Aircraft Financing: Fifth Edition 9781526519726, 9781526519757, 9781526519740

Table of contents :
Editor’s Introduction
Orbis Introduction
Authors
Part I Market Context
1 Aviation Finance Introduction
(Raymond Sisson – SCALE Aviation; Credit Suisse)
Introduction
Overview of funding 2020/2021 to date
Airline landscape
Aircraft leasing
Commercial bank lending
Investment banks and capital markets
E-notes or equity certificates
Lessor EETC summary
Lessor EETC with multiple airlines summary
Conclusion
2 Overview of Aircraft Financing Markets
(José Abramovici –Crédit Agricole CIB)
Introduction
Post-World Trade Center attacks
Global financial crisis (GFC)
Covid-19 crisis
Source of funds for airlines during the Covid-19 crisis
Global liquidity in today’s market
Main trends for aircraft finance
The need for finance
Regulatory frameworks
The end of the dominance of the US dollar
Financing objective: the financier’s perspective
Aircraft as investments
Debt and tax lease market
Carbon emissions
Tax based leasing
Islamic leases
The aircraft leasing market
Debt capital markets
Private equity markets and hedge funds
Public equity markets
3 Aircraft Capital Markets
(Zarrar Sehgal – Clifford Chance)
Introduction
Structure
Private placements and Rule 144A offerings
Enhanced equipment trust certificates
Asset-backed securities transactions
Green bonds
Trends 2015–2021
Conclusion
Part II Business Model – Key Elements
4 Aircraft as Investments
(Dick Forsberg – Senior Advisor – PwC AFAS)
Introduction
Why invest in aircraft?
Airlines
Lessors
Who invests in aircraft?
Selecting the right assets
Understanding aircraft values
Acquiring the assets
Taking care of asset value
Monetising the metal investment
5 Legal Issues in Aircraft Finance
(Rob Murphy – Arthur Cox LLP)
Introduction
Structural issues
The role of special purpose companies
Leases
Share security
Aircraft mortgages
Liens
Cape Town Convention
Summary
Legal issues
Legal opinions
Conflict of laws
Political and repossession risks
Sovereign immunity
Liabilities of the financier and lessor
Liability under the Civil Aviation Act 1982
Liability in tort
Product liability
Liability under health and safety law
Possessory liens
Other rights of detention
Airport charges
Navigation charges
Aircraft registration
Validity of collateral
Priority of collateral
Enforcement of collateral
Sale arrangements
Penalties
Exchange control
Judgment currency
Choice of law
Enforceability of English court judgments post-Brexit
Contractual issues
Quiet enjoyment
Hell or high water clause
Wilmington Trust SP Services Dublin Ltd v Spicejet
Return condition and maintenance-related matters
Manufacturer’s warranties
Insurance
Engine pooling
Cross-default and cross-collateralisation
Asset value guarantees
General indemnities
Tax-leveraged financings
Withholding taxes
Aircraft trading/transfers/security
‘As is’ disclaimer
Other case law developments
Global Knafaim Leasing Ltd v Civil Aviation Authority Ltd
Pindell Ltd v AirAsia BhD
Shaker v VistaJet Group Holdings SA
Alpstream AG v PK Airfinance Sarl
Novus Aviation Ltd v Alubaf Arab International Bank BSC(c)
Checklist of key documents
6 Cross-border Aircraft Leasing: Key Taxation Considerations
(Joe O’Mara – KPMG)
Introduction
Tax issues on origination of aircraft leases
Stamp duties
Import taxes
Registration taxes
Tax issues during an aircraft lease
Withholding tax and lease payments
Sales taxes
Stamp duties
Security deposits and maintenance reserves
Tax issues on transfers of aircraft
Sales taxes
Stamp duties
Income taxes
Registration taxes
Contractual matters
Conclusion
7 In-House Valuation – Lessor Perspectives
(Randy Nightingale – Aircastle)
Internal valuation versus external valuation
Pros and cons of internal valuation team (internal team)
Pros and cons of external valuation (appraiser)
Key aircraft valuation terms
Appraiser differences
Approach to internal valuation
Structural influences
Components of valuation and risk
Other key valuation influencers
Necessary skills
Coordination with contributors
Importance of data and evaluation
Documentation, communication and applying best practices
Conclusion
8 Risk in Aviation Finance
(Arthur Gaskin – Aviation Consultant)
Introduction
Portfolio risk management
Asset risk analysis
Counterparty risk analysis
Transaction risk analysis and security
Jurisdictional risk analysis
Credit risk analysis of airlines and lessors
Accounting policies and the basis used for accounting
Foreign exchange, interest rate and fuel hedging strategy
Quantitative analysis
Cash flow statement analysis
Predictions of bankruptcy
Stress testing
Tax strategy
Qualitative factors in credit analysis
Ownership
Management expertise
Competitive environment
Business plan
Regulatory environment
Technical, maintenance and records issues
Covid-19
Tailored approach
Conclusion
Appendix I – Key financial ratios
Appendix II – Airline specific ratios
Appendix III – Key cash flow ratios
Appendix IV – Altman’s Z-score model
Appendix V – Further reading
9 Environmental Issues and the Aviation Industry
(Rob Murphy and Fintan Kerins – Arthur Cox LLP)
Introduction
Key targets
Aviation specific initiatives
CORSIA
Emissions trading scheme (ETS) – for the aviation sector
How emission reductions can be achieved
Aviation working group (AWG) initiatives
Sustainable investment/financing initiatives
EU taxonomy
Bonds and loans
Sustainability linked loan principles
Conclusion
Part III Core Products and Regional Markets
10 Export Credit Financing
(Jeffrey Wool – Aviation Working Group; and William Coleman – Holland & Knight)
Introduction
Regulatory framework
The beginning
Sector understanding on export credits for civil aircraft
WTO litigation
From LASU to ASU 2007
The home market rule
ASU 2011
The ‘supercycle’
Export credit’s homecoming
Future developments
Conclusion
Annex Transaction structures
Part A
Part B
11 Operating Leasing – Lessor Perspectives
(Update by Rob Murphy – Arthur Cox LLP)
Introduction
Introductory considerations
Core products and regional markets
Key features of aircraft operating leases
Rental payments
Maintenance reserves/supplemental rent and related matters
Security deposit
Term
Quiet enjoyment
Net lease
Insurance
Deregistration
Return conditions
Transfer/assignment/security
Demand for operating leasing
Efficiency of financing
Fleet planning flexibility
Residual value risk
Cost of capital equipment
Supply of available aircraft
Select business model considerations
Core themes
Diversification of funding sources
Flexible capital structure
Management of aircraft throughout their lifecycle
Maintenance accounting
Differentiation of aircraft operating lessors
Lease management capability
Technical compliance
Repossession
Reconfiguration
Remarketing
Aircraft/lease servicing
Conclusion
12 A Lessee’s Guide to Aircraft Leasing
(Michelle Johnson – flydubai)
Introduction
Types of leases
Finance lease
Operating lease
The leasing arrangement
Operational flexibility
Lessee’s other obligations
Other provisions
13 Pre-delivery Payment Financing
(Rob Murphy – Arthur Cox LLP)
Introduction
Key issues relating to the security package
Legal nature of PDP
Lenders’ key concerns
Assignable price/step-in price/access to credit memoranda
Escalation in purchase price
Amendments to purchase agreement
Insolvency risk
Standstill period
Realisation of the security
Buy-back option
Disclosure of the purchase agreement
14 Regional Markets
Brazil
(Edward Sheard – GECAS; and Fabio Falkenburger – Machado Meyer)
Introduction
Types of lease transactions
Taxation
Other issues to be considered by lessor
Insolvency issues
Insurance (war risks)
Security interest over aircraft and engines
Outbound leasing and export financing of Brazilian manufactured aircraft
Russia
(Mikhail Loktionov and Alexey Tokovinin – Freshfields Bruckhaus Deringer)
Introduction
Registration of aircraft
Effect of RCA registration
Deregistration from the RCA
Aircraft mortgages
Leasing of aircraft
Repossession of aircraft
Recognition of foreign judgments
India
(Marylou Bilawala – Wadia Ghandy & Co; and Gautam Nayak – CNK & Associates LLP)
Introduction
Acquisition of aircraft
The regulatory regime applicable to the airline industry
Operation, maintenance and management of airports
Foreign exchange requirements
Air transport operators and foreign direct investment in air transport operators in India
Import taxes
Lease rentals
Tax gross up clause
Transfer of ownership of aircraft
Stamp duty on documents
Cape Town Convention
Growth of the corporate jet sector
Setting up aircraft operating lease units in International Financial Services Centres (IFSC)
Conclusion
China
(Wang Ling and Wang Ning – KWM)
Introduction
Key legal and regulatory issues in the Chinese aviation market
Cape Town Convention in China
Recent developments in the Chinese aviation market
Germany
(Konrad Schott – Freshfields Bruckhaus Deringer)
Introduction
Legal environment
German regulatory and civil law
Insolvency and restructuring
Outlook
Japan
(Paul Greenwell and Akihiko Takamatsu – Clifford Chance)
Introduction
JOLCOs and JOLs
Japanese airline insolvencies
Titleholder structure
Japanese aviation market and legal issues
15 Islamic Finance
(William Coleman – Holland & Knight)
Introduction
Sharia’h fundamentals
Sources and schools
Themes
Sharia’h contracts
Governing law versus the Sharia’h
Structures
ljarah and ijarah wa iqtina
16 Insurance Considerations
(Glen Brighton – Willis Towers Watson)
Introduction
What is the risk?
Asset risk
Liability risk
Insurance-based risk transfer
Lessee insurances
Lessor insurances
Airline insurance – detailed principles and practices
The insurance buying environment
Airline insurance coverage – detailed analysis
Aircraft financing and insurance
Aircraft hull insurance
Loss payable clause
Breach of warranty cover
Contribution rights
Waiver of subrogation
Notice of cancellation or change
Set-off rights
Liabilities
Severability of interests
Indemnities
Reinsurance
Practical application of insurance to financing
Certificates of insurance
Letter of undertaking
Conclusion
17 Aircraft Repossession – Practical Considerations
(Phil Seymour – IBA Group)
Introduction
Operational and cost considerations
The legal process
Legal costs
Securing the aircraft
Pre-ferry flight parking and maintenance
Suitable parking facility
Engine repossession considerations
Possible liens
Securing the records
Inspection of aircraft
Regulatory considerations
Maintenance and refurbishment
Insurance
Ongoing asset management
Post-repossession action items
18 Global Aircraft Trading System (GATS®)
(Dominic Pearson – Watson Farley & Williams LLP)
Introduction
The need for a ‘game change’ and the development of GATS as a new system for trading aircraft
GATS legal framework
Trust structure; avoidance of lease novation
UINs
Trust branches
Designated transactions; GATS standard form instruments
Favourable FAA/ACC opinion for United States trust branch GATS instruments
Partial beneficial interest transfers
Limitation on GATS trustees’ resignation rights
Advance requirements
Benefits of GATS to financiers
The GATS Platform
GATS e-Ledger; searches
Entity profiles and categorisation
GATS professional entities
User accounts and authentication
GATS escrow facility; GATS fees
Digital signatures and GATS digital certificates
Visualisation of digital signature on GATS instruments
Configuration of execution block
Multiple signatories per transacting entity; witnessing of digital signatures
Validation of GATS instruments
What’s next for GATS?
19 Airline Restructurings
(William Glaister, Philip Hertz, Jennifer DeMarco, Gabrielle Ruiz and Marisa Chan – Clifford Chance)
Introduction
Consensual restructurings
Statutory restructuring processes
Insolvency procedures
Jurisdiction
United States
Automatic stay
Other key Chapter 11 measures
Jurisdiction
‘Ipso facto’ provisions – Section 365 of the Bankruptcy Code
US certificated air carriers – Section 1110 of the Bankruptcy Code
Alternative A of the Cape Town Convention
United Kingdom
Schemes of arrangement
Jurisdiction
Restructuring plans
Alternative A of the Cape Town Convention – UK Cape Town Regulations 2015, reg 37
Cape Town Convention compliant arrangements
‘Ipso facto’ provisions – Insolvency Act 1986, s 233B
Part IV Regulatory Matters
20 The Regulatory Framework for Airline Operations
(Alan Ryan – Freshfields Bruckhaus Deringer)
The international framework
Introduction
Chicago Convention 1944
Five Freedoms Agreement
Bilateral treaties
The EU regulatory framework
EU competition rules and the air transport sector
TFEU, Article 101
TFEU, Article 102
Merger Regulation
Ground handling
State aid
Slot allocation
Introduction
Slot Allocation Regulation
Airline licensing
US airline licensing requirements
Aircraft registration – Chicago Convention
Nationality requirements
Registration in the EU
Under Regulation 1008/2008
Code-sharing
Conclusion
21 International Conventions Affecting Aircraft Financing Transactions
(Laura Cunningham and Domhnall Breatnach – Arthur Cox LLP)
Introduction
Cape Town Convention and Aircraft Protocol
International interests
Perfection and priority of international interests
Remedies for creditors
Declarations
Geneva Convention
Rome Convention on Precautionary Arrest
Rome I Regulation on contractual obligations
Rome II Regulation on non-contractual obligations
Brussels Regulation on jurisdiction and enforcement of judgments
Hague Convention on Choice of Court Agreements
Third-party liability conventions
Further reading
22 Basel III and IV – The Regulatory Framework
(Brendan Wallace and Ruth Lillis – Arthur Cox LLP)
Introduction
Basel Capital Accord and Basel II
Basel III
Part 1: strengthening the global capital framework
Part 2: liquidity standards
Treatment of object finance under Basel III
Basel IV
Basel III and Basel IV– impact for aviation finance
23 Accounting Developments in Aircraft Finance
(Killian Croke – KPMG)
Introduction
Which framework?
Lease accounting
IFRS
US-GAAP
Lease modifications
Leases – responding to the Covid-19 pandemic
Aircraft and related components, depreciation and amortisation
Impairment of aircraft and related assets
Maintenance accounting
Use of special purpose entities/companies
Conclusion
24 Aircraft Financing – The Compliance Universe
(Rob Murphy and Fintan Kerins – Arthur Cox LLP)
Introduction
Anti-money laundering and countering the financing of terrorism
Anti-bribery and corruption
Sanctions and export controls
Cyber resilience and data protection
Price fixing, market abuse
Insider dealing
Other regulatory filings/procedures
Summary
Conclusion
Index

Citation preview

Aircraft Financing Fifth Edition

Dedication

To my amazing wife Joanne and my wonderful parents Bob and Rose Murphy.

Aircraft Financing Fifth Edition Rob Murphy With Specialist Contributors

BLOOMSBURY PROFESSIONAL Bloomsbury Publishing Plc 50 Bedford Square, London, WC1B 3DP, UK 1385 Broadway, New York, NY 10018, USA 29 Earlsfort Terrace, Dublin 2, Ireland BLOOMSBURY and the Diana logo are trademarks of Bloomsbury Publishing Plc © Chapters and Appendices are the copyright of the individual contributors 2022 All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage or retrieval system, without prior permission in writing from the publishers. While every care has been taken to ensure the accuracy of this work, no responsibility whatsoever for loss or damage occasioned to any person acting or refraining from action as a result of any statement in it, or any errors, omissions or opinions, can be accepted by the authors, editors, contributors or publishers. This publication seeks to provide a summary of aspects of the subject matter covered. It does not purport to be comprehensive or to render legal or tax or other advice. The views expressed are those of the relevant author or contributor and do not necessarily reflect the views, policies or practices of their respective firms, employers or affiliated companies. All UK Government legislation and other public sector information used in the work is Crown Copyright ©. All House of Lords and House of Commons information used in the work is Parliamentary Copyright ©. This information is reused under the terms of the Open Government Licence v3.0 (http://www.nationalarchives.gov.uk/doc/opengovernment-licence/version/3) except where otherwise stated. All Eur-lex material used in the work is © European Union, http://eur-lex.europa.eu/, 1998-2022. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. ISBN – Paper: 978 1 52651 972 6 ISBN – Epub: 978 1 52651 973 3 ISBN – Epdf: 978 1 52651 974 0 Typeset by Evolution Design and Digital (Kent) To find out more about our authors and books visit www.bloomsburyprofessional. com. Here you will find extracts, author information, details of forthcoming events and the option to sign up for our newsletters The publishers have made every effort to contact the copyright holders of the diagrams included in the book. If any have been missed, please contact us.

Editor’s introduction

The last edition of this book was published just over ten years ago. For much of that time the aviation industry experienced consistent growth with many positive stories across all key participants – airlines, aircraft lessors, investors, financiers, the OEMs as well as the wide range of professionals who support activity and transactions in the industry – financial advisory, technical/engineering, legal, accounting, tax, corporate services and other disciplines. In this phase we saw the emergence of new aircraft lessors who have grown into leading positions in the market; M&A activity in various segments with some high profile large scale impactful transactions; the expansion of airlines including the emergence of new airlines with the development and refinement of the low cost model as the dominant concept underpinning stable earnings growth; the expansion of capital markets products and the growth of the capital markets as a core supply channel of capital to the industry; increasing leasing product simplification and commoditisation; the increasing emphasis on aircraft portfolio trading as a core lessor business channel – an outlet serving multiple purposes notably portfolio diversification and expansion and profit generation; the development of multiple aircraft lease and asset management platforms allowing myriad investors to access the market and creating quite a fragmented picture in the operating lessor world; a variety of regulatory and tax changes and initiatives including BEPS, MLI and anti-tax avoidance rules, all of which have a significant impact on cross-border lease and financing transaction structuring; a heightened focus on compliance related themes and most critically the realisation, as the decade drew to an end, that substantial changes are needed to ensure that the industry’s environmental impact is tackled and that over time we create and pursue activities, initiatives and ventures and build businesses that are sustainable in the long term and have a positive impact on, and bring positive benefits to, the environment and to people. The world changed for all of us in 2020 with the Covid-19 pandemic and many lost lives and loved ones. Not surprisingly the impact of the pandemic on the aviation industry is covered extensively in this book. The level of destruction of demand for air travel caused by the Covid-19 pandemic – and all that follows from that – was unprecedented and the long-term effects will no doubt be significant and lasting. Overall, the content of the book has been refreshed and updated and new chapters covering the important topics of Environmental Sustainability, Restructuring, Compliance and the innovation brought about by the Global Aircraft Trading System (GATS) have been added. We have divided the book into four core sections. First, there are some chapters grouped under ‘market context’ which set the scene, giving the reader a high-level overview of and introduction to aircraft leasing and financing. Second, the focus turns to ‘the business model – key elements’ with an insight into transaction structuring, looking at the credit, the asset, the legal structuring and the tax drivers. Third, we delve into some of the ‘core products and regional markets’, including coverage of some v

Editor’s introduction of the larger jurisdictions. Lastly, ‘regulatory matters’ are addressed – from aviation regulation, the Cape Town Convention, compliance and accounting developments. In putting this edition together, with the help of our contributors, I  have endeavoured to give industry participants and those interested in the aviation sector an insight into some of the key elements that are relevant, and will no doubt continue, to be relevant, to aircraft leasing and financing transactions and to the aviation industry. The work and engagement from the contributors, who are highly experienced and very well regarded in our industry, is greatly appreciated. It has been an honour to collaborate with them on this edition. I also would like to acknowledge with thanks the excellent support from Carly Murphy on my team and from Bloomsbury Professional – Andy Hill and his team – all who helped pull everything together to make sure that we got this project over the line. The content, legal references and other materials in this book are up to date as at 30 June 2021 and we are a little later in going to print than the team had planned due to continuing delays caused by the Covid-19 pandemic. All royalties from this book are donated to Orbis who work tirelessly to ensure that everyone has sustainable access to quality eye care no matter where they live. Orbis is well known and supported by the aviation industry and I and the other contributors to this book appreciate the opportunity to support the Orbis mission. Rob Murphy 12 January 2022

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The Orbis story

Orbis works to ensure everyone has sustainable access to quality eye care, no matter where they live. Orbis’s mission is to eliminate the threat of avoidable blindness in low-income countries, restore sight, where possible, and build a legacy of quality eye care for a future that will ensure no one will go needlessly blind. The concept of Orbis began in the late 1960s when Dr David Paton, a renowned US ophthalmologist, recognised the lack of eye care and ophthalmic teaching in developing nations where blindness was widespread. At the time, 90% of the world’s avoidable blindness occurred in the developing world. Paton recognised the need to close this gap, but no in-country training for doctors and nurses existed and the high costs of tuition and international travel prevented most doctors and nurses in low-income countries from travelling to receive training. In 1973 Orbis was launched. And with that, a unique and lasting alliance between the aviation and medical industries was born. Through recognising the need for basic eye care in low-income countries, a group of aviation and medical specialists converted a DC-8 plane into the world’s first fully functional teaching eye hospital, which took off on its first project to Panama in May 1982. In 2016, Orbis launched its third-generation Flying Eye Hospital. The Orbis Flying Eye Hospital is a state-of-the-art teaching facility complete with an operating room, classroom and recovery room. This unique plane flies a team of elite eye care specialists to developing countries where they create a tailored and customised curriculum for partner hospitals based on existing capabilities. The high profile of the plane helps to raise awareness of the issues of blindness in the countries it visits. The plane always creates huge interest wherever it goes. The need for basic eye care ophthalmic training – and therefore Orbis – in developing countries was great, and as such Orbis introduced hospital-based training programmes and fellowships to provide additional skills-building opportunities for eye care professionals. In 1999, long-term country programmes were created in Bangladesh, China, Ethiopia, India and Vietnam – similar programmes are also underway in parts of Latin America and the Caribbean. These permanent offices are run by local staff and develop and implement an array of multi-year projects to improve the quality and accessibility of eye care to residents, particularly in rural areas and impoverished urban communities. Many of these programmes focus on the treatment and prevention of childhood blindness, cataract, trachoma and corneal disease. Training is at the heart of Orbis. And Orbis’s telemedicine platform – Cybersight – allows a group of expert volunteers and staff to provide on-demand advice for complex cases, mentoring to local eye care professionals on diagnosis and vii

The Orbis story treatment. This award-winning platform provides long-distance mentoring and education, online courses and lectures, symposiums and case follow-up to eye teams in 199 countries. Dr Maurice Cox first set up Orbis in Ireland in 2005. The team in Ireland is focused on raising funds and supporting a specific project in rural Ethiopia. In countries like Ethiopia, where health care facilities are scarce and poverty rampant, blind and visually impaired people constitute some of the most neglected sections of society. Through raising awareness, building partnerships and carrying out sight-saving work in even the hardest-to-reach places, Orbis ensures that the three main causes of preventable blindness and visual impairment – cataract, refractive error and trachoma – are being addressed. Eye diseases like Trachoma paralyse entire communities – adults unable to work, children unable to learn, and families unable to live freely. For every dose of antibiotics distributed, that person is no longer in pain or discomfort. They are no longer at risk of infecting their loved ones. They no longer need a family member to stay at home to care for them. It transforms lives. Over the past two decades, Orbis has made huge strides in the fight to end trachoma. Through the coordinated distribution of antibiotics, we have rid whole districts of this devastating disease. Furthermore, Orbis in Ethiopia enhances the local government’s capacity to manage the treatment of eye diseases through intensive training and capacity building initiatives, health systems strengthening and community engagement. On behalf of the board, staff, volunteers and beneficiaries of Orbis, Clare O’Dea (Chair, Orbis Ireland) would like to thank everyone involved in creating this book. ‘We are always humbled by the generosity of others and it is through the support of everyone who has contributed to the publication of this book that Orbis can continue its work in the hope that one day there will be no more avoidable blindness in the world. This is a massive undertaking, but one that not only brings the gift of sight to those who are needlessly blind but is also vital to the social and economic development of the societies in which they live. Through the support of all who have contributed to this book and all who have purchased this book, this goal could become a reality.’

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Authors

GENERAL EDITOR Rob Murphy Rob Murphy is a market leader in the aviation sector with extensive experience across a wide spectrum of industry activities. He is Co-Chair of Irish law firm Arthur Cox’s Aviation Group. Rob also acts as Senior Strategic Advisor to leading central Asian airline Air Astana and as a business advisor to other industry participants. Rob is programme leader of the Law Module of the MSc in Aviation Finance degree at the Smurfit Business School, University College Dublin. Rob was partner at leading international law firm Freshfields Bruckhaus Deringer where he led the firm’s global aviation and asset finance team advising some of the industry’s largest lessors and airlines on a wide variety of matters including large scale financing, M&A and restructuring and also acted as external legal advisor to the Aviation Working Group (AWG). He also held the position of Chief Operating Officer and General Counsel at aircraft lessor CDB Aviation playing a lead role in the formation and build out of the CDB aviation platform. Rob started his career in the industry at Irish based aircraft lessor Guinness Peat Aviation – GPA Group.

Editorial Assistant to the General Editor Carly Murphy Carly Murphy received her Master’s in Publishing from Kingston University in 2014. She went on to found and run a successful Irish Design Shop in Dalkey, Co Dublin for five years. She has spent 2021 working at a Michelin Star Restaurant in West Cork while coordinating the publication of this book. She has a great interest in working with creatives in a wide variety of fields.

Contributors José Abramovici José Abramovici is the Global Head of Asset Finance Group of Crédit Agricole CIB. The Asset Finance Group includes: aviation; rail; real estate/lodging; shipping; cross-border tax lease and management of affiliates (235 staff in 12 countries; Euro 28 billion of assets). As far as Aviation Group and Rail Finance is concerned José is responsible for leading a team of 55 professionals (based in Hong Kong, New York, Paris, Frankfurt, Tokyo) in charge of the global relationship with all airline groups, aircraft and engine leasing companies, airline ix

Authors related business (MRO, ground handling etc), airports and rolling stock lessors. This includes origination/structuring all asset based transactions and coordination of all bank’s product lines (advisory, asset management, IPO, M&A, derivatives, DCM, ABS) with its clients. José is 63 years, is an aeronautics engineer and holds a post-graduate European MBA programme of HEC Graduate School of Management and a certificate of CISL (Cambridge Institute for Sustainability Leadership). Prior to joining Credit Agricole CIB in 1991, José has held different executive positions in various technical departments of airlines including Air Inter, the former French domestic airline (now Air France). He is also a board member of AerDragon, an aircraft leasing affiliate of Credit Agricole CIB and President of the Club Bank’Air. Zoya Afridi Zoya Afridi is an associate in the transactional pool of Clifford Chance in New York. She graduated from Georgetown University Law Center in 2020 and joined Clifford Chance in January 2021. Zoya is interested in continuing to gain cross-border transactional experience and particularly asset finance experience. Marylou Bilawala Marylou Bilawala is a Senior Partner in Wadia Ghandy & Co. Wadia Ghandy & Co is a full-service law firm in India, established in 1883, offering a wide range of legal services across a broad spectrum of practice areas and sectors, including transactional, regulatory, advisory and dispute resolution services. Marylou set up the aviation department for Wadia Ghandy & Co in 1999. She has been practising aviation law in India since 1994 and has advised foreign lessors on some of the first leases of aircraft with private airline operators in India as also the first repossession actions initiated by foreign owner/lessors of aircraft in India. She has also assisted foreign lessors, owners and financiers of aircraft in making representations to the Government for changes in the law. She has also spoken at conferences and workshops organised by the Ministry of Civil Aviation, Government of India on leasing of aircraft through units set up in ‘International Financial Services Centres’ in India. She has continuously been ranked in Band 1 from the time Chambers and Partners Asia Pacific introduced Aviation rankings for India and named in India Business Law Journal as one of India’s top 100 lawyers. Domhnall Breatnach Domhnall Breatnach is a Senior Associate in the Litigation, Dispute Resolution and Investigations Group of Arthur Cox LLP. He advises a wide range of clients, including public and private companies, financial institutions, and statutory and government bodies, on all aspects of commercial litigation and dispute resolution, in particular in the Commercial List of the High Court of Ireland. He advises a number of leading clients in the aviation and aircraft sectors. Glen Brighton Glen Brighton is Executive Director at Willis Towers Watson. He started working in the insurance market in 1984. Pure luck found him working in aviation which turned into a lifelong passion. He is now head of Aerospace Risk Management Services (ARMS) – Advisory practice at Willis Towers Watson. He has worked on transactions involving over 20,000 aircraft, from A380’s to corporate jets, with in excess of 200 different airlines/operators. ARMS is x

Authors a specialist aviation insurance practice used by both financiers and lessors in aircraft lease/finance transactions, whether that is commenting on the insurance provisions of the lease/finance agreement, or building the insurance provisions from scratch. Working closely with the clients legal advisors ARMS will also give commentary on current industry practice and advice as to the adequacy of coverage and current market standards, in a market which is constantly changing this knowledge is vital to the successful conclusion of a transaction and to ensure the asset is properly protected. Marisa Chan Marisa Chan is the Knowledge Director for the Global Asset Finance Group at Clifford Chance. She specialises in transportation asset and structured finance, with a focus on the aviation sector, and has been involved in multiple airline restructurings and insolvencies and aircraft repossessions. She is responsible for knowledge and education for the group and has contributed articles to: the Journal of International Banking and Financial Law; the International Financial Law Review; the Law and Financial Markets Review; McBain’s Aircraft Finance – Registration, Security and Enforcement (including co-authoring the England and Wales chapter); McBain’s Aircraft Liens and Detention Rights; and the Cape Town Convention Academic Journal. William Coleman William Coleman is partner in the Holland & Knight Asset Finance team. Before joining Holland & Knight, William served as counsel at one of London’s ‘Magic Circle’ law firms where he spent more than 15 years working in various international offices, including London, Hong Kong, Frankfurt, Dubai and Riyadh. While at Holland & Knight, Mr Coleman also spent a year based in the firm’s Bogotá office. William specialises in a wide variety of general finance, asset and structured transactions (both conventional and Islamic financings) and has acted for a range of clients including banks, financial institutions, airlines and aircraft lessors. His focus on the aviation industry has been complemented by two secondments to the in-house legal departments of AerCap and Emirates Airlines. William has also co-authored the Saudi chapter of McBain’s Aircraft Liens and Detention Rights and has written various position papers for the Aviation Working Group (AWG). His work with the AWG has also included supporting various initiatives in the United Arab Emirates concerning the implementation of the Cape Town Convention. Killian Croke Killian Croke is the Lead Audit and Assurance Partner in KPMG’s Dublin office specialising in aviation finance, leasing and banking. He has 25 years’ experience in providing audit, assurance, transaction services and other advisory work to a wide variety of aviation finance clients, including publicly traded companies and securitisation vehicles. He is sought out regularly for his advice on the structuring of complex transactions, the application of IFRS, US-GAAP, HKG/PRC GAAP; internal control and corporate governance matters. He has worked with a range of aircraft leasing companies and securitisation vehicles, including AerCap, Avolon, SMBC, Orix, DAE-AWAS, GECAS, ICBC, SKY, and Genesis Lease. Killian has assisted many clients with on-boarding private equity investment, debt capital market transactions (144A-type offerings), equity IPOs, and acquisitions and divestitures He has advised on many of xi

Authors highest profile corporate actions taken by aircraft lessors including M&A  of aviation portfolios/leasing companies, listing of securities by aircraft lessors on the NYSE and other stock exchanges and the transfer of large aircraft portfolios to Ireland from various locations around the world. Laura Cunningham Laura Cunningham is a Partner in Arthur Cox’s Aviation and Asset Finance Group who specialises in asset and structured finance with a focus principally on aircraft, rolling stock and ship finance, leasing and related tax driven structures. Laura is an Irish solicitor based in Ireland. She previously worked internationally in aviation with Milbank principally in their London office having also spent time in Milbank’s Singapore office. Prior to Milbank, Laura worked in Freshfield Bruckhaus Deringer’s aviation and asset finance team in London having trained as a solicitor with Arthur Cox. Laura has represented leasing companies, international financial institutions, equity investors and airlines in a broad range of cross-border transactions including joint ventures, ABS, export-credit supported financings, restructurings, Islamic financings, PDP facilities, finance and operating leasing, asset portfolio sale and purchase transactions and sale and leaseback transactions. Laura is a board member of AWAR (Advancing Women in Aviation Roundtable) which promotes the development and advancement of women leaders in the aviation industry and a lecturer at the MSc in Aviation Finance at the UCD Michael Smurfit Graduate Business School. Jennifer DeMarco Jennifer C  DeMarco is a partner in the Banking and Finance practice of Clifford Chance specialising in financial restructuring and bankruptcy. Ms DeMarco primarily represents financial institutions in US and international debt restructurings and financial transactions including in connection with debtor-in-possession financings. Complementary to her corporate restructuring experience, she is also an experienced bankruptcy court litigator, having appeared in bankruptcy courts throughout the US. Relevant experience includes advising creditors on the LATAM, Aeromexico and Avianca US  Chapter  11 bankruptcy cases. Fabio Komatsu Falkenburger Fabio Komatsu Falkenburger is a partner of the infrastructure area of Brazilian law firm Machado Meyer and heads the aviation practice, based in São Paulo, Brazil. He has over 22 years of experience in this market, representing clients worldwide in financing and regulatory matters. Fabio is a member of the legal panel of AWG and coordinator of the Brazilian National Contact Group, and has been consistently recognized by peers and clients as a leading lawyer in this field. Dick Forsberg Dick Forsberg has almost 50 years’ aviation industry experience, working with airlines, operating lessors, arrangers and capital providers in a variety of roles spanning business strategy, industry analysis and forecasting, asset valuation, portfolio risk management and airline credit assessment. He retired from leading aircraft lessor Avolon in March 2019 and now provides advisory and consultancy support to the industry. He is currently supporting PwC’s Aviation Finance Advisory Services team as an external Senior Consultant. As a founding xii

Authors executive and Head of Strategy at Avolon, Dick’s responsibilities included developing and promoting the company’s business strategy with investors, lenders and stakeholders, defining the trading cycle of the business, providing the primary interface with the aircraft appraisal and valuation community, industry analysis and forecasting, driving thought leadership initiatives, setting portfolio risk management criteria and determining capital allocation targets. He has published a number of White Papers on key industry issues and is a regular speaker, moderator and panellist at industry conferences and aviation schools. Prior to Avolon, Dick was a founding executive at RBS  Aviation Capital and previously worked with IAMG, GECAS and GPA following a 20year career in the UK airline industry. Dick has a Diploma in Business Studies and in Marketing from the UK Institute of Marketing and is a member of the Royal Aeronautical Society. He is a past Board Member and Vice-President of ISTAT (The International Society of Transport Aircraft Trading) and serves on the board of the ISTAT Appraisers’ Program. Arthur Gaskin Arthur Gaskin is a senior aviation finance and tax professional with over 25 years international and domestic experience in financial services and aviation finance. His experience extends to aircraft leasing, treasury and capital markets, debt capital raising, tax, private and investment banking. He is a qualified Irish Chartered Accountant and a qualified member of the Irish Taxation Institute. He completed the inaugural MSc in Aviation Finance at UCD Michael Smurfit Graduate Business School attaining a 1st class honour. Mr Gaskin currently acts as an advisor to a leading aircraft lessor on the financial and tax implications of numerous global cross border transactions. He has also recently advised investors seeking opportunities in the aviation sector including the setup of a global aviation lessor platform, the financial viability of maintenance facility operations in Europe and on the acquisition and pricing of several support organisations to the aviation sector. William Glaister William is Head of Clifford Chance’s Global Asset Finance Group, specialising in leasing and financing of heavy transport assets (aircraft, ships and rolling stock), including the securitisation of transport assets and tax driven structures employed in such financings. William has been a partner since May 2000, he is based in London and also worked in Clifford Chance’s Hong Kong and Singapore offices. Recent relevant experience includes acting for all the creditors in the Malaysia Airlines Group English scheme of arrangement and for the company in the Irish scheme of arrangement for Nordic Aviation Capital. He is also involved in other ongoing airline restructurings, including certain US Chapter 11 cases. Paul Greenwell Paul Greenwell is a partner at Clifford Chance and has worked in the Tokyo and Hong Kong offices since 2001. He specialises in asset and structured finance, in particular, in relation to the Japanese and Chinese markets. Philip Hertz Philip Hertz is Global Head of the Restructuring and Insolvency practice at Clifford Chance LLP. His practice involves complex cross border insolvency xiii

Authors and restructuring work. He is a member of the Association of Business Recovery Professionals (R3), INSOL and the Insolvency Lawyers’ Association (ILA). Mr Hertz is a past ILA president and a continuing member of the Insolvency Lawyers’ Association Council and he also continues to serve on its technical committee. He is the co-author of the chapters entitled ‘Schemes of arrangement’ in Tolley’s Insolvency Law and ‘Compromising shareholder claims both generally and in listed companies’ in The Law and Practice of Restructuring in the UK and US, as well as numerous articles on insolvency-related topics. Mr Hertz’s recent experience includes advising senior creditors’ committees, companies and private equity houses in relation to the restructuring of a number of distressed international groups. Most recently, Philip acted for the creditors in the MABL Scheme and for the respective companies in the Nordic Aviation Capital DAC Irish scheme and the gategroup restructuring plan. Clifford Chance LLP also advised the creditors in the Virgin Atlantic Airways restructuring plan. Michelle Johnson Michelle Johnson is Senior Vice President Legal Affairs with flydubai and is responsible for advising members of the senior management team and overseeing all legal matters for the airline. Since commencing operations in June 2009, flydubai has become the second largest airline operating from Dubai International with a network of more than 95 destinations in 50 countries. As a senior executive with over 20 years of experience in capital markets, corporate law, financing, international aviation and regulatory, Michelle has a proven track record in developing and implementing complex transactions and legal processes. Michelle was appointed as General Counsel and Company Secretary for Air Berlin PLC and served on the group companies’ boards of directors. For several years, Michelle worked at international law firms in Washington, DC, USA and Frankfurt, Germany. Michelle was awarded her juris doctor, cum laude, from the American University in Washington, DC. Fintan Kerins Fintan Kerins is an associate with Arthur Cox’s Aviation and Asset Finance Group who has extensive experience in advising international and domestic clients on aircraft leasing and shipping matters and secured financing transactions in Ireland. Fintan has particular experience advising international clients on their Irish aircraft leasing platforms, including advising on initial set up, corporate structure, corporate governance, bond issues and ongoing aircraft leasing transactions. Fintan regularly advises clients on aircraft sale and leaseback transactions, ABS transactions, joint ventures and related financings/ refinancings, as well as leasing transactions involving Japanese operating lease (JOL) and Japanese operating lease with call option (JOLCO) structures. Fintan graduated with an LLB from Trinity College Dublin and has a diploma in Aviation Leasing and Finance from the Law Society of Ireland. Fintan lectures at the MSc in Aviation Finance at UCD  Michael Smurfit Graduate Business School and has received numerous individual rankings from international legal publications. Ruth Lillis Ruth Lillis is a partner at Arthur Cox LLP. She has a broad finance practice with extensive experience advising on all aspects of domestic and international finance across a wide variety of sectors with a particular focus on asset finance. xiv

Authors Wang Ling Wang Ling is the managing partner of KWM. She specialises in banking, international finance, project finance, aircraft and equipment lease financing, acquisition finance, and real estate finance. As one of the few outstanding Chinese lawyers in the area of aviation, Ms Wang specialises in aircraft and equipment leasing. She has rich experience in a wide variety of aircraft and equipment leasing transactions and has handled a great number of aircraft transactions for many well-known multi-national clients. Mikhail Loktionov Mikhail Loktionov is a global transactions group partner and the managing partner of Freshfields Bruckhaus Deringer’s Moscow office, and has been with the firm since 1996. He heads the firm’s finance practice in Russia and regularly advises major Russian and international banks and financial institutions as well as borrowers on a wide range of financing transactions, including those in the aircraft finance sector. Mikhail graduated from Moscow State University (MGU) and the University of Illinois. Gautam Nayak Gautam Nayak is a senior partner at CNK & Associates LLP, a firm of Chartered Accountants, based primarily out of Mumbai, India, with offices in Ahmedabad, Bangalore, Chennai, Delhi, Gift City and Vadodara in India, and Dubai and Abu Dhabi in the UAE. While he specialises in direct taxes, including cross-border taxation, the firm provides services in the fields of indirect taxes, statutory and internal audit, and transaction tax advisory services. He speaks and writes extensively on various issues under direct taxes. Randy Nightingale Randy Nightingale is EVP Analytics and Investments at Aircastle. He has over 20 years’ of aviation leasing experience, working with three different lessors. Randy’s focus at Aircastle is valuation, understanding the current market and trends, strategy and building confidence in decisions. In addition to these areas, Randy works with airframe and engine manufacturers, equipment appraisers, analysts, financiers and other lessors. Wang Ning Wang Ning is partner of KWM and specialises in asset financing, securitisation and debt capital markets, establishment, restructuring and bail-out of financial institutions, international and domestic lending and general banking practice. Wang Ning has extensive experience in aircraft financing and leasing practice, he assists various domestic and overseas lessors, financiers and airlines in all types of transactions in the cross border and domestic markets, including US Ex-Im guaranteed financing, European ECA financing, French tax leasing, JOLCO leasing, Chinese tax bonded area leasing, etc. In addition, Wang Ning also represents clients in numerous business jets acquisition transactions, and he is quite familiar with each aspect of the purchase, importation, financing and operation of the business jet transactions. Joe O’Mara Joe O’Mara is the Head of Aviation Finance in KPMG  Ireland, the leading advisory firm in the global aviation finance market. Joe is a tax partner who xv

Authors advises some of the largest aircraft lessors in the world, as well as major investors into aviation. He has extensive experience in advising on tax issues relating to capital markets transactions, M&A and various fund structures. He sits on the AWG’s GATS Tax Advisory Board and he has also written and presented on key tax issues impacting the aviation sector. Dominic Pearson Dominic is a Partner in the Assets and Structured Finance group at Watson Farley & Williams LLP. Dominic has extensive experience in both the London and New York markets advising banks, ECAs, underwriters, issuers, borrowers, lessors and airlines in a broad range of aviation finance transactions including aviation related asset-backed securitisations (ABS), other complex warehouse and portfolio financings, and large portfolio sales. He is one of the principal advisors to the Aviation Working Group in relation to the Global Aircraft Trading System (GATS®), and is their lead lawyer on the drafting of the GATS ‘e-terms’ and standard form trust documents. He is also the firm’s representative on the executive committee of AWG’s legal advisory panel. Dominic was named on Airline Economics’ prestigious 40 under 40 2020 list, which recognises the most outstanding individuals in that age group active in the aviation finance and leasing industry. Dominic is qualified to practice in both England and Wales as a solicitor and the US states of New York and California. Gabrielle Ruiz Gabrielle Ruiz is a Knowledge Director for the Global Restructuring and Insolvency Practice at Clifford Chance LLP. She has over 23 years’ experience, specialising in all aspects of corporate restructuring and insolvency law. Ms Ruiz is the co-author of ‘Compromising shareholder claims both generally and in listed companies’ in The Law and Practice of Restructuring in the UK and US, and also co-author of ‘An overview of corporate restructuring and insolvency law in England and Wales’ in Global Insolvency and Bankruptcy Practice for Sustainable Economic Development: International Best Practice (2015), as well as numerous articles on insolvency-related topics in restructuring and insolvency and finance and banking journals. She is a member of the Association of Business Recovery Professionals (R3) technical committee, as well as the Insolvency Lawyers’ Association, where she serves also on its technical committee. Ms Ruiz is a member of INSOL. Alan Ryan Alan Ryan is a competition and regulatory partner with Freshfields Bruckhaus Deringer now based in its new Silicon Valley office in Menlo Park, California. Alan has over 30 years’ experience in advising on the most complex competition and aviation regulatory matters in the EU and its member states and the UK. Prior to relocating to California in 2020, Alan was a longtime partner in the Brussels office and has also worked in the firm’s London and Washington offices. In the aviation space, Alan has been involved in many of the most high profile, precedent-setting cases. In the field of competition law he has worked on many of the most important mergers that have shaped the industry including United/ Continental, Lufthansa/Swiss, Iberia/Clickair/Vueling and also acted for the Irish Department of Transport on Ryanair/Aer Lingus. In the non-merger area he has achieved many ground breaking wins for his clients including the air cargo cartel case and the European Commission’s GDS investigation. In the aviation xvi

Authors regulatory field he has worked on some of the most high profile cases on slots (eg Monarch), restructurings (Monarch and Flybe), ownership and traffic rights. Konrad Schott Konrad Schott has been a partner of Freshfields Bruckhaus Deringer since 1999 in Frankfurt. He covers the transport sector, specialising in banking and finance law, in particular asset and project finance, including aircraft finance, leasing, rolling stock, sector related transactional work, and structured investments. Konrad studied law in Giessen, Germany, and Madison, Wisconsin, and holds a doctor degree of the university of Frankfurt am Main. Konrad regularly advises airlines, operating lessors, financiers and other clients in the aviation sector. He focuses on aircraft financings, capital markets transactions, M&A activities as well as restructurings. Konrad supported the leading German airline on most of its aircraft financings since 2001, accompanied Air Berlin and NIKI in their insolvencies, and advised gategroup on the acquisition of Lufthansa’s European catering business, as well as Malaysia Airlines on its successful restructuring. Zarrar Sehgal Zarrar Sehgal is a partner and the Head of Clifford Chance’s Banking and Finance practice in the Americas, Co-Head of the Asset Finance Practice and Head of Clifford Chance’s Global Transport and Logistics sector group, based in New York. He concentrates his practice on a wide variety of international asset finance transactions, including representing underwriters and issuers in public offerings and private placement of securities, including portfolio securitisations and debt and equity offerings. Zarrar has particular expertise in financings involving aircraft and has worked on several of the most significant securitisations and financings in the market. Phil Seymour Phil is President of IBA  Group, having originally joined in 1997 to head the technical management department. He is an aviation specialist giving valuable insight into all aspects of aviation consulting. He is a regular contributor at aviation conferences as a prominent industry authority, and has advised in a number of high profile M&A  projects for clients including Goldman Sachs and Terra Firma, and as an expert witness to the High Court. His career began with British Airways as an Air Transport Engineer and he subsequently held positions in several airlines before qualifying as a Senior Appraiser in 2002. In 2018, Phil was bestowed the title of Appraiser Fellow by the ISTAT Appraisers’ International Board of Governors. The designation recognises Phil’s outstanding service to the appraisal profession for over 20 years as an ISTAT appraiser, six of which as the elected Chair. Edward Sheard Based in Shannon Ireland, Ed is responsible for GECAS Legal across Europe, Canada, Latin America and the Caribbean as well as the engine leasing portfolio, a position that he took over in July 2019. Ed began his career with GECAS in October 2007 as VP and Counsel in São Paulo, covering accounts in Latin America and the Caribbean (LAC). In January 2011, he was promoted to VP and Lead Counsel for LAC, and then to SVP and Lead Counsel, LAC in 2013. In September 2015, Ed relocated to Dubai with responsibility for GECAS Legal across its portfolio in Middle East, Africa and CIS. Ed previously worked as xvii

Authors an associate/senior associate in the asset finance teams of city law firms such as Freshfields Bruckhaus Deringer, Stephenson Harwood and Clyde & Co. He has handled numerous international structured finance and leasing transactions for aircraft and aircraft engines, sale and lease backs, repossessions, litigations, and restructuring workouts. Ed holds a Bachelor’s (LL B Honours) degree in ‘European Law and Languages’ as well as two Master’s degrees (LL  M) in ‘International Business Law’ and ‘Banking and Finance Law’, and is a frequent speaker on aircraft leasing matters. Raymond C Sisson Raymond (Ray) C Sisson is the Chairman of SCALE Aviation and a Managing Director with Credit Suisse. Ray has over 30 years’ experience in various leadership roles in the aviation industry in both aircraft leasing and finance. Prior to joining SCALE Aviation and Credit Suisse, Ray was on the Advisory Board of Hudson Structured Capital Management and CEO of AVi8 Air Capital. Ray spent six years as President and CEO of AWAS (top six commercial aircraft lessor), growing AWAS’s fleet to 315 aircraft, with an asset value in excess of $12.5 billion, serving over 110 airlines in 49 countries. Ray began his aviation career at GE Capital Aviation Services, spending 13 years working in the European and Asian regions, as well as opening up the Middle East, Africa and Russian Federation region based in Dubai. Ray has also served as President and CEO of Titan Aviation Leasing, and as Chief Commercial Officer of SR  Technics. Ray holds a Bachelor of Arts in Economics from Bucknell University, a Juris Doctor from Georgetown University Law Center, and a Master of Business Administration from the University of Chicago. He is on the Board of Orbis Ireland, an affiliate of Orbis International – an international non-profit non-governmental organisation dedicated to saving sight worldwide. Akihiko Takamatsu Akihiko Takamatsu is counsel in the Tokyo office of Clifford Chance and qualified bengoshi (lawyer) in Japan in 2007. He specialises in domestic and cross-border asset finance, aircraft finance, ECA finance, project finance, structured finance, financial regulations, insolvency and restructuring and other general banking transactions. He is a longstanding member of Clifford Chance’s Global Asset Finance Group and has worked in the Hong Kong and London offices of Clifford Chance. He regularly advises banks, operating lessors, other types of financiers, ECAs and investors in all aspects of asset finance and leasing, in particular, in relation to aviation and maritime transactions in the Japan market. He advises various international lessors on leases and deliveries of almost all aircraft into Japanese airlines. He is also an acknowledged banking law expert and advises various Japanese and international institutions on regulatory and compliance matters. Alexey Tokovinin Alexey Tokovinin is a senior associate at the Moscow office of Freshfields Bruckhaus Deringer, and joined the firm in 2009, bringing over six years of experience of working in other international law firms. He is a graduate of the international law department of the Moscow State Institute of International Relations (MGIMO). Alexey specialises in project finance, M&A  and commercial contracts with a particular focus on transport and infrastructure. Alexey has advised airlines and other operating lessees and other clients xviii

Authors in the aviation sector. He has played a leading role in a number of hallmark joint ventures, M&A  deals and complex transport and infrastructure projects, including a number of market-leading PPP and M&A projects in the aviation sector. Brendan Wallace Brendan Wallace is a partner at Arthur Cox and part of the firm’s capital markets and financial regulatory teams. He advises a broad range of clients on regulatory capital, financial markets infrastructure, trustee and agency law, securities regulation and debt capital markets matters. He also regularly advises corporate and institutional clients on netting, collateral and hedging issues and capital management structures. Jeffrey Wool Jeffrey Wool is the Secretary General of the Aviation Working Group, the leading organisation advancing international aircraft financing and leasing. He acts in that capacity on secondment from Holland & Knight, where he is a partner and the firm’s Director of International Law and Policy. In parallel, Mr Wool has had a long academic career, and is currently a Senior Research Fellow at the Commercial Law Centre, Harris Manchester College, University of Oxford.

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Contents

Editor’s Introduction v Orbis Introduction vii Authorsix

Part I Market Context

1

1

Aviation Finance Introduction 3 (Raymond Sisson – SCALE Aviation; Credit Suisse) 3 Introduction3 Overview of funding 2020/2021 to date 3 Airline landscape 4 Aircraft leasing 6 Commercial bank lending 7 Investment banks and capital markets 9 E-notes or equity certificates 11 Lessor EETC summary 13 Lessor EETC with multiple airlines summary 14 Conclusion14

2

Overview of Aircraft Financing Markets 15 (José Abramovici –Crédit Agricole CIB) 15 Introduction15 Post-World Trade Center attacks 16 Global financial crisis (GFC) 16 Covid-19 crisis 16 Source of funds for airlines during the Covid-19 crisis 17 Global liquidity in today’s market 18 Main trends for aircraft finance 19 The need for finance 19 Regulatory frameworks 19 The end of the dominance of the US dollar 19 Financing objective: the financier’s perspective 20 Aircraft as investments 20 Debt and tax lease market 21 Carbon emissions 21 Tax based leasing 22 Islamic leases 22 The aircraft leasing market 22 Debt capital markets 23 Private equity markets and hedge funds 23 Public equity markets 23

3

Aircraft Capital Markets 25 (Zarrar Sehgal – Clifford Chance) 25 Introduction25 xxi

Contents Structure26 Private placements and Rule 144A offerings 26 Enhanced equipment trust certificates 27 Asset-backed securities transactions 28 Green bonds 29 Trends 2015–2021 30 Conclusion31

Part II Business Model – Key Elements

33

4

Aircraft as Investments 35 (Dick Forsberg – Senior Advisor – PwC AFAS) 35 Introduction35 Why invest in aircraft? 37 Airlines37 Lessors39 Who invests in aircraft? 40 Selecting the right assets 41 Understanding aircraft values 43 Acquiring the assets 49 Taking care of asset value 50 Monetising the metal investment 51

5

Legal Issues in Aircraft Finance 55 (Rob Murphy – Arthur Cox LLP) 55 Introduction55 Structural issues 55 The role of special purpose companies 56 Leases57 Share security 58 Aircraft mortgages 58 Liens59 Cape Town Convention 59 Summary59 Legal issues 60 Legal opinions 60 Conflict of laws 61 Political and repossession risks 62 Sovereign immunity 63 Liabilities of the financier and lessor 64 Liability under the Civil Aviation Act 1982 65 Liability in tort 65 Product liability 65 Liability under health and safety law 67 Possessory liens 67 Other rights of detention 68 Airport charges 68 Navigation charges 68 Aircraft registration 69 Validity of collateral 70 Priority of collateral 72 Enforcement of collateral 72 Sale arrangements 74

xxii

Contents Penalties75 Exchange control 75 Judgment currency 76 Choice of law 76 Enforceability of English court judgments post-Brexit 77 Contractual issues 77 Quiet enjoyment 77 Hell or high water clause 78 Wilmington Trust SP Services Dublin Ltd v Spicejet79 Return condition and maintenance-related matters 80 Manufacturer’s warranties 81 Insurance81 Engine pooling 83 Cross-default and cross-collateralisation 83 Asset value guarantees 83 General indemnities 85 Tax-leveraged financings 85 Withholding taxes 85 Aircraft trading/transfers/security 85 ‘As is’ disclaimer 86 Other case law developments 87 Global Knafaim Leasing Ltd v Civil Aviation Authority Ltd87 Pindell Ltd v AirAsia BhD87 Shaker v VistaJet Group Holdings SA88 Alpstream AG v PK Airfinance Sarl88 Novus Aviation Ltd v Alubaf Arab International Bank BSC(c)89 Checklist of key documents 90 6

Cross-border Aircraft Leasing: Key Taxation Considerations 91 (Joe O’Mara – KPMG) 91 Introduction91 Tax issues on origination of aircraft leases 91 Stamp duties 91 Import taxes 91 Registration taxes 92 Tax issues during an aircraft lease 93 Withholding tax and lease payments 93 Sales taxes 95 Stamp duties 96 Security deposits and maintenance reserves 96 Tax issues on transfers of aircraft 96 Sales taxes 96 Stamp duties 97 Income taxes 97 Registration taxes 98 Contractual matters 98 Conclusion99

7

In-House Valuation – Lessor Perspectives (Randy Nightingale – Aircastle) Internal valuation versus external valuation Pros and cons of internal valuation team (internal team) Pros and cons of external valuation (appraiser)

101 101 101 101 102 xxiii

Contents Key aircraft valuation terms 102 Appraiser differences 103 Approach to internal valuation 103 Structural influences 103 Components of valuation and risk 103 Other key valuation influencers 104 Necessary skills 105 Coordination with contributors 105 Importance of data and evaluation 106 Documentation, communication and applying best practices 106 Conclusion107 8

Risk in Aviation Finance 109 (Arthur Gaskin – Aviation Consultant) 109 Introduction109 Portfolio risk management 109 Asset risk analysis 109 Counterparty risk analysis 110 Transaction risk analysis and security 110 Jurisdictional risk analysis 111 Credit risk analysis of airlines and lessors 111 Accounting policies and the basis used for accounting 111 Foreign exchange, interest rate and fuel hedging strategy 114 Quantitative analysis 119 Cash flow statement analysis 123 Predictions of bankruptcy 126 Stress testing 127 Tax strategy 129 Qualitative factors in credit analysis 129 Ownership130 Management expertise 130 Competitive environment 131 Business plan 132 Regulatory environment 132 Technical, maintenance and records issues 132 Covid-19133 Tailored approach 135 Conclusion135 Appendix I – Key financial ratios 136 Appendix II – Airline specific ratios 137 Appendix III – Key cash flow ratios 138 Appendix IV – Altman’s Z-score model 138 Appendix V – Further reading 139

9

Environmental Issues and the Aviation Industry 141 (Rob Murphy and Fintan Kerins – Arthur Cox LLP) 141 Introduction141 Key targets 142 Aviation specific initiatives 143 CORSIA143 Emissions trading scheme (ETS) – for the aviation sector 145 How emission reductions can be achieved 146 Aviation working group (AWG) initiatives 146

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Contents Sustainable investment/financing initiatives 147 EU taxonomy 147 Bonds and loans 148 Sustainability linked loan principles 148 Conclusion149

Part III Core Products and Regional Markets

151

10 Export Credit Financing 153 (Jeffrey Wool – Aviation Working Group; and William Coleman – Holland & Knight) 153 Introduction153 Regulatory framework 153 The beginning 153 Sector understanding on export credits for civil aircraft 154 WTO litigation 155 From LASU to ASU 2007 156 The home market rule 157 ASU 2011158 The ‘supercycle’ 161 Export credit’s homecoming 161 Future developments 162 Conclusion162 Annex Transaction structures 163 Part A 163 Part B 164 11 Operating Leasing – Lessor Perspectives 167 (Update by Rob Murphy – Arthur Cox LLP) 167 Introduction167 Introductory considerations 168 Core products and regional markets 171 Key features of aircraft operating leases 172 Rental payments 172 Maintenance reserves/supplemental rent and related matters 173 Security deposit 173 Term173 Quiet enjoyment 174 Net lease 174 Insurance174 Deregistration174 Return conditions 175 Transfer/assignment/security175 Demand for operating leasing 176 Efficiency of financing 176 Fleet planning flexibility 176 Residual value risk 176 Cost of capital equipment 177 Supply of available aircraft 177 Select business model considerations 177 Core themes 177 Diversification of funding sources 178 Flexible capital structure 178 xxv

Contents Management of aircraft throughout their lifecycle 179 Maintenance accounting 179 Differentiation of aircraft operating lessors 180 Lease management capability 180 Technical compliance 180 Repossession181 Reconfiguration182 Remarketing182 Aircraft/lease servicing 183 Conclusion183 12 A Lessee’s Guide to Aircraft Leasing 185 (Michelle Johnson – flydubai) 185 Introduction185 Types of leases 186 Finance lease 186 Operating lease 189 The leasing arrangement 190 Operational flexibility 193 Lessee’s other obligations 194 Other provisions 194 13 Pre-delivery Payment Financing 197 (Rob Murphy – Arthur Cox LLP) 197 Introduction197 Key issues relating to the security package 197 Legal nature of PDP 199 Lenders’ key concerns 199 Assignable price/step-in price/access to credit memoranda 199 Escalation in purchase price 199 Amendments to purchase agreement 200 Insolvency risk 200 Standstill period 200 Realisation of the security 200 Buy-back option 200 Disclosure of the purchase agreement 201 14 Regional Markets 203 Brazil203 (Edward Sheard – GECAS; and Fabio Falkenburger – Machado Meyer) 203 Introduction203 Types of lease transactions 203 Taxation205 Other issues to be considered by lessor 208 Insolvency issues 209 Insurance (war risks) 211 Security interest over aircraft and engines 211 Outbound leasing and export financing of Brazilian manufactured aircraft 211 Russia212 (Mikhail Loktionov and Alexey Tokovinin – Freshfields Bruckhaus Deringer) 212 Introduction212 xxvi

Contents Registration of aircraft Effect of RCA registration Deregistration from the RCA Aircraft mortgages Leasing of aircraft Repossession of aircraft Recognition of foreign judgments

212 214 214 215 219 221 221

India224 (Marylou Bilawala – Wadia Ghandy & Co; and Gautam Nayak – CNK & Associates LLP) 224 Introduction224 Acquisition of aircraft 224 The regulatory regime applicable to the airline industry 225 Operation, maintenance and management of airports 226 Foreign exchange requirements 227 Air transport operators and foreign direct investment in air transport operators in India 228 Import taxes 229 Lease rentals 230 Tax gross up clause 230 Transfer of ownership of aircraft 231 Stamp duty on documents 231 Cape Town Convention 231 Growth of the corporate jet sector 232 Setting up aircraft operating lease units in International Financial Services Centres (IFSC) 233 Conclusion234 China235 (Wang Ling and Wang Ning – KWM) 235 Introduction235 Key legal and regulatory issues in the Chinese aviation market 235 Cape Town Convention in China 237 Recent developments in the Chinese aviation market 238 Germany241 (Konrad Schott – Freshfields Bruckhaus Deringer) 241 Introduction241 Legal environment 242 German regulatory and civil law 243 Insolvency and restructuring 245 Outlook246 Japan248 (Paul Greenwell and Akihiko Takamatsu – Clifford Chance) 248 Introduction248 JOLCOs and JOLs 249 Japanese airline insolvencies 254 Titleholder structure 258 Japanese aviation market and legal issues 259 15 Islamic Finance 263 (William Coleman – Holland & Knight) 263 Introduction263 xxvii

Contents Sharia’h fundamentals 263 Sources and schools 263 Themes264 Sharia’h contracts 265 Governing law versus the Sharia’h265 Structures266 ljarah and ijarah wa iqtina 267 16 Insurance Considerations 271 (Glen Brighton – Willis Towers Watson) 271 Introduction271 What is the risk? 271 Asset risk 271 Liability risk 271 Insurance-based risk transfer 272 Lessee insurances 272 Lessor insurances 273 Airline insurance – detailed principles and practices 273 The insurance buying environment 273 Airline insurance coverage – detailed analysis 274 Aircraft financing and insurance 278 Aircraft hull insurance 278 Loss payable clause 279 Breach of warranty cover 279 Contribution rights 279 Waiver of subrogation 280 Notice of cancellation or change 280 Set-off rights 280 Liabilities280 Severability of interests 281 Indemnities281 Reinsurance281 Practical application of insurance to financing 282 Certificates of insurance 282 Letter of undertaking 282 Conclusion283 17 Aircraft Repossession – Practical Considerations 285 (Phil Seymour – IBA Group) 285 Introduction285 Operational and cost considerations 286 The legal process 287 Legal costs 287 Securing the aircraft 287 Pre-ferry flight parking and maintenance 287 Suitable parking facility 288 Engine repossession considerations 288 Possible liens 289 Securing the records 289 Inspection of aircraft 289 Regulatory considerations 290 Maintenance and refurbishment 290 Insurance290 xxviii

Contents Ongoing asset management Post-repossession action items

290 291

18 Global Aircraft Trading System (GATS®) 293 (Dominic Pearson – Watson Farley & Williams LLP) 293 Introduction293 The need for a ‘game change’ and the development of GATS as a new system for trading aircraft 294 GATS legal framework 294 Trust structure; avoidance of lease novation 294 UINs295 Trust branches 295 Designated transactions; GATS standard form instruments 296 Favourable FAA/ACC opinion for United States trust branch GATS instruments 297 Partial beneficial interest transfers 298 Limitation on GATS trustees’ resignation rights 298 Advance requirements 298 Benefits of GATS to financiers 298 The GATS Platform 299 GATS e-Ledger; searches 299 Entity profiles and categorisation 299 GATS professional entities 300 User accounts and authentication 301 GATS escrow facility; GATS fees 301 Digital signatures and GATS digital certificates 302 Visualisation of digital signature on GATS instruments 303 Configuration of execution block 303 Multiple signatories per transacting entity; witnessing of digital signatures304 Validation of GATS instruments 304 What’s next for GATS? 304 19 Airline Restructurings 307 (William Glaister, Philip Hertz, Jennifer DeMarco, Gabrielle Ruiz and Marisa Chan – Clifford Chance) 307 Introduction307 Consensual restructurings 307 Statutory restructuring processes 307 Insolvency procedures 308 Jurisdiction308 United States 308 Automatic stay 309 Other key Chapter 11 measures 309 Jurisdiction310 ‘Ipso facto’ provisions – Section 365 of the Bankruptcy Code 310 US certificated air carriers – Section 1110 of the Bankruptcy Code 310 Alternative A of the Cape Town Convention 310 United Kingdom 311 Schemes of arrangement 311 Jurisdiction313 Restructuring plans 313 xxix

Contents Alternative A of the Cape Town Convention – UK Cape Town Regulations 2015, reg 37 Cape Town Convention compliant arrangements ‘Ipso facto’ provisions – Insolvency Act 1986, s 233B

Part IV Regulatory Matters

314 315 316

319

20 The Regulatory Framework for Airline Operations 321 (Alan Ryan – Freshfields Bruckhaus Deringer) 321 The international framework 321 Introduction321 Chicago Convention 1944 322 Five Freedoms Agreement 322 Bilateral treaties 323 The EU regulatory framework 325 EU competition rules and the air transport sector 325 TFEU, Article 101 327 TFEU, Article 102 327 Merger Regulation 329 Ground handling 333 State aid 334 Slot allocation 336 Introduction336 Slot Allocation Regulation 337 Airline licensing 341 US airline licensing requirements 342 Aircraft registration – Chicago Convention 343 Nationality requirements 344 Registration in the EU 344 Under Regulation 1008/2008 344 Code-sharing345 Conclusion345 21 International Conventions Affecting Aircraft Financing Transactions347 (Laura Cunningham and Domhnall Breatnach – Arthur Cox LLP) 347 Introduction347 Cape Town Convention and Aircraft Protocol 347 International interests 349 Perfection and priority of international interests 349 Remedies for creditors 350 Declarations351 Geneva Convention 352 Rome Convention on Precautionary Arrest 353 Rome I Regulation on contractual obligations 354 Rome II Regulation on non-contractual obligations 355 Brussels Regulation on jurisdiction and enforcement of judgments 356 Hague Convention on Choice of Court Agreements 358 Third-party liability conventions 359 Further reading 361 xxx

Contents 22 Basel III and IV – The Regulatory Framework 363 (Brendan Wallace and Ruth Lillis – Arthur Cox LLP) 363 Introduction363 Basel Capital Accord and Basel II 363 Basel III 364 Part 1: strengthening the global capital framework 364 Part 2: liquidity standards 367 Treatment of object finance under Basel III 368 Basel IV 369 Basel III and Basel IV– impact for aviation finance 370 23 Accounting Developments in Aircraft Finance 373 (Killian Croke – KPMG) 373 Introduction373 Which framework? 374 Lease accounting 374 IFRS375 US-GAAP376 Lease modifications 376 Leases – responding to the Covid-19 pandemic 377 Aircraft and related components, depreciation and amortisation 378 Impairment of aircraft and related assets 380 Maintenance accounting 380 Use of special purpose entities/companies 381 Conclusion383 24 Aircraft Financing – The Compliance Universe 385 (Rob Murphy and Fintan Kerins – Arthur Cox LLP) 385 Introduction385 Anti-money laundering and countering the financing of terrorism 385 Anti-bribery and corruption 388 Sanctions and export controls 389 Cyber resilience and data protection 391 Price fixing, market abuse 392 Insider dealing 393 Other regulatory filings/procedures 393 Summary394 Conclusion394 Index397

xxxi

Part I Market Context

1 Aviation Finance Introduction Raymond Sisson

INTRODUCTION 1.1 March 2020 through to mid-2021 has provided the starkest economic contrast in global aviation finance the world has ever seen. Those of us who lived and worked in aviation finance during the post 9/11 downcycle and Global Financial Crisis (GFC) starting in 2008 struggled mightily to support the aviation market during those challenging periods, but in retrospect those challenges were manageable compared to the havoc wreaked by Covid-19. When airlines globally stop flying, and when deliveries and re-deliveries of aircraft stop (whether new at Original Equipment Manufacturer (OEM) factories, planned transitions/returns at airline hubs, or even required repossessions) because flight crews and technical teams cannot fly, banks cannot lend, and airports are empty because masks/PPE are not yet available, the erstwhile essential aviation industry struggles not only to see a way forward, but likewise struggles to manage day-to-day. To quantify this challenge, the Covid-19 crisis resulted in a 66% decline in global traffic, with around 50 airlines failing in 2020. This environment is made even more stark with the realisation that strong airlines were seen to fail, and even previously seemingly unassailable large-scale low-cost carrier’s (LCC) demanded (and got) rent concessions and deferrals from lessors as a critical component to their survival. Yet, now, in mid-2021, aviation demand is returning strongly, led by robust China and US performance, and green-shoots emerging in Europe. Investor demand for asset backed securities (ABS) are healthy – oversubscription is once again in fashion. Purchase and leasebacks with airlines who managed a good payment/ performance record through the Covid-19 crisis are hyper-competitive with lease rate factors of 0.6 and below. Lessors’ sales of portfolios of aircraft are matched with strong buyer demand. Forecasted airline traffic will be 65% higher in 2021 versus 2020. And last, but not least, commercial banks are lending at loan to value (LTV) rates edging back up towards pre-crisis levels for better credit, at very competitive interest rates.

Overview of funding 2020/2021 to date 1.2 In 2020, average bank aviation lending was down 80% compared with 2019, though drawing any bank-specific conclusions from that percentage is impossible – some banks remained very active whereas others stepped back from aviation lending entirely.1 Yet, at the industry level, commercial aircraft delivery funding volume totalled $59 billion, a 40% decrease from 2019 levels and a 53% drop relative to 2018. 1

Source: Ishka.

3

1.3  Aviation Finance Introduction EXHIBIT 1.1 INDUSTRY DELIVERY FUNDING

Source: The Boeing Company – Reproduced with their kind permission

1.3 Industry-wide, the level of leased fleets is trending towards 46%, with expectations that this trend will continue to 50% – driven in no small part by the realisation at airlines that leased aircraft create more flexibility to negotiate early returns as well as rent concessions/deferrals where financial circumstances demand. Given the uncertainty of finding a new home for a particular aircraft once it is surplus to requirement at an airline, the underlying residual value risk is better held by a lessor whose business model is, per se, leasing and re-leasing aircraft through a 25-year useful economic life-cycle rather than by an airline whose strategy and business model involves operating such aircraft for a defined subset of that 25-year period.

Airline landscape 1.4 The International Air Transport Association (IATA) is forecasting that total air passenger numbers in 2021 will be 52% lower than they were in 2019, as pandemic restrictions continue to hinder travel. In 2022 IATA predicts that passenger numbers will recover to 88% of pre-pandemic levels. Banks will rightly balance LTVs and pricing on a risk-adjusted basis relative to airline demand reflecting these projected customer travel patterns.

4

Introduction 1.4 EXHIBIT 1.2 AIRLINE INDUSTRY FINANCIAL FORECAST

Source: IATA – Reproduced with their kind permission

Airlines posted sharp declines (-70%) in passenger revenues in Q4 2020 amid stagnating air travel demand. Airlines in all regions turned to the cargo business to alleviate the loss on the passenger side and cargo yields remained high during the peak cargo season in Q4. As a result, cargo revenues grew by a robust 43%, partially compensating for the loss in passenger business. On the cost side, airlines had implemented stringent cost-cutting measures. While variable costs, such as fuel, declined in parallel to the loss in revenues, the reductions in fixed/ semi-fixed costs were limited such that, overall, year-on-year decline in operating costs was limited to 41%, not enough to compensate for the fall in revenues. EXHIBIT 1.3 AIR PASSENGER FORECAST

Source: IATA – Reproduced with their kind permission

5

1.5  Aviation Finance Introduction Financial support provided by governments, totalling circa US$175 billion, has been a lifeline for many airlines, while aircraft lessors provided an additional estimated US$35 billion in payment deferrals, lease restructurings, and sale and leaseback financing. However, significant cash burn is expected to continue, and IATA has called for continued support to stabilise the industry. The industry’s debt burden has increased by over 50% to $651 billion. EXHIBIT 1.4 AIRLINE INDUSTRY FINANCIAL FORECAST UPDATE

Source: IATA – Reproduced with their kind permission

With that current landscape understood, the long-term trend for airlines is still very positive, with Airbus’ Global Market Forecast predicting passenger demand to grow at 4.3% per annum, with corresponding strong growth of ~2000 net new city-pair routes through to 2038. These trends go hand in hand with predicted continued improvements in daily utilisation, average seats, load factor and revenue passenger kilometres (RPK) per aircraft. These positive trends, coupled with the resilience of the 25-year useful economic life for passenger aircraft – stretched to 35/40 years for cargo converted aircraft – underpin investors’, and thus commercial lenders’, confidence in aircraft assets, airlines, and lessors as strong lending opportunities.

Aircraft leasing 1.5 Though the benefits of aircraft leasing are broadly understood now, it is perhaps useful to recite briefly what factors have led the industry to grow from 0.5% of the world’s commercial aircraft fleet in 1970 to nearly 46% in 2021. Put simply, aircraft leasing provides an important service, and alternative source of finance, for airlines: • Improved fleet management in response to traffic growth and required capacity: − lessors can provide delivery slots earlier than typical availability from a manufacturer; 6

Introduction 1.6 −

•

•

airlines can quickly lease additional aircraft to meet traffic patterns and react to competitive dynamics; − airlines can up-gauge or down-gauge to a complementary aircraft to manage capacity/demand; − leasing allows for fleet renewal programmes over time to move into newer technology or younger aircraft. Avoid pricing and residual value risk: − manufacturers require large orders to get best pricing, which requires long lead times and conviction around future conditions; − lessors are better positioned to manage residual value risk with aircraft as they age, and newer technology is introduced. Capital management: − airlines avoid a heavy capital outlay that can be better utilised for other operations such as new city-pair route development; − improved liquidity from avoiding long-dated purchase commitments and pre-delivery payment (PDP) obligations; − better ability to match revenue with expense; − off-balance sheet treatment.

Along with commercial aviation finance banks as discussed below, commercial aircraft lessors shouldered a great deal of the burden of grounded aircraft during the Covid-19 pandemic in the form of lease payment holidays, long-term (multiyear) rent deferrals asks (or, perhaps more accurately, demands), unperformed aircraft deliveries/redeliveries, and cessation of maintenance reserve payments due to both aircraft groundings and airline financial struggles. Additionally, lessors were prevented from transacting a material portion of their typical aircraft trading activities (engaged primarily for both monetisation events as well as airline/country/region exposure management) given the inability to trade aircraft with non-performing leases and/or aircraft on lease but which aircraft were parked for indefinite periods (thus raising the airline future performance question). With that said, as of mid-2021 demand has once again been growing for narrow-body aircraft as vaccines make their way around the world and some airlines’ domestic operations show recovery – but meaningful recovery in international travel, and a corresponding demand for widebody aircraft, is uncertain as of mid-2021 – achieving parity in the supply-demand equation for widebody aircraft is likely to take some time.

Commercial bank lending 1.6 At the start of the Covid-19 pandemic in March 2020, and through the following three to four months as airlines/aircraft were grounded, commercial banks (along with lessors as described above) with exposure to aviation shouldered significant financial burden, primarily where committed lines of credit to airlines and lessors were drawn down. Across airlines, lessors and OEMs, commercial banks provided more than US$110 billion in liquidity in 2020. But the complexion of aviation lending activities changed quickly and drastically. LTVs dropped to 50–65% and borrowers were quoted 400bps for many secured deals. Most commercial banks changed their long-term funding strategy, focusing and restricting their lending to strong relationship counterparties on a secured deal – blind-pool warehouses were no longer entertained, even for 7

1.6  Aviation Finance Introduction existing customers with a successful track-record of performing with blind-pool financing. Likewise, non-recourse lending was largely shelved. As the Covid-19 crisis played out in 2020, commercial banks were, at best, freezing their aviation sector exposure, and most were looking to severely curtail such exposure. Thus, airlines were finding bilateral loan approvals being rejected by bank credit committees. Quite a few banks began to set aside capital to prepare for an anticipated wave of restructurings. Bankers noted that a mixture of increased credit risk, distressed loan portfolios, and a weak/non-existent syndication market as the pandemic raged profoundly limited new bank deals for airlines and lessors. The sudden absence of a substantive syndication market was partially ameliorated by appetite from some institutional investors via the private placement market, especially as most new commercial aviation paper boasted yields over ~200bps. However, the depth of this private placement market was limited and generally directed toward better credits. Without a fully substantive and functioning syndication market, commercial aviation finance banks were forced to book and hold deals which, in addition to the other constraints being imposed by the impact of Covid-19, even further reduced their capacity for new deals. This became particularly problematic for large facilities like warehouse financings – often used by investors/lessors to acquire and construct growing portfolios of leased aircraft. In such a severely constrained market, undrawn facilities became even harder to sell to other financial institutions. Leading up to the Covid-19 crisis, given the hyper-competitive landscape faced by banks in winning loan mandates, there was an embrace by some commercial aviation finance banks of, what might most charitably be described as, ‘relaxed’ credit criteria and underwriting due diligence standards. The advent of the Covid-19 crisis, and the grounding of the vast majority of the world’s airline fleets, was a clear wake-up call – banks moved immediately to vigorously overhaul their credit criteria and underwrite due diligence playbooks and minimum criteria. A  focus on relationship and winning at all costs was replaced by a detailed understanding of the underlying credit (or issuer), the asset (aviation bankers became as expert in the ‘metal’ as many lessors), and the structure of the deals. The Covid-19 crisis has starkly demonstrated the need for commercial aviation finance banks to redevelop stringent underwriting due diligence – simply put, pre-crisis, some banks were not adequately disciplined in extending credit. PostMarch 2020, some banks began to decline non-recourse and blind-portfolio warehouses, especially where the protections against inadequate terms and conditions were not in place – including concerns over weak credit airlines, illiquid aircraft types and aggressive advance rate, amortisation profiles, cash flow protections, maintenance cost assumptions, etc. Pre-crisis, there was the view that warehouses would always be refinanceable in ABS markets – Covid-19 rapidly changed that view, as the ABS market effectively closed down for months. Commercial aviation finance banks pivoted for a period to a much more conservative approach, with funding limited to top tier credits – that is to say, airlines with access to funds via state support or capital markets, and new technology aircraft or liquid classic narrow-body aircraft. NB: do not confuse state support with sovereign/flag carriers – we have seen, and continue to see, a raft of flag carriers declaring bankruptcy, and anticipate more through the remainder of the year. Airlines with lower credit ratings were considered, but require well secured transactions with liquid young aircraft, secured by other 8

Introduction 1.7 airline assets such as strategic routes, slots and gates, and even then, are offered relatively low LTVs (relative to pre-Covid-19 levels) and targeted to transactions that have a high probability of reasonably near-term refinancing in the capital markets. Even in the face of such a conservative approach to bank lending, some banks continue to leave the commercial aviation lending space, mirroring a similar exodus during the GFC. Another recent change in the approach to lending is in the robust adoption of strict environmental, social and governance (ESG) standards. In working towards the goals set forth in the Paris Climate Agreement, banks are looking to the standards set by the International Civil Aviation Organization (ICAO). ICAO’s Environmental Protection Standards are contained in Annex 16 to the Convention on International Civil Aviation, and it is broken up into four different volumes: • Volume I: Aircraft Noise – focuses on noise limits at source (for example, engines) as well as operations adjustments to achieve noise abatement; • Volume II: Engine Emissions – focuses on gases released below 3,000 feet, (for example, hydrocarbons (HC), nitrous oxides (Nox), smoke) which affects local air quality; • Volume III: Airplane CO2 Emissions – relates to emissions at an aircraft level and specific to new production aircraft; and • Volume IV: Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) – applies only to international flights and requires airlines from participating states to monitor, report and verify their emissions, with a view to offsetting. This document along with data used in ICAO’s CORSIA CO2 Estimation and Reporting Tool (CERT) is likely to form the basis for banks’ carbon intensity metric/measurements. Over time, banks can be expected to severely limit/decline transactions which involve the financing of aircraft/engine assets that do not comply with a progressively stricter level of ICAO/Paris Climate Agreement limitations.

Investment banks and capital markets 1.7 With that said, as of June 2021, a return to ‘normality’ is starting to be seen – LTVs inching back up into the 65–75% range with margin ranges in the low 200bps for new aircraft, low to mid 200bps for mid-life aircraft, and engines and regional aircraft being quoted in the high 200s/low 300bps. This is largely the result of investment banks and the capital markets stepping up with significant support for aviation lending/finance – both in terms of the amount of capital available for commercial aviation as well as innovative structures which support both airlines and lessors. This continues the trend that really commenced in earnest, in ever more material amounts, in 2013. Since 2013, the amount of aircraft paper issued in the 144a market has grown significantly: • $8+ billion debt, $1+ billion equity issued in 2019; • >24 servicers have come to market since 2013. Large lessors typically issue both rated debt and equity residuals (or ‘E-notes’): • large lessors typically have significant new order commitments with the manufacturers going out years, representing a big funding need; 9

1.8  Aviation Finance Introduction • • •

these lessors have investment grade ratings with corporate debt, and generally must maintain a young fleet for corporate rating purposes; in order to finance new purchases as well as manage concentrations to lessees, the lessors tend to sell aircraft that reach ‘mid-life’; previously, lessors would sell aircraft to other lessors. With the 144a equity market, lessors can recycle capital, retain servicing and customer relationships, and tap into a new investor universe.

The less-established lessors typically issue only rated debt, though some have issued equity as well: • smaller or less-established leasing companies (or specialist credit funds) access the 144a rated debt market for efficient term financing; • for lessors without access to corporate bonds, 144a rated debt presents an attractive financing channel; • we see relatively standardised structures, no mark-to-market risk, efficient fixed-rate pricing, and seven-year term debt; • some of these platforms have also sold part of their equity.

