Look Before You Lease: Upgrade Rights

A reader has asked us to go over upgrade rights, one of the most difficult provisions for lessees to negotiate.

For years, lessees of various types of equipment, especially computer and other high technology equipment, have requested that each of their lessors commit to keep the equipment up-to-date. There are many ways this might be done, including

  • Upgrade rights - under which the lessor agrees to finance modifications or additions to the equipment.
  • Termination for obsolescence rights - under which the lessee has the right to terminate the lease by paying the difference between the amount received when the equipment is sold to a third party and a pre-agreed "termination value."
  • Refresh provisions - generally, giving the lessee the right to return the equipment to the lessor and have it replaced with newer model units.
  • Sublease/early buyout, cancellation rights - A potpourri of rights for the lessee to terminate the lease or find a new buyer or user of the equipment, or even buy the equipment and sell it to a third party in order to free up space for new equipment.

With the exception of the refresh provision, which are actually a variation of the upgrade rights and are difficult to obtain from non-vendor lessors, the upgrade rights are generally best suited to this particular lessee need.

Here the lessees face a new problem, under the heading of "Upgrade Rights", lessors have devised a wild assortment of provisions. In many leases, the so-called "upgrade right" is nothing more than an obligation for the lessee to continue to do business with the same lessor. Forms used by several large computer lessors require the lessee to use the lessor for financing new equipment, or at least give the lessor a right of first refusal on any future financing.

This may not be all that unreasonable, except that it is rare for these forms to give the lessee any assurance that the lessor will be willing to price the new lease on the same basis as the original lease. Few lessors are willing to agree that the rent will be the same, subject to changes in the lessee's credit and changes in prevailing market rates.

A few suggestions for provisions lessee should seek are:

  • An agreement to fund any modification or addition to the equipment requested by the lessee, which the lessee designates an improvement to the equipment, so long as the value of the equipment is not impaired.
  • An obligation to structure the rentals on the same basis, using the same assumptions, as applied to the originallease, subject to (1) demonstrable changes in the lessee's creditworthiness and (2) changes in prevailing interest rates. As to the latter, the ideal situation would be an indexing of the rent to treasury notes, prime rates, LIBOR, or another standard selected by the parties. Alternatively, the lessor might be willing to state that the rate offered the lessee will be the same as the lessor routinely offers similarly-situated lessees for similar types of equipment. (Obviously, this leaves plenty of room for argument later).

There are other concerns regarding upgrades, such as ensuring that the lease term for the upgrade is co-terminus with the original equipment and making it clear that the lessee has the right to seek financing elsewhere if the lessor declines or does not live up to its obligation.

This brings about an even more important point. Most equipment leases contain provisions restricting the lessee's right to make changes in the equipment. An upgrade right, even if well drafted, is not as valuable as having the right to obtain financing elsewhere if the lessor does not provide a satisfactory offer. Even where the lessor does not provide that it may be the only source of financing for upgrade, many lessors know full well that the lessee cannot upgrade the equipment without the lessor's consent. Consider this "standard" lease language:

"Lessee shall not make any modification to or alteration of the Equipment, except in the course of repairs required by this Lease, without Lessor's prior written consent."

In other words, before agreeing to any language on upgrade, or deciding that upgrade rights are not important and new financing can be arranged later, the lessee should carefully examine language regarding modifications to the equipment. May the lessee make these modifications? Must the modifications be "readily-removable?" If any part is removed, what action must the lessee take with respect to it (return it to the lessor?).

If the terms of the lease permit the lessee to make improvements to the leased equipment, a second issue arises where the lease contains standard language similar to the following:

"Any equipment which is attached to or made a part of the Equipment shall, without further act, become the property of Lessor and an accession to the Equipment."

Under the state law, an "accession" is a smaller piece of equipment attached to the main unit. Any lien benefitting a secured party which exists as to the primary unit attaches to the new equipment as well. In other words, the new equipment becomes subject to the interest of the secured party in the larger piece at the time it is attached.

If there is any question as to whether the lessor has the right to claim an interest in the new equipment, it is unlikely that any other lessor (or any lender, for that matter) will want to finance the new equipment. Again, this can frustrate any attempt to upgrade the equipment even if the lessor has not stated that the lessee must obtain its consent to make any modification or that any upgrade must be financed by the original lessor.

Careful drafting allows the lessee to obtain a waiver of interest in the new equipment from the original lessor, for the benefit of the new lessor or lender. Experienced lessors will require (1) that the lessee obtain a similar waiver from the new lessor or lender for the original lessor's benefit, so that each party agrees to claim no interest in the other's equipment and (2) that the new items may be removed so long as any damage to the main unit is repaired.

The main message is that any offer of "upgrade rights" should be carefully evaluated. In many documents we have reviewed, the offer of an upgrade right is in fact what the poet, John Donne, called "a frail bubble's shadow" of value. It may be more valuable simply to obtain the right to terminate the lease before the end of its term or sublease the equipment to a third party (now generally available from major computer lessors) and obtain assurances that an upgrade may be added if additional funding can be obtained from a third party.

Where upgrade rights are needed, the priorities outlined above should be obtainable if the lessor is serious about keeping the lessee's business.