Theoretical and Regulatory Framework of Leasing

Chapter 2 Management of Financial Services - MY Khan

Lease - definition

A lease is an agreement whereby the lessor conveys to the lessee , in return for rent, the right to use an asset for an agreed period of time. A financing arrangement that provides a firm with an advantage of using an asset, without owning it, may be termed as leasing.

Characteristics of lease

The Parties The Asset The Term The Lease Rentals

Types of Lease

Financial Lease : Operating Lease Conveyance Type lease Leveraged Lease Sale and Leaseback Partial Pay-Out Lease Consumer Leasing

Ballon Lease Close end leasing Swap Leasing Wrap Leasing Import Leasing Cross Border leasing International Leasing

Types of Lease...

Financial Lease
Also called Capital Lease A contract involving payment over an obligatory period, of specified sums sufficient in total to amortize the capital outlay , besides giving some profit to the lessor. ICAI defines it as : financial lease is a lease under which the present value of the minimum lease payments at the inception of the lease exceeds or is equal to substantially the whole of the fair value of the leased asset.

Financial lease...

It is non-cancelable in nature. The lessee is responsible for the maintenance of the asset leased. The lease generally provides for the renewal of the lease on expiry of the lease contract. Variants : full payout lease , True Lease

Operating Lease

An operating lease is a type of lease whereby the asset is not fully amortized during the non-cancelable period of the lease , and where the lessor does not rely on the lease rentals for profits. Short term lease on a period to period basis. Period of the lease is less than useful life of the asset.

Operating Lease...

The lease is cancelable at short notice by the lessee. The lessee has the option of renewing the lease after the expiry of the lease period Asset maintenance and insurance etc. is the responsibility of the lessor and he charges for the same. It is a high risk lease to the lessor, as any time it may be cancelled by the lessee.

Types of Lease
Net Lease : A variant of operating lease, where the lessor is not concerned with the repairs and maintenance of the leased asset.

Lessor does not provide: - repairs, maintenance, servicing of lease property - purchasing parts and accessories. - loan of a replacement/substitute - purchase of insurance for the lessee.

Types of Lease

Conveyance Type Lease : Very long type of lease applicable to immovable property. Objective to convey the title in property. Lease periods as long as 99 to 999 years. Leveraged Lease Where a financier is involved for the whole or a part of the financial requirement. Used for high value asset. The financier will have charge over the leased asset, over and above the lease rentals.

Types of Lease.

Sale and Leaseback: Owner of the asset sells it to the lessor, and gets the asset back under the lease agreement. Ownership transfer from the original owner to the lessor, who again leases out the asset. Immediate financing to the seller company, whose funds are tied up in the asset.

Types of lease..

Partial pay out lease: Full payment of the lease in several leases. Consumer Leasing :Leasing of consumer durables like Refrigerator, televisions, etc. Balloon Lease : a lease which has zero residual value at the end of the lease period. i.e. low lease rentals at the inception, high in the mid years, and low again at the end of the lease. Close end leasing : the asset is reverted to the lessor at the end of the lease. Open end leasing : the lessee guarantees a minimum value to the lessor , from the sale of the asset at the end of the lease term. If on sale of the asset, the residual value is less , then lessee pays to the lessor the difference amount.

Types of Lease..

Import Leasing : - leasing of imported capital goods. - beneficial to the lessee, because arranging other sources of funds takes long. Lenders do not usually finance the import duty which forms sizable portion of the cost. - during which the prices of imported goods may rise + fluctuation in exchange rates may happen.

Types of Lease..

Cross Border Leasing : A lease where the lessor is in one country and lessee in another. The Jurisdiction of lessors and lessees are in two different countries. Eg. Leasing of airplanes. International Leasing A case where the leasing company is operating in various countries through its branches. International leasing is active in countries like U.S., Japan, HongKong etc.

Regulatory framework of leasing

Provisions under Contract Act relating to Bailment: two parties - lessor - bailor, lesseebailee. Transfer of possession of goods from bailor(lessor) to bailee(lessee), for a specific purpose. As under bailment, on accomplishment of purpose the goods transferred from lessee to lessor.

Regulatory framework of leasing..

Liabilities of Lessee(Bailee).. Reasonable Care :

The lessee to take reasonable care of the asset. If he fails he is liable to for loss or damage to the goods that he has caused. If goods damaged despite of reasonable care, (floods, riots etc), then the lessee is not responsible. Generally lease agreements make the lessee responsible , irrespective of lessees negligence.

Regulatory framework of leasing..

Unauthorized Use not Permitted to the Lessee: The lessee is not allowed to use the leased asset , for any purpose other than one specified in the lease agreement. If he does so , then the lease agreement is terminated, and lessor recovers the possession of the goods. Return of Goods : The lessee has to return the goods : on completion of the lease term; or the lease agreement has been terminated by the lessee or lessor/or automatic termination of the agreement because of breach of conditions.