Asset-backed securities (ABS) 1.8 Perhaps one of the key innovative structures utilised by lessors is asset backed securitisation (ABS). ABS’ have been standardised over the past almost decade and thus would typically contain the following: (1) collateral profile; (2) capital structure/liability structure; and (3) reserve accounts and credit support features. (1) Collateral profile: – typically, lessors construct a portfolio with a minimum of 18–20 aircraft for an issuance to achieve adequate diversity, and thus achieve optimal ratings from the rating agencies (such as S&P, Fitch, and Kroll); – mid-life aircraft (~5–10 years old on average) on long-term leases (~4–5 years remaining) tend to be popular given reasonable average basis (~US$25 million/aircraft) and cash yield dynamics (~1.0% lease yield per month, high percentage of cash maintenance reserve payers); – portfolios tend to have a relatively high number of narrow-body aircraft, particularly 737-800 and A320-200 aircraft given their popularity; – some portfolios have also had a few widebody aircraft (up to ~40% of the portfolio), which tend to be placed with stronger airlines but pose remarketing risk should a widebody aircraft be returned; – issuances tend to be well-diversified by aircraft types, lessee, country, jurisdictions, and year of lease expiry. (2) Capital structure/liability structure: – debt quanta tend to be $400–750 million totals given the high cost of aircraft and the need for diversification; – seven-year anticipated repayment date (ARD) structure, with a 200bps step-up in interest and full cash sweep if not repaid by the ARD; 10

Introduction 1.9 –

terms have become substantially similar across issuances since ~2017, though certain items (maintenance reserve mechanics, security deposit reserve mechanics, cash flow sweeps) depend on issuances’ collateral and specific cash flows; – Classes A and B feature straight-line amortisation designed to deleverage to ~45% (Class A) and ~55% (Class B) projected LTV by ARD; – Class C bonds typically have seven-year straight-line amortisation, and are subordinated to principal and interest on Classes A  and B and typically viewed as a ‘cash flow’ bond payable through lease cash flows. (3) Reserve accounts and credit support: – expense reserve account – typically funds three months of operating expenses (for example, trustee/administration fees); – maintenance reserve account – traps cash flow through the waterfall to provide for lumpy maintenance expenses; – security deposit account – traps cash flow through the waterfall to return security deposits to lessees at lease expiry; – Class C  reserve account – provides credit enhancement for Class C bonds – can be used to meet timely interest or principal at ARD; – liquidity facility – committed line from a creditworthy bank that provides for nine months of interest on the Class A and B.

E-notes or equity certificates 1.9 ‘E-notes’ or ‘Equity certificates’ started being sold in 144a format in mid-2018. Prior to the STARR  2018-1 issuance, structured equity was sold through a private placement process: (1) Rationale: – large lessors view this market as an alternative to the secondary aircraft sale market, where aircraft is programmatically sold piecemeal to manage concentrations. This market allows lessors to retain servicing of the assets and keep lessee client relationships, while also generating sales proceeds to recycle into new aircraft acquisitions; – other lessors view this market as a way to expand asset management capabilities. (2) Alignment of interests: – sellers typically retain ~10% of the equity certificates alongside the anchor investor and 144a equity investors; – in addition, sellers have shown different ways of ensuring alignment of interest, for example, incentive fees based on appraiser; – benchmarks or a private equity (PE) style promotes structure after meeting IRR hurdles; – the ‘asset manager’, a role typically filled by the servicer or an equity investor acting as a CLO collateral manager, is paid a fee to manage investor relations and update/roll forward the model each month. 11

1.9  Aviation Finance Introduction (3) Marketing process: – typically, an ‘anchor investor’ will be involved early in a transaction and takes the lead on performing legal diligence and technical diligence, sometimes opining on collateral selection and negotiating terms; – the anchor investor will typically commit for 20–25% of the equity and enter into a lock-up agreement to restrict selling for two to three years. In exchange, the anchor investor receives a discount to the market-clearing price; – the balance of the equity certificates (typically 60–70%) will be offered alongside the debt in a 144a/Reg S offering. (4) Marketing material available: – appraisals are provided from three third-party appraisers, which include forecasted values and forecasted lease rates; – a maintenance forecast is provided from a third-party specialist, which shows projected inflows and outflows; – the sponsor provides a model on DealVector, which allows investors to run various stress scenarios. (5) Modelling: – there are three key assumptions: forecasted lease rates; forecasted sales value; and sale timing; – in addition, the following assumptions can be tweaked in the model: aircraft on ground time; transition costs; and expenses. (6) Other: – 144a/Reg S equity certificates do not need NDAs to share, are not subject to risk retention, are TRACE-eligible, and up to 25% can be ERISA-eligible with the proper ERISA compliance certificate. EXHIBIT 1.5

Source: KPMG from a joint webinar with the IBA – Reproduced with their kind permission

12

Introduction 1.10 EXHIBIT 1.6

Source: KPMG from a joint webinar with the IBA – Reproduced with their kind permission

Other attractive structures for airlines and lessors are lessor EETCs and lessor EETCs with multiple airlines.

Lessor EETC summary 1.10 •

A lessor EETC is a non-recourse issuance sponsored by a lessor, backed by aircraft on-lease to a single airline obligor. Unlike traditional EETC structures, a lessor holds the equity in the issuing trust and is contracted to serve as a servicer/remarketing agent.

•

Both a lessor EETC and traditional airline EETC typically target young aircraft, though there are differences including amortisation, balloons, and call protection.

•

The lessor EETC structure offers another capital markets product for term financing.

•

The product is appealing to both corporate and securitised products investors who are familiar with individual airline names and/or lessors, and can price and evaluate the risk associated with the offering.

•

If there is sufficient lease cash flow available, the bonds could be structured so as to be entirely repaid from the contractual cash flows.

•

Given the failure of airlines in 2020, investors find value in having an in-place servicer capable of working through a bankruptcy and lease restructuring.

•

Given disclosure issues, such an issuance is more likely to be 4(a)2 rather than 144a.

•

The aircraft are secured by first priority perfected mortgages (including without limitation lease assignments), Cape Town registrations, insurance, warranties, and assignment of (re)insurances. 13

1.11  Aviation Finance Introduction

Lessor EETC with multiple airlines summary 1.11 A  hybrid – in between a single airline lessor EETC and a more diversified pooled ABS issuance: • construct a portfolio consisting of two to three airlines that are publicly rated and domiciled in the US, UK, or other select areas of developed Europe where bankruptcy cases have had positive case law; • target would be up to 12 aircraft, generally younger, with long remaining lease terms; • past airline behaviour in bankruptcy (affirm/reject actions), if applicable, are key if 11 US Code Section 1110 is not applicable.

CONCLUSION 1.12 For the past 50+ years, commercial aviation, including financiers, have operated in an environment where RPK’s (the number of revenue-paying passengers carried multiplied by the distance flown in kilometres) has grown at 1.5x of global GDP. Such demand for global air traffic has remained resilient, robust, and consistent, doubling every 15 years. Notwithstanding Covid-19, though the pace of growth may change, in absolute terms growth in commercial aviation demand will continue for amongst others, the following reasons: low air fares; growth of LLCs; more accessible air travel with new airports; increased travel and tourism as part of overall increased consumer spending; higher living standards as part of a rapidly expanding middle class; and increased liberalisation of markets in Asia. Covid-19 has raised some significant questions which OEMs, airlines, lessors and commercial aviation finance banks, and governments, need to answer before the world faces another global pandemic. Amongst those questions are: • How do OEMs hedge delivery risk on their order books, given the broad and crucial supply chains necessary for such orderbooks? • Are large airline orderbooks sustainable in a world where regional or global pandemics remain a risk? • Is residual value risk best held by lessors, with their 25-year useful economic life of aircraft business plan and ability (in the absence of a global shut-down of aviation) to transition aircraft to performing airlines? • How can commercial aviation finance banks iterate financing structures to more seamlessly allow the transition of aircraft across airlines, national borders, security packages, and lessors to ensure aircraft stay in operation? • Looking at lessons learned from Covid-19, what model of government support of airlines worked best, and how can both those lessons learned as well as funding globally, be shared to ensure that the world’s aviation infrastructure can survive future pandemic/economic shocks? In the meantime, the continued demand for travel, both business and leisure, ensures that the global distribution of vaccines and desire to get back on planes, will underpin the industry rebound. If previous commercial aviation cycles and corresponding recovery periods are any guide for us in a post-Covid-19 world, recovery can be anticipated over the following 24–48 months.

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2 Overview of Aircraft Financing Markets José Abramovici

INTRODUCTION 2.1 In the early 1990s, the finance market for aircraft was dominated by Japanese banks, in particular, financing aircraft through the Japanese leveraged lease (JLL) market, which could underwrite and keep big ticket items on their balance sheets. However, when the availability of Japanese credit deteriorated as a result of the Japanese credit crunch beginning in the late 1990s, the German landesbanks took over from Japanese banks as the leading player in the aircraft finance market, mainly due to their strong credit ratings, low cost of funds and ability to structure German leveraged leases. Following the World Trade Center attacks in 2001, many German banks reduced their lending activities in the aircraft finance market as a result of their involvement in a number of high-profile airline bankruptcies and restructurings, for example, Swissair, Sabena, United Airlines and Air Canada. Additionally, the disappearance of state guarantees for the landesbanks had a negative impact on their previously strong credit ratings. A few German banks have, however, developed themselves into global transportation finance houses and have built their aircraft portfolios during the down cycle which followed the World Trade Center attacks and the global emergency caused by Severe Acute Respiratory Syndrome (SARS). Whilst the participation of Japanese and German financiers has fluctuated over recent times, French banks have remained active in aircraft financing during this period. French banks initially led the Airbus export credit market due to the attractiveness of the former Large Aircraft Sector Understanding (LASU) forward interest rate mechanism and then diversified their aircraft portfolios by introducing all other aircraft manufacturers and aircraft types, as well as expanding into a wide range of financing structures such as JLLs, Japanese operating leases (JOLs), French tax leases (FTLs), Export-Import Bank of the United States (Ex-Im Bank) financing and non/limited recourse financings. The presence of French banks has remained strong through the various bank mergers over the past several years. US banks in the past have dominated the Ex-Im Bank market, big ticket syndications and US leverage lease markets for many years, but in general have decreased their activity into commercial aircraft financing before Covid-19. Some, however, remain active in the aircraft securitisation, secured bonds, high-yield bonds and export credit/export bonds markets. A  few 15

2.2  Overview of Aircraft Financing Markets British banks also remain active, but lend to target specialised markets such as export credit, Islamic finance or commercial aircraft financing in selected countries such as countries in the Middle East region. Finally, a few Japanese banks remain active in aircraft finance for first-tier airlines, export credit and  JOLs. This chapter will review the consequences of the unprecedented Covid-19 crisis on the financing of aircraft.

POST-WORLD TRADE CENTER ATTACKS 2.2 After the Word Trade Center attacks, many banks changed their approach towards aircraft financing from a corporate credit or ‘name lending’ approach to the asset-based or asset-backed approach. Generally, banks were no longer prepared to risk the need to repossess aircraft and become lessors of repossessed aircraft in order to recoup their losses.

GLOBAL FINANCIAL CRISIS (GFC) 2.3 Following the sub-prime financial crisis in 2007/2008, many banks had to reallocate capital from international aircraft financing to their core domestic businesses in connection with taking government funds to support the repair of their balance sheets. These changes have compounded to cause a number of banks to withdraw from the aircraft financing market completely. In 2010, according to estimations, there were approximately only a dozen international banks capable of arranging cross-border aircraft transactions on a global basis – a significant reduction from the number of banks active in the market pre-credit crunch. During the last decade, a number of Chinese and Middle Eastern banks have become active within the aircraft finance markets which has helped to fill the void created by the financiers exiting the market, though their activity, to date, has had primarily a regional focus. There have, however, been transactions where Chinese banks have participated in financings for first-tier airlines and aircraft leasing companies outside the Asia-Pacific sector.

COVID-19 CRISIS 2.4 The Covid-19 crisis differs from all previous aviation crises for the following reasons: • its magnitude – it is a worldwide crisis affecting all airlines in the world as the revenue passenger kilometres (RPK) drop is massive: January– November 2020 (–65%) with international traffic more severely affected (January–November 2020: –75%); • its duration – during the previous crises (9/11 and GFC), it took two to three years for the traffic to recover the level of pre-crisis, while it is expected that the impact of Covid-19 will last up to four to five years; • expected industry losses of ~ $160bn over 2020/2021 – expected to wipe out the profits of the previous five years; 16

Covid-19 crisis 2.5 •

airline debt has ballooned from $430bn in 2019 to $651bn in 2020 (source: IATA);

•

public airline ratings down by two notches in average with most public ratings subject to negative outlooks;

•

while only a handful of airlines have actually ceased trading since the Covid-19 outbreak, a significant number of large airlines in various jurisdictions have been placed under bankruptcy or rehabilitation protection in order to renegotiate their debt/lease contracts, reorganise/ downsize operations and raise additional debt (often through debtor-inpossession – ‘DIP’ – type of financings). Some companies have already faced restructuring in 2020 and this could be reasonably expected to continue during the course of 2021. The massive governmental aids, the covenant holidays, the loan deferrals etc have helped some airlines to avoid the liquidity crisis but all debts will have to be repaid/refinanced (or converted in equity for state loans) at some point;

•

while the leasing market was limited to 25% in 2000, 36% in 2010, lessors own at least 45% of the world aircraft fleet in December 2020.

EXHIBIT 2.1 IATA FORECASTS

Source: IATA – Reproduced with their kind permission

Source of funds for airlines during the Covid-19 crisis 2.5 •

Massive support from governments to their airlines in many countries: cash grants (mostly to support continued employment); equity injections; state-backed loans ~ $161bn government bailout/relief approved globally; ~ $15bn additional in the works; $70–80bn more needed according to IATA.

•

Significant amounts raised in the private and public markets, sale and leaseback, enhanced equipment trust certificates (EETC), and bank market.

•

Limited bank debt capacity: aviation banks have either frozen their new lending policy or they have set new high standards in terms of credit, asset, structure, single airline concentration or ticket size. In particular, 17

2.6  Overview of Aircraft Financing Markets

• •

•

•

underwriting large commercial debt facilities has become more challenging because distribution channels are very limited. Funding by equity investors looking for senior debt leverage (limited recourse aircraft warehouse, refinancing of existing portfolios). Large facilities secured by aircraft, engines, parts, or intangible assets (miles, slots, brands) underwritten by US investment banks with capital markets refinancing. Export credit agencies from the US and Europe, supported by the credit of their governments which were quasi inactive over the last few years will resume their guarantees to the lending banks. Emergence of competing funding platforms outside the traditional bank market.

The major lessors, backed by their strong parent (large financial institutions or major corporates) and/or ample liquidity/solid balance sheet have been able – so far – to access the capital markets (it was not the case during the GFC as commercial paper, corporate bonds, asset-backed securities (ABS) markets were virtually shut down) and to rely on their core banks.

GLOBAL LIQUIDITY IN TODAY’S MARKET 2.6 The consulting firm ‘Independent Strategy’ has compared global liquidity to a massive inverted pyramid (see Exhibit 2.2), which represents at least eight years of the world’s gross domestic product (GDP) and is growing at least five times as fast. At the bottom of the inverted pyramid is the ‘power’ money or reserve money, which represents the liquidity created by the balance sheets of central banks. Liquidity from commercial banks is part of the global liquidity (conventional credit multiplier mechanism of commercial banks). Liquidity created by securitisation comes next in the pyramid which, in theory, enables risk to be pooled and averaged, allowing claims on illiquid assets to grow further, relative to the reserve money in the system. At the top of the pyramid comes the huge credit derivatives, interest rate derivatives, and other ‘exotic’ asset markets, a system in which each institution, by ‘insuring’ against losses, was able to further increase its claims of physical and financial assets without increasing precautionary reserves of capital or reserve money. If applied to the global liquidity which was needed by airlines and aircraft leasing companies in 2020, this pyramid shows that: (1) credit derivatives instruments such as credit default swaps (CDSs) became very expensive or were in short supply; (2) there have been a number of EETCs but since March 2020, the number of limited recourse aircraft or engine lease portfolio securitisations (ABS) has been considerably reduced. The ABS which closed before Covid-19 have been under pressure with significant downgrades of the subordinated tranches; (3) new aircraft secured loans have been provided by a dozen of aviation banks still active in the aircraft finance markets in 2020; and (4) export credit or state guaranteed loans supported by the credit of the governments which provide guarantees to the lending banks consume low capital reserves. 18

Main trends for aircraft finance 2.9 EXHIBIT 2.2 THE LIQUIDITY PYRAMID: GLOBAL LIQUIDITY BY SOURCE OF CLAIM

Source: Independent Strategy – Reproduced with their kind permission

MAIN TRENDS FOR AIRCRAFT FINANCE The need for finance 2.7 Given the total financing requirements of aircraft leasing companies and airlines for the next decade, new financing sources will need to be tapped through the capital markets. Capital markets will have to fill the financing void, with only a portion of the total financing needed coming from ‘traditional’ sources such as commercial debt, export credit financing and tax leasing. A significant challenge for the aviation industry as a whole, as well as the aircraft finance industry, will be the relatively huge financing requirements of India, China and the Middle East. The aviation industry is cyclical, and is particularly vulnerable to war, terrorism, pandemics (SARS, Covid-19), adverse natural climatic conditions or volcanic ash clouds, in addition to the usual risk factors such as oil price volatility and global economic growth. Higher pricing and tighter structures will need to reflect these additional risk factors.

Regulatory frameworks 2.8 Basel II and progressive Basel III/IV implementation will favour export credit-backed transactions and other structured transactions such as ABS or ABS style transactions with highly rated/well secured senior tranches supported by liquidity facilities. Banks will continue to be constrained by stringent liquidity requirements imposed by the authorities which regulate them and will aim to free up more liquidity through covered bonds mechanisms (for example, ‘Pfandbrief’ in Germany, or ‘société de credit foncier’ in France). More countries are highly likely to ratify the Cape Town Convention, which may have a positive impact on the financing costs in those jurisdictions as ratification in many cases should result in an improvement to those jurisdictions’ legal framework.

The end of the dominance of the US dollar 2.9 If the European Union successfully overcomes the current Covid-19 crisis, there may be more demand for euro financing by airlines given the 19

2.10  Overview of Aircraft Financing Markets growing share of euro revenues for Asian and Middle Eastern carriers, beyond the traditional European airlines. In addition, the continued contribution of the European aerospace industry in aircraft manufacturing may support the demand for such financing by denominating aircraft sales in a mix of US dollar and euro currencies. In the long term, the importance of the Chinese airline market and the emergence of the Chinese aerospace manufacturing industry may lead to the use of the Chinese yuan to finance aircraft deliveries in China.

FINANCING OBJECTIVE: THE FINANCIER’S PERSPECTIVE Aircraft as investments 2.10 The management of a bank typically seeks a double digit return on equity (after reserves and taxes) which itself is based upon net income generated by a given risk (that is, the weighted assets number or the economical capital to be allocated to a specific aircraft finance transaction). One could afford to have a low return for the year after the World Trade Center attacks if the overall profitability of the bank’s portfolio over a complete aviation cycle meets the bank’s criteria. If a bank accepts a long-term view and builds a solid aircraft loan portfolio through all points of the aviation cycle, the business of secured aircraft finance is generally a sound business. By contrast, banks entering at the top of the aviation cycle with hopes of building a portfolio within a very short period of time would need to accept high leverages and low margins, therefore making it more difficult to generate adequate returns, especially if, for whatever reasons, their shareholders decide to exit the business after a few years. Financing aircraft will remain attractive to long-term players because of the lengthy economic life of aircraft (for example, cargo aircraft have an economic life of 25 to 35 years), downside protection due to the intrinsic value of engines and rotables, asset mobility and the possibility of generating cash flows after default by re-selling or re-leasing the asset. The new technologies/services (composite materials, power-by-the-hour solutions, standardised maintenance) should also bring more comfort to the asset-based lenders. Sound aircraft finance transactions are based upon three pillars: (1) the quality of credit worthiness of the obligor; (2) the quality of the asset; and (3) the robustness of the structure of the transaction (for example, loan to value (LTV) ratio, rate of amortisation, security package, protection for market disruption and increased costs). Before the unprecedented Covid-19 crisis, a bank could afford to have one loose parameter out of three, but a transaction was unlikely to survive the previous down cycles if based only on one pillar. The lessons to be drawn from the Covid-19 crisis is that financiers will have to focus again on structuring their transaction on the three pillars above ie (1) an obligor which is well positioned to survive the Covid-19 crisis based upon a strong balance sheet pre-Covid-19 and/or proven support from its government by way of recapitalisation, state guaranteed loans etc; (2) new technology assets with better fuel efficiency, for example, cargo aircraft; (3) conservative structure with reasonable LTV rates, lender’s friendly amortisation, no or low balloon; in case of limited recourse portfolio financing, the financiers will require first-tier lessees with diversification, a majority of new technology aircraft in the pool, and tighter parameters in order to have a faster amortisation of the loan. 20

Financing objective: the financier’s perspective 2.12 Banks with a global offer, such as debt capital markets, equity capital markets, advisory, hedging and asset/cash management, will always seek side business which consumes little balance sheet capacity in order to achieve a multi-product relationship and maximise overall client profitability.

Debt and tax lease market 2.11 Export credit will continue to support part of the aircraft financing needs and will increasingly become a commodity controlled by a few banks which: (a) have the lowest internal liquidity costs; (b) can refinance themselves in the capital markets (bonds or sovereign conduits); or (c) can enhance the value of 100% guaranteed Ex-Im Bank or ECA paper through utilising tax efficiencies. Ex-Im Bank, UK  Export Finance have been the most active in supporting long-term capital markets bonds issuances. Given the growing presence of the regional aircraft makers, the Organisation for Economic Cooperation and Development (OECD) decided to replace the old LASU agreement with the new Aircraft Sector Understanding 2011 (ASU  2011) which France, Germany, Spain, the UK, the US, Brazil, Canada and Japan have agreed to follow, and which now includes parameters on which export credit agencies in these countries provide export credit support with respect to both ‘regional’ aircraft (as well ‘large’ aircraft which previous ASUs covered). The ASU scheme is intended to create consistent and transparent set of rules and ensure a balanced relationship between export credit financing and commercial financing. However, export credit was subject to controversial debate in 2010 involving the so-called ‘home-country’ airlines (airlines from the countries which are manufacturing Boeing and Airbus aircraft, the US, the UK, France and Germany), and hence the development of the new ASU 2011 which reduces distortion of competition among the participants to the previous ASU and any sources of financing. Export credit, if available, will bring certainty of financing to the airlines and aircraft leasing companies.

Carbon emissions 2.12 Whilst carbon emissions from air transportation represent a low single digit percentage of global industrial carbon emissions, it has attracted, and will continue to attract, attention from governments and the travelling public, since climate change awareness is growing. Airlines integrate environmental considerations into their business strategy and take commitments. Banks are following the green initiatives of their clients (re-fleeting, carbon offsetting, investment in sustainable aviation fuels) and increasingly look to arrange sustainability-linked loans based on meaningful sustainability performance targets. Many banks have already taken into account technological obsolescence of the aircraft they are financing and favour more eco-friendly new generation aircraft (which are given a better internal scoring by the banks). The European Banking Authority (EBA) encourages the banks to identify and manage their environmental, social and governance (ESG) risk. In the near future, banks will need to monitor the carbon performance of their aircraft portfolio and its trajectory and to this end they will be able to use instruments such as a carbon calculator promoted by the Aviation Working Group (AWG) and the aircraft and engine manufacturers. 21

2.13  Overview of Aircraft Financing Markets

Tax based leasing 2.13 Tax based leasing products are likely to remain limited to Japanese leases structured for selected assets (mainly popular narrow bodies, cargo aircraft during Covid-19) and to some niche markets, such as Spanish operating leases and the French based tax leasing products. The all-in costs for airlines is likely to be reduced by the implementation of tax based leases, but the tax benefits derived from such will always be dependent upon changes in tax rules such as depreciation policy and corporate tax rates.

Islamic leases 2.14 Islamic leases will be boosted by the emergence of Middle Eastern airlines, which have placed huge orders for new aircraft and will be supported by the emergence of investor liquidity in the Islamic market. Islamic leases are an efficient way to diversify sources of finance.

The aircraft leasing market 2.15 Sale and leaseback transactions will remain the financing instrument of choice for a number of low cost and newly established airlines, as well as continuing to be a flexible instrument for the major airlines. Aircraft leasing companies shall continue to grow in excess of their current representation of ownership of more than 45% of the world aircraft fleet. Sale and leaseback transactions are an efficient way for an airline to monetise upfront any potential upside value in an aircraft and/or to improve return on capital employed by hedging the future residual value risk for the airline. Equity analysis, when assessing a sale and leaseback transaction, will analyse the ability of the airline to withstand a down cycle by reviewing flexibility in the airline’s fleet with the possibility of reducing non-core assets. Accordingly, if an airline has a good mix of owned aircraft and leased aircraft in its fleet, this will be seen as a positive factor by rating agencies and equity analysis. Many aircraft leasing companies will continue to fund themselves through strong shareholders or borrow external funds on a recourse or non-recourse basis. There is currently a growth in new Chinese aircraft leasing companies and some of these companies are global players. In the past decade, airlines have tapped the German operating lease market with success. This particular type of operating lease uses German Kommandigesellschaft (KG) funds designed for the German retail investors’ market. Due to some losses post-2008 by German investors in various markets, including the US real estate and container shipping sector, for example, the focus of KG investors is now primarily the security of the investment rather than the return on the investment. KG investors used to favour core aircraft operated by flag carriers over a long-term lease with on-going equity free cash. PostCovid-19, a focus will include the liquidity and the environmental performance of the aircraft as some airlines decided to phase out their A380 earlier than initially expected. Some aircraft lease companies have set up joint ventures with Middle Eastern equity investors and will use non/limited recourse finance to finance themselves. 22

Financing objective: the financier’s perspective 2.18

Debt capital markets 2.16 So long as the margins for the best credit rated airlines in Europe and Asia remain relatively low, and after one airline in Latin America has decided to reject the aircraft from its EETC, the EETC opportunities outside the US will remain low. In the US, major airlines and low-cost carriers (LCCs) that have placed large orders are likely to continue to use the long-term securitisation market to supplement sale and leaseback financing as well as secured mortgage debt for liquid aircraft (such as Boeing 737NG /Max aircraft and Airbus A320Neo family aircraft). Aircraft lease portfolio securitisations and high-yield secured bonds should remain as funding alternatives, though based upon a more conservative structure than before Covid-19, due to the need for aircraft leasing companies to refinance short to medium term warehouse facilities. Recently, some aircraft leasing companies have received equity investment from private equity and hedge funds. Private equity funds, hedge funds and the capital markets will allow diversification of financing sources. The Islamic bond market (sukuk) should provide additional capacity. An alternative source of funds from capital markets is the covered bond market. The covered bond market is used by some banks to refinance their aircraft commercial mortgage loans and/or their export credit loans into the deep capital markets (the European covered bond market is one of the largest bond markets in Europe).

Private equity markets and hedge funds 2.17 There has been a growing appetite from private equity funds as well as hedge funds to invest in either aircraft portfolios or LCCs and, over the last few years, billions of US dollars in equity have been invested by these funds in the acquisition of aircraft leasing companies, aircraft cargo conversions and LCCs. Typically, private equity funds used to seek in excess of 15% per annum return on their equity after a period of investment of three to five years, with an exit through a private sale or an initial public officering (IPO). It remains to be seen whether these rates of return will continue, especially in light of the relative low interest rate environment and low LTV ratios that are prevailing in the current aircraft financing markets. Hedge funds are more opportunistic and short-term focused and they have been seen trading high-yield paper of US airlines (for example, unsecured claims and high-yield bonds). Private equity funds in the US have been active in the US airline industry for some time and private equity funds have now been seen investing outside the US.

Public equity markets 2.18 As IPOs are a natural exit for the private equity funds which have invested in LCCs in regions including Asia/Pacific and India, it is possible that there will be an increase in the number of IPOs post Covid-19 as investors look for growth, experienced and proven management, strong profitability, and increasing market shares. However, some of the recent IPOs for LCCs have not been very successful and this is likely to hinder the likelihood and/or success of future IPOs, especially if increased competition in a post Covid-19 continues to affect airlines’ profitability. 23

2.18  Overview of Aircraft Financing Markets Many see potential for IPOs of unlisted aircraft leasing companies, which may attract more interest from educated and experienced institutional investors. Aircraft leasing companies generally have diversified portfolios, strong cash flows and the ability to distribute regular dividends while keeping the potential upside in the residual value of the assets, which is attractive to such investors. However, the current market valuations for existing listed aircraft leasing companies are probably too low to sustain secondary issuances and, therefore, new IPOs may take some time until the air cycle improves substantially after Covid-19. The equity or equity linked markets will be key to partially offset the equity value destruction caused by the current crisis and will be needed to improve the balance-sheet leverage burden for many airlines which have tapped the commercial debt, the state guaranteed debt and the debt capital markets to increase their liquidity in order to cope with the cash burn. All debt will have to be repaid and/or refinanced in the next years post-Covid-19.

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3 Aircraft Capital Markets Zarrar Sehgal 1

INTRODUCTION 3.1 When evaluating the history of aircraft finance, it is evident that it has evolved within a notable pattern of cyclicality. The industry is highly elastic to external factors, such as global and regional economic conditions, international trade, geopolitical tensions, and world health scares.2 Despite a halt in the momentum of capital markets issuances a little over a decade ago, the markets have been in a palpable state of resurgence since 2014 and 2015, with more than US$3 billion of issuances in both 2014 and 2015.3 The aviation industry has only continued to thrive in the last five years. In fact, Boeing predicts that by 2032, the world’s commercial aircraft fleet will be nearly 47,000 aircraft.4 In addition to Boeing and Airbus, new aircraft types have entered the market, such as Bombardier and Comac. This, coupled with the Cape Town Convention, which established a system of recognising international rights in aircraft and aviation assets in addition to providing the ability to give effective notice of ownership and security interests to third parties, has only further boosted the industry.5 The purpose of this chapter is to specifically explore how the capital markets have remained an important source of capital in the aviation industry since 2016, even in the face of the Covid-19 pandemic. In general, capital markets improve transactional efficiencies by bringing together institutional investors with those seeking capital. They are composed of both primary and secondary markets. Primary markets are open to investors who buy securities directly from the issuing company, whereas the secondary market consists of existing securities traded between investors.6 Capital markets investors are particularly attracted to aviation financing as, compared to other assets with long-term lives, the return on investment in aircraft often exceeds the returns derived from such competing investments. As 1

Zarrar Sehgal would like to thank Zoya Afridi, an Associate of Clifford Chance US LLP, and Madalyn Miller, formerly of Clifford Chance US LLP, for their help with this chapter. 2 See Peter Manofsky and John Bella, Jr ‘Collateral Pools Shift as Aircraft ABS Accelerates’ 4 J of Structured Finance 20, 20–21. 3 Glen Fest, ‘For Aircraft Lease ABS, Age is Only a Number’ Asset Securitization Report. 4 Clyde and Co, LLP, ‘Aviation Finance & Leasing: Global Overview’ (6 July 2018) Lexology, https://www.lexology.com/library/detail.aspx?g=4c925aac-dc26-41e8-87ff-dab1d27eb373. 5 Ibid. 6 Adam Hayes, ‘Capital Markets’ (31 March 2021) Investopedia, https://www.investopedia.com/ terms/c/capitalmarkets.asp.

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3.2  Aircraft Capital Markets a result, airlines and aircraft lessors have increasingly turned to capital markets as a source of funding, the proceeds of which are most often used to purchase aircraft or refinance already-owned aircraft.7 In the last five years, this has only increased. In 2015, roughly $17 billion of aviation-related debt securities were sold in the US capital markets. In 2016, the capital markets volume by issuer was approximately $50 billion. This has consistently grown since then, with only a small dip in that volume by issuer in 2018. In 2020, the capital markets volume by issuer was at an all-time high at over $120 billion.8 Typically, the majority of this capital markets activity was lessor-issued securities. This, however, has also changed in the last five years, with US airlines now being the biggest issuers, followed by non-US airlines and lessors, respectively.

STRUCTURE 3.2 Typically, aircraft and aviation-related assets are purchased by an airline, an aircraft lessor, or some other entity.9 These purchases and operations are financed using a variety of structures, such as a secured loan, an operating or finance lease, or a capital markets transaction. In an aircraft-related capital markets transaction, the entity will issue bonds or notes secured by a mortgage on the aircraft.10 Within the capital markets framework, there are three primary structures as outlined below.

Private placements and Rule 144A offerings 3.3 Section 4(a)(2) of the US Securities Act 1933 is known as the ‘private placement exemption’ and allows issuers to avoid the restrictions of Section 5 of the Securities Act by raising capital without the cost and delays of the US  Securities and Exchange Commission (SEC) registration. The exemption does not involve a public offering, but rather, it allows an issuer to raise unlimited capital from sophisticated investors. However, any shares sold using this exemption are restricted and cannot be resold without SEC registration or an applicable exemption.11 A Rule 144A offering refers to Rule 144 under Section 5 of the Securities Act of 1933. Typically, there are restrictions on the purchase and sale of privately placed securities. Rule 144A allows for the resale of such securities under a specific set of circumstances. These circumstances allow the securities to be sold to qualified institutional buyers, with the rationale being that sophisticated institutional investors do not require the protection of an ordinary investor, therefore doing away with the need for SEC registration of the securities in question.12 7

Vedder Price, ‘Aviation Debt Capital Markets are Growing: An Overview of Recent Trends’ (May 2016) https://www.vedderprice.com/aviation-debt-capital-markets-are-growingoverview-of-recent-trends?overview. 8 Boeing, ‘Current Aircraft Finance Market Outlook: 2021’, https://www.boeing.com/resources/ boeingdotcom/company/key_orgs/boeing-capital/current-aircraft-financing-market/assets/ downloads/2021-current-aircraft-finance-market-outlook-english-final.pdf. 9 Richard Furey, ‘Structuring Aircraft Financing Transactions’, Holland & Knight LLP, https:// www.hklaw.com/-/media/files/insights/publications/2019/02/structuring-aircraft-financingtransactions-w0016292.pdf?la=en. 10 Ibid. 11 Morrison and Foerster, ‘Mechanics of a Section 4(a)(2) Offering’, https://media2.mofo.com/ documents/170608-4a2.pdf. 12 Furey, above, n 9.

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Structure 3.4 In the world of aviation finance, these rules exempting registration allow airlines and lessors to raise funds in the capital markets by issuing securities without the costly and arduous requirements of SEC registration. While enhanced equipment trust certificates (EETC) and asset-backed securities (ABS) transactions (each described in more detail below) are typically completed in these non-registered formats, airlines and lessors also utilise these formats for other types of offerings, including unsecured financings, private placements of single-credit lessor financings and other more highly concentrated pools and certain other bespoke financing structures.13

Enhanced equipment trust certificates 3.4 Another way aircraft capital markets transactions are structured is through enhanced equipment trust certificates (EETCs). EETCs focus on rated securities. These are issued by airlines through special purpose vehicles (SPVs) that are created with the sole intention of owning aircraft and are secured by the aircraft themselves.14 The majority of EETC transactions are single airline transactions, typically with one airline purchasing or leasing multiple aircraft. Either the airline will purchase the aircraft outright or an owner trustee will purchase the aircraft and subsequently lease it to an airline.15 EXHIBIT 3.1 EETC STRUCTURE A diagram of a typical EETC structure is set out below:

13 Furey, above, n 9. 14 Furey, above, n 9. 15 Furey, above, n 9.

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3.5  Aircraft Capital Markets In EETC transactions, if an airline is purchasing the aircraft outright, the airline will issue equipment notes in tranches for each aircraft purchased.16 These equipment notes for each tranche of debt are then accumulated and held by a trustee who functions solely as ‘a pass-through’ to then issue certificates to investors. If an owner trustee is purchasing the aircraft to then lease to an airline, the transaction structure is similar; however, the owner trustee issues the equipment notes rather than the airline itself.17

Asset-backed securities transactions 3.5 Asset-backed securities (ABS) transactions have garnered significant popularity in the last several years and aircraft ABS are an incredibly important source of funding for the aviation industry.18 Here, the transaction provides for the issuance of debt securities by a special purpose entity which owns a diverse pool of aircraft on lease to several underlying operators.19 The lessor typically acts as the seller and services the aircraft. The cash-flows from the leases to those operators, along with any other cashflows received by the issuer in connection with the underlying aircraft, are used to service payments of principal and interest owed to the holders of the securities. In recent years, the underlying collateral has been expanded to include not just traditional aircraft, engines and related leases, but also finance leases and aviation-backed loans. Many recent transactions, beginning in 2017, also include a syndicated equity component whereby the first loss position in the underlying assets is also sold in a separate capital markets transaction to a syndicate of investors. Post-Covid-19 transactions have, to date, not included equity sales. As this first loss position was the hardest hit during the Covid-19 crisis, it is unclear when this feature will return to the market. ABS transactions have become particularly attractive as they spread the credit risk among different lessees. This stands in contrast to an EETC transaction, where that credit risk is limited to one counterparty.20 Investors are able to choose their investment based on their personal return objectives and risk tolerance and are given opportunities outside of unsecured corporate bonds or consumer-based securitisation investments.21 Furthermore, despite the Covid-19 pandemic and its economic effects, aircraft ABS has been fairly insulated as the ABS structure is designed to absorb losses due to lessee bankruptcy.22

16 Furey, above, n 9. 17 Furey, above, n 9. 18 Structured Finance Association, ‘Alternative and Emerging Asset Class Spotlight: Aircraft ABS’, see https://media2.mofo.com/documents/170608-4a2.pdf. 19 Furey, above, n 9. 20 Furey, above, n 9. 21 Structured Finance Association, above n 9. 22 Ibid and see Furey, above, n 9.

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Structure 3.6 EXHIBIT 3.2 ABS STRUCTURE A diagram of a typical ABS aircraft financing is set out below:

Green bonds 3.6 Green finance generally has grown tremendously, with sustainability pledges progressing much further in the aviation industry as compared to other sectors. Airlines and aviation organisations such as airports have continued to make commitments for net zero carbon emissions or similar decarbonisation trajectories.23 In 2014, the green bond principles were introduced to provide clarity on what types of projects are considered ‘green’, how progress for green projects should be tracked, and how to use proceeds from such projects. The green loan principles built on that, to promote consistency across financial markets in developing the green financing market. Green bonds were originally created to fund projects with environmental benefits.24 They are fixed-income instruments that are typically asset-linked and, within the aviation industry, are typically intended to encourage sustainability and clean transportation. They can be particularly attractive given the tax exemptions and tax credits offered, providing a monetary incentive to focus on the climate issues they are inextricably linked to. Although green bond issuance had a slow start, it began to pick up in 2016, and in 2017 green bond issuance accounted for $161 billion of investment globally. In 2018, ANA  Holdings, Inc (ANA HD) became the first airline to issue green bonds, doing so to enhance stakeholder recognition of environmental responsibility initiatives. The proceeds from the green bonds were for a training centre to grow the ANA HD airline business and focus on environmental performance.25 In 2019, Etihad secured a $111 million loan to invest in a number of green initiatives, and in 2020, the airline sold $600 million of green bonds and used the proceeds to replace old fleet and finance sustainable aviation fuel research.26 These are but a few examples of aviation deals in green bonds in the last few years, a sector that will surely continue to grow globally as the aviation industry focuses on a sustainable recovery from the Covid-19 pandemic. 23 Alastair Blanshard and Mekahl Vohra, ‘The opportunity for green finance in the aviation sector’ (21  December 2020), ICF, https://www.icf.com/insights/transportation/opportunity-greenfinance-aviation-sector. 24 Ibid. 25 ANA  Group, ‘ANA HOLDINGS  Becomes World’s First Airline to Issue Green Bonds’ (28 September 2018), https://www.anahd.co.jp/group/en/pr/201809/20180928.html. 26 Blanshard and Vohra, above, n 23.

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3.7  Aircraft Capital Markets

TRENDS 2015–2021 3.7 Looking at the history of aircraft finance and capital markets over the last six years, there are a few major trends that jump out, including the general increased use of debt capital markets financing, the shift to aircraft ABS, and the continued strength of capital markets even in the face of the Covid-19 pandemic.27 In 2015 and 2016, the first marked increased use of debt capital markets in aircraft and aviation asset financing was beginning to be seen. There was an uptick in the demand for air travel, leading to significant fleet growth and renewal.28 Airlines thereby met that growth by increasing their fleets or refleeting, using both fully owned and leased aircraft. In fact, the growth was significant enough that during this time, there were significant backlogs in the pipelines of major manufacturers such as Boeing, Airbus, Bombardiers, and Embraer.29 A  large majority of the aircraft purchased were financed and debt capital markets in the US quickly became the leading source for that financing given the flexibility such transactions provided in the aviation sector. This time period also saw record volume of aircraft ABS, with over $4 billion of ABS debt securities issued to finance over 200 aircraft in 2015.30 There was also a significant increase in lessor unsecured bond activity and the private placement of secured debt securities in both Rule 144A transactions and EETC-like structures. Furthermore, in 2016, the sector began to see a growing number of market participants, leading to more affordable funding options for commercial aircraft purchasers. In 2016 alone, over $100 billion of commercial aircraft deliveries occurred, with the capital markets and commercial banks responsible for twothirds of that number.31 In 2017 and 2018, the industry began to see lessors rely on capital markets for a significant portion of their funding as capital markets issuances climbed to well over 35% of funding obtained by lessors.32 2017 also saw the rise of capital markets activity as related to aircraft leasing platforms in Ireland. The country began to see multiple establishments of aircraft platforms and holding of aviation assets in Irish companies. Cayman-incorporated Irish tax-resident vehicles became a widespread and efficient way to structure and deliver ABS transactions, which continued to garner increasing popularity and remains the dominant structure to date for the issuance of aircraft ABS transactions.33 2019 actually was the strongest year for aircraft ABS, with nearly $9 billion in issuances, a 15% increase over 2018’s level.34

27 Global Transportation Finance Newsletter: May 2016, Vedder Price, https://www.vedderprice. com/-/media/files/vedder-thinking/publications/2016/05/aviation-debt-capital-markets-aregrowing-an-overv/files/global-transportation-finance-newsletter--may-2016/fileattachment/ global-transportation-finance-newsletter--may-2016.pdf. 28 Global Transportation Finance Newsletter, n 27 above. 29 Global Transportation Finance Newsletter, n 27 above. 30 Global Transportation Finance Newsletter, n 27 above. 31 Boeing, above, n 8. 32 Annika Wolf, Richard Graham, John Middleton, and Yuri Sugano, ‘Failing Birds in the Sky: Dealing with Airlines in Financial Distress and Beyond’ (2017) 26 No 5 J Bankr L & Prac NL, Art 6. 33 Airfinance Annual: 2017–2018, Airfinance Journal, www.airfinancejournal.com. 34 Structured Finance Association, above, n 18.

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Conclusion 3.8 2020 began strong with the aircraft financing environment high in liquidity and providing low capital costs. However, as the Covid-19 pandemic hit and decimated the aviation industry, the credit spreads also widened, the capital markets closed, and bank capacity was quickly used up. Despite this, as the global crisis went on, capital markets came back. Even in the midst of the crisis, capital markets, as shown below, remained fairly satisfactory, especially as compared to other methods of financing. It was then the first and only market to bounce back in 2021.35 EXHIBIT 3.3 AIRCRAFT FINANCING ENVIRONMENT

Source: The Boeing Company – Reproduced with their kind permission

The issuances during 2020 comprised of more equity, convertible bonds, and secured issuances than had been typical in the years preceding. Furthermore, 2020 saw more secured debt as lessor capital market activity, the majority of which was unsecured, decreased. Still, US airline issuance volume increased dramatically, and non-US airlines also began to issue more in capital markets with increased reliance on equity and convertible debt.

CONCLUSION 3.8 In concert with the growing importance of aircraft operating lessors, in the last decade lessors have increasingly relied on the capital markets as a source of financing.36 These developments paired with an increase in demand for air travel and improved market conditions will be major factors in the development of the aircraft capital markets in the coming years. Despite a lack of large mergers or acquisitions in the last few years, it seems that the aftershocks of Covid-19 have driven consolidation among major market players, lessors and airlines alike. In March 2021, AerCap and General Electric announced that AerCap was acquiring General Electric Capital Aviation Services 35 Boeing, above, n 8. 36 Boeing Capital Corporation, ‘Current Aircraft Finance Market Outlook 2015’, available at http://www.boeing.com/resources/boeingdotcom/company/key_orgs/pdf/BCC-market-ReportWEB.pdf.

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3.8  Aircraft Capital Markets (GECAS), the largest commercial leasing and financing company in the world by number of aircraft, for $30 billion. This deal has led to over 2,000 aircraft, 900 aircraft engines, and 300 helicopters to be housed under one enormous leasing entity. AerCap expects the acquisition to yield $7 billion annually in revenue.37 This acquisition further showcases that airlines are increasingly eager to lease, rather than own, their aircraft fleets. This trend is likely to continue as airlines recover from the Covid-19 downturn and are unlikely to buy aircraft outright as they repay their own debts. March of 2021 continued to be a hot spot for the aviation industry with the acquisitions of DVB  Bank Group (DVB) and Fly Leasing Limited (FLY). EnTrust Global and Strategic Value Partners (SVPGlobal) acquired the aviation investment and asset management branch of DVB. DVB, one of the top ten aviation service companies in the world, represents $5 billion in total asset platform. The newly acquired platform will build upon DVB’s existing business in providing financial investors with solutions to deploy capital in aircraft assets.38 Furthermore, the Carlyle Group’s aviation investment and servicing arm, Carlyle Aviation Partners, signed an agreement to acquire FLY. This sale of FLY’s portfolio of 84 aircraft and seven engines holds an enterprise value of $2.36 billion.39 Although leasing firms suffered during the Covid-19 pandemic, recent deals provide promise and comfort looking forward in 2021. In particular, 2020 was an unprecedented year in the global economy, and especially for the aviation industry. However, the industry is especially resilient and an incredibly important drive in the global economy. It seems that the ABS transaction structure will be important in continuing to drive the market as it is slowly coming back in 2021 and especially as the banking market will continue to be constrained for some time, following the lingering economic effects of the pandemic. The ABS market has also continued to expand with the sale of equity in the market, allowing lessors to retain portfolio servicing and collect servicing fees from the transactions.40 Allowing for tradable equity also increases the pool of investors, as investors can then purchase smaller positions in ABS equity, and provides for a secondary market for investments.41 Furthermore, there have also been numerous US airline EETCs in the last year. Boeing predicts diversified funding will keep flowing into the aircraft financing sector and volumes of capital markets for aviation specifically will continue to grow. 2021 will hopefully continue to be a year of efficient capital deployment and liquidity in aviation finance.

37 Madhu Unnikrishnan, ‘$30 Billion Merger Between AerCap and GECAS  Tilts New Momentum Toward Aircraft Leasing’ (10 March 2021) Airline Weekly, https://airlineweekly. com/2021/03/30-billion-merger-between-aercap-and-gecas-tilts-new-momentum-towardaircraft-leasing/. 38 Aviation Week Network, ‘DVB Bank Selling Aircraft Selling Management Business’ (15 March 2021), https://aviationweek.com/air-transport/airlines-lessors/dvb-bank-selling-aircraft-assetmanagement-business. 39 Carlyle, ‘Carlyle Aviation Partner to Acquire Fly Leasing for $17.05 Per Share’ (29  March 2021), https://www.carlyle.com/media-room/news-release-archive/carlyle-aviation-partnersacquire-fly-leasing-1705-share. 40 Structured Finance Association, above, n 18. 41 Ibid.

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Part II Business Model – Key Elements

4 Aircraft as Investments Dick Forsberg

INTRODUCTION 4.1 Investing in aircraft assets is, on first principles, no different to making investments in any other asset class. In its simplest form, the mantra of ‘buy low, sell high’ applies, although perhaps it should be modified to ‘buy well, sell better and manage assiduously in between’. Those readers that have worked their way through to here from Chapter 1, will now be fully aware of the highly cyclical nature of the commercial aviation industry. The importance of this fundamental fact cannot be overstated when it comes to investing in aircraft – and within the broad definition of ‘investing’ should be included any transaction that relies on the asset’s future value as security against a financing arrangement. Commercial lending banks, for example, are just as much taking asset risk on the provision of secured debt into an aircraft financing as an operating lessor taking that asset onto their books – although some banks only come to realise this when they are facing a loan default and possible (re) possession of the asset. The industry cycle has been a core component of commercial aviation for over 50 years – in other words since almost the dawn of the jet age. Throughout all of that period of time aircraft have been bought and sold at various stages of their economic lives, including at the end of their lives for part-out, with the aim of making some money along the way. Whilst the volume of trading does not come close to that seen in some other asset classes and the details and pricing of aircraft trades are not generally disclosed, there is more than enough empirical evidence available to establish close correlations between: (a) the age of an aircraft and its value; and (b) the proportion of the asset’s value that can be realised through a sale at each stage of the industry cycle. Understanding these relationships, along with the ability to manage the assets during the hold period, is critical to building a successful aircraft investment portfolio. The industry cycle influences not only aircraft values, but also the relationship between supply (seats/payload and aircraft) and demand (passengers, freight), airline profitability, financial liquidity and aircraft trading activity. All are linked and the transition from one phase of the cycle to the next is at the heart of extracting value from aircraft investments (Exhibit 4.1).

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4.1  Aircraft as Investments EXHIBIT 4.1 AIRLINE AND LESSOR EARNINGS TRENDS

Before getting into the detail of how to better understand these key investment drivers, it is worth noting that there are multiple investment models, each requiring different skill sets, or at least different combinations of skills, to manage the portfolio and protect investor value. There are also different types of investor, from hands-on traders of metal (either whole aircraft or components) to arm’s-length passive financial investors for whom an aircraft represents an opportunity to diversify a financial portfolio or manage a tax position. In between are a wide range of participants, from specialists to generalists, equity and debt providers, whose intimacy with aircraft operations, technology and value trends is diverse and frequently incomplete. Each investor category and each business model will have its own focus, requirements and priorities when it comes to building an aircraft portfolio. The criteria applied to the selection of assets for investment, as well as the timing and routes for realising the embedded value in the investments will depend on the business model adopted and the requirements and motivations of the investors; however the basic rules for selecting the right assets, paying the ‘right’ acquisition price and realising the expected profit on disposal apply to all investors and all business models. At its simplest level, the investment economics of an aircraft portfolio can be expressed as: Return = 1∫n (Rent, Term, PV, FV, CoF) In other words, transaction economics are a function of the purchase price, the future sale price, the lease income stream, which is itself a function of the terms of the lease agreement, and the all-in financing costs. Whilst all of the elements of the investment proposition are important, if the wrong asset type is purchased, too high a price is paid, or the investor has unrealistic expectations of future value performance, the expected returns will not be met. Whilst many established leasing platforms apply a through-the-cycle trading strategy, flexing their acquisitions and sales activity as market conditions dictate, 36

Why invest in aircraft? 4.3 some investors see aircraft investment as a pure cycle play, buying when values are within a cyclic low range and aiming to sell as the cycle approaches a future peak (Exhibit 4.2). EXHIBIT 4.2 AIRLINE AND LESSOR EARNINGS TRENDS

Source: Ascend by Cirium

Others apply their specialist ability to manage values as aircraft approach the end of their economic lives, following a different strategy again, where technical management of component lives (especially engines) is the overriding criterion. At the time of writing, the Covid-19 pandemic continues to run its course having already caused unprecedented disruption to the global airline industry and with the path of recovery and the ultimate extent of the permanent damage inflicted on aviation still far from clear. There will undoubtedly be changes in the demand for, and values of, a wide range of aircraft types and vintages – some changes will be permanent, others temporary. The pandemic has created immense challenges for airlines, financiers, lessors and investors. But it also creates opportunities for a significant expansion of the aircraft leasing and investment base. The industry has proven its resilience over multiple cycles and shock events and many, though not all, market segments will fully recover with time. The fundamental principles of identifying, assessing and capitalising on aircraft investment opportunities that will be discussed over the course of this chapter are not changed by an event such as Covid-19, which simply underscores the need to invest the time and intellectual capital to fully understand the risk-reward framework of the sector.

WHY INVEST IN AIRCRAFT? 4.2 For investors wishing to participate in the commercial aviation sector, whether as acquirers of physical assets (aircraft, engines, etc) or paper instruments, a key decision will be in what part of the industry to invest in, with two principal options: airlines or aircraft lessors.

Airlines 4.3 Airline business models are highly complex, requiring diverse skills encompassing sales, operations, engineering, safety, product and network development, regulatory compliance, cost control and capital management. 37

4.3  Aircraft as Investments Airlines have short-term visibility to revenue streams, which are exposed to relentless competitive pressures. Airlines are vulnerable to exogenous events that can cause rapid and material movements in their underlying financial performance. These events, which are wide-ranging and include foreign exchange movements, oil price fluctuations, pandemics, war, political unrest and weather events, can have a disproportionate impact on airlines due to their high capital cost structure, whereby changes to revenues or operating costs are hard to mitigate in the short term and mainly flow straight to the bottom line. Most airlines operate in an intensely competitive environment and are selling a highly perishable commodity product – often at marginal prices. As the structure of the industry has changed over the past 30+ years from mostly governmentowned (or influenced) airlines to more commercially focused enterprises, the freedom, as well as the desire, to compete in an increasingly unregulated market has also grown. Additionally, the democratisation of the internet removed the last remaining barriers to customer transparency, allowing passengers to check, compare and select fares and products on a dynamic basis. Whilst this has enabled the insurgent low-cost carrier (LCC) sector to flourish, for many other airlines, especially legacy network carriers, it has resulted in a loss of control over pricing that continues to require painful changes to cost structures – changes that are often inhibited by labour, and by operational or political constraints. In many cases, the barriers and cost of entry for start-up airlines are low, yet failing businesses can continue to operate seemingly indefinitely, often inflicting collateral damage on their healthy competitors through discounting or capacity dumping, despite financial and competition laws that are designed to limit such eventualities. From the slow deaths of Pan Am and TWA in 1991 and 2001 respectively, to the more recent examples of Olympic Airways and Alitalia, the vulnerability of legacy airlines to their over-protected pasts is clear. Although there are growing numbers that have succeeded in turning their business models around – some with the support of bankruptcy protection (United, Delta, American, Japan Airlines, LATAM) and others through fundamental changes to cultural and management habits (British Airways, Iberia, Aer Lingus) – many prominent legacy carriers are still, in 2021, struggling to overcome their past (Air France, Lufthansa, Malaysian Airlines). Over the long run, airlines have generated some of the worst returns on capital of any industry. Their long history of thin profitability punctuated by heavy losses, exacerbated by their vulnerability to external events and shocks, was only addressed in the restructurings that took place in the aftermath of 9/11 and the emergence of LCCs as a significant force. Nevertheless, despite a record run of ten consecutive years of profitability from 2009, 65% of total industry profits in 2019 were still earned by North American airlines and, although the industry has significantly improved the commercial aspects of the underlying business models over the past 15 years, relatively few airlines are yet making consistent profit margins that cover their cost of capital. 38

Why invest in aircraft? 4.4

Lessors 4.4 Compared to airlines, the leasing business model is simpler, with a few key variables influencing financial and competitive performance. Lessors have little or no direct exposure to operational contingencies or to exogenous events – and as the industry is US dollar-denominated – insulated even from direct foreign exchange movements. To the extent that lessors are impacted through their lessees, portfolio diversity in terms of asset types and a regional dispersion of lessees running different business models, will substantially mitigate exposure. Unlike the airline industry, which engages in billions of customer transactions annually on the passenger side of the business alone, lessors are engaging with no more than 500 airlines to place small quantities of aircraft on lease – slightly more than 1,000 in 2019, including lease extensions. Transactions can therefore be structured to ensure that specific economic and financial outcomes are achieved, in a way that airlines cannot hope to emulate, even with sophisticated yield management algorithms. Additionally, leasing transactions are of long duration, typically between five and 12 years, providing a high level of visibility and certainty to future income streams. The consequence of this combination of simplicity and long-dated contracts, overlaid with strong risk management and fiscal discipline, has been a track record of consistent profitability, with lessors generating attractive risk-adjusted returns through the industry cycles during which many of their airline customers (and their investors) have made material losses. These strong and stable return characteristics also compare favourably with many other asset classes. Exhibit 4.3 compares the returns generated by aircraft lessors relative to other investment opportunities, including airlines, set against the lower volatility of lessor financial performance. EXHIBIT 4.3 RETURNS ON AIRCRAFT AND OTHER ASSET CLASSES 2000–2019

Sources: PwC, Bloomberg, OECD, US Fed, company financial statements

When translated into a 20-year trend comparison of investment performance (Exhibit 4.4), the wide range of outcomes, in respect of both absolute returns and 39

4.5  Aircraft as Investments volatility is clear to see, with commercial aircraft leasing platforms1 consistently outperforming other asset classes through the cycles. EXHIBIT 4.4 20-YEAR INVESTMENT RETURN PERFORMANCE

Sources: PwC, Bloomberg, OECD, US Fed, company financial statements

It must be noted at this point that these returns will not be realised simply by leasing a portfolio of aircraft. Lease economics can generate solid and consistent returns, but the real value deriving from a lease platform and driving the returns highlighted above will accrete over time as the platform matures and additional activities are developed that leverage the wider capabilities and skills of the platform. These, for example, may include the creation of third-party management or joint venture opportunities, access to deep pools of well-priced capital and, arguably the Holy Grail for lessors, an investment-grade credit rating. As a final point in support of investing in the sector via the leasing channel, lessors are uniquely aligned with their investors and shareholders through their shared desire to protect the residual value of their assets over their life, which a lease platform will support through maintenance oversight, active marketing and lease management.

WHO INVESTS IN AIRCRAFT? 4.5 There are two broad categories of aircraft investors – the metal people and the money, or paper, people. The metal investors are those that first come to mind when thinking about aircraft as investments, but the latter are also an important component of the broader market, especially with respect to sustaining financing liquidity. They include the buyers of enhanced equipment trust certificates (EETC) and aircraft asset-backed securitisation (ABS) tranches and investors in the public market lessors. Whilst the former rely mainly on the tranched structure of their investment vehicles to manage risk, the latter will apply the same judgement and investment decision tools as would be applied to any stock market transaction. 1

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Weighted average annual ROE: ACG, AerCap, ALC, Avolon, BOC, DAE, FLY Leasing, ICBC, SMBC, and ILFC.

Selecting the right assets 4.6 Many of the largest global banks, including Bank of China, RBS, ICBC, Wells Fargo and Standard Chartered, have taken significant equity positions in aircraft leasing platforms, bringing many billions of dollars of risk-weighted assets onto their books and leveraging their balance sheets and low cost of capital to finance their portfolios. Sovereign wealth funds, private equity, fixed income and institutional investors such as GIC, Oakhill Capital, Cinven, Castlelake and Carlyle have become increasingly invested in the sector, especially since the start of the recovery cycle that followed the 2008/09 Global Financial Crisis. The majority of these invest directly in aircraft leasing platforms, whilst a growing number are participating alongside established lessors through joint ventures, sidecars or managed funds. Several operating lessors trade in the public markets, not only in the US but more recently and increasingly in Hong Kong and China, deepening the pool of investors and, due to the number of shareholders, becoming proxy investors themselves, with a considerable amount of freedom to make investment decisions within the organisation. There are also several examples of corporate investors taking substantial positions in the aircraft leasing space, the most enduring example being General Electric, but several others will come to mind, including China’s HNA Group and Japanese conglomerates Orix and Mitsubishi Corporation. Whilst these primary investors tend to be well informed on the sector and closely associated with an asset management platform that supports their investment activities, secondary investors generally take an arm’s length approach and rely extensively on third party managers for industry knowledge, investment decisions and asset management. At the secondary level, investors can buy into managed ABS structures that offer passive participation in pools of leased assets that are blended to de-risk the portfolio and come with a recognised asset manager to support the income stream. Other variations on this theme include managed funds for high yield investors, typically with a high equity component and generating strong cash yields and lower internal rate of returns (IRR). There are also a number of financial and tax-based structures that cater for the specific needs of an investor group (Japanese operating leases (JOLs), JOLs with call option (JOLCOs), KG Funds, etc). In short, the industry has always been innovative in developing ABS structures that are investor friendly and do not require first-hand industry expertise on the part of the investor.

SELECTING THE RIGHT ASSETS 4.6 The first step towards building an aircraft investment portfolio is to ensure that the assets acquired will achieve the value growth required and expected by the investors. However, all aircraft are not equal when it comes to value retention, as Exhibit 4.5 illustrates. This chart compares a selection of aircraft that were purchased new in 2011 and shows their retained market values after ten years, represented as a percentage of their original market value as presented by the same appraiser. There is a large difference between the best and worst performers, with value retention ranging from 60% down to 20% – a gap that can never be closed by any structuring or contractual terms of the transaction. 41

4.6  Aircraft as Investments EXHIBIT 4.5 AIRCRAFT VALUE RETENTION 2011–2021

Sources: Ascend by Cirium, author’s analysis

Whilst it is often possible to make a profitable investment in a weakerperforming asset at some point in its life-cycle, it is critical that investors can make a determination of the likely value retention performance of their target aircraft at whatever point in the life-cycle they are choosing to invest – and also to ensure that they have the appropriate asset management skills and resources at their disposal, as the requirements will vary considerably through the life of the aircraft. The wide variation in aircraft value retention goes beyond simple trading volatility, which is more related to how the market behaves at different points in the cycle – more of this later. The fundamental ability of an asset to retain more, rather than less, of its value over time is essentially a reflection of its liquidity and the way to better understand the value retention capabilities of different aircraft types is to compare their relative liquidities. In order to do this, it is necessary to identify the key drivers that influence an aircraft’s attractiveness over its lifetime. It is important here to think about attractiveness to investors rather than to the airlines that operate the aircraft, although for several of the factors the interests of the two will coincide. The core drivers, of which no more than a dozen or so will be relevant, can be broken out into market-related and performance-related metrics. The former include such things as total sales (in service and future orders), customer base (number of airlines and geographic dispersion) and the level of lessor commitment, with negative factors including the level of manufacturer support (whether the OEM still exists; proportion of the fleet held on the OEM’s own balance sheet) and the number of aircraft in storage. Performance-related factors include the level of technology, the stage of the aircraft’s production life-cycle, its operating economics and fuel burn, family membership, mission flexibility, potential for freighter conversion and the degree of cabin and specification standardisation. Having selected the appropriate factors, which should all be measurable today and capable of being forecast into the future, a system of scores and weights can be developed and applied so that a ‘perfect’ investor aircraft would have a score of 100. In this way it is possible to build up a relative hierarchy of investment scores for each aircraft variant under consideration, allowing an investor to 42

Understanding aircraft values 4.7 apply a cut-off threshold score, above which an investment in the asset type would be deemed acceptable. This is illustrated in Exhibit 4.6, which includes a target investment threshold of 55%. EXHIBIT 4.6 RELATIVE LIQUIDITY RATINGS

The criteria selected and the scores and weights applied will vary depending on the investor’s objectives and business model, but the output – a set of ‘relative liquidity scores’ – will allow any investor to identify investment targets that meet their criteria on a consistent and objective basis. An ability to look ahead through projections of the core criteria adds a significant dimension to the power of this approach by identifying future inflection points that can be used to guide investment acquisition and disposition decisions within the portfolio. Thus, aircraft types with ratings that begin below the threshold but rise to cross it over time are potentially attractive future acquisition targets, whilst those whose ratings are above the line but trending down are more likely to be disposal candidates.

UNDERSTANDING AIRCRAFT VALUES 4.7 Having identified the aircraft types that meet the investment criteria and will therefore be core target assets for the investment portfolio, the next step is to understand how their values will perform through the phases of the industry cycle and over the longer term, starting with what is an appropriate acquisition price and extending over the life of the aircraft. The inherent volatility of value behaviour, which is influenced by the combination of market and asset characteristics, creates a material risk dynamic that must be recognised and addressed by any prudent investor. Statistical regression analysis (measured by R2) has shown that around 60% of an aircraft’s underlying value retention is directly correlated to the age of the asset. This can be seen in Exhibit 4.7, which shows the distribution of values achieved on the sale of several thousand aircraft over the years, expressed as percentages of their original cost. 43

4.7  Aircraft as Investments EXHIBIT 4.7 FUTURE SALE VALUE AS PERCENTAGE OF ORIGINAL

The real expertise lies in figuring out what influences the remaining 40% of value retention. All of the factors identified earlier in the relative liquidity analysis have a role to play in determining value retention, with the relevance of each varying over time. At any point in the life of an asset, its value will be closely linked to its remaining economic life and, from an accounting standpoint, this can be benchmarked by calculating the net present value of the expected cash flows over the remainder of the aircraft’s economic life, making appropriate assumptions around lease terms, lease rates, default probabilities, transition costs, etc. Economic life is ultimately determined by the ability of an aircraft to generate profits for the airlines that operate it both in absolute terms and also relative to alternative aircraft types that might be available as competitors at the outset or introduced later in its life. As a broad rule of thumb, current generation 100+ seat commercial jets will have an economic life of around 25 years, although many will still be in commercial service beyond 30 years and life extension through cargo conversion is also possible for some aircraft. Whilst there is always plenty of debate, especially during low points in the industry cycle, around the appropriate assumptions for economic life, which directly impacts depreciation policies and aircraft values, there continues to be strong evidence, as shown by the survival curves in Exhibit 4.8, that economic life, as measured by continued operation of aircraft fleets, has not materially changed since the 1970s.

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Understanding aircraft values 4.7 EXHIBIT 4.8 PASSENGER JET SURVIVAL CURVES: 1970–2000 BUILD YEARS

Sources: Ascend by Cirium, author’s analysis

Around 50% of the fleet consistently remains in service at 25 years of age. Short-term cycle-driven events, such as the parting out of a small number of young in-production aircraft, should not be taken as a signal that the entire fleet has had its useful life curtailed. It should also be noted that, whilst it is important to be able to account for an aircraft’s value at any point in its life, asset trading activity and value realisation is closely aligned to the different phases of the industry cycle. Over the past several decades, a pattern of value volatility has been established around the inflection points of the cycle, influenced by the liquidity of the asset in question, and it is this volatility that drives the cyclical aircraft investment model. Whilst the amplitude of this volatility will vary depending on the aircraft type and its relative liquidity, there is a consistent temporal correlation between value movements across all aircraft, which results in values rising and falling broadly in phase. This can clearly be seen in Exhibit 4.9, which contrasts the value movement of two quite different aircraft through a cycle. EXHIBIT 4.9 MARKET TO BASE VALUE RATIO – CONSTANT FIVE-YEAR-OLD AIRCRAFT

Source: Ascend by Cirium, author’s analysis

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4.7  Aircraft as Investments At this point, it is worth setting out some definitions of the key terms that are used when describing an aircraft’s value. All of these are defined by ISTAT (the International Society of Transport Aircraft Trading), which is the industry body representing the interests of aircraft owners, appraisers and traders) and those most commonly encountered are set out in the box below.2 ‘Base Value is the Appraiser’s opinion of the underlying economic value of an aircraft in an open, unrestricted, stable market environment with a reasonable balance of supply and demand, and assumes full consideration of its “highest and best use.” An aircraft’s Base Value is founded in the historical trend of values and in the projection of value trends and presumes an arm’s-length, cash transaction between willing, able and knowledgeable parties, acting prudently, with an absence of duress and with a reasonable period of time available for marketing. In most cases, the Base Value of an aircraft assumes its physical condition is average for an aircraft of its type and age, and its maintenance time status is at midlife, mid-time (or benefiting from an above-average maintenance status if it is new or nearly new, as the case may be).’ ‘Market Value (or Current Market Value if the value pertains to the time of the analysis) is the Appraiser’s opinion of the most likely trading price that may be generated for an aircraft under the market circumstances that are perceived to exist at the time in question. Market Value assumes that the aircraft is valued for its highest, best use, that the parties to the hypothetical sale transaction are willing, able, prudent and knowledgeable, and under no unusual pressure for a prompt sale, and that the transaction would be negotiated in an open and unrestricted market on an arm’s-length basis, for cash or equivalent consideration, and given an adequate amount of time for effective exposure to prospective buyers.’ ‘Securitized Value or Lease-Encumbered Value is the Appraiser’s opinion of the value of an aircraft, under lease, given a specified lease payment stream (rents and term), an estimated future residual value at lease termination, and an appropriate discount rate.’ Comment: The Securitized Value or Lease-Encumbered Value may be more or less than the Appraiser’s opinion of Current Market Value. Moreover the Appraiser may not be fully aware of the credit risks associated with the parties involved, nor all related factors such as the time-value of money to those parties, provisions of the lease that may pertain to items such as security deposits, purchase options at various dates, term extensions, sub-lease rights, repossession rights, reserve payments and return conditions. Source: ISTAT  Appraisers Program Handbook, Revision #9, Effective 1 March 2020

2 At the time of writing, the ISTAT definitions are under review, with some amendments anticipated. The latest version of all the definitions can be found on the ISTAT website, ISTAT. org. See ISTAT Appraisers Program Handbook, pp 15–16.

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Understanding aircraft values 4.7 One fundamental aspect of base values and market values is that they provide valuations of the aircraft as a stand-alone asset. Base value is the most widely used term to describe an aircraft’s underlying, intrinsic value ie  before any impact resulting from prevailing market conditions. It is frequently applied to a ‘standard’ aircraft specification and configuration, particularly when quoted in a generic sense or presented in a broader table or list of values, rather than applied to a specific aircraft or serial number. Since base value pertains to a somewhat idealised aircraft and market combination it may not necessarily reflect the actual value of the aircraft in question, but is a nominal starting value to which adjustments may be applied to determine an actual value. It is also true to say that in real life an aircraft rarely sees base market conditions, as base market is a transitional state in the cycle between weaker and stronger conditions. The market value of a specific aircraft will remain consistent with its base value in a stable market environment, but where a reasonable equilibrium between supply and demand does not exist, trading prices, and therefore market values, will vary from the base value for that aircraft. The extent to which market values vary relative to base values through the cycle will be determined by their attractiveness to airlines and to investors ie their relative liquidity. The qualities of the aircraft will dictate the level of volatility attached to it and this helps to create the arbitrage opportunity for aircraft investors. Although the ability to lease an aircraft may be one of the factors taken into consideration by an appraiser when reaching a value opinion (leasing would come under the definition of ‘highest and best use’), standard appraisals do not take into consideration any value enhancement or decrement deriving from an associated lease structure generating cash flows and an income stream for the aircraft owner. In an industry where more than 90% of aircraft are traded with a lease attached (other than for part-out), it would clearly be helpful to have an assessment of the value of the aircraft plus the associated financing and leasing structures. This is the purpose of the lease-encumbered valuation (LEV). Although there is no single approach for this analysis amongst the appraiser community, the most commonly used methodologies take account of the present value of the net cash flows over the lease term, including any maintenance return condition adjustments, and other risk mitigants, discounted at an appropriate rate for the credit quality of the lessee, plus the future value of the asset at lease maturity, also discounted but using a level slightly above the risk-free rate (typically US Treasuries) associated with the lease term. Although an LEV analysis will often give incremental value over and above the ISTAT-defined base or market value of the stand-alone asset, in certain circumstances lease encumbrance can have a downward impact on the value – where, for example, the lease has been contracted during a period of market softness, perhaps with a weak airline credit and at a depressed lease rate. So, where can investors go to find out what an aircraft is worth? Most stakeholders in the industry rely heavily on professional aircraft appraisers, of which there are many, offering a wide range of resources and capabilities, each catering to a different mix of customers and markets. At one end of the spectrum lie the largest appraisal companies, selling a range of advisory services, with global coverage, extensive analytical resources and heavily invested in intellectual capital. At the other end of the scale are independent sole, or small team, appraisers that 47

4.7  Aircraft as Investments rely on their contacts and networking to supplement their analysis, but usually have extensive industry experience. In the middle are a number of mid-sized organisations, often with a more technical focus and capability and well-suited to preparing more customised sets of values than their larger peers will typically be asked to provide. In each case, it is important to remember that as customers, investors are buying opinions, not black and white facts. Whatever the level of modelling and analysis that the appraisers bring to bear on the task, their output will inevitably be a blend of art and science. The assumptions that they build into their forecasts and their individual views of markets, technical developments, manufacturers capabilities, etc, will result in a set of value opinions that may differ from those provided by their competitors. Whilst the variations are usually quite narrow for base values of the most popular in-production single aisle aircraft, the divergence may be substantial for widebodies or for less liquid aircraft and tends to increase with the forecast horizon. Exhibit 4.10 plots the value opinions of eight appraisers in respect of half-life3 base values for a standard specification new build 787-9 delivered in January 2020. The value opinions span a range of US$15 million at delivery and US$25 million after 12 years, the typical term of a new widebody lease. EXHIBIT 4.10 787-9 HALF-LIFE BASE VALUE OPINIONS FROM EIGHT APPRAISERS

The average (mean) valuation at year 12 is US$73.6 million and the standard deviation is $8.6 million, which produces a range of potential value outcomes between $56 million and $91 million based on a 95% confidence limit (Exhibit 4.11).

3

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Half-life is a notional maintenance status that assumes that the airframe, engines, landing gear and major components are half-way between their major overhaul intervals and that life-limited parts have used 50% of their life.

Acquiring the assets 4.8 EXHIBIT 4.11 HIGH-LOW 787-9 VALUATION RANGES AT 1, 2 AND 3 STANDARD DEVIATIONS

These outcomes illustrate how important it is for investors to select their appraisers carefully and to understand their capabilities, methodologies and characteristics. An investor should take the time to become familiarised as fully as possible with the core assumptions and considerations that are going into the appraiser’s analysis to ensure that they do not represent diametrically different views to their own.

ACQUIRING THE ASSETS 4.8 The window of opportunity to potentially acquire assets at attractive discounts to their long-run base values begins to open as the cycle moves into its weakest phase and lasts until a point in the recovery when the level of discount available no longer supports the return criteria for investors. Rather than attempting to identify the exact nadir in the cycle and cluster purchases narrowly around that point, most investors’ principal buy phase will span several years, from the early stages of the upturn until market values no longer support the desired return criteria. Acquisitions may be sourced through three broad channels: (a) through the purchase and leaseback of aircraft delivering to airlines as part of their own direct orders with the manufacturers, or of aircraft already delivered and unencumbered on the airline’s balance sheet; (b) through the purchase of aircraft or portfolios of aircraft from other lessors and investors; and (c) by way of direct orders placed with the manufacturers. Whilst the sale and leaseback channel is a widely tapped source for established investors, portfolio acquisitions are attractive as a way of getting earning assets onto the books quickly. An extreme example of this is the acquisition of an entire platform, which is often the strategy employed by investors seeking to create a presence and relevance in the sector as a long-term primary participant. Such acquisitions will typically be priced at a premium to the book value of the assets to reflect the additional resources, capabilities and maturity of the platform being acquired – a skilled workforce, committed asset financing, established systems and processes, a global footprint, etc. Examples 49

4.9  Aircraft as Investments of this strategy include Bohai Capital’s acquisition of Avolon in 2016 and Bank of China’s purchase of SALE a decade earlier. The alternative entry route for investors wishing to build a platform is dependent on identifying a seasoned executive team that can drive the build-out process of a start-up business from the ground level; sourcing and implementing the infrastructure, initial debt financing and workforce – some of which may be outsourced – alongside the process of identifying, negotiating and securing assets for lease. Examples of this approach include RBS Aviation Capital in 2001, Avolon in 2010 and Griffin in 2020 – each at key recovery inflection points in the cycle. Direct orders may not be appropriate for all business models but can provide a strategic benefit by creating a pipeline of aircraft available for placement into airlines throughout the cycle, even at times when sale and leaseback pricing has become relatively unattractive. Direct orders broaden the lessor’s product offering and open up additional channels of dialogue with airlines and, critically, with the manufacturers, which can be hard to engage with where there is no direct customer relationship. Direct orders are ideally placed during the weaker phase of the cycle, when competitive pricing is more likely to be available, resulting in a delivery stream of well-priced aircraft peaking towards the top of the cycle when the placement of new assets is highly sought after by the airlines and supports strong lease rates.

TAKING CARE OF ASSET VALUE 4.9 Having selected the target aircraft and made prudent investments at the right point in the cycle, investors will have their eyes on some point in the future when they can expect to harvest the embedded value of these aircraft as market values rise with the cycle recovery. However, in order to ensure that the aircraft they sell still retain all of the value they expect, it will be essential to manage the aircraft assiduously from a technical and risk perspective. Technical asset management begins even before the asset is acquired, as there is potentially significant value to be lost or gained around the detailed specification of the aircraft. Beyond the core characteristics of the aircraft (weight, engine type, engine thrust) are a wide range of option items that may be selected by a purchaser, either for inclusion in a new build aircraft or added/removed at a later date. These will include options that enhance performance (such as auxiliary fuel tanks, winglets), address operational requirements (traffic collision avoidance system (TCAS), crew rest modules, air-stairs, cargo loading systems) or enhance the on-board product (in-flight entertainment systems, galley layouts, over-sized overhead bins). Some may be required for regulatory purposes and most will have both a cost (to acquire and install) and a value, which should be considered in the context of whether the item is a long-term enhancement for the majority of possible future operators of the aircraft. Some of the items are high cost but may not be high value and a detailed specification review by technical experts will ensure that the investment price paid reflects the value of the selected specification. Technical input into the drafting of a lease contract is also highly valueadded, as this is where the return conditions are defined, as well as the level 50

Monetising the metal investment 4.10 of any maintenance reserves that will be paid during the term of the lease. The determination of appropriate return conditions can have a material impact on the overall financial performance of the investment, running potentially into millions of dollars. Maintenance reserves protect the lessor/investor from the full cost of having to put an aircraft into its return condition in the event of a default and it is important that the correct rate is set to reflect the actual or proposed operation of the aircraft by the lessee. Finally, from a technical perspective, regular inspections of the aircraft throughout its time on lease, plus the ability to audit, approve and monitor the maintenance provider that is taking care of the assets and close technical involvement and support during the redelivery process will all protect and enhance the value of the asset and the investment made. In the same way, a rigorous approach to credit risk management will help to protect the asset and the income stream from the investment, by providing ongoing oversight of the aircraft operator and an early warning of any deterioration in business performance that might suggest that a default may occur. At this point, the involvement of ‘work-out’ specialists, including commercial, financial and technical experts, will determine whether it makes sense to work with the airline as they seek to resolve their problems or whether a termination of the lease should be pursued. It is always better to be decisive in these circumstances, as delay and uncertainty invariably make the situation worse (ie  the level of unpaid receivables keeps on rising; maintenance value continues to be burned off). As has often been said, ‘hope is not a strategy’ and the investment is far better protected by having the ability to move fast and decisively to mitigate any losses.

MONETISING THE METAL INVESTMENT 4.10 The expected returns for primary investors will generally be a combination of the running yield from leases and trading gains on asset disposals, which will be an arbitrage between attractive acquisition prices and strong asset sales performance, which itself is predicated on continued demand and liquidity for the assets. Over the past 20 years, the trading of aircraft between lessors and investors has become embedded in the industry’s DNA. Between 2010 and 2019, the volume of aircraft trading increased on average by more than 11.5% per annum and, by the end of that period, the industry was trading over 1,000 aircraft a year with an estimated market value in excess of $20 billion. The dynamic of sustained demand created by the number of aircraft lessors and investors entering the sector during that decade generally favoured sellers from a value perspective, while buyers benefited from access to on-lease revenue earning assets to accelerate and diversify their portfolio build-out. With the demand for leasing set to rise further through future cycles, the trading dynamic seems to be assured. As noted earlier, long-run risk-adjusted returns for full-service leasing platforms have historically substantially exceeded the ‘sum of the parts’ income from the portfolio’s leased assets. A  full-service leasing platform can enhance trading performance, operating as a ‘machine’ capable of acquiring, managing and disposing of aircraft assets efficiently and profitably, leveraging the skills and experience of the team and an extensive network of relationships with industry stakeholders. A sustained focus on developing funding channels and, at the same 51

4.10  Aircraft as Investments time, driving down the weighted average cost of capital will create a balance sheet resilience that facilitates insurgent and often opportunistic strategies to expand the business and increase enterprise value. Examples of these initiatives include M&A activity, JV and sidecar partnerships with external investors and transactions in scale to support customer airlines with liquidity in challenging times. As with any investment, the exit strategy is best determined at the outset. There are several options available for aircraft metal investors, all of which are time sensitive and generally are brought into play sequentially, at different phases of the developing recovery cycle. In order to build investor confidence, it may be necessary to demonstrate the liquidity of the invested assets early in the recovery cycle by selecting a small number of assets for sale whilst the cycle is still at a relatively low point when trading opportunities may be limited. As the cycle improves, additional distribution channels, including larger bilateral sales, ABS structures and managed funds, will become available. Assets targeted for sale should not simply be those yielding the largest profits; indeed this is often a poor strategy as it reduces the quality and earning potential of the remaining portfolio. Asset sales in support of an overall portfolio strategy can help to reduce concentrations, improve yields and otherwise manage asset and counterparty risk exposures. Pursuing a systematic programme of asset disposals by a combination of ‘retail’ sales of individual aircraft or small clusters of aircraft to smaller investors and more structured ‘wholesale’ disposals (eg securitisations) of larger portfolios of aircraft delivers a number of strategic objectives over and above the harvesting of embedded profit: • it releases equity and enables recycling of capital through further acquisitions; • it enhances platform franchise value by demonstrating an active trading capability; • it confirms the quality of deal underwriting; • it serves as a hedge against the realisation of value solely through a corporate disposal; • where the acquirer is an inexperienced or passive investor, it can add an income stream by establishing a role as an asset manager. One benchmark of how an established industry is perceived by investors is the level of M&A activity. In the leasing sector this is now occurring on a sustained basis throughout industry cycles – in a weaker economic environment through opportunistic distressed or forced sales and in more buoyant times to meet market entry or growth objectives where a higher pricing construct is accepted as a quid pro quo for strategic advantage. Between 2005 and 2008, at least seven significant acquisitions of leasing platforms were closed, including the sale of AWAS by Morgan Stanley to PE firm Terra Firma and Bank of China’s acquisition of SALE from WestLB, Singapore Airlines and Temasek. Over the following decade at least a dozen more M&A transactions took place, including Avolon’s acquisition by Bohai Capital (following an IPO a year earlier) and its subsequent acquisition of CIT’s aircraft leasing business, the 52

Monetising the metal investment 4.10 sale of aviation investment fund manager Apollo to the Carlyle Group, a PE firm, and consolidation in the regional aircraft leasing space through Nordic Aviation Capital’s acquisitions of Aldus and Jetscape. In addition, several new lessor platforms were launched, including Avolon and Air Lease Corporation, both in 2010, the former backed by three private equity investors and the latter by way of a public markets listing. A decade later, these now mature platforms continue to deliver significant value to shareholders, bondholders and investors. Given the cyclical nature of the business and the inherent uncertainty associated with the cycles, investors must be prepared to hold their investments over a longer term if the circumstances for an exit are not favourable. In this regard, having the support of a capable asset management platform will substantially mitigate the risks that arise over time – remarketing, managing defaults, technical asset management, etc. An exit executed under duress or in pursuit of a fixed-term investment strategy is unlikely to realise the anticipated returns and investors are well advised to reflect on these issues at the outset.

