life of the leased property. 4. The present value of the minimum lease payments (excluding executor costs) equals or exceeds 90 percent of the fair value of the leased property.

5

Importance Of Lease Financing

Leasing industry plays an important role in the economic development of a country by providing money incentives to lessee. The lessee does not have to pay the cost of asset at the time of signing the contract of leases. Leasing contracts are more flexible so lessees can structure the leasing contracts according to their needs for finance. The lessee can also pass on the risk of obsolescence to the lessor by acquiring those appliances, which have high technological obsolescence. To day, most of us are familiar with leases of houses, apartments, offices, etc.

6

Essential Elements of Leasing Parties to a Lease Contract: Essentially two parties  Lessor – is the owner of the asset that is being Leased.  Lessee – is the receiver of the services of the asset under a Lease contract.  Lessor and Lessee can be Individual or legally recognised party.  The lessor is either the asset‘s manufacturer or an independent leasing company  Lease broker – big ticket Leases use him.  Major Players in Lease Market:  oBanks- Indian & Foreign /FIs  subsidiaries of Banks/FIs,  NBFCs  Asset – Subject matter of Leasing contract; Automobiles, Plant & Machinery, Equipments, Land & building, Factory, a running business, aircraft, Ships, etc.  Ownership – remains with the Lessor  Use - of the asset is allowed to the Lessee.  Lease Term – Primary /secondary Lease Term.

7

 Lease Rentals – is the consideration for the lease transaction. So structured to recover the investment cost, during agreed period.

8

Types Of Lease Agreements

Lease agreements are basically of two types. They are (a) Financial lease and (b) Operatinglease. The other variations in lease agreements are (c) Sale and lease back (d) Leveraged leasing and (e) Direct leasing.

9

1. FINANCIAL LEASE Long-term, non-cancellable lease contracts are known as financial leases. The essential point of financial lease agreement is that it contains a condition whereby the lessor agrees to transfer the title for the asset at the end of the lease period at a nominal cost. At lease it must give an option to the lessee to purchase the asset he has used at the expiry of the lease. Under this lease the lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of the economic life of the asset. The lease agreement is irrevocable. Practically all the risks incidental to the asset ownership and all the benefits arising there from are transferred to the lessee who bears the cost of maintenance, insurance and repairs. Only title deeds remain with the lessor. Financial lease is also known as ‗capital lease‘. In India, financial leases are very popular with high-cost and high technology equipment.

10

2. OPERATING LEASE An operating lease stands in contrast to the financial lease in almost all aspects. This lease agreement gives to the lessee only a limited right to use the asset. The lessor is responsible for the upkeep and maintenance of the asset. The lessee is not given any uplift to purchase the asset at the end of the lease period. Normally the lease is for a short period and even otherwise is revocable at a short notice. Mines, Computers hardware, trucks and automobiles are found suitable for operating lease because the rate of obsolescence is very high in this kind of assets. Key Words Explain the meaning of ‗long term,‘ ‗nominal cost,‘ and economic life

11

Differentiation Between Operating lease and Financial Lease

BASIS

Financial Lease

Meaning

Long-term,

non-cancellable

Operating leas

lease

A Lease which is a short term one

contracts are known as financial

and one which does not cover the

leases.

useful life on an asset is called an operating lease.

Form

In this type of lease, money is provide

The lessor is carrying on business of

by lessor and the asset is purchase

leasing and he holds such assets or is

form outside

a manufacturer of such asset leases its asset

Maintenance

The lessee undertakes the maintenance

In this type of lease, repairs and

of the asset, paying insurance premium

maintenance is done by the lessor.

ect. Risk Obsolescence

of

In this types of lease, the lessee bears

In this types of lease, the lessor bears

the risk

the risk

obsolescence, so far as he

uses the asset.

obsolescence during the

period of the lease.

12

BASIS

Financial Lease

Operating leas

Period of Lease

Period of lease – whole useful life of

Period of lease – for shot time.

asset. Option to Buy

Option to buy for lessee.

Period of lease – for shot time.

Accounting

According

international

No entry is made in the balance sheet of

Entries

accounting standard-17, an entery iis

the lassee under this type of lease,

made in the balance sheet of the

because lease is in the form of a hired

lessee on both the side

asset

to

the

13

3. Sale and Lease back: It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the buyer), who in turn leases back the same asset to the owner in consideration of lease rentals. However, under this arrangement, the assets are not physically exchanged but it all happens in records only. This is nothing but a paper transaction. Sale and lease back transaction is suitable for those assets, which are not subjected depreciation but appreciation, say land. The advantage of this method is that the lessee can satisfy himself completely regarding the quality of the asset and after possession of the asset convert the sale into a lease arrangement. The sale and lease back transaction can be expressed with the help of the following figure.  The owner(Lessee) of the equipment sells it to a Leasing company (Lessor).  The Lessor, leases the equipment back to the Lessee.  Under this arrangement, the assets are not physically exchanged but it all happens in records only.  The seller assumes the role of a lessee and the buyer assumes the role of a lessor.  The seller gets the agreed selling price and the buyer gets the lease rentals. Two sets of cash flows occur:  The lessee receives cash today from the sale. 14

 The lessee agrees to make periodic lease payments, thereby retaining the use of the asset.

