In a competitive market, equipment vendors understand that

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1 The Dangers of Bundling A recently filed Norvergence case highlights potential bundled transaction pitfalls. By Paul D. Gamez In a competitive market, equipment vendors understand that simply comparing features and functions of their products to competitors offerings provides minimal differentiation and generally results in price competition and eroding margins. To combat this dynamic, many vendors choose to provide more comprehensive offerings that bundle their equipment with an array of services designed to deliver more value to the customer than a simple equipment sale. In the large majority of instances, reputable vendors deliver services to their customers satisfaction and, in many instances, equipment finance companies (lenders) provide additional value to customers by sending one invoice that combines service and equipment costs into a single payable amount. Lenders benefit from increased business, vendors generate sales by differentiating themselves from ordinary equipment re-sellers and customers receive a bundle of equipment and services that generates cost savings and/or helps them realize the full benefit of the equipment they selected. The traditional equipment leasing transaction (in which only the equipment is financed and services are billed separately by the service provider) exists under a time honored legal convention. This convention is statutorily protected by Articles 2A and 9 of the Uniform Commercial Code, which provides lenders certain hell or high water repayment protection. Unfortunately, the traditional structure does not always provide the significant advantages to customers and vendors that a bundled transaction can provide. Lenders have attempted to respond to market demands while balancing the risks inherent in bundled transactions in a variety of ways, including separating the service charge from the equipment charge on the invoice, financing only the equipment portion of the transaction and acting as a pass-through billing agent on the service portion, etc. A recent Federal Trade Commission (FTC) lawsuit against a lender highlights many of the issues lenders confront when deciding whether to pursue a single source, high-volume bundled business opportunity. 48 LT September 2007

2 The history of Norvergence and its impact on the equipment finance industry is well known, particularly within the small ticket community. Norvergence s collapse in 2004 triggered litigation in courts throughout the U.S. Norvergence customers and lenders scrambled to cut their losses, while a defunct Norvergence entered into bankruptcy. Since then, customers, attorneys general and the FTC have worked to free lessees of their payment obligations, advancing a variety of theories to reach this objective. The unique factual background present in the Norvergence cases led many lenders to settle their cases by waiving some or all of their customers remaining payment obligations. Recently, the FTC filed suit in a federal district court against a large Norvergence funding source, IFC Credit Corporation. The suit against IFC attempts, among other claims for relief, to rescind the agreements customers entered into, stop current collection efforts and force the lender to disgorge payments already received. The suit is premised on the Federal Trade Commission Act that prohibits unfair or deceptive acts or practices in or affecting commerce, and is designed to protect consumers. (See Section 5(a) of the FTC Act, 15 U.S.C. s. 45(a).) Although there are many other Norvergence cases on file, this article focuses only on this lawsuit. Although this case has not yet been litigated and it is impossible to predict whether the FTC will be able to prevail on its factual allegations and legal arguments, the allegations serve With Norvergence s collapse, old arguments that at least a segment of traditional non-consumer transactions should receive consumer transaction protections have resurfaced. as a reminder that certain lending practices are likely to receive intense scrutiny if a single source, high-volume, bundled program collapses because the service provider fails to deliver the promised services/results. There are several key business issues this litigation raises for lenders balancing the risks and rewards that accompany these ever more common bundled business opportunities. These risks may be present whether the equipment lease and service arrangement are bundled into one agreement or are contained in separate agreements. Consumer Protection Traditionally, transactions that financed equipment used for business purposes did not trigger consumer protection laws. In the aftermath of Norvergence s collapse, however, old arguments favoring the proposition that at least a segment of traditional non-consumer transactions should receive consumer transaction protections have resurfaced. Norvergence customers consisted primarily of small businesses, nonprofits and charitable organizations, including many small churches. We don t know if the FTC will prevail in attempting to classify these entities as consumers within the meaning of the Federal Trade Commission Act. What is clear, however, is that this and similar customer demographics very well may garner the attention of state attorneys general and the FTC. Even well crafted business purposes language in financing agreements and existing case law indicating that the entities listed above are not consumers cannot prevent the substantial cost of defending litigation designed to relieve this class of customers of their payment obligations, especially when the failure to provide services results in a serious economic burden to customers. That is, when these entities have to pay for an essential service to replace the service they did not receive, while remaining obligated to pay a third party for an equipment lease and/or for a service that the originally chosen vendor will not September 2007 LT 49