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5 Legal Issues in Aircraft Finance Rob Murphy

INTRODUCTION 5.1 In every aircraft financing transaction, there are legal issues which the transaction parties must assess, overcome and negotiate in order to execute the transaction. Aircraft finance structures and techniques continue to develop organically and as a result of the changing economic and legal backdrop. However, the vast majority of structures are variations on the few basic structures developed during the formative years of aircraft financing. This chapter examines the basic structures of aircraft financing and their modern forms and discusses some of the common principal legal and contractual issues that typically arise in an aircraft financing transaction. We will first review some structural elements and then turn to legal and contractual issues.

STRUCTURAL ISSUES 5.2 Aircraft finance transactions are based principally on two basic structural concepts. These are: (1) an ownership and lease (involving either a finance lease or an operating lease) arrangement – title-based with lease structure; and (2) a secured loan arrangement (that is, a loan to a borrower with a mortgage over the aircraft) – loan/mortgage. A key feature of the development of aircraft financing in the past decade or so is that most transactions will combine both concepts. The amalgamation of the ownership/lease structure and the loan/mortgage structure has become the most common financing structure in the industry and the vast majority of transactions are built around this hybrid structure. This hybrid structure usually involves the following elements: • ownership of the aircraft by a single purpose company which is usually structured so as to minimise as far as possible the risks of bankruptcy (that is, a ‘bankruptcy-remote’ entity); • a lease agreement directly between the special purpose company (SPC) owner and the airline operator or between the SPC owner and a leasing company (usually an operating lessor) who then leases the aircraft to the operator; and • a mortgage over the aircraft in favour of the financier (or agent bank) or a trustee or collateral agent acting on behalf of the banks. Each of these elements will be looked at in turn. 55

5.3  Legal Issues in Aircraft Finance

The role of special purpose companies 5.3 Principally, aircraft are financed through a secured lending approach where legal title to the aircraft is held by a company specifically and solely incorporated for the purpose of owning the aircraft (an SPC). The SPC will be located in a jurisdiction that has a stable ‘creditor-friendly’ legal system. Tax neutral jurisdictions are often used – for example, the Cayman Islands and Bermuda. However, other jurisdictions such as Ireland, The Netherlands, Singapore, Hong Kong and Delaware, USA are also very popular. Chinese free trade zone areas – such as Tianjin, Shanghai and Xiamen – have also been used for lease transactions with Chinese airlines. The SPC will acquire title to the aircraft primarily with finance provided by the financier pursuant to a loan agreement. The SPC may be a group member of the entity, which has sought the financing, whether it is an airline or an aircraft leasing company. Alternatively, the ownership of the SPC may also be held outside the group of the person seeking the financing. It is quite commonplace in the industry to use an ‘orphan’ ownership structure where the shares of the SPC are held on trust (usually for charitable purposes) and where the SPC is managed by a professional corporate service provider. Commercial considerations as well as legal, tax and accounting factors will be taken into account in order to select the appropriate structure. For example, in some cases an orphan structure is not workable in the context of the tax planning objectives of the counterparty requiring the financing. A key objective of the SPC structure is to ensure bankruptcy remoteness. The primary building blocks here are: • limitation on recourse; • non-petition covenants; • limitation on purpose; • the use of independent directors; and • covenants and arrangements to ensure that the SPC conducts a business that is separate from the originator/party requiring financing. Looking at these in turn – the transaction counterparties will agree to limit recourse to the SPC such that its personal liability is limited to the proceeds of the assets that are owed by it and secured in favour of the financiers. This is important both in terms of maintaining the solvency of the SPC and also so that directors of the company can be satisfied as to the company itself entering into the transaction for minimal retained consideration. Counterparties will also agree not to petition bankruptcy of the SPC, through a standard ‘non-petition’ clause – reinforcing the bankruptcy remoteness proposition. The financing documents and, in some cases, the documents relating to the incorporation of the SPC will contain a comprehensive set of provisions dealing with the single purpose nature of the SPC. In a nutshell, ‘SPC-related covenants’ will prohibit the SPC from participating in any business other than the ownership and leasing of the aircraft and entering into any other documents or incurring indebtedness other than the financing documentation relating to the aircraft. The purpose of the SPC covenants is to prevent the SPC from incurring any liabilities other than those incurred to the financiers. Some flexibility will need to be 56

Structural issues 5.4 provided by the financiers in respect of certain, unavoidable, liabilities which are incurred by the SPC in the ordinary course of its business, for example, as a result of the operation of law. This will be very tightly defined. SPC-related covenants are necessary because the insolvency remoteness of the SPC and the financier’s secured position would be severely prejudiced if the SPC incurred any liabilities other than those permitted. These covenants are, therefore, a key method by which the financier can control the SPC in this respect. Where the SPC is part of the counterparty’s group, lenders may wish to build in additional bankruptcy remoteness protections by the use of independent directors and the maintenance of the SPC’s business as separate and distinct from the counterparty’s business.

Leases 5.4 A  key document in most structures is the lease agreement, whether it is an operating lease or a finance lease. From a legal standpoint, the lessor/ financier should satisfy itself as far as possible that the lessor’s title as owner of the aircraft will be recognised in the relevant jurisdictions and that the lessor’s right to terminate the lease and repossess the aircraft (which will be expressly provided for in the lease agreement) will be recognised and given effect to. An examination of the laws in the state of registration and the state of incorporation/ principal place of business of the lessee operator is, therefore, essential. If the aircraft is ‘habitually based’ in another jurisdiction, the laws of that jurisdiction will also be relevant – for example, the lessor may want to repossess the aircraft when it is located in that jurisdiction. The financier will also need to check that there is no risk that the lessee (as the person in possession of the aircraft) is deemed to have acquired an equity interest in the aircraft (which might mean that it could confer valid title on a third party, or that it could assert an interest in the residual value of the aircraft against the lessor). This is sometimes described as the risk of ‘equity build-up’ in favour of the lessee. This is a particular concern in a hire purchase or conditional sale agreement-type structure as the state of incorporation/principal place of business of the lessee may characterise such an agreement as giving the lessee more than a mere possessory interest and, therefore, may give effect to it as if ownership had in fact passed to the lessee. Finally, the financier will be concerned to have its interests in the aircraft registered, noted or otherwise perfected or publicised to the fullest extent possible under the relevant local laws. In terms of the distinction between operating leases and finance leases the core points are: • in an operating lease the lessor keeps the risk and reward of ownership of the aircraft – the lessor assumes the residual value risk; the lease will be for a defined term – for new aircraft lessors will generally seek an 8/10/12 year term; at the end of the lease the aircraft will be returned in the defined return condition; • a finance lease is basically a financing tool where the rents and payments under the lease will match the lessor’s financing – ie full pay-out rentals and termination sums that meet loan interest and amortisation. Ownership of the aircraft will be passed to the lessee at lease expiry and final payment. 57

5.5  Legal Issues in Aircraft Finance

Share security 5.5 A key factor in the use of an SPC structure is the desire to create as robust a security structure as possible. The security that underpins the SPC structure is a charge over the shares in the SPC that is granted for the benefit of the lenders. It is important to note that a charge over shares does not prevent the SPC from creating security over, or selling, the aircraft before the financier becomes aware of those acts and takes steps to exercise its control over the affairs of the SPC. To address this issue, a financier will need to rely on the negative pledge covenants in the financing documents (as mentioned earlier) and the credentials of the person administering the SPC. It is also important to note that a charge over shares is effectively subordinate to any debts or liabilities (secured or unsecured) of the SPC. A share charge is only as valuable as the net worth of the SPC. This is another reason why the financier will insist that the borrower and the SPC provide covenants that the SPC will not incur any debts or liabilities to third parties.

Aircraft mortgages 5.6 Turning to the aircraft mortgage, the financier will wish to check whether the laws of the state of registration of the aircraft will recognise the proposed form of mortgage, particularly if it is governed by a different law. Very many jurisdictions only recognise a mortgage if it is governed by local law and is in a particular form and language. Some countries do not recognise aircraft mortgages in any form as a valid type of security. In such countries, one may be able to use some different form of security interest such as a pledge, if such a form is recognised in that jurisdiction. In addition, the priority of mortgages and the procedure for perfecting and enforcing mortgages are generally determined by local law, regardless of the governing law of the mortgage. Consequently, the financier and its legal advisers need to check that the local procedural rules are not onerous or prejudicial. In many jurisdictions, the process for enforcing the aircraft mortgage can be protracted and cumbersome – for example, where the mortgaged aircraft may only be sold through a court administered sale, not by private treaty. In very many countries, there may not be a defined process for perfecting the mortgage. Many countries do not have dedicated aircraft mortgage registers or any local register in which an aircraft mortgage may be perfected or indeed any procedure for noting the interests of a mortgagee. Under the laws of England and Wales (English law), and where an aircraft is registered with the Civil Aviation Authority in the UK (CAA), the mortgage can be registered in the CAA’s UK Register of Aircraft Mortgages which confers priority against all subsequent registered mortgages. If the borrower is an English company or has a place of business in the UK, the mortgage should also be filed with supporting particulars at Companies House, the companies’ register in the UK. In some jurisdictions, a mortgage structure may be unattractive and commercially impractical because local law prescribes onerous and costly procedures for creating or perfecting the mortgage. For example, a requirement that the mortgage and underlying loan documents have to be translated into the local language, notarised, consularised and filed in several central registries. Alternatively, the mortgage may be subject to ad valorem documentary tax on the amount that it secures. 58

Structural issues 5.9 Finally, the Cape Town Convention and its wide international acceptance has greatly improved and simplified all key elements associated with the taking, perfecting and enforcement of security over aircraft. See below for a brief discussion and refer to Chapter 21 for more details on the Cape Town Convention.

Liens 5.7 A point to consider under local law is the priority of liens (and similar rights of detention) over an owner’s rights compared with the priority of liens over a mortgagee’s rights. Under English law, it makes little difference to the priority of liens over an owner or mortgagee’s rights whether an ownership/ lease structure or a secured financing arrangement is used. Neither an owner nor a mortgagee takes priority over possessory liens or statutory rights of detention (such as airport authority rights to detain an aircraft for unpaid navigation charges, including Eurocontrol charges).

Cape Town Convention 5.8 The Cape Town Convention1 and its associated Aircraft Protocol2 (collectively, the ‘Cape Town Convention’) have a significant impact on the choice of structure. A  discussion of the key features and advantages of the Cape Town Convention is beyond the scope of this chapter as this is covered at Chapter 21. When structuring the transaction, financiers will wish to ensure that the debtor is situated in a jurisdiction that has ratified or acceded to the Cape Town Convention. Lessors will also attribute a positive risk assessment value in their modelling where the airline is located in a jurisdiction that has ratified the Convention. In the case of a secured loan structure in which an aircraft mortgage is granted to the lender, the borrower/mortgagor must be situated in a contracting state in order for the mortgage to be registered as an international interest on the International Register. In an ownership/leasing structure, the lessee must be situated in a contracting state in order for the international interest constituted by the lease to be registrable on the International Register. The registration of the aircraft in a contracting state is also a ‘connecting factor’ for Cape Town purposes. Hence, one factor to be considered in the structuring phase is what Cape Town ‘connecting factors’ are present or could be worked into the structure so as to optimise the robustness of the structure. The Cape Town Convention is very definitely affecting the choices that lessors and financiers are making in structuring their deals.

Summary 5.9 Financiers will always seek to have the highest level of security possible in an aircraft financing transaction. As the primary building block in the structure, financiers should focus on the benefits of title-based security – ownership by an 1 Convention on International Interests in Mobile Equipment signed at Cape Town on 16 November 2001. 2 Protocol on Matters Specific to Aircraft Equipment signed at Cape Town on 16 November 2001.

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5.10  Legal Issues in Aircraft Finance SPC, bankruptcy remoteness structuring and a lease agreement with the lessor or airline operator. The lease agreement should grant the customary termination and repossession remedies in a default scenario. Allied to this, in most cases, will be a requirement for some form of ‘security over the metal’ – that is, an aircraft mortgage and ideally one that is an international interest registered at the International Registry and perfected (as far as possible) under the laws of the state of registration/operator’s jurisdiction. In relation to the mortgage element, financiers will also take account of the limitations on mortgage-based security which has been discussed earlier, including the availability of mortgage security, enforceability/effectiveness of remedies in a default scenario, perfection and costs. These constraints emphasise the need in the vast majority of transactions to use a title-based/leasing structure as the core basis of the financing structure, with the aircraft mortgage being viewed as a part, but not the fundamental element, of the collateral package.

LEGAL ISSUES 5.10 This section examines some of the principal legal issues which can arise in cross-border transactions. Most of these issues are not confined to aircraft financing, although some are highlighted in the case of aircraft because they are mobile assets. The vast majority of aircraft finance transactions are cross-border where the financier, the SPC/owner, lessor and airline operator are commonly incorporated in different jurisdictions. Where an aircraft is flying on international routes but is both registered and based and/or maintained in a single jurisdiction, for practical reasons, the financier will generally not investigate the laws of the countries to which the aircraft regularly flies in respect of, for example, liens and other rights of detention, or enforcement procedures. However, where an aircraft has ‘hybrid residence’ (that is, the aircraft is registered in one country but habitually based in another country), the financier may consider obtaining independent legal advice in both jurisdictions. Financiers and/or lessors will usually seek to avoid the possibility of more than one jurisdiction being relevant by having restrictions in the financing and lease documents relating to the state of registration and habitual base of the aircraft.

Legal opinions 5.11 In almost all transactions, a financier will conduct legal due diligence in all relevant jurisdictions (apart from its own) through a combination of a jurisdictional questionnaire (where the financier has not financed in the relevant jurisdiction in a previous transaction) and a series of legal opinions. As a result of the increasingly global nature of aircraft financing, legal advice and opinions (although always negotiated to an extent) have become relatively standardised. However, comprehensive and detailed advice from independent local counsel in the state of registration (or any jurisdiction that is relevant) is still essential in order to properly structure the transaction. Local counsel in the state of registration of the aircraft and the jurisdiction of incorporation of an airline, in addition to any corporate-related opinions in relation to the airline, will generally need to opine upon the sort of legal issues 60

Legal issues 5.12 discussed earlier in ‘Structural issues’ at para 5.2 as well as various other issues including whether: • any of the transaction documents need to be filed in the state of registration in order to be enforceable or to protect the financier’s rights in and to the interests created by the documents and the aircraft; • the rights of the financier (as mortgagee) and/or the rights of the SPC (as owner) in and to the aircraft can be recorded on the relevant registry in the state of registration and whether any fees or stamp duties are payable as a result of such registration; • the financing and lease documents are enforceable in the state of registration; • the owner can deregister the aircraft from the aircraft registry upon termination of the airline’s contractual right of possession of the aircraft; and • the airline is in possession of all the correct documents required to operate the aircraft (such as the certificate of registration of the aircraft and the aircraft operator’s certificate) and import the aircraft into the relevant jurisdiction.

Conflict of laws 5.12 In international transactions, it may be necessary to consider whether there is any conflict between the different legal systems involved – for example, between the governing law of the financing documents and the lex situs (that is, the law of the country where the aircraft is situated at the relevant time). The financier will wish to satisfy itself that the lessor (in the case of a lease) or the airline operator (in the case of a loan) has acquired valid title to the aircraft at the beginning of the transaction. It is likely that the sale agreement under which title is transferred will be governed by English or New York law. However, if the aircraft is physically located in some other jurisdiction at the time of sale, a conflict may arise. This is because under the rules of private international law, the validity of a transfer of a tangible asset such as an aircraft is governed by the law of the country where the aircraft is situated at the time of transfer. It will be necessary, therefore, to check with local counsel in the country where the aircraft is situated that the laws of that country will recognise the relevant transfer of title under the sale agreement (for example, by means of a bill of sale or by physical delivery of the aircraft). Similar conflict of laws issues will arise in a loan transaction where the financier is granted a mortgage over the aircraft under English law, but the aircraft is physically situated in another jurisdiction when the mortgage is granted. For example, if the mortgage is taken at a time when the aircraft is located in France, a French form of mortgage will be required. However, a French mortgage may not necessarily be sufficient for the financiers who may prefer to wait until the aircraft is situated in the UK or another jurisdiction where the creation of an English law mortgage is effective under such laws. This issue came under judicial scrutiny before the English courts in the case of Blue Sky One Ltd v Mahan Air.3 In this case, the Commercial Court ruled that 3

Blue Sky One Ltd v Mahan Air [2010] EWHC 631 (Comm).

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5.13  Legal Issues in Aircraft Finance the validity of an English law-governed aircraft mortgage will be determined in accordance with the lex situs of the aircraft on the date that the English lawgoverned mortgage is executed and becomes effective. The lex situs will consist only of the domestic law of the place where the aircraft is situated, not all the legal rules of that country, including its conflict of laws rules. Accordingly, the doctrine of renvoi4 does not apply. One of the aircraft in question was known to be at Schiphol Airport, Amsterdam at the time that the English law-governed mortgage was entered into. The judge looked to Dutch domestic law to determine the validity of the mortgage. As Dutch domestic law does not recognise an English law-governed mortgage as a valid form of security over aircraft, the judge ruled that this mortgage was invalid. The judge would not entertain wider considerations such as how the Dutch conflict of laws rules would treat the mortgage (in accordance with renvoi) as that would ‘produce a very uncertain legal regime’ and the judge was of the view that courts needed to promote simplicity and certainty. This means that for an English law-governed mortgage to be valid, the parties need to ensure that: (a) the aircraft is situated in England at the time that the mortgage is entered into; or (b) the aircraft is situated in a jurisdiction where the domestic law recognises the English law mortgage as a valid form of security. The Blue Sky case brings into sharp focus the commercial impracticality of the lex situs rule when applied in the context of aircraft financing transactions. The Cape Town Convention has addressed this issue as the lex situs is not relevant for the validity and enforceability of an international interest created under the Cape Town Convention.

Political and repossession risks 5.13 In the context of an aircraft financing, political and repossession-related risks range from overt confiscation by the host government to covert deprivation action. An extreme example of covert deprivation action is a refusal by the local immigration authorities to issue entry visas to the flight crew appointed by the financier to remove the aircraft and a refusal to deregister and permit the export of the aircraft. It is sometimes possible to obtain some form of separate undertaking from the host government that it, and its subordinate governmental agencies, will cooperate in permitting the removal of the aircraft or its sale proceeds at the relevant time. However, this is likely to have moral rather than legal force, because the government is unlikely to waive sovereign immunity. In any event, if the undertaking is breached, proceedings in the courts of the host government are unlikely to be productive. In transactions where political risks are considered significant by the lender, some form of independent protection can be considered. Typically, this takes the form of a separate political risk insurance policy. The policies currently available in the London market cover a broad range of covert and overt political actions. However, like any insurance contract, they are subject 4

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The doctrine of renvoi (literally, ‘sending back’) means the application by a court of conflict of laws rules to determine whether a case needs to be ‘sent back’ to another jurisdiction to be decided.

Legal issues 5.14 to exclusions, conditions and warranties which may be breached by the assured. Cover is not generally available for a period of time commensurate with a typical financing term. As a result, the lender will remain exposed to political risks for the duration of the financing term after the expiration of the policy. In cases that do not consist of overt confiscation by the host government, there may be difficulties in proving causation. For example, the insurers may claim that the assured’s loss was caused by one of the excluded risks, not by covert political action. It is also important to note that a political risk policy does not cover mere delays and difficulties in repossession (for example, delays in obtaining a local court order where there is no governmental interference). The Cape Town Convention, if applicable to the aircraft leasing or financing transaction, provides some very helpful benefits for lenders and lessors where repossession of the aircraft is required as a result of a default by a borrower or lessee under a loan or lease agreement. Provided that the registry authority is situated in a contracting state and this contracting state has made the appropriate declaration, the registry authority will honour a request for the deregistration and export of an aircraft provided that: (a) the request is properly submitted by the authorised party under a recorded irrevocable deregistration and export request authorisation (an IDERA)5; and (b) the authorised party certifies to the registry authority, if required by that authority, that all registered interests ranking in priority to that of the creditor in whose favour the authorisation has been issued have been discharged or that the holders of such interests have consented to the deregistration and export. The authorisation may not be revoked by the debtor without the consent in writing of the authorised party.

Sovereign immunity 5.14 Where the airline operator is owned by the state, the issue of sovereign immunity may apply. Sovereign immunity needs to be considered in deciding: • whether a state can be sued; and • whether provisional attachment and subsequent enforcement can be taken against its assets. Sovereign immunity may also apply where some form of contractual obligation is assumed by the state itself (for example, by way of a guarantee provided by the state). Under public international law, foreign states were historically accorded absolute immunity from jurisdiction or enforcement rules in relation to all their activities, whether governmental or commercial activities. However, as governments and governmental bodies became increasingly involved in normal commercial activities, this traditional theory has become progressively restricted so that it applies only to public and governmental acts. This restrictive approach is enshrined in English law by the State Immunity Act 1978 (the ‘UK Immunity Act’) and in the US by the Foreign Sovereign Immunities Act 1976 (the ‘US Immunity Act’).

5

The form of the IDERA is annexed to the Aircraft Protocol.

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5.15  Legal Issues in Aircraft Finance Under the UK Immunity Act, a state6 is not immune from proceedings in respect of which it has submitted to the jurisdiction of the UK courts. A state is also not immune from proceedings relating to: (a) a commercial transaction entered into by the state; or (b) an obligation of the state which, by virtue of a contract (whether a commercial transaction or not), falls to be performed wholly or partly in the UK. Subject to these restrictions, the UK Immunity Act provides that a state is immune from the jurisdiction of the UK courts. A  separate entity7 is immune from UK jurisdiction only if the proceedings relate to anything done by it in the exercise of sovereign authority and the circumstances are such that a state itself would have been immune. Unlike the US Immunity Act, the UK Immunity Act expressly states that loans and guarantees, as well as the supply of goods or services, constitute commercial activities and, therefore, are not subject to sovereign immunity. In order to obtain the full benefits of the UK  Immunity Act, the loan or lease should provide that the airline should appoint an agent for service of process within England, together with a consent for the giving of any relief in connection with the proceedings, a general consent to the issue of any process and the manner of service of process, and a submission to the jurisdiction of the English courts. If such a submission is included, no express waiver of immunity is technically necessary, but such a waiver is normally included to avoid any doubt. Finally, the Cape Town Convention also helps on sovereign immunity (see Article XXII of the Aircraft Protocol).

LIABILITIES OF THE FINANCIER AND LESSOR 5.15 The question of lessors and financiers being exposed to legal liability as a consequence of their participating in owning, leasing and financing aircraft is a relevant consideration. The dominant lessor/financier community view is that their role is simply to provide credit to the industry and that there is no justifiable theory to support passenger or third-party liability against these parties. These risks should fall to be addressed by the airlines and manufacturers, as appropriate. The dominant policy thrust of the third-party liability, international conventions relevant to the aviation industry support the theory of non-liability of lessors/financiers. In this context, some US court decisions at state level have pushed in the opposite direction and are, therefore, a cause for concern. For example, decisions in Florida, Michigan and Illinois relating to relevant subjects (such as the liability of an aircraft lessor in the context of aircraft accidents and negligent entrustment) have declined to follow US federal laws that are designed to protect lessors, owners and secured financiers. This section will discuss the liabilities of the financier and the lessor under English law in respect of the aircraft.

6 7

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‘State’ under the State Immunity Act 1978 means any foreign or commonwealth state other than the UK. References to a ‘state’ include the sovereign or other head of that state, the government of that state or any governmental department of that state. ‘Separate entity’ means an entity which is distinct from the executive organs of the government and is capable of suing or being sued.

Liabilities of the financier and lessor 5.18

Liability under the Civil Aviation Act 1982 5.16 Under the UK’s Civil Aviation Act 1982, strict liability (that is, liability irrespective of fault) is imposed on the owner of an aircraft for loss or damage (including death or personal injury) caused to persons or property on the ground by the aircraft or by an article or person falling from the aircraft. However, where the aircraft has been bona fide demised, let or hired out for any period exceeding 14 days and the crew are not employees of the owner (that is, a dry lease), this strict liability is transferred to the lessee.8 This provision will therefore not apply, in practice, to an aircraft financier, whether the financing is lease-based or mortgage-based.

Liability in tort 5.17 Although the financier may not be liable to third parties by virtue of a statutory provision and may not have a connection by way of contract with an injured third party, the financier may still incur liability under English law if a third party can establish that the financier owes it a ‘duty of care’ and has been negligent in failing to properly discharge that duty of care. Under English law, an aircraft is not considered to be an object dangerous in itself9 and the principle of strict liability would not apply, and liability is likely to be based simply on negligence.10 It is extremely unlikely that a successful negligence claim in the English courts could be pursued against an aircraft secured financier or a lessor (in the absence of unusual circumstances, such as if the financier/lessor failed to take action, despite actual knowledge that the aircraft was in an unsafe condition or being improperly operated). In the international context, it should be noted that, while the relevant conventions generally ascribe liability to the aircraft operator, they also tend to protect operators rather than financiers.11 In terms of assessing potential liabilities for accidents involving aircraft, because such liabilities may be determined in the jurisdictions in which accidents occur, it is impossible to predetermine which rules might apply.

Product liability 5.18 Under the European Union product liability regime (implemented in 1985 by Directive 85/374/EEC12 (the ‘Directive’)), the producer of a product will

8 Civil Aviation Act 1982, s 76(4). 9 Fosbroke-Hobbes v Airwork Ltd [1937] 1 All ER 108 at 112, per Goddard J. 10 This is in contrast to the position under US law where an aircraft has been held to be a ‘dangerous instrumentality’ (that is, a thing that is inherently dangerous) with the result that liability for the tort of negligent entrustment has occurred in the context of a lessor leasing an aircraft to an operator who is deemed not to have the requisite standards and qualifications to operate them. See the US case Layug v AAR Parts Trading, Inc, No 00L9599, 2003 WL 25744436 (Ill Cir Ct May 16, 2003); Ellis v AAR Parts Trading, Inc, 357 III App 3d 723, 828 NE2d 728 (III App Ct 2005) (referred to collectively as the ‘Air Philippines case’). 11 But note the protection given to financiers, owners and lessors in the new Convention on Compensation for Damage Caused by Aircraft to Third Parties (not yet in force), which is discussed in Chapter 21. 12 Council Directive 85/374/EEC of 25 July 1985 on the approximation of the laws, regulations and administrative provisions of the member states concerning liability for defective products.

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5.18  Legal Issues in Aircraft Finance be liable for relevant damage caused to a consumer by a defect in that product. Aircraft and their component parts fall within the definition of ‘products’. Aircraft manufacturers, whether established in the EU or elsewhere, clearly fall within the definition of a ‘producer’ (that is, the manufacturer, own-brander or first importer into the EU) and could be sued in a national court under the regime instituted by the Directive. Financiers and lessors, however, only seem likely to be caught by the regime to the extent that they can be considered to be a first importer. In the UK, the Directive has been implemented by the Consumer Protection Act 1987 (CPA 1987), which imposes strict liability on the same parties provided for by the Directive. The CPA  1987 extends secondary liability, in certain circumstances, to the ‘supplier’ of a product, but only where the supplier in question does not identify the manufacturer, own-brander or first importer of the product, or cannot identify its supplier, within a reasonable time of receiving a request from the claimant to do so.13 Under the CPA 1987, it is a complete defence for the party proceeded against to show (among other things) that they ‘did not at any time supply the product to another’.14 ‘Supply’ expressly includes the selling, hiring out or lending of goods and the entering into of a hire-purchase agreement to furnish the goods.15 However, in relation to aircraft, the CPA 1987 specifically provides at s 46(9) the following exemption for service providers (and possibly wet lease/operating lessors): ‘[A]ircraft … shall not be treated … as supplied to any person by reason only that services consisting in the carriage of goods or passengers in that … aircraft …, or in its use for any other purpose, are provided to that person in pursuance of an agreement relating to the use of the … aircraft … for a particular period or for particular … flights …’16 This provision is intended to remove the possibility of liability for carriers in the context of the provision of flight services. This is consistent with wider rules of law (as embodied, for example, by the Montreal Convention 1999),17 which place limits on carrier liability. If there is no ‘supply’ within the meaning of the CPA 1987 then the complete defence referred to above will apply. The CPA 1987 provides a further exemption that operates to protect financiers and lessors in certain circumstances.18 Under this provision, if a person (the ‘ostensible supplier’) supplies goods to another person (the ‘customer’) under a hire purchase, conditional sale or credit-sale agreement or under an agreement for the hiring of goods (other than a hire-purchase agreement) and: (a) the ostensible supplier carries on the business of financing the provision of goods for others by means of such agreements; and (b) in the course of that business, acquired its interest in the goods supplied to the customer as a means of financing the provision of them for the customer by a further person (the ‘effective supplier’); then the effective supplier, not the ostensible supplier, will be treated as supplying the goods to the customer. This helps the ‘straightforward’ finance

13 14 15 16 17

CPA 1987, s 2(3). CPA 1987, s 4(1). CPA 1987, s 46(1). CPA 1987, s 46(9). Convention for the Unification of Certain Rules Relating to International Carriage by Air signed at Montreal on 28 May 1999. 18 CPA 1987, s 46(2).

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Liabilities of the financier and lessor 5.20 lessor. There may, however, be a greater issue for the wet lease lessor, depending on the precise nature of the leasing arrangements. The risks of liability need to be covered in the transaction. The financier should always include a comprehensive disclaimer with regard to the condition of the aircraft. The lease or mortgage should also contain an extensive general indemnity to cover such risks (from whatever cause and even if arising out of defects present at the time of the sale) and, in addition, the lessee and/or the borrower should be required to effect third-party liability insurance for the benefit of the lessor and/or the mortgagee.

Liability under health and safety law 5.19 In the UK, the enforcement of health and safety-related duties in relation to aircraft is shared between the Health and Safety Executive (HSE) and the UK  Civil Aviation Authority Safety Regulation Group (CAA SRG), pursuant to a Memorandum of Understanding between them. Essentially, the HSE is responsible for regulating the occupational health and safety of work activities on and around an aircraft on the ground, whereas the CAA SRG is responsible for regulating the occupational health and safety of crew members whilst they are on board an aircraft. Broadly speaking, health and safetyrelated duties will fall on the operators of aircraft and, accordingly, it is most unlikely that a non-operator financier would be fixed with such duties, unless by its conduct it is taken to have assumed them (such as where the financier had exercised inspection rights and failed thereafter to require the lessee to address a material safety issue that had been identified). Although the Health and Safety at Work etc Act 1974, s 6 places duties on everyone in the supply chain to ensure that articles of plant or equipment for use at work are at all times safe and without risks to health, the supplier’s obligations in this regard do not attach to a financier in respect of items that are the subject of a hire purchase, conditional sale or credit-sale agreement, for example, where ownership of such items is vested with the financing organisation.19

Possessory liens 5.20 Liens are potentially a significant concern for the financier/lessor, because they may be exerted against the aircraft by repairers or workmen in any jurisdiction to which the aircraft flies. Whether or not a lien arises, and how it can be exercised and enforced, depends on the law of the place where the aircraft is located. Under English law, a repairer’s lien can only be exercised against the asset to which the unpaid charges for work carried out relate (and not against other assets that happen to be in the possession of the repairer). The lien only arises if the work has been completed and has improved the asset (so a lien will not arise in respect of mere maintenance). It is a question of fact in each case whether there has been improvement. On the other hand, a repairer’s lien can be exercised against the aircraft (or part of the aircraft, such as an engine) even if the repairs were commissioned by the airline (that is, the lien can also be upheld against an ‘innocent’ owner or mortgagee).

19 Health and Safety at Work etc Act 1974, s 6(9).

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5.21  Legal Issues in Aircraft Finance The financing documents will commonly prohibit the airline from permitting liens to arise but unless the repairer has notice of this prohibition, it will be entitled to assume that it will have a lien for unpaid charges.

OTHER RIGHTS OF DETENTION 5.21 Under English law there are certain statutory provisions that permit the relevant authorities to detain and sell aircraft. Other jurisdictions have similar rules relating to the detention of aircraft. These statutory provisions in the UK relate to airport and navigation charges.

Airport charges 5.22 Under the Civil Aviation Act 1982, any UK airport authority is authorised to detain an aircraft located in the UK which has accrued unpaid airport charges (whether or not the charges were incurred by the current operator of the aircraft) and also to detain any other aircraft operated by the defaulting operator.20 If the charges are not paid within 56 days after the detention date, the authority can obtain a court order to sell the aircraft and use the proceeds to satisfy the unpaid charges.21 The airport authority has a statutory duty to ensure that the aircraft is sold for the best price that can reasonably be obtained.22 Accordingly, if the financier suffers loss as a consequence of a sale at an undervalue, it has a statutory action for breach of duty against the authority.23 The broad scope of this provision means that a financer’s aircraft may be detained to satisfy charges incurred not by its own lessee/borrower, but by a previous operator, or charges that do not relate to the financed aircraft at all, but have been incurred in respect of other aircraft in the fleet. It is some comfort to the financier that if the airport authority proposes to sell an aircraft, it must take steps to notify any persons whose interests may be affected, and to give them an opportunity of becoming a party to the proceedings.

Navigation charges 5.23 A similar statutory right of detention exists under s 73 of the Transport Act 2000 and reg 4 of the Civil Aviation (Chargeable Air Services) (Detention and Sale of Aircraft for Eurocontrol) Regulations 2001 (SI 2001/494) for unpaid charges in respect of air navigation services supplied by the CAA and Eurocontrol (in the case of the latter authority, the CAA will effectively detain the aircraft on behalf of Eurocontrol). This right of detention extends to aircraft that at the time of detention are being operated by a new, non-delinquent operator. Financiers/lessors developed the practice of requiring airlines to authorise Eurocontrol to provide periodic statements to the financiers of any outstanding Eurocontrol charges. Eurocontrol and the Aviation Working Group (AWG) 20 21 22 23

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Civil Aviation Act 1982, s 88(1)(a). Civil Aviation Act 1982, s 88(1)(b). Civil Aviation Act 1982, s 88(4). Civil Aviation Act 1982, s 88(5).

Aircraft registration 5.24 developed this concept into a more formalised statement of accounts dispatch system. Under this system, with an airline’s express consent, Eurocontrol will send a lessor/financier an electronic file of that airline’s monthly statement of account. This keeps the lessor/financier up to date on the general situation and could serve as an early warning of potential problems. Eurocontrol is contemplating implementing a web-based access system for financiers and leasing companies. When acquiring a used aircraft (whether from an airline, a financier or a liquidator or similar officer), it is prudent to insist on an indemnity from the seller in respect of any liabilities or security interests imposed on the aircraft in respect of any pre-purchase period. However, as in any transaction, the value of such an indemnity depends on the creditworthiness of the indemnifier. In addition, a significant period may elapse between the acquisition date and the date when the CAA or other authority acquires an opportunity to seize the aircraft.

AIRCRAFT REGISTRATION 5.24 The registration requirements of the aviation authority that is responsible for the operator will be a factor that influences the leasing and financing structure. Generally, there is no ‘flag of convenience’ in terms of aircraft registration. Virtually every nation’s rules on registration require either the owner or the operator to have a connection with the particular nation. Some registers operate on the basis of title only, and others on the basis of both ownership and operation. Certain title registers (such as the Federal Aviation Authority (FAA) registry in the US) permit registration in the name of the economic owner, for example, a lessee under a full pay-out finance lease or a purchaser under a conditional sale agreement. In most cases, aircraft are registered in the jurisdiction of the operator. There are notable exceptions where foreign registers (for example, Ireland and Bermuda) are used to register aircraft that are operated in other jurisdictions. This type of arrangement is based on the transfer of functions provisions of the Chicago Convention (article  83bis). The reasons for this are either operational (for example, the airline in question needs to be operating aircraft on a particular register in order to fly the routes that it wishes to operate) or relate to security/ financing concerns, where the financiers/lessors have concerns (for example, as to deregistration risks) with a particular register and foreign registration of the aircraft strengthens the security structuring. Early investigation of the particular register’s requirements is essential. In the UK, the Air Navigation Order 2016 (SI  2016/765) (the ‘Order’) contains a miscellaneous list of the classes of persons who are ‘qualified’ to be the owner of a CAA-registered aircraft, with the principal category being any Commonwealth company.24 However, whether or not a qualified person is the owner, the aircraft may be registered by the CAA if it is ‘chartered by demise’ to a qualified person.25 Nevertheless, the Order also provides that an aircraft shall not be registered in the UK if (among other things) it could ‘more suitably be registered’ in some other Commonwealth country, or it would ‘not be in the public interest’ for the

24 SI 1995/1970, art 4(3). 25 SI 1995/1970, art 4(5).

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5.25  Legal Issues in Aircraft Finance aircraft to be registered in the UK.26 The practical effect of these rules is as follows: • if the aircraft is owned by a UK airline or leased to a UK airline, it will be eligible for registration on the basis of the operator’s identity, regardless of the identity/nationality of the owner or mortgagee; • conversely, where an aircraft is being operated by a non-UK airline, the CAA will generally refuse registration, on the grounds of either suitability of some other Commonwealth state, or general inexpediency. An exception is made in practice for short-term (12 months or less) wet leases or winter leases. The CAA considers that it is not appropriate for an aircraft to be subject to CAA airworthiness standards in circumstances where the aircraft is based offshore and supervision of those standards is impracticable. This means that the CAA is clearly not a ‘register of convenience’ for financiers; and • if the operator of the aircraft is an English company, the Order does not look behind the corporate veil. In other words, there is no requirement that the shareholders or officers of the company must be UK nationals or residents. This contrasts with the nationality tests in the US prescribed by the Federal Aviation Act and in other jurisdictions such as Italy. Within the aviation industry, the registration of aircraft on the FAA registry in the US using non-citizen trusts (NCTs) is also quite prevalent. There is well established practice and precedent documentation around this structure. The FAA has previously raised some concerns on the use of NCTs and, in 2011, a consultation process commenced between the FAA and interested parties. Following a two-year consultation process, the FAA published a policy clarification on the use of NCTs, taking effect on 16  September 2013.27 This policy clarification introduced a number of notable changes, namely the treatment of trustees as owners/operators for the purposes of regulatory compliance and the introduction of greater information and documentary filing requirements.

VALIDITY OF COLLATERAL 5.25 In a title-based financing, such as a lease, the financier needs to satisfy itself that it has acquired valid title to the aircraft from the seller. In the case of a used aircraft, the financier’s lawyers should check the entire chain of title back to the manufacturer (for example, by insisting on production of the complete series of bills of sale). Checking the chain of title is often not commercially feasible and will not necessarily prove valid title, because the bill of sale alone will not necessarily be effective to pass title in the jurisdiction in which the asset was located at the time of sale. In a security-based financing, the financier needs to satisfy itself that the airline has validly acquired title and that the financier itself has acquired a valid first priority security interest. English law (unlike certain civil law jurisdictions) is relatively flexible as regards the form of documentation required to create a mortgage. If the validity of a mortgage is challenged, it is likely to be not on 26 SI 1995/1970, art 4(2)(c) and (d). 27 Notice of Policy Clarification for the Registration of Aircraft to US Citizen Trustees in Situations Involving Non-US Citizen Trustors and Beneficiaries, Docket No FAA-2011-0012 – available at https://www.govinfo.gov/content/pkg/FR-2013-06-18/html/2013-14434.htm.

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Validity of collateral 5.25 the grounds of improper form, but rather on the basis that the mortgagor lacked the necessary corporate capacity to grant the mortgage or on the basis of certain provisions of insolvency law. As regards corporate capacity, it will be necessary to check the company’s constitutional documents as well as requiring properly drafted board resolutions. Lenders will generally require a legal opinion on those aspects. Insolvency laws usually provide a mechanism for challenging security created within a fixed ‘jeopardy’ period by reason of the security being deemed to be a preference or fraudulent conveyance in favour of the secured creditor. English law is no exception. In the event of the insolvency of an English company, the main grounds on which a prior transaction (including a mortgage) might be set aside are ‘transactions at an undervalue’28 and ‘preferences’29 under the Insolvency Act 1986 (IA 1986). A  transaction at an undervalue is one entered into by a company for a consideration of lesser value than the value provided by the insolvent company. In such circumstances, the court may make an order restoring the position to that which it would have been if the company had not entered into the transaction. However, the court will not make an order if the insolvent company had entered into the transaction in good faith for the purpose of carrying on its business, and there were reasonable grounds at that time for believing that the transaction would benefit the company. A preference is given if the company does or permits anything that puts a creditor (or a guarantor) of the insolvent company in a better position in liquidation than that in which the creditor/guarantor would otherwise have been. Again, the court has the power to restore the position so as to cancel the preference. This provision only applies if the insolvent company was influenced by a desire to produce the preference in favour of the relevant third party. In relation to transactions at an undervalue and preferences, the provisions only apply if the company was at that time unable to pay its debts as they fell due (or became unable to pay them as a result of the transaction).30 In addition, a transaction at an undervalue may only be challenged if it has taken place in the two years prior to the commencement of insolvency proceedings. The equivalent period for preferences is only six months.31 However, where the transaction at an undervalue or the preference is between ‘connected’ parties (for example, a company and its director), there are some important modifications to these rules. The period within which preferences can be set aside is extended to two years32 and there is presumed to be the requisite desire to give a preference unless the contrary is shown.33 In relation to transactions at an undervalue, the period within which the transaction can be set aside is two years, but the company is presumed to be insolvent at the time of the transaction.34 This makes the application for an order to set aside the transaction easier from an evidential perspective.

28 29 30 31 32 33 34

IA 1986, s 238. IA 1986, s 239. IA 1986, s 240(2). IA 1986, s 240(1)(b). IA 1986, s 240(1)(a). IA 1986, s 239(6). IA 1986, s 240(2).

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5.26  Legal Issues in Aircraft Finance However, where a mortgage is given to secure the amount of the loan advanced to finance the acquisition of an asset, it is unlikely, in practice, that the mortgage will be set aside on the basis that it is either a transaction at an undervalue or a preference. One of the issues to consider in an aircraft financing, as in any other transaction, is whether any of the financing documents (apart from the express collateral documents, such as the aircraft mortgage) create a security interest that should be registered, particularly if registration is necessary in order to perfect the security. This is an important issue under English law, because an unregistered charge is void against a liquidator or administrator, and against any creditor of the company (although not against the company itself). The types of provision that may be thought to require registration are undertakings by the company to create security in future (this may constitute an equitable charge) and provisions constituting an assignment (by way of security). If a lease or loan agreement contains such a security interest, a confidentiality issue arises. Each English company (and each registered foreign company in the UK) is required to keep a copy of every document creating a charge at its registered office (or a UK place of business notified to the registrar) and these copies are open to inspection by any creditor or shareholder. Accordingly, as there are likely to be confidential provisions in the loan agreement (such as the interest rate and facility fees), which neither the company nor the financier will wish to be disclosed to other creditors, a common solution is to incorporate any provisions that may constitute registrable charges into separate documents that can be separately filed.

Priority of collateral 5.26 Different countries employ different systems and rules to determine the priority of security interests. Priority might be determined by the time of creation of the security interests, or by the time of registration or the date of action. In England, the priority of security interests is generally determined by the time of creation. But aircraft have a separate register under the Mortgaging of Aircraft Order 1972 (SI  1972/1268). This Order provides a statutory system for the priority of mortgages over CAA-registered aircraft. However, registration is not evidence of validity, so the financier must still satisfy itself that the mortgage is valid in the first place. It is also possible to preserve priority in advance through the use of priority notices, which give the mortgage priority from the date of the priority notice, provided that the mortgage is valid in the first place and is filed within 14 business days after the filing of the priority notice.

Enforcement of collateral 5.27 The financier will wish to be satisfied that, in the event of a default by the airline or insolvency proceedings against the airline, it has ready access to the aircraft. If the lessee or borrower is an English company, the key statute is the IA 1986. The IA 1986 preserved (subject to certain amendments) the traditional concept 72

Validity of collateral 5.27 of liquidation and created a separate new procedure called ‘administration’, which applies to insolvent companies and is designed to assist in either the preservation of profitable parts of the business as a going concern or the orderly realisation of the company’s assets. Administration can provide the company with a breathing space, either prior to liquidation or, in some cases, as an alternative to liquidation. It involves the appointment of an insolvency practitioner (known as an administrator) who carries out the administration proposals. The IA 1986 also includes some provisions that have a major impact on secured creditors. First, the IA 1986 provides that once an application for an administration order or out-of-court appointment of administrator has been filed with the court, no steps may be taken to enforce any security over the company’s property or to repossess goods in the company’s possession under any ‘hire purchase agreement’ except with the permission of the court (and subject to such terms as the court may impose).35 The expression ‘hire purchase agreement’ is defined much more widely than in the normal sense, as it includes conditional sale agreements, ‘chattel leasing agreements’ and retention of title agreements.36 A  ‘chattel leasing agreement’ is defined as an agreement for the bailment of goods which is ‘capable of subsisting’ for more than three months.37 No distinction is made between operating leases and finance leases. This provision means that a lessor or mortgagee should be advised to apply to the court for a repossession order as soon as it becomes aware of the filing of an administration application or an outof-court administrator appointment. The court will conduct a balancing exercise in determining whether a permission for enforcement or repossession should be granted. These provisions of the IA 1986 restricting repossession of leased or mortgaged assets do not contain any exclusions for the benefit of aircraft financiers that would correspond to Section 1110 of the US Bankruptcy Code. Second, the administrator is given power to sell leased and mortgaged property as if they were the owner (and as if there were no mortgage). A  court order is required for such a sale and the administrator has to satisfy the court that the sale will be likely to promote the purpose of the administration order. The administrator is then required to apply the net sale proceeds in discharging the sums due under the mortgage or lease.38 It is not clear what is to happen to the balance of the sale proceeds. It appears they may be retained in the administration, which for an operating lessor would be seriously prejudicial. In order to protect the financier, the IA  1986 also provides that if the sale price realised by the administrator is less than open market value, the administrator is required to make good any shortfall. Commentary on this provision of the IA 1986 is fairly speculative until sufficient case law becomes available. However, it is worth noting that in relation to leased property, the drafting of the relevant provisions is expressed in terms that are readily applicable in the case of a single-tier lease structure but are difficult to construe in the case of a multi-tiered structure. It is possible that the court would hold the provision to be inapplicable in a head lease/sub-lease structure.

35 36 37 38

IA 1986, Sch B1, para 43(2) and (3). IA 1986, Sch B1, para 111(1). IA 1986, s 251. IA 1986, Sch B1, para 71.

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5.28  Legal Issues in Aircraft Finance The IA 1986, and its accompanying rules, do not clarify who has status to appear before the court on an application to sell the aircraft. For example, it is not clear whether an interested third party such as an asset value guarantor would have status. The rules merely state that the administrator must give notice of the venue for hearing the application to the holder of the security or the owner under the lease.39 In any event, in the case of big-ticket equipment such as aircraft, there may be scope for the financier to argue before the court that in a specialised market they are likely to be more skilled than the administrator in arranging a sale at the best price available. Section 1110 of the US Bankruptcy Code, which applies where the operator is a US air carrier, provides for the return of an aircraft that is subject to a lease or financing transaction, within 60 days of bankruptcy filing unless the airline cures all defaults and confirms that it will perform the agreement. The insolvency regime under the Cape Town Convention seeks to replicate this concept as contracting states have the option of making a declaration for ‘Alternative A’ of Article XI (Insolvency remedies) of the Aircraft Protocol. Under Alternative A, the insolvency administrator or the debtor must either return possession of the aircraft to the creditor or cure all defaults and agree to perform future obligations, in each case, no later than the waiting period set out in the declaration. Countries which ratify the Cape Town Convention are encouraged to make an Alternative A  declaration with a waiting period of between 30 and 60 days. The Alternative A  provisions (which are similar to Section 1110 protection) are designed to provide a high level of certainty in the default/repossession scenario and is particularly helpful in making aircraft financing attractive to investors, especially in capital markets transactions. Insolvency and restructuring issues and practices with a particular reference to developments since the outbreak of the Covid-19 pandemic are covered extensively in Chapter  19, including in particular Chapter  11 of the US Bankruptcy Code and the English statutory restructuring processes available under the UK  Companies Act 2006, Parts 26 and 26A and the impact of changes as introduced by the Corporate Insolvency and Governance Act 2020 (‘CIGA 2020’).

SALE ARRANGEMENTS 5.28 In a security-based structure, once the financier has succeeded in taking possession of the aircraft following a default, it will probably exercise its right under the mortgage to appoint a receiver. In English law, a mortgagee, when exercising its power of sale, owes a duty to the mortgagor to take reasonable care to obtain a proper price. One way of satisfying this duty may be to accept the highest bid at a properly publicised auction or to arrange a private sale on the basis of more than one valuation. However, the mortgage will invariably state that any receiver appointed by the financier is deemed to be the agent of the airline and, accordingly, it is the airline that is responsible for any negligence or misconduct by the receiver.

39 Insolvency Rules 1986, SI 1986/1925, r 2.51(2).

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Exchange control 5.30

PENALTIES 5.29 In a lease financing, the lease will provide that on the occurrence of any of a number of specified events of default, the lessor will be entitled to: (a) terminate the lessee’s right to possession of the aircraft; and (b) require the lessee to pay to the lessor an amount equal to the outstanding balance of the finance (either by reference to a specific table of termination values or by reference to an amount representing the aggregate of all future lease rentals, discounted to present value). In English law, the enforceability of such provisions is not always as straightforward as one might expect. As a general principle of English contract law, where the parties to a contract agree that, in the event of a breach, one will pay to the other a specified amount, such amount may be classified by the courts either as a penalty (which is irrecoverable) or as liquidated damages (which are recoverable). A penalty is a contractual provision, the true purpose of which is not to facilitate the recovery of damages suffered by the lessor (without the difficulty and expense of proving actual damage), but rather to ensure that the contract is not broken by requiring payment of an amount which is extravagant in comparison with the greatest loss that the lessor may have suffered. Case law also establishes that if the lessee commits a breach of the lease that is not sufficiently serious to amount to repudiation by the lessee of its commitment, a provision in the lease that purports to make the lessee pay for breaches occurring after the date of termination (regardless of the gravity or triviality of the breach that led to the termination) is unenforceable as a penalty. Upon a first review, these principles appear to undermine the fundamental business arrangement from the lessor’s perspective. However, in practice, the pitfalls of the penalty concept can be largely avoided by making it clear in the lease that the time for performance by the lessee of each of its obligations (including rental payments) is ‘of the essence’. If such a provision is included, the court is much more likely to be persuaded that, for example, a failure to make a single rental payment constitutes repudiation of the contract, therefore justifying the lessor in demanding payment of the full outstanding balance instead of merely the unpaid rental. It will also be helpful if the lease requires the lessor to give the lessee credit for any resale or re-lease proceeds received by the lessor after the date of termination. Generally, the penalty issue does not arise in a loan transaction, where the outstanding balance of the loan represents a debt already owing by the airline to the financier, so that the legal proceedings by the financier in the event of a default will be for recovery of that debt, and not for damages. The penalty principle only applies to actions for damages, not debt.

EXCHANGE CONTROL 5.30 In many jurisdictions, airlines (like other entities) are subjected to exchange control regulations. The financier will wish to satisfy itself, as one of the conditions precedent to closing, that all necessary exchange control consents from the airline’s central bank have been obtained. In some transactions, the financier may seek a direct undertaking from the central bank to ensure that the necessary foreign currency is made available to the airline to enable it to service 75

5.31  Legal Issues in Aircraft Finance its obligations throughout the financing and that the airline will be permitted to remit that currency to the financier without restriction. Little can be done to guard against the subsequent imposition of exchange control, other than to provide for the loan to be accelerated or the lease to be terminated in those circumstances if acceleration or termination can be achieved in time.

JUDGMENT CURRENCY 5.31 There is always an inherent risk that the financier may at some stage recover payments from the airline in a currency other than the stated currency of obligation. For that reason, the financing document should include an undertaking by the airline to indemnify the financier for any losses that the financier suffers as a result of any payments in such other currency. In a cross-border financing, this problem may arise because of legal restrictions in the airline’s country regarding the recoverability of judgments in foreign currencies. For example, although the lease or loan agreement will probably be denominated in US dollars, if the airline defaults or becomes insolvent the financier will probably have to take legal proceedings in the local courts to recover the outstanding loan. Local law may provide that judgments can only be given in the local currency, perhaps converted from the currency of obligation (dollars) at some arbitrary rate or by reference to exchange rates on some date other than the date when the judgment award or payment is made. Under English law, if a contract provides expressly (or impliedly) for the debt to be paid, or damages to be calculated, in a particular currency, judgment will be given in that currency. However, in a cross-border transaction, the financier’s advisers should seek advice from local counsel in the airline’s country to establish the procedural rules governing this aspect.

CHOICE OF LAW 5.32 Any cross-border financing transaction involves more than one nation and, therefore, potentially, more than one body of law. As regards equipment leasing, the international community has made some efforts to impose uniform rules on leasing contracts. However, it is unusual to find any form of standardised documentation of this kind in use in aircraft financings. When analysing any financing, a fundamental issue is determining the correct governing law of the financing document. Generally, the financing document will contain an express choice of law. It is important for the parties to be confident that this choice of law will be upheld in the event of a subsequent dispute. The Rome I regulation40 on contractual obligations (the ‘Rome I Regulation’) and the Rome II regulation41 on non-contractual obligations (the ‘Rome II  Regulation’) provide that parties to a contract are free to agree on the law applicable to their contractual and non-contractual relationships, subject to certain exceptions. This means that domestic courts in the EU member states 40 Regulation (EC) No 593/2008 of the European Parliament and of the Council of 17 June 2008 on the law applicable to contractual obligations (Rome I). 41 Regulation (EC) No 864/2007 of the European Parliament and of the Council of 11 July 2007 on the law applicable to non-contractual obligations (Rome II).

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Contractual issues 5.35 which signed the Rome I Regulation and the Rome II Regulation will uphold the parties’ choice of law, provided that the choice of law does not prejudice public policy in that forum or restrict the application of any mandatory provisions of the law of the forum. A problem encountered in some cross-border financings is that the laws of the airline’s own country may insist that the financing document (particularly if it is a lease or mortgage) is governed by those laws. In these cases, it is particularly important to obtain the advice of local counsel regarding the effect of those laws on the enforceability of the contract terms. Most aircraft financing transactions are, by express choice of the parties, governed by English law or New York law.

Enforceability of English court judgments post-Brexit 5.33 In the wake of Brexit, the enforceability of English court judgments is a point to consider for aircraft lessors. Prior to the UK’s departure from the EU, recognition and enforceability of judgments between EU and European Free Trade Association (EFTA) states was governed by the Brussels I  Regulation (Regulation (EU) No  1215/2012) and the Lugano Convention. After the 31  December 2020 these laws are no longer applicable to the UK and whilst it was initially hoped that the UK would be able to accede to the Lugano Convention in its own right, the consent required to invite the UK to accede was refused by the EU in July 2021. The remaining viable international convention to govern recognition and enforceability is the Hague Convention on Choice of Court Agreements (the ‘Hague Convention’) which the UK acceded to in September 2020 (applying from 1  January 2021) and to which the EU is party. The Hague Convention is significantly more limited in its application as it is restricted to exclusive jurisdiction clauses (or where the agreement is silent as to exclusivity) and likely does not apply to asymmetric jurisdiction clauses. Moreover, it does not cover interim relief such as injunctions and freezing orders. In situations not covered by the Hague Convention, the rules of private international law are determinative. Therefore, in Ireland where a UK judgment does not fall within the remit of the Hague Convention it will be dealt with under common law principles.

CONTRACTUAL ISSUES 5.34 This section covers some of the main contractual issues although, clearly, it is not comprehensive as such a treatment is outside the scope of this chapter.

Quiet enjoyment 5.35 ‘Quiet enjoyment’ means the right of the airline to use the aircraft in its business throughout the period of the financing, without interference from the financier or other parties in the transaction. 77

5.36  Legal Issues in Aircraft Finance In a two-party structure (whether by way of loan or lease), this is a straightforward issue, as transactions involving documents will contain a quiet enjoyment covenant from the lender or lessor. In transactions involving more than two parties (such as multi-tiered lease structures or structures combining a secured loan with a lease), the airline should be advised to obtain an express quiet enjoyment undertaking from all relevant lessor and secured financier parties, because: (a) the airline has no direct contractual relationship with those parties; and (b) in the absence of an express undertaking, it may be uncertain as a matter of law whether the airline would acquire any implied quiet enjoyment right. In return for this direct quiet enjoyment undertaking, the ‘unconnected’ third party will typically insist on certain reciprocal undertakings from the airline (for example an undertaking to enter into a direct lease with the third party if the airline’s direct contracting counterparty defaults or becomes insolvent). However, in some multi-tier transactions, such quiet enjoyment arrangements may be inappropriate. For example, an airline may acquire the use of an aircraft under a long-term finance lease and then agree to sublease it on a short-term basis (for example, under a winter lease) to a second airline. In those circumstances, the owner/lessor would normally insist on the original lessee providing it with an assignment of the lessee’s rights as sublessor under the sublease. However, alternatively, the owner/lessor might agree to waive such a requirement if the sublessee expressly agrees with the owner/lessor that its rights as sublessee are subordinate to those of the owner/lessor and, accordingly, the sublessee will relinquish possession of the aircraft to the owner if the intermediate airline defaults under the headlease. The Cape Town Convention also supports the quiet enjoyment rights of lessees – see Article XVI of the Aircraft Protocol.

Hell or high water clause 5.36 A key provision of any lease agreement is the so-called ‘hell or high water’ clause – the basic concepts are that: • the obligations of the lessee under the lease agreement are absolute and unconditional notwithstanding any event – including for example the nonavailability of the aircraft, insolvency of the lessor or breach by the lessor; • the lessee has no right of set-off or withholding; • the lessee has no right of termination, cancellation or surrender of the lease. Lessees will often seek to water this provision down – specifically by trying to exclude certain situations – for example, breach of quiet enjoyment by the lessor. Lessors will resist these types of carveouts on the basis that the hell or high water clause is a fundamental principle of the leasing product and is an essential component to ensure that the aircraft is financeable and tradeable. The Covid-19 pandemic has put the enforceability of hell or high water clauses under scrutiny and the provision was examined in SalamAir SAOC  v LATAM Airlines Group SA.42 SalamAir SAOC (SalamAir) accepted delivery of three aircraft on lease from LATAM Airlines Group SA (LATAM). The leases included hell or high water provisions obliging SalamAir to pay rent and other 42 [2020] EWHC 2414 (Comm).

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Contractual issues 5.37 associated payments in accordance with the terms of the lease, which were ‘absolute and unconditional irrespective of any contingency whatsoever’. In response to the Covid-19 pandemic, the aviation authority in Oman (like many of its counterparts worldwide) issued regulations which forced airlines to cease operating commercial passenger flights. SalamAir consequently refused to pay rent under the lease and returned the aircraft to LATAM. In response, LATAM sought to enforce its rights under security deposit letters of credit as a remedy for the unpaid rental. The court held that SalamAir could not prove a sufficiently arguable case that the aircraft leases had been frustrated by the aviation authority’s regulations in response to the pandemic. The commercial court held that the existence of the hell or high water provision was fundamentally inconsistent with the argument of SalamAir that the grounding regulations in Oman had the effect of terminating the lease, thereby freeing them from their obligation to pay rent. The court went on to clarify that a long-term fall in the demand for air travel would likewise fail to frustrate the lease on its terms. The decision serves as a reminder that contractual certainty and predictability remain the hallmarks of the English commercial court, and offers little hope to airlines who may attempt to terminate leases governed by English law by the doctrine of frustration. It indicates that lessees will have to fulfil their payment obligations even during a worldwide pandemic, particularly where leases contain hell or high water provisions which include unforeseen circumstances.

Wilmington Trust SP Services Dublin Ltd v Spicejet 5.37 The issue of hell or high water provisions further arose in Wilmington Trust SP Services Dublin Ltd v Spicejet43 which concerned SpiceJet’s lease of three aircraft from Goshawk. Use of one aircraft was curtailed as a result of Covid-19 restrictions, whereas the other two MAX  8 aircraft were grounded in India by the Indian Directorate General of Civil Aviation since 2019 as a result of the fatal crashes involving other MAX 8 aircraft due to design defects. In the wake of these restrictions SpiceJet defaulted on its rental payments and summary judgment was sought by the lessors to recoup the arrears. The key issue for the High Court in England was to consider the arguments of the lessee in light of the hell or high water clause, which noted that rental payments were ‘absolute and unconditional and shall not be affected or reduced by any circumstances …’. In relation to the first aircraft, the defence of illegality was proffered noting that operation of the aircraft would have been illegal in light of Covid-19 restrictions. This was rejected by the court noting that Spicejet had utilised the aircraft during the pandemic and under the hell or high water provision the lessee had assumed the burden of all risks and maintenance of the aircraft. As such it would be ‘impossible’ to interpret the lease so as to suspend rental payments. Concerning the lease of the two MAX 8 aircraft, a defence of frustration was made arguing that the purpose of the lease was to carry out commercial flights and this could not be achieved due to the grounding of the aircraft. The court was prepared to assume the hell or high water provision did not necessarily exclude the possibility of frustration, however, under the provision the risk 43 [2021] EWHC 1117.

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5.38  Legal Issues in Aircraft Finance of grounding was foreseen and had been allocated. SpiceJet’s attempt to rely on frustration was ultimately dismissed as the ‘loss of use’ did not represent a sufficient proportion of the lease term, only about 10%, so the deal was not ‘radically different’ in its performance. This case further confirms the position that the English courts’ focus is on whether the contract can be performed. That is, if: (a) the aircraft has been delivered to, and accepted by, the lessee; and (b) the lease provides that any subsequent risks are on the lessee through a comprehensive and sufficiently clear ‘hell or high water’ clause, then there can be no frustration, except possibly in very rare scenarios. For example, if it was impossible to operate the aircraft for a sufficient proportion of the lease term, rendering performance ‘radically different’. Despite summary judgment being granted in favour of Goshawk, the court ruled that the judgment was to be stayed as any immediate obligation to pay could result in the insolvency of Spicejet and would adversely affect Goshawk. The stay on judgment was to enable an effective mediation or alternative dispute resolution between the parties. This decision will not be welcomed by the leasing community and will force lessors to think carefully when considering their options when lessees default on rent payment obligations.

Return condition and maintenance-related matters 5.38 In lease financings, the return condition of the aircraft at the end of the lease may be important. This depends on whether the lease is a finance lease or an operating lease. A  finance lease will not usually contain detailed stipulations regarding the physical condition of the aircraft on redelivery at the end of the lease term. Instead, it will simply provide in general terms that the aircraft must be in ‘good condition’, subject to ‘fair wear and tear’ from normal commercial operation. Nonetheless, the lease will oblige the airline to store the aircraft at its expense pending resale if it is not sold on the return date. In an operating lease, the return condition of the aircraft will have a critical effect on the residual value of the aircraft on redelivery. As a result, very detailed stipulations regarding the return condition are commonplace. Such stipulations also appear in hybrid ‘walk away’ leases, that is, finance leases where the lessee has an option to return the aircraft at a pre-agreed date or dates (often called ‘window dates’) during the lease term, without the lessor having recourse to the lessee for the unamortised cost. Return condition provisions in operating leases can also contain provisions for maintenance adjustment payments under which the lessor is compensated for the condition and/or utilisation of major components. These provisions can either appear in the lease alongside obligations to pay ongoing maintenance reserves or sometimes operate where such reserves are not payable during the lease term (typically, for very creditworthy airlines). They can sometimes, although not often, operate on the basis of a two-way adjustment (sometimes referred to as an ‘upsy/downsy’ clause) whereby either party can have a payment obligation by reference to the condition of major parts as compared with an agreed benchmark. Other key technical matters that give rise to negotiations in lease transactions include the scope of maintenance obligations; compliance with FAA or European 80

Contractual issues 5.40 Aviation Safety Agency (EASA) standards versus the local aviation authority; airworthiness directive cost sharing and the use of maintenance reserves and, in particular, the increasing use of flight hour agreements or similar arrangements with engine suppliers – the latter arrangements can give rise to significant complexity and additional risk issues for lessors/financiers. There is also the issue, briefly discussed elsewhere in this hook, of the credit risks associated with the payment of maintenance reserves and how these are addressed. For engine maintenance and refurbishment, the development by engine OEMs of maintenance products giving airlines more certainty on the cost of maintenance has given rise to a number of developments including: •

payments by airlines directly to engine OEMs under maintenance agreements in lieu of payments of engine maintenance reserves;

•

agreements between the lessors and the engine OEMs to ensure that the lessors get the benefit of the value built up in these direct payment arrangements in the event of a lessee default and/or on return of the aircraft.

Manufacturer’s warranties 5.39 A purchase agreement for new aircraft is generally entered into between the manufacturer and the airline at a time before the airline has arranged (or finalised) its financing for the acquisition. In the purchase agreement (or in ancillary documents, such as the product assurance document and customer support document), the manufacturer provides various product warranties to the airline together with additional support facilities (for example, maintenance training, flight training and service support). In a lease structure, the purchase agreement is usually novated or assigned (by an agreement between the manufacturer, the airline and the financier) so that the financier assumes the right and obligation to purchase the aircraft. It, therefore, becomes important to determine how the original warranties will be allocated between the airline and the financier. A common method is for the three parties to agree (often in a separate agreement) that for as long as the airline remains the lessee of the aircraft, the airline (rather than the financier as purchaser) will be entitled to the benefit of the warranties and other support items. However, if the lease is terminated following an airline default or insolvency the financier will, on notifying the manufacturer, be substituted as the beneficiary. In loan structures, the aircraft mortgage will typically include a security assignment to the financier of the benefit of the manufacturer’s warranties. However, the drafting of the security assignment should make it clear that the assignment may only be exercised in the event of the airline’s default or insolvency and that the airline is entitled to exercise the warranties at any time prior to default or insolvency. The manufacturer should consent to any such assignments.

Insurance 5.40 As aviation insurance is discussed in detail in Chapter 16, this section provides only a very brief mention of key insurance issues. 81

5.40  Legal Issues in Aircraft Finance From a contractual standpoint, the lessor/financier will have full recourse to the airline for the outstanding balance of the financing or an ‘agreed value’ if the aircraft suffers a total loss. This follows from the concept that risk of loss passes to the lessee once it obtains possession of the aircraft. However, in practice, the financier will not rely on the airline’s credit alone. The financier and its advisers will insist on reviewing the airline’s fleet insurances thoroughly in order to satisfy themselves that the financier has a good prospect of recovering sufficient insurance proceeds to discharge the financing in full. In addition to reviewing the hull and war policies, the financier will also insist on being named as an additional assured under the airline’s fleet liability policies so as to protect it (as well as the airline) against potential ‘deep pocket’ claims by passengers, dependants or other affected third parties in the event of a crash or other incident. Airline insurances give rise to a whole series of detailed legal concerns from the financier’s perspective, which are beyond the scope of this chapter. However, the key point to note is that the introduction a few years ago of a standard form of policy endorsement (AVN67B and its subsequent developments – C and D) in the London insurance market to record the interests of the financier has greatly simplified the lawyer’s task in this area. In the immediate aftermath of the 9/11 attacks, certain commercial aviation insurance covering war risks was withdrawn and governments stepped in with various programmes to cover these risks and keep the airlines flying. This intervention was always intended to be temporary and markets have since come back to underwrite the required coverage. However, the reaction to such terrorist acts affecting the industry highlight the need for a more stable long-term solution to such events, also emphasising the point that aviation insurances should be available to airlines on commercially reasonable terms. Finally, another action in the UK commercial court relating to the Blue Sky case44 – since settled out of court – concerned the protection of a lessor or financier under the insurance cover. The insurers had refused to pay the financier’s hull insurance claim. The defences raised by the insurers brought into question the protection which lessors and financiers have as ‘contract parties’ under the AVN67B insurance endorsement. This endorsement is designed to protect a contract party from the insurance being invalidated due to acts or omissions of third parties, including their misrepresentations and non-disclosure, unless the contract party has caused, contributed to, or knowingly condoned the relevant third party’s act or omission. The financier was named as a contract party on the insurance certificate. The insurers alleged that a contract party owes them a separate duty of factual disclosure at the time the insurance is entered into and renewed. In other words, if the contract party is aware or ought to be aware of certain matters that might be material to the risk, it has to make sure they are properly disclosed to the insurers. This proposition becomes all the more concerning when examples of the non-disclosure by the contract party include the operator’s safety record, its operating routes, the structure of the financing and security taken (share pledge/mortgage/lease) and the potential maintenance provider for the aircraft. These issues were not tested by the court as the case was settled; however, if the insurers are really entitled to this type of defence, then it does call into question the robustness of the insurance protection available to financiers. 44 Blue Sky One Ltd v Mahan Air [2010] EWHC 631 (Comm).

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Asset value guarantees 5.43

ENGINE POOLING 5.41 This section will briefly discuss the issue of engine pooling. ‘Pooling’ is a broad term that embraces: (a) the interchange of large and small items of equipment between different aircraft in one airline’s fleet; and (b) the interchange of equipment between different airlines. Financing and leasing documents commonly permit pooling subject to customary restrictions, most notably relating to the preservation of ownership. Pooling of complete engines or complete engine modules tends to cause most discussion, because a single engine constitutes a substantial proportion of the total aircraft value. When it comes to engine interchange and pooling, most lessors and financiers adopt the following principles: • tending to allow reasonably flexible interchange arrangements within the lessee’s fleet but more cautious arrangements for wider interchange or pooling (that is, where other airlines are involved); • title tracking, namely the principle that a detached engine will remain vested in the original financier/owner irrespective of its location. This is in contrast to ‘title exchange’, the principle that if substitution of an engine takes place, the financier will acquire title to the substituted engine, at least while it is on the financier’s airframe. Title issues can be complex where the local laws imply a concept of title transfer or annexation on installation of the engine on another airframe. These issues should be verified with local counsel; and • some form of basic acknowledgment of interest, via a recognition of rights acknowledgement or similar agreement. A simple form of this document is currently in discussion between the AWG and the International Air Transport Association (IATA) and a form is also attached to the IATA short-term engine lease. Some airlines (particularly very creditworthy airlines) may demand maximum flexibility in engine pooling arrangements, for example, by having the right either to exchange title or to preserve title under such arrangements and having the right to pool outside the fleet. These matters are negotiated on a case-by-case basis, but a lessor/financier is unlikely to accept a flexible title exchange right. Even if the financing documents state that the airline may only exchange the original engines for engines of the same age and condition, there is a risk that, on repossession, the installed engine will differ (in one aspect or another) from the original engines and will consequently possess a different residual value.

CROSS-DEFAULT AND CROSS-COLLATERALISATION 5.42 In multi-aircraft leases/financings, it is essential to ensure that the documents contain adequate trigger provisions to ensure that: (a) a default by the airline in respect of any one aircraft will entitle the lessor/financier to terminate the leasing/financing of the other aircraft too; and (b) each aircraft and/or the collateral given under each lease stands as collateral not only for the loan or lease debt attributable to it but also for the debt attributable to the other aircraft.

ASSET VALUE GUARANTEES 5.43 A  type of collateral that is common in aircraft financing (although less so in recent years than in the 1990s) is the asset value guarantee (AVG) or 83

5.43  Legal Issues in Aircraft Finance residual value guarantee (RVG). This is an undertaking by a third party to the financier that if the financed aircraft is resold on termination of the financing and the resale proceeds fall short of a pre-agreed amount, the third party will pay to the financier all or part of the shortfall. These arrangements are much less common now than in previous years although they are still a feature of some transactions and a brief summary is included in this chapter for the sake of completeness. The AVG first emerged in aircraft financings as a form of support by the manufacturer (generally known as a ‘deficiency guarantee’) under which the manufacturer agreed that if the airline defaulted under the financing and there was a ‘deficiency’ of resale proceeds, the manufacturer would make good to the financier all or part of that deficiency. As these traditional deficiency guarantees were predicated on a default by the airline, the manufacturer would typically insist on receiving a counter indemnity from the airline in respect of any payments made under the deficiency guarantee. They evolved into financing instruments that support leases to the airline with ‘walk away’ or ‘option’, rights (that is, the airline has an option to redeliver the aircraft at pre-agreed dates, with either no obligation or a limited obligation to pay off the balance of financing on those dates), as well as (or instead of) situations where the airline defaults or becomes insolvent. Negotiations on AVGs or similar instruments of all kinds tend to focus on specific contractual provisions, particularly the rights of the guarantor (for example, the right to ‘cure’ payment or other defaults by the airline), remarketing rights, rights of pre-emption and the right to approve any future amendments to the other financing documents. The guarantor will also insist that the AVG provisions ensure that it is not exposed to certain related risks. In particular, the guarantor will expressly disclaim responsibility for the presence or absence of liens on the aircraft, for any defect in the return condition of the aircraft, for any damage that is (or should be) covered by insurance, and for exchange rate risks (for example, if the financing is denominated in a currency other than US dollars). Interesting legal issues also arise in connection with AVGs. For example, it may be important to determine the legal character of an AVG as a contract. Generally, an AVG is not a guarantee (or contract of suretyship) in the legal sense of the word. It is a contract of indemnity, that is, an undertaking to keep a third party (the beneficiary of the AVG) harmless from loss and it represents a primary obligation of the ‘guarantor’. By contrast, a contract of guarantee is an undertaking to answer for the debt or default of another person and to see to it that the other person performs its primary obligations. Nevertheless, AVGs do possess certain characteristics of genuine guarantees. For example, the traditional manufacturer’s deficiency guarantee provides that the obligation to make a payment is conditional on a default by the airline. The benchmark against which the resale proceeds are measured to determine the deficiency is, broadly, the unamortised balance of financing, not a table of projected residual values for the aircraft and the manufacturer may be expressly entitled to certain subrogation rights that are not dissimilar to those available to a guarantor. Another legal issue is whether an AVG constitutes a contract of insurance. If it does, and the asset value guarantor was held to be carrying on an insurance business, the guarantor might require authorisation from the relevant regulatory authority. 84

Aircraft trading/transfers/security 5.47

GENERAL INDEMNITIES 5.44 Finance leases and operating leases will usually include some form of general indemnity by the lessee in favour of the lessor in respect of all operational matters and taxes. This indemnity will cover the risk of operating the aircraft and all liabilities associated with the aircraft and will be widely drafted with limited exclusions that generally follow a market standard. The operational tax indemnity will cover taxes associated with the document itself (for example, stamp duty or other documentary taxes), taxes associated with the sale or transfer of possession of the aircraft, value added taxes and taxes incurred as a result of the operation of the aircraft. However, the well-advised lessee will usually insist on excluding from this indemnity taxes on the overall income or capital gains of the lessor (except in tax-leveraged leases). Again, these indemnities are core pillars of the leasing contract and underpin the assumed risk allocation as between the lessor and lessee. They need to be carefully drafted so as to ensure no gaps are created that undermine the lessor’s business model.

TAX-LEVERAGED FINANCINGS 5.45 In financings that are based on the availability of tax benefits to one or more parties in one or more jurisdictions, the tax indemnity provisions may extend to income taxes. In some transactions, these provisions are expressed not as indemnities but as provisions entitling the lessor to adjust rentals and/or termination payments if the assumed tax benefits are refused or disputed by the tax authorities, or are not available at the time, or to the extent, anticipated. Due to tax changes in the UK and other key jurisdictions, these tax-based transactions are much less prevalent today than in past years. Chapter 14 discusses this type of structure that is available in Japan.

WITHHOLDING TAXES 5.46 The parties and their advisers will usually satisfy themselves before the transaction closes that the financier and the airline are based in jurisdictions which do not impose withholding tax on payments (whether of rental in a lease structure, or of interest in a loan structure) from the airline to the financier. Nonetheless, there is always the risk of a future change of law. The airline is typically expected to assume this risk, by way of a requirement for rentals or interest payments to be grossed up if withholding tax is imposed in future. In this case, the well-advised lessee will usually request undertakings by the financier: (a) to pass back to the airline any tax credit or similar benefits realised by the financier as a result of the withholding; and (b) to cooperate with the airline (albeit at the airline’s cost) in seeking to restructure the transaction so as to circumvent the imposition of withholding tax. Tax matters are covered in Chapter 6.

AIRCRAFT TRADING/TRANSFERS/SECURITY 5.47 Aircraft trading has become a core element of any lessor’s business and the momentum on buying and selling aircraft with leases attached and generally 85

5.48  Legal Issues in Aircraft Finance in groups including large portfolios is a defining feature of the last ten or so years in this business. Underpinning this activity are the provisions in the lease agreement dealing with the sale of the aircraft and novation or assignment of the lease. This is a critical clause for the lessor to get right. It will be framed on the basis that the lessor is entitled to sell the aircraft and transfer the lease without requiring the lessee’s consent. The lessee will usually look for some protections on a number of matters including: • the credit worthiness of the new lessor; • the experience of the new lessor or a servicer acting for the new lessor; • that no additional/increased costs or liabilities will arise for the lessee as a result of the transfer; • the jurisdiction/principal place of business of the new lessor which if different to the existing lessor could impact the tax treatment. A key development in aircraft trading is the development of the Global Aircraft Trading (GATS) system and documentation. The topic is outlined in detail in Chapter 18. These elements are relevant to aircraft trading and ABS structures and some elements are relevant to secured aircraft financing transactions. For completeness, it should be noted that some of these sale/novation transactions get implemented by way of sale of the SPC that owns the aircraft. This avoids the need for a transfer of title and lease novation/assignment but there will likely be a need for some action at the lessee side since a properly advised airline will usually require some form of parent support in the case of a lease from an SPC.

‘AS IS’ DISCLAIMER 5.48 A  further key point for a lessor is that the aircraft is delivered in an ‘as is’ condition – ie the lessor is not giving any warranty as to the condition or fitness for purpose of the aircraft. The airline lessee must satisfy itself as to all technical matters. This concept is underpinned by the ‘disclaimer’ or ‘exclusion of liability’ clause in the lease agreement. In this clause the lessor and lessee agree that the lessor has no liability for any of these matters and that upon execution of the certificate of acceptance the aircraft is accepted in an ‘as is’ condition. This topic was considered in ACG Acquisition XX LLC v Olympic Airlines SA.45 In 2008, ACG Acquisition XX LLC (ACG) entered into a five-year lease with Olympic Airlines SA (Olympic) in relation to a 17-year-old aircraft. The lease agreement required ACG to deliver the aircraft to Olympic ‘as is, where is’ but also contained an undertaking that the aircraft would comply with the detailed requirements specified in the lease agreement as to the condition of the aircraft at delivery. The aircraft was returned from AirAsia and immediately delivered to Olympic who signed a certificate of acceptance which confirmed the aircraft complied in all respects with the conditions required at delivery under the lease agreement. Within a matter of weeks, serious defects were discovered when Olympic put the aircraft into service and the certificates of airworthiness were withdrawn, forcing Olympic to ground the aircraft. Olympic ceased paying rent under the lease and as a result ACG sued for breach of contract.

45 [2012] EWHC 1070 (Comm).

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Other case law developments 5.51 The Court of Appeal held that while the aircraft was not in an airworthy condition or the specified delivery condition at the time of sale, ACG could rely on the absolute nature of the acceptance certificate as conclusive proof of compliance with the contract. Further, rent and maintenance reserves became due under the lease agreement once Olympic accepted and leased the aircraft from ACG. In relation to the delivery condition, it is imperative that due care is given to the drafting of these provisions. Lessors should ensure that the certificate of acceptance is unequivocal on acceptance and that the obligation to pay rent should be absolute. Equally, lessees and purchasers need to exercise caution and satisfy themselves of the condition of the aircraft at delivery and may wish to consider insisting on greater pre-delivery testing and inspection rights under lease and sale agreements and ensure that these are rigidly adhered to.

OTHER CASE LAW DEVELOPMENTS 5.49 While an in-depth review of all case law applicable to the industry is beyond the scope of this chapter, there are some relevant case law developments in the English courts which are worth briefly considering.

Global Knafaim Leasing Ltd v Civil Aviation Authority Ltd46 5.50 Global Knafaim Leasing Ltd (Knafaim) leased an aircraft to Zoom Airlines Inc (Zoom). The aircraft was detained by the CAA for outstanding Eurocontrol fees and the British Airport Authority for non-payment of airport charges. The charges levied on the aircraft related to all amounts owed by Zoom to Eurocontrol in respect of all aircraft in Zoom’s fleet. To release their aircraft, Knafaim were required to discharge the entire fleet lien. Knafaim claimed levying all outstanding charges against one aircraft was unfair and disproportionate especially since Zoom was insolvent, and that the charges were anti-competitive. The claim was dismissed by the High Court which held that the fleet lien power did not contravene European or international laws and rather it was in the ‘public interest’ that the charges should be enforced. In practice, prudent lessors should monitor lessees’ performance and should include extensive and clearly defined covenants in leases to provide for information and access for the lessor. Lessors should monitor aircraft operations, especially in the UK/CAA-controlled airports where the lessee is in financial difficulty. Letters permitting access to lessee account information, Eurocontrol or other applicable authorities should be a condition precedent to closing.