15

4. Leveraged Lease: Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and the asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor, the owner of the asset is entitled to depreciation allowance associated with the asset.  3 parties to the transaction.  Lessor ( Equity investor)  Lender  Lessee.  The Leasing company (Equity investor)  buys the equipment, through substantial borrowing, and  with full recourse to the Lessee and without recourse to it.  The Lender obtains an assignment of the Lease and a first mortgage of the equipment.

16

5. Direct Lease

 Under direct leasing, a firm acquires the right to use an asset from the manufacturer directly.  The ownership of the asset leased out remains with the manufacturer itself.  Bipartite Lease – Equipment supplier-cum-Lessor and Lessee.  Tripartite Lease (Sales-aid-Lease) – Equipment supplier, Lessor and Lessee.

17

Single Investor Lease •

Only two parties – Lessor and Lessee.

•

Leasing company (Lessor) funds the entire investment, having appropriate mix of Equity-cum-Debt.

Finance raised by the Lessor, is without recourse to the Lessee

Domestic Lease and International Lease

 When a lease agreement is made between citizen of same countries, it is called Domestic lease  When a lease agreement is made between citizen of different countries, it is called International lease

18

19

Features of Financial Service A Financial Lease is structured to include:  The Lessee selects the equipment meeting his requirement  The Lessee negotiates the price, delivery schedule, installation, warranties, maintenance, etc.  The Lessee informs the above details and Lessor makes the payment directly to the Seller(manufacturer /distributor).  The equipment is directly delivered to the Lessee by seller.  The Lessee enjoys exclusive and peaceful possession and use of the equipment.  Enters in to the Lease agreement with Lessor.  The Lessor pays the amount directly to Seller(Manufacturer/supplier).

20

Advantages of Leasing  Provides full Finance  Flexible  Saves from Recurring cost of finance  Absence of restrictions  Tax Benefits  Increases the capacity to borrow  Useful in case of fast changing technology  Faster and Cheaper credit

Limitations of Leasing  No Benefit of Residual Value  High cost of leaseing  No benefit of ownership  Not Flexible  Disputes 21

Factors affecting Leasing Decisions  Availability of cash  Effect on Borrowing Capacity  Shifting the Risk of Obsolescence  Convenient Arrangement  Less Restrictions on Firm  Salvage Value  Tax Benefits  Leas Expenses

Institutions In the field of Leaseing.  All India Financial Institutions  Leasing Companies  Banks  Financial Companies  Industrial Groups having Leasing Companies

22

Difficulties Faced by Leasing Companies in India

 Competition  Lack of Trained Employees  Proportion of Debt-Equity not maintained  Lack of Provision for Depreciation  Low Investment of Promoters  Shortage of Funds  Inefficiency of Management  Government Attitude

23

LEASING IN INDIA  Leasing has grown by leaps and bounds in the eighties but it is estimated that hardly 1% of the industrial investment in India is covered by the lease finance, as against 40% in USA and 30% in UK and 10% in Japan  The prospects of leasing in India aregood due to growing investment needs and scarcity of funds with public financialinstitutions.  This type of lease finances is particularly suitable in India where a largenumber of small companies have emerged more recently. 

Leasing in the sphere ofland and building has been in existence in India for a long time, while equipment

 leasing has become very common in the recent times.

24

DIFFERENCE BETWEEN LEASE FINANCING AND HIRE PURCHASE

BASIS

LEASE FINANCING

HIRE PURCHASE

Meaning

A lease transaction is a commercial

Hire purchase is a type of instalment

arrangement, whereby an equipment

credit under which the hire purchaser

owner or manufacturer conveys to the

agrees to take the goods on hire at a

equipment user the right to use the

stated rental, which is inclusive of the

equipment in return for a rental.

repayment of principal as well as interest, with an option to purchase.

No option is provided to the lessee

Option to user

Option is provided to the hirer (user).

(user) to purchase the goods. Nature expenditure

Components

of

Lease rentals paid by the lessee are

Only interest element included in the

entirely revenue expenditure of the

HP instalments is revenue expenditure

lessee.

by nature.

Lease rentals comprise of 2 elements

HP instalments comprise of 3 elements

(1) finance charge and (2) capital

(1) normal trading profit (2) finance

recovery.

charge and (3) recovery of cost of goods/assets.

