Severability is No Substitution for a Well-Constructed Muni Lease
By David C. Kutcher - Chapman and Cutler

Lessors in the municipal leasing market have continually struggled with the effect of including a “non-substitution clause” in their muni equipment lease-purchase agreements. For several years lessors had taken the position that a properly drafted non-substitution clause that is not overly burdensome on the lessee could effectively dissuade a lessee from procuring similar equipment upon an occurrence of an event of default without jeopardizing the validity of the lease-purchase agreement.

Lessors began to consider more seriously the implications of non-substitution clauses when the Florida Supreme Court determined in 2000 that a non-substitution clause, which provided that in an event of non-appropriation the lessee could not procure similar equipment for one fiscal year after such event of non-appropriation, was violative of the Florida Constitution. On April 24, 2002, the United States Court of Appeals for the Eleventh Circuit, in Frankenmuth Mutual Insurance Company v. Escambia County, Florida, held that:

(1) the non-substitution clause, which the Florida Supreme Court ruled in 2000 was violative of the Florida Constitution, is severable from the computer lease-purchase agreement (the “Lease”) as evidenced by a severability clause in the Lease, and the balance of the Lease would remain in effect so long as Escambia County, as lessee (the “County”), had approved the Lease; and

(2) although the County’s governing body had not initially approved the Lease, the County had ratified the Lease through budgetary and other actions taken during the early years of the lease term.

The Escambia County case originates from a dispute involving a computer lease entered into by the County in 1992. In 1995, the County notified the lessor/investor that the County would not continue to make lease payments inasmuch as the County was of the view that the Lease was void and unenforceable because the County had not properly authorized its execution. The lessor/investor filed suit shortly thereafter.

The Florida Supreme Court’s decision in 2000 that the non-substitution clause violated the Florida Constitution and, if not severed, would invalidate the Lease was the first reported judicial decision that a non-substitution clause is unenforceable under applicable State law and may jeopardize the validity of the entire lease-purchase agreement. Since the Florida Supreme Court’s decision, non-substitution clauses have been removed (to the extent possible) from equipment lease-purchase agreements in Florida and the trend in the muni leasing industry has been to evaluate carefully any perceived benefit of a non-substitution clause against potential invalidity of the lease-purchase agreement, depending upon applicable State law.

The federal court’s decision to sever the non-substitution clause from the Lease because the “essential terms” remain intact and the balance of the Lease remains “meaningful and viable” is obviously helpful in supporting an otherwise valid Lease. However, several courts in other States have not severed offensive provisions from muni equipment lease-purchase agreements to support the validity of such agreements. In summary, a severability clause may prove to be useful in certain circumstances, but should not be viewed as a substitute for a well-constructed muni equipment lease-purchase agreement whose terms are valid and enforceable under applicable State law.