Pindell Ltd v AirAsia BhD47 5.51 BBAM Aircraft Holdings (BBAM) had leased an aircraft to AirAsia via an entity by the name of Pindell Ltd. Redelivery of the aircraft was delayed due to AirAsia’s failure to comply with the return condition specified in the lease agreement. BBAM had already signed a sale agreement with Nordic Aviation Capital in respect of the aircraft and this sale ultimately fell through due to the 46 [2010] EWHC 1348 (Admin). 47 [2012] EWHC 2516 (Comm).

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5.52  Legal Issues in Aircraft Finance aircraft not being made available for sale in the correct condition prior to final date in the sale agreement. BBAM sued AirAsia for loss of profit arising from the aborted sale. The Commercial Court however dismissed the claim holding that the loss of profit claimed by BBAM was ‘too remote’ and ‘not foreseeable’ and thus AirAsia were held not to be liable for the loss of sale. This decision highlights the exposures that lessors and lessees must address in lease negotiations and throughout the life of the lease to ensure that their obligations are clear and defined. It would be prudent for lessors to ensure that a lease should only extend for non-compliance with redelivery condition at the lessor’s behest and that losses arising from failure to dispose or otherwise place an aircraft as a result of a lessee default be express heads of damage (and conversely, lessees should be cognisant of express indemnities to this effect in redelivery clauses). Lessors should also exercise caution when negotiating onward sales and leases of aircraft.

Shaker v VistaJet Group Holdings SA48 5.52 Charles Shaker had paid to VistaJet Group Holdings SA a $3.55 million deposit pursuant to a Letter of Intent (LOI) for the purchase of an aircraft. Under the LOI, the deposit was to be taken from the purchase price of $23.7 million subject to the termination of the LOI by a specified cut-off date of 26 August 2010. The deposit would be refundable if ‘despite the exercise of their good faith and reasonable endeavours fail to reach agreement, execute and deliver the Transaction documents’ by the cut-off date. This date was subsequently extended five times to 17 January 2011. The final extension included an acknowledgement that despite the exercise of good faith, more time was necessary. No agreement was made by this cut-off date and the buyer sought to have their deposit returned but the seller refused claiming a breach of good faith obligation. The commercial court maintained that good faith and the requirement to use reasonable endeavours to reach agreement, execute and deliver transaction documents does not give rise to an enforceable obligation in law. The duty to negotiate in good faith is unworkable on the basis that it is materially inconsistent with the position of a negotiating party. Parties should be aware that such obligations, notwithstanding that they are included in transaction agreements are unlikely to have binding effect. This does not mean that the LOI cannot be drafted to make certain provisions binding upon parties, however clearly defined and legally established standards should be the basis for contractual obligations as opposed to ambiguous terms. In the present case, VistaJet’s obligation to refund the deposit under the LOI as drafted was held to be enforceable, notwithstanding the court’s conclusion on the other disputed terms.

Alpstream AG v PK Airfinance Sarl49 5.53 PK Airfinance Sarl (PK) had financed the purchase of seven aircraft by Alpstream Aviation Ltd (Alpstream) who then leased the aircraft to Blue Wings. PK was granted a mortgage of the aircraft as security for financing. In 2009 Blue

48 [2012] EWCA Civ 1595. 49 [2015] EWCA Civ 1318.

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Other case law developments 5.54 Wings collapsed. Alpstream defaulted and PK sought to enforce its mortgages. PK repossessed the aircraft and arranged remedial works to restore the value of the aircraft before organising the sale of the seven aircraft at public auction. PK itself subsequently bought the aircraft, being the only bidder at the auction. Alpstream claimed that PK had breached its duty as mortgagee to obtain the best price for the aircraft and argued that Alpstream received less than it deserved from the transaction because there were insufficient sale proceeds to flow to it through the agreed payment waterfall. The claim was dismissed on appeal, with the Court of Appeal holding that a mortgagee does not have an obligation to a mortgagor to pay more than they are willing to pay, irrespective of whether the sale was conducted poorly and/or an independent valuation would have produced a higher figure, and that in this instance, the contractual provisions in the waterfall were inconsistent with the establishment of a trust, as Alpstream were contending. This case serves as a reminder of mortgagee’s duties in the context of enforcement. Mortgagees are entitled to take such steps as they consider reasonable when enforcing security and materialising the benefit thereof. The mortgagee’s duty is to get the best price reasonably obtainable – generally a low hurdle – as opposed to the market value at the time. Prudent borrowers should ensure provisions within security documents are drafted in such a way to oblige the secured parties to maximise the value of the security when enforcing rights.

Novus Aviation Ltd v Alubaf Arab International Bank BSC(c)50 5.54 Novus Aviation Ltd (Novus) and Alubaf Arab International Bank BSC (AAIB) entered into negotiations for AAIB to part finance the purchase by Novus of numerous aircraft. AAIB signed a commitment letter sent by Novus, however Novus did not execute the letter. The parties both then took steps to progress the transaction, including nominating directors, setting up bank accounts, incorporating a special purpose company and engaging legal counsel to complete the necessary documentation. AAIB subsequently decided the transaction was no longer financially viable from its perspective and its board resolved not to continue participation in the transaction. Novus sued for breach of contract. The commercial court rejected AAIB’s contention that the commitment letter was not legally binding and held that, notwithstanding the fact that Novus had not signed the letter, there was a clear intention to create legal relations, awarding Novus damages. The decision in Novus highlights the significance of careful and diligent drafting of heads of terms and the importance of a clear and unambiguous statement as to whether or not there is an intention to create legally binding obligations. Parties should separate particular provisions which they intend to be legally binding from those that are not. It should be stated unambiguously that the terms are only binding upon signature by all parties. It would also be wise to state that acceptance, rejection or amendments to terms can only be waived in writing and signed by all counterparties so as to reduce the risk of an implied waiver or verbal discussions, and also to include a general presumption as to the authority of the signatories to bind the parties to avoid any potential argument to the contrary. 50 [2016] EWHC 1575 (Comm).

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5.55  Legal Issues in Aircraft Finance

CHECKLIST OF KEY DOCUMENTS 5.55 Finally, as a brief – not exhaustive – checklist of key documents likely to require drafting, review and negotiation in aircraft financing/leasing transactions, the following may be a useful reference point: • operating lease agreement; • finance lease agreement; • loan agreement/loan facility agreement – including various sub-categories for example: warehouse facility; revolving credit facility; term loan; single/multiple aircraft loan; secured/unsecured loans; • security documents – including aircraft mortgage, lease security assignment and SPC share charge; • servicing agreement – under which a servicer/asset manager will provide services to an asset owning entity; • hedging agreements – under which risks – such as interest rate risks – are managed; • suite of condition precedent documents – will be set out in the lease agreement/loan agreement – including relevant legal opinions; • pre-contract documents – letter of intent, memorandum of understanding, terms-sheet or similar and local law legal diligence questionnaire.

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6 Cross-border Aircraft Leasing: Key Taxation Considerations Joe O’Mara

INTRODUCTION 6.1 When considering cross-border aircraft leasing transactions it is necessary to examine a number of taxation issues. The leasing of the aircraft may have taxation implications on both origination of the lease, commencement of the leasing of the aircraft pursuant to the lease, and ongoing taxation consequences associated with the payments to be made under the lease. Furthermore, aircraft are frequently bought and sold; for example, from a manufacturer to a financing vehicle pursuant to a sale between two lessors or from a lessee to a lessor as part of a sale and leaseback transaction where the lessee/original owner is seeking a means to refinance its assets. In such transactions it is advisable to consider tax issues arising as a result of the transfer of the aircraft, as well as the leasing of the aircraft.

TAX ISSUES ON ORIGINATION OF AIRCRAFT LEASES Stamp duties 6.2 The conclusion of an aircraft lease agreement can attract taxes such as stamp duties or other similar documentary taxes. Although the territoriality of such taxes will differ from country to country, taxes can often potentially arise in both the country in which the asset is physically located on the date of execution of the leasing agreements and in the country where a party executes the leasing agreements. In some cases, stamp duties may not be imposed in a jurisdiction unless the agreements (whether in original or in copy format) are brought into the jurisdiction or perhaps as a condition to a party seeking to present the agreements in a court in that jurisdiction pursuant to a legal action. Therefore, a lessee and a lessor may agree not to take agreements into, for example, the lessee’s jurisdiction of incorporation/tax residence in order to avoid the imposition of any stamp duties payable in such jurisdiction. However, if there is a subsequent legal dispute, for example a termination of the lease which results in the lessor seeking to repossess the aircraft from the lessee’s jurisdiction, the lessor will be required to pay the stamp duty on the leasing agreements before it can enforce its rights in a court of law in the lessee’s jurisdiction.

Import taxes 6.3 The vast majority of transactions involving aircraft are cross-border and, therefore, the leasing of an aircraft is highly likely to involve the delivery 91

6.4  Cross-border Aircraft Leasing: Key Taxation Considerations of an aircraft to a lessee incorporated or tax resident in a jurisdiction which is different to the jurisdiction of incorporation/tax residence of the lessor. This is, therefore, likely to require the aircraft to be imported into the lessee’s jurisdiction of incorporation/tax residence. The import of an aircraft will frequently result in the imposition of customs duties and/or value added taxes (VAT) or other similar sales taxes on the aircraft, and the lessee and/or the lessor’s local tax advisers should be able to advise as to whether any temporary import tax reliefs may be applicable (depending on the length and terms and conditions of the lease) which result in relief of the entire tax liability or at least a reduction in the rate of such tax depending upon the nature of the aircraft or the lessee. Relief from customs duties is available with respect to aircraft imported into the European Union (EU) where the aircraft is registered on a civil aviation register at the time of import. Similarly, a 0% rate of VAT is applied provided that the imported aircraft be operated by an international commercial operator. However, any person wishing to avail themselves of such tax relief should be aware that the relief is not necessarily applied consistently across all member states of the EU and, therefore, may be available in one member state, but not another depending on the terms of the transaction. For example, some member states limit the application of the 0% rate of VAT to transactions entered into directly with a qualifying airline, while other member states apply the 0% rate of VAT on transactions entered into between two lessors provided that the aircraft is ultimately operated by a qualifying airline. Furthermore the test as to whether an airline is ‘international’, which, as discussed earlier, is a condition of obtaining the relief, is not applied consistently between member states. Some member states interpret ‘international’ to mean any airline which does not operate principally domestically in that particular member state whilst other member states will apply an air miles or turnover test in order to assess what proportion of air miles are flown on, or turnover generated by, international flights relative to domestic flights. An important factor to consider in cross-border aircraft transactions is which transaction party will be liable for the payment of any import taxes. Whilst local law may impose import taxes on either the importer or the exporter, in many leasing transactions the parties agree that the lessee will be listed as the importer of record and consequently will have the primary obligation to discharge such taxes (whether on behalf of the lessor where the lessor is legally liable or otherwise). In some jurisdictions, the aircraft will not be cleared through customs until the taxes are paid, but in other jurisdictions there may be deferred payment terms or a self-assessment system. In any event, if taxes which are due are not paid, it is possible that the lessor or owner of the aircraft may incur a secondary liability and there is also the possibility of the aircraft being seized or a lien being imposed on the aircraft until such time as the due import taxes are paid (including any related interest and penalties for late payment). Consequently, in the event that such taxes are payable, the lessor would be advised to ensure that the terms of the lease agreement require the lessee to provide a copy of an official receipt, or other evidence of the payment of such taxes.

Registration taxes 6.4 The import of an aircraft is also likely to require local registration of that aircraft, for example, on the local aircraft registry maintained by the local aviation authority. Apart from any legal issues connected with such registration, 92

Tax issues during an aircraft lease 6.5 registration of the aircraft in a jurisdiction, and maintenance of such registration, may result in the imposition of levies or duties on the aircraft, the lessee or the lessor/owner.

TAX ISSUES DURING AN AIRCRAFT LEASE Withholding tax and lease payments 6.5 Insofar as lease payments are concerned, the tax which tends to attract most of the attention of transaction parties is withholding tax on the lease rent payments. Whilst withholding taxes often represent a full and final income/corporate tax liability in respect of a lease payment, it is important for transaction parties to be aware that this is not necessarily always the case. Depending on the particular circumstances of a cross-border transaction, there may be an obligation for a lessor to make a self-assessment for income tax and/or file tax returns in the jurisdiction of incorporation/tax residence of the lessee. Refunds of some or all withholding taxes may also be available where local law permits a foreign tax resident lessor to take a tax deduction for funding and operating costs which may not have been taken into account in applying the withholding tax. Double taxation agreements between two or more countries may also provide for reductions in income taxes on cross-border leasing transactions. Transaction parties should be aware that most double taxation agreements (particularly those which follow the Organisation for Economic Cooperation and Development (OECD) model) provide for a reduction in tax liabilities but that even where a double taxation agreement provides for a lower rate of income tax, the lessee may nevertheless be required to withhold the full amount of tax and the lessor would need to apply for a refund of the excess withheld in order to effectively obtain the reduction. Typically, however, most countries will have a clearing system which will allow the lessor and/or the lessee to apply a lower rate of withholding tax where certain conditions are satisfied (for example, the completion of a withholding tax exemption form or the provision of a tax residency certificate). When negotiating aircraft leases, it is important for the transaction parties to seek advice in order to ensure that they are aware of such formalities and related procedures which need to be followed before any lease payments fall due. Lessors often also require that such formalities are fulfilled as a condition to the commencement of the lease. Transaction parties should give consideration as to how a particular transaction is characterised under local law and practice as well as under any double taxation agreement. For example, some countries treat operating leases and finance leases differently or the authorities in the lessee’s jurisdiction of incorporation/ tax residence may have a different definition of operation lease and finance lease than that in the lessor’s jurisdiction. This might result in, for example, a lease being characterised as a ‘finance’ or ‘financial’ lease in the lessee’s jurisdiction which may otherwise have tax consequences. In addition, the transaction parties should obtain advice on the local interpretation of double taxation agreements before entering into a lease agreement in order to avoid unintended consequences. For example, some countries treat a payment under a finance lease as a ‘royalty’, whereas others treat it as ‘interest’ and others simply treat it as ‘business profits’, each potentially resulting in a different tax treatment. 93

6.5  Cross-border Aircraft Leasing: Key Taxation Considerations In recent years, the entitlement of lessors to the benefits of double taxation agreements is an issue which has come increasingly into focus. In some double taxation agreements there will be an explicit requirement that the lessor be the ‘beneficial owner’ of the lease rentals in respect of which benefits under a double taxation agreement are being claimed in order for those benefits to be available. Additionally, even where no explicit requirement is included in the text of a double taxation agreement, this condition could come under focus of the tax authority in the lessee’s jurisdiction of incorporation/tax residence. The term ‘beneficial ownership’ is not well defined and is subject to a significant degree of interpretation. At a minimum, it can be said to refer to an interest in the economic benefit of property. Where one person holds property as a bare nominee or bare trustee for another, the other person will, in general, be considered to be the beneficial owner of that property. However, the fact a person is not acting as a bare nominee or bare trustee for another does not necessarily mean that they are the beneficial owner. In an aircraft leasing context, there is an increasing tendency by the tax authorities in a number of jurisdictions to link the concept of ‘beneficial ownership’ with the level of substance a lessor possesses in its jurisdiction of incorporation/tax residence. The major development in the area of double taxation agreements has been the implementation of the Multi-Lateral Instrument (MLI). In November 2016, pursuant to the OECD’s Base Erosion and Profit Shifting (BEPS) initiative, the MLI was issued with the intention of implementing the double taxation agreement-related aspects of the BEPS initiative, without the requirement to update/renegotiate individual tax treaties. Under the MLI framework, participating countries can designate their double taxation agreements to be Covered Tax Agreements (CTAs) and, then subject to its treaty counterparty signing up to the MLI and also selecting the agreement as a CTA, certain changes are made to the double taxation agreement between those two countries. Some MLI provisions are minimum standards that countries must adopt, with limited exceptions, in respect of all their CTAs. Other provisions are optional, and in general apply only where both parties to the CTA have made the same choices. Most countries which have signed up to the MLI have opted to incorporate a principal purpose test (PPT) to their chosen CTAs, the impact of which is to deny a benefit under a CTA in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit (unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the CTA). It is worth noting that the PPT is very subjective and each counterparty jurisdiction could interpret it differently. This risk of different interpretations may give rise to some uncertainty in its application in an aircraft leasing context until such time as MLI signatories develop guidance on circumstances in which the test can be passed or failed. Another important development in this area has been the launch of the Global Aircraft Trading System (GATS) by the Aviation Working Group (AWG), which aims to facilitate the trading and financing of aircraft equipment by reducing the burdens on lessees, lessors and financiers. Under the GATS system, aircraft are owned in a common law bare trust established under the laws of the United States, Republic of Ireland or Singapore. GATS will also permit the use of a Delaware statutory trust which has a separate legal personality. One of the main benefits of holding an aircraft in a trust is that the economic and beneficial 94

Tax issues during an aircraft lease 6.6 ownership of that aircraft can be transferred from one party to another without having an impact on the contractual rights, remedies and protections agreed in the relevant lease agreement. The professional trustee is the lessor of record both before and after the transfer and, hence, there should be no need to novate or assign the underlying lease agreement as a result of a mere beneficial interest transfer of the underlying trust estate. Ultimately, the decision as to whether or not to hold an aircraft in a trust will be influenced by the approach of the lessee’s jurisdiction of incorporation/tax residence to trusts from a withholding tax perspective (ie whether the local tax authority is willing to disregard the trust for the purposes of applying the benefits of a double taxation agreement). One of the objectives of the GATS project is that there is global recognition of the GATS trust as a fiscally transparent entity (or ‘a pass-through entity’) for tax purposes. Lease agreements usually contain tax ‘gross up’ and tax indemnity clauses pursuant to which the lessee agrees to make all lease payments net of local taxes and indemnify the lessor in respect of any local taxes it incurs. When negotiating such clauses the transaction parties need to consider which party should bear any taxes which result from a change in law after the lease agreement has been entered into (although it is a generally accepted fundamental principle of operating and finance leasing that the lessee takes general change-in-law risk). In addition, it is also important for the transaction parties to consider what representations each other should make in relation to tax matters (such as, whether it is appropriate for a party to represent as to its place of tax residency or its right to rely on the provisions of a particular double taxation agreement). These types of representation have the potential to take on an increased significance in the negotiation process where a lessee displays concerns with respect to the ‘beneficial ownership’ and/or MLI issues discussed above. Completion of any administrative procedures to apply lower rates of withholding taxes should also be considered such that the parties will cooperate to ensure that any lower rates of tax which could apply are claimed.

Sales taxes 6.6 Lease payments may attract taxes such as VAT, similar sales taxes or other consumption taxes. These tax liabilities are usually imposed on the lessee, but this is not always the case and, consequently, it is important when drafting a lease agreement to ensure that it is clear whether or not the lessor can charge sales taxes on top of the lease rental payments. This is particularly important where the lessee is not able to get a refund for these taxes. As with sales taxes on imports, it is worthwhile investigating any special rates of tax that may apply (such as the 0% rate of VAT on transactions with qualifying airlines provided for under EU VAT law). If a lessor is required to pay sales taxes on lease payments, this can place a significant administrative burden on the lessor, particularly if communication with the tax authorities in the lessee’s jurisdiction must be conducted in a foreign language (which can result in an otherwise relatively simple administrative process becoming expensive as a local administrator will need to be engaged to overcome the language barrier). The alternative method, applicable in some countries, is for the lessee to be required to account for any sales taxes which arise. While there is still some administrative burden associated with this, typically it is less onerous than requiring the lessor to administer the collection of the tax. 95

6.7  Cross-border Aircraft Leasing: Key Taxation Considerations

Stamp duties 6.7 Other local taxes can also apply to lease payments and leased assets. Stamp duties, for example, may arise in connection with lease payments where the lease agreement is within the scope of the lessee jurisdiction’s territoriality. As noted earlier, a lessor may also incur local income tax/corporate tax liabilities on lease rentals in addition to withholding taxes applied on the lease payments. Local asset taxes, use taxes, or other taxes which can apply based on various criteria or conditions may also apply.

Security deposits and maintenance reserves 6.8 In aircraft leasing transactions, the transaction parties should give consideration as to what tax treatment will apply to any security deposit payments or maintenance reserve payments to be made under the leasing agreements. In some cases, such payments may be treated as a simple cross-border deposit arrangement with no direct tax consequences. In other jurisdictions, however, such payments may be treated as rental payments and may incur withholding tax in the same manner as ordinary lease rent payments.

TAX ISSUES ON TRANSFERS OF AIRCRAFT Sales taxes 6.9 As noted at para  6.1, a sale of an aircraft may attract transfer taxes. Typically, a principal concern will be whether sales taxes could arise on the transfer of title. In this regard, there are a number of aspects of sales taxes which need to be considered by transaction parties in an aircraft sale transaction. Consideration should be given as to which countries may, or will, assert taxing rights over the transfer of title of the aircraft. Often, the tax authorities of the jurisdiction in which the aircraft is physically located might assert taxing rights on the grounds that the aircraft is physically located within their territory. However, even where a country asserts a basic taxing right over aircraft sold in its territory, there may be special rules and exemptions which apply in certain circumstances. For example, if the aircraft is sold in the course of, or in contemplation of, the export of that aircraft to a buyer in a foreign country, sales taxes might not apply to that sale in the vendor country (however, the sale might instead be considered to occur in the country of the buyer/importer which may give rise to other sales taxes). Other countries might also assert taxing rights on different bases. For example, the state of registration of the aircraft might consider it to be a local asset and consequently consider its sale to be within its tax net. Once the potential jurisdictions concerned have been identified, the nature of the transaction under the relevant local law should be analysed. In some countries, for example, the creation of a finance lease with a bargain purchase option might be considered to be a ‘sale’ for sales tax purposes where in others it may be treated as a lease and a possible future sale of an asset. Also, in some jurisdictions, how an asset is used at the time of the sale may be relevant. For 96

Tax issues on transfers of aircraft 6.11 example, if an aircraft is used or exploited for commercial purposes, it might be treated as a business asset and might, consequently, be subject to a different sales tax treatment than an aircraft which is used for leisure purposes or for some other non-business purpose (for example, used by public emergency services). Furthermore, if trusts are used the local treatment may be different to that applicable to a transaction involving the transfer of legal title. For example, some countries will consider the transfer of full beneficial ownership of an aircraft to be taxable (and may ignore the transfer of bare legal title) whereas others might consider only the transfer of legal title to an aircraft to be taxable (and may ignore the transfer of beneficial ownership). Once the nature of a transaction under local tax law is established, consideration should be given as to whether any special rates or regimes might apply. As mentioned earlier, this might include special rates for certain types of aircraft or differing treatment depending on the circumstances of the transaction, for example, whether the aircraft is exported after the sale. In the event that a transfer of title will result in the imposition of sales tax, the transaction parties should determine which party has the obligation to charge and collect the liability. Typically, this is the seller, but this is not always the case. Consideration should also be given to whether the sales tax can be recovered by either party. Where it can be recovered (and assuming it is a reasonably significant amount), this should be expressly addressed in the sale agreement in order that the party who is bearing the sales tax risk on the transfer of title can oblige the other party to assist in the recovery of the tax (if their assistance is required as part of the recovery procedure). However, it should be noted that even where, in principle, the tax can be recovered, in practice it may take some time, perhaps a matter of years, for a refund to be processed. Consequently, even where sales taxes are refundable, careful consideration should be given to the impact of a potentially protracted cash flow cost in waiting for the refund, as well as the administrative costs of pursuing the refund.

Stamp duties 6.10 As discussed earlier at para 6.2, the application of stamp taxes will vary from country to country; however, often they can arise in the country in which the asset is physically present on the date of execution of the sale agreements or in the country where the sale agreements are executed. As noted earlier, in some cases stamp duties may not fall due in a particular jurisdiction if the relevant agreements are not brought into that jurisdiction or until a party seeks to rely on such agreements in a court in that jurisdiction. Therefore, in some jurisdictions, stamp duties may be avoided, provided the sale agreement and related documents are never brought into that country.

Income taxes 6.11 The sale of an aircraft will often have an income tax or a capital gains tax impact for the owner of the aircraft in their country of tax residency and/ or incorporation. However, it can also attract income taxes or capital taxes in 97

6.12  Cross-border Aircraft Leasing: Key Taxation Considerations other countries. While some double taxation agreements may exclude leased moveable equipment from such taxation, this is not always the case. Therefore, in an aircraft sale transaction, consideration should be given to any income tax/capital gains tax liabilities that might arise as well as the basis for the potential liability; for example, by virtue of the lessor having a taxable presence (such as a branch) in the foreign country, because the aircraft is located in that country or because the aircraft is registered in that country. Where a liability exists, it should be established how this liability is calculated. For example, a liability may be based on the gross sales proceeds or on any gain arising from the transfer of title. Where the tax is computed on the gain, the various components of the gain computation should be analysed, such as how the base cost is established and which currencies are used in the computation (for example, local currency or the currency used by the seller to purchase the asset), in order to establish whether any of the components are deductible. Whether the purchaser is liable for any withholding taxes payable on the purchase price should also be established. Where any such liability exists, any potential pre-clearance procedures should be investigated so as to avoid the need for the seller to apply for a refund in the event such liability exists. In preparing a sale agreement, while, typically, transaction parties agree that any income tax risk arising in the seller’s jurisdiction is to be borne by the seller, consideration should be given as to which party should bear any other income tax risks and the appropriate clauses should be drafted to differentiate between the two income tax risk exposures.

Registration taxes 6.12 Where an asset is required to be registered in a particular country (in most cases, the relevant lessee’s jurisdiction) a change of ownership may require the aircraft to be re-registered or for the registry to be updated. The parties should check whether this may result in the imposition of any levies or duties associated with that registration process.

Contractual matters 6.13 When drafting an aircraft lease agreement or sale agreement, transaction parties often agree that all, or substantially all, of the tax risk associated with the transaction should be borne by one of the parties (and consequently, an appropriate tax ‘gross up’ clause and tax indemnity is included in the agreement). From the perspective of the party which is not contractually liable for taxes, this arrangement would appear to effectively convert its tax risk to credit risk inasmuch as its counterparty is contractually liable for any tax liabilities accruing to such party. In practice, however, all parties to a transaction should ensure they have a good understanding of all the tax issues in relation to any transaction they enter into because there are a number of potential problems with total reliance on tax gross up and indemnity clauses. Such an approach assumes that the counterparty contractually responsible for the tax liabilities will be able to pay any liabilities which arise. If the counterparty becomes insolvent, then the indemnified party 98

Conclusion 6.14 may have to discharge some of the tax liabilities itself (either as the primary liable party or through secondary liability for the counterparty’s taxes, where such a liability exists). In addition, there may be unusual local taxes and liabilities which are not adequately dealt with by a boilerplate gross up clause or tax indemnity clause. Only by understanding the local tax issues will transaction parties be able to ensure that the transaction documentation clearly ascribes the relevant tax risks between the parties in the manner commercially agreed. Furthermore, where the indemnified party has a primary obligation to pay taxes and file returns (albeit on the basis that the counterparty must ultimately bear the tax liabilities) if the indemnified party does not properly investigate and understand its obligations, this could result in significant interest and penalties (both financial and criminal) arising as a result of failure to discharge its tax obligations. Even where such costs are, in principle, covered by a tax indemnity, the counterparty might argue that it should not have to bear the cost of any interest and penalties where they arose as a result of negligence by the indemnified party in filing its tax returns and such situation may otherwise be an express exception to the counterparty’s liability pursuant to the indemnity clause in the transaction documentation.

CONCLUSION 6.14 There are a wide range of taxation issues which should be considered prior to entering into a cross-border aircraft leasing transaction which can entail the application of tax laws in multiple countries. Frequently, issues and tax heads will differ from country to country and laws common to more than one country (for example, double taxation agreements or international laws such as EU VAT law) will be subject to different local interpretation and practice. Therefore, it is important for transaction parties to ensure that when entering into cross-border transactions all of the relevant local issues are fully investigated and understood.

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7 In-House Valuation – Lessor Perspectives Randy Nightingale

INTERNAL VALUATION VERSUS EXTERNAL VALUATION 7.1 One of the initial decisions of a commercial aircraft owner/investor (investor) is whether they develop internal valuation expertise (internal team) for aircraft valuation or rely upon external valuation expertise (appraiser). This section will compare and contrast the advantages and disadvantages of each. The later sections of this chapter will delve into internal valuation. The starting point for this valuation is a consideration of deal volume. This includes both how many deals will be reviewed and the amount of money the investor is looking to spend on aircraft over a multi-year horizon. Further, the investor needs to understand their ability to build and retain an internal team versus relying on one or more appraiser. Ultimately, the investor needs to make a decision about which approach is most appropriate for their current and longterm goals.

Pros and cons of internal valuation team (internal team) 7.2 Pros Cons Internal team preferences are specific Different appraisers have different to the Investor. opinions on current and future values for aircraft. Internal team can focus on key Internal team may not be as aircraft and engine types. proficient with as many aircraft or engine types as an appraiser. The understanding of each deal is Internal team may have less possibly greater if it is done by the availability than an appraiser. internal team. Able to track known deals and trends Certain appraisers see many to understand market. Access to all of more market transactions than an the investor’s deals. internal team. Ability to coordinate with key Time, effort and cost to train and functions including: legal; technical; retain an internal team. commercial; and risk. 101

7.3  In-House Valuation – Lessor Perspectives

Pros and cons of external valuation (appraiser) 7.3 Pros Cons Using an appraiser allows for a lower Adding more appraiser services fixed cost base for the investor. increases cost to the business. Easier to add appraiser capacity for large projects like M&A or large portfolios transactions. Appraisers generally have a broader knowledge of aircraft and engine types.

Appraisers generally have a broader knowledge of maintenance costs and intervals.

Investor’s upside and downside do not impact the appraiser. Appraiser objectives may not align with investor’s objectives. Appraiser may not be as aware of lessee and jurisdiction concentration risks as an internal team. Internal teams, if properly trained, can identify maintenance compensation upside and downside to each transaction.

Key aircraft valuation terms 7.4 The following terms will be used throughout this chapter: • Current market value (CMV): This is the value of the aircraft in the current market. It assumes an arm’s-length transaction that is not distressed. As implied in the description, CMV only applies to a current value (near term) not the value in a future year as the ‘current market’ could change significantly over the next year or more. CMV should also consider an average maintenance condition. This would typically be about half-life condition by age five and better for younger aircraft. CMV generally does not assume that a lease is in place as there is a separate description/value for a lease-encumbered value. • Base value (BV): This is the value of the aircraft in an average market that assumes that supply and demand is reasonably balanced. BV should consider applicable historical trends and projections of future values. BV assumes an arm’s-length transaction that is not distressed. BV can apply either to the near term or a future year, assuming balanced conditions. BV should also consider an average maintenance condition. This would typically be about half-life condition by age five and better for younger aircraft. BV generally does not assume that a lease is in place as there is a separate description/value for a lease-encumbered value. • Lease-encumbered value (LEV): This is the value of the aircraft considering an associated lease. This value includes consideration for the following lease terms: rent; lease term; security; maintenance compensation; any lessor commitments; an estimate of future residual values; lessor or lessee options to purchase the aircraft or extend the lease; and any other material terms which can influence value to the lessor or lessee. Finally, the LEV will take into consideration an appropriate discount reflecting risks associated with the lease, lessee/operator, jurisdiction, and aircraft. 102

Approach to internal valuation 7.7

Appraiser differences 7.5 It is important to note that different appraisers may have materially different CMVs, BVs and LEVs. This may be due to a variety of reasons including preferences, judgement, methodology, opinions about supply and demand and applicable historical data points. The user of appraiser values should consider multiple sources, experience of each appraiser and potential bias.

APPROACH TO INTERNAL VALUATION Structural influences 7.6 As noted in the ancient Greek expression ‘know thyself’ the approach to valuation for an aircraft should first consider the following aspects: ownership structure; debt structure; cash flow structure; and performance metrics. For instance, a publicly traded lessor may look for a different return and growth profile than a lessor that is closely held. A  publicly traded lessor generally focuses a little more on sequential growth and quarterly profitability, while a closely held lessor can focus on value changes which may be outside of financial statements. Debt structure changes the leverage, risk and profitability of that deal. The higher the debt-to-equity ratio, the higher the risk is elevated, and the levered returns can be significantly higher if the deal performs as expected. Cash flow structure is key to understanding if aircraft cash flows after the initial investment will cover debt service and transition costs or whether the investor may need to provide additional cash after the initial investment. Finally, the key metrics that the owner will use to evaluate the deal and measure actual to estimated performance must be established. The one measure that is commonly used is unlevered internal rate of return (IRR). IRR provides the average annual return of all deal cash flows excluding debt service. In addition to unlevered IRR, measures of profitability by year are important to many owners.

Components of valuation and risk 7.7 The next step in valuation is to consider the following three key attributes of the deal: asset; lessee/operator; residual value. The asset incorporates details about the aircraft type, date of manufacture, engine type and thrust. The lessee/ operator, while important during a strong market, is crucial during a down market. The risk of repossession and restructuring is highly dependent upon the lessee/operator. Finally, the future residual value has a major impact on the evaluation of each deal. There are a couple of ways to consider a residual value. It is important to consider appropriate prospects for the aircraft at the end of the current lease. These alternatives include: • an extension of the current lease; • transition and lease to another operator; • conversion to a freighter; • sale as is, or part-out. The assumed residual value is the net present value (NPV) of all future cash flows of applicable options. 103

7.8  In-House Valuation – Lessor Perspectives

Other key valuation influencers 7.8 The other primary value drivers for an aircraft with a lease include: (1) rent; (2) maintenance compensation; (3) security structure; (4) contract/lease; (5) debt assumptions; (6) aircraft specification. Rent is generally the most significant cash flow component for newer aircraft. It may or may not adjust to interest rate movements. Typically, rents will have less adjustments for interest rates when leases are originated in low interest rate environments. Over the past five years in a strong majority of operating lease transactions rents do not adjust for interest rates after the original delivery date. Maintenance compensation is the agreement between a lessee and lessor for the usage of major technical components. Examples typically include: overhauls to the airframe; landing gear; auxiliary power unit (APU); engine performance restoration (EPR); and engine life limited parts (LLP). Typically, the aircraft will be returned in a different condition than at delivery. The maintenance compensation terms define who pays, how much and when the payments are due. The amounts related to maintenance compensation can be very material and are a key consideration with regard to the riskiness of the cash flows. A lease that includes monthly cash payments of maintenance compensation provides strong benefits to the lessor related to the receipt of cash before a claim is expected. Generally, these cash flows would be factored into the valuation model until they are expected to be repaid. The security structure includes security that the lessee provides for the lease commitments. This may include separate amounts tied to maintenance. Security amounts may include cash deposits, letters of credit, or guarantees from another party. The quality of the contract/lease has a significant impact on risks during the lease and its value at lease expiry. The lease and amendments will need to be reviewed to understand any lessee and lessor options, maintenance standards, minimum return conditions, ability to substitute parts or engines, etc. Since many leases are individually negotiated it is important to understand the lease and amendments. Value drivers (1)–(4) all assume that an aircraft is subject to a lease. Assumptions can be made for aircraft off lease that include anticipated downtime, storage cost, transition cost, modification cost, and maintenance expenses. Clearly, there is more volatility and uncertainty for the investment in an aircraft that is not on lease. Debt is used by the investor to allow for a smaller investment in the aircraft. The key assumptions include: the initial advance rate; base interest rate; assumed debt margin; duration of the debt; and the debt balloon at the end of the lease. Understanding the debt service cost is key to understanding whether the lease cash flows are adequate to service the debt. One other aspect to consider in relation to an aircraft is the specification (spec). It is important to understand if the current spec will require material costs at 104

Coordination with contributors 7.10 transition to another operator. Aspects to consider include: low thrust levels on engines; low operating weights; and cabin configurations that are less common. For instance, an all-economy high-density configuration for single-aisle aircraft generally is more desirable and leads to lower transition costs. One final aspect to consider for valuing and measuring the return of a deal is the investment horizon. For the valuation of an aircraft that is one-year-old with 11 years of lease term remaining, a typical investment horizon would be 11 years. For an 11-year-old aircraft with one year of lease term remaining it is best to consider an investment horizon that includes realistic assumptions for a second lease. When evaluating the returns of an aircraft which has a life of 20+ years, an investment horizon of one or two years is just too short to consider only one lease.

NECESSARY SKILLS 7.9 Most lessors set up a group structure with varying degrees of experience within the pricing/valuation team. This allows for more experienced professionals to mentor the less experienced team members. Successful valuers can come from diverse backgrounds and generally have the following traits: desire/passion; strong communication skills; are observant; are logical; and have the ability to see correlations. As noted by Malcom Gladwell in his book Outliers, there is a high correlation between thousands of hours of deliberate practice and people with extraordinary skills. Even with excellent mentorship it is a multi-year process to develop valuation proficiency. The following variability leads to challenges in developing a deep understanding of valuation: • cyclical nature of the aviation finance; • development of new aircraft types; • individually negotiated leases; • maintenance costs and time between intervals (especially for new aircraft and engine types); • projected supply and demand by aircraft type; • innovations in financing; • innovations in structuring. Due to the significant impact of economic cycles that may take five to ten years to play out – patience is required to achieve a high level of expertise.

COORDINATION WITH CONTRIBUTORS 7.10 The valuation model should not only consider the simple commercial terms, but it should also consider input from all of the key teams within the lessor. Communication with other teams is the key to properly valuing a deal: • Technical: – current and future maintenance condition; – costs of maintenance and intervals between overhauls; – operational environment influence and spec influence; 105

7.11  In-House Valuation – Lessor Perspectives – transition and modification costs; – quality of maintenance standard and return conditions. • Risk/credit: – estimate of lessee/operator risk; – jurisdictional risk. • Commercial: – current lease terms vs market; – assumed supply demand at lease expiry; – estimate of residual at lease expiry. • Legal: – understanding of any terms which could influence value or risk profile; – understanding of any rights and options. • Capital markets: – debt assumptions applicable to the deal; – consideration of lease cashflows vs debt service.

IMPORTANCE OF DATA AND EVALUATION 7.11 Data and evaluation are a key factor in providing a feedback loop to the decision makers. Properly done, this should provide a current picture of the market and how it has been trending. Ten years ago, there were far fewer transactions and data was more difficult to capture; today there are more transactions that allow for decent datasets to create good feedback about valuations which are independent from appraiser input.

DOCUMENTATION, COMMUNICATION AND APPLYING BEST PRACTICES 7.12 The goal of the valuation process can be simplified into ‘Generating confidence in decisions’. This confidence is earned through the following: • clear documentation of any deal being considered (including explanations as applicable); • tracking of deals in process, completed deals and high confidence comparable deals; • communication of results and trends; • evaluation of internal valuations vs third party appraised values; • having flexibility to make changes to improve the documentation or process; • ensure that each active deal is compared with deals with similar traits. The valuable feedback loop creates an important connection point between the valuation team and the senior decision makers in a lessor. The key for valuation team will be to communicate evaluations objectively to build confidence in the process and decisions. Deciding to avoid a transaction is as important as agreeing to a transaction. 106

Conclusion 7.13

CONCLUSION 7.13 Different investors may choose different valuation approaches depending upon their size and anticipated deal volumes. For those that build or upgrade an internal valuation team, there are numerous benefits including understanding the aircraft leasing market and trends. Reflecting on past performance and transactions is also helpful in building experience and proficiency. Finally, structuring a valuation team with suitable mentorship, thoughtful documentation and analysis, applying best practices and communicating in an objective manner will boost confidence in decisions.

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8 Risk in Aviation Finance Arthur Gaskin

INTRODUCTION 8.1 This chapter will provide the reader with an overview of the key areas of concern in risk analysis of the aviation industry. It focuses on the credit worthiness of an airline or an aviation lessor. The majority of the focus will remain on airlines, given that there are a great deal more airlines acting as going concerns than aviation lessors, but, nonetheless, the techniques that are used to examine airlines can equally apply to aviation lessors. Credit techniques are used by a plethora of interested parties who participate in the aviation industry. The techniques used are applied by banks, investors, credit agencies, pension funds, insurance companies, in fact anyone with an interest in investing in aviation assets. This can range from buying stocks on quoted airlines or aviation lessors, to acquiring bonds in aircraft asset-backed securitisations, to bankers lending vast sums to original equipment manufacturers (OEMs), airlines or lessors to manufacture or acquire aircraft. The financial information provided by participants in the aviation industry comes with caveats, in that it is typically backward looking, with limited forwardlooking statements, whereas investing in aviation assets is with a view to a long-term strategy. While financial data are extremely important in analysing the industry, these are open to interpretation, have certain limitations, and will not provide the full picture for interested parties. It is imperative to understand this fact and to place its importance in the wider context of risk management, regarding players in the aviation markets.

PORTFOLIO RISK MANAGEMENT 8.2 Credit risk analysis is a subset of the portfolio risk analysis approach taken by lenders or suppliers of capital/aircraft to either airlines or aviation lessors. Typically, the providers of finance or credit will utilise a four-pillar approach to this analysis. These four pillars are. (1) asset risk analysis; (2) counterparty risk analysis; (3) transaction risk analysis and security; (4) jurisdictional risk analysis.

Asset risk analysis 8.3 Portfolio management refers to the art and science of making decisions regarding investment mix and policy, matching investments to objectives and asset 109

8.4  Risk in Aviation Finance allocation, while balancing risk against performance. All players from investors, airlines, bankers, and lessors must optimise their portfolio management. Asset risk analysis refers to the aircraft or asset type which is subject to finance. It will also refer to the engine type on each aircraft. In order to alleviate this risk, providers of finance or lessors will seek to optimise their portfolio of assets. The asset selection will require a disciplined approach, which will seek liquid, high quality assets, whereby there is a large installed fleet and operator base for the asset, on a global basis. For example, the Airbus A320 (A32F) family and Boeing 737 (B737S) series have a significantly larger number of airlines that utilise these fleets (circa 300) than say families of widebody aircraft. Financing these aircraft reduces asset risk as they provide significantly wider options to transition them to other operators if there is a credit default with the original operator or owner. The avoidance of aircraft types with shallow secondary operators, through lease or acquisition, mitigates asset and impairment risk. A  deeper pool of operators provides financiers with more comfort, as this makes the asset more liquid, generates more trading opportunities, which facilitates ongoing portfolio management. The key goal of asset risk analysis is to acquire a liquid portfolio of in-demand aircraft assets today, while investing in the most in-demand aircraft for tomorrow, thereby maximising their utilisation and residual value under ownership.

Counterparty risk analysis 8.4 Counterparty risk analysis refers to the risk that the counterparty will not meet its obligations under the terms of a contract that it has entered into with the provider of finance or an asset under a lease or loan agreement. Counterparty risk is subdivided into two areas. These are quantitative risks and qualitative risks. Each of these risks hold equal weight in practice and will be analysed in more depth later in this chapter. To accurately establish levels of counterparty risk will require investment and time from a wide variety of sources. It will require a strong team within the organisation providing the finance, but equally sources external to it can be utilised, such as regulatory or governmental sources. Over time a degree of counterparty risk can be established, but this will deviate, due to many factors both internal and external to the counterparty (for example, from poor financial performance to staff strikes, to macroeconomic or political/ legal changes). Investment is required to understand these factors and to mitigate the risk levels. Ideally a finance provider will seek to be proactive and anticipate these issues, take early corrective action if possible, and mitigate the downside risks.

Transaction risk analysis and security 8.5 The structure of the transaction refers to the risks involved from a commercial, legal and tax perspective. There are a multitude of areas which can affect the risk associated with a transaction. From a credit perspective the most important aspect will be the security deposit or letters of credit supplied 110

Credit risk analysis of airlines and lessors 8.8 by the counterparty. Are these based on industry standards or are supplements required? Are government guarantees or parent guarantees provided and how adequate are they? A key risk area relates to maintenance reserves and their management over the length of the transaction. Does the operator of the asset provide supplemental rents, and will these protect against future maintenance obligations over the duration of the contract? What is the past performance of the operator of the asset regarding maintenance reserves and have they proven difficult to manage in previous transactions? Many lease agreements are based on power by the hour (PBH), or flight hour agreements (FHA) as opposed to monthly lease rentals (many now prevalent during the Covid-19 pandemic). It will be necessary to understand how these arrangements impinge on the credit risk of the transaction, as inherently they are likely to increase these levels of risk towards the owner of the assets.

Jurisdictional risk analysis 8.6 Jurisdictional risk refers to the risk involved in conducting business with the counterparty’s home jurisdiction. Certain jurisdictions will be inherently riskier than others due to sovereign risk, such as political stability, the credit rating of the jurisdiction, macro-economic environment and so on. A  key feature of jurisdictional risk analysis is to establish if the counterparty jurisdiction has signed up to the Cape Town Convention. The most significant risk for the owner of any aviation asset is to have the asset impounded or to have a lien placed on it by a sovereign jurisdiction. This can happen for a variety of reasons (eg the operator of the asset has failed to pay local taxes due), but it is the owner who suffers the most significant costs in lost revenue and equally in repossession risk ie in legally obtaining repossession of the asset if necessary. Jurisdictional risk analysis will focus on the issues involved in obtaining repossession of an asset and equally understanding creditor rights within each jurisdiction. This will require knowledge of the legal process involved, but equally any knowledge gleaned from experience of those that have previously repossessed assets from the same jurisdiction.

CREDIT RISK ANALYSIS OF AIRLINES AND LESSORS 8.7 A detailed credit risk analysis of an airline or aviation lessor will require scrutiny of the financial information provided by them. This will include audited annual financial information, quarterly management accounts and forecasts, business plans and projections. All of this information is equally valid and will provide its user with a valuable tool to assess the organisations’ credit risk, and how that fits in with the organisations overall risk profile.

Accounting policies and the basis used for accounting 8.8 The accounting policies of any organisation are the starting point in reviewing its financial information. As the aviation industry is a global one 111

8.9  Risk in Aviation Finance with lessors and airlines located all over the globe, the basis of accounting ie  international financial reporting standards (IFRS), US generally accepted accounting policies (US GAAP), or local GAAP should be established. Each basis uses different methodologies to account for certain items, depending on judgements, estimates or prior experience. Each basis can account for the same item quite differently. In the airline industry this can manifest itself regarding revenue recognition, treatment of operating or finance leases, the accounting treatment of frequent flyer programs and numerous other issues. Understanding which basis is used and how items are accounted for within IFRS, US GAAP or local GAAP is a requisite first step in credit analysis. The second step is to understand the critical accounting policies adopted and the methodology used to adopt those accounting policies. The directors of a company present the financial statements for review and they are based on their judgement regarding the most appropriate accounting policies to be used. Some industry specific examples should clarify this.

Depreciation policy 8.9 The largest expense that any airline or aviation lessor potentially will have will be the acquisition of aircraft and aircraft engines. This will throw up the issue regarding the most appropriate depreciation policy to be employed by the owner of these assets and the level of information disclosed in the financial statements. Aircraft are typically used over a 20–25-year time frame, although in many cases they can be used for many years longer than that. Given the size of the investment in them, the depreciation policy can have a material impact on the financial statements. A review of many airlines will show that aircraft can be depreciated over anything from 15–30 years on a straight-line basis, or a reducing balance basis, a sum of the digit’s basis, or they can be depreciated over a certain timeframe with a defined residual value remaining eg  15–20% of the original value. Many airlines and lessors do not specifically outline the depreciation policy by aircraft type (eg narrow versus widebody aircraft, A32F or B737S) although some airlines do so. The more information available to the user of the financial information, the better the possibility of making an informed decision as to the appropriateness or otherwise of that policy. A further issue to consider is to establish if the accounting policy is consistently applied year on year by the owner of the asset. Does it change over time, in order to improve the financial position of the organisation, and how realistic is the policy when reviewing potential residual values implicit in the financial data? When an organisation invests billions of dollars in these assets, this accounting policy is critical to understand the financial position of an organisation as it is open to wide variation, different estimates, and interpretation.

IFRS 16 8.10 The vast majority of leases utilised within the aviation industry are operating leases (as opposed to finance leases). The accounting treatment for operating leases is based on IFRS 16, which changed the accounting treatment from annual reporting periods on or after 1 January 2019, with earlier adoption allowed. This change has had significant implications for lessee accounting and therefore financial statement analysis and credit analysis of the lessee. 112

Credit risk analysis of airlines and lessors 8.11 Prior to the change, operators of aviation assets under operating leases charged their profit and loss account with the annual lease charge, which typically was included in operating expenses ie above the line of operating profit. There was no balance sheet entry for the lessee. In 2019 and subsequent years, adopting IFRS 16, the lessee should create a right of use asset and corresponding liability on the balance sheet, over the term of the lease. The profit and loss account will be charged with depreciation of the right to use asset and an interest charge. The depreciation charge for the right to use asset is included above the operating profit line, whereas the interest charge is debited, below the operating profit line and is included in net interest expense. On the balance sheet side, the liability created for the right of use asset is typically displayed between current liabilities (less than 12 months) and longterm liabilities (1+ year). This is done for ease of comparatives and analysis. Within the cash flow statement, the depreciation charge for the right of use asset is added back to net cash from operating activities in the normal way. The interest charge, however, is included within cash flows used in financing activities as ‘repayment of lease liabilities’. This change in methodology under IFRS 16, for a relatively simple accounting entry, can create a distortion in comparing the same entity’s financial performance from one year to the next, across all of the main primary financial analysis tools available (profit and loss account, balance sheet and cash flow statement). This creates a mismatch over the prior treatment of the same asset in prior years unless the lessee has restated their financial statements in prior years. If they have not done so, the user of the financial statements will have to do so in order to obtain a meaningful comparative. In addition, certain airlines and lessors will have adopted the policy over different timeframes, so comparatives between entities in the same industry should be done under the same accounting policy. This example displays the inherent risks in reviewing financial information, for the same company. This can also apply to different airlines within the same markets, who may be slow to adopt the accounting policy, or who may not do so under local GAAP accounting. It can also be applicable to other existing accounting policies under the different basis, and it will apply when further changes are made in the future.

Deferred tax 8.11 Deferred tax is a complex area that can provide significant difficulties for users to understand. Deferred tax is provided in full, using the balance sheet liability method, on temporary differences arising from the tax bases of assets and liabilities and their carrying amounts in the consolidated financial statements. Deferred tax is determined using tax rates and legislation enacted or substantively enacted by the balance sheet date and is expected to apply when the temporary differences reverse. In calculating the corporation/income tax liability of a company, the tax calculation in any year may legally utilise temporary timing differences on assets and/or liabilities to generate the cash tax liability for a particular period. These timing differences may reverse in the future, and the deferred tax calculation is utilised to ascertain what this reversal may be. If available, the user of a set of financial statements should obtain a copy of the deferred tax calculation, and ideally a copy of the entity’s corporation tax calculation. This will shed light 113

8.12  Risk in Aviation Finance on the suitability or otherwise of carrying a deferred tax asset. A deferred tax liability should always be included in the financial statements under the prudence principle. Temporary timing differences typically apply due to differences between accounting depreciation on assets versus tax depreciation on the same assets and also due to the availability of the carry forward of tax losses. Many jurisdictions do not allow an entity to carry forward tax losses permanently, so an assessment is required to establish if they will ever be utilised in full, and if the deferred tax asset they provide will be recoverable in full in the future. In many cases it will not be, and therefore the carrying of the deferred tax asset is inappropriate and will distort the analysis and performance of the entity under review. A  deferred tax asset is recognised to the extent that it is probable that future taxable profits will be available against which temporary differences can be utilised. The carrying amounts of deferred tax assets are reviewed at each balance sheet date and reduced to the extent that it is no longer probable that a sufficient taxable profit will be available to allow all or part of the deferred tax asset to be realised. Every jurisdiction each year will have an annual finance bill or tax budget, whereby the personal and corporate tax rules are changed. These are generally outside the control of management of entities in the corporate world. Is it prudent to retain a deferred tax asset, when the basis for its retention can be removed annually by the local parliament or government and management have little or no input regarding it? Just three areas which typically arise in practice regarding the impact that accounting policies have on the financial information provided to users of these statements have been highlighted. There is effectively an infinity of different scenarios that can arise and the appropriateness or otherwise of their use will differ over time and between different industries. However, it is imperative to understand their impact in order to make an informed decision on the information provided by each entity over time, and also across different entities within the same industry.

Foreign exchange, interest rate and fuel hedging strategy 8.12 For airlines and aviation lessors, foreign exchange/interest rate risk and their fuel hedging strategy are vital components that must be managed efficiently, hopefully to reduce costs but equally to manage costs and to provide certainty for management and debtholders.

Foreign exchange risk 8.13 As the aviation industry uses the US dollar to transact for aircraft acquisitions and lease rates, airlines will have to manage their foreign exchange risk if their income is in non-US dollar as most of their expenditure costs (aircraft through acquisitions/leases, maintenance costs, funding costs, fuel costs etc) will be in US dollar. This can create significant issues if income is booked in a currency which is perpetually weak against the US dollar. As an example, Ryanair, in its recently published 2020 financial statements, notes that its income comes primarily in euro (66%) and pounds sterling (24%), yet its expenses are primarily in euro, pounds sterling and US dollar. Ryanair’s operations can be 114

Credit risk analysis of airlines and lessors 8.14 subject to significant direct exchange rate risks between the euro and the US dollar because a significant portion of its operating costs (particularly those related to fuel purchases) is incurred in US dollars, while practically none of its revenues are denominated in US dollars. Appreciation of the euro against the US dollar positively impacts Ryanair’s operating income because the euro equivalent of its US dollar operating costs decreases, while depreciation of the euro against the US dollar negatively impacts operating income. It is Ryanair’s policy to hedge a significant portion of its exposure to fluctuations in the exchange rate between the US dollar and the euro. From Ryanair’s perspective, fluctuations between the euro and pound sterling will have an impact on revenues and costs, which must also be managed through derivative instruments. For airlines that receive income in currencies that are consistently weaker than the US dollar, this can have a dramatic effect on income, as flights may become too expensive for airline customers to cover the airline’s costs, the majority of which are always quoted in US dollar. This can have a dramatic effect very quickly and significantly impact on the credit of the airline in a short space of time. Airlines in Latin/South America and Asia have suffered from these currency fluctuations throughout their history.

Interest rate risk 8.14 Airlines can typically use interest rate hedges or cross-currency interest rate swaps in order to manage their interest rate exposures. Their goal is to either minimise the cost of borrowings incurred or to provide certainty on their costs of borrowings. This can be done by swapping variable rate exposures to fixed rate exposures, vice versa, or by locking in a lower variable rate. This will depend on the needs and strategy of the organisation and it should be discussed with management, including the accounting treatment of these derivatives. Again looking at Ryanair’s  2020 financial statements, the company entered into a series of cross-currency interest rate swaps to manage exposures to fluctuations in foreign exchange rates of US dollar-denominated floating rate borrowings, together with managing the exposures to fluctuations in interest rates on these US dollar-denominated floating rate borrowings. Cross-currency interest rate swaps are primarily used to convert a portion of the company’s US dollar-denominated debt to euro and floating rate interest exposures into fixed rate exposures and are set to match exactly the critical terms of the underlying debt being hedged (ie notional principal, interest rate settings, re-pricing dates). Ryanair believe these derivatives to be effective and account for them through equity. For an aviation lessor, its funding costs and how it manages those costs, is one of the most important strategic aspects of its business. Lessors must look at this cost on a daily basis and should attempt to find as many sources of liquidity as the market will provide to them. To give this area its full due would probably require a complete textbook in itself. Nonetheless, from a credit perspective, a lender or investor needs to understand the strategy employed by management, assess its role in past performance and calculate the effective borrowing rate enjoyed by the lessor. Given the tight margins generated on lease rate factors, the cost of funding and available liquidity at an appropriate rate is key to the success of the business and it requires frequent analysis and review. Failure to manage this cost effectively can put the viability and going concern nature of the business into doubt. 115

8.15  Risk in Aviation Finance

Fuel hedging 8.15 The main area to review is that of the fuel hedging strategy for airlines. This is a key area which should be looked at in intricate detail. If this area is managed incorrectly it can have a material impact on the organisation. The strategy should be monitored constantly and altered if necessary. Any financial ratios which are utilised in assessing an airline should be reviewed based on any fuel hedging impact and the accounting treatment adopted by the airline, regarding its fuel hedging strategy ie when are gains/losses booked to the profit and loss account or reserves, and how do they materially impact the financial statements etc. Fluctuations in the value of these derivative contracts can materially impact this analysis. The cost of jet fuel for airlines is cyclical and subject to substantial variations while the revenue received from passengers is essentially flat. Fuel costs can make up to circa 30% of the overall operating costs of an airline, so a focus on them is imperative: they constitute a substantial portion of Ryanair’s operating expenses (approximately 37% and 36% of such expenses in fiscal years 2020 and 2019, respectively) after considering Ryanair’s fuel hedging activities. Fuel prices are subject to a number of social and political influences which cause fluctuations in the cost of the commodity. Political events such as wars will often lead to an increase in the cost of fuel. Government legislation has effects on the price of jet fuel such as increasing taxes. Limits in refining capacity can affect the cost of jet fuel and any interruption in that refining capacity will affect the cost of all refined product. The question to ask is should an airline hedge or not hedge for jet fuel? Not all airlines agree on the necessity of hedging. It is not always successful and if market forecasts are incorrect it may lead to higher costs and significant losses for the airline. Hedging for an airline should be similar to purchasing an insurance policy to protect against a rise in jet fuel prices. By investing in futures in the commodities markets airlines are able to lock in a price today that will be paid in the future for a commodity. If nothing else, hedging jet fuel gives the airline the ability to plan and price their product based on a stable price of the commodity. Hedging is an investment and like all investments there are risks associated with that investment. It requires an airline to forecast the future direction of a commodity and make an informed decision. It must decide not only how much to hedge but what tools to use to hedge their position. Although paying below market price for crude oil is a welcome benefit of a hedging programme, it is often not even the main objective. As the price of oil fluctuates, it creates large swings in unhedged airlines costs. Due to this, the main goal of a hedging programme is to stabilise costs and, in turn, profitability. In broad terms, hedging means locking in the cost of future purchases, and it gives airlines a better understanding of their costs for the year. This gives an airline a better understanding of what it must do, and how it must perform, in order to obtain acceptable profitability. Stable fuel prices result in stable costs, which result in stable cash flows and, in turn, stable profits. This stability, according to hedge theory and airline management, results with a higher price for the airline’s stock.1

1

116

See Morrell, P, and Swan, W  ‘Airline Jet Fuel Hedging: Theory and Practice’ (2006) 23(6) Transport Reviews, 1st ser, 1–15.

Credit risk analysis of airlines and lessors 8.15 Risk exposure is playing an increasing role within commercial aviation because there has been a decrease in airfares due to increasing competition. This, in turn, has made air travel a commodity market, making it impossible for airlines to raise ticket fares in response to higher fuel prices. In fact, fuel has increased as a percentage of average operating costs from 12% in 2001 to 33% in 2012 – IATA (2012). There are primarily two types of airlines in operation in today’s market: (a) legacy carriers; and (b) low-cost carriers (LCCs). Due to their cost-cutting attempts, research has found that fuel costs account for a higher percentage of operating costs with LCCs than with legacy carriers.2 The reason for this is because LCCs can influence the cost of staff, cleaning, airport fees, and operations; however, with fuel, these carriers must obey the market and pay the same price as legacy carriers. Fuel hedging allows large fuel consuming companies such as airlines to lock in prices and margins in advance, therefore reducing the potential risk of volatility within the fuel market. It also allows these companies to stabilise their fuel expenses, giving investors and executives a better understanding of the performance of the airline. While most companies who are overly dependent on fuel for daily operations engage in some form or percentage of fuel hedging, there are still some that do not. There are two main reasons why a company would not hedge. First, it may be because the company is not worried about volatility in the fuel market because it can pass on any and all increases in fuel prices to its consumers without affecting margins. Second, the company could be confident that the market price of fuel will drastically fall. Both of these strategies are risky and highly speculative. Specifically, within the commercial aviation sector, there are three main types of contracts used for fuel hedging. The first option is over-the-counter (OTC) contracts such as swaps, options, and combinations (collars). The second option that airlines have is futures contracts that are traded on an exchange. This option tends to be slightly less risky than its OTC counterpart. Lastly, in the third option, airlines have the option not to hedge their fuel consumption. Fuel hedging is a form of risk management derivative that is both tremendously complex and also financially risky. The reason why it is so important for airlines to understand the complexity and risks involved in hedging is because, by agreeing to a fixed price of fuel, airlines are facing the potential of losing or gaining a lot of money. One of the major issues with aviation fuel hedging is that kerosene (jet fuel) is not actively traded on any exchange, such as the New York Mercantile Exchange (NYMEX) or the Intercontinental Exchange (ICE). Due to this, the hedging of jet fuel must be done OTC. There are inherent risks with trading OTC, such as illiquidity and associated counterparty risks. Since kerosene is only traded OTC, and OTC trades carry more risk, airlines typically ‘cross-hedge’ their fuel demand with commodities that trade on commodity exchanges such as the NYMEX or ICE. Commodities that share the most similar characteristics as kerosene are crude oil, heating oil, and gasoil. Although gasoil typically shows the strongest correlation, crude and heating oils are most often used by airlines. In fact, in the US aviation industry, crude oil accounts for the biggest share of underlying commodities with 39.1% (heating oil – 30.9%; kerosene – 24.6%).

2

Volpe, Nicholas, ‘Do Fuel Hedging Derivatives Provide any Economic Benefit to Commercial Airlines within the United States?’ (2016) Economics Student Theses and Capstone Projects 12.

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8.16  Risk in Aviation Finance Kerosene spot prices and crude oil spot prices, however, have correlation factor of only 0.63 since 2002 (see Volpe 20163). The imperfect correlation of the price of an underlying cross-hedge instrument with its purchased asset price is known as basis risk. Jet fuel futures contracts do not exist, so futures on crude or heating oil must be used instead to hedge jet fuel purchases. Because these futures contracts are based on an underlying commodity other than jet fuel, they introduce basis risk because they are not perfectly correlated. Basis risk is generally defined as: Basis risk = spot price of hedged item – futures price of selected contract In the case of the airline industry, the airline is short jet fuel and must go long on futures on a separate commodity. By not hedging, airlines are taking on the risk of rising commodity prices into their business model. If or when fuel prices rise dramatically, airlines cannot pass all or any of the cost on to their customers. Empirical evidence does not support the assertion that a hedging strategy is not valuable. In fact, Carter et al4 (2006) have shown using regression analysis that there is a hedging premium for stocks of airlines using derivatives to hedge jet fuel price exposure. This turned out to be between 12–16% and was statistically significant, which is very supportive of the notion that hedging helps to create value for a firm. The hedging premium can be attributed to the benefits an airline reaps by generating more consistent, stable cash flows. Airlines that hedge are better able to predict future cash flows and earnings and make investments during the high stages of the price cycle, both of which are positively valued by investors.

Accounting treatment 8.16 The accounting for jet fuel hedging, foreign exchange and interest rate hedging is worthy of its own chapter, but it cannot be kept in a vacuum away from the derivative traders. It is essential that trades are structured and tested in a way that will enable the firm to receive the preferable accounting treatment, otherwise earnings volatility will be increased rather than decreased. Trading desks play a crucial role in ensuring that both the internal and external accountants have the information they need, so an intimate knowledge of the relevant accounting standards is necessary by all parties involved. Taking the example of an airline that is short jet fuel and must purchase the commodity in the future as it is needed for consumption. This type of hedging strategy is defined as a cash flow hedge of a forecasted transaction. The accounting guidance for such a transaction specifies that the derivative must be marked-to-market on the balance sheet. The offsetting journal entry, however, is not booked to earnings but rather to the Statement of other Comprehensive Income (SCI) and changes in shareholders’ equity. Entries to the SCI account are booked directly to retained earnings, bypassing the income statement. Then, when the forecasted transaction impacts the income statement, the amounts booked to SCI are released to the income statement, offsetting the earnings fluctuations from the price of jet fuel. The net result is that the derivatives are

3 4

Volpe, Nicholas, ‘Do Fuel Hedging Derivatives Provide any Economic Benefit to Commercial Airlines within the United States?’ (2016) Economics Student Theses and Capstone Projects 12. Carter, DA, Rodgers, DA, and Simkins, BJ, ‘Does Fuel Hedging Make Economic Sense? The Case of the US Airline Industry’ (2006) Air Transport Association, 1–48.

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Credit risk analysis of airlines and lessors 8.18 carried at market value on the balance sheet, but there is no volatility introduced to the income statement. The accounting rules have an important implication for hedging strategy and in particular for the forecasting techniques of the usage of fuel. For example, if only a percentage of fuel which is hedged is actually used in a period, the unused portion of the hedged instrument should be taken from the SCI and released to the profit and loss account. Therefore, any unexpected usage of jet fuel will have direct implications for the profit and loss account and earnings volatility. Where does all of this leave our credit analysis of an airline? Clearly, from a credit risk perspective, it is imperative to understand the strategy used by the airline and its appropriateness or otherwise. One should consider the potential downside risks if the strategy used is inappropriate. Is the strategy consistently applied? Has it proven to be effective in the past? Is it consistent with their peers in the marketplace? A  subjective analysis will be required to assess its effectiveness or otherwise. In addition, one should also review the accounting policy applied and amend/alter any of the analysis of the airline accordingly, in order to find the true operational performance of the airline. This may require amending the quantitative analysis of the airline, the use of what if analysis and certainly stress testing the profit and loss account and balance sheet to a worst-case scenario. It should be borne in mind that if management of an airline has failed to manage these risks appropriately, it may put the viability of the airline into question, given the size and materiality of the contracts involved. An intimate and up-to-date knowledge of the strategy and performance employed by management will be required, on an ongoing basis.

Quantitative analysis 8.17 Quantitative analysis measures the financial performance of a company based on the financial statements prepared by it. The analysis examines the main financial statements prepared by a company, by reviewing its main components including the profit and loss account, the balance sheet and the cash flow statements. This analysis should be used as a guide and a tool, to assist in reviewing the performance and credit analysis of an organisation. There is no one size fits all answer. Ratio analysis is used as a guide to compare performance with industry standards, how the company has performed in the past, its future prospects etc. It should be used in conjunction with other tools available, including the qualitative factors available. No specific ratio is more important than another one, but an overall picture should be achieved in the analysis which will demonstrate where the company is performing well and where the inherent risks reside. The formula for each ratio is noted in Appendix I to this chapter.

Liquidity 8.18 Two liquidity ratios are used to assess the company’s ability to meet its short-term obligations. The airline industry is unusual in that customers typically pay for their service in advance, often 12 months in advance, so airlines will hold deferred income within its current liabilities. These should be excluded from the analysis as they relate to non-refundable claims on the airline. 119

8.19  Risk in Aviation Finance A current ratio of 1.0 for the airline industry is considered to be appropriate. If the ratio is higher than this, it may imply that the business is generating more cash than it can profitably reinvest for expansion purposes. An alternative view is that the airline may be building up a war chest, which it can then use to profitable advantage in the future eg  acquire aircraft in a depressed market, defend its market share etc. LCCs typically seek to apply this strategy. Given the fact that airlines and aviation lessors consume vast amounts of cash, it may be prudent to take the view that one can never have too much cash for unexpected circumstances. Covid-19 is certainly an occasion where this would apply. The acid test ratio adjusts current assets for stocks of inventories held. It seeks to apply liquid current assets to short-term liabilities. The purpose of the ratio is to identify current assets that can be converted into cash at very short notice. For many companies the two ratios will differ as many companies hold significant levels of stocks, which are deemed to be illiquid. Holding significant levels of stocks is unlikely to be the case for airlines or lessors, but it is necessary to review the current assets in detail, assess those that cannot be converted into cash quickly and remove them from the level of current assets. The two ratios are unlikely to be materially different for either an airline or a lessor. Common examples of liquid current assets include cash and cash equivalents, marketable securities, current account receivables. Inventories should always be excluded. Other assets that some analysts may exclude are deferred taxes, prepaid expenses, short-term assets such as landing rights and airport usage rights. Ultimately the acid test ratio provides a clearer picture of the company’s short-term ability to meet its current obligations. The company’s working capital (current assets less current liabilities) may be affected by the seasonality of the business, so it may be advisable to calculate these ratios within the financial year (using management accounts) to assess if additional short-term funding is required.

Activity ratios 8.19 Activity ratios give an insight into the short-term financial operations of the firm. The most useful ratio is that of turnover to capital employed. This ratio expresses how productive the capital used by the business has been in generating turnover. It is a key ratio to use and the higher the ratio is, the better utilisation of assets. Care should be taken in assessing performance over time and between different airlines. It can be dangerous where there are large differences in the accounting policies utilised (eg the timing of the introduction of IFRS  16), the use of outsourcing and other off-balance sheet financing. The analyst should ensure that they are comparing apples with apples and not apples with oranges. The other two ratios for airlines relate to accounts receivable turnover and accounts payable turnover. The accounts receivable turnover ratio is a measure of the average number of accounts receivable cycles during a specified time period. When calculating the ratio, net credit sales are used, since only the portion of revenue collected on credit should be analysed. Total revenue is often used as a proxy if there is no split between credit and cash sales in the financial statements. Distortions can arise in calculating this ratio as accounts receivable on the balance sheet relate to a point in time. The balance may vary significantly during the year or be distorted due to seasonality factors. An average over the period should be utilised. 120

Credit risk analysis of airlines and lessors 8.20 A higher ratio indicates that accounts receivable is being collected more quickly than lower ratio values. The metric can be expressed in day form if the number of days in the period (typically 365) is divided by the ratio calculated. The accounts payable turnover ratio measures how quickly a company is paying its creditors. It is based on purchases by credit or a proxy may be used, which would be operating expenses, less depreciation, less payroll. The measure can also be expressed in day format. Ideally, any company will seek to have a wider difference between accounts receivable and accounts payable, as this will provide it with short-term working capital. The analyst should review the financial statements for an airline or lessor in detail to assess which costs should be included or excluded and the form of the ratio should be consistently applied over time and across different companies.

Profitability 8.20 A profitability ratio is used to analyse the efficiency or success of the business. It allows a user to compare the profits or losses generated against certain baselines, allowing for easier comparison. Care should be taken because industry and market dynamics can easily distort how companies perform based on these metrics. The first ratio is the operating profit margin ratio. It determines the level of operating income generated from every unit of sales, earned through normal business operations. It excludes extraordinary items, interest expenses and taxes, which can be affected by how the business is capitalised. It should remain stable over time. Operating profit is commonly referred to as earnings before interest and taxes (EBIT). The operating ratio gives an indication of management efficiency in controlling costs and increasing revenues. Given airlines and lessors invest heavily in aviation assets, this ratio can be distorted by changes in depreciation policy, or a switch from the ownership of assets to operating leases. An alternative ratio to overcome this problem is to look at operating profit after interest charges, expressed as a percentage of operating revenues. EBITDA (earnings before interest, tax, depreciation and amortisation) can also be used as a proxy for operating cash flow in utilising this ratio or alternatively EBITAR which is EBITDA with operating rental expenses added back. Care should be taken with these proxies, as none of them consider capital costs and their relationship with operating costs. The profit margin or net margin incorporates all facets of a company’s financial structure, including taxes, interest, and other non-operational expenses. It is not uncommon for airlines to experience very low or negative margins, while aviation lessors typically retain very low margins. This ratio has the advantage over the operating ratio as it is free of any distortion based on operating leases. However, the components of the ratio should be examined to establish if there has been a material effect on it, through asset disposals, restructuring costs or asset write downs. Return on equity (RoE) is the net profit after interest and tax expressed as a percentage of shareholders’ funds. This metric is very sensitive to the capital employed, as it does not consider the debt utilised fully, to generate the shareholders’ funds. This ratio should be used with caution, as an airline or lessor with a more heavily debt financed balance sheet may have an artificially higher RoE, than a competitor which is more equity financed. 121

8.21  Risk in Aviation Finance The return on assets ratio (RoA) measures the net income of the company against its total assets and it is a useful way to demonstrate the return that has been made on the assets employed. Airlines and aviation lessors are highly capital intensive, so their RoA is likely to be lower than those of companies in other industries. Airlines would typically have assets such as aircraft, flight and ground equipment, spare parts, gate leases, landing slots which are the fixed capital assets employed by the business. It may be more useful to utilise this fixed capital assets number and exclude cash, deferred taxes, and receivables in order to assess the return on assets that generate revenues. Some airlines also exclude the interest expense from net income and omit the cost of borrowing, in order to get a better picture of the return generated by the assets employed. As mentioned elsewhere in this paper, the effect of IFRS  16 should also be accounted for in assessing this ratio and prior period comparatives.

Leverage 8.21 Leverage ratios take a macro level approach to analysing companies. They asses the capital structure of the company and the company’s ability to meet its obligations. The process of using debt for financing in lieu of equity is commonly referred to as financial leverage. Debt is typically cheaper than equity, and interest costs are typically tax deductible, whereas dividend payments are not. While debt may be a cheaper source of finance, too much debt can bring with it risk of default. The classic leverage ratio is the debt to equity ratio or gearing ratio. It is the long-term debt of the company divided by shareholders’ funds. It determines the proportion of a company’s capital structure which is composed of debt or equity. The more heavily financed an entity is by debt, the greater likelihood of unstable profit swings, due to movements in the cost of capital. Most airlines and many aviation lessors have higher levels of debt than they have equity. Comparisons between companies in the same industry will help to determine the potential for variability of future earnings. This ratio has also been affected by operating lease rentals and the changes of IFRS 16. Airlines, now as lessees, have to include the present value of operating lease obligations on their balance sheet, which should be included in total debt. Possibly a better measure of this ratio is to use ‘net total debt’ by reducing debt by cash and cash equivalents and to compare this with shareholders’ funds, which gives one a measure of a solvency ratio. The lower the debt to equity ratio or solvency ratio, the greater a firm’s capacity to borrow further finance, due to the lower default risk for potential lenders. The final and crucial ratio to review under leverage refers to times interest earned. This ratio measures a company’s ability to meet its interest payments. It is critical to determining the level of risk to which a company is exposed. The ratio refers to EBIT over the interest expense. The higher this ratio is, the more easily a company can meet its interest payments. Banks and lenders will typically look for a ratio of 2.5–3.0 times the interest charge. The higher this ratio is, the more ability a company has to meet its interest obligations. As the ratio tends towards 1.0, concerns will grow about the company’s ability to meet its current obligations. 122

Credit risk analysis of airlines and lessors 8.23

Stock market ratios 8.22 Many airlines and aviation lessors are quoted on stock markets and it can be useful to assess how the markets perceive their performance, as investors have a vested interest in them, and they devote considerable resources to their ongoing assessment and review. The earnings per share ratio (EPS) refers to the profit after tax attributed to the company, divided by the number of ordinary shares issued. It is expressed in cents. EPS helps to standardise a company’s earnings based on its outstanding shares. It ultimately reflects the income earned for every individual shareholder. EPS can also be calculated on a fully diluted basis, as it allows for the issue of future shares from employee share options and also from convertible bonds into shares. The absolute value and growth in this ratio are a key target for management of quoted companies, and it is a vital benchmark for investment and credit analysis. While EPS retains widespread use, other measures such as economic value added, and other cash-based ratios are gaining traction as they are less distorted by one-off items. It should also be noted that the EPS metric can be influenced by management that buyback shares using cash generated by the business. This will increase the EPS metric, without an actual increase in earnings for the business, so management have the ability to distort this ratio directly. The price earnings ratio (P/E) compares the recent profitability of the company with investor expectations about its future profitability. It is expressed as the current market price per share divided by the EPS. Every investor is aware of this ratio when searching for stock market values. If earnings are expected to increase strongly into the future, this will push up the share price and will result in a higher P/E ratio as measured against current or historical figures. To account for this, a forecast of EPS can be employed. Forward looking P/E ratios may signal if the current stock price is either under or overvalued in light of the company’s future prospects. The dividend payout ratio measures the percentage of earnings paid out as dividends. It refers to dividends distributed per share divided by the EPS. A higher ratio signals that the company is performing well, and that management expect this to continue. A low ratio may indicate the opposite, or it may indicate that cash is re-invested into the business. The ratio helps an investor to understand the dividend policy of the company and accordingly an expected value for the stock. The dividend yield ratio is useful for investors to evaluate their investment in an airline or lessor and to compare it with other investment opportunities. Historically, airlines and lessors, have low dividend yields and dividend payout ratios. The weakness of these ratios is that they do not consider any potential capital gain on the value of the stock.

Cash flow statement analysis 8.23 The cash flow statement explains the major changes in the balance sheet which have arisen in the period under review, typically one year. It outlines the cash flowing in and out of a company during the period. None of the other main financial statements provide information directly on the use of cash, how it 123

8.24  Risk in Aviation Finance was generated and utilised. An industry such as aviation, which can be seasonal, is highly leveraged and the cash flow statement is a key tool, if not the most important tool, a credit analyst can use in reviewing an airline or an aviation lessor. The cash flow statement will be divided into three main categories which outline the cash changes due to operating activities, investing activities and financing activities. Cash flow analysis is broadly used by many credit analysts, financiers, and auditors to evaluate the company’s short-term liquidity and long-term solvency. Armen5 proposes the use of eight cash flow ratios in analysing US airlines which he divides into two subdivisions: (a) liquidity and solvency; and (b) going concern. These are outlined in Appendix III.

Liquidity and solvency 8.24 The first ratio used is the operating cash flow ratio. It is the relationship between the net cash flows generated from operating activities and the company’s current liabilities. It indicates the extent to which the company is able to meet its current liabilities and clearly the higher this is, the better. Armen6 found that low-cost carriers such as Southwest and JetBlue have significantly higher value of operating cash flow ratios as opposed to legacy carriers. This was explained by the fact that low-cost carriers have relatively smaller total current liabilities and can cover a larger part of their current liabilities with cash from operations. The second ratio used by Armen is the funds flow coverage ratio. Mills and Yamamura7 propose this ratio as one that measures whether the company can pay off its unavoidable obligations such as interest, debt repayments and preferred dividends, if any. Therefore, the ratio is the relationship between earnings before interest, taxes, depreciation and amortisation and so-called unavoidable expenditures such as interest, tax-adjusted debt payments and tax-adjusted preferred dividends. To adjust for taxes, one needs to divide debt repayments or preferred dividends by (1 – effective income tax rate). The rule of thumb for this ratio is that it should be at least one, and a value below one indicates that the company is not able to fully cover unavoidable expenditures and will need to raise more funds or cash so as not to default on these obligations. Armen found that US legacy carriers had difficulties generating EBITDA that covered their unavoidable expenditures. The same could not be said about LCCs, whose funds flow ratio typically exceeded one. The third ratio used is the cash interest coverage ratio. This ratio measures the extent to which the company is able to pay off its interest obligations on all debt using cash flows from operations. Therefore, it is necessary to compute the cash interest coverage ratio by dividing cash flows from operating activities (to which we also add back interest paid and taxes paid), by interest paid in the period. The higher this ratio, the more interest coverage available to the company. Armen found that low cost carriers had much higher ratios than legacy carriers, because

5 6

Armen, S, ‘Performance Assessment of Major US Airlines via Cash Flow Ratios’ (2013) 22(2) Annals of the University of Oradea, Economic Science Series, 398–408. Armen, S, ‘Performance Assessment of Major US Airlines via Cash Flow Ratios’ (2013) 22(2) Annals of the University of Oradea, Economic Science Series, 398–408. Mills, JR and Yamamura, JH, ‘The power of cash flow ratios’ (1998) 186(4) J of Accountancy, 53–61.

7

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Credit risk analysis of airlines and lessors 8.25 they were more profitable, generating more free flow cash, and also because they held less debt than legacy carriers. The final ratio employed under liquidity and solvency is cash to current debt coverage ratio. It shows the company’s ability to pay off its current debt with cash generated by operating activities after paying out cash dividends. Current debt for this ratio is restricted to liabilities that mature within the next 12 months. For airlines, those liabilities are short-term borrowings and current maturities of long-term debt and capital lease obligations. Accordingly, the ratio is a relationship between the company’s cash flows from operations less cash dividends and its current debt. The higher this ratio is, the more solvent the company is deemed to be. In the study by Armen, Southwest Airlines had the highest value of cash current debt coverage ratio as it had relatively small current debt maturing within a year, whereas American Airlines had a ratio below one, not being able to fully cover current debt maturities for three consecutive years.

Going concern 8.25 The first ratio utilised to examine the going concern position of an entity is the cash to capital expenditure ratio. It is the relationship between free cash flow from operations to capital expenditure in the period under review. Mills and Yamamura8 state that this ratio underpins whether a company has sufficient funds to reinvest for future growth, and whether it is able to pay off its current and long-term debt with remaining cash from operations. This ratio emphasises a company’s financial health and its ability to finance growth. Within the aviation industry, which can be cyclical, it may have a frequently changeable value of cash to capital expenditure ratio. The industry itself is highly capital intensive, and because of this the ratio may be low. The second ratio compares the company’s cash flows generated by operating activities to total liabilities (cash to total debt ratio). This ratio is extremely important because it measures the company’s ability to meet its future commitments. Companies with consistently low ratios over time are likely to encounter financial difficulties in the future. Investors have begun to focus on the concept of free cash flow (total free cash ratio), because it is a more reliable measure of a company’s financial health, and cannot be readily manipulated. The term ‘free cash flow’ can be defined in numerous ways. A conventional definition is that free cash flow equals cash flow from operations less capital expenditure within 12 months, less shortterm debt within 12 months, less interest payments and cash dividends. Total free cash flow should also be reduced by rentals due within 12 months under operating leases and any other short-term off-balance sheet items. This total free cash flow amount is then compared with total liabilities and off-balance sheet commitments. The ratio is very effective in ascertaining the adequacy or otherwise of the cash flow generated by the business to meet its short- and long-term commitments. It effectively highlights the levels of additional liquidity required by the business, if any, in order to meet its future commitments. 8

Mills, JR and Yamamura, JH ‘The power of cash flow ratios’ (1998) 186(4) J of Accountancy, 53–61.

