The 'Right of Choice' in the Financial Leasing Contract
is one of the most important means of external financing created by commercial dealings. It is a legal contract through which the Lessee (the investor) can obtain her/his financing needs, and the lessor (the finance company) can guarantee its rights to retrieve the money used to finance the lessee, in addition to the expected profit. Depending on the legislation there can be differences.
By using this form of leasing, the lessee is funded in kind, not in cash. That is what distinguishes this way from other financial ways. Besides that financial leasing is characterized by the rights which the lessee has at the end of the contract period. It is called the "Right of Choice". So what is that right?
The "Right of Choice" is defined as the right which is granted to the lessee to choose between three options at the end of the financial leasing process, provided that she/he has fulfilled her/his obligations towards the lessor. These options are
1. Purchase the object of financial leasing contract (The Asset)
: At the end of the contract, the lessee can activate her/his "Right of Choice" to buy the asset, in whole or in part, by paying the agreed price when signing the financial leasing contract, taking into consideration the money paid as a rental fee during the term of the contract.
2. Extend the contract
: The lessee may choose to extend the contract to an additional period, in condition that the rental fee during the extension period should take into consideration the value of the asset after using. Conditions of this extensional period should be set up upon signing the essential contract.
3. Returning the asset to the lessor
: If the lessee finds that the asset is no longer needed, she/he usually chooses to return it to the lessor.
An example: A finance leasing company (the lessor) funds a food production company (the lessee) with a canning machine with a 5-year financial leasing contract. The lessor buys the machine for $5 million and expects a profit of 20% of the price of the machine. The annual rental fee is $900.000. At the end of the contract the lessee has the right to choose between:
- Either buy the machine for 1.5 million $;
- Extend the contract for a period of three years at 500,000 $ annually;
- Or return the machine to the lessor.
The "Right of Choice" is given to the lessee only, who exclusively decides what to do, without requiring the consent of the lessor. Therefore, if the lessor is given the right to agree to what the lessee may chose at the end of the contract, then the contract cannot be considered as a "financial leasing".
I think that although there are differences between laws about how to regulate the provisions of the financial leasing contract, the "Right of Choice" remains a useful tool that enables the lessee to obtain renewable investment means and allows her/him to keep updated with the latest technological developments and to replace old equipment with new ones directly without any additional costs. So what do you think as a manager of a production facility: Does the "Right of Choice" in the financial leasing contract encourage you to use it as a financing method over other possibilities?
Guojin Liu, (2010), Finance Leasing In International Trade, The University of Birmingham, Thesis, P. 266.
Tanja Kangas, (2009), Privity of Contract in Financial Leasing, Helsinki Law Review, P. P. 69-100.