Principal & agent agreements: What are they and how do they operate?

Introduction

The financing of lease contracts by way principal and agent (“P&A”) agreement is a common commercial technique to enhance the supply of business equipment in Australia.

The P&A structure permits a sale of goods where a transaction might not otherwise be possible. For example, a customer may not be able to afford to acquire the goods, or it may better manage its working capital by not expending its cash. A P&A agreement offers the customer the right to use the goods by way of lease from a financier, the P&A agreement’s principal.

Legal basis

The legal effect of a P&A agreement can appear unclear because commercial practice often gives a different meaning to the word “agent”, as compared to what the law understands the meaning of “agent” to be.

In a general sense an agent is a person who introduces parties that may wish to transact business.  The act of introducing those parties in no way binds them to the transaction. Under a P&A structure on the other hand the agent has specific authority conferred upon him by the agreement to create legal relations between its principal and a prospective customer.

The law’s flexibility with regard to its rules concerning agency permits an exception to the basic legal principle of “privity of contract”; that is, parties to a contract cannot confer rights or impose obligations in respect of the contract upon anyone but themselves. A P&A agreement permits the agent to create legal relations (for example a lease agreement) binding a third party financier with the end-user customer.

Thus, through the technique of the P&A agreement, the financier and the lessee are as completely bound to each other under the lease agreement as if each had contracted direct with the other.

Undisclosed Principal

The key plank upon which legal and commercial practice of the P&A is built is the law of the undisclosed principal.

In legal terms, the doctrine of the undisclosed principal says that where a party makes a contract with another party, and the first party is the duly authorised agent of a principal, the principal can itself enforce that contract. This is so even though, when the contract was entered into, the first party (agent) did not necessarily disclose to the other party (customer) that it was entering into a contract in the capacity of agent of a principal.

So, even though a lessee may enter into a lease agreement in the belief that the party with whom it is contracting is the actual lessor, the validity of the lease is not affected by the fact that the latter party was not the true owner of the leased goods, provided the necessary P&A was in place.

The agent/broker or agent/vendor gains the flexibility to create and preserve the customer relationship under the doctrine of the undisclosed principal. The principal may, because of its funding of the transaction, assume all rights against the customer, however from the customer’s point of view, by virtue of its commercial relationship it is dealing with the agent.

Other Advantages

If a vendor (supplier) and a financier agree on a P&A structure, this will permit the financier to obtain the tax benefits of depreciating the equipment by virtue of owning the equipment. Such a benefit is not available to the financier from simply purchasing the underlying lease cash flows, nor from lending on the basis of loan serviced by recourse to those cash flows.

For the agent/vendor, a P&A facility should enable the GST component of the equipment’s sale price to be funded on an “all-up” basis. Once again, assigning or pledging underlying lease cash flows will not confer this kind of advantage. In the absence of a P&A agreement the vendor would be obliged to allot working capital to deal with the timing of applicable tax payments.

Further, under a P&A structure the financier will most likely assume the administrative burden of registering its rights to the equipment on the Personal Property Securities Register. Conversely, the agent/vendor will usually be freed from this tedious but important chore.

Default and Enforcement

The doctrine of ‘undisclosed principal’ means that the principal/financier may at any time, but usually following prolonged breach or default by the customer, disclose its existence. The principal/financier may then specify continuation of the contract, demand a payout or commence recovery action against the customer.

The undisclosed principal always has the right to intervene and directly assume what are, in fact, its own rights and obligations under the leasing contract with the customer. The fact that the underlying contract was made without disclosure of the principal’s existence or authority is irrelevant.

So, a customer/lessee cannot dispute the contract on the basis that the principal’s identity was unknown to it at the time it signed its contract with the agent. The principal’s existence or identity does not impact upon the validity of the transaction.

The right of a principal/financier to enforce a contract prevails over the rights of the agent. Generally speaking the courts will not regard the terms of a contract as excluding the intervention of an undisclosed principal, except in the unlikely event that the agent as sole contracting party is clearly intended.

Similarly, describing the agent as “owner” of goods under, for example, a lease agreement does not diminish the rights of the principal to its ultimate ownership of those goods. The purpose of such a statement in the underlying lease is simply to make it clear to the customer/lessee that, as between it and the agent, the agent has the better title to the goods.

In any event, what is important to the customer is that the goods are made available to it in accordance with the terms of the lease. Generally speaking, personal performance by the agent/owner is not important to the performance of a hiring contract. What is fundamental is that the customer/lessee has possession of the goods and is able to freely use them in the intended manner.

Conclusion

The P&A agreement is a powerful financing tool in the hands of a properly appointed agent. For both principal and agent it is a simple yet effective marketing vehicle or sales aid. Each gets the sale it might not otherwise have made without the involvement of the other. However, a P&A agreement also comprises a delicate legal mechanism. The agent/vendor must have the requisite authority to sign up customers. Without that authority the P&A agreement is of no use in the financing of transactions with third party customers.