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8.26  Risk in Aviation Finance The final ratio is the cash flow adequacy ratio. It evaluates a company’s capability to meet its continuous financial commitments and is the basic measure of cash sufficiency. The formula starts with EBITDA less taxes paid, interest paid and capital expenditures which is then compared to the average of annual debt maturities scheduled over the next five years. The higher the ratio, the more creditworthy the company is, which means that it generates more free cash to pay off annual maturities of long-term debt. The airline industry is highly susceptible to seasonality and economic slumps. Difficulties in generating sufficient cash flow result from slowing demand for air travel, increased operating expenses mainly driven by rising fuel prices, higher labour costs, and higher funding costs. Armen9 found that low-cost carriers have less liquidity problems then legacy carriers. One of the explanations is that low-cost carriers have relatively less debt and capital lease obligations than legacy carriers do, which tend to be highly leveraged. Moreover, low-cost carriers have engaged in hedge activities for fuel to a larger extent than legacy carriers, which has ensured that their financial performance has remained stable, while fuel prices have fluctuated.

Predictions of bankruptcy 8.26 The ability to predict the correct financial health of the operator of an aviation asset is critical for users such as investors, credit rating agencies, banks, underwriters, auditors, and regulators. The aviation industry has been quite unique over the past century: it requires vast injections of capital, returns low margins, has strong unions in many jurisdictions and yet it retains commodity pricing. It is not necessarily an obvious industry with which to make large returns. Traditional ratio analysis is frequently used to analyse companies in the aviation industry regarding their performance and viability. However, when predicting if a company will go out of business altogether, it is useful to group a number of these ratios together to create a statistical model, which predicts insolvency, and can be used as a tool for investment decisions. Altman’s Z-score model was developed to predict failure of publicly traded listed manufacturing firms, which was later modified to predict failures in private and in publicly traded listed non-manufacturing firms. These became known as the alternate Z-score model. The approach of Altman’s Z-score formula has achieved ample acceptance by accountants and auditors for financial health representation. Bankers and the courts have also used it for loan evaluation and claims settlements. Altman’s Z-score model can be applied to the modern economy to predict distress and bankruptcy two to three years in advance. The model is outlined in Appendix IV. Beaver (1967) in his research evidenced that certain financial accounting ratios such as ‘Cash Flow/Total Debt’, gave statistically significant signals well before actual business failure. Beaver’s empirical results suggested that the model he used in his research has greater predictive ability in assessing the financial health of a firm in the long term. However, the Z-score model developed by Altman 9

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Armen, S ‘Performance Assessment of Major US Airlines via Cash Flow Ratios’ (2013) 22(2) Annals of the University of Oradea, Economic Science Series, 398–408.

Credit risk analysis of airlines and lessors 8.27 has proved to be more successful in the short-term and is widely accepted by later researchers. Altman found that his five ratios outperformed Beaver’s (Cash Flow/Total Debt) ratio hypothesis. Fijorek and Grotowski, in their research,10 analysed Polish company bankruptcies. They studied 13,288 companies, of which 1,198 went bankrupt in Poland. They concluded that the sudden increases in current liabilities to total assets ratio should be continuously monitored and closely investigated as this financial ratio is also a very strong predictor of bankruptcy. They also suggested that analysis of sales-related ratios, especially the return on sales and the total assets turnover ratios, are critical as any significant decrease in them clearly indicates inefficient use of the company’s assets and hence a symptom of an incoming crisis. Despite the plethora of researches and developments in financial health assessment and failure prediction, Altman’s Z-score remains the most widely used model, because of its strong failure predictability and ease of use. Kumar and Anand11 used Altman’s Z score model on Kingfisher Airlines during the period 2005–2012 to assess if the model could predict future failure within the airline. The models were able to predict the severe financial distress of the firm and also highlighted potential distress for investors. The mean Z-score for Kingfisher Airlines was 0.019, paving the way for an early-warning alarm for probable future bankruptcy if remedial action was not taken. One should note that the model is based on probability indicating likely future failure, which may be reversed depending on the firm’s future actions or strategy. The model should be used as a guide, along with other traditional tools and the limitations of the model should be applied to any decision making.

Stress testing 8.27 In assessing the credit risk of any organisation, it is imperative to carry out a stress testing of the financial results or forecasts. Stress testing examines the performance based on a movement in key expectations or upon different scenarios. Some key metrics that can be used to examine stress testing include: • high, low, medium probabilities on certain key metrics; • the impact of a 1% rise or fall interest rates or a 25bp movement over expected rates; • a 1% rise or fall in economic growth rates for a particular market, country, or region; • a 1% rise or fall in fuel costs; • a 1% rise or fall in labour rates. Investors, shareholders, and finance providers are demanding scenario modelling that shows that airline and lessor entities understand the potential impact on their customers, capital, and liquidity bases. Dynamic financial modelling and stress testing processes will be key to this understanding. This includes the 10 Fijorek, K and Grotowski, M ‘Bankruptcy Prediction: Some Results from a Large Sample of Polish Companies’ (2012) 5(9) I Business Research, 70–77. 11 Kumar, M and Anand, M ‘Assessing Financial Health of a Firm Using Altman’s Original and Revised Z-Score Models: a Case of Kingfisher Airlines Ltd (India)’ (2013) 2(1) J of Applied Management and Investment, 36–48.

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8.28  Risk in Aviation Finance development of macro-economic scenarios, credit loss modelling and impact analysis on key metrics, financial ratios and in particular on covenants. In order for stress testing to be really effective some key steps are required in this process.

Define scope and governance 8.28 Airlines and lessors should establish dedicated teams tasked with defining objectives and governance guidelines and ensuring proper coordination among the business, risk, and finance departments, while a direct relationship to the board is critical.

Define scenarios using a multidisciplinary approach 8.29 Some organisations have created departments focused on the sole task of developing and managing enterprise stress testing. Such groups typically use external scenarios (such as macroeconomic shocks) as benchmarks that assist in developing specific internal scenarios. Defining scenarios that are useful to business lines, as well as the risk and finance functions, requires the effective participation and cooperation of multiple teams and specialists.

Data and infrastructure 8.30 Institutions continue to struggle with data quality, availability, and comprehensiveness despite significant investments in both capabilities and infrastructure in recent years. Legacy systems and silos may hinder the flexibility required for effective stress testing. Therefore, a flexible platform for aggregating financial data that integrates information from across the organisation is crucial.

Calculate stressed key performance indicators 8.31 Once the data is captured and centralised, the next step is to model the impact of different scenarios on institutional cash flows ie on income and capital. This will require a deep understanding of the key business drivers. Quantitative measures are of particular interest to senior management as they link stress testing directly to performance. Common implementation challenges include lack of internal skills and data, shortage of relevant resources, time constraints, and a dearth of skilled personnel. Best practices include developing internal models using dedicated quantitative teams, as well as using third-party models and services to accelerate the process, decrease internal workloads, and fill gaps in key skills and capabilities.

Reporting and action based on results 8.32 Requirements for stress testing come from a variety of external and internal sources. These include regulators, the board of directors, business line management, credit providers, investors, and fund managers. These requirements will grow and evolve over time, making effective reporting consume an increasing amount of both time and resources, within both airlines and lessors. Reporting tools that address these requirements will offer significant benefits. The structure of reports will vary widely, so flexibility and the ability to adapt to changing requirements are critical capabilities. 128

Qualitative factors in credit analysis 8.34 Stress testing should be part of both the business planning process and credit risk analysis. Monitoring and stress testing sensitive limits should provide useful input to risk appetite discussions. Investing in efficient tools, processes, and systems should help industry players turn stress analysis into an effective tool for business planning and risk management enabling more confident decision making.

Tax strategy 8.33 The aviation industry is a truly global one with many cross-border transactions. Due to its global nature, tax plays a very significant role, which must be managed efficiently in order to maximise returns for investors and shareholders. The tax strategy of an airline or an aviation lessor should be understood as it will dictate the corporate structure of the entity/group and it will also shed a light on the levels of risk that management and shareholders wish to take operating the business. Management should be asked to outline the corporate structure of an entity/ group and to explain the purpose behind each entity, each entity type, and its continuing ongoing need. The answers to these questions will inform the user as to the levels of risk that management wish to take, the strategy of the group as a whole (seeking to expand, retrench etc) and their attitude to tax risk and legal risk. Typically, corporate structures are used for very specific legal/tax reasons. Are management seeking to operate the business in the most commercially efficient way or are they prepared to take some risks on areas that might be considered grey ones? A  crucial area to consider, especially within the aviation industry for lessors, is the level of risk that applies to third-party repossessions of aircraft assets. Many of these problems derive from the non-payment of local taxes (eg import taxes, duties, filing corporate tax returns etc), which may be a primary liability for the operator of the asset, but remain a secondary liability for the owner of the assets. What risk mitigants have management put in place to ensure that the owner of the asset is not going to suffer loss? What budget and personnel are involved to ensure that these risks are kept to a minimum? The attitude of management towards these risks will most likely match the attitude that applies to other risks ie an aggressive or a conservative one.

QUALITATIVE FACTORS IN CREDIT ANALYSIS 8.34 A common misconception of credit analysis is that qualitative factors or ‘soft’ issues carry much less weight than quantitative financial information. Nothing could be further from the truth and qualitative factors should carry at least as much weight in the overall decision-making process as quantitative factors. By their nature, qualitative factors will be subjective, so experience over time in managing relationships across a wide section of customers will greatly assist in establishing the credit worthiness of an airline/lessor. 129

8.35  Risk in Aviation Finance

Ownership 8.35 The type of ownership of the operator of the asset will play a key role in assessing their credit worthiness. Ownership can take the form of a state-owned airline to a new start up with one or two aircraft and everything in between. A  government owned operator may be considered a stronger candidate given that typically governments may have stronger credit ratings than commercial operators. This does not always remain the case, whereby there are numerous examples of governments reneging on debt payments. However, typically a government operator may have more focus on job creation and investment in its jurisdiction through commercial links provided by air travel than the profit motive of a commercial operator. State owned operators may have more access to finance to keep payments running, but these may also have conditions attached. Commercial organisations may be privately owned or have their shares quoted on an independent stock exchange. For those that are quoted, there is likely to be more financial information available concerning their operations and more robust scrutiny of their performance and business plans, from fund managers, investors and the media. Assessing the experience of the owners in running an airline or lessor, their past performance and their relationship with staff and unions, can be a judgement call based on prior circumstances.

Management expertise 8.36 Management expertise, their track record and relationship with their shareholder(s) is crucial to assessing credit risk. If this area is weak and management performance is poor, then credit risk will increase, regardless of the company’s operational and financial performance. Some key subjective considerations include: • Industry and market knowledge and experience. • Experience and track record, in particular during difficult economic circumstances. • Relationship with shareholders and staff. • Business plan – is it achievable and realistic? • Is the organisational structure flat and does it adapt quickly to changing circumstances? • Is there a can-do attitude within the organisation ie is it energetic and does that come from the top management? • Do management and staff have skin in the game ie share options? Have they changed jobs frequently? • How have your competitors fared in the past working with these people? How has your organisation found them? • Are they challenging to manage and how have they behaved in the past at the end of a lease? How responsive are they to managing issues/concerns, what have their return conditions been like in the past? A lot of these issues are deemed the ‘softer’ issues, as they can be difficult to quantify and put a number on them. Over time, a general picture will emerge as to management’s ability and their relationships with vested interests in their performance. It is advisable to speak with as many stakeholders as is available 130

Qualitative factors in credit analysis 8.37 and to communicate regularly with management, over concerns if they arise at early stages, rather than deal with issues when it may be too late.

Competitive environment 8.37 For anyone working in the aviation industry, either with an airline or an aviation lessor, it is very clear that the environment is highly competitive. Margins are extremely tight and the number of players in both sectors of the industry can change dramatically over a short period of time. In assessing the competitive environment of a counterparty, the clearest way to do this is to look at the characteristics of strong credits, and those of weaker credits. (1) Characteristics of a strong credit: –

Has the counterparty’s credit remained stable over a sustained period of time? If it has done so, this implies that the counterparty is a major player in the industry, with a unique market niche, with robust brand awareness.

–

Are there significant barriers to entry which prevent competitor access? These barriers to entry could range from local government support/laws, regulatory or liquidity issues, slots at airports, open skies rights. Is there something unique that gives the counterparty a competitive advantage?

–

Does the business have a focused and proven strategy which has been refined over many years? The obvious example is low-cost carriers who look to boost capacity and sell seats cheaply, like the ‘pile it high and sell it cheap’ philosophy of other industries.

–

Can the counterparty be flexible, respond to pricing issues and also to competitors? Can they be flexible, yet also remain profitable in the long run? This implies that the counterparty retains some margin buffers to withstand temporary shocks, and it also implies that they are non-unionised, or, if so unionised, management can control them.

–

Can the counterparty access capital cheaply and quickly? This is very important, in particular in the current circumstances of Covid-19. Can management access cheap capital, quickly, in order to take advantage of unexpected market opportunities ie  is the balance sheet strong and able to withstand this extra debt and does management invest their cost savings back into the business?

–

Does the counterparty invest in technology which is the most up to date for their customers, is user friendly and is easily accessible? Does the technology used enable them to enter new business areas, at their ease?

(2) Characteristics of a weak credit: –

Weaker credits are counterparties that are lower tiered competitors and not identified as the number one player in the market that they serve. If there is a downturn in the markets they serve, this generates significant problems for the counterparty.

–

Weaker credits will typically change their strategy over time, or they may have a strategy that sends out different messages and signals. 131

8.38  Risk in Aviation Finance

–

–

Stronger credits will have a core product and will not try to be all things to all people. Weaker credits will have a confused message and generally insufficient capital available. This will mean that they will not be flexible and will not be able to take advantage of unexpected market opportunities. It is likely that they will struggle to raise capital quickly and will be unable to adapt to a changing market. Weaker credits may have seasonality or cyclical concerns, they may have had an inconsistent performance history, potentially a thin equity base, and also may have had the triggering of financial covenants, in the past.

Business plan 8.38 Management of the operator should provide a comprehensive business plan which outlines the strategy and expected performance of the organisation over the next few years. The plan should outline how this performance is to be achieved, how remedial action is to be performed when targets are not met, and the strategy used to achieve the plan. Like many of these qualitative factors, a subjective analysis of the plan will be required. Is it feasible, realistic, or achievable? Have management in the past achieved their business plans? How will the organisation’s competitors react to this strategy? All of these questions will have to be considered and they should confirm and be consistent with the viewpoint gained from assessing the operator’s credit analysis in other areas.

Regulatory environment 8.39 The operator of an asset will have dealings with a number of regulators while operating the asset. The aviation industry has several regulation and oversight bodies such as: the European Aviation Safety Agency (EASA); International Civil Aviation Organisation (ICAO); Office of Foreign Assets Control (OFAC); Civil Aviation Administration of China (CAAC); and Eurocontrol, to name just a few. In assessing the credit analysis of the counterparty, understanding the quality of their relationship with regulators will be informative as to the quality of the operation and their management. Is the operator regularly audited by these organisations, are there issues or concerns expressed by them in the media? These relationships should be checked and reviewed to assess their impact on the credit worthiness of the operator.

Technical, maintenance and records issues 8.40 A  key issue regarding the ownership and use of an aircraft/aircraft engine are the technical records and maintenance condition of the asset. The care and attention that is applied to these issues will give any interested party a key source of information regarding the ability of the operator’s management to manage their assets and pay their debts when due. If the airline or lessor 132

Covid-19 8.41 fails to pay for the use of the asset and a creditor needs to repossess the asset, a key issue will be the quality of the maintenance records of the asset and the condition of the asset when it is repossessed. It is imperative that the owner of the asset ensures at all times that these records are maintained and are kept up to date. The owner must ensure that the appropriate maintenance of the asset is carried out continually and on time. All assets should have a maintenance profile which will be based on their use and number of cycles. The asset should be available for review to ensure that this has been carried out correctly and on time. The owner needs to understand the assets position in the maintenance cycle, its physical condition at all times, ensure that airworthiness directives are applied, and note the physical location and condition of the records of the asset. It is vital that the owner of the asset gets this right. They should build up positive relationships with personnel of the operator of the asset to assess and ensure that all records are up to date, are easily available for inspection, and that they can be scanned quickly. If issues arise in this area (for example, staff turnover, a deterioration in the quality of the records available), it may point to issues in other parts of the operator’s organisation and can act as a flag regarding credit issues. It is a key issue, which should never be overlooked, and it will require continual investment on behalf of the owner to review the position.

COVID-19 8.41 This edition of Aircraft Financing will be published in the second year of the Covid-19 pandemic crisis, and it would be remiss not to comment on it. The crisis has had a devastating effect on airlines and aviation lessors alike, on a global basis. In 2020, airlines globally are estimated to make losses of $118bn, with additional losses likely of circa $38bn in 2021. Globally governments have provided supports through direct cash injections or wage and industry subsidies to the tune of $173bn in 2020, with more required in 2021 as the pandemic continues to grip the industry globally.12 While this support has been directed at airlines, it is clear that this has also been required in order to alleviate cash issues at lessors, to enable airlines make some lease payments for their fleet of aircraft on lease. Without these payments and their continuation in 2021, many airlines and indeed aviation lessors would potentially have entered a form of examinership or liquidation. The question that many observers and credit analysts have is whether or not this was predictable? The short answer would appear to be ‘no’, as not too many observers of the industry had even heard of Covid-19 in 2019 or within Quarter 1 of 2020. The aviation industry has a very strong and deserved reputation for the mitigation of prior global risks since the 1970s. There have been a number of crises such as the oil crisis in the 1970s and 1980s, the Asian debt crisis of 1997, 9/11 (2001), SARS  (2003), the global financial crisis (2008), the Euro crisis (2010), Ebola (2014) and the Russian crisis of 2014. Covid-19 is distinguishable from all other prior global events, because this crisis has hit the entire globe at the same time and it has also severely restricted air 12 IATA, ‘Economic performance of the airline industry’ (November 2020), see https://www.iata. org/en/iata-repository/publications/economic-reports/airline-industry-economic-performance--november-2020---report/.

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8.41  Risk in Aviation Finance travel for global populations with no clarity as to when and where it can return, however slowly, to its pre-crisis levels. For the industry as a whole, many airlines may not have been directly affected by each of the earlier crises outlined. Aviation lessors, with global imprints, were able to diversify away from locations with credit risks, by remarketing aircraft and other aviation assets, to locations and airlines that were not affected. For those airlines that became bankrupt, various mechanisms were utilised to support them, such as bankruptcy law protections/ restructuring frameworks in key jurisdictions (eg  US, UK and Ireland) and government supports. For lessors that were struggling to find liquidity, they were effectively taken over by competitors with stronger balance sheets and access to capital. Capacity for the industry as a whole did not materially fall. This is not the case with the Covid-19 crisis, where global capacity has been cut, there is an oversupply of aircraft, and it will take several years before demand and air travel meets that capacity. From a quantitative analysis perspective, all companies must disclose any postbalance sheet events that materially affect the financial performance of the company ie any events which arise before the financial statements are signed by the auditors and the directors of the company. Aside from discussions with management and industry observers, this is the one area where the directors formally disclose issues of which they are aware that impact the financial results of a company. A second area for credit analysts to consider is whereby the financial statements are signed off by the auditors and directors on a going concern basis, as opposed to a breakup basis. The auditors and directors will assess the likely going concern nature of the company for a period of 12 months after the formal signing of the financial statements. This can be up to 18 months after the balance sheet date, of the audited financial statements, based on information available at the date they are signed. Management will clearly have guidelines and procedures in place to deal with concerns or issues that arise, which they are aware of, to mitigate against these risks. To be fair to all concerned, it is not realistic, to believe that anyone saw the full extent and impact of the Covid-19 crisis in Quarter 1 2020. It is clear, however, that the strategy to deal with known risks pre-Covid-19 is now not fit for purpose. For those companies in the industry that survive this crisis, management for both airlines and aviation lessors must heed some of the lessons learned over the past 12–18 months and prepare differently for the next potential crisis. The time for that preparation is now. The lessons learned during this crisis need to be learned today and into the future, with a plan put in place for the next crisis that arises. It is clear, that as the aviation industry is a global one, global crises will re-occur into the future. Since 2000, there have been six to seven major crises that have had a global impact on the industry. One can predict with certainty that another crisis is likely to happen in the future. As deforestation and climate change increase the spread of new diseases, the likelihood of the next pandemic similar to Covid-19 grows stronger. The economic devastation caused by Covid-19 has also renewed discussion about ways to decrease the risk of viruses spilling over closer to their source. Scientists are collaborating more across research fields, which is critical for research into areas such as zoonotic disease, which cuts across ecology, epidemiology, and molecular biology. Advances in genetic sequencing could arm us better when the next virus arrives. There is now a fresh acknowledgment that human health is deeply connected to the health of our planet. 134

Conclusion 8.43 Covid-19 is neither the first nor will it be the last health emergency we will face. Sally Davies, the former chief medical officer of England, and her fellow scientists estimate that: ‘we will face a pandemic or health emergency at least once every five years from here on. There is a chance that this is the optimistic scenario. The reality could be far worse’.13 This sobering prediction, if accurate, will have profound implications for not only global health, but equally for the financial health of airlines and lessors. On top of this are potential issues concerning the environment and the larger footprint on the planet that aviation is expected to leave in the future. It really makes it imperative that shareholders, debtholders, and investors prepare now for this future eventuality and put into practice lessons learned from the current crisis.

TAILORED APPROACH 8.42 It should be clear from the analysis in this chapter, that there is no one size fits all when it comes to a risk review of an airline or aviation lessor. There are so many different issues that can affect an entity within the industry, that it is important to cover as many of them as possible and to make an informed opinion as to their credit status. There is always risk associated with this decision because factors that may be key for one operator may differ in importance for another, or they may change over time. Investors, lenders, and other stakeholders will have to make a tailored approach for each entity that they review. The approach for each entity is likely to differ, but certain key factors (strong and effective management, cash flow, margins) will always be important, and they should be sought out on a consistent basis. Stakeholders should look for warning signs at any early stage of this process and act accordingly on those signs, rather than wait for improvements when it may be too late to act and redress issues.

CONCLUSION 8.43 Risk analysis is a very complex and evolving area. There is no magic potion which will provide all of the answers for an analyst, and there are infinite issues and signals which need to be covered in order to give the analyst the best possible outlook in assessing the risk of an airline and an aviation lessor. It is important that the analysis takes place routinely and that warning signs are adhered to and that corrective action to issues are implemented at an early stage. Qualitative factors such as the strength and experience of management can outweigh quantitative factors and should be given at least equal prominence in the overall review. Constructive dialogue is vital to ensure that mutually beneficial ways forward can be found during times of financial difficulty. This is especially so during the current Covid-19 pandemic. The old saying is that ‘cash is king’. This has never felt more relevant than during these unprecedented times, where free cash flow and access to available liquidity will differentiate between those that survive and those that do not.

13 Davies, Sally ‘The next pandemic is on its way. Coronavirus must help us prepare for it’, see https://www.theguardian.com/commentisfree/2020/sep/26/next-pandemic-coronavirus-prepare Guardian Newspaper (2020).

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8.43  Risk in Aviation Finance

APPENDIX I – KEY FINANCIAL RATIOS Liquidity ratios (i) Current ratio (ii) Acid test ratio

= Current Assets/Current Liabilities = (Current Assets – Inventory)/Current Liabilities

Activity ratios (i)

Turnover to capital employed = Total Revenue/Average Net Assets (Long-term debt plus shareholders’ funds) (ii) Accounts receivable turnover = Credit Sales/Accounts Payable (iii) Accounts payable turnover = Credit Purchases/Accounts Payable

Profitability ratios (i)

Operating profit margin

(ii) Profit margin (iii) Return on equity (ROE) (iv) Return on assets (ROA)

= Earnings before interest and tax (EBIT)/ Total revenue = Net income/Total revenue = Net income/Total stockholders’ equity = Net income/Total assets

Leverage ratios (i) Debt to equity (D/E) = Total debt/Total stockholders’ equity (ii) Debt ratio = Total debt/Total assets (iii) Times interest earned (TIE) = EBIT/Interest expense

Stock market ratios (i)

Earnings per share (EPS) outstanding shares (ii) Price earnings ratio (P/E) (iii) Dividend pay out (DPO) (iv) Dividend yield

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= Net income/Average number of = Market price per share/EPS = Dividends distributed per share/EPS = DPO/Market price per share

Appendix II – Airline specific ratios 8.43

APPENDIX II – AIRLINE SPECIFIC RATIOS (i)

Available Seat Miles (ASM) = Number of seats per aircraft * flight distance in miles (ii) Available Seat Kilometres = Number of seats per aircraft * flight (ASK) distance in kilometres (iii) Revenue Passenger Miles = Number of revenue passengers * flight (RPM) distance in miles (iv) Revenue passenger = Number of revenue passengers * kilometres (RPK) flight distance in kilometres (v) Total cost per available seat = Total expenses / Available seat miles mile (CASM) (ASM) (vi) Operating CASM = Total operating expenses / ASM (vii) Passenger revenue per = Total passenger revenue / ASM available seat mile (PRASM) (viii) Operating revenue per = Total operating revenue / ASM available seat mile (Operating RASM) (ix) Revenue per revenue = Passenger revenue / RPM passenger mile (RRPM) (x) Load Factor = RPM/ASM (xi) Breakeven Load Factor = CASM / RRPM (BLF)

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APPENDIX III – KEY CASH FLOW RATIOS Liquidity and solvency (i)

Operating cash flow

= Net cashflows generated from operating activities/Current liabilities (ii) Funds flow coverage ratio = EBITDA/(Interest plus tax adjusted debt repayments plus tax adjusted preference dividends) EBITDA = Earnings before interest, tax, depreciation and amortisation (iii) Cash interest coverage ratio = (Cashflows generated from operations plus interest paid, plus taxes paid)/ Interest paid (iv) Cash to current debt ratio = (Cashflows generated from operations less cash dividends paid)/Current debt

Going concern (i)

Cash to capital expenditure = Cashflows generated from operations/ Capital expenditure (ii) Cash to total debt ratio = Cashflows generated from operations/ Total liabilities (iii) Total free cash ratio = Cashflows generated from operations less capital expenditure / Total liabilities plus off balance sheet commitments (iv) Cash flow adequacy ratio = (EBITDA less taxes paid less interest paid less capital expenditure)/Average annual debt maturities over five years

APPENDIX IV – ALTMAN’S Z-SCORE MODEL Z = 6.56A + 3.26B + 6.72C + 1.05D Where: A = Net working capital/Total assets B = Retained assets/Total assets C = EBIT/Total assets D = Book value of equity/Total liabilities The status of a company per the model for private industrial companies is as follows: For a stable private company Z > 2.6 Grey zone

1.1 < Z < 2.59

Unhealthy company

Z < 1.1

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Appendix V – Further reading 8.43

APPENDIX V – FURTHER READING Allayannis, G, and Weston, J P, ‘The Use of Foreign Currency Derivatives and Firm Market Value’ (2001) 14(1) The Rev of Financial Studies, 243–276 Altman, EI, ‘Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy’ (1968) J of Finance, September, 550–612. Altman, EI, Marco, G  and Varetto, F, ‘Corporate Distress Diagnosis’ (1994) 18 J of Banking and Finance, 505–529 Armen, S, ‘Performance Assessment of Major US  Airlines via Cash Flow Ratios’ (2013) 22(2) Annals of the University of Oradea, Economic Science Series, 398–408 Beaver, W, ‘Financial Ratios Predictors of Financial Distress’ (1967)  J  of Accounting Research, 70–112 Beaver, W, ‘Alternative Financial Ratios as Predictors of Failure’ (1968) Accounting Rev, January, 113–122 Berghöfer, B, and Lucey, B, ‘Fuel Hedging, Operational Hedging and Risk Exposure – Evidence from the Global Airline Industry’ (2014) 34  I  Rev of Financial Analysis, 124–139 Carter, DA, Rodgers, DA, and Simkins, BJ, ‘Does Fuel Hedging Make Economic Sense? The Case of the US Airline Industry’ (2006) Air Transport Association, 1–48 Carter, Rogers, and Simkins, ‘Does Fuel Hedging Make Economic Sense? The Case of the US  Airline Industry’ (16  September 2002) Oklahoma State University Carslaw, CA and Mills, JR, ‘Developing ratios for effective cash flow statement analysis’ (1991) 172(5), J of Accountancy, 63–70 Casey, CJ, McGee, VE and Stickney, CP, ‘Discriminating Between Reorganized and Liquidated Firms in Bankruptcy’ (1986) 61(2), The Accounting Rev, 249– 249 Cobbs, R, Wolf, A, ‘Jet fuel hedging strategies: options available for airlines and a survey of industry practices’ (2004) 467 Finance 1–22 Davies, Sally ‘The next pandemic is on its way. Coronavirus must help us prepare for it’, see https://www.theguardian.com/commentisfree/2020/sep/26/ next-pandemic-coronavirus-prepare, Guardian Newspaper (2020) Figlewicz, RE and Zeller, TL ‘An analysis of performance, liquidity, coverage and capital ratios from the statement of cash flows’ (1991) 22(1) Akron Business and Economics Rev, 64–81 Fijorek, K  and Grotowski, M, ‘Bankruptcy Prediction: Some Results from a Large Sample of Polish Companies’ (2012) 5(9) International Business Research, 70–77 Friedlob, GT and Schleifer, LLF Essentials of Financial Analysis (2003), New Jersey: John Wiley & Sons, Inc Giacomino, DE and Mielke, DE ‘Cash flows: Another approach to ratio analysis’ (1993) 175(3) J of Accountancy, 55–58 139

8.43  Risk in Aviation Finance IATA, ‘Economic performance of the airline industry’, https://www.iata.org/ en/iata-repository/publications/economic-reports/airline-industry-economicperformance---november-2020---report/ (November 2020) Kahya, E, ‘Prediction of business failure: A funds flow approach’ (1997) 23(3) Managerial Finance, 64–71 Kumar, M and Anand, M, ‘Assessing Financial Health of a Firm Using Altman’s Original and Revised Z-Score Models: a Case of Kingfisher Airlines Ltd (India)’, (2013) 2(1) J of Applied Management and Investment, 36–48 Levin, Doron, ‘Hedging helps low-cost airlines hold down price of aviation fuel’, The Detroit Business News (18 March 2004) Mills, JR and Yamamura, JH, ‘The power of cash flow ratios’ (1998) 186(4) J of Accountancy, 53–61 Morrell, P, and Swan, W, ‘Airline Jet Fuel Hedging: Theory and Practice’ (2006) 26(6) Transport Reviews, 1st ser, 1–15 Ohlson, JA, ‘Financial ratios and the probabilistic prediction of bankruptcy’ (1980) 18(1) J of Accounting Research, 109–131 Patrick, P, ‘A  comparison of ratios of successful industrial enterprises with those failed firms’ (1932) Certified Public Accountant, October, November and December, 598–605, 656–62 and 727–731 Rao, VK, ‘Fuel price risk management’ in GFK Butler, MR (Ed), Handbook of Airline Finance (1999) 41, 1–422 Ryanair, (2020) see https://investor.ryanair.com/wp-content/uploads/2020/07/ Ryanair-Holdings-plc-Annual-Report-FY20.pdf Stiglitz, JE ‘Why Financial Structure Matters’ (1988) J of Economic Perspectives 2(4), 121–126 Trottman, Melanie, Southwest Airlines ‘Big Fuel-Hedging Call Is Paying Off as Carrier Was Able to Protect Itself Against Soaring Energy Prices in Second Half’ (16 January 2001) Wall Street Journal Volpe, Nicholas, ‘Do Fuel Hedging Derivatives Provide any Economic Benefit to Commercial Airlines within the United States?’ (2016) Economics Student Theses and Capstone Projects 12 Wells, AT, and Wensveen JG  Air Transportation: A  Management Perspective (5th edn, 2004) Belmont, CA: Thomson Learning

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9 Environmental Issues and the Aviation Industry Rob Murphy and Fintan Kerins

INTRODUCTION 9.1 This chapter will explore initiatives and themes that are focused on the environmental impacts of the aviation industry. It will touch on key elements of the current schemes in operation and some recent industry and regulatory steps and developments. This is, of course, a very large subject and therefore the chapter has had to focus in outline on regulatory or quasi regulatory/industry aspects that have a direct impact on the leasing, financing and airline sector. The authors’ comments here are inevitably outline. Undoubtedly there has been increased focus in recent years from consumers, investors and corporates on environmental and sustainability practices when making financial decisions. There is a building market for ‘sustainable loans’ – ie debt facilities where the terms of the lending offer the borrower some form of incentive to achieve targets for improving their environmental, social and governance (ESG) or sustainability performance. This is a growing market. In 2020, over US $500 billion of ESG bonds were issued globally. One can expect the volume of environmentally focused lending to grow year on year. In the aviation sector, the ESG emphasis has centred around environmental sustainability – more than social or governance considerations – and for obvious reasons. However, this is not a static picture and social and governance elements are also coming into sharp focus. It is a fast moving and expanding series of topics and the channels of primary focus are widening and being added to – almost on a weekly basis. On the environmental side, the landscape is a blend of technological change and innovation together with governmental, regulatory and industry-wide change initiatives and target setting. This is the background against which all key industry participants are evaluating their role and contribution and reaching for greater impacts. The focus is – and must be – on building sustainable outcomes. According to the Environmental Protection Agency (EPA) the current global aim is to tackle climate change resulting from human activities whose greenhouse gas emissions are changing the composition of the earth’s atmosphere.1 The External Intergovernmental Panel on Climate Change (IPCC) states that: ‘Most of the observed increase in global average temperatures since the mid-20th century is 1 Environmental Protection Agency, ‘What is Climate Change?’, see https://www.epa.ie/ environment-and-you/climate-change/what-is-climate-change/#d.en.84718.

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9.2  Environmental Issues and the Aviation Industry very likely due to the observed increase in anthropogenic (produced by humans) greenhouse gas emissions.’2 In terms of airline industry impacts: a 1999 report by the Intergovernmental Panel on Climate Change found that aviation accounts for approximately two percent of human-induced greenhouse gas emissions.3 A particular area of focus was on aviation emissions impacts at higher altitudes, such as: carbon dioxide (CO2); NOx; contrails; and soots. In 2020, global annual international aviation emissions were already around 70% higher than in 2005. The International Civil Aviation Organisation (ICAO) forecasts that, in the absence of additional measures, by 2050 they could grow by a further 300%.4 In October 2013, the 38th Session of the ICAO Assembly adopted Resolution A38-18, which resolved that the ICAO and its member states, with relevant organisations, would work together to strike a collective medium-term aspirational goal of keeping the global CO2 emissions from international aviation from 2020 at the same level (so called ‘carbon neutral growth from 2020’).5 The ICAO  Assembly also identified a series of measures to help achieve this carbon neutral growth goal. These include: aircraft technologies (lighter airframes, higher engine performance and new certification standards); operational improvements (improved ground operations and air traffic management); sustainable alternative fuels; and market-based measures.6

KEY TARGETS 9.2 As may be expected, there are various channels of activity in striving for greenhouse gas reduction: (1) Paris Agreement: the Paris Agreement is the key international treaty focused on climate change. It was adopted by 196 Parties in Paris, in December 2015. It came into force in November 2016. A detailed review of the Paris Agreement is beyond the scope of this chapter but some key elements are worth highlighting, notably: (a) the goal to limit global warming to well below 2 degrees Celsius, preferably to 1.5, compared to pre-industrial levels; (b) a five-year cycle of climate action planning with participating states expected to submit, execute and update their plans for carbon reduction and tackling greenhouse gases. (2) EU focus: following on from the Paris Agreement, the European Commission has produced the Green Deal policy initiatives. The stated aim is to make the EU climate neutral in 2050. While the Paris Agreement is not 2

Climate Change 2014, ‘Synthesis Report Summary for Policymakers’, see https://www.ipcc.ch/ site/assets/uploads/2018/02/AR5_SYR_FINAL_SPM.pdf. 3 IPCC, ‘Aviation and The Global Atmosphere Report 1999’, see https://archive.ipcc.ch/ ipccreports/sres/aviation/index.php?idp=0. 4 European Commission, ‘Reducing Emissions from Aviation’, see https://ec.europa.eu/clima/ policies/transport/aviation_en. 5 International Civil Aviation Organisation, ‘Resolutions Adopted by the Assembly 2013’, see https://www.icao.int/Meetings/a38/Documents/Resolutions/a38_res_prov_en.pdf. 6 International Civil Aviation Organisation, ‘Environmental Protection’, see https://www.icao. int/environmental-protection/Pages/A39_CORSIA_FAQ1.aspx.

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Aviation specific initiatives 9.3 specific to aviation, the EU’s Destination 2050 is a flagship sustainability initiative for Europe’s aviation sector. This drills down further in terms of focus than the Paris Agreement and the European Green Deal. There is a focus on: (a) aircraft and engine technologies; (b) sustainable aviation fuels; (c) air traffic management/aircraft operations; and (d) economic measures. These key elements map the IATA focus noted below. The overall target is to achieve net zero CO2 emissions for all flights within and departing the EU, UK and EFTA by 2050. (3) IATA: naturally the issue of carbon impacts has for some time been in sharp focus for airlines. Back in 2009, the airline representative body – the International Air Transport Association (IATA) set out a strategy focused on carbon emissions. The strategy targets: (a) improvement in fuel efficiency – average of 1.5% per year from 2009 to 2020; (b) a cap on net aviation CO2 emissions from 2020 (carbon-neutral growth); and (c) a reduction in net aviation CO2 emissions of 50% by 2050, relative to 2005 levels. IATA’s strategy is focused on these key elements with a view to achieving tangible and measurable reduction in greenhouse gases and also putting in place a global market-based measure, to address any remaining gap by way of robust sequestration/offsets projects.

AVIATION SPECIFIC INITIATIVES CORSIA 9.3 Developed by the ICAO in 2016, The Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA) is a global market based measure (MBM) aimed at tackling carbon emissions from the aviation industry through the introduction of offsetting requirements. The ‘aspirational goal’ of the scheme is to ensure that any growth in international flights after 2020 is carbon neutral. To achieve this goal the scheme seeks to cover a broad range of aviation activity by taking a route based approach whereby all operators facilitating international flights from one CORSIA contracting state to another are covered by the scheme. Where the origin and/or destination states of an international flight are not party to CORSIA the flight will not fall within the remit of the scheme. Furthermore, exemptions exist for certain aircraft operators such as those carrying out humanitarian operations or operators with less than 10,000 tonnes of annual CO2 emissions. The implementation of CORSIA is mapped across three phases: the pilot phase (2021–2023); a first phase (2024–2026); and a second phase (2027–2035). During the pilot and first phases, offsetting requirements will only apply to flights between states that have indicated their voluntary participation. Reporting in July 2020, the ICAO noted 88 states had indicated their participation in the 143

9.3  Environmental Issues and the Aviation Industry scheme from 1 January 2021.7 Among these include states with strong aviation industries such as the USA and United Kingdom. Other states, such as Grenada and South Sudan, have indicated their intention to voluntarily participate from 1 January 2022. In the second phase ICAO member states will be required to participate where they have a share of 2018 Revenue-Tonne Kilometres (RTK) greater than 0.5% of total RTKs or the state’s total share reaches 90% of total RTKs.8 Exemptions exist for developing countries although they can continue to voluntarily participate. Offsetting obligations (from 2021–2029) will be calculated through multiplication of the operators’ annual emissions by the growth factor of the aviation sector. This formula will be changed in 2030 and will take into account an operators growth factor. This will form, at a minimum, 20% of the calculation from 2030–2032 and then 70% from 2033–2035. Airlines will then be required to buy emissions offsets in other industries to achieve their offset obligations. Essential to the scheme is the monitoring and reporting stage which was operative between 2019 and 2020. This period was necessary to establish the sectorial baseline from which future sectoral growth will be compared for the purposes of calculating carbon offset obligations. During this stage all ICAO member states were required to submit a State’s Emissions Report based on the Emissions Report and Verification Report submitted by aircraft operators. In light of the Covid-19 pandemic the ICAO resolved that 2019 emissions values would be used in place of 2020 emissions values as the reduction in international aviation activities and emissions in 2020 would generate a sectorial baseline which would not be representative of aviation emission levels pre-pandemic.9 CORSIA has been the subject of some criticism with academics noting that both CORSIA and the EU ETS (see below) were unlikely to have a significant impact in terms of emission reductions.10 Despite this, the ICAO have noted that CORSIA will increase the demand for emission units for the purposes of carbon offsetting, and this in turn will increase the ‘incentives to invest in emissions reduction projects in participating states.’11 Moreover, in 2021 the EU Commission announced as part of their ‘Fit for 55’ proposals to maintain the EU ETS in conjunction with CORSIA, such that the EU ETS will cover intra-European Economic Area (EEA) flights and CORSIA will cover extraEuropean flights between EEA countries and third party countries and flights by EU carriers between third party countries. In light of these proposals, IATA

7 International Civil Aviation Organisation, ‘CORSIA  States for Chapter  3 State Pairs’, see https://www.icao.int/environmental-protection/CORSIA/Documents/CORSIA_States_for_ Chapter3_State_Pairs_Jul2020.pdf. 8 International Civil Aviation Organisation, ‘Climate Change Mitigation: CORSIA’, see https:// www.icao.int/environmental-protection/CORSIA/Documents/ICAO%20Environmental%20 Report%202019_Chapter%206.pdf. 9 International Civil Aviation Organisation, ‘ICAO Council Agrees to the Safeguard Adjustment for CORSIA in light of COVID-19 Pandemic’, see https://www.icao.int/Newsroom/Pages/ ICAO-Council-agrees-to-the-safeguard-adjustment-for-CORSIA-in-light-of-COVID19pandemic.aspx. 10 Jörgen Larsson, Anna Elofsson, Thomas Sterner & Jonas Åkerman ‘International and national climate policies for aviation: a review, Climate Policy’ (2019) 19:6, 787–799, DOI: 10.1080/14693062.2018.1562871 available at https://www.tandfonline.com/doi/full/10.1080/1 4693062.2018.1562871. 11 International Civil Aviation Organisation, ‘Benefits for CORSIA Participation’, see https://www. icao.int/environmental-protection/Pages/A39_CORSIA_FAQ5.aspx#:~:text=Participating%20 in%20CORSIA%20will%20increase,reduction%20projects%20in%20participating%20States.

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Aviation specific initiatives 9.4 have noted their concern that the EU would not implement CORSIA on all international flights.12

Emissions trading scheme (ETS) – for the aviation sector 9.4 The EU’s move to extend the ETS to aviation was a defining step for the industry. The ETS was designed to achieve the EU’s emissions targets agreed under the Kyoto Protocol as well as the EU’s self-imposed target of reducing its emissions by 20% by 2020. The ETS is a ‘cap and trade’ system. A  cap was originally placed on greenhouse gas emissions from installations in the EU, which has now been extended to include aviation. Aircraft operators must monitor and make an annual report of the emissions from the aircraft which it operates.13 Significantly, the aviation ETS is not restricted to emissions in the EU, but instead places a cap on the total of emissions from flights that ‘depart from or arrive in an aerodrome situated in a Member State’. The cap is, therefore, not limited to emissions in EU airspace, but also applies to emissions outside EU airspace in respect of flights departing from or arriving in a member state. Further, the ETS requires aircraft operators to obtain and surrender allowances equal to their emissions during the preceding calendar year. The requirement to obtain and surrender allowances is based on the entirety of flights that begin or end in the EU, regardless of what percentage of such flights occurs inside or outside of EU airspace. It covers the total fuel used during the entire flight, including time spent on the ground at the airports of departure and arrival. Enforcement of the ETS Directive is implemented at EU member state level and, therefore, the rights of the authorities to impose detention rights and lien rights over aircraft is likely to differ between each applicable EU state. The EU ETS scheme was met with some adverse reaction from the airline industry, with particular criticism from China, the US, India and Russia. The US enacted the EU Emissions Trading Scheme Prohibition Act which prohibits US carriers from participating in the scheme and China threatened to withhold $60 billion in orders from Airbus. Facing this pushback, the EU decided to limit the geographic scope of the EU ETS to intra-EEA flights until 2016 and support the ICAO’s effort in developing a global measure. Following the ICAO’s proposal of a new global offsetting scheme (namely the Carbon Offsetting and Reduction Scheme (CORSIA)) in 2016, the intra-EEA flight limit has been retained pending a review of the EU ETS and an examination of how this may be revised to facilitate implementation. Should there be a failure to amend existing EU ETS legislation, the scheme will revert back to its full scope in 2024. A proposal for the amendment of the EU ETS scheme was adopted by the European Commission in July 2021 in the first tranche of the Commission’s ‘Fit for 55’ measures aimed at supporting Europe’s climate policy framework and putting the EU on track for a 55% reduction in carbon emissions by 2030, and 12 International Air Transport Association, ‘Tax is not the Answer to Aviation Sustainability’, see https://www.iata.org/en/pressroom/pr/2021-07-14-01/. 13 The monitoring and reporting of the emissions must be based on the principles set out in Annex IV, Part B  of the Amended Directive (see Article  14(1) of the Amended Directive), which provides, inter alia: ‘Emissions shall be monitored by calculation. Emissions shall be calculated using the formula: Activity data × Emission factor × Oxidation.’

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9.5  Environmental Issues and the Aviation Industry net-zero emissions by 2050. As of the time of writing, the proposed amendment has been referred to the European Parliament’s Committee on Environment, Public Health and Food Safety.

How emission reductions can be achieved 9.5 CORSIA also underpins the aviation industry’s commitment to technology, operational and infrastructure advances in order to continue to reduce the sector’s carbon emissions. Emission reductions can be achieved through a range of measures that are open to airlines for example: • cooperating with governments and air navigation service providers to use the shortest feasible routes; • careful planning of fleet changes using the newest technology aircraft; • where there is an option, using aircraft best suited to particular sector distances; • improving load factors; • flying at optimal speeds and altitudes; • operating newer, fuel efficient aircraft; • using more fuel-efficient navigation techniques; • eliminating single use plastics from their operations; • using sustainable fuels.

AVIATION WORKING GROUP (AWG) INITIATIVES 9.6 The environmental impact of aviation is a key focus of the AWG. In the past 12 months it has developed the carbon calculator to address the shortfall of reliable data on carbon impacts of flying. The calculator uses OEM data based on a consistent set of assumptions agreed between the participating manufacturers. It enables users to perform advanced calculations. It is designed to generate reliable and consistent CO2 emissions information for aircraft and aircraft portfolios based on aircraft-specific operational information that is generally available to airlines, aircraft lessors, aircraft financiers, and other aviation investors. For more information on the AWG carbon calculator readers may access the AWG website at www.awg.aero. The AWG has also developed a statement of principles on environmental regulation and has also focused its attention on assessing the potential impacts on leasing and financing of environmental regulations, disclosure requirements and governmental policies. A key piece of policy attention is the EU taxonomy on green financing as it applies to aircraft financing and leasing (see below) and the AWG has inputted to this, focusing on five key standards: feasible improvement; incentive; aircraft class differentiation; ICAO certification; and data based self-reporting. Again more useful details are available at the AWG website. In September 2021, the AWG submitted a letter to the EU  Commission on its preliminary recommendations for taxonomy technical screening criteria (TSC) for passenger air transport published on 4 August 2021. In its letter, the 146

Sustainable investment/financing initiatives 9.7 AWG argued that the approaches taken by the Commission in respect of the decommissioning of aircraft and sustainable aviation fuels (SAF) requirements are unworkable and that amendments should be made to the TSC’s provisions on qualifying aircraft and corporate finance. Whether these points raised by the AWG will be reflected in the revised TSC remains to be seen.14

SUSTAINABLE INVESTMENT/FINANCING INITIATIVES EU taxonomy 9.7 The EU taxonomy (Regulation (EU) 2020/852) is a classification system, framing a list of environmentally sustainable economic activities and a framework for sustainable investment. The EU taxonomy came into force on 12 July 2020. It seeks to create security for investors, protect private investors from so-called ‘greenwashing’, help companies to plan the transition, mitigate market fragmentation and eventually help shift investments where they are most needed. It does this by setting out appropriate definitions to companies, investors and policymakers on which economic activities can be considered environmentally sustainable. The EU taxonomy applies to financial products marketed as ‘green’ in the EU and sets out four key conditions that an economic activity has to meet in order to qualify as environmentally sustainable: (1) making a substantial contribution to at least one environmental objective; (2) doing no significant harm to any other environmental objective; (3) complying with minimum social safeguards; and (4) complying with the technical screening criteria. In March 2021, the Steer publication ‘Sustainable finance taxonomy for the aviation sector’ covered various key elements relating to the aviation sector. The report identifies four sectors active in air transport to be considered for inclusion in the taxonomy, namely: aircraft-related activities (such as air transport and aircraft manufacturing); fuel production, storage and distribution; air traffic management; and airport-related activities (for example, airport operation and ground handling and constitution of airport infrastructure). To what extent the Steer Report’s proposals will reflect the final technical screening criteria adopted by the European Commission remains to be seen. In February 2021, the AWG submitted a letter to the EU  Commission on principles for the EU taxonomy on green financing applicable to aviation financing and leasing. In that letter, in line with its policy position as noted above, the AWG expressed support for a single international system for classification of green aircraft financing and leasing, with a focus on avoiding conflicting national or regional standards, and based on five principles: feasible improvement; incentive; aircraft class differentiation; ICAO certification; and data-based self-reporting – see the AWG website (www.awg.aero) for more details.

14 Available at http://awg.aero/wp-content/uploads/2021/09/AWG-Letter-to-EC-re-EUTaxonomy-Aviation-22-September-2021.pdf.

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Bonds and loans 9.8 Green bond principles (GBPs) and green loan principles (GLPs) were developed by the International Capital Markets Association and Loan Market Association (LMA) respectively – in 2014 and 2016. Both are focused on green financing, with a particular emphasis on ‘green projects’ – both in terms of development and integrity. Both are based on four basic pillars: (1) Use of proceeds – loan proceeds must be used for projects which provide clear environment benefits. (2) Process for project evaluation and selection – the borrower clearly communicates its environmental sustainability objects and how the project meets eligibility criteria. (3) Management of proceeds – transparency and integrity – ie make sure that the use of funds for the sustainable goals can be tracked. (4) Reporting – the requirement for borrowers to keep up-to-date information on the use of proceeds on an annual basis. Loans provided under GBPs and GLPs will usually involve external review, verification, certification and rating by a third party. Often there will be a margin ratchet depending on whether the borrower achieves certain specified environmental targets. This product can work well in aviation where an old fleet is being replaced with new technology aircraft, as was the case in the Braathens Regional Airlines ATR fleet replacing the BAE 146 fleet in 2019, part of which was financed in this way.

Sustainability linked loan principles 9.9 This is a further development by the financial industry associations. Introduced in 2019 by the LMA, Loan Syndications and Trading Association, and the Asia Pacific Loan Market Association, sustainability linked loan principles (SLLP) have the aim of facilitating and supporting environmentally and socially sustainable economic activity and growth. The SLLP are recommended guidelines. They may be applied by market participants on a transaction basis depending on its characteristics. The concept is that lenders are able to incentivise the sustainability performance of the borrower. Sustainability linked loans are any types of loan instruments which incentivise the borrower’s achievement of ambitious, predetermined sustainability performance objectives. Unlike GBPs and GLPs, sustainability linked loans need not apply to a particular project. In most cases, proceeds are used for general corporate purposes. A borrower’s sustainability performance is measured using sustainability performance targets (SPTs), which include key performance indicators, external ratings and/or equivalent metrics. Sustainability linked loans will often link the borrower’s performance to margin redetermination over the life of the loan. The SLLP set out a framework, enabling all market participants to clearly understand the characteristics of a sustainability linked loan, based around the following four core components: 148

Conclusion 9.10 (1) Relationship to borrower’s overall corporate social responsibility (CSR) strategy – the borrower of a sustainability linked loan should clearly communicate to its lenders its sustainability objectives. (2) Target setting – measuring the sustainability of the borrower – appropriate SPTs should be negotiated and set between the borrower and lender group for each transaction. (3) Reporting – borrowers should make and keep readily available up-to-date information relating to their SPTs. (4) Review – external review of SPTs is encouraged.

CONCLUSION 9.10 Off-setting programmes need to be underpinned by core elements that go to best practice – in particular they must ensure additionality and be aligned with social and environmental priorities with no negative impacts. They must also be transparent and verifiable. Critically they can only be a part of any business’s meaningful programme to reduce its footprint. For the aviation industry, the momentum around innovation to achieve tangible results in terms of carbon reduction is building. The reality is that aircraft powered by carbon-neutral fuels are on the way – some are already flying – and the potential is clear. Innovation and research into cleaner fuels and effective technology and operational strategies with tangible results is continuing and accepted as needed in order for the aviation industry to thrive. As aviation activity worldwide increases, the pressure on aircraft operators, airports and air traffic management to increase capacity is intensifying the debate on the environmental impact of aviation. The aviation finance community is increasingly grappling with ESG and environmental metrics, as scrutiny grows over its role in the climate crisis. Environmental sustainability in the aviation industry is a complex, political and fast-moving topic. The EU has led the way in terms of introducing measures targeting an environmentally sustainable aviation industry. The wider governmental/intra-governmental picture is a bit more mixed but becoming more aligned. Key aviation industry organisations – including IATA, ICAO and the AWG – are on the front foot in policy development and thought leadership. Manufacturers and airlines are placing the issues at the heart of their business planning, and innovative start-ups are gaining momentum. Lessors and financiers are giving the issues much more focus and the wider financial industry associations are playing their part in developing principles and frameworks. Throughout 2021, there were a number of important initiatives and commitments made by airlines and industry organisations towards reducing emissions and promoting sustainability. British Airways (BA) launched its ‘BA Better World’ sustainability programme in September 2021, aimed at reducing emissions and waste as well as making positive contributions to the communities it serves.15 As part of this programme, BA committed to a partnership with BP to source SAF in respect to all of its flights between London, Glasgow and Edinburgh during the United Nations Climate Change Conference (COP26) in Glasgow in November

15 See https://www.britishairways.com/en-gb/information/about-ba/ba-better-world.

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9.10  Environmental Issues and the Aviation Industry 2021. Emissions produced by SAF release carbon that has previously already been released unto the atmosphere, unlike emissions produced from traditional jet fuel, which release carbon previously locked under the ground. BA’s move towards using SAF comes in connection with the signing in September 2021 of the World Economic Forum’s ‘Clean Skies for Tomorrow Coalition’ ambition statement by 60 companies (including BA, Qantas, American Airlines, Heathrow Airport and Airbus) committing the signatories to raise the current use of SAF from 0.01 per cent to 10 per cent of the fuels used by 2030.16 Furthermore, members of IATA pledged in October 2021 to reach net zero carbon emissions by 2050, an ambitious step by the organisation that counts 292 airlines as members.17 On the financing side, Etihad Airways announced also in October 2021 that it had raised $1.2 billion with a loan linked to ESG targets in aviation, a move that the airline touted as the first sustainability-linked loan in global aviation tied to ESG targets, which include measures aimed at reducing carbon emissions and improving corporate governance.18 As COP26 prepares to sit, leaders in the aviation industry are seeing it as inevitable that it will be impacted by any outcomes from the conference that aims to accelerate action of the Paris Climate Accords and the UN Framework Convention on Climate Change. Key players in the industry are seeing this as a real opportunity to implement meaningful and lasting change. For example, with the UK holding the COP26 presidency, Heathrow Airport has called upon the British government to take leadership on committing to decarbonised aviation, emphasising an increased use of SAF as a means to lead emission-reducing efforts.19 Carbon/greenhouse gases reduction is and must be the key focus – this is grounded in technological and operational innovation and in capital investment in replacing the old with the new. A key part of this will be established players opening up their extensive range of leasing and financing toolbox to the next generation equipment. Sequestration and offsets will continue to play an important part – and the focus must be on sustainable sequestration projects that meet the highest ethical and environmental standards. CORSIA gives the industry a frame for this channel. Science-based measurement is at the heart of all efforts. The AWG is to be commended for its carbon calculator initiative in this regard. All businesses in the industry must – as indeed all of us must – embed this in the culture and DNA. Sustainable financing/capital investment principles and developing regulatory taxonomies (such as the EU initiative) can underpin and speed up the much needed supply of capital. Critically, all aviation industry players – not just the manufacturers and the airlines – must play their part in building sustainable outcomes.

16 See https://www.weforum.org/press/2021/09/clean-skies-for-tomorrow-leaders-commit-to-10sustainable-aviation-fuel-by-2030/. 17 See https://airlines.iata.org/news/net-zero-carbon-emissions-by-2050?&redirectcounter=1. 18 See https://www.etihad.com/en-nl/news/etihad-raises-us12-billion-in-first-sustainabilitylinkedesg-loan-in-global-aviation. 19 See https://www.heathrow.com/latest-news/-eathrow-urges-ministers-to-announce-asustainable-aviation-fuel-mandate-at-cop26-to-cut-aviation-emissions.

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Part III Core Products and Regional Markets

10 Export Credit Financing Jeffrey Wool1 and William Coleman

INTRODUCTION 10.1 Export credit support for aircraft financings has existed for decades. Initially designed to assist emerging market buyers in their purchase of Westernmanufactured aircraft, the early focus was on ensuring that competition between exporters was driven by price and quality as opposed to the favourability of accompanying financial support. Over time, however, export credit grew into a mainstream financing solution particularly when credit markets were restricted or perceived as being too expensive. The result, inevitably, was its increased regulation as evidenced by the multiple revisions to the underlying rulebook that were an attempt to balance and regulate the complex and numerous competing interests of its participants. Since the most recent revision in 2011, the industry has enjoyed a remarkable period of sustained growth and abundant credit, which, in turn, helped alleviate some of the issues that informed these earlier revisions. But once again, as the aviation industry reels from the impact of Covid-19, a renewed focus on the next iteration of the export credit product’s evolution can be expected, as new ingredients such as sustainability and social impact criteria filter into the export credit equation. The purpose of this chapter is to provide an overview of the evolution of the regulatory framework within which export credit for aircraft equipment operates, as well as to present some of the most important past and current issues surrounding such transactions. In addition, the Annex provides an overview of the two structures frequently used in such transactions.

REGULATORY FRAMEWORK The beginning 10.2 The period between 1814 and 1914 was an era of developing world trade. Events such as World War I and the Great Depression greatly disturbed that trend, eventually resulting in trade protectionism. The Berne Union, established in 1934 in reaction to accusations of unfair and anticompetitive conduct among countries scrambling to win exports for their domestic industries, was the first body to set parameters for the operation of export credits and fair trade. Its impact was not long lasting, as World War II shattered the world’s economies. 1 Jeffrey Wool has contributed to this article in a personal capacity. His comments do not necessarily reflect the views of any grouping with which he is affiliated.

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10.3  Export Credit Financing The post-World War II era opened up not only the economies ravaged by war, but also those of newly independent countries. The potential for trade and, therefore, exports was now much greater. It was also riskier. In response to these factors, Western governments formed export credit agencies, or ECAs, and used them to extend official support through loans, loan guarantees and political risk insurance to help export their goods to new markets. The success of ECAs was immediate. However, not only did they help reduce commercial and political risk (and thus promote exports and support employment), they soon came to be seen by some as tools to potentially create competitive advantage and trade distortion. The main criticism was that they indirectly provided subsidies. Western governments therefore agreed to adopt guidelines that sought to monitor export practices and established, in 1963, the Trade Committee of the Organisation for Economic Cooperation and Development (the OECD). In 1978, the OECD agreed the ‘Arrangement for Officially Supported Export Credits’ (the ‘Arrangement’). This became the formal guidelines within which all OECD member states (the largest economies and main manufacturers at that time) and their ECAs were expected to comply. The Arrangement was put in place to foster a level playing field and to provide an institutional framework for an orderly export credit market. In other words, the goal was to prevent an export credit race whereby exporting countries compete on the basis of who grants the most favourable financing terms. Instead, that competition should be on the basis of who provides the highest quality goods and the best service for the lowest price. The Arrangement covered export credit support with a duration of two years or more in the form of guarantees, indemnities, insurance policies and subsidies. It addressed the terms and conditions of the directly funded export credit, not the terms and conditions of the particular guarantees or indemnities. Primarily, the Arrangement dealt with issues such as the percentage of the contract eligible for support, the percentage of contract payments that must be covered by a cash payment, the maximum repayment term for export credit support and the parameters for setting applicable interest rates in circumstances where fixed interest rates are officially supported. The Arrangement also included complex provisions on deviation and derogation through the concepts of common lines and matching.

SECTOR UNDERSTANDING ON EXPORT CREDITS FOR CIVIL AIRCRAFT 10.3 The Arrangement did not specifically deal with commercial aircraft and it was not until 1986 that the OECD put in place formal guidelines on export credit support for aircraft through the Large Aircraft Sector Understanding (given its common reference, and for simplicity, LASU). LASU was complementary and a part of the overarching Arrangement. LASU’s goal was to ensure a level playing field among manufacturers within their respective aircraft categories, categorising aircraft into Large (Airbus, Boeing and (the now defunct) McDonnell Douglas), Category A (turbine-powered aircraft generally between 30 and 70 seats), and Category B (other turbine-powered aircraft). It also assisted airlines (particularly in developing countries), which, unlike their competitors, did not otherwise have access to long-term dollar-based funding for their aircraft acquisitions. LASU introduced a degree of regulation by limiting export credit 154

WTO litigation 10.4 support to a maximum 85% of the total aircraft net price, maximum repayment terms of ten to 12 years, and minimum interest rates. It did not, however, address the pricing for export credit guarantee or insurance (pure cover), which was to become the primary form of official support for large aircraft. At the time LASU came into effect, the large aircraft manufacturers were Airbus, Boeing and McDonnell Douglas, making the LASU essentially a US-European agreement. The use of export credit financing support in aircraft financings was perceived, to a greater or lesser degree, as a last resort option. In those days, the Export-Import Bank of the United States (Ex-Im) cooperated mainly with its own set of US commercial banks, whereas the European banks dealt primarily with their respective ECAs, namely (using their contemporary titles) BPI France Assurance Export (BPI France) in France, Euler Hermes KreditversicherungsAG (Euler Hermes) in Germany and the UK Export Finance (UKEF) in the UK. The financial products on offer were limited. European ECAs (on differing terms) offered insurance and Ex-Im provided guarantees. The former had disadvantages. As a result, the European ECAs began cooperating more closely and sought to innovate through an expanded set of products covering guarantees, interest rate support and complex aircraft financings. The 1990s were marked by landmark deals and a shift towards a closer relationship between export credit support and commercial lending. Notable deals of that time included the 1991 Air India US$640 million facility for Boeing 747s syndicated by 27 banks, the Guinness-Peat Aviation US$430 million financing of 15 Airbus A320s, and the ‘tres amigos’ TAM, TACA and Lan Chile facility for 150 Airbus aircraft. These were followed by an US$813 million deal for Korean Airlines with Ex-Im and the record-breaking US$4.3 billion European ECA backed facility with ILFC in 1998. This was not only a trend, but a new chapter. Export credit support was no longer a last resort option used in downturns when commercial markets restricted. Export credit support took a place in the mainstream of aircraft financing.

WTO LITIGATION 10.4 The 1990s saw an increase in regional aircraft travel and marked the start of a rivalry between two of the world’s largest regional aircraft manufacturers. Canada’s Bombardier introduced its 50-seat ‘Canada Regional Jet’ (CRJ) 100 in 1992. Brazil’s Embraer moved into the regional aircraft market soon thereafter with its ERJ135 aircraft. A  battle ensued, both in the marketplace and at the World Trade Organization (WTO). Both Bombardier and Embraer, and their respective governments, alleged that the other benefited from state subsidies and therefore violated the Agreement on Subsidies and Countervailing Measures (SCM Agreement). There were attempts to negotiate a settlement, but these failed. As Brazil was neither a member of the OECD nor a participant in its export credit regime, the two countries could only resolve their disputes at the WTO. In 1998, Canada challenged Brazil’s exchange rate subsidy scheme, PROEX, which effectively reduced any loan interest rate for the purchase of Embraer aircraft. Brazil’s counter-arguments that as a developing country it enjoyed looser disciplines on subsidy than Canada, and that it was entitled to subsidise Embraer in order to cancel out the effects of Canada’s subsidies to Bombardier, were largely rejected. The WTO partly based its conclusion on the position that trade retaliations would be tantamount 155

10.5  Export Credit Financing to inviting a ‘race to the bottom’. Canada was authorised to impose tariffs on Brazilian goods, which Canada declined to apply. A second dispute ensued when both companies competed for a large contract to sell aircraft to Air Wisconsin Airlines. In response to a Brazilian financing offer for Embraer aircraft, the Canadian government agreed in early-2001 to provide Air Wisconsin with a low interest credit line to help Bombardier secure the order. Following Brazil’s challenge, in 2002 the WTO found the Canadian subsidy illegal and authorised Brazil to impose sanctions, which Brazil declined to apply. As part of its deliberations, the WTO dispute settlement mechanism panel examined the Arrangement and the LASU against subsidies provisions of the SCM Agreement. It ruled that direct lending financing, refinancing and interest rate support were exempted forms of subsidy pursuant to the safe haven item (k) of the SCM Agreement, but the panel did not extend this exemption to the pure cover support offered by ECAs. Ambiguity in the interpretation of the terms of the Arrangement and the LASU, along with the protracted disputes before the WTO, highlighted the need to expand the reach of the LASU and invite Brazil into the Arrangement.

FROM LASU TO ASU 2007 10.5 The disputes between Brazil and Canada at the WTO and the disparity in terms offered by different ECAs created a need for greater predictability and necessitated the modernisation of LASU, which culminated with the signing of the Aircraft Sector Understanding 2007 (ASU 2007). Its goal was to maintain a level playing field among manufacturers, but also, and this developed in the course of negotiations, to increase pricing to reflect perceived transactional risk, as seen through the business cycle. In addition to this ‘risk-based pricing’ approach, the ASU  2007 also sought to establish a mechanism that enabled enhanced discussions among its signatories (otherwise known as ‘Participants’) so that, unlike LASU, pricing would be reasonably dynamic. The list of Participants to the ASU 2007 expanded to include Brazil, eliminating the need to turn to the WTO for any future disputes between Embraer and Bombardier. The ASU 2007 provided official support in the following forms: • pure cover (export credit guarantees or insurance); • official financing support in the form of direct credit, refinancing or interest rate support; or • a combination of the first two points. The ASU 2007 introduced a bifurcated system – which, as noted below, was a structural problem requiring subsequent redress – that provided different export credit support terms for Category 1 (large) aircraft and Category 2/3 (regional and smaller) aircraft. It introduced a risk-based pricing system, with borrowers of Category 1 aircraft or Category 2/3 aircraft paying a certain minimum premium based on their risk classification. Participants could provide official support up to 85% of the net aircraft price, with the borrowers having to pay the remaining deposit of 15%. The maximum repayment terms depended on aircraft category broken down as follows: 12 years for Category 1 aircraft; 15 years for Category 2 aircraft; and ten years for Category 3 aircraft. Provisions which effectively increased the economic life of a credit transaction were prohibited. 156

The home market rule 10.6 The repayment of principal and payment of interest were to be made in equal instalments, no less frequently than every quarter for Category 1 aircraft, and semi-annually for Category 2/3 aircraft. The Participants charged a minimum premium rate (MPR), which reflected the credit worthiness of the borrowers and ranged between 4% and 7.5% for Category  1 aircraft, paid upfront in the (common) case of pure cover. The applicable Category 2/3 aircraft premium was commonly paid as an annual spread (and updated annually). All borrowers were subject to a risk category rating system similar to the one used by credit agencies. There were five risk categories for Category 1 aircraft and 15 risk categories for Category 2/3 aircraft. In addition to the MPR, there were also risk mitigants, affecting borrowers with a rating of BB- or lower, but these risk mitigants only applied to Category  1 aircraft transactions. In such transactions, a borrower with a risk rating of BB- to B+ was subject to one risk mitigant, those rated B  to B- to two risk mitigants, and those rated CCC to C to three risk mitigants. The three types of risk mitigants were: • 5% reduction from the 85% export credit support (three risk mitigants would equal 70% maximum export credit support); • straight line amortisation; and/or • repayment term not exceeding ten years. The inclusion of a Cape Town Convention discount was another material change. Prior to the ASU 2007, Ex-Im provided a discount by offering a onethird reduction on the otherwise applicable premium for borrowers who were based in a country that had ratified key declarations and effectively implemented the Cape Town Convention. This was an initiative the European ECAs had not immediately embraced, and its practice thus resulted in a difference in applicable terms. There was therefore a need to address this issue in the ASU 2007. The Participants did so by agreeing that borrowers based in a jurisdiction that had ratified and effectively implemented the Cape Town Convention were eligible for a discount, ranging from five to 20%, based on risk category, for Category 1 aircraft, and a flat 10% discount for all borrowers of Category 2/3 aircraft. In the latter case, however, the legal systems of all Participants were deemed equivalent to the Cape Town Convention, and thus the borrowers therein were automatically eligible for the discount. This point was corrected in the subsequent changes to the ASU.

THE HOME MARKET RULE 10.6 The home market rule (or restriction of export credit supported transactions in home markets, ‘the Rule’) is an informal arrangement whereby, in the case of direct competition between supported aircraft, the European ECAs and Ex-Im agree not to provide export credit support to borrowers based in their own or in each others’ home markets (the ‘Home Markets’). By way of example, this means that a borrower in France cannot obtain export credit support from France’s BPI France (as such would not be an export), nor from Ex-Im (to ensure no advantage vis-à-vis the European manufacturer). The same would apply in reverse to a US airline. The effect of the Rule is that airlines in the UK, Germany, France, Spain and the US would not have access to export credit support. Over the years, the Home Market airlines have voiced their concerns over the Rule, 157

10.7  Export Credit Financing which they view as unfair and which prevent an airline-to-airline level playing field. In short, affected airlines have not been able to access credit on the same terms as their competitors. Concerns were raised by such airlines in the course of the negotiations of and the revisions to the ASU 2007. Furthermore, neither Canada nor Brazil recognised the Rule, as it was not formally documented in the ASU 2007 text. This means that export credit financing of Bombardier and Embraer aircraft could be offered under the ASU 2007 terms to borrowers in the Home Markets, whereas the equivalent support for Airbus and Boeing aircraft was not available. The negotiations leading up to the Aircraft Sector Understanding 2011 (ASU  2011) inevitably dealt with the effects of the Rule. On the one hand, airlines from the Home Markets pressed for an improvement of their position under, or the elimination of, the Rule, whilst on the other hand, manufacturer level playing objectives needed to be maintained. In the end, the ASU 2011, like the ASU 2007, declined to formally address the Rule (which therefore remains a practice, and not an express term), but instead sought to improve the position of the Home Market airlines by seeking to better align the cost of export credit support and commercial credit. However, this ‘market pricing’ approach was resisted by some non-Home Market airlines and others who argued it was inconsistent with the original justification for export credit (facilitating exports and related policy objectives). In addition, the Home Market governments separately agreed to disapply the Rule where, in a direct competition, Canadian or Brazilian ECAs offer export credit support to borrowers in Home Markets. In such instances, Home Market ECAs can match the support offered to the Home Market borrower.

ASU 2011 10.7 Two factors led to the need to revise the ASU 2007. First, Bombardier announced its intent to manufacture a new aircraft, the CSeries, to the market. That put unbearable pressure on, and exposed the problems with, the bifurcated system set out in the ASU 2007 with suggestions – subsequently demonstrated – that the size and capacities of the CSeries made it a competitor with the smaller aircraft in the Airbus A320 family and Boeing 737 series. In short, the CSeries brought into question the underlying premise that there existed two distinct sets of manufacturers: those producing large aircraft; and those producing regional and smaller aircraft. The CSeries effectively blurred any such aircraft categorisation. Second, the global credit crisis that followed the collapse of Lehman Brothers in 2008 led to a material restriction in commercial credit, which in turn resulted in a greater reliance on export credit support. In that setting, the grandfathering provisions of the ASU  2007 made export credit terms particularly attractive. Export credit support rapidly increased to 30% of all aircraft financings, with higher percentages for some sub-groupings of borrowers and aircraft. Airlines unable to obtain export credit support began to express their disagreement more vocally with the terms of the ASU  2007 and the Rule which, they claimed, favoured airlines not subject to the latter. While the LASU and the ASU  2007 sought mainly to level the playing field for manufacturers, the ASU 2011, which came into effect on 1 February 2011, was sensitive to airline level playing field objectives. It did so through ‘market based pricing’, which was designed to make export credit support relatively 158

ASU 2011 10.7 less attractive than when compared to the risk-based pricing approach of the ASU  2007. The ASU  2011 further materially tightened the terms applicable to stronger credit borrowers. Otherwise, the emphasis on a manufacturer level playing field was maintained on the assumption that the effects of the Rule were adequately mitigated through the Home Markets matching regime described above. The terms of the ASU 2011 did not apply to grandfathered transactions, governed by the ASU  2007, or the great-grandfathered transactions, governed by the LASU (with a minimum 3% MPR) which benefited from bespoke transitional arrangements. These arrangements were subsequently modified to reflect a sunset date of 31 December 2020, and are therefore no longer applicable. Most fundamentally, the distinction between Category 1 aircraft and Category 2/3 aircraft was abandoned in favour of a single system applying the same terms (save in respect of grandfathering) regardless of the type of aircraft. The standard maximum repayment term was set at 12 years, compared to up to 15 years for Category 2 aircraft under the ASU 2007. The rules allow for an exceptional 15year repayment period, but this comes with a 35% surcharge on the MPR. The repayment term cannot be stretched through pari passu sharing of security rights with commercial debt. Instalments are to be paid quarterly, which was a change from the ASU 2007 (which allowed semi-annual instalments for Category 2/3 aircraft). Semi-annual repayment is possible with a 15% surcharge on the MPR. A significant change in the ASU 2011, when compared to the ASU 2007, was the increase in the MPR. Under the ASU 2011 the MPR consists of two elements: the risk-based rate (RBR), which reflects the risk viewed through the business cycle; and the market reflective surcharge (MRS), which seeks to align export credit support with commercial debt pricing at any point in time. This feature of the ASU 2011 has drawn considerable attention given the relatively high level of complexity and potential volatility produced by the reset system. The RBR is reset annually using a four-year moving average (based on Moody’s loss given default data for first lien senior (non-aircraft) secured bank loans). The first RBR reset occurred on 15 April 2012, and subsequent RBR resets apply from 15 April of each following year. The MRS to be added to the RBR is calculated for each risk category and is based on the 90-day moving average of Moody’s Median Credit Spreads (MCS) with an average life of seven years. Each MCS spread is to be discounted because the raw MCS figures are for unsecured exposure rather than asset-backed transactions. The first MRS reset occurred on 15 April 2011, with subsequent MRS resets occurring on a quarterly basis – although only applied when positive and in excess of 25 basis points. The MPR is subject to a cap of 200%, and a floor of 100%, of the RBR. The quarterly MPR increase resulting from an MRS reset may not exceed 10% of the previous quarterly MPR. The borrowers are rated according to a risk category (RC) scale ranging from one to eight, mirroring rating agencies’ ratings (AAA to C). The ratings are based on the borrower’s senior unsecured credit rating and are determined by the Participants and kept on a list that is available to all Participants on a confidential basis (the ‘List’). Ratings are revised annually, but are subject to interim changes should the borrower’s rating change. Once determined for a transaction, however, a rating can be extended by up to 18 months. The List may be updated on an ad hoc basis. There is a process for establishing a borrower’s RC in case of disagreement among the Participants, which includes resorting to a credit rating agency for a 159

10.7  Export Credit Financing rating should the Participants fail to agree. A borrower that is not on the List can request a risk classification from a credit rating agency at its own expense. The result does not bind the Participants. Those falling into RC 1 (AAA to BBB-) can now only obtain export credit for 80% of the aircraft net price amount, whereas all other borrowers can borrow up to 85% of the aircraft net price amount (subject to risk mitigants, which might reduce the financed amount). In line with the ASU 2007 (for Category 1 borrowers), the ASU 2011 imposes risk mitigants that correspond to the credit rating of the borrower. The ASU 2011 includes a matrix of ‘B’ risk mitigants in addition to the ones introduced in the ASU  2007, and which are now called ‘A’ risk mitigants. Any of the ‘A’ risk mitigants can be substituted with a 15% surcharge on the MPR. The ‘B’ risk mitigants are: • a security deposit (cash collateral or letter of credit) equal to one quarterly instalment of principle and interest; • advance payment of one quarterly instalment of principal and interest on each lease payment date; and/or • maintenance reserves in a form and amount reflective of best market practice. The number of applicable risk mitigants increases as the rating of the borrower decreases. Those rated BB- are subject to one ‘A’ risk mitigant whereas those rated B+ are subject to one ‘A’ risk mitigant and one ‘B’ risk mitigant. The lowest rated borrowers, CC to C, are subject to three ‘A’ risk mitigants and one ‘B’ risk mitigant. In order to be eligible for the ASU  2011 terms listed above, the transaction must be asset backed. This includes: (a) a first priority security interest in the aircraft and engines; (b) in a lease structure, assignment and/or first priority security interest of or in the lease payments; and (c) cross-default and crosscollateralisation of all aircraft and engines owned legally and beneficially by the same parties under the financing, when permitted under applicable law. The ASU 2011 permits non-asset backed transactions in certain cases, and at a significant premium, the only exception being sovereign borrowers in RCs 1–3. There is currently a maximum Cape Town Convention discount of 10% under the ASU  2011, which is available if the borrower is based in a country that has ratified and properly implemented the Cape Town Convention. The relevant country must also have made the qualifying declarations.2 A list of countries that are eligible is maintained by the OECD Secretariat. Countries can be removed from, or reinstated to, the list depending on how they implement and apply the Cape Town Convention although any such change after disbursement in respect of an aircraft does not affect the MPR analysis for that aircraft. Finally, the ASU 2011 imposes no restrictions on the actual volume of export credit support and each Participant reserves the right to withdraw from the ASU 2011 by notifying the OECD Secretariat.

2 As defined in Annex 1 of the ASU  2011 (‘qualifying declarations’ means: (i) insolvency (Protocol, article XI, Alternative A  (With no more than a 60 calendar day period); (ii) deregistration and export (Protocol, article XIII); (iii) choice of law (Protocol, article VIII); and (iv) either: (a) non-judicial remedies (Convention, article  54(2); or (b) expedited court remedies, Protocol, article X). Certain other declarations would be disqualifying. There are special rules applicable to EU countries, given aspects of European law.

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Export credit’s homecoming 10.9

THE ‘SUPERCYCLE’ 10.8 The period between 2011 and the Covid-19 outbreak in early-2020 saw the aviation industry enjoy a period of remarkable growth and sustained profitability. An abundance of liquidity and capital to fund aircraft deliveries coupled with – importantly – the continued growth of aircraft lessors keen to build their portfolios by entering into new aircraft sale and leaseback transactions substantially reduced the need for traditional export credit support. This effect was compounded by the failure to re-authorised Ex-Im in 2015 (which meant it remained essentially dormant until the start of 2020) and the United Kingdom Serious Fraud Office investigation into Airbus in 2016 (which resulted in Airbus export credit cover being available on a limited, case-by-case basis). Furthermore, whilst there is little publicly available empirical analysis of the ASU 2011 pricing, a 2015 study3 suggested that export credit support was materially more expensive than commercial bank debt for all but the highest RCs.4 Such availability of commercial credit, coupled with the above market cost of export credit, also reduced concerns about the Rule.

EXPORT CREDIT’S HOMECOMING 10.9 Whilst the decline of export credit during this ‘supercycle’ period was precipitous, accounting for a low single digit percentage of aircraft deliveries in 2019 globally, the impact of Covid-19 means that its resurrection is foreseeable. Indeed, seen through a traditional lens, the essential raison d’etre of export credit is to respond in moments of disruption and heightened risk by providing predictable and stable financing (albeit at a price). Much of that thinking was informed by a historic lack of alternatives and the assumption that absent export credit support the wider aviation industry ecosystem would suffer intolerable harm. Elements of that philosophy are evident in Ex-Im’s ‘additionality’ criteria. This element of the approval process is at its core intended to introduce a more forensic test when examining whether its support of a given transaction is necessary, and not, in fact, a substitute for private sector financing: the rules appear to be designed essentially to ensure that the bank’s involvement is genuinely facilitating a transaction that would otherwise not proceed without its support. But the contemporary financing landscape, with a much greater diversity of products, participants and (non-bank) deep pockets, looks very different to that leading up to the ASU 2011. Leasing companies – many with investment grade ratings – have demonstrated the ability and appetite to support deliveries. Insurance and guarantee supported structures are now commonplace. Private equity backed participants are able to provide alternative financing solutions. As such, and notwithstanding the severe damage that the Covid-19 pandemic has wrought across the industry, liquidity in the broadest sense has remained robust. How this particular fact pattern will be viewed through an ‘additionality’ lens remains to be seen, as does the broader question as to how the ASU 2011 methodology for calculating the MPR will respond to current market dynamics. 3 4

See the 2015 Aviation Working Group’s submission to the OECD comparing the ASU 2011 and current market pricing as assessed by the Aviation Working Group’s independent technical expert, Professor Vadim Linetsky. A point confirmed in litigation surrounding the Ex-Im’s support for select transactions.