3 provide, litigation premised on consumer protection principles is likely to follow. Service Contracts and Hell or High Water Lenders and their funding sources rely on the hell or high water re-payment obligation traditionally associated with equipment finance contracts. The FTC suit challenges that conclusion, arguing that lenders cannot enforce equipment rental agreements that, in practical effect, finance unperformed services, not equipment. The FTC maintains that the necessary consideration for payment, the provision of promised services, did not occur. The complaint relies on a number of allegations to suggest that the contracts in question, though similar to most small ticket leases, should be treated as service contracts that require the delivery of services in exchange for the receipt of monthly payments. In Norvergence, the service agreement and the equipment rental contract were not bundled into one agreement but were two separate contracts that Norvergence and the customer entered into. The rental agreement was then assigned to a lender. However, the complaint alleges that Norvergence s marketing materials made clear that the primary value Customers were receiving was communications services. Additionally, Norvergence s sales strategy included securing potential customers telephone, cellular and/or Internet bills. Norvergence Standard small-ticket documentation may receive substantial scrutiny should the economic benefits of the entire bundled transaction fall short of the vendor s up-front promises. would then discount these monthly payments to arrive at an attractive monthly payment amount unrelated to the cost of the equipment the rental contract purported to finance. Allegedly, the price paid by Norvergence for the equipment was substantially less than the sum of the payments on the rental agreements. Though many contracts financed the same piece of equipment, monthly payments varied substantially from one contract to the next contract. Although Customers also signed a service contract and made payments to Norvergence pursuant to the terms of that contract, the vast majority of their total payment was allocated to the rentals under the equipment rental contracts. These allegations, although still unproven in the litigation, exemplify the challenges lenders can face when financing equipment and services. Documentation Concerns Private label, small ticket, bundled transactions generally include assignment, waiver of defenses, hell or high water and choice of law/forum selection clauses designed to support the enforceability of these contracts and to reduce enforcement expenses. The FTC argues that many of these relatively standard clauses, as used by Norvergence and numerous lenders, advanced the fraudulent Norvergence scheme and played a critical role in causing customers injury. According to the complaint, Norvergence acted as a re-seller of carrier services and needed to make payments to carriers in order for carriers to continue to provide services to customers. Norvergence used the equipment funding it received from the assignment of equipment rental contracts to pay carriers. The ability to obtain funding from lenders depended, in turn, on providing lenders with an enforceable contract. By labeling the document that contained the bulk of customers payment obligations an equipment rental agreement, and because most equipment lease contracts provide hell or high water and waiver of defenses 50 LT September 2007

4 re-payment protections for lenders, Norvergence was able to secure the funding it needed from lenders willing to accept the assignment of these contracts. Focusing on some specific clauses in the equipment rental agreements, the FTC argues that: 1. Non-cancellability language was hidden in small print on the back of the one page rental agreement; 2. The express assignability of these rental agreements, in concert with waiver of defenses language enabling the assignee to receive the benefit of the contracts (payments) without the corresponding obligation to provide promised services, helped created a false impression that lenders could enforce a service contract irrespective of whether services were being provided; 3. Whether or not the rental agreements were governed by Article 2A of the UCC (providing lenders hell or high water protection) was unclear; and 4. The floating forum selection clause allowed suit to be brought in the contract assignee s home state, a forum often unknown to the customer at the time the equipment rental agreement was signed, and inconvenient and cost-prohibitive for customers when collection actions were filed against them. Though the equipment rental contracts are not lengthy documents (the front and back of one piece of paper), the FTC claims that they were part of an eight-document package that confused unsophisticated customers. In Managing business risk can create legal risks for lenders in the form of exposing them to claims that they participated in or materially assisted fraudulent conduct. any event, the challenges advanced by the FTC are a reminder that standard small-ticket, private label documentation, especially those clauses that allow lenders to enforce contracts when services are not provided, may receive substantial scrutiny should the economic benefits of the entire bundled transaction fall short of the vendor s up-front promises. Due Diligence Demands As noted above, well-executed bundled transactions provide significant value. The FTC suit demonstrates the heightened scrutiny the due diligence process receives in a bundled transaction scenario, whether the equipment rental and service agreements are bundled into one agreement or are contained in separate contracts sold by the vendor at the same time. For example, understanding the role the equipment plays in providing value and how that value is communicated to customers, can be critical. According to the complaint, Norvergence s marketing approach centered on an outcome, namely, savings on communications/internet costs. The lender allegedly knew or should have known about the 5-year price guarantee on communication services, and that the equipment was not capable, on its own, of delivering those savings. Evidence that lenders were financing services, not equipment, according to the FTC, can be found by examining lenders internal processes/procedures. According to the complaint, the Lender should have discovered the correct fair market value of the financed equipment (thus uncovering its limited value) in the ordinary course of: 1. complying with generally accepted accounting practices that require a determination of the actual value of the financed equipment when a lender treats agreements as leases for accounting and tax purposes; 2. collecting the appropriate amount of property tax on equipment, and; 3. determining an appropriate equipment insurance charge to assess. Had the lender conducted sufficient due diligence up front, the complaint seems to suggest, it would ve uncovered the deception involved in September 2007 LT 51