25

Evolution of Leasing •

Leasing activity was initiated in India in 1973.

•

The first leasing company of India, named First Leasing Company of India Ltd. was set up in that year by Farouk Irani, with industrialist A C Muthia.

•

For several years, this company remained the only company in the country until 20 th Century Finance Corporation was set up - this was around 1980.

•

By 1981, the trickle started and Shetty Investment and Finance, Jaybharat Credit and Investment, Motor and General Finance, and Sundaram Finance etc. joined the leasing game.

•

The last three names, already involved with hire-purchase of commercial vehicles, were looking for a tax break and leasing seemed to be the ideal choice.

•

The industry entered the third stage in the growth phase in late 1982, when numerous financial institutions and commercial banks either started leasing or announced plans to do so.

•

ICICI, prominent among financial institutions, entered the industry in 1983 giving a boost to the concept of leasing.

•

Thereafter, the trickle soon developed into flood, and leasing became the new gold mine.

•

This was also the time when the profit-performance of the two doyen companies, First Leasing and 20th Century had been made public, which contained all the fascination for many more companies to join the industry. 26

•

In the meantime, International Finance Corporation announced its decision to open four leasing joint ventures in India.

•

To add to the leasing boom, the Finance Ministry announced strict measures for enlistment of investment companies on stock-exchanges, which made many investment companies to turn overnight into leasing companies.

•

As per RBI's records by 31st March, 1986, there were 339 equipment leasing companies in India whose assets leased totaled Rs. 2395.5 million.

•

One can notice the surge in number - from merely 2 in 1980 to 339 in 6 years.

•

Subsequent swings in the leasing cycle have always been associated with the capital market - whenever the capital markets were more permissive, leasing companies have flocked the market.

•

There has been appreciable entry of first generation entrepreneurs into leasing, and in retrospect it is possible to say that specialised leasing firms have done better than diversified industrial groups opening a leasing division.

•

Another significant phase in the development of Indian leasing was the Dahotre Committee's recommendations based on which the RBI formed guidelines on commercial bank funding to leasing companies.

•

The growth of leasing in India has distinctively been assisted by funding from banks and financial institutions.

•

Banks themselves were allowed to offer leasing facilities much later - in 1994.

27

•

However, even to date, commercial banking machinery has not been able to gear up to make any remarkable difference to the leasing scenario.

•

The post-liberalisation era witnessed the slow but sure increase in foreign investment into Indian leasing.

•

Starting with GE Capital's entry, an increasing number of foreign-owned financial firms and banks are currently engaged or interested in leasing in India.

28

Evolution of Hire-purchase •

The British concept of hire-purchase has, however, been there in India for more than 6 decates.

•

The first hire-purchase company is believed to be Commercial Credit Corporation, successor to Auto Supply Company.

•

While this company was based in Madras, Motor and General Finance and Instalment Supply Company were set up in North India.

•

These companies were set up in the 1920s and 1930s.

•

Development of Hire-purchase took two forms: – consumer durables – and automobiles

•

Consumer durables hire-purchase was promoted by the dealers in the respective equipment.

•

Thus, Singer Sewing Machine company, or Murphy radio dealers would provide instalment facilities on hire-purchase basis to the customers of their products.

29

Leasing and Hire-purchase: A vanishing distinction •

Essentially, asset-based financing in India particularly by non-banking financial companies is split in two documentation modes - lease and hire-purchase.

•

These two are technically different instruments, but in essence, there is not much that differs between the two, except for the caption.

•

In spite of the substantive similarity, historically, there has been a diametric separation between these two forms.

•

The assets usually subject matter of hire-purchase have been different from those generally leased out.

•

Leasing has been used mostly for plant and machinery, while hire-purchase has commonly been used for vehicles.

•

The reasons for this diametric distinction are more historical than logical.

•

Hire-purchase, essentially a British form, entered India during the Colonial era, and thrived as almost the only form of external finance available for commercial vehicles.

•

For the financiers, as witnessed World-over, commercial vehicles was the natural choice for several asset-features he loves: lasting value, ready secondary market, self-paying feature, etc.

•

Hence, the industry of hire-purchase became synonymous with truck-financing.

30

•

Besides, the motor vehicles laws gave the surest legal protection any law could give to a financier: the financier would not have to carry any of the operational risks of a motor vehicle, and yet, any transfer of the vehicle would not be possible without the financier's

•

Leasing, essentially a US-innovation, entered the country significantly in the early 80s, and was propagated as an alternative to traditional modes of industrial finance.

•

Besides, the early motivation (which continues with a number of players even now) of leasing was capital allowances, more significantly the investment allowance, which was not available for transport vehicles.

•

Hence, the leasing form historically clung to industrial plant and machinery.