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10.10  Export Credit Financing

FUTURE DEVELOPMENTS 10.10 A  portent of things to come can be seen in the recent common line proposal issued by the European Council in March 2021 which was developed explicitly as a reaction to the economic downturn resulting from the Covid-19 pandemic (the ‘2021 Common Line’). As mentioned above, a common line is an instrument under the ASU  2011, which allows the Participants (of which the European Union is one) on an exceptional basis to divert from the ASU provisions with regard to a specific transaction or temporarily for a non-specific number of transactions. Whilst the definitive text of the 2021 Common Line does not (at least, as at the time of writing) appear to be public, drafts that are available seem to suggest the intent is to permit ASU Participants – albeit for a 12-month period – to support their respective manufacturers of civil aircraft whose business is threatened by short-term liquidity problems of the operators and buyers of new aircraft and engines. It does so by providing such operators and buyers with deferred loan principal repayment terms. More concretely, these deferred terms are for 12, or if certain conditions are satisfied, 18 months following delivery. An interesting and potentially important feature of the proposed 2021 Common Line concerns incentives linked to environmental factors. In circumstances where such operators and buyers have adopted, or commit to adopting, a public CO2 emissions monitoring and reduction plan, that can add an incremental sixmonth deferral period referenced above. It remains to be seen to what extent this feature will be engaged. However, it is a clear indication of the future trajectory of the ASU product – and the expectation that environmental, social and governance (ESG) matters will become a relevant feature of export credit support much in the same way that these topics are rapidly gaining traction in all areas of the financial and corporate world. Other future developments include the transition of export credit structures into the Global Aircraft Trading System (GATS®) and a renewed discussion on the Cape Town Convention discount. The former is a logical evolution of the product into what is an enhanced and potentially more efficient ownership structure. The latter is a consequence of the increasingly mature framework surrounding the Cape Town Convention – as the Convention has gained adherents and currency, the broader focus has inevitably shifted towards the more nuanced topic of compliance, and a discount regime that has the capacity to flex depending on an assessment based on compliance (rather than mere implementation) would also represent a significant gear shift in terms of how export credit intersects with, and supports, the Cape Town Convention.

CONCLUSION 10.11 The expected increase in demand for export credit support will inevitably result in its increased assessment. As before, a critical element will be how the embedded pricing mechanisms respond to market dynamics and whether the current package is able to sustain the right balance between export credit and an expanded commercial market. And such assessment is likely to occur in an environment where ESG criteria will be brought to bear in a direct and empirical manner: indeed, it seems difficult to envisage any amendments to the ASU not addressing these topics. 162

Transaction structures 10.12

ANNEX TRANSACTION STRUCTURES Part A EXHIBIT 10.1 ECA-SUPPORTED FINANCE LEASE STRUCTURE

10.12 ECA A

ECA B

ECA C

Lessor Parent/ Charitable Trust

ECA Guarantee

85% (80% for RC1) of net

ECA Lenders ECA Loan

Loan payments

Share charge

100% ownership

SPC Lease rental

ECA Lease Lessee

Purchase Agreement Assignment

Security Trustee Security package (mortgage, assignment of lease and insurances, warranty arrangements)

15% (20% for RC1) of net price Purchase Agreement Manufacturer

ECA aircraft financings are typically structured as finance leases. The ASUs have been negotiated on that basis. One such financing lease structure is outlined in Part A. It shows an export credit financing supported by the relevant ECAs (ECA A  and ECA  B) and led by a designated ECA (ECA  C) issuing a guarantee to the syndicate of lenders (ECA Lenders). There is a loan agreement between the syndicate and the borrower, normally a special purpose company (SPC). The structure is initiated with the incorporation of the SPC, which will enter into a loan with the lenders. The sole purpose of the SPC will be to acquire and finance lease the aircraft. The SPC will be established in a tax neutral jurisdiction, and may be a company owned by a charitable trust and controlled by lenders through a share charge. Prior to delivery of the aircraft, the airline will assign its right to take title to the aircraft under the purchase agreement to the SPC. The manufacturer will then transfer title to the aircraft to the SPC on receipt of the purchase price from the SPC. The SPC will finance up to 85% (80% in the case of RC 1), assuming there is no reduction by the use of risk mitigants, through the loan agreement with the lender(s). The remaining 15% (20% in the case of RC 1) will be provided by the airline. In most transactions, the residual amount will be paid by the airline from its own cash reserves (or out of existing pre-delivery payments), but it can also be provided by way of a commercial, subordinated loan or indeed using thirdparty equity when, for example, combined with a JOLCO (Japanese Operating Lease with Call Option). The lease between the SPC and the airline will be structured so that the lease rental payments match the loan payments. At the same time as the aircraft is delivered, the security trustee will be provided with a security package. Security is granted at all levels of the transaction: the airline will grant security to the SPC and the SPC will in turn grant security to the security trustee. A typical security package will include: 163

10.13  Export Credit Financing •

an assignment by way of security by the airline of its insurances in the aircraft to the SPC, and a further assignment by the SPC to the security trustee along with customary arrangements relating to manufacturer warranties;

•

the SPC will also grant a mortgage to the lenders and account pledges over the accounts in which the finance lease rentals are paid; and

•

the lenders will also take security over the shares of the SPC through a share charge granted to the security trustee.

Recourse to the SPC will be limited to the security provided by the SPC. The structure will be such that the airline will take any structural risk associated with the transaction. The default risk will come from the airline. There are very few circumstances in which the SPC can default. If such a default occurs, the transaction documentation may allow for a period during which the airline can try and restructure the transaction in order to cure the default, provided the ECAs are unaffected throughout. However, should the restructuring fail, or not be curable, the security trustee will be able to enforce the security granted and repossess the aircraft, or, in the case of an operating lessor, take over the role of the lessor under the lease.

Part B EXHIBIT 10.2 ECA-SUPPORTED CAPITAL MARKETS STRUCTURE

10.13 Indenture Trustee

ECA Guarantee

ECA Benefits from security package Share charge

Security Trustee Loan 85% (80% for RC1) of net price ECA Market Note

Assignment of security Borrower (SPC) Issuer Finance Lease

Issuer Parent Charitable Trust 100% ownership

85% (80% for RC1) of net price Manufacturer

Airline/Operating Lessee 15% (20% for RC1) of net price Reimbursement agreement Sponsor Guarantee

ECAs have supported several capital markets-based transactions in recent years. A  capital markets transaction may be structured in two steps: (a) an initial financing by bank lender(s) under a structure similar to other typical ECA lending arrangements; and (b) at the election of the sponsor, a refinancing of the note 164

Transaction structures 10.13 or notes issued to the bank lender(s) (the ‘Bank Note’) pursuant to the on-sale of interests in a similar note containing slightly different terms and conditions (the ‘Capital Markets Note’) to investors in the capital markets, typically once a sufficient volume of aircraft has been originated into the structure. The Capital Markets Note is designed to be exempt from the registration requirements of the US  Securities Act of 1933, as amended, and other US securities laws based on a guarantee of regularly scheduled payments of interest and principal provided by the ECA (the ‘Guarantee’). The refinancing is advantageous to the sponsor because the refinancing will be timed to achieve, in coordination with the initial purchasers, a lower interest rate (often fixed-rate) than was payable to the bank lenders. From the perspective of investors, interests in the Capital Markets Note, as government guaranteed notes, are treated as having equivalent risk to equivalent duration government bonds, but with a better coupon. Because investors will look to the credit of the ECA instead of the aircraft underlying the transaction, a more limited disclosure document is used in marketing interests in the Capital Markets Note compared to other securitisation and structured finance transactions. Under the mechanics of the capital markets offering, if the sponsor decides to refinance, the Bank Note will be transferred from the bank lender(s) to one or more initial purchasers. The initial purchaser will then effect an exchange of the Bank Note for the Capital Markets Note immediately prior to the settlement of the refinancing into the capital markets. The Capital Markets Note will be registered in the name of the clearing system or its nominee, and the initial purchasers’ positions and those of the ultimate investors will be held through bookkeeping records of the direct and indirect participants of the clearing system. There are important differences between the terms of a capital markets refinancing transaction and the more common ECA lending. Upon refinancing, the role of the ‘Borrower’ (SPC) changes and it becomes the ‘Issuer’ and is therefore subject to risk in the event of non-performance. The Issuer and the sponsor will typically indemnify the ECA and most other transaction participants for securities law risks. In many other respects, however, the SPC as Issuer shares the same attributes as the SPC under a loan, for example, it is insolvency remote and its equity interests will normally be pledged to the security trustee, along with the standard security package assignment. The guarantee is provided to a trustee under an indenture acting for the benefit of the noteholders instead of (directly or indirectly to) one or more lenders, and the indenture trustee is the only party able to make a demand under the guarantee. Additionally, in order to achieve the relevant securities exemption, the default interest rate on the Capital Markets Note is equivalent to the non-default rate while in the hands of investors. Although the security package is similar to the ECA loan transaction described in Part A above, under the Part B loan structure, the ECA carries the risk of any deficiency in the security package as opposed to the loan transactions where lenders carry such risk, as investors will look to the guarantee for payment of scheduled interest and principal. The ECA will, in turn, seek reimbursement through a reimbursement agreement/sponsor guarantee between the airline/ holding company/sponsor and the ECA. Investors will not have the benefit of such reimbursement agreement. The ECA is also able to enforce the standard security package granted under the transaction until it is paid in full and may have the right to exercise early termination provisions in certain cases. 165

11 Operating Leasing – Lessor Perspectives Update by Rob Murphy1

INTRODUCTION 11.1 An aircraft operating lease is a contract in which the owner of an aircraft receives periodic rental payments in return for granting to a lessee the right to use an aircraft for a period that is shorter in duration than its useful economic life and these periods will vary from transaction to transaction. Like all core elements of the global airline industry, aircraft operating leasing is a long-term growth sector and has been one of the more profitable segments of the aerospace sector. This chapter will provide an overview of aircraft operating leasing – from the perspective of the lessor – and will highlight features that make the operating lease an attractive product from the perspectives of airlines, aircraft financiers and investors. This chapter is organised into the following sections: (1) introductory considerations; (2) core products and regional markets; (3) key features of aircraft operating leases; (4) demand for operating leasing; (5) select business model considerations; and (6) differentiation of aircraft operating lessors. Note that this chapter is very high level and by its nature choices have been made in relation to the points covered. It does not purport to be an exhaustive exploration of key themes – rather attempts to note and give a focus on some points that are material to the lessor’s perspectives. Overall, the operating lease as a product to meet the demands of airlines to grow their fleets has gone from strength to strength since the early days of leasing as pioneered by Dr T A Ryan and his ground breaking team at Guiness Peat Aviation in Shannon, Ireland, and indeed other first movers in the product. More than that, aircraft leasing companies have developed into highly efficient sustainable organisations mobilising intellectual capital across a wide range of disciplines to service the growing needs of airline customers and to generate significant and 1

The author wishes to acknowledge with thanks the kind permission of Gordon Chase to allow me the privilege of updating the content of the chapter on this topic written by himself and our late, most respected and dear friend and colleague Erwin den Dikken for the last edition of this work. I remember Erwin fondly in updating their chapter. All errors and omissions are mine.

167

11.2  Operating Leasing – Lessor Perspectives reliable profits for shareholders. The operating lease product itself is relatively straightforward in concept but it is founded on some core pillars – commercial, legal, risk, finance, tax, technical and operations – that must be respected and managed appropriately in the execution to ensure sustained success. There is also the need for continued innovation and development which the most successful lessors have kept to the forefront of business planning and organisational culture. There are many examples of this – not least the development of products such as the asset-backed securitisation products through which the lessors access the deep pool of funding in the capital markets using pooled assets and diversified portfolios to achieve cost effective financing solutions. The manner in which operating leasing businesses met the challenges of the Covid-19 pandemic is testament to the depth of quality in these organisations, to the maturity of the various ‘platforms’, and to this segment of the industry generally. Overall, the response of lessors to airline customer’s needs and financial distress was measured and nimble – not a one size fits all mind set. The operating leasing industry has come through the last 18 months stronger, and with a deeper impact into airline relationships than was the case pre-pandemic. The use of the product by airlines right across the board, including the top tier names who, pre-Covid, did not prioritise operating leasing in their fleet planning, is growing. It is a very reasonable prediction that operating leasing will become the dominant product to meet aircraft demand into the medium and longer term. The airline industry is meeting the challenge to reduce its environmental impact in a number of ways, including most critically, by replacing older aircraft with new technology aircraft that are more fuel efficient and have a lower greenhouse gas emission impact. Airlines are increasingly relying on operating lessors to work with them on their fleet renewal priorities to meet this goal. The Covid-19 pandemic has also had a dramatic and unprecedented negative impact on the finances of airlines. Most simply do not have the financial strength to embark on large capital expenditure programmes. Airlines are therefore increasingly turning, and will continue to turn, to operating lessors with access to a much wider range of capital sources, as they are better able to provide a solid basis on which airlines can plan their fleet needs.

INTRODUCTORY CONSIDERATIONS 11.2 Between 1990 and 2011, the worldwide western-built large commercial passenger jet fleet increased in size from 6,754 to 13,950 in terms of numbers of aircraft. In 1990, the estimated total number of large commercial passenger aircraft subject to operating leases was 793, or 12% of the world fleet. By 2011, this number had increased to 5,780, or 41% of the world fleet. In the past ten years the numbers have risen substantially such that by 2020 the operating leased commercial aircraft fleet is estimated to be just under 50% of the world’s fleet in terms of value, at approximately US$331 billion. This trend is likely to continue given the ability of lessors to obtain debt finance at cheaper rates than airlines, plus their greater ability to remarket off lease aircraft. It is evident that the proportion of commercial passenger aircraft that are subject to operating leases has grown significantly during a period characterised by strong growth in the installed world aircraft fleet itself. In the years up to the outbreak of the Covid-19 pandemic in 2020, air travel growth expressed in terms of revenue passenger kilometres (RPKs), a measure of passengers flown whereby one RPK represents one kilometre flown by one passenger, had doubled every 15 years, and was anticipated to grow by 4.3% per annum from 2018. 168

Introductory considerations 11.2 The Covid-19 pandemic has fundamentally altered these projections which were predicted in 2019. As can be seen from Exhibit 11.1 and IATA’s latest global airline forecasts, RPK growth in 2019 was 4.1% year-on-year, but this declined dramatically by circa 66% in 2020 and despite year-on-year growth in 2021, is forecast to remain at less than half the levels of RPK in 2019 (down by 57%). This is reflected in the drop of passenger numbers from 4.5 billion to 2.4 billion per annum. EXHIBIT 11.1 IATA AIRLINE INDUSTRY UPDATE APRIL 2021 2019

2020

26.4

–126.4

–47.7

Operating margin, % revenue

5.2%

–28.2%

–9.4%

RPK growth, %ch year-on-year

4.1%

–65.9%

26%

4.5

1.8

2.4

Passenger load factor, % ASK

82.6%

65.1%

67.3%

Passenger yield, %ch year-on-year

–3.7%

–8.7%

–3%

Cargo yield, %ch year-on-year

–8.2%

40%

5%

77

46.4

68.9

0.3%

17.5%

–15%

Net post-tax profit, USD bn

Passenger numbers, billion

Fuel price, USD/barrel Non-fuel unit costs, %ch year-on-year

2021F

www.iata.org/economics | Outlook for the global airline industry – April 2021 update

Source: IATA Airline Industry Update April 2021 – Reproduced with their kind permission

The Covid-19 pandemic had an overly dramatic impact on passenger traffic and predictions of traffic recovery varies within certain ranges. The outlook for international air travel will depend on the vaccination rollout and the level of infections from Covid-19. The impact of new variants of the original disease and the effectiveness or otherwise of existing and new vaccines will be critical for international travel. The pace and rollout of vaccines varies across numerous jurisdictions, and it is particularly slow in many developing economies. Any potential delay, due to political or health factors in the rollout of the vaccine, will have a detrimental effect on the level of international travel and consequently on the aviation industry. EXHIBIT 11.2 RPKS AS A % OF 2019 LEVELS (IATA)

Source: IATA – Reproduced with their kind permission

169

11.2  Operating Leasing – Lessor Perspectives As can be seen from Exhibit 11.2, IATA are predicting that RPKs in 2021 will only reach 2019 levels in the US domestic and Chinese domestic regions. They are not anticipated to reach 2019 levels in Europe, Asia or on international routes until 2022 at the earliest. Airlines that primarily serve domestic routes within these regions are likely to recover more quickly than those that serve international routes. After many years of growth and profitability, the aviation industry is now entering a decade of uncertainty. As Covid-19 spreads across the world, the industry lost over US$118 billion in 2020, according to IATA, and it saw many airlines seek bankruptcy protection or some form of restructuring or stop flying entirely. 2021 continued to be challenging with some signs of improvement for example for airlines in the US and China, where domestic travel is rebounding. In many cases though there is continuing cash burn. In 2020, reduced demand for air travel led global carriers to put thousands of aircraft into storage, converted some for carrying cargo, and cancelled or deferred some deliveries of new planes. At its nadir, the global fleet had only about 13,000 aircraft in service, less than half the number flying in January 2020 before the pandemic was declared. Today, the 2021 fleet is up to more than 23,700 aircraft. By 2031, it is forecast that the fleet will number more than 36,500. But it is still a far cry from pre-Covid projections, which put the 2021 global fleet at 28,800 and the 2030 fleet at more than 39,000.2 In 2021, the global fleet is approximately 5,000 units lower than what was initially anticipated. It will take several years for international passenger growth to rise to absorb this excess capacity in the market. This is reflected in the timing of the growth of the global fleet market up to 2030. EXHIBIT 11.3 GLOBAL FLEET FORECAST BY REGION 2021–2031 (OLIVER WYMAN)

Source: Oliver Wyman Global Fleet and MRO Market Forecast 2021–2031 (oliverwyman.com) – Reproduced with their kind permission

2 See Oliver Wyman ‘Global Fleet and MRO  Market Forecast 2021–2030’ at https:// www.oliverwyman.com/our-expertise/insights/2021/jan/global-f leet-and-mro-marketforecast-2021-2031.html.

170

Core products and regional markets 11.3 As can be seen from Exhibits 11.3 and 11.4, production of new aircraft is likely to be impacted in the next two to three years which signifies that the forecasted growth in fleet requirement for the first half of the next decade will be lower than that anticipated for the latter half of the decade. This appears to be the case for all regions, except China, India, and Africa. On a global basis, robust annual growth of 2.5% is still forecasted despite the impact of the pandemic on global demand. This is however a 6.5% decline on the anticipated requirement of 39,000 aircraft for 2030, predicted prior to the pandemic. EXHIBIT 11.4 GLOBAL FLEET FORECAST BY AIRCRAFT TYPE 2021–2031 (OLIVER WYMAN)

Source: Oliver Wyman Global Fleet and MRO Market Forecast 2021–2031 (oliverwyman.com) – Reproduced with their kind permission

CORE PRODUCTS AND REGIONAL MARKETS 11.3 Investors in the aircraft operating leasing industry have enjoyed strong returns by taking advantage of the cyclicality that has been inherent in the industry. Growth of air travel, and therefore demand for leased aircraft, has been positively correlated to growth in global gross domestic product. The cost and complexity of modern aircraft means that their manufacture and acquisition is a long-term process. Aircraft manufacturers and airline fleet planners by necessity work in timeframes spanning several years. Aircraft orders are often placed many years in advance of scheduled delivery dates. It is axiomatic that the forecasts underpinning even the most sophisticated fleet plans cannot accurately predict the economic climate several years later. The inherent difficulty of accurately forecasting demand, and therefore the appropriate level of supply, has resulted in long periods in previous economic cycles during which there has existed a material imbalance between the availability of aircraft and demand for air travel. This imbalance has manifested itself through the economic cycle in the volatility of both the prices of aircraft and the rates at which they are available for lease. How the market has performed through the various shock events that have been seen – including the global financial crisis in 2008 and the Covid-19 pandemic – serve to underscore this point. The capital intensive nature of the aviation industry and its consequent reliance on leverage has, in some instances, exacerbated the cyclicality and volatility 171

11.4  Operating Leasing – Lessor Perspectives of both aircraft prices and lease rates in the market. During economic upturns, financing has become more readily available, enabling buyers of aircraft to bid up prices, and sellers who purchased aircraft during downturns to realise profits that have been, in some cases, considerable. Conversely, during economic downturns, sources of liquidity have tended to be constrained. This has caused a reduction in the number of industry participants with the capability to raise funds to purchase certain types of aircraft. Liquidity constraints affecting aircraft owners have also, in some instances, led to the availability of aircraft at lower, and occasionally distressed, prices. A  particular feature of the reaction to the Covid-19 pandemic has been the dominance of the sale and leaseback product offered by well capitalised operating lessors as a source of finance to airlines. Through 2020 and into 2021, operating lease transactions have been executed with the strongest credit – top tier – airlines who historically would have purchased and financed their aircraft. This, together with the proactive handling by experienced operating lessors of airline liquidity stresses, has been a defining theme of the past 18 months. The overall sense of things is that operating leasing will continue to grow and become an even more important and significant component of the supply of capital in the industry. Factors that have enabled equity investors to earn attractive returns in the operating leasing industry in the past have included: • the identification and selection of a partner with the right industry expertise, relationships and track record to be successful; and/or • the capability to invest capital throughout the economic cycle. Providers of debt finance, on the other hand, are aware that aircraft offer distinct advantages over some other asset classes when viewed as collateral. Some of the factors that have made equity investors successful in the operating lease industry apply also to debt financiers. The aircraft management capabilities of some aircraft operating lessors can provide risk mitigants which some sophisticated providers of debt finance to the operating lease industry find compelling.

KEY FEATURES OF AIRCRAFT OPERATING LEASES 11.4 As a general matter, aircraft leases can be divided into two broad types: operating leases; and finance leases. Finance leases can be distinguished from operating leases in that, pursuant to a finance lease, the lessee takes the risks and rewards of ownership of the leased asset. Finance leases may, for example, provide for the transfer of ownership of the aircraft to the lessee at the end of the term or be granted for a term which equals the useful economic life of the aircraft. Under an operating lease, the lessor retains title to the aircraft and assumes risk in relation to the residual value of the aircraft at the end of the term. Certain important features of operating leases are described below.

Rental payments 11.5 Rental payments have been customarily paid in US dollars, reflecting the choice of currency for new aircraft, and are usually paid monthly in advance. The determinants of the level purchasers of rental payments include the market 172

Key features of aircraft operating leases 11.8 demand for the aircraft type, the age of the aircraft, interest rates, the condition the aircraft is expected to be returned in and the lessor’s view of the residual value of the aircraft at the expiry of the lease term.

Maintenance reserves/supplemental rent and related matters 11.6 Many aircraft operating leases require the payment of maintenance reserves usually termed supplemental maintenance rent. These rental amounts are generally paid at rates which reflect the utilisation of the aircraft and the amounts paid accrue in notional maintenance funds. When an aircraft which is subject to a lease pursuant to which supplemental rent is payable, undergoes maintenance, the lessor will (subject to conditions) agree to contribute towards the cost of certain pre-defined maintenance events by using amounts in the maintenance fund. Supplemental rent is also often referred to as ‘maintenance reserves’. This is a key security concept for the lessor as a core element of the value of the aircraft is based on its maintenance status and the obligation of the lessee to put the aircraft into a defined condition at return, or the lessor having the available funds from the reserves to do so in the event of a default. Some airlines will resist paying supplemental rentals and seek to negotiate a lease end adjustment mechanism reflecting the condition of airframe, engines and key components at redelivery. Other themes to be aware of here include: • the use of a maintenance letter of credit rather than cash reserves; • the use by airlines of maintenance agreements with original equipment manufacturers (OEMs) – in particular engine OEMs – to underpin certainty on maintenance and overhaul and in lieu of receiving maintenance reserves the lessor will need to obtain a direct agreement with the OEM to cover the cost of maintenance/overhauls after the lease ends; • the requirement on used aircraft for lessors to make contributions to the next lessee by reference to utilisation of the prior lessee and the condition of the aircraft; • the request of some lessees that the lease end adjustment is ‘two-way’ – so-called ‘upsy/downsy’ – always resisted by the lessor.

Security deposit 11.7 Security deposits are typically required in an amount equal to two, three or more months’ lease rental, payable at inception of the lease. In the event of a default, the lease will provide that the lessor is entitled to apply the deposit amount against any losses it suffers as a result of the default. This requirement may also be fulfilled via a letter of credit rather than cash.

Term 11.8 The term of an operating lease is shorter than the projected useful life of an aircraft. It is usually in the lessor’s interest for the term to be as long as possible and, for new aircraft, lease terms of 12 years are not uncommon. Unless a specific early termination option is negotiated, the lease will not typically be able to be terminated by the lessee during the term. 173

11.9  Operating Leasing – Lessor Perspectives

Quiet enjoyment 11.9 A lessor pursuant to an aircraft operating lease will typically covenant in favour of the lessee not to interfere with the lessee’s quiet use, possession and enjoyment of the aircraft during the term of the lease, provided the lessee is not in default of its obligations.

Net lease 11.10 Aircraft operating leases customarily provide that the payment obligations of the lessee are unconditional in all circumstances. Even if the lessor breaches the terms of the lease, the lessee must continue to make rental payments. This is known as the ‘hell or high water’ clause. The lessee would have recourse against the lessor, but it must pursue such recourse while continuing to meet its payment obligations under the lease. In addition, operating leases usually provide that the lessee is responsible for all maintenance and insurance of the aircraft during the term of the lease and for obtaining all licences and permits necessary to lawfully operate the aircraft. This is a key provision of the lessor – it is a core pillar of the lessor’s business model and underpins its ability to finance and trade the aircraft. Various legal challenges to the hell or high water clause have affirmed its validity – these are discussed in Chapter 5: Legal Issues in Aircraft Finance.

Insurance 11.11 In light of the value and replacement cost of aircraft, it is important that they are adequately insured at all times. Operating leases contain strict requirements with respect to insurance of the aircraft. Many operating lessors purchase contingent hull and liability insurance policies which are designed to provide an indemnity to the lessor in the event that the insurances provided by a lessee in satisfaction of lease insurance obligations do not operate. Under a typical lease agreement, a lessor will require a wide range of provisions to appear within the lessee’s insurance policies including those related to loss payee, severability of interest, non-contribution, breach of warranty and notice of cancellation. When the operating lease first emerged as a financing tool, each lessor had different insurance requirements. To respond to the growth in aircraft leasing, the insurance market, including both brokers and underwriters together with the leasing and financing community, came together and agreed the airline finance lease contract endorsement. The current provision, AVN67B, has been in widespread use since 1994. This endorsement provides a comprehensive range of standard insurance ‘comforts’ to lessors and has reduced the amount of time and expertise spent on the negotiation of lease-related insurance provisions. Insurances are discussed extensively in Chapter 16.

Deregistration 11.12 The lease will often require that the lessee grants a power of attorney in favour of the lessor for the deregistration of the aircraft. The purpose of this power of attorney is to effect the removal of the aircraft from the register on 174

Key features of aircraft operating leases 11.14 which it appears during the term of the lease without the lessee’s consent. It is intended to be used in the event of a default by the lessee. In some jurisdictions, it is not certain that a deregistration power of attorney is enforceable. In those jurisdictions, there remains a risk that the lessee’s cooperation would be required in order to effect deregistration. The Convention on International Interests in Mobile Equipment 2001, the Cape Town Convention, affords material risk mitigants to lessors and financiers of aircraft, including with regard to deregistration. The Cape Town Convention provides for an instrument known as an Irrevocable Deregistration and Export Request Authorisation, or IDERA. An IDERA granted by a lessee to a lessor and acknowledged by the aircraft registry gives the lessor the right to deregister the aircraft without the consent of the lessee. Aircraft registry authorities in jurisdictions which have ratified the Cape Town Convention with appropriate declarations are legally obliged to give effect to a deregistration request made pursuant to an IDERA. Refer to Chapter 21 for more details on this topic.

Return conditions 11.13 Aircraft operating leases stipulate the required condition of the aircraft at lease expiry. It is of importance to investors in operating lease products that the aircraft is in the contracted condition at the end of the term. The condition should be such that all major maintenance due during the period immediately after redelivery is performed prior to return. This will enable the aircraft to be remarketed effectively and re-leased in the shortest time possible after lease expiry. On occasion, financial compensation is accepted from the lessee in return for a waiver of some of the return condition requirements.

Transfer/assignment/security 11.14 A key concept in the operating lease is the ability of the lessor to: • sell the aircraft; • transfer the lease by novation or assignment; • create security over the aircraft and the lease. The lessor will need to be able to take these actions without requiring the consent of the lessee and with its cooperation in terms of documents to be signed or provided by the lessee and/or actions to be done by the lessee in order to implement the transaction. This is another core pillar of operating leasing. It is relevant to the trading of aircraft or portfolios of aircraft; the financing of aircraft and to securitisation products such as ABS transactions – all of which are key channels of financing and liquidity. The lessee will want to make sure that its rights are protected and lessees will focus on some key points including: • that no additional costs or liability will be incurred by it as a consequence of the transfer – for example, withholding taxes on lease rentals; • the experience and creditworthiness of the new lessor; • the lessee’s quiet enjoyment of the aircraft. 175

11.15  Operating Leasing – Lessor Perspectives The Global Aircraft Trading System (GATS) is a significant and very progressive development for the industry and will smooth the efficiency of aircraft trading going forward. GATS is covered in Chapter 18.

DEMAND FOR OPERATING LEASING 11.15 As noted above, the proportion of the world aircraft fleet that is subject to operating leases has grown strongly over recent decades, a period in which the world aircraft fleet itself has also expanded in size materially. This trend demonstrates that there is demand among airlines for operating leasing products. Below are some of the factors which have influenced that demand.

Efficiency of financing 11.16 Aircraft operating leases are reasonably unusual when compared with other forms of financing, in that the amount required to be contributed by the lessee as upfront funding from its own equity or other funds is low. Aside from a security deposit covering a few months lease rental, operating leases can, for certain practical purposes, provide to an airline the equivalent of financing at an advance rate of 100%. This is an attractive proposition for both well-established and start-up airlines. In the case of start-up airlines, operating leasing may indeed be the only method by which the airline will be able to acquire the necessary capacity to begin operations. For well-established and start-up airlines alike, operating leasing has the effect of freeing up capital to be deployed in other areas of the business. If one views the airline business as a reasonably commoditised service industry, the opportunity to use scarce capital to improve the service offered to passengers rather than in investing in flight equipment is attractive.

Fleet planning flexibility 11.17 It is evident that, for several reasons, predominately driven by the costs of acquiring and operating aircraft, airline fleet planning is a long-term undertaking. However, the nature of an airline operation is such that short-term events can affect the long-term prospects of the business. While the average duration of an aircraft operating lease is not short, it is considerably shorter in most cases than the expected useful life of an aircraft. This makes operating leases attractive to airlines from a fleet planning perspective. The knowledge that the asset can be returned at the end of the lease term at little cost provides an increase in operational flexibility that could be used, for example, to take advantage of market opportunities that may not justify the greater investment and risk associated with acquiring rather than leasing aircraft.

Residual value risk 11.18 The aviation industry has been inherently cyclical and, as a result, aircraft values have demonstrated volatility, in some cases, to a considerable degree. An airline is not typically in the business of speculating on asset values. 176

Select business model considerations 11.22 If the aircraft operated by an airline are owned by it and appear on its balance sheet, the airline is at risk of making substantial losses during periods in which aircraft values are depressed. These losses may be realised either if sales of aircraft are required at below their depreciated book value, or if accounting rules require that impairment charges are taken to book values. These noncore activities have the ability to mask the financial performance of what may otherwise be a financially healthy underlying operation. Operating leasing removes this risk from an airline’s perspective – this adds value as it enables management and investors to focus on the financial performance of the core transportation activity.

Cost of capital equipment 11.19 Large aircraft operating lessors are able to place orders with manufacturers for large numbers of aircraft. Significant discounts will usually be made available by manufacturers to bulk buyers of aircraft. These discounts can provide a competitive advantage to such bulk buyers. A sufficiently low entry price may enable them to generate the returns required by their shareholders.

Supply of available aircraft 11.20 Aircraft orders are often placed many years in advance of scheduled delivery dates. During periods of increasing demand for air travel, it is often difficult or even impossible to secure near-term delivery slots of new aircraft from manufacturers. For an airline which wishes to take advantage of a strongly improving market environment, often the only source of ‘lift’ is an aircraft leased from an operating lessor.

SELECT BUSINESS MODEL CONSIDERATIONS 11.21 In evaluating the business models of aircraft operating lessors, there are several factors which should be taken into consideration. Certain select considerations which may be relevant are described below. Aircraft operating lessors are not geographically constrained and, provided they are of sufficient scale, are able to deploy the aircraft they own across a broad range of customers and geographic regions. This ability to diversify, if implemented, mitigates the risk that events affecting air travel demand in specific regions will materially adversely affect the business of an aircraft operating lessor as a whole.

Core themes 11.22 In establishing its platform, the lessor will need to plan and put in place the essential building blocks: • commercial strategy – including target returns, product offering and pricing model; • people planning; • funding plan and financial control and reporting elements; 177

11.23  Operating Leasing – Lessor Perspectives • • •

risk assessment methodology and monitoring framework; transaction legal; technical – including asset acquisition, transitions, asset management and all related procurement; • contract management infrastructure, including invoicing and collections; • systems; • corporate legal, compliance and audit; • ESG focus/priorities. Covering these elements in any detail is outside the scope of this chapter – and many of them are covered elsewhere in this book – which will focus on a few business consideration items as follows.

Diversification of funding sources 11.23 The cyclicality exhibited by the world economy and its impact on the financial markets has, in the past, affected the aircraft operating leasing industry. During past economic downturns, certain sources of liquidity for the acquisition and financing of aircraft have become unavailable. In order to profitably manage an aircraft operating lessor over the long run, it is imperative that capital is available on a continuous basis. A lessor may mitigate the risk of a decrease in available liquidity by establishing relationships with a wide range of financiers and by being active in a wide range of capital markets.

Flexible capital structure 11.24 In addition to drawing capital from a diverse range of sources, it is important from the perspective of a lessor that its capital structure is flexible enough to withstand unforeseen events. Investing in aircraft is a longterm undertaking. Structuring long-term investments with short-term debt involves certain risks. These risks are increased if, for example, loan terms require bullet repayments at the end of short tenures. In the event that the market experiences a downturn, the aircraft may not have sufficient value at the end of the term to meet a bullet repayment obligation. Similarly, if a loan collateralised by an aircraft contains periodic financial covenants that test, for example, the ratio of the loan to value of the aircraft, the borrower may be required to make unscheduled and potentially material repayments to lenders during periods of market weakness. A  lessor can mitigate the risks associated with market volatility and liquidity events to some degree by building flexibility into the repayment profiles of its debt obligations. Some aircraft portfolio securitisations, for example, apply all surplus cash generated above the amounts required to pay interest to the repayment of principal. This method of amortisation protects a lessor in the event that, as a result of lessee defaults, the transaction does not generate as much revenue as was anticipated. Provided the lease revenue generated by the aircraft is sufficient to enable interest payments to be made on the notes, in addition to certain other payments, the securitisation itself will not default. From the perspective of some noteholders and for the issuer, often the operating lessor, this has been an attractive feature. 178

Select business model considerations 11.26

Management of aircraft throughout their lifecycle 11.25 When analysing the business model of an aircraft lessor, one must consider the exit strategy available to the lessor for older aircraft. Over time, the combined value of a typical aircraft’s parts will eventually exceed the value of the aircraft as a whole operating asset, at which time the aircraft may be retired from service. Aircraft lessors and airlines often retire their aircraft by selling or consigning them to companies that specialise in aircraft and engine disassembly. Some lessors have the capability to disassemble aircraft and engines for parts at the end of their life either in-house or through close relationships with specialists in this area. This provides both a potentially valuable ancillary revenue source and the capability of those lessors to manage aircraft throughout their lifecycle.

Maintenance accounting 11.26 In most aircraft operating leases, the lessees are responsible for maintenance of the aircraft during the term of the lease. In some of these leases, the lessor will require the lessee to pay supplemental maintenance rent as a form of security. Supplemental maintenance rent is calculated with reference to the utilisation of airframes, engines and other major life-limited components during the lease. The accounting by lessors for the receipt of supplemental maintenance rent is mixed, but can generally be summarised in two accounting methods. Some lessors account for the receipt of supplemental maintenance rents in a similar manner to the accounting for basic rents and record supplemental maintenance rents as lease revenue. Other lessors consider supplemental maintenance rents to be deposits and, therefore, record supplemental maintenance rents as a liability on the balance sheet. Since supplemental maintenance rents are typically a significant percentage of basic rents, the two different accounting models have a material impact on both revenues and net income in certain periods. The accounting treatment for supplemental maintenance rents also has an impact on how the lessor accounts for actual maintenance events for which it has received supplemental maintenance rents. Lessors that account for supplemental maintenance rents as deposits will record the actual maintenance events for which they have received supplemental maintenance rents as a repayment of a deposit. In this case, the maintenance event does not affect the income statement, which is consistent with the accounting treatment of the receipt of supplemental maintenance rents. This assumes that the charge for the actual maintenance event equates with the supplemental maintenance rents received by the lessor. Where the actual charge differs from the supplemental maintenance rents received, the difference is taken to the income statement. Lessors that account for supplemental maintenance rents as revenue generally have two options to account for the maintenance events for which it has received supplemental maintenance rents. The lessor is allowed to either expense the maintenance event when incurred or capitalise the maintenance event and consequently depreciate the cost over the remaining economic life of the maintenance event. All else being equal, capitalising the cost of maintenance events has the potential to increase the risk that, as an aircraft ages, its market value declines at a faster rate than its book depreciation and, therefore, the risk that accounting rules may require an impairment charge to be taken on the book value of the aircraft at some point during its economic life. 179

11.27  Operating Leasing – Lessor Perspectives The different maintenance accounting methods will have no impact on the income statement covering the entire economic life of the aircraft. However, the maintenance accounting for supplemental maintenance rents as revenue will generally result in a higher net income in the first part of an aircraft’s economic life when compared to the maintenance accounting for supplemental maintenance rents as deposits. Accounting matters and developments are dealt with extensively in Chapter 23.

DIFFERENTIATION OF AIRCRAFT OPERATING LESSORS 11.27 Some sophisticated debt financiers have historically found that making capital investments in the aviation industry through operating lessor partners has, in some cases, reduced the risk associated with those investments considerably.

Lease management capability 11.28 Most large lessors have a sophisticated in-house lease management capability. In some cases, that capability is externally recognised as a result of the use of aircraft portfolio securitisations. A key requirement of lenders into such structures is that the aircraft and leases will be managed in a manner that will maximise the revenue generation potential of the assets, subject to the diversification criteria required by the financing structures. Lease management capability is, therefore, a factor to which credit rating agencies attach considerable weight when analysing and rating such transactions. It may be that the credit committees of providers of commercial debt finance can take comfort from the external scrutiny and evaluation of the in-house lease management capability of operating lessors who have acted as servicers to securitised portfolios of aircraft leases.

Technical compliance 11.29 One of the many common interests providers of debt finance and operating lessors have when working in partnership is to ensure that the aircraft that forms the collateral for the financing transaction is maintained to the highest possible standard. This is important from the point of view of the operating lessor, as the lessor usually has provided the equity finance for the transaction. The lessor’s return on equity may be influenced materially by the value of the asset at the end of the investment horizon. If the exit from the investment involves a sale of the aircraft, the lessor will, of course, want to extract the highest sales price possible. From the perspective of a debt financier, in the event that enforcement of the collateral package should be required, it is self-evident that the higher the value of the collateral, the more likely it is that the lender will be able to maximise recovery of proceeds as a result of the sale of the collateral. At the beginning of the lease term, where they are payable, the rates at which maintenance rent is charged should be appropriate. Many aircraft operating lessors have a wealth of information with regard to the expected cost of 180

Differentiation of aircraft operating lessors 11.30 maintenance events and, therefore, the capability to negotiate and determine a level for the rates of maintenance rent that enables the lessor and the lender to be adequately protected against the cost of maintenance, both during the term of the lease and against an unscheduled early lease termination. During the lease term, an important aspect of technical compliance is the management of claims by the lessee for contribution to the costs of maintenance events. The maintenance of aircraft is an expensive undertaking and considerable expertise is required to evaluate claims for contribution by lessees and determine the exact amount the lessee is entitled to pursuant to the terms of the lease and the amount that should be retained by the lessor to cover the anticipated cost of future maintenance events. From the standpoint of collateral value, the actual physical condition of the aircraft should be monitored throughout the term of the lease. Operating leases invariably require the regular reporting of utilisation data for the aircraft. In the event the utilisation data differs from expectations, this may indicate that an unscheduled maintenance event affecting the aircraft has occurred which requires further investigation. In addition to the receipt of operational data, many large aircraft lessors have a continuous programme of technical audits whereby technical personnel visit the airlines and physically inspect the condition of the aircraft and the state of the records. At expiry of the lease term, the aircraft should be returned in the condition specified by the lease. Large aircraft lessors handle a large number of lease return processes. Expertise is capable of being deployed to ensure that the aircraft complies in all material respects with the required condition.

Repossession 11.30 The aircraft financier should consider how best to protect the return the investment is projected to generate, in the event that the operator of the aircraft defaults during the term of the transaction. Some financiers find that the capabilities of operating lessors provide significant protection in the event of such an airline default. In the event of an airline default during the term of the transaction, securing possession of the aircraft and records, and transporting both to a safe location, must be carried out as expediently as possible. Due to the size of their portfolios and their long operating history, some aircraft lessors have a significant amount of experience of successful aircraft repossessions. There are many variables which can influence a lease default and repossession situation and some of them are unpredictable. In order to effectively deal with such a situation, advance preparation is vital. A responsible lessor will typically monitor the financial health of its customers very closely and will use its network of contacts to gather early warning signals of an airline’s deteriorating financial condition. Information will be gathered in respect of the exact maintenance status of the airframe and engines, the location of the aircraft and the technical records, the routes on which the aircraft operates, the rights of other creditors to impose liens on the aircraft and the legal system in the jurisdictions in which the airline is based and to which it flies. 181

11.31  Operating Leasing – Lessor Perspectives In the event of an airline insolvency, some jurisdictions impose a stay of execution on creditors, sometimes for considerable periods. Meanwhile, the employees may not be receiving their salaries and the required maintenance of the aircraft might not be carried out. lf, following a lessee default, it becomes clear that the most appropriate course of action is to repossess the aircraft, the objective is likely to be to secure possession and safe custody of the aircraft and the records before the airline files for insolvency protection. In order to actually effect the physical re-taking of possession of an aircraft, there is often a considerable amount of logistical coordination required. For example, a safe destination for the aircraft will need to he found, pilots will need to be contracted to fly, the necessary consents for access to the airfield and arrest of the aircraft will need to be obtained, and a flight plan would need to be filed. Matters to do with aircraft repossession and relevant international conventions are dealt with elsewhere in this book – in particular Chapter 21.

Reconfiguration 11.31 It is important to the success of any repossession procedure that advance preparations are made in order to enable the aircraft to generate revenue in the shortest time possible. A vital part of these preparations is the work that will need to be performed on the aircraft in order to put it into a condition that is attractive to as wide a range of potential customers as possible. The cost of reconfiguration is influenced by several factors including the aircraft type, the cabin specification operated by the prior lessee and the modifications required to ensure remarketability. The cost of reconfiguring aircraft and the lead time required to install the necessary equipment can be substantial. If the aircraft in question is part of an order the lessor has placed with a manufacturer, during the process of defining the initial specification of the aircraft with the first operator, the lessor can, on occasion, encourage the lessee to incorporate elements in the specification that are of wide appeal to other operators of the same aircraft but that may require considerable cost and/or lead time to retrofit. Work required after a lease default to reposition galleys or to rewire an aircraft cabin to install communications, navigation or in-flight entertainment equipment can be significantly more expensive than the cost of performing such work during the manufacturing process for an aircraft. Lessors who have large order books with aircraft manufacturers or who deal with a large volume of re-leasing activity customarily have a network of agreements with suppliers that can provide the lessor with attractive pricing and lead time arrangements for the supply of aircraft equipment. These arrangements can reduce the time taken and expense incurred to place the aircraft into a condition in which it is capable of re-entering revenue service.

Remarketing 11.32 If the lessee of an aircraft has defaulted, the aircraft will need to be delivered on lease to a new customer in order that it can generate revenue. The 182

Conclusion 11.34 placing of aircraft on lease is obviously a core activity of aircraft lessors and most have in-house teams working full time on this activity. Large lessors will typically own and lease multiple aircraft of the type that requires re-leasing and will, therefore, have a pre-existing network of contacts to whom they can immediately market the aircraft.

Aircraft/lease servicing 11.33 Many lessors will offer servicing coverage to investors or financiers pursuant to a servicing agreement. This agreement will define the core services to be provided – aircraft and lease management – and the fees to be paid – usually a periodical management fee and specific success-type fees based on remarketing for lease or sale. The servicing agreement will also cover a range of topics including: • standard of care/liability; • dealing with conflicts; • a variety of operational/process matters; • termination events. Certain ratings agencies assign servicer evaluation rankings across various industries and underlying collateral types and such rankings may become more prevalent in the aviation industry. Over time the form and content of servicing agreements has become well developed and key elements are reasonably standardised though as always transactions and substance can vary. This has become a defined business line for many lessors and a core business for certain service providers.

CONCLUSION 11.34 Clearly, aircraft operating leasing has seen a marked growth in popularity over recent decades. Efficiency in the financing of aircraft operating lessors has facilitated the supply of operating leasing products that are attractive to potential customers. The demand for these products has enabled the aircraft operating leasing industry to make a significant contribution to the development of the wider aviation industry to date. It is evident that the impact of the operating lease industry will continue to grow. As noted in the introduction to this chapter (see para  11.1), it is reasonable to assume that operating leasing will become the dominant source of aircraft supply to airlines in the medium to long term. Lessors are well placed to support airline customers as they grapple with key pressures – especially the combined pressures of the need to mitigate environmental impacts and deal with the financial fallout wrought by Covid-19. The operating lease business model is sustainable and has proven to be resilient even in the face of the most unprecedented threat that Covid-19 has brought to bear. At their best, operating lessors are businesses that thrive on the highest quality of performance, led by diverse teams of people with a focus on innovation, problem solving, and an execution mindset that respects the integrity of the core elements of the product.

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12 A Lessee’s Guide to Aircraft Leasing Michelle Johnson

INTRODUCTION 12.1 Many airlines are by definition international carriers, serving markets which extend beyond their national borders. Similarly, aircraft leasing and financing is international, with participants ranging from relatively small, regional operating lessors to large financial institutions providing, directly or indirectly, financial support through loans or finance leases to airlines. Leasing as a form of financing was developed in the United States in the 1950s and has since been exported to become a global means of supporting aircraft acquisition. Although exact figures may be difficult to ascertain, it has been estimated that more than half of all commercial aircraft in service in 2019 were under lease.1 This ratio which has been stable for some time may experience a shift as the consequences of the coronavirus pandemic (Covid-19) continue to be felt by the aviation industry. Airlines that traditionally favoured asset ownership models have been forced to raise liquidity through sale and leaseback transactions in order to shore up their finances. Such transactions may however be tempered by the volume of rent deferrals as well as the number of aircraft redelivered per schedule or as part of an airline restructuring, either in or out of court, with the ability to redeploy aircraft limited. The impact of the black swan event that is Covid-19 has been significant. At the peak of the crisis in April 2020, airline revenues dropped 90%2 resulting in huge rates of cash burn.3 To varying degrees many airlines amassed significant amounts of debt, grounded large numbers of aircraft, and enacted far reaching redundancy programmes. 1

International Air Transport Association, Annual Review 2020 (November 2020); see also, World Leasing Yearbook 2021, World Leasing Yearbook (42nd edn, 2021), as to the volume of leasing generally. 2 International Air Transport Association, Annual Review 2020 (November 2020). 3 See eg  IATA, Economics Analysis (9  October 2020 and 26  February 2021) [hereinafter IATA  Economics Analysis]. IATA  Economics Analysis estimates that Q2 2020 had been the worst quarter of 2020 for airlines as the industry faced unprecedented loss of revenue (circa 80% compared to the same period of the previous year), with an almost full grounding of passenger fleets despite strong cargo revenue. As a result, airlines turned their focus on cutting expenses during this period. However, operating costs could only be reduced by circa 50% year-onyear due to unavoidable fixed and semi-fixed costs such as labour and maintenance costs. As a result, IATA estimates that the industry burned US$51 billion of its cash reserves in Q2 2020. IATA Economics Analysis further reported that cash burn in the second half of 2020 was around US$77 billion and for 2021 it is estimated that the total cash burn could be between US$75 billion to US$95 billion.

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12.2  A Lessee’s Guide to Aircraft Leasing The economic turmoil of the pandemic resulted in a number of airlines winding down or seeking restructuring in administration,4 a number which would have been far worse had it not been for the US$173 billion of government support provided to the industry in 2020.5 This chapter should be considered in this context.

TYPES OF LEASES Finance lease 12.2 Leases are broadly characterised either as operating leases or finance leases, although the distinction between the two in practice may become blurred. Generally, a finance lease (or a capital lease under the United States generally accepted accounting principles (US GAAP)) is a form of aircraft financing whereby all risks and rewards associated with aircraft ownership lie with the lessee. The lessee generally will either directly, or through its nominee, have an expectation of receiving title to the aircraft at the end of or during the lease term, usually pursuant to the exercise of an early termination or purchase option. Typically, a finance lease is concluded for new or relatively new aircraft and seldom employed for secondhand or older aircraft. Under a finance lease, the lessee assumes the amortisation as well as the residual value risk and has economic ownership of the aircraft, whereas the lessor/financier will have legal title. As a result of economic ownership, the lessee will have the benefit of aircraft depreciation. As lease classification under accounting and tax rules may differ, a lease may be considered a finance lease for accounting treatment and an operating lease for tax purposes. To give a full picture, there also are occasionally so-called hire purchase agreements where title to the aircraft transfers automatically to the lessee upon payment of the last scheduled rent which is a hybrid structure between leasing and an instalment purchase. A  cross-border lease is a transaction where the lessor, the lessee, and other related parties are located in two or more jurisdictions and perhaps are subject to different accounting or tax regimes.6 Notwithstanding general international financial reporting standards (IFRS) and US GAAP principles, relevant national law will determine whether a party is able to depreciate the aircraft and, hence, the possibility of double depreciation (otherwise known as a double dip transaction) arises. A double dip transaction is one where both the lessee and the lessor are able to treat the lease as a finance lease so that both the lessee and the lessor have the economic benefits of depreciating the aircraft. The possibility to double dip is due to the fact that some countries have an economic ownership test for determining entitlement to tax depreciation whilst others have a test based on a mix of economic and legal ownership. Even in transactions where only one party is able to depreciate the aircraft, there may be other tax or accounting benefits that may be shared between the parties. Although there are many variations and each jurisdiction will have its own nuances and, at times highly complex, structures, a simplified cross-border leasing arrangement for new aircraft is shown in Exhibit 12.1. 4 5 6

Phil Seymour, IBA Market Update Webinar 19 (January 2021). The report estimated that there were 33 airline failures in 2020. International Air Transport Association, Annual Review 2020 (November 2020). Michael D Rice, Current issues in aircraft finance, 56 J Air L & Com 1027, 1034–40 (1991).

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Types of leases 12.2 EXHIBIT 12.1 A TYPICAL CROSS-BORDER LEASING ARRANGEMENT

(1)

(2) (3)

The airline directly or indirectly establishes a special purpose vehicle (SPV) which holds legal title to the aircraft and acts in the capacity of both lessor and borrower. The SPV’s business will be limited to carrying on the business of leasing the aircraft. The financier will finance the SPV’s purchase of the aircraft from the original equipment manufacturer. The financier will be granted a mortgage over the aircraft together with a security package. The airline will enter into a finance lease with the SPV and at the end of the lease period, or at specified dates, will have the option to purchase the aircraft for a preagreed sum. The transaction documents will typically be governed by English or New York law. Source: Author’s own

Although there are a number of relatively standard structures, which have been developed to take advantage of favourable tax and accounting treatment, such as, inter alia, the tax-incentivised Japanese operating lease with call option and the French tax lease, special attention needs to be paid in the structuring of any cross-border lease. A  detailed review is beyond the scope of this chapter, but issues to be addressed may include apportionment of tax risks, particularly the risk of a change in tax treatment or recognition, and change of law risks. Following the financial crisis in 2008, cross-border aircraft transactions benefited from significant subsidies by the United States Export Import Bank for the sale of Boeing aircraft and the relevant export credit agencies in France, the United Kingdom, and Germany for Airbus aircraft. However, in the years prior to Covid-19, there had been an abundance of liquidity, new market participants, and substantial market appetite for aircraft financing. Combined with premium increases for export credit guarantees7 implemented under the new Aircraft 7

Jane M Cavanaugh, In search of a level playing field: the 2011 Aircraft Sector Understanding, Int’l L  Off (27  April 2011), https://www.internationallawoffice.com/Newsletters/Aviation/ International/Katten-Muchin-Rosenman-LLP/In-search-of-a-level-playing-field-the-2011Aircraft-Sector-Understanding.

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12.2  A Lessee’s Guide to Aircraft Leasing Sector Understanding, bribery scandals as well as the deauthorisation of the US  Export Import Bank and its subsequent lack of board quorum, exportsupported transactions were reduced to insignificant levels.8 In its wake, a similar form of financing, Aircraft Finance Insurance Consortium (AFIC), Aircraft Non-Payment Insurance arose to support the delivery of Boeing aircraft. AFIC was intended to replicate, in large part, traditional export credit agencies (ECA) support. In lieu of an ECA guarantee, the financing relies on an insurance policy to cover an airline payment default. Although the transaction structure is similar to an ECA financing, it is different inasmuch as the insurance consortium providing the financing are not backed by sovereign entities. As a result they will take into greater consideration the airline’s corporate risk rating, with the lenders providing liquidity for the financing adjusting their credit analysis and risk cost to the risk represented by the commercial insurers rather than a sovereign (zero weighted) risk. The insurers, in turn, only have several, but not joint, liability, with each insurer only responsible for its share of the risk exposure. A similar, but potentially more flexible non-payment insurance product called Balthazar was developed by Airbus for the financing of its aircraft. It remains to be seen if this crisis will see a marked return of ECA financing, notwithstanding the premiums, or an increase in AFIC, Balthazar or the rise of other financial products. Traditionally, leases could be structured to achieve a particular balance sheet treatment. As the lessee under an operating lease was not considered the economic owner, neither the aircraft as an asset nor the rental payments as liabilities were recorded.9 This changed for most companies in 2019 with the introduction of the new US GAAP rules (ASC 842, Leases) and IFRS 16. Under these rules, aircraft operating leases are on the balance sheet which has had a significant impact on the financial statements and key ratios of airlines worldwide.10 Further, as most lease obligations are denominated in US dollars, this increases a non-US airline’s foreign exposure to currency fluctuations in their profit or loss accounts. For lessors, their accounting practices did not change, and lessors continue to reflect the underlying asset on the balance sheet for operating leases. For financing arrangements, the balance sheet reflects a lease receivable and the lessor’s residual interest, if any.11 Beleaguered by years of scandal and other regulatory concerns, the transition from the London interbank offered rate (LIBOR)12 to risk free rates (RFRs) represents a fundamental shift in financing.13 As opposed to LIBOR, which is a forward looking, term rate with credit spread elements, RFRs are inherently backward looking and exclude term and credit risk. For US dollar transactions, the US Alternate Reference Rate Committee has selected the Secured Overnight

8

See, eg Olivier Bonnassies, COVID: Could the ECAs return in force?, Airfinance Journal (April 2020). In 2018, only 1% of Airbus deliveries were funded via an ECA. 9 William Bosco, Lease accounting: separating myth from reality, ELA (January 2006). 10 Deloitte, Balancing the books IFRS 16 and Aviation Finance 8 (2017). 11 A Veverkova, IFRS 16 and its impacts on aviation industry, Acta Universitatis Agriculturae et Silviculturae Mendelianae Brunensis (2019), at 1370. 12 While non-US dollar LIBOR will no longer be published from 31  December 2021 and US regulators have indicated that new contracts referencing US dollar LIBOR after 31 December 2021 would create safety and soundness risks, the LIBOR administrator, Intercontinental Exchange Inc Benchmark Administration Limited (IBA), announced its intention, subject to consultation, to continue publication of US dollar LIBOR for 1-, 3-, 6-, and 12-month settings until June 2023. 13 B  Gibson, Transitioning out of LIBOR – what is the impact for aviation finance?, Lexology (7 January 2021).

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Types of leases 12.3 Financing Rate (SOFR) published by the Federal Reserve Bank as its RFR.14 As virtually all aircraft transactions are denominated in US dollars, aviation financiers and operating lessors will ultimately likely follow the SOFR, although there may be differences in documentation and methodology employed. For existing or legacy transactions, lessors and financing parties will start to approach airlines with a view to amend existing leases which may include ensuring consistency of LIBOR fallback triggers with existing hedging or financing arrangements. Previously agreed back stop provisions anticipating a temporary unavailability of reference rates by using the lessor’s or financial institution’s current cost of funds as an alternative are not fit for purpose and in any event are likely to be unsatisfactory given a general unwillingness to disclose such internal costs. Similarly break cost provisions which address potential losses that lenders may incur if a financing is terminated early, may have to be reconsidered. Airlines will need to carefully consider how adoption of RFRs may impact their structured financing arrangements, including cash flows, tax and accounting treatment. For operating leases where the limited context of LIBOR generally is the default rate, it may be prudent to consider selecting the US dollar prime rate which may be acceptable to the lessor if it can maintain its economic return.

Operating lease 12.3 A  lease that is not a finance lease is an operating lease. Under an operating lease, the lessor has the economic and legal ownership of the aircraft and, significantly, the residual value risk at the end of the lease term. It is thus incumbent upon the lessor, through a sale or a subsequent lessee, to realise the full value of its asset. From the lessee’s perspective, an operating lease may provide additional flexibility for short- and medium-term capacity requirements. Conceptually, this should result in a more attractive form of financing inasmuch as the lease rental should reflect only a portion of the lessor’s financing costs and depreciation.15 However, operating lessors are likely to include part of the asset risk, in particular the residual value risk into their rental calculation, thereby passing some of the asset cost to the lessee. Additionally, lessees may also wish to compare the economic attractiveness of sourcing a larger number of aircraft from the manufacturer with the flexibility in obtaining a more limited number of aircraft from operating lessors, either through the lessor order book or from their used aircraft portfolio. Each airline will have its particular views as to the type of leasing structure that bests suits its operational and financial requirements. With the change in lease accounting, financial considerations may include the availability and pricing of commercial debt, leveraged lease structures and the ability of the lessee to access, directly or indirectly, the capital markets. A  finance lease enables the lessee to build up hidden reserves and realise the residual value in its financed or owned aircraft fleet and, through one of the standard financing arrangements noted at para 12.2, may provide an additional net present value benefit. Under an operating lease, the lessee will not be building up any hidden reserves but 14 See https://apps.newyorkfed.org/markets/autorates/SOFR. 15 PW  Schroth, Financing leasing equipment in the law of the United States, 58 Am J  Comp. L 323 (2010), at 341–42.

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12.4  A Lessee’s Guide to Aircraft Leasing also, generally, will not be committing as much capital as under a finance lease. The possibility of entering into operating lease agreements with staggered terms enables the lessee to diversify its portfolio and to regenerate more easily its fleet without the necessity of concluding purchase agreements directly with the manufacturer.

THE LEASING ARRANGEMENT 12.4 Once the decision is made to enter into a finance or an operating lease, the parties must document the leasing arrangement that, depending upon the structure selected, will involve negotiating a number of documents, including, inter alia, a sale agreement, loan and loan-related documents, and security documents. The essence of the arrangement is, however, the lease agreement, the principal document that governs the rights and obligations of the lessee throughout the lease term. Regardless of whether the airline has chosen a finance or an operating lease, many of the same or similar issues arise during negotiation and documentation. Principal issues common in lease negotiations are set out below. Often the lessor is not the operating or financing leasing company or institution with whom the airline has entered into the underlying letter of intent or similar arrangement, but rather is an SPV that is managed by the leasing company but whose sole function is the leasing of the aircraft or a group of aircraft to the lessee. The SPV may also be the vehicle through which tax benefits are generated for the ultimate investors or beneficiaries or used by the relevant institution for transaction security or liability purposes. The SPV is usually a limited liability company or, for US financing transactions, possibly a common law or statutory trust, which will hold the aircraft for the benefit of the ultimate aircraft owner. Lessees should exercise caution when agreeing to enter into a transaction with a common law trust. Use of a common law trust in certain statutory-based jurisdictions can create practical problems, such as in compliance with aircraft registration requirements. Furthermore, the trustee, which is often a financial institution specialising in the provision of such services, as well as the beneficiary, may have concerns due to jurisdictional differences in the recognition of beneficial ownership of the aircraft as well as potential liability in the event that the trust was disregarded. Finally, a trust structure may facilitate the transfer of the beneficial interest in the aircraft and the lessor’s commercial position in a manner that it becomes virtually impossible for the lessee to determine the legitimate beneficiary for tax or regulatory purposes. As the particular SPV lessors have very little net worth, the lessee should consider the insolvency risk of its contracting party and the ability of the lessor to fulfil its primary obligations to the lessee, which, under the standard net lease provisions, generally are limited to the covenant of quiet enjoyment and, as is common in operating leasing, the release of moneys held (specifically the security deposit and maintenance reserves) when required under the terms of the lease. A lessee can obtain comfort on this point by requesting the parent company to provide a guarantee or comfort letter supporting the SPV’s obligations. If the entity does have sufficient net worth, then the SPV should provide a net worth certificate and make representations to the same effect. With respect to quiet enjoyment, the lessee should ensure that any financing bank provides it with a letter of quiet enjoyment ensuring that the lessee’s quiet enjoyment of the aircraft is conditional only upon the fulfilment of its obligations 190

The leasing arrangement 12.4 under the lease.16 The lessee will want to assure itself that quiet enjoyment cannot be affected by a lender’s sale of the aircraft following enforcement caused by an aircraft lessor or owner default, which is not simultaneously a lessee event of default. The letter of quiet enjoyment or acknowledgement of assignment will usually provide that the lessee will, at the election of the financial institution following enforcement, perform its obligations for the benefit of the bank. In such circumstances, the lessee should, depending upon the structuring of the transaction and the availability of alternative ring-fencing measures, consider whether the bank also should be obligated to fulfil certain obligations of the lessor, in particular, relating to the return of maintenance reserves paid. The failure to explicitly include such a provision may, in the event of a lessor insolvency, lead to the inequitable result of the lessee continuing to pay rent and maintenance reserves to the bank (or new lessor) without the corresponding obligation to remit such maintenance reserves for use in performing the redelivery check or scheduled maintenance. Due to the non-negotiable ‘hell or high water’ provisions17 of lease agreements (which, depending upon the factual circumstances at hand, may not be entirely enforceable in the relevant jurisdiction), the lessee will have little success in refusing to continue such payments, which if not made may not only negatively impact the lessee’s creditworthiness in the leasing community, but also may result in unintended cross-defaults in other lease or financing arrangements. In such event, the lessee has only the unsatisfactory recourse to, most likely, a foreign judicial system and, in light of the length and cost of litigation generally, the nature of a SPV and the relatively clear language in many standard quiet enjoyment letters, success on the merits is anything but certain. Furthermore, the lessee should at the time of lease negotiation consider that aircraft are frequently traded or sold among many different institutions with various degrees of professionalism, market recognition, and funding. Often aircraft are sold with the lease attached, meaning that the lessee, as a result of the sale and novation (a tri-party agreement between the original lessor, the transferee, and the lessee), will have entered into a contractual relationship with a new lessor not of its choosing. The lessee should consider mitigating the potential risks associated with such a sale during the initial lease negotiations. Such matters may, in addition to the standard no greater obligations clause, include a detailed review of tax clauses and indemnity provisions, which are usually initially assessed in conjunction with the identity and jurisdiction of the original lessor. In particular, the lessee should consider the appropriateness and breadth of its indemnities and whether such indemnities would be appropriate for other jurisdictions and lessor corporate structures. In finding the balance between ensuring the lease is easily tradable and the problems that an airline can face from a new owner, the parties can agree to restrict any such transfers to a transferee that is: (a) not a competitor of the airline; (b) an experienced lessor; and (c) has sufficient net worth. Further, in order to discourage over trading and ensure the airline is motivated to cooperate, a novation fee can be agreed and will be paid in addition to any legal or registration costs incurred by the airline. 16 See, eg  RG Wells & JT  Curry, Protecting the aircraft lessee’s quiet possession right under the Cape Town Convention, Bloomberg Banking & Fin Rep (1 June 2009); see also WB Piels, Leasing documentation: considerations under Article  2A of the Uniform Commercial Code, 1410 PLI/Corp. 883 (February 2004), at 917. 17 See, eg  PL  Durham, Recent challenges to the hell or high water clause: is New York law a refuge for lessors after ACG Acquisition XX LLC v Olympic Airlines SA?, Am Bar Ass’n Ann Meeting, Aircraft Fin Subcomm (August 2010). See also Gen Elec Capital Corp v FPL Servs Corp, 986 F Supp 2d 1029, 1036 (ND Iowa 2013).

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12.4  A Lessee’s Guide to Aircraft Leasing Recognising the importance of aircraft trading as well as a certain degree of market standardisation, the Aviation Working Group (AWG)18 published a template novation agreement in 2017 and, in 2018, announced the development of the global electronic aircraft trading system (GATS). GATS relies on the use of trusts established in the United States, Republic of Ireland or Singapore and the recording of subsequent electronic transfers of beneficial interest through a standard form thereby replacing the necessity for a novation agreement. While the GATS platform eliminates in theory the involvement of the airline, there are a number of issues that remain to be sufficiently addressed, including unintended tax affects, recognition of trusts and insolvency treatment. Advice should be sought before agreeing to the use of this structure. Just as a lessor will undertake a credit assessment of the asset and the lessee as well as a jurisdictional analysis in calculating its rental and upon which to base its requirement for a security deposit and maintenance reserves, the lessee should consider undertaking a similar review of the lessor. It is not unlikely that the lessee over the term of the lease will pay a significant amount in the form of security deposits and maintenance reserves, the latter of which it will expect to receive over the term of the agreement upon the completion of the required maintenance events. If the lessor, or a subsequent lessor who purchased the aircraft, were to become insolvent, the lessee may, unless appropriate arrangements are made in the initial documentation, have only an unsecured claim against the lessor’s estate and, in the case of maintenance reserves, such a claim may involve several million dollars. The potential problem is further highlighted by the standard maintenance reserve qualification, which provides that reserves are the sole property of the lessor. Although from a lessor’s perspective such a provision is necessary as a protection against claw back from the lessee’s insolvent estate, it does not protect the lessee from a lessor insolvency. Due to lease standardisation, it is unlikely that a lessee will be in a position to amend such provisions. Notwithstanding, other arrangements to secure such moneys for the purpose for which they were originally intended can be implemented.19 No amount of prudence can completely insulate a lessee from a lessor or future lessor insolvency as the receiver, particularly in the absence of a mortgagee as a preferred creditor, may have the ability to terminate the lease and sell the aircraft for the estate’s creditors.20 Appropriate arrangements vary and can include letters of credit (for both the security deposit and maintenance reserves), end of lease term compensation in lieu of maintenance reserve payments, the use of blocked or accounts charged to the lessee, or an agreement that a reputable and, from the lessee’s perspective, a creditworthy third party will administer the reserves. In finance leasing transactions, the lessee will have a paramount interest in ensuring that a lessor insolvency does not affect the lessee’s ability to obtain title at the times agreed upon in the lease. The lessee may request a second ranking mortgage or pledge over the aircraft as security for the lessor’s obligations to transfer title, or should 18 AWG is a not-for-profit entity comprised of manufacturers, lessors, and financiers to establish and promote the financing and leasing of aircraft; see http://www.awg.aero/. 19 Aside from the counterparty risk, the lessee should consider whether it wishes to require the full pay-out of moneys held in a particular maintenance reserve account upon accomplishment of the relevant event. In this respect, the lessee and the lessor have opposing interests. Whereas the lessee considers the reserves should be attributable solely to the maintenance events and, hence, payable in full for the event, the lessor may view the reserves (or part of the reserves) as income to be used in its cash flow analysis. 20 See, eg § 103 Germany Insolvency Code; 11 USC § 365.

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The leasing arrangement 12.5 enter into an appropriate agreement with the relevant financial institutions requiring its participation in the enforcement of any first ranking mortgage, particularly the transfer of title upon payment of the relevant termination amount.

Operational flexibility 12.5 Finance leases and operating leases should each provide the lessee with the necessary operational flexibility. The operational requirements of lessees will vary but may include, inter alia, flexibility with respect to subleasing, part and engine pooling or interchange, maintenance, and return conditions. As an aircraft lease generally is for a period of at least three years, each lessee should consider its requirements for operational flexibility not only at the time of lease commencement but also in the future with potentially changed market circumstances. In this respect, subleasing provisions and their restrictions should be reviewed carefully. It is not uncommon for a lessee, due to its own capacity adjustments, to sublease an aircraft. In the absence of suitable subleasing provisions and jurisdictions to which the aircraft can, without further consent, be subleased, the lessee may find itself in the undesirable position of discussing the merits of such sublease with its lessor and, possibly, the lessor’s lenders, notwithstanding the fact that the lessee remains the primary credit risk for the lessor. As the lessor already has placed the aircraft, it may have a reduced incentive to consent to the sublease or the lessor may be tempted to place another of its own aircraft directly with the envisaged sublessee. In light of the near collapse of aviation due to Covid-19, lessors have to a limited extent shown a willingness to agree to power by the hour (PBH) agreements whereby the lessee would, subject to a floor, pay only for the hours flown with the ceiling typically not exceeding the pre-agreed rental rate or market conditions. Due to the value and operational significance of aircraft engines, engine interchange and pooling can be a significant point of discussion. Larger airlines will often have entered into engine pooling arrangements. Optimally, the lease should contain the flexibility for the lessee to enter into standardised arrangements without the lessor’s consent. Provisions to the contrary, especially those requiring prior written consent, could inhibit the airline’s ability to join a pooling arrangement, which carries its own economic benefits apart from the lease. In any event, an airline should, without the need for further permission, be entitled to interchange engines within its own aircraft fleet. Lessors will frequently request recognition of rights or similar letters acknowledging the lessor’s and financier’s interests in the engine as a condition to any such installation. A  lessee should consider such request carefully including with a view towards current and future administrative burdens. For some airlines, an alternative may be for the lessee to implement a multi-party arrangement, for example, a protocol, for the mutual recognition of rights in engines, to which any new lessor will accede, with documentation kept to a minimum. Although the status of the engine upon removal may vary depending upon the jurisdictions involved, lessor concerns with respect to title to the engine generally can be appropriately dealt with in the lease documentation. Additional security through the relevant filings can be obtained in those jurisdictions where the Cape Town Convention21 has been ratified. 21 Convention on International Interests in Mobile Equipment and associated Aircraft Protocol signed at Cape Town on 16 November 2001.

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12.6  A Lessee’s Guide to Aircraft Leasing Although it is self-evident in an operating lease where the operating lessor maintains the residual value risk, the financing lessor or institution will, in an operating lease structure, also have a significant interest in the maintenance and return conditions. Although such provisions require appropriate scrutiny by technical specialists, it is important to ensure that the maintenance and especially the redelivery conditions are clear and unambiguous. If return compensation in lieu of maintenance reserves is agreed, the lessee should consider capping the amount of compensation payable for individual events. A delay in delivery is often accompanied by late penalties and may lead to litigation.22 If the aircraft is not placed with a follow-on lessee, the lessor may have an incentive to prolong the redelivery process. As a result, some lease agreements provide for a detailed dispute resolution mechanism, often including an experienced third party to minimise the risk of an unjustified and prolonged redelivery process. Return conditions and compensation depending on the maintenance status of the aircraft at return amount to a substantial additional financial burden for the lessee and should be given considerable attention when planning and negotiating a lease.

Lessee’s other obligations 12.6 Aside from the obligation to properly maintain, operate, and insure the aircraft, the lessee has a number of other obligations, including the obligation to register and maintain the aircraft, and to protect the interests of the lessor and financiers. In both financing and operating leases, this may include, inter alia, registering the lessor’s and potentially other related interests pursuant to the Cape Town Convention, which to date has been ratified by over 80 countries.23 The lessee should be familiar with the potentially expansive application of the Cape Town Convention, including lessor’s rights following a default, deregistration and assignment.24 With respect to assignments and transfers, aircraft on operating leases are, as noted earlier, actively traded among lessors. Subject to the provision of letters of quiet enjoyment and an assumption of costs, lessees are generally required to assist in such transfers. In documenting the lease agreement, the lessee may wish to consider additional requirements to such transfers, in particular, the appropriateness of segregating maintenance reserves and security deposits in light of the potential change in counterparty risk.

OTHER PROVISIONS 12.7 A chapter on a lessee’s guide to aircraft leasing would not be complete without mentioning representations and warranties, ongoing covenants, as well as events of default. Lessors will often seek far reaching representations and warranties, which go beyond due existence, incorporation, and receipt of relevant authorisations. A lessee should consider whether and the extent to which

22 See, eg Pindell Ltd v AirAsia Berhad [2010] EWHC 2516 (involving a claim by a company ultimately owned by BBAM for damages resulting from a lost sale due to a late redelivery). 23 According to the records at https://www.unidroit.org/ as of 24 January 2021. 24 Chapter III (Default remedies) and Chapter IX (Assignment of associated rights and international interests; rights of subrogation) of Cape Town Convention; see also Article IX (Modification of default remedies provisions) of Aircraft Protocol.

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Other provisions 12.7 such requests can and should be accepted, particularly if the representations and warranties are repeated beyond lease execution and aircraft delivery. A  lessor will often seek the right to terminate the lease agreement upon the occurrence of a wide variety of events, some of which are wholly unrelated to the lessee’s performance under the lease agreement and potentially subjective. Suggested events of default often include low financial cross-defaults to any other indebtedness incurred by the lessee, vague material adverse change clauses, disposals or mergers that have not been consented to by the lessor, overly broad insolvency clauses which could capture standard renegotiations with one or more creditors, as well as changes in law that may negatively impact the lessor’s or its financier’s position under the lease or related documents. Lessees should carefully consider if and the extent to which such clauses are acceptable, particularly given the dramatic impact of the current pandemic or any future similar event. Although the lessor will have a genuine interest in the financial health of its lessee, such provisions have no relationship to the lessee’s fulfilment of its obligations under the lease. Indeed, as the obligations on a lessee are so numerous, separate events of default that are independent of the lessee’s performance of its contractual obligations should to the extent possible be avoided or minimised. Lease provisions have been carefully negotiated and standardised over a long period of time; however, Covid-19 has tested the suitability of such provisions in the context of a global and sudden reduction in passenger numbers due to an event not of the airlines’ own making. In respect of Covid-19, much of the initial focus from airlines was on the utility of the concept of force majeure (or lack thereof) to leasing arrangements as a means of avoiding default under the lease agreements and similar financing arrangements. As noted above, the market standard legal positions around such provisions are not structured in the airline’s favour. Notwithstanding, lessors and lenders have had limited appetite to try to collapse structures and repossess aircraft, in part due to the limited remarketing scope. Force majeure in common law jurisdictions generally is a creature of contract and, therefore, must be clearly defined in an agreement. Airlines may in the future try to include a concept of a ‘super force majeure event’, which would be defined to include situations that materially impact the operation of a majority of airlines globally or regionally. The effects of such an inclusion will need to be carefully considered, particularly any impact on the ‘net lease’ or ‘hell or high water’ provisions in the lease agreements which will be strongly opposed by lessors. Any such provision also may have a broader impact on the lessor’s or financing parties’ overall risk assessment as well as their ability to access capital markets products which, in turn, may negatively affect the pricing of a transaction. Lessees may, however, have some ability to introduce clauses tempering, to a limited extent, the pre-Covid-19 market standard to at least require lessors or financing parties to discuss appropriate measures in light of a super force majeure event or a non-tail specific grounding event, such as with respect to the recent Boeing 737  MAX worldwide grounding. For example, standard lease agreements often include broad provisions with respect to the constitution of total loss and insolvency-related events. Total loss may be defined to include an event depriving the lessee from use of the aircraft for a specified period of time, often not exceeding 90 days. Similarly, it is not uncommon for lessors to try to cast insolvency-related events of default to include a rescheduling of debt with one or more creditors. Either provision, if accepted without appropriate 195

12.7  A Lessee’s Guide to Aircraft Leasing qualification, could lead to an unintended requirement for a potentially uninsured total loss payment or event of default and corresponding consequences. Each airline, within the confines of its individual market and against the backdrop of its financing/leasing structures should use this opportunity to consider potential amendments to the foregoing and other provisions.

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13 Pre-delivery Payment Financing Rob Murphy

INTRODUCTION 13.1 This chapter summarises, on a high-level basis, the key legal issues arising in pre-delivery payment (PDP) financing. It will focus mainly on the perspective of the secured lenders and draw some contrasts with the security position that typically applies in long-term financing transactions. A  PDP financing relates to the secured funding of certain payments which are required to be made to the manufacturer prior to delivery of the aircraft. These payments are payable on signing the purchase agreement and on other dates in the run up to the scheduled delivery date of the aircraft in amounts corresponding to a preagreed percentage of the manufacturer’s base price. Under the PDP financing, the lenders will make advances to the borrower (disbursed directly to the manufacturer) on the dates and in the amounts specified in the loan agreement. The borrower will be required to repay those advances on or prior to delivery and will usually fund this obligation from financing obtained to purchase the aircraft. To cater for the delayed delivery scenario, the PDP loan will be repayable on the actual delivery date or a defined ‘long-stop’ date. The PDP loan will provide for interest to be paid on a periodic basis – usually monthly – and, in rare cases, for interest to be rolled up and paid at the time of principal repayment. A  PDP financing gives rise to particular interface issues with the manufacturer which relate to the fact that the borrower will assign its rights under the purchase agreement as security for the loan. Such assignment will be consented to by the manufacturer. Over the past few years, manufacturers have very developed approaches on key legal risks in PDP which are mainly driven by policy issues on the business side. Note that the export credit agencies have not offered support for PDP financing. Reasons include the nature and amount of the exposure, policy considerations including what might be expected of manufacturers, and potential conflicts with the rights and interests of long-term financiers (if not the ECA). Overall, the availability of PDP financing as a discrete product – ie unconnected with a longer term sale and leaseback transaction – has been very limited in recent years. It remains to be seen whether there will be greater demand from airlines for this product in the short- to medium-term and whether that will be met by parties who are willing to provide this financing solution.

KEY ISSUES RELATING TO THE SECURITY PACKAGE 13.2 In PDP financings, the primary security for the advances is the purchase agreement and certain rights (credits/warranties) under any engine general terms 197

13.2  Pre-delivery Payment Financing agreements entered into between the customer and the engine manufacturers. The rights which the customer as ‘buyer’ has against the manufacturer have a value. In a default and enforcement scenario, this value may be realised by the lenders as follows: (1) the rights may he sold to a third-party purchaser for such price as the lenders may be able to negotiate, hopefully to recover the loan and accrued interest and expenses. In almost all cases, this will be subject to the manufacturer’s prior consent; or (2) the lenders may choose to ‘build out’ the aircraft – namely, to finance the purchase of the aircraft at delivery – with a view to a subsequent sale or leasing transaction to cover their investment and costs. In structuring the security package, the lenders’ key concern will be to ensure that they can step into the position of the customer and be treated as the ‘buyer’ by the manufacturer. In order to achieve this, the lenders will need to be able to: (1) ‘trump’ the right of the manufacturer to terminate the purchase agreement for customer breach (particularly insolvency) by having a documented step-in arrangement within a defined notice period; (2) make further PDPs under the purchase agreement, notwithstanding that these payments may not have been contemplated by the financing arrangements with the customer in order to keep the purchase agreement ‘alive’ pending the sale; and (3) assign the purchase agreement, but this will require the prior consent of the manufacturer; or (4) purchase the aircraft at delivery for a price that is certain — taking account of airframe and engine credits and escalation arrangements – such that the lenders can accurately model their financial exposure in an enforcement scenario. Following a borrower loan default or a purchase agreement default, the lenders will need to decide whether or not they wish to step in and perform the purchase agreement. Usually, the manufacturer will require some time period for the decision making – that is, such that the position is not open-ended. Also, the manufacturer will usually require the right to repay the lenders and take back the delivery positions – that is, have the security assignment discharged. This is referred to as ‘the manufacturer’s option’. In considering their position, the lenders will gauge the likelihood of the market value of the delivery position or the aircraft exceeding the indebtedness due by the customer, the amount of further investment that will need to be made and the timescale involved in recovering that investment. If there is no market for the delivery position of the aircraft or certainty over the price payable for the aircraft, the lenders may decide to give up their rights to step into the position of the borrower. As a counterbalance to the manufacturer’s desire for certainty, it is equally important for the lenders to retain flexibility in the exercise of their rights following a borrower default and not to be ‘locked in’ to a purchase agreement which they do not wish to perform. The time periods around the exercise of the various rights will be subject to negotiation. Also, the price payable on exercise of the manufacturer’s option will not be equal to all sums owing under the facility agreement – the manufacturer will seek to limit its exposure to principal and interest (capped). If other sums (for example, breakage costs) are to be included, these will also need to be subject to a cap. 198

Lenders’ key concerns 13.5

LEGAL NATURE OF PDP 13.3 The security over the purchase agreement will usually take the form of an assignment by way of security. By way of example, under English law, this means that the assignment to the lenders is subject to an express or implied ‘equity of redemption’ in favour of the borrower – that is, the borrower is entitled to the return of their asset if they discharge their indebtedness to the lenders. With an assignment by way of security, lenders will need to check for certain legal issues that may affect the security. These will generally be matters of local law. Notably, as to whether the insolvency of the borrower will effect the validity or enforceability of the lenders’ rights under the purchase agreement. In many jurisdictions, the lender will be required to ‘perfect’ their security, for example by filings or registration, in order to keep it out of the insolvency officer’s reach and to ensure priority over other creditors. Registration options may be limited. As the aircraft is not yet delivered, security interests over it cannot at the moment be registered on the International Registry under the Cape Town Convention. The security assignment cannot be registered with any aviation authority. Hence, registrations – for example, Companies House type filings – regarding the assignment of contract rights are required.

