The Current Cumbersome System of Equipment Lease Documentation – High in Friction
When it comes to putting equipment leases on the books, with limited exceptions the equipment leasing industry operates much like it did 25 years ago. The prospective lessee identifies a piece of equipment it needs, selects a vendor and the specific equipment required and executes a purchase order. If financing is needed, the lessee embarks on a search for a suitable funding source. Once identified, the lessee begins the process of applying for credit with the lessor. At each step of the way, the developing transaction is evidenced by an exchange of hard documentation. Although an email exchange may facilitate the transaction, at the formative stage the prospective lessee is filling out paper documents: purchase orders, credit applications, purchase order assignments and the like.
The prospective lessor for its own part is reviewing that hard documentation, and putting together its own package of documents: master lease agreements, schedules, corporate resolutions, delivery and acceptance certificates and guarantees. If the lessor is functioning as a broker, it in turn may be looking for a place to park a deal with all the documents that process entails. All of this activity imposes an enormous amount of friction on the process with time delays to analyze the deal, credit score and transmit documents, fund the transaction, verify equipment acceptance and obtain executed documents.
The industry has recently started to move toward electronic signatures, but many lessors and their banks still want blue ink signatures on hard paper documents, with all the delay that entails. The whole process is needlessly time-consuming. However, most if not all the friction associated with the old way of doing business could be eliminated by developing technology known as blockchain technology.
Blockchain Technology – What is it?
In technical terms, a blockchain is a decentralized peer-to-peer network that maintains a distributed ledger of transactions. It may be public or private, and permissioned or non-permissioned.
A. What is a decentralized ledger?
A database, as in an Excel spreadsheet, that stores information like names, addresses, contract terms, purchase prices, monthly payments, etc. A ledger is centralized if the information is all maintained by one party, such as a lessor. A good example is a bank account. At its heart, a bank account is a simple ledger of debits and credits to the account of the depositor. And while a depositor may keep a record, the official account is maintained by the bank; it is centralized on the bank’s system.
A decentralized system is stored on any number of computers connected to a common network such as the Internet. Each computer, or node, contains a complete history of every transaction completed on a particular blockchain beginning with the first transaction processed on the first block of the blockchain. The ledger is distributed.
Each block contains a timestamp and a link to a previous block. Linking blocks chronologically results in the chain of blocks, hence a blockchain. Once recorded, the data in a block cannot be altered retroactively without creating an obvious incompatibility with later blocks, which depend on the original data from earlier blocks. For that reason, a blockchain is tamper evident, giving an integrity that makes a blockchain extremely tamperproof.
B. Peer-to-Peer Network
A network of computers, or nodes, connected to a common network. The nodes are all connected, but in a de-centralized manner; there is no single server to which all nodes connect. The network of nodes all operate under the same set of rules, or protocol. The protocol is expressed in computer code that resides on each node in the network. The agreed-upon protocol ensures that only information upon which the network reaches consensus will be included in the blockchain. The network of computers all running the protocol code must come to agreement upon whether a change to a blockchain should be made, and if so, what that change should be. No one node (computer) could unilaterally impose a change on the blockchain.
C. Public or Private: Permissioned or Non-Permissioned
An example of a public blockchain is Bitcoin, which is open to the public and is described as open or non-permissioned. A private network would be similar to that maintained by the Federal Reserve with its member banks, though this comparison is not precise as the Fed operates a centralized ledger system, with each member connected to the Fed, which maintains the official ledger. However, each participant must have permission to join the network.
In a blockchain, permission also functions at a separate level. One node that has permission at one point in the blockchain may drop out and no longer have permission to participate later in time in the chain.
D. The Protocol
The protocol consists of the common code, or software application, that each computer in the network agrees to use. The protocol spells out in detail all the rules and procedures that govern the working of the network. A peer-to-peer network could implement its own unique protocol, but more likely is that a network would opt to utilize one of the existing protocols, such as IBM’s sponsorship of the Linux Foundation’s Hyperledger Project, which focuses on identifying and addressing important features for an enterprise-class, cross-industry open standard for distributed ledgers.
A concept most often associated with blockchain is the “smart contract.” In the context of blockchain, a smart contract has nothing to do with the traditional idea of a legal contract. Smart contract refers to a programming code that gets executed on the blockchain to automatically build a contract. A smart contract involves a proposed transaction, with two or more parties that is implemented autonomously. Once initiated, human input would not be required to consummate the contract. The smart contract would be coded and digitally recorded on the blockchain by the efforts of the various nodes. In the context of equipment leasing, all the familiar, much loved UCC Article 2A terms and conditions would be folded into the smart contract by the programming code.
Equipment Leasing – How Would Blockchain Work?
