What is a Financial Lease Agreement? What should the Lessee consider before entering into a Financial Lease?

Currently, many small and medium-sized enterprises opt for financial leasing as an effective solution to access machinery and equipment for their production and business operations. However, in addition to cash flow advantages and flexibility in appraisal procedures, financial leasing also entails various legal risks that enterprises should anticipate prior to entering into the Agreement. This article aims to provide enterprises with an overview of common risks, as well as an appropriate approach when participating in a Financial Lease Agreement. 

1.Overview of the Financial Lease Agreement

Pursuant to Clause 1 Article 3 of Circular No. 26/2024/TT-NHNN on financial leasing activities of general finance companies and financial leasing companies, financial leasing is defined as a medium- and long-term credit activity conducted on the basis of a Financial Lease Agreement between the Financial Lessor and the Financial Lessee. Accordingly, the Financial Lessor purchases the leased asset at the request of the Financial Lessee and retains ownership of the leased asset throughout the lease term. The Financial Lessee uses the leased asset and makes lease payments throughout the lease term in accordance with the Financial Lease Agreement.

Clause 5 Article 3 of this Circular further provides that a Financial Lease Agreement is an agreement entered into between the Financial Lessor and the Financial Lessee in respect of the financial leasing of one or more leased assets in accordance with this Circular and relevant laws. A Financial Lease Agreement is an irrevocable agreement.

Accordingly, a Financial Lease Agreement may be understood as an irrevocable agreement mutually negotiated and entered into by the parties, whereby the Financial Lessor purchases the asset at the request of the Financial Lessee and retains ownership of the asset throughout the lease term, while the Financial Lessee is entitled to use the asset and is obliged to make periodic lease payments as agreed.

2.Common risks in a Financial Lease Agreement

Proper identification of risks inherent in the nature of a Financial Lease Agreement constitutes an important basis for the Lessee to proactively prevent and mitigate potential risks. Such risks include:

a.Risk arising from the irrevocable nature of the Financial Lease Agreement: As a Financial Lease Agreement is irrevocable, the Lessee is not entitled to unilaterally terminate the Agreement throughout the lease term, unless otherwise provided by law or agreed by the parties. In the event that the enterprise encounters financial difficulties, changes its business strategy, or the leased asset is no longer suitable, the Lessee remains obliged to continue performing its payment obligations. Early termination of the Agreement may be deemed a breach of contract and may give rise to penalty and compensation liabilities.

b.Risk arising from the fact that the collateral of the Financial Lease Agreement is the leased asset itself: In a Financial Lease Agreement, the leased asset simultaneously serves as collateral securing the Lessee’s performance of its obligations. In the event that the Lessee delays or fails to perform its payment obligations, the Financial Lessor is entitled to repossess the leased asset. Such repossession may result in disruption or suspension of production and business operations, as the leased asset is often core machinery or equipment, thereby causing serious adverse impacts on the enterprise’s operations.

c.Risk arising from the medium- and long-term duration of the Financial Lease Agreement: A Financial Lease Agreement is a medium- or long-term contract closely associated with the lifecycle of the leased asset. During the long-term performance of the Agreement, the Lessee may face various risks, such as market fluctuations, technological obsolescence rendering the leased asset inefficient, or changes in laws, tax policies, or business conditions that adversely affect the exploitation and use of the asset.

d.Risk arising from regulations on the handling of assets upon expiration of the financial lease term: Pursuant to Clause 3 Article 2 of Circular No. 45/2013/TT-BTC guiding the management, use, and depreciation of fixed assets, upon expiration of the financial lease term, the Lessee is entitled to choose either to purchase the asset or to continue leasing it in accordance with the Agreement, provided that the total lease payments are at least equal to the value of the asset at the time of execution of the Agreement. Accordingly, if the Lessee opts to continue leasing, in substance, the Lessee has fully paid the value of the asset throughout the lease term without acquiring ownership thereof. Conversely, if the Lessee purchases the asset at this stage, the actual usable value of the asset may have significantly decreased due to depreciation or technological obsolescence.

3.Key considerations for enterprises before entering into a Financial Lease Agreement

In order to mitigate risks and potential disputes, the Lessee should pay special attention to the following contractual provisions from the negotiation and execution stage:

a.Prior to entering into a Financial Lease Agreement, the Lessee should carefully review and negotiate provisions relating to circumstances under which the Lessee is entitled to terminate the Agreement prior to its expiry. Although a Financial Lease Agreement is irrevocable, the law allows the parties to agree on cases of termination. In addition, financial obligations arising from early termination should be clearly stipulated in order to avoid the risk of being subject to obligations exceeding the Lessee’s financial capacity.

b.Where the leased asset serves as collateral securing payment obligations, the Lessee should pay close attention to provisions on asset repossession in the Agreement. Specifically, the Agreement should clearly stipulate events constituting default, notice periods, and cure periods prior to repossession. Transparent regulation of these matters from the outset enables the Lessee to proactively mitigate the risk of sudden repossession, which could seriously affect production and business operations.

c.Given that Financial Lease Agreements are of a medium- or long-term nature, the Lessee should carefully assess the compatibility between the lease term and the useful life of the asset prior to execution. At the same time, attention should be paid to provisions on extension or amendment of the Agreement in the event of changes in market conditions, technology, or legal regulations. Clearly anticipating such mechanisms in the Agreement will help the Lessee limit risks arising throughout the performance period.

d.To mitigate risks arising from the handling of assets upon expiration of the financial lease term, the Lessee should clearly agree in the Agreement on the option between purchasing the asset or continuing the lease, together with the applicable conditions. In the case of purchase, the method for determining the purchase price should be stipulated in a manner consistent with the remaining value and actual condition of the asset at the time of expiration of the Agreement. At the same time, the Lessee should proactively assess the asset’s useful life and depreciation level in order to select an appropriate handling option, thereby avoiding financial risks and ensuring stable production and business operations.

The foregoing constitutes an analysis of risks that enterprises may encounter when participating in a Financial Lease Agreement. Proper understanding of the nature of the Agreement and full identification of risks associated with each contractual provision are critical factors enabling enterprises to make appropriate decisions and minimize disputes during performance. Enterprises should carefully review provisions on rights and obligations, lease term, asset repossession mechanisms, and early termination prior to execution in order to safeguard their lawful rights and interests.

Should enterprises require further discussion regarding the review of Financial Lease Agreements, legal risk assessment, or consultation on drafting provisions suitable for their business needs, please contact TNTP for timely advice and support.

Sincerely,