Regulatory framework of leasing.

Not to set up an Adverse Title: must inform the lessor of any adverse claim. Payment of Lease Rental: Insure and Repair the Goods: Liabilities of the Lessor(Bailor):

Theoretical Framework of Leasing

Liabilities of Lessor (Bailor): Delivery of Goods: - Ensure delivery of goods to the lessee, along with documents for lawful use of asset. Lease commences on delivery. Peaceful Possession: - Lessor must ensure quite possession of the goods during the lease term Fitness of Goods To Disclose All Defects: all known defects to be disclosed. If not then the lessor has to compensate the losses incurred by the lessee due to such defects.

Theoretical Framework of Leasing

Remedies for Breach;

Remedies to the Lessor: - Forfeiture : forfeiture of all lease rentals paid up to the date of termination, even if it exceeds the amt. of benefit received by the lessee. - Repossession : repossession of goods on breach of lease through serving of a notice on lessee. For repossession of goods physical force can be used by the lessor. Remedies to the lessee: may claim damages for loss resulting from the termination. This includes increased lease rentals he has to pay on new lease asset obtained + damages for not allowing him to use the asset from termination date to the the date of expiry of the lease term.

Theoretical Framework of Leasing

Insurance of the leased Asset ; Both lessor or lesse can obtain the insurance. Generally obtained by the lessee, covering loss due damage by fire, riot, faulty handling, Act of God etc. Claims Proceeds : in case of asset being fully destroyed, the claims received , adjusted against the lessors dues. In case of partial damage, the claim proceeds to be adjusted against amount financed, and then for balance lease rentals is computed. Sub Lease by lessee : not allowed unless provided in the lease agreement. Except for assets where sub lease is apparent. Sub lease becomes the lease of the original lessor as well. If Main lease is terminated then the sub lease gets automatically terminated.

Lease Documentation and Agreement

Lease Approval Process:

Appraisal of the Lease proposal. Sanctioning of the credit amount. Letter of Offer, with stipulated time for acceptance. Acceptance of Offer by lessee within stipulated time, with Board Resolution for acceptance of the offer. Documents required: Purchase Order, Invoice, Bill of Sale from supplier, delivery note, insurance policies, import license, copy of shops and establishments registration certificate, copies of Audited balance Sheet and P&L A/c. for 3yrs, M of A and Articles of Assocation, Provisional results for the first 6 mths, IT returns/Salary certificate,

Lease Documentation and Agreement..

All these documents to be obtained by the lessor from the lessee. They are called Attendant Documents as they help in taking a decision for the lease proposal. Insurance Policy compulsory for the leased asset, in the name of the lessor account lessee. Policy should be in the custody of the lessor.

Lease Agreements

It specifies the legal rights and obligations of the lessor and lessee. Usually a Master lease is signed containing the qualitative terms in the main part, and the equipment details, rentals, credit limits and payment duration etc in attached schedules. Additional lease facilities are finalized under supplemental lease agreements, with reference to the Main Master Lease Agreement.

Lease Agreements...

Clauses in Lease Agreement:

Nature of the lease : financial lease, operating lease etc. Description : of the equipment, its actual condition, size, estimated useful life, components etc. Delivery and Re-delivery : when and how the equipment would be delivered to the lessee and redelivered by him. Lease Rentals ; procedure for payments of lease rentals with the rates. Besides, the late payment charges. Repairs & Maintenance : responsibility of repairs, insurance etc. Title : identification and ownership of equipment. Events of default and Remedies : consequences of default and recourse available to the lessor.

Tripartite Lease Agreement

Three parties - Manufacturer, lessor(financier) and lessee. Guarantee Agreement : in addition to master
lease agreement. Guarantor liable for the due amt. of lessee. He signs the guarantee agreement. If Guarantor is a company then Board Resoultion for the same is a must. Income and Address proof of Guarantor taken. Agreement on a stamp paper.

Tripartite Lease Agreement...

Promissory Note:

Lessee to execute an unconditional promissory note in favour of lessor for the full amount of lease rentals payable, counter guaranteed by the guarantor. Beyond three years, a fresh promissory note to be executed.

Receipt of Goods:
In case of tripartite lease , the manufacturer/supplier/lessor, delivers the goods directly to the lessee, so he has the execute the receipt for the goods.

Tripartite lease agreements...

Collateral Security/Hypothecation Agreement:

Sometimes required if financial position of the lessee is weak. Collateral security may be a Promissory Note by lessee , insurance policies, shares etc. No Pledge Deed is required. A deed of Hypothecation may be executed on stamp paper of appropriate value.