•

For several years, there was no lease of vehicles, because the Motor Vehicles law protection was not applicable to a lease, and there was no investment allowance on vehicles, and for reciprocal reasons, there was no hire-purchase of industrial machinery.

•

These reasons have vanished over time. •

The Motor Vehicles law now treats leases and hire-purchase at par from the viewpoint of financier-protection.

•

Investment allowance has been abolished, and hence, there are no predominant tax-preferences to a lease.

•

The RBI treats lease and hire-purchase at par and has stopped giving a distinctive classification to leasing and hire-purchase companies.

31

Lessors

•

Specialized leasing companies

•

Banks and bank-subsidiaries

•

Specialized Financial institutions

•

One-off lessors

•

Manufacturer-lessors

32

Specialized leasing companies •

These large companies which have an organizational focus on leasing, and hence, are known as leasing companies.

•

Till recently, most of them were diversified financial houses, offering several fund-based and non-fund based financial services.

•

However, recent SEBI rules on bifurcation of fund-based and non-fund based activities has resulted into hiving-off of merchant banking divisions of these entities.

•

Most of these companies also offer hire-purchase activities, and some of them might have a consumer finance division as well.

•

These companies are known, in regulator's jargon, as non-banking financial companies, or NBFCs for short.

•

The terms NBFCs includes several other financial concerns too, and all such companies are regulated by the Reserve Bank of India.

•

There were no entry barriers to leasing business till recently, but the January 1997 amendments to the RBI law now require any non-banking finance company to have a prior registration with the RBI, and the conditions of registration virtually amount to authorization by the RBI.

33

Banks and bank-subsidiaries

•

Till 1991, there were some ten bank subsidiaries active in leasing, and over-active in stock-investing.

•

The latter variety was ravaged in the aftermath of the 1992 securities scam.

•

In Feb., 1994, the RBI allowed banks to directly enter leasing.

•

So long, only bank subsidiaries were allowed to engage in leasing operations, which was regarded by the RBI as a non-banking activity.

•

However, the 1994 Notification saw an essential thread of similarity between financial leasing and traditional lending.

•

Though State Bank of India, Canara Bank etc have set up leasing activity, it is not currently at a scale to make any difference on the leasing scenario.

•

This is different from the rest of the World, where banks are front-runners in leasing markets.

34

Specialized Financial institutions •

There is a wide variety of financial institutions at the Central as well as the State level in India.

•

Apart from the apex financial institutions, viz., the Industrial Development Bank of India, the Industrial Finance Corporation of India, and the ICICI, there are several financing agencies devoted to specific causes, such as sick-industries, tourism, agriculture, small industries, housing, shipping, railways, roads, power, etc.

•

In most States too, there are multiple financing agencies for generic or focussed cause

•

Most of these institutions are using the lease instrument along with traditional financing instruments.

•

Significantly, the ICICI was one of the pioneers in Indian leasing.

•

At State level also, financial institutions are active in leasing business

35

One-off lessors •

Some of the companies engaged in some other business which gives them huge taxable profits, have resorted to one-off leasing on a casual basis to defer their taxes.

•

These people are interested only in leasing of high-depreciation items, preferably those entitled to 100% depreciation.

•

The major items eligible for 100% depreciation are gas cylinders, certain energy-saving devices, pollution control devices etc.

•

Severe scrutiny by revenue officials into lease transactions at the time of assessment has dampened the enthusiasm in this line of leasing activity, however it carries on.

•

Mostly such lease transactions are syndicated, at times even funded, by active players in leasing markets.

36

Manufacturer-lessors •

This part of the lessor-industry is in highly under-grown form in India, for simple reasons.

•

Vendor leasing is a product of competition in the product market.

•

As competition forces the manufacturer to add value to his sales, he finds the best way to sell the product is to sell it without the buyer having to pay for it instantly.

•

Product markets so far for most durables were oligopolistic, and good products used to sell even otherwise at a premium.

•

With the economy decisively moving towards market orientation, competition has become inevitable, and competition brings in its wake sales-aid tools.

•

Hence, the potential for vendor leasing is truly great.

•

Presently, vendors of automobiles, consumer durables, etc. have alliances or joint ventures with leasing companies to offer lease finance against their products.

•

However, there is no devoted vendor leasing of the type popular in most of the advanced markets, where a specific leasing company or leasing program takes exclusive charge of a vendor's products.

37

The lessees •

Corporate customers with very high credit ratings: These essentially look at leasing to leverage against assets which are otherwise not bankable, or for pure junk financing.

•

Public sector undertakings: This market has witnessed a very rate of growth in the past.

•

With budgetary grants to the PSUs coming to a virtual halt, there is an increasing number of both centrally as well as State-owned entities which have resorted to lease financing.

