Should the cancelation clause contain provisions similar to call premiums or any restrictive covenants and/or penalties of the type contained in bond indentures? Explain your answer.
Lewis Securities Inc. has decided to acquire a new market data and quotation system for its Richmond home office. The system receives current market prices and other information from several online data services and then either displays the information on a screen or stores it for later retrieval by the firm’s brokers. The system also permits customers to call up current quotes on terminals in the lobby.
A cancellation clause in the lease agreement lowers the risk of company L, that is the lessee as it is no longer bound to pay the lease payments for the whole term of the agreement. In the adverse situations, when the company wants to cancel the lease contract, it can cancel anytime.
On the other hand, a cancellation clause increases the risk of lessor as the lessor has to bear the risk of uncertainty of the contract as well as the risk of high residual value.
However, the lessor can mitigate the high risk by deliberately increasing the lease payments or putting restrictions or penalties on the use of cancellation clauses.
The lessor is able to bear the high risk of uncertainty and residual value when the lease gets cancelled by leasing the equipment to some other party after cancellation and diversifying the high risk in the advantageous portfolios.
From the standpoint of the Company L which is the lessee, the cancellation clause will decrease the riskiness of the lease agreement because the lessee can cancel the agreement anytime whenever the leased agreement is generating losses or the company wants upgraded equipment.
However, from the standpoint of the lessor, inclusion of a cancellation clause will increase the risk because the lessee can cancel the agreement anytime during its time period and harm the expected lease payments and interest income of the lessor. The lessor will bear the risk of residual value as well as of the uncertainty of the lease payments.
If a cancellation clause is added in the lease agreement, the lessor may take the following steps to mitigate the effects of the risk:
Increase the amount of lease payments.
Fix a time upto which the lessee cannot avail the benefit of cancellation.
Imposing penalty on cancellation of agreement.
No, the cancellation clause should not contain any penalties or restrictions as the lessor manages the uncertainty of lease agreement through the acquired expertise at disposing of used equipment in case it gets cancelled and easily bears high risks through diversified portfolios.