LENDERS’ KEY CONCERNS Assignable price/step-in price/access to credit memoranda 13.4 A threshold concern for lenders will be to get certainty on the price for which they can purchase the aircraft in a default scenario – usually referred to as the ‘assignable price’ or ‘step-in price’. This can be achieved in a variety of ways including most typically by way of direct agreement with the manufacturer. In order to enhance the position, lenders may also require an assignment of any credit memoranda held by the customer – both airframe and engines. Credit memoranda can be used to reduce the amount of the purchase price, reduce the cost of initial spares provisioning or to purchase goods and services from the manufacturer; usually purchasers will wish to apply the credit memoranda to the final purchase price. Manufacturers may not always make available to the lenders the same credit memoranda offered to their customer. This point will be negotiated on a case-by-case basis. It makes sense for purchasers to negotiate this point upfront with the manufacturer at the time of entering into the purchase price. Operating lessors who are structuring a PDP transaction as part of a forward sale and leaseback transaction and who have their own forward order agreement with the manufacturer may be able to negotiate a step in at their purchase price – both to simplify matters and also to make the pricing on a par with their own purchase agreement.

Escalation in purchase price 13.5 Likewise, lenders will wish to get the benefit of any fixed or capped escalation arrangements that the purchaser has negotiated with the manufacturer. Again, a point ideally to be agreed upfront with the manufacturer. 199

13.6  Pre-delivery Payment Financing

Amendments to purchase agreement 13.6 Lenders may want to control any amendments to the purchase agreement which impact on the value of the aircraft or the availability of the security. Matters relating to price – for example, voluntary changes to specification or relating to delivery schedule (for example, swapping or sliding delivery positions) will be of concern to the lenders. The borrower and the manufacturers may want to restrict interference by the lenders in the ongoing performance of the purchase agreement.

Insolvency risk 13.7 An insolvency of the borrower will trigger an entitlement on the part of the manufacturer to terminate the purchase agreement and will also entitle the lenders to accelerate the loan and enforce the security. In stepping in to enforce the security, the lenders will want the manufacturer to deduct from the agreed purchase price any PDPs already made – whether these are financed by the lenders or by the borrower’s own funds. The manufacturers will be concerned that there is a risk that the insolvency officer of the customer may seek to ‘clawback’ some or all of these amounts as part of the insolvency estate. Manufacturers may seek to cover off this risk by way of an indemnity from the lenders and lenders naturally resist such a request given the potential financial exposure for them. This ‘clawback’ issue can be the subject of protracted negotiations and the parties have focused on structuring solutions – that is, adapting the contractual and security arrangements such that the risk is judged to be sufficiently reduced or mitigated. SPC-style (special purpose company) structures have been adopted in a number of instances to try to achieve a bankruptcy remote structure. It is advisable to take legal advice on this topic in the relevant jurisdictions.

Standstill period 13.8 Lenders will want to have a period following a customer default to decide whether or not to exercise their security. Usually, a standstill period will be negotiated to allow time for this decision making.

Realisation of the security 13.9 Following a customer default, lenders may seek realisation of the security by onward assignment of the purchase agreement. Lenders may want flexibility to assign and should be able to do so without the manufacturer’s consent provided certain conditions agreed with the manufacturer are met. Manufacturers seek to control those assignments on the basis that they need to control the market for their products and prevent interference by lenders in manufacturers’ legitimate marketing efforts. Manufacturers may (including for legal reasons) also have an interest in the identity of the end-users of its product.

Buy-back option 13.10 Lenders may want to ensure that the remedies available on a customer default are not controlled by the manufacturer and that the lenders can recover 200

Lenders’ key concerns 13.11 the cost of funding and interest on the PDPs. Manufacturers may require an option to ‘buy-back’ the lender’s interest in the purchase agreement following a customer default. The price for the buy-back will be negotiated – it will cover principal and some other key elements, interest and perhaps other costs (for example, break costs) – but will not be an open-ended commitment from the manufacturer to pay all sums due under the loan agreement.

Disclosure of the purchase agreement 13.11 Most aircraft purchase agreements are subject to restrictions of confidentiality. Lenders may be concerned that clauses disclosed may not cover the entirety of a subject matter and that such partial disclosure may impair their ability to enforce lenders’ security. Lenders may seek to obtain representations from the borrower that the disclosed provisions are complete, accurate and not misleading, and that there are no other provisions in the purchase agreement which would render ineffective, diminish or prejudice the ability of the lenders to enforce the benefit of the disclosed part of the purchase agreement. Manufacturers may be willing to consent to the disclosure of the purchase agreement (or more limited therein) with the agreement of the customer. That may not apply to customer-specific features (including commercially sensitive items, such as the level of credit memoranda).

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14 Regional Markets In this chapter the following key markets are covered: Brazil Russia India China Germany Japan

BRAZIL Edward Sheard and Fabio Falkenburger Introduction 14.1 Brazil is the largest aviation market in Latin America and the country’s air transportation market experienced significant growth until 2019, when it was severely affected by the Covid-19 pandemic. The domestic market has decreased markedly, while the international market virtually disappeared during 2020 and the first quarter of 2021, reducing passenger demand in May 2020 by 92.4% with respect to domestic flights and 97.3% with respect to international flights (compared to the same period in 2019), according to a survey conducted by the Brazilian Civil Aviation Agency (ANAC). This led to a number of lease restructurings, deferral negotiations and the early return of aircraft, in order to meet the airlines’ respective fleet reduction requirements. Notwithstanding the above, once the current restrictions are lifted and the global pandemic is controlled, it is expected that airlines will seek to expand/renew their respective fleets, which should create demand for leasing and financing structures. As a general rule, Brazilian airlines use two main types of financing when adding aircraft to their fleet: (1) export credit financing; and, more frequently, (2) cross-border operating leasing, primarily under operating leases due to the favourable tax treatment applicable to this type of lease, as well as the other legal and regulatory factors addressed in Chapter 12.

Types of lease transactions Finance and commercial lease transactions (arrendamento mercantil) 14.2 Lease transactions in Brazil are regulated by Law 6.099 of 14 September 1974 (the ‘Leasing Law’) as amended, which deals with, amongst other things, the tax regime applicable to such transactions. The Leasing Law defines lease transactions as transactions negotiated by and between a lessor and an individual or legal entity (as lessee), by which the 203

14.3  Regional Markets lessor acquires an asset and leases it to the lessee, pursuant to agreed terms and conditions and for the exclusive use of the lessee. These transactions are classified as either: (a) finance lease transactions (arrendamento mercantil financeiro); or (b) commercial lease transactions (arrendamento mercantil operacional). The main difference between both types of lease lies in the inclusion of a purchase option, which must be exercised at the market value in the case of commercial leases,1 while the parties can freely establish the price payable upon exercise of a purchase option in finance leases. Also, a guaranteed residual value can only be provided in finance leases. The Leasing Law also establishes that such lease agreements must include clauses regarding: (a) the term of the lease agreement; and (b) the value of the instalments of rent (which must be paid at maximum intervals of six months). Also, the Leasing Law establishes that leasing transactions are subject to the regulation of the Brazilian Central Bank (Banco Central do Brasil (BACEN)) and that the Brazilian National Monetary Council (Conselho Monetário Nacional (CMN)) is responsible for laying down specific rules regarding this form of commercial activity. In this context, the CMN issued Resolution 2.309 of 28 August 1996, as amended, which currently regulates domestic leasing activities (that is, leasing transactions fully carried out inside Brazil) and stipulates certain mandatory provisions to be included in the respective finance and commercial lease agreements.

Operating lease transactions (arrendamento simples) 14.3 Brazilian law also includes provisions which cover the more customary operating lease agreements (arrendamento simples), in which the lessor/owner does not grant the lessee with an option to purchase the asset at the end of the lease term. In addition, the aircraft is imported into Brazil under a special temporary admission regime, as it shall not remain in the country following the expiry of the lease term.

Cross-border lease transactions 14.4 Cross-border lease transactions entered into between a foreign lessor and a Brazilian lessee are regulated by CMN  Resolution 3.844/2010, which determines that the term of a cross-border lease must be no longer than the useful life of the asset.2 In addition, the depreciation of the asset should be limited according to its useful life. CMN Resolution 3.844/2010 also provides that certain criteria must be observed on cross-border finance lease transactions in order to ensure that instalments of principal are evenly distributed across the lease term so that, at any time, the proportion between the amount paid to the lessor and the total amount of the lease is not higher than the proportion between the expired term and the entire lease term. Although not expressly provided therein, it is possible to interpret that the rules applicable to domestic lease transactions, to the extent not conflicting 1 Commercial lease agreements are commonly used within the domestic lease market in transactions involving the lease of fleet cars and computers. 2 According to CMN Resolution 3.844/2010, the useful life of the asset may be defined by either the aircraft manufacturer or by an independent expert.

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Brazil 14.6 with Resolution 3.844/2010, should also be applicable to cross-border lease transactions.

Taxation Special regime applicable to operating leases (arrendamento simples) 14.5 Transactions structured as operating leases (arrendamento simples) may benefit from a temporary admission customs regime. In this case, a special tax regime would apply to both the importation of the aircraft and rent payments made by the lessee under the lease. The special customs system for the temporary admission of aircraft may be applied by the customs authorities for the term specified in the lease agreement and the lessee shall be required to pay Brazilian import taxes proportional to the period in which the aircraft shall remain in Brazil. If the special customs regime applies to a transaction, the lessee (as importer) will be required to execute a commitment letter and offer a guarantee to the tax authority for the entire amount of the suspended taxes.3 Finally, the lessee must undertake to pay all federal taxes due on the import transaction, should it choose to use the aircraft for a purpose other than the one described in the special custom regime application.

Withholding tax on payments 14.6 As a general rule, payments made by Brazilian lessees to non-resident beneficiaries, such as lessors, are subject to a 15% rate of withholding tax (WHT). Currently, the general WHT rate applicable to such payments is 15% in finance leases.4 Until 2020, there was a 0% rate applied to finance lease agreements concerning aircraft and engines installed or to be installed on such aircraft, in connection with finance and commercial lease agreements. This reduced rate was not renewed as from 1 January 2021, so that there is a 15% WHT applicable to the interest portion of leases entered into up as from 2021. As regards operating leases (arrendamento simples), there is a debate as to the applicable WHT rate for aircraft and engines5 subsequent to recent changes in the applicable laws and regulations. This is due to the fact that, in order to mitigate the effect on the airlines arising from the Republic of Ireland being listed as a low tax jurisdiction (LTJ), the Brazilian government issued an administrative rule6 determining that operating lease transactions entered into by Brazilian airlines should have the same tax treatment as finance leases. Therefore, in that case, the 15% rate applicable to finance leases would also apply to operating leases. However, one could argue that Section 2-A of Normative Instruction 1.455/2014 may no longer apply (as it does not have a corresponding legal statute), in which case operating leases would be taxed according to a specific rule that grants 0%

3

Such guarantee can be either presented by the lessee or any third party and is more commonly presented as a contracted bank guarantee or insurance bond. 4 Please note that, with regard to finance leases, the rate is applied over the interest portion remitted. 5 See item I, Article 1, of Law 9,481/1997 (as amended). 6 Section 2-A of Normative Instruction 1,455.

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14.7  Regional Markets WHT rate to simple lease transactions not carried out with a company located in a LTJ. However, it should be noted that a 25% rate shall apply in certain specific situations, such as when the beneficiary is located in a LTJ. The Brazilian tax legislation defines a LTJ as a country or location that either does not impose income tax or imposes income tax at a rate lower than 20%, or where the laws of that country or location impose restrictions on the disclosure of shareholding composition or the ownership of the investment.7 A  list of LTJs is published by the Brazilian Revenue Service from time to time,8 and currently includes Ireland, Cayman Islands, British Virgin Islands, Bermuda, Cyprus and Barbados, amongst others.

Double tax treaties 14.7 Brazil has entered into double tax treaties (DTTs) to avoid double taxation in connection with taxes on income and on capital with many countries, including Italy, Spain, France, Austria, Mexico and Japan. DTTs may provide for a limitation on WHT to be imposed on interest payments derived from a Brazilian source as well as on the payment of royalties. Lease payments (principal and interest) could qualify as a royalty for the purposes of some of the DTTs to which Brazil is a party and therefore such treaties are often considered by lessors/lessees when structuring a transaction.

Capital gains taxes over the disposition of aircraft 14.8 Under Article  26 of Law 10.833/2003, capital gains realised outside Brazil in transactions involving assets located in Brazil are subject to WHT at the rate of 15% (a 25% rate applies if the beneficiary is located in a LTJ) even if the relevant transaction only involves two non-resident parties. Therefore, the sales of an aircraft or engine could potentially trigger Brazilian capital gains taxes if the asset is located in Brazil at the time at which title is transferred from seller to buyer. There is a lack of clear guidance by the Brazilian tax authorities regarding the precise criteria for an asset to be deemed to be located in Brazil for capital gains tax purposes. Where an aircraft is imported into Brazil under a temporary admission regime (that is, in the case of operating leases – arrendamento simples), it is possible to argue that the mere fact that the aircraft is operated by a Brazilian carrier, registered in Brazil for regulatory purposes and physically located in Brazil, does not cause the aircraft to be located in Brazil for the purposes of the imposition of WHT. This interpretation has some merit due to the fact that ‘assets or rights located in Brazil’ must be interpreted as relating to assets located in Brazil on a permanent basis, that is, as Brazilian assets, not only physically located in Brazil at the time of transfer of title but intrinsically linked to Brazil on a definitive basis. If an aircraft entered Brazil under the temporary admission customs regime, which requires the re-exportation upon expiry of the lease term, there may be grounds to argue that the transaction should not generate the imposition of WHT in Brazil on potential capital gains. However, in view of the lack of clear guidance in both

7 8

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See Article 24 of Law 9,430/1996 (as amended). See Normative Instruction 1,037/2010 (as amended).

Brazil 14.10 the applicable laws and regulations and administrative or judicial precedents, this remains a controversial issue which requires analysis on a case-by-case basis.

Other taxes associated with the leasing of aircraft IMPORT TAXES

14.9 As a general rule, the importation of aircraft into Brazil is subject to: (a) federal duties, such as (i) import duty (1.1) and (ii) tax on manufactured products (IPI); and (b) a state tax called tax on the distribution of goods and services (ICMS), which must be paid upon customs clearance of the aircraft. The 1.1 rates vary depending upon the tariff code of the relevant product, as provided by the Brazilian tax authorities. The basis for calculation will be the customs value of the imported goods, including the cost of: (a) insurance; (b) transport of the goods to the port or place of importation; and (c) loading, unloading and handling charges associated with the transportation of the imported goods to the port or place of importation. Aircraft are currently subject to 1.1 at a 0% rate. IPI tax rates also vary depending upon the tariff code for the applicable product. The IPI rates applied to aircraft are reduced to: (a) 0% whenever such products are either acquired or leased by a licensed air carrier for operation on authorised routes; and to (b) 5% whenever such products are either acquired or leased by a company engaged in air taxi services; otherwise, such products shall be subject to a 10% IPI rate. The basis for calculation will be the customs value of the imported good plus the amount paid as import duty. ICMS is calculated on the same basis as import duty. ICMS rates may vary from state to state and also depending on the tax classification number of the imported goods. The ICMS tax applicable to aircraft may be reduced to 4% in most states if the taxpayer (that is, the lessee) is included in a list of beneficiaries published by the Ministries of Defence and Finance. It is worth mentioning that the ICMS assessment on the importation of aircraft (or any other equipment) under a lease transaction could be challenged by the importer – based on certain constitutional principles and case law – before the Brazilian courts. In this sense, there is uncertainty as to whether such tax should be imposed on the importation of goods under an operating lease agreement to the extent that there is no transfer of ownership of the leased asset, although state tax authorities, in general, take the position that ICMS is due in those cases. Currently, the Superior Court of Justice and the Federal Supreme Court (STF) have consolidated the position by declaring that ICMS is not due on the import of goods under finance lease and operating lease transactions when there is no transfer of ownership over the leased asset.9 However, a final binding decision (which should then be mandatorily followed by lower Brazilian courts) has not been issued on this point of law. PIS/COFINS

14.10 Rent payments made by a Brazilian lessee are subject to the contribution to the Profit Participation Program on Imports (PIS-Import) and the Social 9

For example, see appeals to the Federal Supreme Court RE 461968SP and RE 514.641/MG and appeal to the Superior Court of Justice 1.131.718/SP.

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14.11  Regional Markets Security Financing Contribution on Imports (COFINS-Import). Currently, the rates of both PIS-Import and COFINS-Import due on payments to non-residents of Brazil in connection with the lease of aircraft used in the activities of the Brazilian taxpayer are reduced to 0%.10 TAX ON SERVICES

14.11 The tax on services (ISS) is a municipal tax imposed on the rendering of services by a Brazilian taxpayer and on the importation of services from abroad, pursuant to the terms of Complementary Law 116/03 (‘LC  116/03’), which contains a list of the taxable services. Currently, finance and commercial lease transactions (arrendamento mercantil) are listed as taxable services under LC 116/03. Since ISS is a municipal tax, each municipality has the authority to enact a local law dealing with such tax, provided that the general provisions of LC 116/03, including its list of services, are respected. In general, ISS tax rates vary from 2% to 5%.11 With regard to operating lease agreements (arrendamento simples), rent payments would not be subject to the imposition of the ISS because these transactions are considered to have the same legal nature as the rental of moveable goods. The STF issued a binding decision ruling that the rental of moveable goods should not be subject to ISS.12 TAX ON FINANCIAL AND CURRENCY EXCHANGE TRANSACTIONS

14.12 The tax on financial and currency exchange transactions (IOF/ exchange) is currently imposed at a 0.38% rate on the conversion of Brazilian reals into foreign currency for the performance of payments to non-residents of Brazil. Hence, the foreign exchange transactions related to rental payments made by a Brazilian lessee to a foreign lessor will be subject to IOF/exchange at a 0.38% rate. The Executive Branch is authorised to increase the rate of the IOF/ exchange at any time in connection with future transactions, up to a 25% rate.

Other issues to be considered by lessor Foreign exchange controls 14.13 Although now less restrictive than was previously the case, Brazil still has foreign exchange controls. Therefore, cross-border lease transactions are subject to approval and registration with BACEN  Resolution 3.844/2010 expressly provides that cross-border leases are subject to registration with the Registry of Financial Operations (Módulo Registro de Operação Financeira, or simply ‘ROF’), which must be concluded prior to the aircraft’s arrival in Brazil. The Brazilian lessee must submit the financial conditions of the relevant lease agreement to BACEN via its electronic system, which will then electronically issue the ROF, summarising and formally approving the financial terms and conditions of the lease agreement. The relevant agreement itself does not need to be physically presented to BACEN. However, BACEN may require a

10 See Law 10,865/2004. 11 5% rate is the maximum ISS rate allowed permitted by LC ll6/03. 12 Binding Ruling No  31 of 17  February 2010 issued by the STE, which rules that it is unconstitutional to charge ISS on the rental of movable assets.

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Brazil 14.15 lessee to provide that agreement at any time in order to verify that it reflects the information previously disclosed by the lessee in its electronic submission. Once the ROF has been issued, the lessee must apply for a schedule of payments, which will list and authorise the amounts and dates of any scheduled payments to be remitted out of Brazil pursuant to the terms of the lease and will serve as a basis for the closing of the relevant foreign exchange agreement.

Ultimate beneficial owner 14.14 Brazilian law requires that the ultimate beneficial ownership (UBO) of a foreign aircraft/engine lessor is disclosed to the tax authorities.13 In this sense, lessors are required to present a form disclosing their UBO or, in the case of listed companies, a declaration of non-existence of an UBO. Lessors are also required to register on the Brazilian taxpayer’s registry and appoint an individual resident in Brazil to represent them in the country.

Insolvency issues 14.15 The current Brazilian insolvency legislation is Law No  11101 of 9 February 2005, as amended (the ‘New Bankruptcy Law’). It introduced, for the first time in Brazilian legislative history, both judicial and extra-judicial recovery procedures (which are similar to Chapter  11 provisions under the United States Bankruptcy Code). According to the New Bankruptcy Law, a debtor must propose a restructuring plan and its creditors must vote on that plan within 150 days from the date on which the debtor filed for bankruptcy protection. However, Section 199 of the New Bankruptcy Law (as originally enacted) provided that rights of lessors under aircraft finance lease transactions (arrendamento mercantil) would not be affected by the granting or approval of the judicial reorganisation of the lessee (that is, the 180-day stay period granted to companies in this situation). The very first test of this new legislation was the judicial reorganisation of Varig (the former Brazilian flag carrier), started in 2005. During such proceedings, notwithstanding the provisions of Section 199 of the New Bankruptcy Law, lessors faced difficulties when seeking to enforce their rights, and a series of decisions were granted in favour of the company (to the detriment of operating lessors’ ability to repossess their aircraft). Such decisions were rendered on the grounds that: (1) the majority of Varig’s fleet had been leased pursuant to operating lease agreements (arrendamento simples) which, by a literal interpretation of the law were not entitled to benefit from Section 199; and (2) Section 49 (§3rd) of the New Bankruptcy Law prevents creditors from seizing assets from the debtor which are deemed essential to the continuity of such debtor’s activities during the stay period in a judicial reorganisation. The Varig precedent created a high degree of uncertainty among aircraft lessors and financiers in general. This situation led to an amendment to the New Bankruptcy Law in November 2005 which: (a) extended the benefit of Section 199 to creditors under any type of lease agreement; and (b) clarified that 13 See Normative Instruction 1,863/2018.

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14.15  Regional Markets the carve-out contained in Section 49 (§3rd) is not applicable to aircraft lease transactions. Therefore, a restructuring airline must now pay rent and comply with its other lease obligations in order to retain a leased aircraft in its fleet. The Cape Town Convention and Aircraft Protocol were approved by the Brazilian Senate in late-May 2011.14 The last stage in the legislative ratification process was the official approval of the Brazilian President and the subsequent deposit of the officially approved bill with Unidroit. The Cape Town Convention was only fully incorporated into the Brazilian legal system on 15 March 2013,15 whilst on 18 March 2014, ANAC issued a resolution regulating the implementation of the Cape Town Convention in Brazil and establishing the rules to be observed by the relevant interested parties in connection therewith. It should be noted that Brazil made the following declarations (which meet the requirements of Annex 1 of the 2011 Aircraft Sector Understanding): (1) insolvency: Article XI  Alternative A  (Chapter  11 of the United States Bankruptcy Code equivalent) applied with a 30-day stay period; (2) choice of law: Article VIII of the Aircraft Protocol applied; (3) deregistration: Article XIII of the Aircraft Protocol applied with periods of: – ten days for the remedies specified in Articles  13, paras 1(a)–(c); and – 30 days for the remedies specified in Article 13, paras 1(d)–(e). While the provisions of the amended New Bankruptcy Law have been successfully tested during the reorganisation procedures of Variglog (a Brazilian cargo company) and BRA (a Brazilian low-cost carrier), in 2018 there was the first precedent case regarding application by Brazilian courts of the Cape Town Convention in combination with the New Bankruptcy Law. A Brazilian airline named Oceanair Linhas Aéreas filed for judicial reorganisation on December 2018, and managed to obtain before the bankruptcy court (first instance) an initial stay period of 60 days, which was continually renewed until it was overturned on appeal by the State Court (second instance) in April 2019. The decisions taken by the first instance bankruptcy judge were viewed as a breach of the Cape Town Convention, as the declarations made by the Brazilian government provided for a maximum 30-day stay period. Furthermore, one could also argue that the stay period should be zero days based on the language of Section 199 of the New Bankruptcy Law. The State Court, when overturning the bankruptcy court’s decision, expressly stated that the Cape Town Convention and Section 199 of the New Bankruptcy Law must apply and be respected by bankruptcy courts. In view of this decision, lessors were able to safely repossess their assets. However, as the matter has not been ruled on by the STF, it does not have a binding effect for future insolvency cases, which leaves a certain degree of uncertainty as to the immediate application of the Cape Town Convention. It should be noted that a very positive development during the Oceanair case was that ANAC expressly acknowledged its obligations to comply with the deregistration of aircraft pursuant to the terms of an Irrevocable De-Registration and Export Request Authorisations (IDERA), and promptly performed such actions upon request from certain lessors. However, the customs authorities did 14 Legislative Decree No 135 of 2011. 15 Date of enactment of Decree nº 8.008/2013.

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Brazil 14.18 not recognise the rights of lessors to export aircraft based on the use of IDERAs, on the grounds that it is still necessary for the Brazilian tax authorities to issue regulations on the procedures required for proper implementation of IDERAs into the customs system.

Insurance (war risks) 14.16 Following the events of 11 September 2001, in line with action taken by other governments around the world, the Brazilian federal government issued a series of provisional measures purporting to provide additional insurance coverage to Brazilian air transportation companies in the case of war and terrorist acts. This matter is currently regulated by Law No 10,744/2003, which authorised the Brazilian government to assume up to US$1 billion in third party liabilities in the case of terrorist acts and acts of war concerning aircraft which are: (1) registered with the Brazilian civil aviation authority; and (2) operated, in Brazil or abroad, by Brazilian public transportation companies (excluding air taxi companies).

Security interest over aircraft and engines 14.17 Security interests over aircraft and engines registered in Brazil must be created and perfected in accordance with local laws formalities, that is, registration of the relevant security interest with the Brazilian Aeronautic Registry (Brazil adopts the lex situs rule for conflict of laws issues). Upon ratification of the Cape Town Convention and incorporation thereof in the Brazilian legal system, security interests created within the international registry should be recognised as duly perfected security interests under Brazilian law. Notwithstanding, as local law provides for the registration of security interests of Brazilian registered aircraft with the Brazilian Aeronautic Registry, it is recommended that the document relating to that security interest is also filed locally.

Outbound leasing and export financing of Brazilian manufactured aircraft 14.18 There is no relevant market for the leasing of aircraft by Brazilian lessors to non-Brazilian lessees. The only movements observed in this sense are those cases where Brazilian airlines sublease aircraft under dry or wet subleases with a view to fleet reduction/optimisation. On the other hand, Brazilian (Embraer) manufactured aircraft remain attractive to the market and airlines worldwide (mainly regional) continue to place orders and have such aircraft in their fleet. Many of those transactions rely upon the support of BNDES-Exim, the export credit arm of the Brazilian development bank. The structure normally contemplates disbursements in Brazilian Reals to Embraer and financing in US dollars to the airlines, aiming at ensuring an inflow of foreign funds into the country. 211

14.19  Regional Markets

RUSSIA Mikhail Loktionov and Alexey Tokovinin Introduction 14.19 This section of Chapter  14 will focus on registration formalities in Russia relating to the registration of aircraft, aircraft mortgages and aircraft leases. The enforcement of Russian law aircraft mortgages will also be examined, together with a brief discussion of the recognition and enforcement of foreign judgments in Russia in the context of enforcing foreign law and Russian law aircraft mortgages.

Registration of aircraft State register of civil aircraft 14.20 The state register of civil aircraft of the Russian Federation (RCA) is currently maintained by the Federal Aviation Agency (the ‘Agency’) of the Russian Ministry of Transport. Civil aircraft duly registered with the RCA acquires Russian nationality. Pursuant to the Air Code of the Russian Federation (the ‘Air Code’),16 ‘civil aircraft’ are aircraft that are used for general and/or economic purposes. They are distinguished from ‘state aircraft’ used for the performance of state functions. According to the Air Code,17 unmanned aircraft, except for unmanned civil aircraft with a maximum take-off weight of 30kg, and manned civil aircraft, except for ultra-light civil aircraft weighing 115kg and less, must be registered with either: (a) the RCA; or (b) a civil aircraft register of a foreign state, provided that the Russian Federation and the relevant foreign state have entered into a treaty on mutual recognition of airworthiness. Registration of aircraft with the RCA does not entail registration of legal rights to, or transactions involving, aircraft and therefore cannot be considered as evidence of legal interests in such aircraft. Legal interests in aircraft (such as ownership) and transactions involving aircraft (such as leases or mortgages) are registered with the Unified Register of Rights to Aircraft and Transactions Therewith (the ‘Register of Rights’). The Register of Rights is discussed in greater detail at para 14.24ff. State-owned aircraft, which are aircraft owned by the state and used for military, police, customs or other state purposes, are registered with a register of stateowned aircraft (RSA) following the procedure set forth in the Ministry of Defence Order No 460, dated 28 November 2002 (as amended). A discussion of the RSA is beyond the scope of this section.

Registration process 14.21 The procedure for civil aircraft registration is currently governed by Administrative Rules of the Federal Aviation Agency for the Provision of State 16 Air Code, Article 21. 17 Air Code, Articles 33(1) and 33(1.1).

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Russia 14.21 Service of State Registration of Civil Aircrafts and Maintenance of State Register of Civil Aircrafts of the Russian Federation approved by Order of the Ministry of Transport No  457 dated 5  December 2013, as amended by Orders of the Ministry of Transport No 255 dated 6 July 2017 and No 512 dated 7 December 2017 (‘the Rules’). As discussed above, registration requirements do not apply to ultra-light civil aircraft pertaining to general purpose aviation. The Rules do not apply to unmanned civil aircrafts with a maximum take-off weight of 30kg or less or unmanned free balloons. The key stages of the registration process18 are summarised below: • • • •

receipt and registration of the documents required for registration with the RCA; verifying that all the relevant data on the aircraft is complete and verifying the accuracy of the documents being filed; recording relevant entries about the aircraft in the RCA and assigning RCA identification markings to the aircraft; and issuance of an RCA registration certificate to the applicant.19

In order for aircraft to be registered with the RCA, the following documents should be submitted to the registration authority: • • •

an application prepared on the basis of the standard forms attached to the Rules and providing information on the aircraft and its owner; documents (or their notarised copies) evidencing the right of ownership to the civil aircraft; and document evidencing deregistration of the aircraft from a foreign civil aircraft register or an export certificate of airworthiness.

Although the Rules do not specifically state which particulars are actually recorded in the RCA, the application must contain information on both the aircraft and its owner. Accordingly, Clause 18 of the Rules deals with entries concerning aircraft, while Clause 19 addresses those concerning aircraft owners. Under Clause 18 of the Rules, the application for registration must contain specific information on the aircraft, including: the type (name given by the manufacturer); the serial number; date of manufacture; the name of the manufacturer; maximum take-off weight; type and number of the engines; and engine power. Under Clause 19 of the Rules, the application must include specific information on the aircraft owner, including the full name of the legal entity or full name and ID data (if the applicant is an individual) and address or address of residence (if the applicant is an individual), as well as primary state registration number and tax identification number. Information on the aircraft owner will be submitted in Russian and, if the aircraft is engaged in international flights and at the discretion of the applicant, in English.The Rules provide that amendments to the RCA may be made in certain circumstances, including a change of ownership of the aircraft, a change of the owner’s address and a change of the aircraft’s name as a result of its re-equipment.

18 Clause 36 of the Rules. 19 If the registration is denied, the applicant should be notified of it within ten days after the relevant decision has been taken.

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14.22  Regional Markets

Effect of RCA registration 14.22 As discussed, the Air Code20 stipulates that aircraft duly registered with the relevant Russian register (for example, the RCA for civil aircraft) acquires Russian nationality. This principle conforms with Article 1721 of the Chicago Convention,22 to which Russia is a party. This entails a multitude of consequences which, although not addressed by the Air Code itself, can be derived from various enactments of the Russian law encompassing both private and public law. In particular, Russian nationality causes the aircraft to be deemed immovable property located in Russia, which therefore requires the registration of legal interests in such aircraft with the Register of Rights. Furthermore, Russian conflict of laws rules provide that legal interests in aircraft that are subject to registration and the exercise and protection of these interests are governed by the law of the jurisdiction where such aircraft has been registered.23 Moreover, the place of registration affects the choice of forum. A Russian state commercial (arbitrazh) court of a place where the relevant aircraft has been registered has exclusive jurisdiction over claims with respect to the rights to such aircraft.24 As a practical matter, an aircraft which has Russian nationality is subject to certain Russian law requirements (for example, certification) and procedures. Finally, as a procedural matter, in order to be exported from Russia the aircraft would need to be deregistered from the RCA.

Deregistration from the RCA 14.23 The Air Code provides that aircraft may be deregistered in the following circumstances:25 • retirement or withdrawal from service; • sale or other legal transfer of title to the aircraft to a foreign individual, legal entity or state, provided that the aircraft in question will be exported from Russia; and • breach of RCA requirements. The Rules also require an aircraft to be deregistered where the aircraft is to be registered with a foreign aircraft register or with a different Russian registry (for example, with the RSA if the aircraft is being reassigned to state aviation). Depending on the purpose of deregistration, different sets of documents are required to be submitted to the registration authority. For example, if deregistration is carried out in order to transfer proprietary interests in the

20 Air Code, Article 33(4). 21 Article  17 provides that aircraft shall have the nationality of the state in which they are registered. 22 Convention on International Civil Aviation, signed at Chicago on 7 December 1944. 23 Civil Code of the Russian Federation, Article 1207. 24 Arbitrazh Procedure Code of the Russian Federation, Article 38(2). 25 Air Code, Article 33(5).

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Russia 14.25 aircraft to a foreign individual, legal entity or state, the following documents are required: • an application prepared on the basis of the standard forms attached to the Rules and containing information on the aircraft and its owner; • certificate of registration or a duplicate of such (if the original certificate has been lost); • documents (or their notarised copies) evidencing transfer of the interests in the aircraft to the relevant foreign entity; and • irrevocable power of attorney prepared on the basis of the form provided by Protocol to the Convention on International Interests in Mobile Equipment on Matters Specific to Aircraft Equipment and registered with the Agency (if needed). Under the Air Code,26 upon deregistration the certificate of state registration becomes invalid and has to be returned to the Agency.

Aircraft mortgages Registration of mortgages 14.24 Pursuant to Federal Law On State Registration of Rights to Civil Aircraft and Transactions Therewith No 31-FZ dated 14 March 2009 (the ‘Registration Act’), the existence, creation, transfer, termination or limitation (encumbrance) of legal interests in civil aircraft which are subject to registration in accordance with the Air Code, as well as state-owned aircraft used for commercial purposes, must be registered with the Register of Rights. In particular, rights of ownership to aircraft, mortgages and other encumbrances are subject to registration with the Register of Rights. The Register of Rights is maintained by the Agency. The procedure for registration with the Register of Rights is currently set out in the Registration Act and the Rules on Maintaining the Unified Register of Rights to Aircraft and Transactions Therewith approved by the Decree of the Government of the Russian Federation No 958 dated 28 November 2009, as well as in the Administrative Rules of the Federal Aviation Agency for the Provision of State Service of State Registration of Rights to Civil Aircrafts and Transactions Therewith approved by Order of the Ministry of Transport No 170 dated 6 May 2013. The Air Code requires that information about aircraft mortgages should also be registered with the RCA.27 However, such registration would not evidence the legal interest in the aircraft.

Registration process 14.25 In order for the mortgage to be registered with the Register of Rights, certain documents should be submitted to the Agency, including the following: • an application for registration of the mortgage with the Register of Rights prepared on the basis of the standard form; • an original of the mortgage agreement;

26 Air Code, Article 33(6). 27 Air Code, Article 33(10).

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14.26  Regional Markets • •

a loan agreement or other agreement under which the relevant secured obligations have arisen, as well as all documents specified as appended to the mortgage agreement; and an independent evaluation of the mortgaged asset – if a mortgaged asset (in whole or in part) is owned by the Russian Federation, a constituent member of the Russian Federation or any Russian municipality.

Amendments may be made to the entries on the Register of Rights Registration of amendments to the mortgage agreement and registration of a change of mortgagee resulting from an assignment of the rights under the mortgage agreement should be carried out as a separate registration procedure.

Effect of registration 14.26 Registration of the mortgage with the Register of Rights is the only evidence of the rights of the mortgagee in respect of the aircraft. In addition, Federal Law On Mortgage dated 16  July 1998 (as amended) (the ‘Mortgage Act’), which applies to mortgages generally, establishes a general rule that priority of mortgages is established according to the date of registration.28 Consequently, registration with the Register of Rights should secure priority for the mortgagee over claims by other creditors over the aircraft.

Deregistration from the Register of Rights 14.27 The Registration Act does not expressly provide for a deregistration procedure. However, according to the Agency’s website (www.favt.ru), deregistration of the mortgage is effected within three days after a joint application by the mortgagee and the mortgagor or a judgment of a Russian court on the termination of the mortgage is submitted to the registration authority.

Russian law aircraft mortgages 14.28 Russian conflict of laws rules provide that the law governing proprietary interests in aircraft is the law of the jurisdiction where the aircraft is registered.29 Russian law will, therefore, apply to a mortgage over an aircraft registered with the RCA. Russian law does not distinguish aircraft mortgages from mortgages over other assets. Under Russian mortgage law, any mortgage agreement must contain certain provisions, including the following: • a description of the mortgaged asset, its location and other information sufficiently detailed to identify it; • evidence of the mortgagor’s title to the mortgaged asset and registration of such title by the registration authority; • the value of the mortgaged asset; • a description of the underlying obligation secured by the mortgage, including the amount, term and legal grounds which have given rise to such obligations. In particular, if the secured obligation has arisen out of an agreement, the mortgage agreement should specify the parties to such underlying agreement, as well as its date and place of execution. It is advisable that other material

28 Mortgage Act, Article 11. 29 Civil Code, Article 1207.

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Russia 14.30

•

terms of the underlying agreement should also be specified in the mortgage agreement, for example, the interest rate and repayment schedule in the case of a loan agreement. If the amount of an underlying obligation can only be determined in the future, the mortgage agreement should provide for a procedure to be followed in order to determine such amount; and if the rights of the mortgagee are evidenced by a mortgage deed (zakladnaya), it should be mentioned in the mortgage agreement.

Under the Arbitrazh Procedure Code,30 Russian courts will have exclusive jurisdiction over any dispute that arises out of transactions in connection with an aircraft registered with the RCA. A Russian court will also have jurisdiction over an action brought by the mortgagee against the mortgagor in respect of a mortgage of an aircraft registered abroad provided that the parties have entered into a written agreement to that effect, and provided that such an agreement does not interfere with the exclusive jurisdiction of any foreign court.31 It must be noted that spare parts cannot be mortgaged under Russian law. Although Russian law provides no specific rules for the pledge of spare parts for aircraft, generally, spare parts (including future parts) may be pledged, provided that such parts are capable of being separated from the aircraft and can be properly identified in the pledge agreement.

Foreign law aircraft mortgages 14.29 Where a party to the mortgage agreement is a foreign person and the aircraft is not registered with the RCA, then the parties to the mortgage agreement are free to choose a foreign law as the governing law of the mortgage agreement. However, Russian law provides for a number of restrictions regarding the application of foreign law by a Russian court, including the following: • notwithstanding the choice of foreign law as a governing law of a contract, certain rules of Russian law which are deemed mandatory (for example, Russian law provisions regarding settling claims during a Russian party’s bankruptcy) may still apply to the agreement; • certain provisions of a foreign law contract may be unenforceable to the extent that the consequences of such provisions being applied to the relevant contract would be contrary to Russian public policy; • if, in giving effect to a foreign law governing a contract, a Russian court is unable to determine the meaning of the foreign law, it may apply Russian law notwithstanding the choice of foreign law as the governing law of the contract; and • enforcement of a foreign law contract by a Russian court is, in any case, subject to the nature of the remedies available in Russian courts and any other procedural issues which may be applicable in a particular case.

Enforcement of Russian law mortgage 14.30 Under Russian law, a mortgage may be enforced without judicial intervention only if the mortgagor and mortgagee have consented in writing to out-of-court enforcement (in the case of the mortgagor, such consent must be notarised). 30 Arbitrazh Procedure Code of the Russian Federation, Article 38(2). 31 Arbitrazh Procedure Code of the Russian Federation, Article 249.

217

14.30  Regional Markets An agreement to enforce a mortgage using the out-of-court procedure may provide for: (a) a sale of the aircraft through an open auction; or (b) a mortgagee acquiring the aircraft for itself or for a sale to a third party, at an agreed price, in which case the mortgagee must set off the outstanding amount secured by the mortgage against the acquisition price of the aircraft. Moreover, even if the agreement provides that the aircraft should be sold at an open auction, the mortgagee may take possession of the aircraft instead of the proceeds from the sale of the aircraft if the auction is announced to have been frustrated.32 The auction is announced to have been frustrated if: (1) there were fewer than two bidders at the auction; (2) during the auction, the price of the aircraft did not increase in comparison with the opening price; or (3) the winning bidder failed to pay the price within the required period of time.33 To enforce a mortgage in court proceedings, the mortgagee should file an application to a relevant Russian arbitration court of first instance. It should be noted, however, that a court may refuse to enforce a mortgage if it finds that the breach of the terms of the underlying mortgage agreement is extremely immaterial and the amount of debt in default is apparently disproportionate to the value of the aircraft. Unless proved otherwise, those conditions are assumed to be met, if: (1) the unpaid amount is less than 5% of the value of the aircraft (as specified in the mortgage agreement); and (2) performance of the secured obligation is overdue by less than three months. In order to secure the enforcement of a mortgage, the aircraft may be attached by the court at the request of the claimant (that is, the mortgagee). At the same time, while ordering such security, the court may request the mortgagee to post a guarantee or other security which, if requested, must not be less than one half of the value of the claim,34 so as to ensure compensation for the defendant of the losses that may arise as a result of the attachment, should the mortgagee’s case not prove successful. If the court decides in favour of the mortgagee, it will order that the aircraft is offered for sale through a public auction or, if the court is so requested by the mortgagor and the mortgagee, through a simplified open auction. The proceeds received from the sale of the aircraft will be applied towards the costs and expenses incurred in connection with the enforcement of the mortgage, and then towards discharge of the mortgagor’s outstanding obligations. A  public auction must be arranged by a specialised organisation engaged by court bailiffs at the location of the aircraft (ie where the aircraft is registered). The auction must be announced in the press and on the internet no earlier than 30 days and no later than ten days prior to the stated date of the auction. An open auction is conducted by an auctioneer who acts on the basis of an agreement with the mortgagee.

32 Mortgage Act, Article 58(2). 33 Mortgage Act, Article 58(1). 34 Arbitrazh Procedure Code of the Russian Federation, Article 94.

218

Russia 14.32

Priority of claims 14.31 Russian Federal Law On Insolvency (Bankruptcy) No  127-FZ dated 26 October 2002 (as amended) (the ‘Bankruptcy Act’) provides for a specific procedure for the discharge of the mortgagor’s liabilities:35 • only 70% (80% in the case of claims under a loan agreement) of the sale proceeds of the mortgaged asset will be ring-fenced and applied towards the discharge of the relevant secured obligations; • 20% (15% in the case of claims under a loan agreement) of the sale proceeds of the mortgaged asset will be applied to discharge the claims of the first priority and second priority creditors, in the case that other assets in the bankruptcy estate are insufficient; and • the balance will be applied towards insolvency expenses and other judicial costs. Any balance remaining after the satisfaction of first priority and second priority creditors in accordance with the procedure set out above will be applied towards the satisfaction of the mortgagee’s claims if the mortgagee remains not satisfied in full. To the extent that the mortgagee’s claims remain undischarged, such claims will rank pari passu with the claims of unsecured creditors. First priority and second priority claims include personal injury claims, claims for payments of severance pay and salaries to the mortgagor’s employees and claims for royalties.

Leasing of aircraft Types of aircraft lease 14.32 Under Russian law, there are two forms of aircraft lease: an operating lease; and a finance lease. Under an operating lease, the lessor transfers the aircraft into the lessee’s possession in return for rental payments. At the end of an operating lease, the aircraft is returned to the lessor, without the lessee having any entitlement to acquire title to the aircraft. A finance lease, on the other hand, usually involves three parties: the seller; the lessor; and the lessee. The lessor undertakes to purchase an aircraft from the seller and lease this aircraft to the lessee. When purchasing the aircraft from the seller, the lessor has to notify the seller that the aircraft will be leased to the lessee, and, accordingly, the lessee may claim directly against the seller for any defects in the aircraft delivered, as well as make other claims which the lessor can make against the seller in connection with the sale (although the lessee may not terminate the sale made between the seller and the lessor without the lessor’s consent). Generally, the lessor is not responsible to the lessee for a breach of the sale contract by the seller, unless it was the lessor itself who selected the seller. Usually, the lessor retains title to the aircraft during the entire term of the lease agreement. However, the parties may agree that title to the aircraft passes to the lessee upon expiration of the lease term (or even before) if the lessee pays the purchase price in full.

35 Article 138 of the Bankruptcy Act.

219

14.33  Regional Markets Where the lessor is a foreign entity, the aircraft lease is governed by a foreign law, and the aircraft is not registered with the RCA, Russian law would also recognise other forms of lease agreements, subject to certain exceptions.

Russian law leases 14.33 As discussed in the context of aircraft mortgages (at para  14.28), Russian law will apply to the leasing of an aircraft registered with the RCA, and Russian courts will have exclusive jurisdiction over any dispute that may arise in connection with the leasing of Russian aircraft. Other than a requirement for the lease to be in writing, Russian law does not stipulate any other requirements with respect to the terms of an aircraft lease compared with other types of lease agreements governed by Russian law. An aircraft lease agreement governed by Russian law would normally include provisions specifying the subject matter of the lease, the term of the lease, provisions about rental payments, events of default and other provisions which the parties may agree to include in a particular lease agreement. Under Russian law, spare parts may be subject to a lease. Russian law establishes no special formalities for the leasing of spare parts, other than the general requirements applicable to all lease agreements.

Registration of leases 14.34 Russian law provides that interests in aircraft, including all encumbrances over aircraft and all transactions involving aircraft, require state registration with the Register of Rights. Accordingly, a lease of an aircraft, being an encumbrance over an aircraft, is also subject to registration with the Register of Rights. Just as with the registration of aircraft mortgages, information on aircraft leases may also be added when registering the aircraft with the RCA. However, such registration is not required to perfect the lease, nor would it be deemed to be evidence of the lessee’s interest in the aircraft. Documents required for the registration of a lease with the Register of Rights will include an application of the parties to the leasing transaction prepared on the basis of the standard form, an original of the lease agreement and written consent of all the owners of the aircraft (if applicable).

Effect of registration 14.35 As discussed in the context of aircraft mortgages (at para  14.26), registration with the Register of Rights is the only evidence of the existence of a legal interest in the aircraft. Therefore, if a lease is registered with the Register of Rights, the lease may only be contested in formal court proceedings.

Deregistration from Register of Rights 14.36 The Registration Act does not expressly provide a deregistration procedure for leases. However, according to the Agency, depending on the terms of the relevant lease agreement, deregistration may be effected upon a joint application by the lessor or the lessee or otherwise in accordance with the provisions of the relevant lease agreement. 220

Russia 14.38

Repossession of aircraft 14.37 In theory, repossession of an aircraft by the lessor upon an event of default under the lease should be possible as Russian law generally requires the lessee to return the aircraft to the lessor upon the termination of the lease, and permits self-help remedies. In practice, however, repossessing the aircraft without judicial intervention may prove difficult, as this will require the cooperation of airport services and other third parties, who may be unwilling to cooperate without a court order. Generally, a Russian court will have jurisdiction over an action brought by the lessor to repossess the aircraft in the following circumstances: • the leased aircraft is registered with the RCA and is therefore treated as Russian immovable property; or • if the aircraft is not registered with the RCA: – the parties have agreed to submit their claim/dispute to the jurisdiction of the Russian courts; – an action is brought against a party located in Russia and subject to the jurisdiction of the Russian courts (for example, if the airport unlawfully seizes the aircraft because the lessee does not pay relevant airport/service/fuel payments); – an action is brought against a party which, although is not located in Russia, owns property located in Russia; and – the lease agreement states that it is subject to execution in Russia. Russian law does not allow any fast-track or summary judicial procedure for repossession. To commence court proceedings, the lessor must file a claim with a relevant Russian commercial (arbitrazhny) court of first instance. Once the court has registered the relevant application and supporting documents submitted by the claimant, the judge will assess the documents and, if the application with all supporting documents has been filed in accordance with the procedure prescribed by the Arbitrazh Procedure Code, will initiate proceedings. Once proceedings have been initiated, the lessor becomes entitled to secure his claim while the lessee, if it chooses to do so, may serve their statement of defence (or counterclaim). For the purposes of securing the lessor’s claim, the aircraft may be attached by the court at the request of the lessor. At the same time, while ordering such attachment, the court may request the lessor to post a guarantee or other security which, if requested, must not be less than one half of the value of the claim,36 so as to ensure compensation for the lessee of the losses that may arise as a result of the attachment, should the lessor’s case not prove successful.

Recognition of foreign judgments 14.38 Judgments rendered by foreign courts may only be enforced in Russia if this is provided for in a treaty entered into between Russia and the country

36 Arbitrazh Procedure Code of the Russian Federation, Article 94.

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14.38  Regional Markets where the relevant foreign judgment was rendered. Foreign decrees and other non-judicial acts of foreign governments cannot be enforced in Russia. As of 1  January 2021, Russia has signed and ratified bilateral international treaties on mutual legal assistance with a number of countries.37 Russia is also a party to the Convention on Legal Assistance and Legal Relations in Matters of Civil, Family and Criminal Law (the ‘Minsk Convention’) which also provides for mutual recognition and enforcement of foreign judgments. Apart from Russia, the parties to the Minsk Convention are: Armenia; Belarus; Kazakhstan; Kyrgyzstan; Moldova; Tajikistan; Turkmenistan; Ukraine; and Uzbekistan. There are no bilateral treaties on the mutual recognition and enforcement of foreign judgments between Russia and the UK, Russia and the USA or Russia and the European Union. On several occasions,38 Russian courts have recognised and enforced foreign courts decisions even in the absence of international treaty or express provisions on enforcement in the existing treaty. For example, Russian courts have enforced English court judgments on the basis of a combination of the principle of reciprocity and the existence of a number of bilateral and multilateral treaties to which both the United Kingdom and the Russia are parties. The Russian courts determined that these treaties constituted grounds for the recognition and enforcement of the relevant English court judgment in the Russian Federation. However, in the absence of established court practice, it is difficult to predict whether a Russian court will be inclined in any particular instance to recognise and enforce an English court judgment on these or other grounds. Foreign arbitral awards are recognised and enforced in Russia in accordance with the New York Convention,39 provided that the country where the arbitration took place is also a party to the New York Convention. Should the foreign judgment or arbitral award be recognised, its enforcement is carried out without an examination of the merits of the case. Article 242 of the Arbitrazh Procedure Code provides that an application for the recognition and enforcement of a foreign judgment or arbitral award shall be filed with a Russian commercial (arbitrazhny) court at the debtor’s place of stay or residence or, if that is unknown, at the location of the debtor’s property by a party in favour of which a judgment or an award was rendered. A judge should render its order within one month after the filing of the relevant application. A Russian court will refuse to recognise and enforce a foreign judgment where, for example, (a) the party against which the foreign judgment was rendered has not been timely and properly notified about the time and place of the trial, or was unable to stand before the court due to any other reasons; (b) there exists a judgment in force issued by a Russian court in respect of a dispute between the same parties on the same subject matter and on the same grounds; (c) the 37 These countries are: Albania; Algeria; Argentina; Azerbaijan; Belarus; Bulgaria; China; Cuba; Cyprus; Czech Republic; Egypt; Estonia; Greece; Hungary; India; Iran; Iraq; Italy; Kyrgyzstan; North Korea; Latvia; Lithuania; Macedonia; Moldova; Mongolia; Poland; Romania; Serbia; Slovakia; Slovenia; Spain; Tunis; Vietnam; and Yemen. 38 Federal Arbitrazhny Court of Moscow District – a ruling dated 2 March 2006 on the case number KG-A40/698-06. Higher Arbitrazhny Court of the Russian Federation – a ruling dated 26 July 2012 No BAC-6580/12; Arbitrazhny Court of Moscow District – a ruling dated 28 September 2015 No ϕ05-13737/2014; Arbitrazhny Court of North-Western District dated 6 May 2019 No ϕ07-3152/2017. 39 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards, 1958.

222

Russia 14.38 enforcement of such judgment would contradict Russian public policy; or (d) the subject matter of the relevant dispute is within the exclusive jurisdiction of the Russian courts. Provided that the relevant request has been submitted by the party against which the foreign arbitral award was rendered, a foreign arbitral award may not be recognised and enforced in Russia if, for example, (a) one of the parties to the relevant arbitration agreement had no capacity to enter into such arbitration agreement or such arbitration agreement is not valid for any other reason; (b) the foreign arbitral award was rendered in respect of a subject matter not covered by the relevant arbitration agreement; (c) the subject matter of the dispute was not arbitrable; or (d) the foreign arbitral award otherwise has no legal effect for the parties. Also, a foreign arbitral award may not be recognised and enforced in Russia if a Russian court finds that, under Russian law, the relevant dispute may not be resolved in arbitration proceedings or the enforcement of such foreign arbitral award would contradict Russian public policy. In addition, under recent amendments to Russian law, arbitration clauses or choice of court clauses that involve Russian parties targeted by foreign sanctions may be regarded as unenforceable by the Russian courts. The Russian courts also have exclusive jurisdiction over disputes involving Russian persons targeted by sanctions or arising from anti-Russian sanctions. Existing and new arbitration agreements and choice of court agreements involving Targeted Persons remain enforceable unless a Russian court finds that they are ‘incapable of being performed’, ie that arbitration or litigation outside Russia is no longer possible due to sanctions.

223

14.39  Regional Markets

INDIA Marylou Bilawala, Gautam Nayak Introduction 14.39 On 28  May 1953, the Government of India nationalised the airline industry with the enactment of the Air Corporations Act 1953. Under the provisions of this Act, two air corporations, Indian Airlines Corporation and Air India International, were established and the assets of all the air companies existing at that time were transferred to the two new corporations. The operation of scheduled air transport services came under the control of these two corporations and the Air Corporations Act 1953 prohibited any other persons or their associates from operating any scheduled air transport services from, to or across India. In 1990, the government introduced the ‘open-sky policy’ which allowed air taxi-operators to operate flights from any airport, both on a charter and a noncharter basis, and to decide their own schedules, cargo and passenger fares. On 1 March 1994, the Air Corporation Act 1953 was repealed thereby ending the monopoly of the two air corporations on scheduled air transport services and private operators were permitted to provide domestic air transfer services. In 2004, the government liberalised the air transport policy further and Indian operators were permitted to operate international scheduled air transport services, subject to certain conditions (for example, the airline had to have a minimum of five years’ domestic flying experience and 20 aircraft in its fleet) before it qualified to fly overseas (5/20 Requirement). In 2016, the National Aviation Policy did away with this 5/20 Requirement as it was felt that this stipulation, which was unique to India, needed to be replaced by a scheme which provided a level playing field and allowed airlines, both new and old, to commence international operations, provided that they continued to meet some obligation for domestic operation. Accordingly, the 5/20 Requirement was modified and all airlines could commence international operations provided that they deployed 20 aircraft or 20% of total capacity (in term of average number of seats on all departures put together), whichever was higher, for domestic operations.

Acquisition of aircraft 14.40 The decision of whether to acquire an aircraft on lease or on an ownership basis largely depends on the airline’s requirements, the cost of the aircraft, the availability of capital and taxation issues. Leasing remains the most popular method of aircraft acquisition in India by airlines. Whilst most leases are operating leases, finance leases are also becoming popular. However, finance leases require the prior approval of the Reserve Bank of India (RBI) and there are restrictions on the all-in cost of the borrowing (which is discussed in greater detail at para 14.44) 224

India 14.41

The regulatory regime applicable to the airline industry Registration of aircraft in India 14.41 The Aircraft Act 1934, the Aircraft Rules 1937 and the Civil Aviation Requirements and Circulars issued by the Directorate General of Civil Aviation (DGCA) regulate the manufacture, possession, use, operation, sale, import and export of aircraft and air transport operations in India. The DGCA is the regulatory authority in charge of the safety of civil aircraft in India and the maintenance of the civil aircraft register. A licence is required from the Director General of Foreign Trade (DGFT) for the import of aircraft (for private use and central/state government/public sector undertakings) into India. However, certain categories of operators, such as scheduled and non-scheduled airlines, are permitted to import aircraft into India without the approval of the DGFT, provided that they have obtained a ‘no-objection’ certificate from the DGCA for the import of aircraft. In the case of pressurised aircraft for scheduled, non-scheduled and general aviation operations, the DGCA prohibits the import of an aircraft which is more than 18 years old or has completed 65% of designed economic life in terms of pressurisation cycle and, in the case of unpressurised aircraft, any aircraft which is more than 20 years old. The Civil Aviation Requirement dated 10  September 1998 (as amended from time to time) (the ‘1998 CAR’) sets out the procedures relating to the registration and deregistration of aircraft. Under the provisions of the 1998 CAR, the owner or his authorised representative may apply for the registration of an aircraft. Foreign-owned aircraft cannot be registered in India unless the aircraft is leased to an Indian operator. The registration remains valid for the term of the lease. In the case of foreign-owned aircraft, the certificate of registration of the aircraft will be endorsed in the name of the owner, the lessor and the Indian operator of the aircraft. It may be noted that the 1998 CAR provides that registration by the DGCA is for the purposes of controlling the safety of aviation in India and that registration does not establish the legal ownership of an aircraft in any way. Disputes with regard to the ownership and liabilities of the owners, if any, will have to be decided in an Indian court. The DGCA has the discretion to cancel the registration of the aircraft at any time inter alia if it is satisfied that the lease in respect of the aircraft has expired or has been terminated in accordance with the terms of the lease. However, as per the amended Aircraft Rules 1937, where the provisions of the Cape Town Convention and Cape Town Protocol apply to an aircraft registered in India, the DGCA is mandatorily required to cancel registration of an aircraft, within five working days, without seeking consent or any document from the operator of the aircraft or any other person, if an application for deregistration is received from the IDERA Holder40 (which is dealt with in more detail at para 14.54), in the prescribed form.

40 Rule 3 (28B) defines ‘IDERA Holder’ as the authorised party under an IDERA (defined as the irrevocable deregistration and export request authorisation to be used for getting an aircraft deregistered and exported under the provisions of the Cape Town Protocol) or its certified designee.

225

14.42  Regional Markets

Recognition of mortgagee’s rights 14.42 As a result of an amendment to the 1998 CAR in May 2006, the DGCA now permits the endorsement of the mortgage or hypothecation created over an aircraft registered in India on the Certificate of Registration of the aircraft. Details of the mortgage or hypothecation are required to be disclosed in the application for registration of an aircraft. The consent of the owner or operator to such mortgage or hypothecation is also required and certain documents to this effect should be provided to the DGCA. The record of the mortgage or hypothecation can be removed from the Certificate of Registration on an application made by the owner of the aircraft along with documents supporting the owner’s application, along with the consent of the mortgagee to remove the endorsement of the fact of the mortgage from the Certificate of Registration.

Operation, maintenance and management of airports 14.43 The Airports Authority of India Act 1994 and the rules and regulations issued under the provisions of this Act regulate the establishment, operation, maintenance and management of airports in India. Prior to April 1995, two separate authorities, the International Airport Authority of India and the National Airport Authority of India, regulated national and international airports. However, on 1 April 1995, the International Airport Authority of India and the National Airport Authority of India were amalgamated to create the Airports Authority of India. The Airports Authority of India handles all matters relating to the infrastructure for civil air traffic and transport at the international and domestic airports and the civil enclaves in India. Recently, the Airports Authority of India has entered into several concession agreements with private entities. As a result, several airports have now been privatised and private entities are in charge of managing these airports. Landing, parking, x-ray and ground handling charges are now payable to the Airports Authority of India or the concessionaires who have been granted the right by the Airports Authority of India to develop, operate and maintain the applicable airport in India. The Airports Authority of India or the entity to which the power to maintain the airport has been delegated also has the right to detain aircraft for the non-payment of such charges. The Competent Authority41 under the Airports Authority of India (Management of Airports) Regulations 2003 has the right to detain and stop the departure of an aircraft for non-payment of the requisite fee or charges, until the fees or charges are paid to the Authority, which may include the current and accumulated dues. However, if the aircraft is being exported pursuant to the exercise of rights by the IDERA  Holder, the current and accumulated dues to be recovered from the IDERA Holder shall include only such dues that accrued in respect of that aircraft and in relation to flights operated by that aircraft during the period comprised of three months immediately preceding the date of declared default42 and for the period subsequent to the date of declared default up to the date of 41 ‘Competent Authority’ means in relation to exercise of any power, the authority, the chairperson, and any member authorised by the chairperson, airport director or controller of aerodrome or in charge of any airport or civil enclave or any other officer specified by the chairperson in that behalf. 42 For the purposes of Airports Authority of India (Management of Airports) Amendment Regulations 2018, the ‘date of declared default’ means the date on which the application for deregistration of the aircraft has been submitted to the Director General of Civil Aviation under the Aircraft Rules 1937.

226

India 14.44 departure of the aircraft from India. The Competent Authority however has the right to recover the balance dues, if any from the airline concerned.

Foreign exchange requirements 14.44 Any payment or receipt of foreign exchange to or from India is regulated by the Foreign Exchange Management Act 1999 and the regulations issued under the provisions of this Act. In the case of an outright purchase of an aircraft, the Indian purchaser/importer of the aircraft can make payments to the foreign manufacturer/supplier/seller of the aircraft, subject to and in accordance with the Master Direction on Import of Goods and Services issued by the RBI. There are some restrictions on the amount of advance remittances that can be made towards the purchase of the aircraft and an advance remittance in excess of US$50 million would require a counter guarantee from the bank of the seller/supplier or an unconditional irrevocable standby letter of credit. In the event that the Indian owner wishes to obtain financing from lenders outside India, the borrowing would be subject to the Foreign Exchange Management (Borrowing or Lending in Foreign Exchange) Regulations 2000 (the ‘Borrowing Regulations’) and may also require prior approval by the RBI. The conditions relating to external commercial borrowings set out in the Borrowing Regulations are as follows: (a) the borrower has to satisfy the eligibility criteria set out in the Borrowing Regulations; (b) the amount of borrowing has to be within the amounts set out in the Borrowing Regulations; (c) the lender has to satisfy the eligibility criteria set out in the Borrowing Regulations; and (d) the maturity period and the all-in cost have to fall within the specified limits. In certain circumstances (depending on the amount of the borrowing, the term of the loan, the total all-in cost of the borrowing, the borrower, the lender and the proposed end-user of the borrowing), borrowing from a lender outside India can be made under the ‘automatic route’; that is, without the prior approval of the RBI. In order to ensure that the borrowing can be made under the ‘automatic route’, conditions in respect of the amount of the borrowing, the term of the loan and the all-in cost of the borrowing also have to be satisfied (see Exhibits 14.1 and 14.2 for these conditions) (in addition to the external commercial borrowing conditions referred to above). EXHIBIT 14.1 CONDITIONS IN RELATION TO EXTERNAL COMMERCIAL BORROWINGS UNDER THE ‘AUTOMATIC’ ROUTE43 Amount of borrowing

Average maturity period

Up to US$20 million or its equivalent in a financial year

Three years

Above US$20 million or its equivalent and up to US$500 or its equivalent

Five years

Source: Schedule II of Foreign Exchange Management (Borrowing or Lending in Foreign Exchange) Regulations 2000

43 Note that these conditions are in addition to the external commercial borrowing conditions referred to elsewhere in this section of Chapter 14.

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14.45  Regional Markets EXHIBIT 14.2 CURRENT ALL-IN COST CEILINGS FOR EXTERNAL COMMERCIAL BORROWINGS/FINANCE LEASES All-in-cost ceiling per annum

Benchmark rate plus 450 bps spread [Benchmark rate means 450 basis points per annum over six month LIBOR or applicable benchmark for the respective currency.]

Source: Master Direction on External Commercial Borrowings, Trade Credits and Structured Obligations dated 26 March 2019

In the case of an aircraft taken on lease from a foreign lessor, the RBI permits authorised dealers in foreign exchange (most banks in India are authorised dealers in foreign exchange) to allow the remittance of payment of lease rentals or the ‘opening’ of letters of credit as a form of security deposit towards the payment of rent etc, in respect of aircraft imported into India on an operating lease basis. In order to satisfy itself of the authenticity of the transaction, the authorised dealer has to verify that the necessary approvals from the appropriate authorities (for example, the Ministry of Civil Aviation, the DGCA or the Government of India) have been obtained. There are certain restrictions on the amount of the security deposit in cash which can be provided by the Indian lessee to the foreign lessor. However the security deposit can be provided in the form of a letter of credit, for which there is no prescribed limit. In the case of a finance lease, however (which, for the purposes of foreign exchange regulations, is a lease transaction with an option to purchase the aircraft at the end of the lease term and which is therefore treated as a loan), prior approval of the RBI is necessary for the transaction. The RBI will approve a finance lease, provided that that transaction is in accordance with the general policy of the RBI relating to external commercial borrowings set out in the Borrowing Regulations and discussed earlier. Accordingly: (a) the lessee has to satisfy the eligibility criteria set out in the Borrowing Regulations; (b) the amount of borrowing (lease finance) has to be within the amounts set out in the Borrowing Regulations; (c) the lender/lessor has to satisfy the eligibility criteria set out in the Borrowing Regulations; and (d) the maturity period and the all-in cost have to fall within the specified limits. The Master Direction on External Commercial Borrowings, Trade Credits and Structured Obligations dated 26 March 2019 issued by the RBI provides that the all-in cost includes the rate of interest, other fees and expenses charges, guarantee fees, ECA charges, whether paid in foreign currency or Indian Rupee except the commitment fee and withholding tax in Indian rupees. Exhibit 14.2 shows the current all-in cost ceilings for external commercial borrowings/ finance leases.

Air transport operators and foreign direct investment in air transport operators in India 14.45 The Indian aviation industry contemplates the following three categories of air transport services: (a) scheduled air transport services, which refers to any flight between two destinations which is open to the public and is operated according to a fixed, published schedule; (b) non-scheduled air transport services (for example, a charter service); and (c) cargo services, which may be scheduled or non-scheduled. 228

India 14.46 For the purposes of operating air transport services in India, the operator has to obtain an air transport operator’s licence from the DGCA. Foreign direct investment (FDI) into India is regulated by the Department of Industrial Policy and Promotion, the Foreign Exchange Regulation Act 1999 and the regulations issued under the provisions of this Act. Foreign airlines are allowed to participate in the equity of companies operating cargo airlines (up to 49% under the automatic route and 100% with the approval of the government) and (up to 100%) in helicopter and seaplane services. Foreign airlines are also permitted to invest in the capital of Indian companies, operating scheduled and non-scheduled air transport services, up to the limit of 49% of their paid-up capital. Such investment would be subject to the following conditions: (1) it would be made under the government approval route; (2) the 49% limit includes FDI and foreign portfolio investment; (3) the investments so made would need to comply with the relevant regulations of Securities Exchange Board of India, such as the Issue of Capital and Disclosure Requirements (ICDR) Regulations/Substantial Acquisition of Shares and Takeovers (SAST) Regulations, as well as other applicable rules and regulations; (4) all foreign nationals likely to be associated with Indian scheduled and non-scheduled air transport services, as a result of such investment, must be cleared from a security view point before deployment; and (5) all technical equipment that might be imported into India as a result of such investment shall require clearance from the relevant authority in the Ministry of Civil Aviation. The sectoral caps for FDI in Indian domestic airlines at present are shown in Exhibit 14.3. EXHIBIT 14.3 SECTORAL CAPS FOR FDI Scheduled air transport service/ domestic scheduled passenger airline

FDI up to 49% and investment by non-resident Indians up to 100% is permitted under the automatic route

Non-scheduled air transport service

FDI up to 100% is permitted under the automatic route

Source: Consolidated FDI Policy issued by the Department for Promotion of Industry and Internal Trade Ministry of Commerce and Industry Government of India

In addition, to operate scheduled air transport services (including Domestic Scheduled Passenger Airline or Regional Air Transport Service), the company or body corporate should be registered and have its principal place of business within India; at least two thirds of the board of directors of an Indian airline company and its chairman must be Indian citizens and substantial ownership and effective control should be vested in Indian citizens.

Import taxes 14.46 At present, scheduled and non-scheduled airlines are exempt from paying inter-state goods and services tax (GST) at the time of the import of 229

14.47  Regional Markets aircraft for use in their operations subject to execution of a bond, in such form and for such sum as may be specified by the Commissioner of Customs and binds itself to pay integrated tax (IGST) leviable on the lease rentals. Scheduled airlines are also exempt from payment of Basic Customs duty (BCD) at the time of import whereas non-scheduled airlines are liable to pay BCD at 2.5% on the value and 10% social welfare surcharge and cess on the value plus BCD.

Lease rentals Income tax 14.47 As a general rule, under Indian tax law, payments for use of an aircraft are regarded as a royalty, and are taxable at a flat rate of 10% (plus applicable surcharge and cess, resulting in an effective rate of 10.92%) of the gross amount of royalty. The withholding tax is also at the same rate. India has signed Double Taxation Avoidance Agreements (tax treaties) with over 90 countries. Under Indian tax law, provisions of tax treaties override Indian tax law to the extent that they are more favourable. Therefore, in most cases, the withholding rate as well as the final tax rate would depend upon the relevant tax treaty provisions. India has a General Anti-Avoidance Rule (GAAR), which overrides tax treaties. GAAR provisions apply to an arrangement only if the main purpose of the arrangement is to obtain a tax benefit, besides meeting other conditions. Under GAAR, an impermissible avoidance arrangement can result in any step or part of the arrangement or any accommodating party being disregarded, reclassification or re-characterisation of expenditure, etc.

Inter-state goods and services tax (GST) 14.48 An aircraft leased from a non-resident lessor would be regarded as an import of services by the resident lessee. GST would be payable by the lessee on such lease rentals under the reverse charge mechanism at the rate of 5% in the case of a dry lease and at the rate of 18% in the case of a wet lease.

Tax gross up clause Income tax 14.49 Tax laws recognise the concept of grossing up, with tax being borne by the lessee. Where the agreement provides that tax is to be borne by the lessee, tax laws require grossing up of the income, such that after deduction of tax at the applicable rate, the net amount would be the amount payable to the lessor.

Inter-state goods and services tax (GST) 14.50 Since GST is payable under the reverse charge mechanism on crossborder lease rentals, such GST is in any case the liability of the lessee. 230

India 14.54

Transfer of ownership of aircraft Income tax 14.51 Where the aircraft is located in India at the time of transfer of the ownership of the aircraft, it will be subject to capital gains tax in India. There would be no such tax liability if the aircraft is located outside India at the time of transfer of ownership. The rate of capital gains tax would depend upon the period for which the aircraft was held by the owner prior to the transfer. If it was held for more than three years, the gains would be taxable as long-term capital gains, taxable at 20% plus applicable surcharge and cess (effective tax rate 21.84%). If it had been held for three years or less, the gains would be taxable as short term capital gains at the rate of 43.68%.

Inter-state goods and services tax (GST) 14.52 If the location of the aircraft is outside India at the time of transfer of ownership, there would be no GST liability. A transfer of ownership of the aircraft while it is located in India would attract GST at the rate of 5%.

Stamp duty on documents 14.53 There will also be stamp duty implications on the various agreements executed in a lease or a financing transaction. Stamp duty differs from state to state in India. Some states have enacted their own stamp laws whilst other states have adopted the Indian Stamp Act 1899 (with state-specific amendments of, for example, rates of duties). Liability to stamp duty in a particular state arises only if the instrument is executed in that state or, if the instrument is executed outside that state, if the instrument (and in some states a copy or extract) is subsequently brought into the state and relates to property in the state or a matter done or to be done in that state.

Cape Town Convention 14.54 On 1  July 2008, India acceded to the Convention on International Interests in Mobile Equipment signed in Cape Town on 16 November 2001 (the ‘Cape Town Convention’). In furtherance of the accession to the Cape Town Convention, 2001, amendments were made to Indian statutory law in Rules 30 and Rule 32A of the Aircraft Rules 1937 and the 1998 CAR. Rule 30(7) of the Aircraft Rules 1937 provides that the registration of an aircraft registered in India, to which the provisions of the Cape Town Convention or Cape Town Protocol apply, shall be cancelled, as provided in the Cape Town Protocol, by the Central Government within five working days without seeking consent or any document from the operator of the aircraft or any other person, if an application is received from an IDERA Holder along with: (a) the original or a notarised copy of the IDERA recorded with the DGCA; and (b) a priority search report from the International Registry regarding registered interests in the aircraft ranking in priority along with a certificate from the IDERA Holder that all registered interests ranking in priority to that of the IDERA Holder in the 231

14.55  Regional Markets priority search report have been discharged or that the holders of such interests have consented to the deregistration and export. Rule 32A which has been amended provides that if the registration of an aircraft is cancelled consequent to Rule 30(7) and if an application is made by an IDERA  Holder for export of the aircraft, the Central Government shall take action to facilitate the export and physical transfer of the aircraft, along with spare engine, if any, subject to: (a) the payment of outstanding dues in respect of the aircraft; and (b) the compliance of the rules and regulations relating to the safety of the aircraft operation. It may be noted however that the said Rule 30 of the Aircraft Rules contains a proviso that the cancellation of registration of an aircraft shall not affect the right of the Central Government or any entity thereof, or any inter-governmental organisation in which India is a member, or other private provider of public services in India to arrest or detain or attach or sell an aircraft object under its laws for payment of amounts owed to the Government of India, any such entity, organisation or provider directly relating to the services provided by such aircraft in respect of that object. Further, para 9.2 in the CAR (as amended from time to time) has been amended to also state that for deregistration of an aircraft under Rule 30(7) of the Aircraft Rules 1937, the IDERA Holder would be required to file a request with DGCA as per AIC 12/201844 provided that the deregistration shall not affect the right of any entity thereof, or any inter-governmental organisation, or other private provider of public services in India to arrest or detain or attach or sell an aircraft object under its laws for payment of amounts owed to the Government of India, any such entity, organisation or provider directly relating to the services provided by it in respect of that object. As mentioned above, Regulation 10 of the Airports Authority of India (Management of Airports) Regulations 2003, has also been amended to further provide that in respect of an aircraft which is to be exported under Rule 32A of the Aircraft Rules 1937, the current and accumulated dues shall include only such dues that accrued in respect of that aircraft and in relation to flights operated by that aircraft during the period comprised of three months immediately preceding the date of declared default and the period subsequent to the date of declared default up to the date of departure of the aircraft from India and that the Competent Authority shall retain the right to recover the balance dues, if any, from the concerned airline. Certain laws in India, which conflict with the Cape Town Convention and the declarations made by India under the Convention, still require to be amended, including in particular, insolvency laws.

Growth of the corporate jet sector 14.55 As a result of the increasing demand for business travel, industrial and corporate houses have started to realise the benefits of owning an executive jet and this has led to a sharp increase in the number of corporate jet acquisitions. 44 The DGCA has issued Standard Operating Procedure on 16 November 2018 (SOP) (bearing reference AIC 12/2018) which sets out the procedure/timelines for the implementation of Rule 32A of the Aircraft Rules 1937 after the application for deregistration and export is filed by the IDERA Holder.

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India 14.56 In accordance with the June 2010 Civil Aviation Requirement issued by the DGCA, non-scheduled operators are allowed to operate revenue charter flights for a company within its group companies, subsidiary companies, sister concerns, associated companies and for its own employees (including the chairman and members of the board of directors and their family members), provided that the flights are operated for remuneration, whether such service consists of a single flight or series of flights over any period of time.

Setting up aircraft operating lease units in International Financial Services Centres (IFSC) 14.56 The International Financial Services Centres Authority Act 2019 came into force on 19 of December 2019 to develop and regulate the financial services market in the International Financial Services Centres in India set up under the Special Economic Zones Act 2005, and for matters connected therewith or incidental thereto. On 16 October 2020, the Government of India declared ‘Aircraft lease which shall include operating and financial lease of aircraft or helicopter and engines of aircraft or helicopter or part thereof’ as a financial product under the International Services Centres Authority Act 2019. Accordingly, pursuant to the above amendment, ‘units’ which are engaged in operating and financial lease of aircraft or helicopter and engines of aircraft or helicopter or part thereof, may be set up in an IFSC and avail of the benefits and exemptions applicable to units set up in the IFSC. On 19  February 2021, the International Financial Services Centres Authority (IFSCA), issued a circular providing a framework for enabling setting up of units/ lessors to carry out ‘aircraft operating lease activities’ in the IFSC (‘Framework’). Entities which are desirous of engaging in one or more of the ‘permissible activities’ referred to in the circular, namely ‘operating lease for an aircraft lease arrangement including sale and leaseback, purchase, novation, transfer, assignment, and such other similar transactions in relation to aircraft lease’ and any other related activity with the prior approval of the IFSCA can apply for registration of a unit in the IFSC. The unit would need to comply with the eligibility criteria set out in the Framework including a minimum capital of US$ 2,000,000 or its equivalent in freely convertible foreign currency at all times. A  unit in an IFSC would be eligible for certain exemptions and benefits as notified from time to time including the following. (1) Transactions between the unit in the IFSC and a non-resident head lessor/ owner or bank or any other person would not be subject to the provisions of the Foreign Exchange Management Act 1999 and the regulations framed thereunder (FEMA). Accordingly (by way of example), borrowings from the IFSC would not be subject to the external commercial borrowings regulations above, and payments by a lessee (in the IFSC) to the foreign lessor would not be subject to the provisions of FEMA and accordingly, the conditions and restrictions the external commercial borrowings regulations or FEMA will not apply. (2) Several income tax benefits have been announced such as: – a tax holiday for any ten consecutive years out of a period of 15 years beginning with the year in which the requisite permission for 233

14.57  Regional Markets the operation of the IFSC unit was obtained. Post the tax holiday, companies in the IFSC can avail the concessional tax rate of 25.168% (inclusive of surcharge and cess); – no withholding tax on interest payments to a non-resident by a unit in IFSC; – with effect from the 1  April 2022, the non-resident (lessor) would be exempt from payment of tax on lease rentals received from the IFSC unit for the ten-year period during which the unit in the IFSC is availing of the tax exemption referred to above, provided that the unit has commenced its operations on or before 31 March 2024; – with effect from 1 April 2022, capital gains on the transfer aircraft or aircraft engine which was leased by a unit in IFSC to a domestic company engaged in the business of operation of aircraft before such transfer subject to the condition that the unit has commenced operation on or before 31 day of 2024 shall also be eligible for deduction during the ten-year period during which the unit in the IFSC is availing of the tax exemption. (3) The Gujarat Government issued a notification for exemption of stamp duty chargeable under the Gujarat Stamp Act 1958 in connection with establishment/incorporation/setting up or carrying out or availing, providing any services or acquisition of moveable or immoveable property for the purpose of and in relation to aircraft/aircraft engine/helicopter leasing, and or aircraft/aircraft engine helicopter financing or refinancing or insurance, reinsurance business in or from IFSC in Gujarat (GIFT City) for a period of ten years from August 2020.

Conclusion 14.57 From 1992 onwards, the aviation industry in India has matured, following a shift in policy from an area in which the state carriers’ monopoly was zealously guarded to an era of active partnership between the Government and the private airlines which has promoted healthy competition. The Government has also entered into joint ventures with the private sector for the management of airports. In addition, India has acceded to the Cape Town Convention and introduced amendments to the law to give effect to Indian’s declarations under the Cape Town Convention, as set out above. More recently, in or around 2019, the DGCA deregistered 95 aircraft leased to Jet Airways Limited following the exercise of rights by the IDERA Holders, pursuant to the defaults by Jet Airways Limited under the leases and the lessors/financiers were permitted to export the aircraft subject to paying the outstanding airport and GST dues in respect of the aircraft. Accordingly, the Indian aviation market is well placed for foreign owners and financiers of aircraft to participate in this expanding market.

234

China 14.59

CHINA Wang Ling and Wang Ning Introduction 14.58 The civil aviation transportation market in China has become one of the most quickly growing aviation markets in the world. In 2019, transport turnover for the whole industry was 129.325 billion ton-kilometre (an increase of 7.2% on the previous year), of which the transport turnover of international flights was 46.374 billion ton-kilometre (an increase of 6.6% on the previous year). The transport volume of aviation passenger transportation was 659.9342 million passengers (an increase of 7.9% on the previous year) while the transport volume of aviation cargo and postal transportation was 7.5314 million tons (an increase of 2.0% on the previous year). By the end of 2019, the total number of aircraft in China was 3818; an increase of 179 aircraft during 2019.45 In summary, China’s aviation transportation industry has made rapid development in recent years. This section of Chapter 14 will highlight some of the key legal and regulatory issues affecting the aviation industry in China. This section will also outline some of the recent developments in the Chinese aviation market.

Key legal and regulatory issues in the Chinese aviation market Aircraft registration in China 14.59 The rights and interests of the owner, the lessors and/or the financier in an aircraft transaction are generally recognised under the laws of the People’s Republic of China (the PRC). The PRC laws applicable for the aviation industry include the Civil Aviation Law of the PRC (effective from 1  March 1996), the Civil Code of the PRC (effect from 1  January 2021) and the Enterprise Bankruptcy Law of the PRC (effective from 1 June 2007). A  comprehensive registration system for aircraft exists in China. Aircraft nationality registration for Chinese aircraft is registered with the Civil Aviation Administration of China (the CAAC). Ownership of the aircraft may also be registered with the CAAC; registration makes the owner’s rights effective against a third party. Mortgages over aircraft with Chinese nationality registration may also be registered with the CAAC; registration ensures the mortgagee has a prior ranking security interest over subsequent registered mortgages and/or unsecured creditors. Possession rights (of the operator) over the aircraft may also be registered with the CAAC; again, registration ensures the operator has a prior ranking claim against third parties. Chinese law recognises the concept of a lease in respect of an aircraft. The lessor may assign its rights and interest under the lease, as well as its rights and interest under the aircraft insurances, to the financier. However, no registration system exists for such an assignment. 45 Source: 2019 Statistic Report of Civil Aviation Industry Development issued by the Civil Aviation Administration of China.