•

Their requirements are usually massive.

•

Mid-market companies: The mid-market companies, that is, companies with reasonably good creditworthiness but with lower public profile

•

basically as an alternative to bank/institutional financing, which to them is timeconsuming and tedious.

•

Consumers: Retail funding for consumer durables was frowned-upon at one point of time, but recent bad experience with corporate financing has focussed attention towards consumer durables which incidentally, is all the all-time favorite of financiers Worldover.

•

Most of the larger companies have expressed interest in consumer funding, with ticket size going as low as Rs. 5000.

•

Car customers: Car leasing World-over is a very big market, and the same is true for India.

38

•

So long, most car leases were plain-vanilla financial leases but one now finds few instances of value-added car lease services also being offered.

•

Commercial vehicles: Commercial vehicles customers have always relied upon funding by hire-purchase companies.

•

The customer profile ranges from large fleet owners to individual truckers.

•

Earth-moving machinery customers: These customers have also traditionally relied upon lease financing.

•

Their requirements are generally large - each excavators costs more than Rs. 25 lacs.

•

The income-stream is based on contracts they have - at times, the income generation may be sporadic, or the need might itself be temporary.

•

In fact, operating leases would have been ideal in this market, but they are yet to be launched to any serious degree.

•

Govt. deptts. and authorities: One of the latest entrants in leasing markets is the Govt..

•

The Deptt. of Telecommunications of the Central Govt. took the lead by floating tenders for lease finance worth about Rs. 1000 crores.

•

In its reforms programme, India has limits to the extent to which it can resort to deficit financing, and leasing is easily going to appeal to the Govt. , if not for cost reasons, at least for the fact that it will not feature in national accounts as a commercial financing.

•

As a spin-off, it might even help reducing the reported deficit, as the Govt. resorts to what is loved World-over as a tool of off-balance-sheet financing. 39

Sources of Law on leasing and hire-purchase •

Leasing and hire-purchase are essentially hiring transactions - transactions in which possession of goods is handed over along with right to use, for a stated period and for consideration.

•

Hiring transactions are species of bailments in contract law - therefore, the transactions of lease and hire-purchase are governed by the common law of contracts dealing with bailment transactions.

•

Contracts law, being common law, is codified in the Indian Contracts Act 1872 but is enriched by history of precedents from both English and Indian Courts.

•

Notably, the common law of contracts in India is based largely on the British legal principles, which have by and large been accepted as applicable to India.

•

Therefore, the principal sources of applicable law on lease and hire-purchase transactions are sections 148 to 171 of the Indian Contracts Act dealing with bailments, and a long series of Court rulings, principally on hire-purchase transactions, but of late, on lease transactions as well.

40

Leasing and Hire-purchase •

From legal rights and obligations viewpoint, there is no difference between lease and hire-purchase transactions. Both are viewed as bailment transactions.

•

Accordingly, most of the common law applicable to hire-purchase transactions is also applicable to leases, and vice versa.

•

The difference between the two is principally the non-existence of option to buy in case of lease transactions.

•

In other words, lease transactions carrying an option to buy, explicitly or implicitly, will be treated as hire-purchase transactions.

•

This may lead to differences in taxation treatment, but there is no appreciable difference in legal rights of parties

41

Requirements of a valid lease or hire-purchase •

Both lease and hire-purchase, to be valid, must be valid bailment transactions.

•

Therefore, all the preconditions of a valid bailment will be applicable to lease and hirepurchase transactions too.

•

As the lease contract envisages a delivery of goods to the lessee, to be terminated by redelivery of goods at the end of the lease period, the goods must have the following features:

42

Durability •

The goods must last for at least as long as the lease period.

•

Unless the lessor, or the lessee being under obligation to do so, replaces them and the goods so replaced become the subject matter of the lease, the contract of lease comes to an end as soon as the subject matter of the lease, viz., the leased goods, cease to exist.

•

The goods constitute the very string of relation between the lessor and the lessee, and the relation is snapped the moment the string is broken.

•

There may be doubts as to the existence of an intended lease where the goods leased are known not to have an estimated life at least equal to the lease period.

•

For example, a lease of an umbrella could be intended, but not the lease of an ice cream.

•

That is to say, goods which are consumed in the process of using them are incapable

Movability and severability •

The goods leased are to be returned at the end of the lease period, since the possessory interest is only for a specific period.

•

At the end of the period, the goods must redeliverable.

•

This requires two attributes: – that the goods must not have been permanently attached or affixed to an immovable property and hence rendered immovable, – nor must they have been attached unseverably to any other property 43

Identifiability •

To ensure that the bailee holds the goods owned by the bailor, the goods possessed by the lessee must be held distinct and ascertainable;

•

in other words, the leased goods must not be mixed to render them unascertainable.

