Nonrecourse Agreements: Where Is The Nonrecourse?
May 12, 2001
After reviewing a funding source’s form of agreement for a nonrecourse loan or a non-recourse sale of lease agreement, counsel to the entity selling or financing its leases (referred to in this article as the “seller”) often say to the funding source: “This deal is supposed to be nonrecourse. Why are there twenty representations and warranties, an obligation on the part of the seller to repurchase the lease in the event of a breach of those representations and warranties and an obligation to indemnify the funding source for any breach of those representations and warranties? This non-recourse agreement appears to be a recourse agreement.”
Seller’s counsel is correct insofar as a typical non-recourse loan agreement or non-recourse sale of lease agreement that requires the seller to make numerous representations and warranties with respect to the lease that is being purchased by the funding source or that collateralizes a loan made by the funding source (referred to in this article as a “financing”). In the event of a breach of any such representation or warranty, the funding source typically has recourse to the seller. However, in a nonrecourse agreement, the seller does not represent and warrant that the lessee under the lease will make the scheduled installments under the lease when due. If the seller did make this representation and warranty, then the financing would effectively be a recourse transaction. Without this representation and warranty, however, the funding source assumes the credit risk or risk of non-payment by the lessee. Because the funding source has assumed this risk, the financing is referred to as “nonrecourse”.
Although the funding source will assume the risk of non-payment by the lessee, the funding source will desire to receive assurances on the date of the financing that, among other items, (i) the underlying equipment has been accepted by the lessee, (ii) the seller owns the underlying equipment or has a first priority perfected security interest in the equipment, (iii) the lessee is not the subject of any bankruptcy or insolvency proceeding, (iv) the lessee is not in default under the lease, (v) the funding source has received the sole counterpart original of the lease and (vi) the lease is enforceable against the lessee.
There are at least two means by which the funding source can obtain these assurances and the other assurances it desires. First, it can conduct its own due diligence investigation. However, this is burdensome, if not impracticable, as well as costly. For instance, to assure itself that the lessee is not the subject of a bankruptcy or other insolvency proceeding on the date of the financing, the funding source would have to check the courthouse records in each venue where an insolvency proceeding may be brought by or against the lessee to determine if such a proceeding was instituted. In lieu of conducting a due diligence investigation, the funding source can receive the assurances it desires in the form of representations and warranties from the seller, with a right to require the seller to repurchase the lease or to repay the loan, in the event of a breach of any of those representations or warranties. This is appropriate since the funding source prices the financing on the assumption that it is financing performing paper (i.e., that it will finance a payment stream which, among other items, is owed by a lessee not the subject of an insolvency proceeding and which is secured by a first priority security interest in the underlying equipment). If a funding source is unable to receive the assurances it desires, it would undoubtedly adjust the pricing of the Financing to account for its potential exposure as a result of not receiving those assurances. It is also appropriate since the Seller should bear the risk that the facts that are the subject of the assurances the funding source desires may not be true. For example, with respect to determining whether the equipment is owned by the Seller or subject to a first priority perfected security interest in favor of the seller, the seller, vis-a-vis the funding source, is in a better position to make that determination. This is particularly true if the seller originated the lease.
However, the seller is often required to make representations and warranties with respect to matters over which it has no control or of which it has no knowledge. For example, a seller may object to making a representation and warranty that the lessee on the closing date of the financing is not the subject of a bankruptcy or insolvency proceeding. This is not an unreasonable objection since the seller will not have checked the courthouse records on the closing date to determine whether this representation and warranty is true. Further, it is awkward to insist that the seller make a representation and warranty with respect to a state of facts of which it has no knowledge. On the other hand, the funding source is, of course, entitled to assurance that on the closing date of the financing the lessee is not the subject of an insolvency proceeding. A means to address both the seller’s and the funding source’s concerns is to permit the seller to qualify the representation and warranty by stating that the representation and warranty is “to its knowledge.” Accordingly, the seller would represent that “to the best of its knowledge, the lessee is not the subject of any bankruptcy or other insolvency proceeding.” However, the agreement would also require that the seller repurchase the lease or repay the loan if any representation or warranty is untrue or incorrect when made, without giving effect to any knowledge qualifier contained therein. Accordingly, if the lessee is bankrupt on or prior to the closing date of the financing, and the seller had no knowledge of that fact, the funding source would still have the right to require the seller to repurchase the lease or repay the loan.