5 These allegations make clear that, if a vendor fails to deliver promised services, lenders up front due diligence may be examined. characterizing a service contract as an equipment rental contract. These allegations make clear that, if a vendor fails to deliver promised services, lenders up front due diligence may be examined to determine, among other issues, how the bundled package was represented to customers, if the lender understood what the value of the equipment would be in the absence of accompanying services, and what portion of the customers monthly payments can reasonably be attributed to equipment re-payment versus the provision of services. The Contractual Relationship For lenders, balancing the interests of the equipment supplier and the equipment user can be very difficult, especially when the equipment supplier is capable of delivering substantial volume. The FTC argues that the lender kept a close relationship with Norvergence despite signals that many customers were not receiving or were dissatisfied with their promised services. Typical master program agreements (MPAs) contain provisions that describe how the program will be administered and how risks will be allocated between the parties. The FTC s Complaint argues that the lender did not use the remedies available to it in its MPA with Norvergence, such as enforcing re-purchase obligations on first payment defaults or simply severing the relationship when complaints began to appear and increase. Instead, in order to maintain its business relationship with Norvergence, while mitigating what appeared to be increasing re-payment risks, the lender allegedly increased funding holdbacks and ultimately obtained a security interest in Norvergence contracts not yet assigned to other lenders. Throughout the time the lender took these risk management steps, according to the complaint, additional contracts were funded and collection activities continued. Thus, managing business risk can create legal risks for lenders in the form of exposing them to claims that they participated in or materially assisted fraudulent conduct. Operations/Collections High-volume program administration often requires changes to standard operating procedures. Deviations from standard practices, however, draw attention when litigation ensues, as is evidenced by this recent case. The FTC s complaint highlights several alleged changes to the lender s standard operating procedures, arguing that they played an instrumental role in the continuance of the Norvergence scheme by assuring the funding of a purportedly hell or high water enforceable contract, even if customers were not receiving the benefit of their bargain. For instance, the FTC claims that the lender altered its standard delivery and acceptance form and its telephone verifications so that they emphasized equipment receipt rather than whether the equipment was installed and operational. These practices purportedly continued despite knowledge that the equipment was usually delivered weeks or months before it could be operational, triggering payment obligations that pre-dated the ability to confirm that the promised services existed. The lender also allegedly reiterated a Norvergence promise of anticipated savings in its verifications, a deviation from its general emphasis of limiting this communication to whether functional equipment had been received and was working to the customer s satisfaction. Enforcing a large portfolio of delinquent accounts also often requires unique litigation strategies. Strategic collection strategies are also subject to scrutiny, especially if customers legal representatives and government entities perceive that the litigation process is being used as a vehicle to unfairly extract payment. The FTC challenges the lender s post-funding collection practices by arguing, generally, that 52 LT September 2007

6 the lender unfairly inflicted additional harm (legal costs in addition to costs incurred in replacing services that did not materialize) on Customers by: 1. attempting to enforce a contract for unperformed services by claiming that it is an enforceable equipment finance contract; 2. pursuing re-payment of some contracts without adjusting for funding holdbacks; 3. requiring Customers to defend claims that they engaged in fraud and misrepresentation based on Customers acknowledgement of the delivery of the equipment, which prompted the Lender to fund those transactions; and 4. filing suit in inconvenient, far away venues based on a floating forum selection clause. Bundled transactions, including high volume, single source deals, continue to present valuable business opportunities for vendors, customers and lenders. In the large majority of cases, the vendors equipment functions properly and the vendor delivers the promised services. There have been a very small number of cases where a few vendors have failed to provide the promised services, resulting in customers refusing to pay and suits involving lenders. Anticipating the unique risks these programs pose allows lenders to choose an appropriate strategy to mitigate these risks, while delivering the value a well-supported bundled transaction can bring to the market. Paul Gamez is senior vice president-general manager of the Telecom Business Unit of GreatAmerica Leasing Corporation, Cedar Rapids, Iowa. September 2007 LT 53