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The law of contracts distinguishes between mixture with or without the bailor's consent.

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Where the mixture is with the bailor's consent, the bailor and bailee will have proportionate interest in the lot. [Sec. 155].

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Where the mixture is without the bailor's consent and the goods are unseverable, the bailor becomes entitled to be compensated by the bailee for the loss of goods.

Supreme ownership rights of the lessor •

Indian Courts have generally recognized the ownership rights of a lessor over the leased asset.

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Even if the lease is avowedly a financial lease, such as in case of a hire-purchase transaction, the Courts respect the way the parties have sought to create and protect their rights.

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Obligations relating to the goods •

While enjoying all the rights of ownership,

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the lessor may virtually escape all obligations relating to the goods - conditions of fitness, quality, usefulness for purpose, or any damages on account of defects in goods,

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can be effectively avoided by a disclaimer clause in the agreement

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backed by evidence that the lessor was not involved in selection of the goods

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nor did he influence the lessee's decision as to the goods or the supplier.

Obligations regarding operation and use of the goods •

While being the owner of the goods, the lessor may completely distance himself from obligations relating to the operation and use of the goods.

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This issue is very comfortably settled in India though there is a raging controversy on this point in number of other markets.

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The lessor is not in effective possession and is not the user of the goods.

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The lessee cannot be taken to be the agent of the lessor.

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What Is the Concept of Leveraged Leasing? •

It is simply a lease transaction in which the lessor puts in only a portion, usually 20% to 40%, of the funds necessary to buy the equipment and a third-party lender supplies the remainder.

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Because the benefits available to the lessor are generally based on the entire equipment cost, the lessor's investment is said to be "leveraged" with third-party debt.

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Generally, the third-party loan is on a nonrecourse-to-the-lessor basis and ranges from 60% to 80% of the equipment's cost.

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The nonrecourse nature means the lender can only look to the lessee, the stream of rental payments that have been assigned to it, and the equipment for repayment.

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The lessor has no repayment responsibility even if the lessee defaults and the loan becomes uncollectible.

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Although the concept of leveraging a lease investment is simple, the mechanics of putting one together is often complex.

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Leveraged lease transactions, particularly ones involving major dollar commitments, frequently involve many parties brought together through intricate arrangements.

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The "lessor" is typically a group of investors joined together by a partnership or trust structure. The partnership or trust is the legal owner, or "titleholder," of the equipment.

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The "lender" is often a group of lenders usually acting through a trust arrangement.

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•

This is further complicated by the fact that each participant will be represented by counsel with varying views.

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As a result, the job of organizing, drafting, and negotiating the necessary documents is generally very difficult.

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Because the expenses involved in documenting a leveraged lease can be substantial, transactions involving less than $2 million worth of equipment can be economically difficult to structure as a leveraged lease.

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If, however, documentation fees (such as counsel fees) can be kept within reason, smaller equipment amounts can be financed in this manner.

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In many cases a prospective lessor or underwriter has an in-house legal staff with the ability to originate and negotiate the required documents.

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If so, this will help keep costs down.

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Generally, leveraged lease financings are arranged for prospective lessees by companies or individuals who specialize in structuring and negotiating these types of leases.

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These individuals and firms are referred to as lease underwriters.

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Essentially, their function is to structure the lease economics, find the lessor-investors, and provide the necessary expertise to ensure that the transaction will get done.

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In a limited number of situations, they also find the debt participants. They do not generally participate as an investor in the equipment.

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Underwriting •

Because the vast majority of leveraged leases are brought about with the assistance of lease underwriters, lease underwriting has become synonymous with leveraged leasing.

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The premise on which lease underwriting services are provided by an underwriter (that is, on a "best efforts" or "firm" basis) varies significantly.

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It is, therefore, worthwhile at this stage to explore the two types of underwriter offers: "best efforts" and "firm commitment" underwriting arrangements.

A 'Best Efforts' Underwriting Arrangement Can Be Risky •

Lease underwriting transactions are frequently bid on a "best efforts" basis.

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This type of bid is an offer by the underwriter to do the best it can to put a transaction together under the terms set out in its proposal letter.

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There are no guarantees of performance.

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As a result, a prospective lessee accepting the offer may not know for some time whether it has the financing.

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In practice, a best efforts underwriting is not as risky as it appears.

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Most reputable underwriters have a good feel for the market when bidding on this basis and usually can deliver what they propose.

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Thus, there is a good chance they will be able to get "firm commitments" from one or more prospective lessor-investors to participate on the basis offered. 48

A 'Firm Commitment' Underwriting Arrangement Is Often the Best •

From a prospective lessee's viewpoint, a "firm commitment" underwriting proposal is generally the preferred type of offer.

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When an underwriter has "come in firm" it is guaranteeing to put the proposed lease financing together.