Another concern often raised by counsel to the seller is that if the lessee is unable to make payments under the lease due to its financial deterioration, the funding source will search the non-recourse loan and security agreement or non-recourse lease agreement for a technical breach of a representation and warranty and then request the seller to repurchase the paper on the basis of that breach. For example, the seller will customarily represent that the lease delivered to the funding source constitutes the complete agreement pertaining to the transaction. Assume after the financing is closed that the funding source becomes aware that there was an amendment to the lease agreement which was not disclosed to the funding source and which states that the lessee may self-insure the equipment. The fact that this amendment was not given to the seller constitutes a breach of the representation and warranty. However, reasonable persons would agree that the seller should not be obligated to repurchase the lease from the funding source since the breach of the representation has no connection to the basis for the loss incurred by the funding source, which again is the financial deterioration of the lessee which resulted in the lessee’s inability to pay the installments due under the lease. An appropriate means to address this concern of the seller is to formulate the repurchase obligation such that the requirement to repurchase the lease on the part of the seller is only with respect to a breach of a representation and warranty which “materially and adversely affects the value of the lease or the related equipment or the interest of the seller or the funding source in the lease or related equipment.” Based on this “material and adverse effect” standard, the failure of the seller to disclose the amendment with respect to self-insuring the equipment should not be a basis for the funding source to require the seller to repurchase the lease or repay the loan. Note, however, that the breach of the representation or warranty does not have to be related to the reason for the lessee’s inability to pay the installments due under the lease in order to trigger the seller’s repurchase obligation. For example, assume the seller files for bankruptcy after the financing is closed and that the funding source, when attempting to foreclose on its security interest on the equipment, discovers that UCC-1 financing statements were not properly filed and, accordingly, that it does not have a first priority perfected security interest in the underlying equipment. As a result of this failure, the funding source is unable to realize the value of the equipment. Assume further that, as is customary, the Seller represented to the funding source that the seller owns the equipment or has a first priority perfected security interest in the underlying equipment. In this instance, there would be a breach of a representation and warranty that does materially and adversely affect the value of, and the interest of the funding source in, the equipment. Accordingly, the funding source would have the right to require the seller to repurchase the lease or repay the loan even though the failure to properly file UCC-1 financing statements has nothing to do with the lessee’s bankruptcy.
It is important to further note that, quite properly, the funding source should still receive indemnification from the seller for any loss the funding source incurs as a result of a breach of a representation and warranty even if the breach does not meet the “material and adverse effect” standard for triggering the seller’s repurchase obligation. Furthermore, this indemnification should be made regardless of whether it was a “material breach of a representation or warranty” or a “breach of a material representation or warranty”. Materiality should have no place in an indemnification section since the funding source has incurred a loss that it otherwise would not have incurred except for consummation of the financing. Whether the loss resulted from a material breach or non-material breach is irrelevant to the funding source. A materiality qualifier is appropriately used in connection with the customary closing condition to the financing that the representations and warranties be true in all material respects on the date of the closing financing. This will ensure that the funding source cannot elect not to proceed with the financing as a result of an immaterial breach. However, the funding source should still be indemnified for any loss resulting from that breach.
In the context of a non-recourse financing, the formulation of the seller’s repurchase obligation outlined above, based on a standard of “material and adverse effect”, coupled with the right of the funding source to indemnity for any breach of representation and warranty without regard to materiality, addresses the concern of the seller that it not be required to repurchase lease based on an immaterial breach and, further, addresses the concern of the funding source that it have a remedy with respect to any breach of a representation and warranty whether that remedy is to require the seller to repurchase the lease in the event of a breach that meets the “material and adverse” standard or to be indemnified by the seller.
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