Applying blockchain technology to equipment leasing would have a familiar feel, minus all the paperwork. The same players would be present: lessee, vendor, broker, lessor and lessor’s bank as applicable, etc. New players would potentially include a credit rating service and other such data providers, an electronic document service such as Docusign or E-Signature, an agent for UCC filing purposes, tax agents and others. Instead of phone calls, emails, and the post office or FedEx, the parties would all be present and participating as individual nodes in the peer-to-peer network. Each would have input through a computer running protocol of the lessor’s or its bank’s choosing.
For security purposes, the network would function as a private, permissioned network and the various parties would come and go. For example, if a broker were involved, it might have permission to participate and change the blockchain up to the point of submitting an application, after which it would no longer have permission to add or change data in the block chain. Likewise, a vendor, UCC and tax processing agents, and other parties having limited roles to play. But as in the hardcopy world, the critical players would remain the lessee and lessor, participating through to the end of the lease term.
Blockchain technology would eliminate most, if not all of the friction in equipment leasing, and would be hampered only by things like the time it takes to make a credit decision. If a lessor chose to use a scorecard for credit decisions, even that function would occur at computer processing speeds.
If smart contracts are involved, the process would move even faster. While smart contracts probably won’t have much utility in middle to large ticket leasing, it is easy to envision their application in micro and small ticket transactions, where thousands of look-alike lease transactions prevail.
So Why Isn’t This Happening?
If blockchain technology has such promising application to equipment leasing, why isn’t the industry rushing to put it into play. In two white papers published by the Equipment Leasing & Finance Foundation (the “ELFF”) exploring the Fintech phenomenon and digital documents, the ELFF highlighted a number of adverse factors facing the implementation of blockchain. While ELFF didn’t specifically address blockchain technology in its two papers, at its core blockchain implements cutting edge technology and operates in a paperless digital universe. Therefore, the ELFF’s findings have relevance here.
With respect to the use of cutting-edge technology in the Fintech arena, ELFF identified headwinds facing Fintech such as an unproven capacity to comply with regulatory requirements, loan credit performance in a downturn, sensitivity to interest rate changes, financial instability and operational risks. Untested performance history through a full economic cycle and performance during tightening monetary cycles and economic crises also come into play. On the plus side, ELFF noted that Fintechs slash operating costs and quicken customer service, and are not burdened by legacy technology systems or brick and mortar networks. The use of alternative data to assess risks also changes the landscape.
In the paperless transaction world, the ELFF found that a minority of lessors (33%) is currently originating electronic lease transactions, and an even smaller number of lenders (21%) is willing to accept electronic lease transactions as collateral for loans. This is attributed, in part, to a misunderstanding of legal issues related to establishing control of electronic chattel paper when it is transferred from one owner to another and general issues of enforceability of an equipment lease evidenced only by electronic documentation. Article 2A also plays a role; as adopted in some states many equipment leases must be in writing and signed to be enforceable, and often accompanied by certain disclosures to lessees.
These issues can be managed. Article 9 already addresses electronic chattel paper. Further, the use of an e-vault that addresses the Safe Harbor requirements of Article 9 reliably through a secure methodology to keep track of the identity of the controlling party for electronic chattel paper should alleviate other concerns. In addition, the Federal Electronic Signatures Global and National Commerce Act (“ESIGN”), state enacted Uniform Electronic Transactions Acts and various other laws and regulations can be used to meet the writing, signature and disclosure requirements.
For example, effective January 1, 2020, Illinois adopted the Blockchain Technology Act (“Act”) to address concerns associated with the use of blockchain in smart contracts. The Act defines for its purposes blockchain, protocol (called a cryptographic hash), electronic record, record and smart contract. 205 ILCS 730/5 §5. The Act provides that a smart contract, record or signature may not be denied legal effect or enforceability or excluded from evidence solely because a blockchain was used to create, store, or verify the smart contract, record, or signature. Id. At §10. Where another law requires that a contract or other record relating to a transaction be in writing, as long as the blockchain is in a form that is capable of being retained and accurately reproduced for later reference by all parties, it is enforceable and admissible in evidence. Id. at §15. A limitation, however, is where another law requires a record to be posted or displayed, sent, communicated, or transmitted by a special method. Blockchain won’t suffice, yet, and written notices where required must be sent under the existing legal framework.
Blockchain technology has clear application to the equipment leasing industry, and could give a savvy lessor a competitive edge over a more traditional lessor in capturing new lease deals. There will be growing pains, but those issues are manageable through a variety of tools that have developed in an unrelated fashion to deal with several cutting-edge issues such as electronic signatures and electronic documentation.
In a post Covid-19 world, where parties will continue to practice social distancing, remote working arrangements and other precautions, it will be imperative that the equipment leasing industry develop systems to continue business. Implementing blockchain will provide an efficient, frictionless methodology for equipment lessors to continue to do business in such a constrained environment. Necessity bring the mother of invention; it is likely that lenders will begin to develop a more open attitude towards blockchain and electronic documents as well.