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Typically, before an underwriter submits this type of proposal, it has solid commitments from lessor-investors to enter into the transaction on the terms presented.

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This, however, is not always the case. The underwriter's firm bid may only represent its willingness to be the lessor if it cannot find a third-party lessor.

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A PRACTICAL LOOK AT LEASE DOCUMENTATION

Your equipment lease documents are designed to: •

* Protect lease revenues

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* Protect residual value

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* Protect the lessor from liability

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* Protect enforceability

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Term/Rent •

Generally, the term of an equipment lease will begin on acceptance of the equipment, which sounds much more simple than we all know it actually is.

•

This is one of many areas where the reliance on standard form documentation, without periodic review and a bit of thought in individual circumstances, can lead to disaster.

Coordination of the lease •

the schedule (if a master lease is used), the delivery and acceptance certificate and the purchase order are key

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The date on which the term begins should be clear.

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Most leases clearly state whether the rent is intended to be paid in advance or in arrears.

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Be mindful of this in structuring casualty or termination value tables

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Interest/Late Charges •

Far more common than problems about the term and rent provisions are problems regarding the lessee's late payment of rent.

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Generally, this is not a usury problem in most states — penalty rent is not considered to be "interest" for usury purposes under most state laws.

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However, several types of problems can arise if the late charges are not consistently applied. If the lessee is going to be given grace for any reason, a written letter to the lessee should explain that the lessor reserves the right to reinstitute the penalty later on.

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Late charges fall into several categories.

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Some leases require a single lump sum payment, which should be invoiced to the lessee as soon as it is due.

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Other leases require a calculation of interest, usually from the date due until the date of payment.

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Net Lease/Hell or High Water Clause/Warranty Disclaimer •

The net lease provision states that the lessee is responsible for paying operating costs, taxes and insurance.

•

This effectively means that the rent payment is "net" to the lessor (except for the lessor's income taxes and overhead).

Hell or high water clause

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The hell or high water clause is important to establish that the lessee must pay the full amount of rent whether or not the equipment functions and has no right of offset. If this clause is explained to the lessee, it should be pointed out that the lessee does not, in this clause alone, give up its right to sue the lessor if it feels that the lessor has breached any terms of the lease, including representations regarding the equipment.

Warranty Disclaimer •

Under Article 2A, a warranty is implied by the lessor whether the equipment is leased under a true lease or a disguised security arrangement.

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In other words, you are all deemed to be making an implied warranty that the equipment is "merchantable" and "fit" for the lessee's intended use

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UNLESS THE WARRANTY DISCLAIMER LANGUAGE IS PRESENT IN YOUR LEASE.

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Delivery & Acceptance/Purchase Orders •

As a general rule, virtually all of the lessee's obligations to the lessor, including the obligation to pay rent and to indemnify the lessor, arise only when the equipment has been accepted.

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Likewise, the lessor's obligation to make payment to the vendor of the equipment arises on the lessee's acceptance.

Return Provisions •

One of the provisions which addresses directly the lessor's anticipated residual value realization is the return provision of the lease.

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These provisions include provisions addressing the condition in which the equipment must be on the date of return, the allocation of the costs of redelivery and what additional charges the lessee may be required to pay.

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Purchase/Renewal Options •

On their face, few things are as simple as the concept of a renewal or purchase option. In fact, few provisions cause more problems.

•

It is essential that the Lessor be fully familiar with the terms of the renewal or purchase option provision as it relates to the particular lessee and equipment.

• •

"Fair market value" may be a difficult concept If the lessee desires to exercise a renewal or purchase option, check to ensure that no default exists, that no liabilities are outstanding and that the lessee has complied with all notice and other requirements.

•

In addition, a provision describing how fair market value should be in your lease form.

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Be sure you are comfortable with its workings and the potential cost in dollars and time.

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Contact potential appraisers in advance and be sure that they are familiar not only with the type of equipment but the concept of a fair market value determination for equipment lease purposes.

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Some Terms :-

Gross Lease •

In this form of lease the lessor is responsible for all expenses associated with ownership of the equipment such as maintenance, taxes and insurance.

Net Lease •

A net lease is the opposite of a gross lease.

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Here, the lessee is responsible for expenses related to the operation of the equipment such as maintenance, taxes and insurance.

Residual Value •

This is the value of the equipment at the end of the term.

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LEASE OR BUY •

Companies have usually several options when acquiring capital equipment.

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There are at least three possibilities: – lease – buy and finance through a loan – buy with cash on hand

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Cash flows of these three options are driven by several components including

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interest and discount rates, effective tax rate, number of depreciable years for tax purposes, how long the equipment will be used, and the salvage value at the end of its use

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Simply comparing different cash flows in different time periods may not be practical in order to arrive at a capital investment decision.

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Hence there is a need for a metric that can accurately summarize these cash flows for each investment option.

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Net present value (NPV) is such a metric. NPV is calculated as the sum of present values of current and future cash flows.

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The focus on NPV forces companies to identify all cash flows from these three lease-orbuy options, which ensures that not only the month-to-month payments are considered.

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Hence, from a purely financial point of view, companies should acquire capital equipment based on the option with the lowest NPV. 57

•

By leasing, the company can use its cash for investment in its core business rather than in the infrastructure required to run it.

•

Equipment that is often leased includes computers and peripherals, office furniture, manufacturing and construction equipment, and commercial vehicles.

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Between leasing and financing, leasing usually offers the lowest month-to-month payments.

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But there are also other costs associated with a lease, especially the residual value of the equipment and the buyout price agreed with the leasing company upfront.

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Some lessees make the mistake of focusing on the low monthly payments and don't consider also the choices that they will need to make at the end of the lease.

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Lessees should keep in mind for example that they may need to continue using the equipment, which may require extending the lease or buying out the equipment.

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Both choices may generate additional costs

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Financing the purchase through a loan may make more sense if the company needs to use the equipment longer than just few years.

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Cash purchase could be the preferred option, on the other hand, if the equipment is needed for longer period of time and the interest rate of the lease or loan significantly exceeds company's cost of capital.

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History •

Leasing techniques have been used for financing purposes for several decades in the United States.

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The practice developed as a method of financing aircraft.

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Several airlines in the early 1970s were notoriously unprofitable and very capital intensive. A very prominent bank would purchase aircraft and lease them to the airlines.

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These airlines had no need for the depreciation deductions generated by their aircraft and were significantly more interested in reducing their operating expenses.

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Because the bank was able to claim depreciation deductions for the aircraft,

•

the bank was able to offer lease rates significantly lower than the interest payments that airlines would otherwise pay on an aircraft purchase loan (and most commercial aircraft flying today are operated under a lease).

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In the United States, this spread into leasing the assets of U.S. cities and governmental entities and eventually evolved into cross-border leasing.

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In a globalizing environment, cross-border leasing has not picked up the way it might have been expected.

•

Cross-border lease transactions are generally restricted to aircraft leasing, where this is the most popular means of financing, marine equipment and railroad rolling stock to some extent.

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SUMMARY A lease is an agreement for the use of the asset for a specified rental. The owner of the asset is called the lessor and the user the lessee. Two important categories of leases are: operating leases and financial leases. Operating leases are short team, cancellable leases where the risk of obsolescence is borne by the lessor. Financial leases are longterm, non-cancellable leases where any risk in the use of the asset is borne by the lessee and he enjoys the returns too. The other subparts of finance lease are: sale and lease back and leveraged financing. Under sale and lease back lease the owner of an asset sells the asset to a party, who in turn leases back the same asset to the owner in consideration of lease rentals. Under leveraged leasing a third party (i.e. financier or lender) is involved beside lessor and lessee. Direct lease another type of leases, which is popularly used. Under this, a firm acquires the right to use an asset from the manufacturer directly. Leasing plays an important role in the economic development of a country by providing money incentives to lessee. Lease financing has several advantages. In India, the First Leasing Company Ltd. was set up in Madras in 1973. As per the industrial investment, lease finance in India just like a newborn baby. Hire purchase and factoring are the other forms of financial services. Hire purchase is a type of instalment credit under which the hire purchaser agrees to take the goods onhire at a stated rental. The system of the hire purchase is regulated by the Hire Purchase Act 1972. Small scale firms suffer from the problem of dearth of funds. In this case hire purchase system plays an important role by providing equipment; vehicles etc. on hire purchase without making full payments. NSIC also provides machinery and equipment to Small Scale units on hire purchase basis and on lease basis. Factoring the other financial service under which a financial institution undertakes the task of collecting the book debts of it client

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GLOSSARY Capital lease: It is a lease obligation that has to be capitalized on the balance sheet. It is characterized by: it is non-cancelable; the life of lease is less than the life of the asset(s) being leased; and, the lessor does not pay for the upkeep, maintenance, or servicing costs of the asset(s) during the lease period. Sub-lease: A transaction in which leased property is released by the original lessee to a third party, and the lease agreement between the two original parties remains in effect. Wet lease: A wet lease is any leasing arrangement whereby a company agrees to provide an aircraft and at least one pilot to another company. ‗Dry lease‘ on the other hand, refers to leasing only the aircraft.

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REFRENCE 1. Lease Financing in India by M. Sree Lakshmi 2. Evaluation of Lease Financing by E. Chandraiah 3. Lease Financing & Hire Purchase (Concept, Law & Procedures) With Consumer Credit by S. Venugopalan

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