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14.60  Regional Markets

Bankruptcy of Chinese airlines 14.60 In the event of the bankruptcy of a PRC airline, an aircraft which is leased to a PRC airline will not be regarded as the bankrupt assets of the debtor, and the owner of the aircraft may repossess the aircraft, subject to the consent of the administrator. Regarding the question of whether a foreign lessor/owner could repossess the aircraft upon the bankruptcy of a Chinese airline, the case of East Star Airlines, a Chinese private company, has provided a precedent. In late-2008, East Star’s business was substantially affected by the depressed economic market and East Star had difficulty paying lease rentals to its foreign lessor/owner under its aircraft leases. When the lessor/owner’s various efforts to remedy East Star’s default failed, the lessor/owner terminated the leases in accordance with the lease agreement and petitioned the East Star’s bankruptcy and repossession of the aircraft. Although a number of bankruptcy cases of Chinese domestic companies have been brought to court, very few bankruptcy cases which were petitioned by foreign creditors have been brought before the Chinese courts. There was some uncertainty whether the petition of bankruptcy against East Star by the foreign lessor/owner would be accepted by the court and how long it would take for the petition to be accepted. However, the petition of bankruptcy was accepted by the local Chinese court very quickly. As East Star was the first Chinese airline to go into insolvency, the judges and the administrator examined the case in extreme detail and even sought advice from foreign lawyers (as the governing law of the lease agreement was foreign law) on many issues, particularly the right of the lessor/owner to repossess the aircraft. After examination by the court, the claim of the lessor/owner to repossess the aircraft was upheld. However, despite resolving the issue of aircraft repossession in the event of a Chinese operator’s bankruptcy, the East Star case still leaves some issues to be tested in the future. Such issues include whether a foreign lessor/owner is entitled to repossess the aircraft upon the restructuring of a Chinese airline; that said, it is expected that the recent bankruptcy restructuring case of HNA Group would set more examples for this circumstance. In January 2021, according to the application of corresponding creditors, there were 63 companies within HNA  Group (including Hainan Airlines, China Xinhua Airlines, Chang’an Airlines, Shanxi Airlines, Lucky Air, Fuzhou Airlines, Urumqi Air and Guangxi Beibu Gulf Airlines) which have received notice of bankruptcy reorganisation from the competent PRC court; and the competent PRC court has ruled to accept the bankruptcy reorganisation of these companies. Generally speaking, under PRC bankruptcy law regime, bankruptcy reorganisation is different from bankruptcy liquidation in that: (1) the fundamental purpose is to rebuild the business and operation capability of the insolvent debtor; (2) the insolvent debtor would be able to continue its business and operation if a reorganisation plan is agreed by the relevant stakeholders and successfully executed. Upon receiving from the corresponding creditor the application for bankruptcy reorganisation, the competent court shall render a ruling for acceptance or rejection. During the reorganisation period, subject to the bankruptcy administrator’s supervision, the insolvent debtor shall operate as usual, and its 236

China 14.61 bankruptcy administrator shall submit a daft reorganisation plan for approval within six months (or nine months if approved by court) after the court’s ruling for acceptance. If the reorganisation plan is finally approved, then the court will render a ruling to end the reorganisation period and implement the approved reorganisation plan; otherwise, the court will render a ruling to liquidate the debtor.

Cape Town Convention in China 14.61 On 1  June 2009, the Convention of International Interests in Mobile Equipment and the Protocol of the Convention on International Interests in Mobile Equipment on Matters Specific to Aircraft Equipment (the ‘Cape Town Convention’) came into effect in China. Under the Cape Town Convention, the lessor may register its rights and interests in an aircraft in the International Registry. China has designated the Aircraft Rights Registry under the CAAC as an authorising entry point through which information required for registration will be transmitted to the International Registry. Where a lease or other international interest is required to be registered with the International Registry, the professional User Entity (PUE) must first apply to the CAAC for an authorisation code. In order to grant the authorisation code, the CAAC requires: (a) a standard application form; (b) the Chinese nationality registration certificate of the relevant aircraft object; and (c) relevant evidence of the international interests (evidence is not required for the registration of prospective international interests). After the CAAC grants the authorisation code, the lessor as Transacting User Entity (TUE) may authorise the PUE for the registration (or consent to registration) of the international interest. Upon registration, the International Registry will automatically notify the relevant parties of the registration. CAAC issued the Administrative Procedures for the Deregistration of Civil Aircraft (the ‘Administrative Procedures’), which governs the procedures for the deregistration of aircraft in China and the procedures relating to an Irrevocable Deregistration and Export Request Authorisation (IDERA) under the Cape Town Convention. Under the Administrative Procedures, an Authorised Party under the IDERA will be able to deregister a civil aircraft from the CAAC provided that the IDERA is on file with the CAAC and subject to the conditions set out in the Administrative Procedures. There have been several cases in which the IDERA was accepted by and filed with the CAAC. However, the Administrative Procedures do not address whether an Authorised Party may assign an IDERA in conjunction with the assignment of the security agreement to which the aircraft relates. It appears that an IDERA may only be assigned by removing the existing IDERA on file and filing a new IDERA in favour of the new creditor. China adopted Alternative  A  of Article  XI (Remedies on insolvency) of the Protocol. Alternative A of Article XI states that: ‘2. Upon the occurrence of an insolvency-related event, the insolvency administrator or the debtor, as applicable, shall, subject to paragraph 7, give possession of the aircraft object to the creditor no later than the earlier of: 237

14.62  Regional Markets (a) the end of the waiting period; and (b) the date on which the creditor would be entitled to possession of the aircraft object if this Article did not apply’. The waiting period referred to in Alternative A  is 60  days. The adoption of Alternative A provides creditors with a clear procedure and substantial comfort for enforcing their rights under defaulted contracts. Before the Cape Town Convention came into effect in China, the Chinese courts were able to stay any proceedings taken by a credit against an insolvent airline (including repossessing the aircraft) for unspecified periods of time. In accordance with China’s declaration of Article 53 (Determination of courts) of the Cape Town Convention, the intermediate people’s courts where the headquarters of the relevant airlines of the PRC are located have jurisdiction over aircraft equipment leasing disputes covered by the Cape Town Convention. However, it is unclear whether the intermediate people’s courts will accept jurisdiction over aircraft transaction disputes where the parties have submitted to arbitration to resolve the dispute. Under Chinese law, if the parties to a contract submit to arbitration to resolve a dispute arising from the contract, the court will not accept jurisdiction of the case.

Recent developments in the Chinese aviation market Taxation 14.62 Since 2008, there have been many changes to the tax laws and regulations in China. The new Enterprise Income Tax Law of the PRC (which came into force in 2008) unifies the corporate income tax rate levied on Chinesefunded enterprises and foreign-funded enterprises. There has been no change to the withholding tax rate of 10% imposed on lease rental payments by Chinese lessees to a foreign lessor. However, the business tax, which was applicable to aircraft leasing, has been replaced by value added tax. On 1  May 2016, the Notice of the Ministry of Finance and the State Administration of Taxation on Implementing the Pilot Programme of Replacing Business Tax with Value Added Tax in an All-round Manner (the ‘Value Added Tax Programme’) came into force. The Value Added Tax Programme provides that any entities and individuals that sell services, intangible assets or immovable properties within the territory of China are value added tax payers, and shall pay value added tax (VAT) instead of business tax. The leasing of an aircraft by a foreign lessor to a Chinese lessee could be construed as selling services within China and therefore subject to VAT. According to the Value Added Tax Programme, the VAT rate applicable to leasing of tangible and movable property (such as aircraft) is 17%. After the Value Added Tax Programme, the Ministry of Finance and the State Administration of Taxation jointly issued several notices to decrease such VAT rate to 13%.

New requirements of customs authority 14.63 On 1 April 2011, Shu Shui Fa [2011] No 88 (Circular 88) issued by the General Administration of Customs in China came into effect. Where a loan is granted by an offshore financial institution to a Chinese airline and the aircraft is mortgaged to the financiers as security for the loan, Circular  88 requires the financier to provide a guarantee or a security deposit to the local customs 238

China 14.64 authorities as security for the payment of the taxes (VAT and customs duty) payable in respect of the importation of the aircraft. Where the loan is granted from a Chinese onshore financial institution, an undertaking letter jointly made by the Chinese onshore financier and the Chinese airline may be substituted in place of a security deposit or a guarantee. The letter of undertaking provides that, in the event that the mortgage over the aircraft is enforced, the airline will make payment of the tax payable to the customs authority in full or the proceeds from the enforcement of the mortgage will be applied to discharge the tax payable to the customs authority first. On 21 December 2020, the General Administration of Customs in China issued new Measures for the Administration of the Tax Reductions and Exemptions for Imported and Exported Goods (Circular 245). Different from Circular 88, Circular 245 does not specifically define which kind of security should be provided, but it generally requires that security with the property or rights recognised by the customs should be provided. While it is hard to tell how Circular  88 and Circular 245 will affect aircraft transactions, it is clear that these customs requirements may cause concern to the financier and the lessor and may incur additional transaction costs.

SPVs in bonded area 14.64 In 2007, with the support of the policy regulations of the China Banking Regulatory Committee (now changed to China Banking and Insurance Regulatory Commission, the CBIRC), several Chinese banks established their own subsidiary leasing companies. These leasing companies included: ICBC Leasing; CDB Leasing; BOC Aviation (acquired by BOC and based in Singapore); CCB  Leasing; CMB  Financial Leasing; Bank of Communication Leasing and Minsheng Leasing. Some of these leasing companies have become very active in the aviation market. With the support of the CBIRC as well as other governmental authorities, Chinese leasing companies have become involved in new transaction models since 2010. An example of a new model is the incorporation of a special purpose vehicle company (SPV) by Chinese leasing companies in a bonded area of certain cities, such as Tianjin. Under this model, the SPV lessor purchases the aircraft from the manufacturer with financing support from the banks and enters into an aircraft lease with a Chinese airline. The most important function of this model is that the SPV may enjoy the same deducted tax rate as the Chinese airline, that is, the SPV is not liable for any additional VAT and customs duty. As this model does not result in an additional tax burden for the Chinese leasing companies, it enables the lessor to purchase the aircraft directly from the manufacturer. In addition to the above-mentioned deducted tax rate, in order to promote the leasing industry, Tianjin government grant further tax benefits to SPVs established in Tianjin Dongjiang free trade port zone, such as returns of VAT. That should be one of the reasons why the ‘lease-in and lease out’ structure (ie foreign lessor leases an aircraft to a SPV established by Chinese airline in Tianjin Dongjiang free trade port zone and then subleases such aircraft to the Chinese airline) has become more and more popular in China. As at the end of 2020, more than 1700 aircraft have been delivered to SPVs established in Tianjin Dongjiang free trade port zone and Tianjin Dongjiang 239

14.65  Regional Markets free trade port zone has become the second largest aircraft leasing venue in the whole world.46

Internationalisation of RMB 14.65 Although the controls on conversion between renminbi (RMB) and foreign currencies has not been completely lifted, there has been some progress in RMB payment, funding and investment in cross-border transactions since 2009, and the ‘Internationalisation of RMB’ has gradually become a hot topic in China’s economic and financial field. In 2009, China launched a RMB cross-border trade settlement pilot which focused on payment settlement in RMB in import and export transactions. In January 2011, the People’s Bank of China (PBOC) launched a pilot scheme for RMB settlement of outbound direct investments. PBOC’s pilot scheme allows onshore Chinese companies to make direct investments in RMB in overseas enterprises or projects. In February 2011, the Ministry of Commerce of the PRC released a notice permitting RMB-denominated foreign direct investment in China by offshore investors. In April 2011, a notice of the State Administration of Foreign Exchange addressed the rules and procedures for making investments or debts in RMB. Since 2009, PBOC and other regulatory authorities have issued many regulations and policies every year, aiming to boost the role of RMB in the global market and the theme of these regulations and policies has developed from RMB settlement and payment in export and import transactions to cross-board funding and investment activities. In 2019, the total amount of cross-border RMB payments and receipts was RMB 19.67 trillion yuan, with a year-on-year increase of 24.1%. The size of the RMB reserves was the fifth largest in the International Monetary Fund (IMF)’s Currency Composition of the Official Foreign Exchange Reserves (COFER), with a market share of 1.95%, 0.88 percentage point higher than that of 2016 when the RMB officially joined the Special Drawing Right (SDR) currency basket. The market share of the RMB in the foreign exchange trading was 4.3%, 0.3 percentage point higher than that of 2016. According to the latest statistics, the RMB ranked fifth as a payment currency globally, with a market share of 1.76%.47 The international use of RMB and the supporting regulations and policies has been, and will continue, providing greater opportunities for foreign investors to raise funds and create more business opportunities in China. It is also anticipated that such development in the international use of RMB will also benefit the raising of funds in the global aviation market.

46 Source: news report from Tianjin Daily on 24 January 2021. 47 Source: 2020 RMB Internationalisation Report issued by the People’s Bank of China.

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Germany 14.67

GERMANY Konrad Schott Introduction The airlines 14.66 Germany has demonstrated that it is a stable market for aircraft financing. The economic and legal environment and – until the Covid-19 pandemic – a growing demand for air travel brought German airlines into focus for lessors and borrowers in the global aviation finance industry. The airline landscape has changed, however, in the last couple of years. With the bankruptcy of Air Berlin in 2017 a major operating lease customer vanished, and while the capacity and the market share of Air Berlin were quickly absorbed by other airlines, some of them are non-German, European airlines (such as easyJet and Ryanair) or, as Lufthansa, pursue a different aircraft financing policy. The remaining major players are of course Deutsche Lufthansa AG with its various German and European subsidiaries and brands including Eurowings, Swiss or Austrian Airlines; TuiFly and – following its restructuring – Condor with a strong focus on the attractive touristic routes to the Mediterranean and other holiday destinations. The scenery is complemented by a number of smaller players with niche markets, for example, German-Turkish routes. In the cargo sector Lufthansa Cargo, DHL and Aerologic are to be mentioned. In the middle of Europe, the German airline industry finds itself exposed to numerous competitors. Those may offer routes from Germany to their home destinations, and in the case of European airlines, to any destination within the EU. In particular low-cost carriers continue to expand their market share.

The finance sector 14.67 Banking consolidation led to a number of market exits and portfolio sales (for example, DVB Bank). Other banks (re)commenced aircraft financings, such as ING and Bayerische Landesbank; and German banking institutions remained engaged in ECA-backed financings. Capital market products for (non-ECA) aircraft financings play an insignificant role in the German market. The German aircraft mortgage covered bond (Flugzeugpfandbrief) did not manage to conquer a significant market share, while ECA backed financings could still be used for government-backed covered bonds (öffentliche Pfandbriefe) where the aircraft collateral is not decisive. Yet, recent developments such as an aircraft secured Schuldschein (a German debt instrument) may add an interesting angle. Further the refinancing of aircraft leased to German carriers may well tap into international capital market instruments, like securitisations. For more than two decades outbound aircraft leasing has been dominated by private investor schemes. These days however, outbound leasing by established operating and finance lessors is increasingly backed by institutional investments. Retail funds celebrated a renaissance with a series of A380 and other widebody investments between 2007 and circa 2013, leaving the equity investment made by private investors exposed to the residual value risk and the speculation for 241

14.68  Regional Markets a lease extension or a profitable placement in the secondary market. Already before the Covid-19 pandemic the decline in demand for certain types of widebody aircraft led to long-term storage, premature decommissioning and a steep reduction of aircraft values in what private investors had hoped to be low risk and stable investments, a development that has further been accelerated by the reshuffling of the global aviation industry. These days specialised German leasing companies and arrangers primarily serve a clientele of institutional investors, such as insurance companies, pension funds and family offices who want to invest in aircraft leasing. Lessors and financiers should familiarise themselves with the German regulatory framework for providing leasing and financing. Lending constitutes a licensable business in Germany, even to commercial borrowers, and even if the loan is granted from abroad. There are exemptions available, such as freedom of services in certain contexts, passporting of foreign regulated banks, and providing funds through financial instruments. Providing operating leasing is not a regulated activity, but finance leasing (Finanzierungsleasing) in the meaning of the relevant statutory and administrative rules requires a permit even if provided from abroad, and again certain exemptions can be utilised in this context. In terms of volume, the market for inbound leasing and financing of commercial aircraft appears to be very much dominated by the main airline, Lufthansa, and a couple of mid-size carriers. At the time of writing in 2021, finance leasing seems to be Lufthansa’s preferred choice to address current demand, combined with some direct aircraft financings, occasional sales with operating leasebacks or operating leases. The fleet sourcing for TUIfly appears to be very much steered by TUI group’s aviation hub in the UK, and Condor is yet to start adding new aircraft to its fleet. Lufthansa Cargo, DHL and Aerologic appear to source aircraft via their respective shareholders and group aviation platforms.

Legal environment 14.68 The legal foundation for aircraft finance into Germany is composed of international treaties, EU legislation and German domestic regulatory and civil law.

International treaties 14.69 Germany has signed but not ratified the Cape Town Convention and the Aircraft Protocol. At the time of writing in 2021, ratification is not in sight. The government and major market participants have not prioritised the implementation of the Cape Town Convention, in part because aircraft-based financing has proven to be feasible with the tools which are already available under German law and in part because the implementation may require substantial changes in German civil law. If ratification could be achieved an adoption of Alternative A or B of Article XI, ie accelerated treatment of aircraft repossession in insolvency, appears rather unlikely, as this would entail granting preferential treatment to a specific group of creditors. In practice this should be less relevant, however. Thus far, repossession of an aircraft in the case of the insolvency of a German lessee, did not result in any major obstacles being encountered. German airlines will not be able to benefit from any ECA financings and, hence, also not from further reduced ECA financing rates that may come with the implementation of Alternative A. 242

Germany 14.71 Germany ratified the Convention on the International Recognition of Rights in Aircraft (Geneva Convention) and the Rome Convention for the Unification of Certain Rules Relating to the Precautionary Arrest of Aircraft (Rome Convention).

EU laws 14.70 The EU legislation sets the regulatory framework in particular for the admission and supervision of air carriers, airports and aircraft, safety standards, air traffic, merger control and slot regulation. The registration process for aircraft remains with the national authorities ie for Germany the Luftfahrt-Bundesamt (LBA) in Braunschweig.

German regulatory and civil law Aircraft registration and aircraft mortgage 14.71 In the light of its ICAO membership and the Geneva Convention, Germany provides for a national aircraft register (Luftfahrzeugrolle) with the LBA. The aircraft registry functions as an owner’s registry, ie  the obligation to register an aircraft and to supplement changes of relevant information lies with the owner, including the right to deregister the aircraft. In the registration of an aircraft only the airframe is referred to by model and serial number, but not the engines. At the same time, entries into the German aircraft registry do not constitute proof of title to the relevant aircraft (see below). Pursuant to EU regulation, an aircraft used for commercial operation by a German airline needs to be owned by the operator or to be leased for at least six months. When registering a leased aircraft, therefore, the lease agreement will have to be submitted. The LBA will review the lease agreement not only for formal requirements but will also ensure that the operator enjoys unrestricted freedom in complying with safety, maintenance and operational standards. The law governing title to and encumbrances over aircraft is determined by the state of registration under German conflict of laws rules. This will apply to the airframe and should include engines, parts and accessories installed on the aircraft. Aircraft are considered to constitute moveable property for German civil law purposes, but rather surprisingly follow the rules for registered vessels and real estate in enforcement of aircraft mortgages and in insolvency law. Title to an aircraft can be transferred by simple agreement on the transfer of title for which no specific form is required. As for the transfer of title to any other type of moveable property under German law, transfer of title will only be effective if possession (Besitz) of the item is also transferred from the transferor of title to the transferee. However, if properly observed and handled, the practical implications of this rule remain limited, as possession can also be established indirectly via a leasing or a custody agreement or a chain of leases. The change of ownership of an aircraft is effective upon the agreement to transfer title and the transfer of possession but has – as a matter of regulatory law – to be registered with the LBA with only a declaratory nature of such registration. Engines of modern commercial aircraft are legally considered to be parts separate from the airframe. Installing an engine on a different German airframe will not cause title to the engine to transfer to the owner of that other airframe. Whether an engine 243

14.71  Regional Markets constitutes a simple part (einfacher Bestandteil) of the airframe or an accessory item (Zubehör) thereto remains disputed between practitioners, a distinction that may have a bearing on the coverage of engines by an aircraft mortgage. Aircraft registered in the German aircraft register can be encumbered by way of the registered aircraft mortgage (Luftfahrzeugpfandrecht), an instrument that follows closely the hypothec for the encumbrance of real estate or vessels. The aircraft mortgage can secure one or several claims for payment (including any obligation that can amount to a payment claim, eg a damage claim following frustration of the primary obligation) and is created by a formal grant by the owner in favour of the mortgagee. The grant of the aircraft mortgage needs to be submitted in notarised form to the local court (Amtsgericht Braunschweig) in Braunschweig and needs to be registered in the aircraft mortgage register that is kept by the court in order for the mortgage to become effective. Filing with the court, however, will ensure priority over subsequent filings and can already provide protection of the mortgagee irrespective of any insolvency of the mortgagor before registration is effected. The court will review whether the formal and substantive requirements for an effective aircraft mortgage have been complied with and may request additional information for example, on the parties’ authority and valid representation. Compared to other jurisdictions, the registration processes with the aircraft registry and the aircraft mortgage registry are rather formalistic and document-heavy. Registration of, and any changes to, the aircraft mortgage are expensive and can easily amount to more than € 25,000 for a narrow body aircraft. The aircraft mortgage’s legal scope and means are solely governed by statutory law from which the parties cannot derogate. The aircraft mortgage will encumber the aircraft and proceeds from the hull insurance, but not a rental stream. The mortgage will also pertain to the engines installed on the airframe if they belong to the owner of the (registered) airframe. There are nuances as to the reach of the mortgage if the engines are taken off-wing. The German aircraft mortgage is a strictly accessorial security interest, ie  it only exists in combination with and to the extent of the secured obligation. Any transfer of the aircraft mortgage requires a formal transfer together with the secured claim and the registration thereof in the aircraft mortgage registry. A  novation of the secured claim, for example, will destroy the mortgage as the underlying secured claim is replaced by the novated claim. Practitioners often address the vulnerability caused by the accessorial nature, by introducing an abstract acknowledgement of debt issued by the debtor in favour of the creditor as security for the actual indebtedness or other obligations, and such acknowledgement forms the underlying claim which is secured by the aircraft mortgage. Beyond the registered aircraft mortgage there are only limited ways in which a lien can encumber a German registered aircraft: in theory, a security transfer of title to the airframe or to any (legally separate) parts thereof can be agreed. As holding title to an aircraft or aircraft parts may come with a legal liability exposure in various jurisdictions, this tool is rarely used in practice. Further, for European Union Emission Trading Scheme payments, outstanding VAT and/or customs in case of an import of an aircraft, and unpaid fines imposed as a consequence of a breach of obligations under the German Air Traffic Act (Luftverkehrsgesetz) the relevant authority can register a non-consensual lien over an aircraft registered in Germany, if the debtor is the aircraft owner (and in case of ATC charges if the operator is unknown). 244

Germany 14.73 Workmen or landlord liens, which are generally permitted under the German Civil Code (Bürgerliches Gesetzbuch), cannot be created in respect of German registered aircraft. For claims for salvage, the Act on the Rights in Aircraft (Gesetz über Rechte an Luftfahrzeugen) in principle allows for a first-priority lien.

Enforcement and repossession 14.72 German law does not allow for self-help remedies upon the occurrence of an enforcement event. The German aircraft mortgage is enforced by the court (with the help of court bailiffs) via an auction procedure on the basis of an enforceable title. The latter can be a court judgment but also a notarial submission to enforcement rendered by the mortgagor together with (and ideally at the time of) the grant of the mortgage. Unless the lessee cooperates, repossession of a leased aircraft requires a court judgment. Attaching an aircraft to protect a lessor’s interest is possible on the basis of injunctive relief. Due to the implementation of the Rome Convention the attachment for a payment claim is often precluded for aircraft in scheduled operation, aircraft in commercial service and prepared for take-off, as well as postal service or government aircraft. In a repossession scenario it may be hard to predict the whereabouts of an aircraft that is in operation and to enforce a court decision on the attachment of an aircraft in time. It may be possible, however, to obtain the support of the aviation authorities to assist the court’s bailiff in that process.

Insolvency and restructuring 14.73 The substantial competition in the heart of Europe triggered market exits and consolidation in Germany well before the Covid-19 crisis. The insolvencies of Air Berlin, Small Planet (Germany), Germania and Condor not only reshaped the market but also tested the legal instruments that are available in the crisis of a German airline. Before considering the effects of a restructuring or insolvency proceeding of an airline in terms of legal details and rights of aircraft lessors and financiers, the most important observation might be that, in principle, a German commercial carrier can continue operations even after commencement of insolvency proceedings. Under EU rules the aviation authorities cannot allow for an insolvency administrator assuming full and unrestricted control of an airline in a restructuring or insolvency, but at least all operational responsibility must remain in the hands of qualified and licensed personnel. Any disruption of the established rules and processes that are designed, and specifically approved, to ensure a safe and reliable air transport must be avoided. A  special form of insolvency proceedings, so called debtor-in-possession proceedings (Eigenverwaltung), which have become more frequently used recently can address this need quite effectively. Despite filing for insolvency and the opening of insolvency proceedings, the management of the airline remains in charge of the business and airline operations even in insolvency, but will be supervised by a court appointed custodian and eventually supported by a restructuring officer. The LBA will monitor the situation in such a case very closely (including liquidity, safety and operations) and may allow for a provisional operating licence during this phase. 245

14.74  Regional Markets German law provides for out-of-insolvency restructuring proceedings (since 2021) as well as for a restructuring plan in insolvency and of course windingdown proceedings. The new restructuring proceeding (Restrukturierungsverfahren), which was introduced into German law in order to implement Directive (EU) 2019/1023 of 20 June 2019, allows for a selective restructuring of the debtor’s liabilities. This could include secured aircraft financings and claims for rent that became due and remained unpaid prior to the submission of the offered restructuring plan but should not allow for the rejection or adaptation of aircraft leases. The restructuring proceeding aims at a consensual or nearly consensual reorganisation of the debtor’s liabilities by a consent and voting process but can also allow for cross-class cram-down. Insolvency proceedings will be commenced by the insolvency court upon valid application by the debtor or a creditor, usually by imposing preliminary proceedings and specific protective measures. Those will include a ban on enforcement and, upon application, conceivably an order for the continuous use of critical assets (which could be an aircraft) despite an existing security interest or a claim for repossession, but against adequate compensation. An aircraft lease cannot be terminated by the lessor on the grounds that rent has not been paid prior to the application for opening of proceedings or on the grounds of a deterioration of the debtor’s economic position irrespective of any provision in the lease agreement that aims at such a termination right. While this will block the typical events of defaults that are linked to non-payment, insolvency and economic MACs, any other default (for example, lack of insurance cover) and any payment default that occurs after the filing for insolvency will still allow for a termination of the lease by the lessor, unless the court ordered a continuous use of the aircraft. In practice, lessors and financiers will often wait and see how the situation develops before exercising termination rights and embarking into a cumbersome disorganised repossession process, as long as the aircraft continues to be maintained and insured. In recent insolvency scenarios, on the basis of consensual bilateral arrangements leased aircraft were either allowed to be used for three months and more, with either no rent payment or a very reduced rent or redelivered consensually and in an orderly manner, but in ‘as is, where is’ condition. An insolvency administrator will try to determine rather quickly if an aircraft lease should be terminated and the aircraft returned, as the administrator will seek to avoid any obligations for ongoing rent and the liability of exercising control over an aircraft. In situations where a continuation of operations was not an option, insolvency administrators therefore sought termination of the leases and allowed for repossession of the aircraft immediately. If the debtor pursues the implementation of an insolvency plan, the same protection and rights will be available during preliminary proceedings. The insolvency plan can provide for a reduction of past rent due, and for a termination of a lease going forward as well as reduction of principal and interest under a (aircraft secured) loan agreement. Voting by classes and cross-class cramdown are available. Condor’s insolvency plan proceeding in 2019 and 2020 demonstrated the effectiveness of this tool in the aviation sector.

Outlook 14.74 The size of the German market and the catchment area in the middle of Europe will always generate the demand for international air travel and will 246

Germany 14.74 support an airline industry to meet that demand. Undoubtedly, post Covid-19 travel patterns will change, and at the same time airlines will have to continue to improve on fuel efficiency and their carbon footprint and will require new and more efficient aircraft – and the financings to cover these investments. As long as German politics do not impose more restrictive rules on the national airlines than other European countries, for example, in terms of ESG policies or taxation, the German airline industry appears well positioned to master these challenges.

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14.75  Regional Markets

JAPAN Paul Greenwell and Akihiko Takamatsu Introduction 14.75 Japan has long been one of the world’s most important aviation markets, having a significant domestic airline and aviation manufacturing sector, as well as providing key, long-term sources of debt and equity financing and leasing for the global industry. Two leading airline groups – All Nippon Airways (ANA) and Japan Airlines Co Ltd (JAL) – dominate the full-service domestic market. This duopoly (originally triopoly) emerged in the late 1980s following JAL’s full privatisation in 1987 and the ending of the so-called ‘45/47’ regulatory framework, under which domestic and international flights and routes were allocated to, and dominated by, three Japanese airlines (JAL, ANA and Japan Air System, which was eventually merged with JAL) in 1985. Since the late 1990s, Skymark Airlines, AIRDO, Solaseed Air (formerly known as Skynet Asia Airways), Star Flyer and others have created a large, active domestic market of middle cost carriers (MCCs). In the early 2010s, global low-cost carriers (LCCs), including Jetstar, AirAsia and Spring launched Japanese businesses with one of the Japanese airlines or other local investors as partners. In turn, ANA countered such moves by setting up its own LCCs, including Peach Aviation. The current Japanese civil aviation market is divided into these three principal groups of airlines, namely fullservice carriers, MCCs and LCCs. Globally, Japanese lessors are established providers of aircraft operating leasing capacity. More recently, corporate acquisitions and joint-ventures have created major Japanese investments in the international leasing industry. Among others, the groups of Sumitomo Mitsui Banking Corporation (SMBC) and Sumitomo Corporation acquired RBS  Aviation Capital (rebranded as SMBC  Aviation Capital) in 2012; Mitsubishi HC  Capital Inc (formerly known as Mitsubishi UFJ Lease and Finance) acquired Jackson Square Aviation in 2013; Marubeni Corporation invested in Aircastle in 2013, which was fully acquired together with Mizuho group in 2020; MC Aviation Partners, a subsidiary of Mitsubishi Corporation, partnered with Cheung Kong in 2014 and, by integrating Cheung Kong’s own leasing platform, Accipiter, emerged as a full joint venture called AMCK Aviation in 2019; ORIX  Corporation acquired 30% of the shares in Avolon Holdings in 2018; and Tokyo Century Corporation acquired Aviation Capital Group in 2019. Similarly, Japan has been a major source of aircraft debt financing since the 1990s. Despite the relative contraction during the ‘lost decade’ up to the early 2000s, today three megabanks (MUFG, SMBC and Mizuho), Development Bank of Japan (DBJ) and Sumitomo Mitsui Trust Bank service a very significant proportion of the global aircraft debt financing market. Their market leadership has been followed by a large number of domestic regional banks, financial institutions and institutional investors seeking middle risk, middle return products in a well-understood, mature market. Japan has a high volume of sophisticated retail investors which for decades has been another crucial and relatively stable source of cross-border aircraft financing. These investors can generally be divided into two different types 248

Japan 14.76 – tax investors and yield investors. Tax investors may invest in tax efficient products called JOLCOs and JOLs, which are detailed below. More recently, yield investors, such as mezzanine and equity funds, have provided a relatively significant financing appetite and these funds have been successfully set up and sold to Japanese financial institutions and institutional investors.

JOLCOs and JOLs Economics and structure 14.76 JOLCO is a commercially-coined acronym for a ‘Japanese operating lease with call option’. This is a tax deferral lease whereby the investors in the equity portion of the aircraft value may enjoy the benefit of the depreciating taxable value of the aircraft on an attractive accelerated, declining balance basis. The investor’s motivation is to defer income tax to a future date by taking depreciation losses during the first half (or so) of the lease term in order to decrease its taxable income in those financial years. Given that corporate income tax in Japan has always been relatively high, this product remains attractive to a notable number of Japanese corporates and other retail investors. The JOLCO evolved from an earlier product called the Japanese leveraged lease (JLL). The JLL was first introduced in 1985. This product enabled the equity portion investors to enjoy the benefit of the depreciating taxable value of the aircraft up to the full aircraft value on the basis of a finance lease (ie full pay-out lease) structure. JLLs remained a major source of global aircraft financing until tax law and subordinated regulation reforms were enacted in 1998, which had a severe negative impact on the economics of JLLs financing aircraft leased to non-Japanese airlines. Subsequent tax reforms in 2008 had a similar economic impact on JLLs financing aircraft leased to Japanese airlines. Although the JOLCO has since replaced the JLL, certain central features remain the same, in particular, the economic driver of the JOLCO remains the tax deferral benefit taken by the equity portion investors. Investors in the current JOLCO market can generally be divided into two different types: ‘active’; and ‘passive’. Numerically, and in terms of their relative share of financed aircraft value, passive investors are more common. In a passive investor structure, an equity arranger offers to underwrite the whole of the equity portion of the aircraft investment at closing and then to solicit equity investors in the Japanese retail market, which would invest in the special purpose vehicle (ie the owner/lessor of the aircraft) set up by the equity arranger to acquire the aircraft asset by way of Japanese law profit and loss sharing agreements (ie tokumei kumiai or ‘TK’ agreements) – effectively, a silent partnership. Such passive investors are typically mid-sized corporate investors sourced through the retail investment networks of the major Japanese commercial and investment banks or securities houses and, historically, the major equity arrangers in the Japanese market have been affiliates of such banks or securities houses. A  typical narrow body aircraft investment would require around ten separate TK investors. A  widebody aircraft investment could see multiple equity arrangers set up a small number of co-lessors, each with its own group of TK investors. Usually TK investors would, in aggregate, invest 20–30% of aircraft financed value matched with 70–80% debt financing provided on a limited recourse basis. Please see Exhibit 14.4. 249

14.76  Regional Markets EXHIBIT 14.4 JOLCO TK STRUCTURE

Source: Clifford Chance

TK investors are entitled to share the profits and losses of the lessor arising from the leasing of the aircraft to the airline lessee. The lessor can claim depreciation allowances as the beneficial owner and, historically, on the full taxable value of the aircraft (notwithstanding only a 20–30% investment as the equity portion of the financed amount). This depreciation allowance is passed on to each of the TK investors pursuant to the TK agreements, and is utilised by the TK investors to defer their taxable income arising from their general corporate profits (ie from their businesses other than the leasing of the aircraft). Japanese tax reforms in 2005 introduced the so-called ‘at-risk rule’ which restricted the amount of losses incurred as a result of the depreciation of the aircraft to the extent of the amount of the investment of the TK investor. An active investor, on the other hand, is, under the 2005 tax reforms, allowed to claim depreciation allowances as the beneficial owner on the full taxable value of the aircraft on the basis of its equity being ‘at-risk’ in the structure. An active investor may own the aircraft itself or, more often, create an investment vehicle, such as a Japanese partnership (ie nin-i kumiai or NK) structure which would own the aircraft and of which the investor would be the principal and managing partner, typically also with two bankruptcy remote special purpose entities as general partners in order to enhance the insolvency analysis of the structure. Such investors would need to arrange the transaction by themselves pursuant to Japanese tax laws in order to be considered ‘active’ or ‘at-risk’ investors and therefore enjoy a depreciation benefit in respect of 100% of the taxable value of the aircraft. Please see Exhibit 14.5. EXHIBIT 14.5 JOLCO NK STRUCTURE

Source: Clifford Chance

250

Japan 14.76 Please see Exhibit 14.6. This is a model profit and loss calculation for a JOLCO TK lessor during a typical lease term of 10–12 years depending upon the size of the aircraft. The lessor would receive lease rentals (which are usually fixed although increasingly calculated on a floating rate basis) throughout the term – this is the lessor’s sole profit from the leasing of the aircraft. The lessor will owe the cost of servicing the loan and will take a depreciation loss against the declining taxable value of the aircraft – this is its loss. In respect of depreciation, two calculation methods are available: (1) a straight-line method (which depreciates the aircraft value at the same amount each year); and (2) a declining balance method (which depreciates the aircraft value at the same rate each year and, as a result, allows the aggregate amount of the depreciation losses to be higher in the early years of the lease term). EXHIBIT 14.6 PROFIT AND LOSS DURING LEASE TERM

Source: Clifford Chance

In JOLCO transactions, this accelerated depreciation method, ie (2) the declining balance method, is essential. Please see Exhibit 14.6 again – the lessor would incur larger losses (and thus maximise its tax benefit) during the early years of the lease term. The lessor’s taxable income throughout the lease period is illustrated in Exhibit 14.7. The lessor can create larger losses during the early years of the lease term but would incur increasingly greater income towards the end of the lease term. EXHIBIT 14.7 PROFIT AND LOSS DURING LEASE TERM

Source: Clifford Chance

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14.77  Regional Markets This being said, these charts do not illustrate completely the tax and accounting treatment typically utilised by TK investors. TK investors can consolidate their taxable income/loss at the lessor level together with their other, general taxable income but such consolidation is capped at their actual investment amount in the equity portion of the financed value of the aircraft. As mentioned, given TK investors would typically invest 20–30% of the aircraft financed value, this cap would usually be consumed within a few years. Once such cap is consumed, all the taxable income/loss at the lessor level thereafter would not be consolidated – ie  it would be deemed a zero taxable income/loss. However, although such taxable income/loss would always be deemed zero, the income/loss would be recorded throughout this (later) period for accounting purposes and would be able to be set off against losses in the early years and profits in the later years. In the (typical) last year of the lease term, a purchase option may be exercised by the airline lessee and the equity portion of such purchase option price will be counted as taxable income of the lessor (and the TK investors). As such, the lessor (and in turn, the TK investors via the TK agreements) would have to pay a large amount of tax with respect to the financial year in which the purchase option is exercised. TK investors may absorb such a large taxable income by setting it off against losses incurred in their other businesses or, alternatively, they might seek another JOLCO through which to defer this taxable income. This latter option has resulted in a significant, recurrent pool of investors tapping into the JOLCO market. In order to enable the lessor and the TK investors to claim depreciation allowances on the aircraft, the terms and conditions of the lease and related agreements must comply with relevant tax laws and regulations established by the National Tax Agency of Japan (the ‘NTA’). The core requirement is that the lease must not be a ‘finance lease’; ie that it must be an ‘operating lease’. In order to be characterised as an ‘operating lease’, the lease must be a ‘non-full pay-out’ lease. As a general (but not exclusive) rule, if the aggregate amount of the lease rentals exceeds ‘approximately 90%’ of the purchase price and associated costs of the aircraft, the lease would be treated as a ‘finance lease’, which would, in turn be treated as a ‘sale’ from the lessor to the lessee (a consequence of which is that the lessor could not claim any depreciation allowances with respect to the aircraft). In a JOLCO transaction, the aggregate amount of the lease rentals and the purchase option price, if paid, should be sufficient to cover the purchase price and associated costs of the aircraft in full. However, as the purchase option price is not payable until and unless the lessee exercises the purchase option at the relevant window date, the purchase option price is not included in determining whether it is a ‘non-full pay-out’ lease.

Bankruptcy remoteness 14.77 The special purpose vehicle created to acquire and lease the aircraft as a TK lessor is usually wholly and directly owned by a creditworthy Japanese leasing company (ie the lessor parent). There have been only a very limited number of precedents in which the lessor parent became insolvent. Under Japanese insolvency law, even if the lessor parent is subject to insolvency proceedings, the assets of the lessor would not automatically be considered as forming part of the lessor parent’s insolvency estate. A separate petition for insolvency based on an insolvency event of the lessor must be filed with respect to the lessor in order to subject the assets of the lessor to insolvency 252

Japan 14.79 proceedings. In other words, Japanese insolvency law would not generally recognise the concept of consolidation, subject to the next paragraph. In narrow circumstances, a Japanese court might recognise the doctrine of ‘piercing the corporate veil’ in order to consolidate the assets of a company with those of its parent. This doctrine is most typically applied in situations involving fraud where the existence of the company is abused for the unlawful or unjustifiable purposes of the shareholder. Therefore, it is important that the corporate distinction between the lessor and the lessor parent be maintained throughout the transaction in order to minimise the risk of the application of this doctrine. In a decision of the Tokyo District Court made on 28  March 1995, in a case concerning a JLL involving a TK investor and a lessor parent (which was an affiliate of a Japanese financial institution), the court refused to ‘look through’ the distinct corporate nature of the lessor to the lessor parent. In this case there were no insolvent parties – the TK investors were seeking recovery of their investment from the financial institution on the basis that the TK agreement was invalid due to fraud. It appears that a factor in this decision was that the lessor had been established for the purpose of the JLL transaction as a means of extracting profit and loss for the benefit of the transaction parties, including the TK investors. This decision demonstrates that the Japanese courts understand the nature of the JLL structure and the role of the lessor and gives a positive indication that the distinct legal personality of the lessor in JOLCO transactions would not be disregarded lightly. In addition to the case referred to above, it is worth noting that the trustee of various prominent leasing companies (such as Japan Leasing Corporation, Crown Leasing Corporation and LTCB International Leasing Co Ltd) did not seek to consolidate the assets of the numerous lessor entities established by them for the purposes of JLL transactions when managing the bankruptcy insolvency proceedings of such lessor parents. In each case, the trustee or relevant insolvency official did not collapse the structure of the JLL; the lessor company (acting as lessor) was recognised as a separate legal entity from the leasing company parent (acting as lessor parent) and there was no attempt to seize the assets of the lessor company (acting as lessor) itself – instead the lessor company (acting as lessor) was sold ‘intact’ to a third party.

Equity regulation 14.78 The underwriting and solicitation of TK interests are regulated under Japanese securities law and, as a result: (1) the equity arranger must be licensed as a type-II financial instruments business operator under the Financial Instruments and Exchange Act of Japan (Act No 25 of 1948, as amended); (2) the equity arranger must have paid-in capital of JPY50 million or more; and (3) the lessor must be a limited liability company (kabushiki kaisha) wholly owned by such equity arranger (and, consequently, the lessor cannot be a fully bankruptcy-remote entity as it cannot be owned by an orphan entity).

JOLs 14.79 Japanese TK investors may also make equity investments in operating lease structures without a purchase option (ie  a Japanese operating lease or 253

14.80  Regional Markets ‘JOL’), which gives them access to a much wider airline market than JOLCO lessees. The equity investment structure of a JOL is the same as that of a JOLCO and hence investors can enjoy similar tax benefits. As the lease is structured as a pure operating lease with the expectation of a return of the aircraft, the lessor will naturally be exposed to a residual value risk of the aircraft. This asset risk is mitigated by JOL equity arrangers increasingly having access to inhouse remarketing and aircraft technical management teams, often acquired by corporate takeovers of third-party specialist firms. In recent years, the market has seen a large number of ‘single investor JOLs’ whereby one single investor contributes the whole of the equity portion of the financed value of the aircraft by itself. This single investor JOL structure is attractive to those investors seeking a larger depreciation benefit or, alternatively, an inheritance tax efficient structure requiring a materially significant diversification of investment assets.

Tax tensions 14.80 As a general observation, the NTA has never endorsed any such tax deferral arrangement by such TK investors. Rather, the history of JOLCOs (and JLLs before that) has been a history of battles between the NTA and the Japan Leasing Association. To restrict or prohibit TK investors from deferring tax payments, the NTA has repeatedly tried to amend tax laws and regulations. However, given this structure is designed principally based on depreciation allowances calculated using the declining balance (or fixed rate) method, the NTA would have to restrict or prohibit the declining balance method for depreciation in general (ie with respect to all asset types as well as aircraft). This would adversely affect the accounts of corporations generally. Alternatively, the NTA could try to restrict the lessor from ‘passing’ its profits and losses to the TK investors. However, TK agreements have been widely used to avoid double taxation in various structured finance products (for example, real estate transactions) as well as in JOLCOs and thus it would not be easy for the NTA to change the regime given it would materially adversely affect various structured finance products in Japan. In this context, one notable tax reform was enacted in 2019, resulting in socalled ‘earnings stripping rules’. Where the JOLCO loan is provided by a nonJapanese lender, including a ‘treaty lender’ utilising a double taxation treaty, the new rules provide that the lessor may only recognise interest payments on the loan as a loss (ie the interest deduction rule) up to a cap of 20% of the EBITDA of the lessor on an annual basis. This may negatively impact the equity investor’s expected leveraged lease economics. While there have also been Japanese regulatory issues where a non-Japanese licensed lender lends to Japanese lessors in JOLCO transactions, based on these new rules, equity arrangers may well require loans generally to be booked with non-treaty lenders (with sometimes a small slice of treaty lender debt permitted).

Japanese airline insolvencies 14.81 Although airline insolvencies are uncommon in Japan, the few recent examples have been significant in establishing precedents for orderly procedures for restructuring. In particular, the insolvency proceedings for JAL and Skymark Airlines are detailed in the following paragraphs due to the market significance of these cases. 254

Japan 14.82

JAL corporate reorganisation 14.82 JAL’s case was the first case in Japan where a commercial airline operating internationally went into court-supervised insolvency proceedings. In fact, the JAL case was unprecedented, involving discussions at a political level given JAL’s status as the national flag carrier. Japan Airlines Corporation (currently known as Japan Airlines Co Ltd) and two subsidiaries (collectively, ‘JAL’ in this section) had been considering their options for a corporate turnaround throughout 2009. On 19 January 2010, at the Tokyo District Court, JAL applied for the commencement of corporate reorganisation proceedings pursuant to the Corporate Reorganisation Act of Japan (Act No 154 of 2002, as amended) and obtained the court’s decision for commencement on the same day. At the same time, JAL obtained a decision for support (including potential capital injection and debtor in possession (DIP) financing) from the Enterprise Turnaround Initiative Corporation of Japan (ETIC), an entity jointly established by the government and private enterprise to assist the turnaround of corporate businesses. ETIC was, in fact, appointed as a trustee (kanzainin) of the reorganisation proceedings together with a lawyer. JAL’s turnaround had originally been led by the JAL Rehabilitation Task Force, a private advisory body directly appointed and constituted by the Minister of Land, Infrastructure, Transport and Tourism (MLITT). Following opposition from major financial creditors to the restructuring promoted by the Task Force, JAL commenced turnaround ADR proceedings (ie  a private, non-judicial restructuring arrangement). Finally, a decision was made by JAL to pursue a pre-packaged restructuring through reorganisation proceedings with support from ETIC. JAL’s reorganisation proceedings saw the court make some perhaps unusual (for the Japanese market) approaches to its restructuring, one of which was to allow the continuing payment of trade receivables (including lease payments) even though JAL was subject to judicial proceedings. Although all creditors (ie  not only financial creditors but also trade creditors) would be subject to the proceedings in normal cases, in JAL’s case, the court gave rare permission for the payment of trade receivables and lease payments to continue under the exception provided by law where ‘unless the small amount of the reorganisation receivables is paid at an earlier date, the continuance of the reorganising company would be materially impaired’. In JAL’s case, the court decided that trade receivables up to a few billion Japanese Yen (or equivalent) fell within this meaning of ‘small amount’. Although there is some room for discussion as to this interpretation of ‘small amount’, it may be the case that the court issued this exceptional decision because JAL was engaged in public transportation services and it believed the government comprehensively stood behind JAL’s immediate financing requirements. It is unclear whether a court would issue a similar permission to pay such large amounts of trade receivables in future cases. As there was a doubt about the scope of such court approval for making payments, the trustee then decided to convert those trade claims and lease payments into ‘preferential claims’ (kyoeki saiken) by agreeing settlement agreements with those creditors as preferential claims which could be paid from time to time outside the reorganisation proceedings and with priority over any other reorganisation claims. The corporate reorganisation law grants a power to the trustee to convert any particular reorganisation claim into a preferential 255

14.82  Regional Markets claim based on the rationale that the payment was vital to maintain JAL’s business and corporate value, subject to court approval. Hence, all JAL’s aircraft leases including any operating leases, finance leases and JOLCO leases (except for the relatively small number of leases which were amicably terminated or abandoned due to the overall reduction in the size of JAL’s fleet) were continued and payments were preserved and prioritised outside of the proceedings. On 30  November 2010, the Tokyo District Court issued its approval of the corporate reorganisation plan of JAL which was adopted by a written vote of JAL’s creditors. The plan included, among other things, redundancies of more than 16,000 employees; loan forgiveness of more than JPY520 billion; ETIC’s capital injection of JPY350 billion; the cutting down of routes and fleet; and the continuation of the Oneworld alliance. In particular, under the reorganisation plan approved by the court, both secured reorganisation claims (kosei tanpoken) and unsecured reorganisation claims (kosei saiken) were scheduled to be repaid in annual instalments over seven years after 87.5% of the unsecured reorganisation claims were discharged (ie the repayment rate was 12.5%). JAL’s reorganisation proceedings were unique because: (1) these were the first ‘pre-packaged’ reorganisation proceedings, and the contents of the reorganisation plan was determined mainly by discussions among the main creditors and the trustee, which discussions have been continuing since the commencement of the original turnaround ADR proceedings; and (2) although it used to be believed that corporate reorganisation proceedings were quite rigid, the court displayed some apparent flexibility in JAL’s reorganisation proceedings. In particular, the court’s permission to allow JAL to pay trade claims outside the reorganisation plan was unusual, because it had been understood that such permission would be given only to the payment of small debts. On 28  March 2011, JAL successfully exited its corporate reorganisation proceedings following the approval of the Tokyo District Court and the refinancing by major banks and new capital injections by eight companies, which funds were used to make the approved payments towards all secured and unsecured reorganisation claims. JAL was relisted on 19 September 2012 and ETIC sold all of its shares in JAL. On 10 August 2012, just prior to JAL’s relisting, the Civil Aviation Bureau (JCAB) of MLITT published a so-called ‘8.10 paper’ (the ‘8.10 Paper’) restricting JAL from investing in new businesses and opening new routes during the mid-term plan period for the JAL group from FY2012 to FY2016, which ended at the end of March 2017. The 8.10 Paper’s rationale was that, as JAL was rescued with government support and given JAL’s central role in Japan’s aviation traffic network, JCAB would have to supervise and monitor the management of JAL to ensure that JAL would not prejudice the competitive environment between Japanese airlines by taking any market distorting benefit from the reorganisation. While the 8.10 Paper was not legally binding, JCAB’s supervision did result in some negative impact on JAL’s business, in particular, in respect of the allocation of slots at Haneda Airport. At the time of writing, it remains an open question as to whether the government should exercise or refrain from exercising its discretion to alter the market competitiveness of a private company, even after such company exits from court-supervised reorganisation proceedings. 256

Japan 14.83

Skymark civil rehabilitation 14.83 On 28  January 2015, Skymark Airlines Inc (Skymark) filed for civil rehabilitation proceedings with the Tokyo District Court pursuant to the Civil Rehabilitation Act of Japan (Act No 225 of 1999, as amended) and immediately after that, the court delivered a supervision order and a prohibition of payment order. On 4 February 2015, the court delivered an order for the commencement of civil rehabilitation proceedings. Upon commencement of the proceedings, any payments subsequently made by Skymark were subject to approval by the supervisor appointed by the court. Skymark was, at the time, the third largest airline in Japan, operating 27 Boeing 737 aircraft and five Airbus A330 aircraft, all of which aircraft were leased from operating lessors. No aircraft were held by Skymark on its own account. Skymark had also ordered Airbus A380s, the delivery of which was not completed as a result of the filing. No bank debt was drawn upon at the time of the filing. As an operating lease falls within the category of ‘bilateral executory contracts’ (soumu keiyaku), the debtor or its trustee (if appointed) has the option to terminate or perform any contract to the extent that both parties to the contract still have outstanding obligations, which have not been performed thereunder. Consequently, a lessor does not have any statutory right to terminate a lease and any contractual right of the lessor to terminate the leasing of the aircraft thereunder triggered by the application for civil rehabilitation proceedings is generally considered void. Although no period of time was specified during which Skymark needed to determine whether to terminate or continue the leases, lessors were able to request a reasonable period by which Skymark would make this determination. If there was no response from Skymark within such requested reasonable period, Skymark’s right of termination would be deemed to have been waived. In the end, Skymark decided on a fleet of only Boeing 737 aircraft, which required the leasing of all the Airbus A330 aircraft to be terminated. Where a lessee elects to continue a lease agreement (or the right of termination of the lease is deemed to have been waived, as mentioned above), the original lease terms remain in place; however, it is likely that a lessee would seek to amend commercial terms in its favour in exchange for continuing the leasing of the aircraft. This was no different in these proceedings. Once the restructuring of the relevant lease was agreed between Skymark and each of its lessors, Skymark elected to continue the lease (or the right of termination of the lease was deemed to have been waived, as mentioned above) and the relevant rent claim was regarded as a ‘preferential claim’ (kyoeki saiken) which was to be paid outside the civil rehabilitation proceedings. Skymark elected to terminate the leases of its Airbus aircraft. In the case of a termination, the relevant lessor was required to submit a claim for damages incurred by the lessor with respect to such termination as a rehabilitation claim (saisei saiken) which would only be paid pursuant to the relevant rehabilitation plan. While almost all of the leases in respect of the Boeing 737 aircraft were agreed and continued and lease rents were paid outside of the rehabilitation plan, four creditors in respect of the Airbus aircraft had to submit proof of claims. Among other creditors, including MROs, airports and travel agencies, four large 257

14.84  Regional Markets creditors effectively dominated the vast majority of Skymark’s rehabilitation claims. Skymark, with the support from its sponsors – ie Integral, ANA and a fund organised by DBJ and SMBC – submitted one rehabilitation plan but, at the same time, another large creditor – Intrepid – submitted another plan, with support from Delta. The two plans were voted on by creditors and Skymark’s plan was selected at the creditors’ meeting. Under such plan, sponsors injected new capital into Skymark, and Integral became a 50.1% shareholder and ANA became a 16.5% shareholder of Skymark. The unsecured rehabilitation claims were paid after an approximate 90% hair-cut. The plan was approved by the court on 5  August 2015 and became final on 1  September 2015. Skymark officially exited its civil rehabilitation proceedings on 28 March 2016.

Titleholder structure 14.84 Because of Japanese nationality requirements under the Civil Aeronautics Act of Japan (Act No 231 of 1952, as amended) (Civil Aeronautics Act), which apply to legal owners of Japanese operated aircraft, a cross-border structure has been developed in Japan to allow an aircraft to be registered in Japan by a Japanese legal title owner while the economic ownership of the aircraft remains with a foreign entity. Registration of an aircraft is prohibited if the aircraft is registered in, and therefore has the nationality of, a foreign country. Such foreign registered aircraft may not be operated domestically within Japan unless prior approval is obtained from the MLITT. Furthermore, an aircraft owned by any of the following cannot be registered in Japan, ie cannot obtain Japanese nationality: (1) a person who does not have Japanese nationality; (2) a foreign government, a foreign public body or any other similar association; (3) a legal person or any other association established under the laws of a foreign country; or (4) a legal person whose representative falls within one of the above or of which one third or more of the directors are, or the voting power is held by, a person who falls within one of the above. In summary, if an owner is a corporate entity (ie legal person), only a company established under Japanese law whose representative is or of which more than two thirds of the directors are, and in which more than two thirds of the shareholders are, Japanese persons or Japanese legal persons, is entitled to register the ownership in the aircraft register maintained by the JCAB (the ‘Aircraft Register’). There are no exceptions to these nationality requirements. Due to these nationality requirements, a structure has been developed in Japan to allow an aircraft to be registered in Japan with the ownership to such aircraft vested in a Japanese entity while the ‘economic’ ownership thereof remains with a foreign entity. The aircraft is sold by a foreign entity (the ‘Foreign Owner’) to a Japanese special purpose company (the ‘Titleholder’) more than two thirds of 258

Japan 14.85 whose shares are owned by a Japanese entity (the ‘Titleholder Parent’) (which is usually a Japanese trading company or a leasing company). This satisfies the nationality and corporate structure requirements of the Civil Aeronautics Act. The aircraft is registered in the name of the Titleholder as owner. All the rights relating to the aircraft except the ownership are transferred back to the Foreign Owner pursuant to a ‘conditional sale’ arrangement, pursuant to which: (a) the Titleholder sells the aircraft back to the Foreign Owner but retains the ownership and receives an amount equal to the purchase price minus a stated nominal sum; and (b) the Titleholder is required to transfer the ownership to the Foreign Owner upon the Foreign Owner’s exercise of its right to acquire the ownership upon the payment of the balance of the purchase price in the amount of the stated nominal sum (the ‘Conditional Sale Agreement’). The Titleholder may grant a first priority mortgage (or, in a financing, a second priority mortgage if a first priority mortgage is granted in favour of the lenders) in favour of the Foreign Owner to secure that obligation. The Titleholder Parent may grant additional security, such as a Titleholder Parent guarantee (or a letter of undertaking) and a pledge of the shares or units of the Titleholder, to secure the same obligation. Pursuant to the Conditional Sale Agreement, the Foreign Owner is entitled to lease the aircraft and the aircraft is then leased (either directly or indirectly) by the Foreign Owner to a Japanese airline as lessee. This is a typical structure developed in Japan in order to comply with the nationality requirements. Please see Exhibit 14.8 for illustration. EXHIBIT 14.8 OPERATING LEASE WITHOUT FINANCING

Source: Clifford Chance

Japanese aviation market and legal issues Aircraft mortgage 14.85 As a civil law country, Japan recognises a ‘hypothec’ (teitou ken), which enables the security grantor to continue to use the secured asset until enforcement by the security holder. The security interest in the form of a hypothec under Japanese law is similar to a mortgage under English law, and a Japanese law hypothec is customarily referred to as a mortgage. Therefore, reference will be made to a Japanese law hypothec as mortgage and the holder of such mortgage as the mortgagee. 259

14.86  Regional Markets The mortgage is a security interest that can be granted and perfected without the need to deliver possession of the collateral to the mortgagee and which confers upon the mortgagee the right to receive payment prior to other unsecured creditors from the proceeds of the collateral. The mortgage may be used to create a security interest in real property (land and buildings) or certain types of registrable tangible movables, such as aircraft. Mortgages over aircraft are governed by the Civil Code of Japan (Act No 89 of 1896, as amended) and the Aircraft Mortgage Act of Japan (Act No 66 of 1953, as amended). A mortgage over an aircraft will not be perfected until the mortgage is registered in the Aircraft Register. The order of priority of registered mortgages on the same aircraft will be determined according to the chronological order of the filing of their registration in the Aircraft Register. Because the cost of full mortgage registration (hon toroku) is prohibitive (ie 0.3% of the amount of the secured debts under the mortgage), mortgagees usually provisionally register their mortgage in the Aircraft Register (for a nominal fee of JPY2,000) (kari toroku), and apply for full registration (hon toroku) if the mortgage becomes enforceable. Such provisional registration keeps the priority in perfection of the mortgage at the date and time filed but will not be sufficient protection against any other fully registered mortgage until it is itself transformed into a fully registered mortgage (hon toroku). Upon being converted into a fully registered mortgage, priority will be given based upon the chronological order of the filing of the provisional registration. At the time of writing, Japan has not ratified the Convention on International Interests in Mobile Equipment or the Protocol thereto on Matters specific to Aircraft Equipment (the ‘Cape Town Convention’).

Security trustee and parallel debt 14.86 In secured lending transactions not involving Japanese elements, an institution appointed as security trustee typically holds all security interests granted by the borrower on trust for the lenders as beneficiaries. This device facilitates loan syndication as the beneficiaries to a trust may change (ie upon any loan transfer) without affecting the trust estate (ie the security package held by the security trustee). However, under Japanese law, as it is not possible to separate the security from the underlying secured obligations (ie  a security holder has to be a creditor), no bank is allowed to hold security on trust for the benefit of other lenders (ie it cannot act as security trustee) unless it is duly licensed as a trustee in Japan. Almost all non-Japan based banks are not licensed as a trustee in Japan. If any security requires registration of a security holder for perfection or otherwise, all the lenders need to be registered and such registration needs to be changed upon every loan transfer. As a Japanese mortgage over an aircraft needs to be registered with the Aircraft Register for perfection, the requirements for perfection of the interests of new lenders as mortgagees can be time-consuming and costly. In order to avoid this, a parallel debt structure is often used. A  parallel debt structure establishes obligations owed to one of the financing parties (usually the same party acting as a security trustee/agent), acting as a principal and not as a trustee/agent, that are co-extensive with and parallel to the loan owed to the lenders. Because this parallel debt will never be transferred even if a loan is transferred and remain as a secured obligation, the parallel debt holder may remain as the security holder irrespective of any loan transfer. 260

Japan 14.87 A parallel debt structure, however, has never been tested by the Japanese courts, whether governed by Japanese or non-Japanese law. Despite this uncertainty, this arrangement is efficient if lenders expect any future syndication and therefore the cross-border secured lending market generally accepts this solution. To minimise this uncertainty, the parallel debt structure would typically be governed by a non-Japanese law under which it is believed to be enforceable. The validity of the relevant Japanese security would, then, be based upon the validity of the parallel debt structure under the relevant governing law.

Aviation insurance 14.87 It is market practice that all Japanese airlines arrange insurances with local creditworthy Japanese insurers. Such Japanese insurers undertake the risks of the insured (ie the Japanese airline) and cede 100% of such risks to the Japan Aviation Insurance Pool (JAIP), members of which include all the major nonlife insurance companies in Japan and which provides insurance coverage to the Japanese aviation industry. JAIP allocates the risks ceded from Japanese insurers among JAIP members in accordance with predetermined shares (which are not disclosed). JAIP determines the portion of the risks to be retained by each of its members and reinsures the remaining portion in the international markets through reinsurance brokers.

261

15 Islamic Finance William Coleman

INTRODUCTION 15.1 Whilst the use of Islamic finance solutions in global aviation transactions remains a comparatively specialist product, concentrated in traditionally Islamic regions, the last decade has seen a constant demand from an ever-growing roster of airlines, lessors and other industry participants for access to compliant products that afford them the same range of financing solutions as are available by conventional means. That demand has driven significant innovation, which will only continue as existing conventional products get repurposed and adapted to work within an Islamic compliant framework. It is also important to remember that transactions structured in this manner do not preclude the participation of conventional parties – that is, an Islamic finance product need not only apply as between parties who desire to conduct business in this way for religious reasons. It follows that the use of Islamic finance structures can potentially broaden any investor or lender base. In a similar vein, as (traditionally conventional) borrowers seek liquidity, Islamic institutions can represent an untapped source of funding, particularly in the aviation space where – as discussed below – aircraft constitute an ideal asset class. The purpose of this chapter is not to describe this innovation or future trends. Instead, it is intended to provide a short summary on the topic so as to assist practitioners understand some of the principles behind Sharia’h-compliant aircraft financing and leasing structures. Whilst many practitioners will be familiar with some of the basic tenets of Islamic law (known as the Sharia’h) – such as the prohibition on the charging of interest – any discussion on Islamic finance is incomplete without an initial introduction to the relevant sources, schools and fundamentals tenets.

SHARIA’H FUNDAMENTALS Sources and schools 15.2 The Sharia’h extends far beyond questions of worship and spiritual matters and delves deep into the social, political and economic order. The primary sources of the Sharia’h are constituted by the Qur’an scripture, the Sunna (practices and writings of the Prophet Muhammad) and the Hadith (accounts of the Prophet Muhammad’s deeds). The challenges of applying these primary sources to modem economic circumstances has resulted in the development of additional methodologies based on scholarly consensus (ijma) and analogical reasoning (qiyas) with which it 263

15.3  Islamic Finance is possible to deduce and extract ever more granular interpretation. Accordingly, different schools of Islamic jurisprudence (or madhabs – individually associated with a particular founding jurist and geographical region) have developed over the centuries, each of which has developed to a greater or lesser degree different conclusions on points of interpretation. This divergence of approach leads to the perfectly legitimate outcome where varying points of view on a specific topic are equally valid, and explains the reason why some jurisdictions are more pragmatic and flexible than others when applying analogical reasoning to new Sharia’h-compliant products. On the other hand, some commentators have observed that it may encourage institutions seeking a fatwa (essentially, an official certification issued by a Sharia’h board certifying that a given structure is Sharia’h-compliant) for a proposed structure to select and approach Sharia’h boards on a ‘forum shopping’ basis, rather than with a view to upholding specific, faith-based convictions. These inherent tensions have only been exacerbated by the need for Islamic institutions to operate and compete in a largely secular global financial environment without the benefit of access to some of the risk mitigation strategies available to their secular counterparts (for example, Islamic financial institutions do not have access to the same platform of repo and derivative liquidity management products that conventional financial institutions customarily enjoy). This in turn begs the question whether Islamic finance should be applied so as to merely replicate (to the maximum extent possible) conventional financing economics, or whether it should represent a new departure for contemporary financing arrangements. Either way, the key point is that there is no homogenous, codified rule book. The Sharia’h remains a principles-based guidance system that is capable of, and requires, active interpretation so as to arrive at what are often bespoke and local solutions.

Themes 15.3 Before turning to a summary of the key Sharia’h asset financing structures, it is helpful to understand some of the fundamental themes that distinguish Islamic finance from conventional (that is, interest bearing) financing. These themes, together with developed (essentially canonical) Sharia’h contracts, constitute the ‘tool kit’ that practitioners need to be equipped with in order to develop, and understand, Sharia’h-compliant structures. Sharia’h-compliant financing typically involves a process whereby these various components are assembled in assorted combinations in order to generate a required commercial arrangement which can often closely synthesise a conventional financing (even if there are significant differences in the documentation structure and from a legal and risk perspective). First and foremost, Islamic financing is an asset­ backed, risk-sharing entrepreneurial system based primarily on equity rather than debt that seeks to ensure parties transact in a fair, just and equitable manner. This largely explains the prohibition on riba or interest. Sharia’h does not (at least, to the same extent as in conventional finance) recognise the time value of money or that money can itself be the subject matter of trade or commercial activity – that is, in the way a conventional loan is. Rather, money is merely an instrument of exchange with no intrinsic value. It follows that profit should only be generated when an underlying asset with intrinsic value and utility is bought and sold, or as result of a profitable business activity. In the same vein, the charging and receipt of 264

Governing law versus the Sharia’h 15.5 interest (that is, any positive, predetermined rate of return payable regardless of performance) is unconditionally prohibited under Sharia’h. Interest does not need to be usurious in order to be held to be riba: any and all interest is riba. Other key moral prohibitions include gharar (essentially, excessive uncertainty) and maisir (speculation, gambling or betting where reward or wealth is generated by chance rather than productive effort). As the descriptions suggest, Gharar and maisir share certain features and some scholars would view gharar as the broader generic concept where the uncertainty is incidental to the contractual subject matter (as opposed to its sole purpose – that would be maisir). But collectively they explain the difficulties that Islamic finance has with, for example, conventional derivative transactions (including options and futures) and conventional insurance. Of the two concepts gharar is therefore perhaps the more difficult since virtually all commercial transactions have an element of uncertainty, hence the emphasis on excessive uncertainty at which juncture the threshold of tolerable risk is breached, and the transaction rendered gharar – particularly where that risk is not shared between the parties. A good example of what is generally thought of as permissible uncertainty is that of purchasing shares, the value of which by definition will rise and fall. Certain activities are also haram (constituting forbidden or unethical activities) such as direct or indirect association with adult entertainment, alcohol, tobacco and pork. For example, this is one reason why some Islamic institutions may have difficulties funding assets such as aircraft where their operation could involve the on-board sale and consumption of alcohol. But otherwise, the assumption is that unless prohibited, parties are free to contract as they see fit.

Sharia’h contracts 15.4 Turning to the basic forms of financing techniques recognised under Sharia’h (that is, the canonical contracts referenced above), it is possible to broadly categorise these into the following types: (1) asset-based leasing arrangements: where rental income is payable by the lessee in return for the sale or transfer by the owner to the lessee of the right of use of an asset. Common forms include the ijarah (operating lease) and ijarah wa iqtina (finance lease); (2) equity-based profit and loss sharing arrangements: where financiers (as investors) and borrowers (as co-investor and/or manager) engage in a joint venture or partnership arrangement where profits and losses are shared between the parties in specified proportions. Common forms include mudaraba and musharaka; and (3) debt-based sale arrangements: where indebtedness is generated by the purchase (at cost) and resale (at cost plus profit margin) of an asset by the financiers. Common forms include murabaha, tawarruq, istisna’a, salam, musawama and bai bithaman ajil.

GOVERNING LAW VERSUS THE SHARIA’H 15.5 It is important to remember that the Sharia’h is not capable, as a matter of English law, of constituting a valid choice of law or otherwise qualifying an 265

15.6  Islamic Finance express choice of law. It follows that when adjudicating a matter arising under transaction documentation which is expressed to be governed by English law, the English courts will apply principles of English contract law without enquiry as to whether that same transaction was in fact Sharia’h-compliant. A contractual reference to the application of Sharia’h will be construed as an indication that one or more parties intended to contract in a manner that is in accordance with Sharia’h principles – which it may or may not be – and no further. However, when examining whether a transaction was intra or ultra vires a given contractual counterparty, an English court is bound to consider questions surrounding that counterparty’s legal capacity by reference to the applicable laws of its place of incorporation. At that juncture, issues of the Sharia’h could apply. The best practice to avoid any complications includes: (1) ensuring that any choice of governing law is expressed to be governed by, for example, English law with no reference to application of the Sharia’h; (2) verifying whether the objects of such counterparty expressly consider a requirement for transactions to be Sharia’h-compliant, in which case legal capacity and therefore enforceability is (potentially) contingent on such compliance; (3) obtaining appropriate representations and warranties that the parties are agreed the transaction is indeed Sharia’h-compliant; (4) including an express waiver of defence as to non-compliance with the Sharia’h (that is, establishing an argument of estoppel under English law); and (5) ensuring that each party obtain independent Sharia’h advice and its own fatwa.

STRUCTURES 15.6 A  typical Sharia’h-compliant aircraft financing structure may incorporate many of the features that would customarily apply to a conventional financing (including, for example, the use of a special purpose vehicle (SPV) as owner/borrower; tiered lease arrangements through intermediate lessors; and security arrangements including mortgages, security assignments, account charges and share pledges). Furthermore, it is quite common to see the SPV acquire the relevant asset using funds borrowed pursuant to a conventional facility – whilst this structure can depend on how strict parties are being in relation to Sharia’h compliance, this does not necessarily preclude that same entity subsequently entering into a Sharia’h­compliant ijarah lease structure. Equally, it is not unusual to see the ijarah lease structured alongside a variety of Sharia’h­compliant financing arrangements whilst incorporating many of the above characteristics. For example, as shown below: (1) In a mudarabah structure, the investors or financiers may advance moneys to a SPV acting as rab-al-mal (effectively, an investor acting as agent for the institutions) who, in turn, pursuant to a mudarabah agreement, ‘invests’ that capital with another SPV acting as owner/lessor and otherwise known as a mudarib (effectively the mudarabah manager). Using the investment capital, the mudarib then acquires the aircraft from the manufacturer before leasing it to the operator pursuant to an ijarah. The rental income under the ijarah supports a de minimis profit distribution (expressed as a 266

ljarah and ijarah wa iqtina 15.7 percentage) to the mudarib for its efforts as manager, with the remainder profit paid to the rab-al-mal who in turn distributes such monies to the investors/financiers. (2) In a diminishing musharaka structure, the approach broadly mirrors that described above with respect to a mudarabah save that in this instance the manager itself also contributes capital, and the aircraft is (in effect) held on a joint basis as between the investors or financiers on the one hand and the manager on the other hand, in proportion to their respective capital contributions. During the course of the ijarah to the airline, the rental payments are applied as a series of individual purchases of the investors’ or financiers’ share in the asset which over time is reduced to zero. (3) In a sukuk structure (effectively a tradable Islamic instrument that represents an undivided, beneficial interest in an underlying asset and the associated cash flows), the proceeds of the sukuk issuance would be used by the special purpose issuer vehicle to fund the purchase of the aircraft (or aircraft portfolio). Rental payments under ijarah between the issuer and the airline are applied to service the sukuk certificates. Sukuk are broadly comparable to a conventional bond. Whilst each of these financing structures will have their respective Sharia’h elements, the common denominator will typically be the operating or finance lease to the airline. The remainder of this chapter analyses the main differences between the Islamic ijarah and the conventional lease.

LJARAH AND IJARAH WA IQTINA 15.7 Much as in the conventional sphere, the ijarah (or operating lease) was originally contemplated as a simple commercial arrangement in its own right: an arrangement which enabled an asset to be made available by a lessor to a lessee (who, in return for the payment of rental, could employ that asset to generate income for his own account) without transfer of legal title. Over time, the vanilla operating lease arrangement developed its finance lease sibling. It did not require an enormous leap of imagination to realise that the economics of an operating lease were well suited to, and easily adaptable for, the purposes of creating a new mode of financing in so far as rental could be adapted to incorporate an element of financier return in addition to constituting regular amortisation of principal. From the Sharia’h perspective, the attractiveness of this approach and a key reason for its subsequently widespread adoption was that it represented yet another financing alternative to the (as described above, prohibited) conventional model of interest bearing indebtedness. Ijarah wa iqtina (or finance lease) has in turn developed into one of the most popular and widespread forms of Islamic financing contract today. The overall mechanics of an ijarah will be immediately familiar to practitioners versed in conventional leasing – the two are more alike than they are distinct. However, there are some key differences between the ijarah lease and a conventional lease: (1) Maintenance, repair and insurance: in contrast with most conventional leases, in an ijarah the responsibility for effecting major maintenance and insuring the leased asset remains that of the owner/lessor throughout. From a Sharia’h risk-sharing perspective, risks associated with ownership 267

15.7  Islamic Finance of the physical asset must attach to the owner. Conversely, the lessee assumes only those risks associated with use (or indeed misuse and negligence). From a practical perspective, the point is resolved in the following manner: whilst the owner will expressly agree to procure the maintenance and insurance of the aircraft, it will simultaneously (but customarily pursuant to a separate agreement) appoint the lessee as its service agent to effect maintenance and procure the required insurances on its behalf – and assume the risks associated therewith – in return for a service agent fee. Inevitably, the increased owner cost attributable to that fee is passed through to the lessee by way of increased or ‘supplemental’ rental. From a cash flow perspective, the service agent fee often matches the ijarah supplemental rental amount (both in timing and amount) and the two payment streams are netted off against each other. (2) Floating rental amounts: floating rental amounts are potentially void due to their inherent uncertainty (gharar). They have also attracted the disapproval of some scholars on the basis that incorporating a floating benchmark (such as LIBOR) over the life of a transaction is suspiciously akin to an interest-based financing. Conversely, other scholars have argued that the use of such benchmarks to generate non-uniform rental payments is not in itself un-Islamic – they are simply external, mutually agreed upon benchmarks (which, whilst variable, are in and of themselves certain concepts) that do not alter the fundamental nature of the payment as constituting an amount paid in return for rights of use of an asset where, importantly, the lessor retains ownership risk as described above. This is arguably far removed from an interest-based payment arrangement. Accordingly, it is not unusual to see ijarah that incorporate a floating rental amount based on a conventional benchmark. But other approaches can be adopted in lieu of, and/or combined with, a pure floating rental to achieve incremental comfort from a Sharia’h perspective on the point. For example: –

a ‘floating’ rental payment can be recharacterised as a series of regular fixed rental periods (or terms) where each period is subject to a fresh (and fixed) rental calculation based on the relevant benchmark at such time; and

–

an ‘assumed’ base (that is, fixed) rental return is subject to a mechanic whereby the profit portion can be increased or discounted based on a formula that tracks the difference between the initial assumed base rate and the applicable floating rate.

Finally, it should be noted that a fixed rate lease, even where the rate is expressed to be calculated by reference to a specific but variable benchmark, does not typically present any Sharia’h issues. (3) Default interest: default interest in the conventional sense is highly unIslamic. Equally, a penalty or charge levied for late payment (even, according to some scholars, where such payment represents the actual loss or costs sustained by the lessor) may be held to constitute riba. Notwithstanding, it is common to see late payment fees in Islamic documentation – a default or late payment fee applied in this manner serves the entirely legitimate and permissible objective of incentivising the counterparty to perform in a timely manner. However, if necessary, it is possible to generate a similar economic outcome by other means: for example, the application of a discount for each day that a payment is made prior to a stipulated 268

ljarah and ijarah wa iqtina 15.7 longstop date will result in a de facto incremental rental payment for each day payment is delayed after its due date. Otherwise, late payment charges (or the amounts above and beyond actual loss or costs sustained) can be rendered permissible if donated to a charity. (4) Purchase options in finance leases: including a lessee purchase option in the ijarah documentation may be considered by some scholars as potentially un-Islamic for a number of reasons. It may fall foul of the rule against interconditionality of contracts (that is, where an agreement to transfer title to the aircraft at lease expiry or otherwise is viewed as a pre-condition to the parties entering into the lease arrangement ab initio) and, as a general rule, forward contracts are prohibited other than in very limited circumstances. However, it is common for the lessor to grant to the lessee an undertaking (or unilateral promise) that it will sell or gift the aircraft to the lessee in specific circumstances, such as lease expiry and early prepayment. The lessee typically grants to the lessor a parallel undertaking to purchase the aircraft from the lessor in other specific circumstances (for example, following an event of default) – this is functionally equivalent to a lessor put option. Importantly, this lessee undertaking is viewed quite distinctly from an acceleration of rental payments – which is not permissible under the Sharia’h – even if the option can be priced so as to achieve the same economic outcome. The key components are: – that each party (as beneficiary) has the benefit of an undertaking, granted unilaterally and independently of any beneficiary obligations, which each may (or may not) elect to exercise, even if the economics render the election a de facto certainty; and – each respective unilateral undertaking is contained in separate documentation to the ijarah itself (meaning that an ijarah wa iqtina is in fact comprised of two distinct elements: an ijarah agreement and applicable unilateral undertakings, all documented separately). As emphasised earlier, there is no uniform approach to what constitutes a Sharia’h-compliant ijarah transaction. Different Sharia’h boards can (and do) adopt significantly different views on the same terms. It follows that whilst many Sharia’h-compliant aircraft financing transactions apply the techniques described above, there is an inherent tension between upholding Sharia’h principals on the one hand and reflecting the expected commercial risk allocation on the other. Indeed, this issue applies to many contemporary Islamic structures when designed and required to produce the same economic outcome as compared to their conventional equivalents. By way of example, a fundamental point of contrast between a conventional lease and an ijarah transaction concerns the approach taken to risks associated with ownership of the physical asset. Under the former, it is the lessee rather than the lessor who assumes practically all risks and obligations associated with the asset (as can be seen from the scope of the customary operational indemnity and ‘hell or high water’ provisions, to name but two examples). Under an ijarah, the roles are materially reversed as described above. On a related topic, there are scholars who take the position that actual lessee fault is a necessary ingredient for liability under an indemnity, as distinct from their use in a conventional context where indemnities are simply a means of allocating risk. Total loss provisions can also present a challenge from a Sharia’h perspective. Consistent with the expectation that the lessor/owner is required to assume the risks associated with the ownership of the leased asset, the traditional Sharia’h position is that the 269

15.7  Islamic Finance obligation to pay rent ceases on destruction of the leased asset. A corollary is that the lessor should also assume the risks associated with any delayed insurance payout. But these are some examples of what are largely theoretical fault lines. Ultimately, Sharia’h-compliant aircraft leasing and financing transactions are perfectly capable of achieving what non-Islamic counterparties would recognise as an essentially comparable product.

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16 Insurance Considerations Glen Brighton

INTRODUCTION 16.1 The aviation insurance industry is now well over 100 years old, but still relatively young compared to the marine insurance market. It is more than ever a global marketplace with insurers based on every continent, but still highly specialised. Lloyd’s of London and the London-based brokers are still considered the epicentre of the industry. Insurance policies are contracts of ‘uberrima fides’, that is, done in the ‘utmost good faith’. Because the insured knows information about the risk being insured, he or she must act in the utmost good faith in making disclosures to the insurer either directly or through a broker. This disclosure enables the insurer to assess the risk properly, to decide whether or not to accept it, and, if so, to determine at what premium and on what terms. This chapter will use the operating lease as a basic model since the majority of the risks and the insurance implications of the operating lease are common to most types of aircraft financing.

WHAT IS THE RISK? 16.2 There are two main insurable risks in any aircraft financing transaction: (1) asset risk (the aircraft, engines or other parts); and (2) liability from operating aircraft risk.

Asset risk 16.3 If the asset is actually or effectively lost or destroyed during the term of the lease, the lessee will be obliged to pay the ‘agreed value’ to the lessor to compensate the lessor for the loss of the aircraft. An aircraft is a high-value asset so this represents a significant credit risk and a lessor (and its financiers) will generally require that the lessee insures against the risk of loss by taking out aviation hull insurance. However, as discussed below, all parties must recognise that commercial insurance will not cover all causes of loss, so some asset risk will remain.

Liability risk 16.4 Under a conventional aircraft operating lease, there are three main sources of liability risk for a lessor/owner (and its financiers): 271

16.5  Insurance Considerations (1) aircraft third-party/passenger legal liability: the possibility that the lessor/owner and/or financier may be named in litigation relating to an operational loss of the aircraft; (2) general legal liability: liability arising out of claims not directly caused by an accident involving the aircraft (for example, arising out of airline ground or service operations). This type of liability is highly unlikely to affect a lessor/owner and/or a financier; (3) aircraft products liability: liability arising out of losses alleged to have been caused by a defect in a product distributed by the lessor/owner (that is, the aircraft or its parts). To date, there has been little experience of lessors/owners and/or financiers being successfully sued for any material amounts as a result of losses arising out of their aircraft portfolio activities. Further, the potential liability exposure for a lessor/owner and/or financier may vary depending on the jurisdiction and the structure of the transaction. However, in any aircraft financing transaction a lessor/owner and/or financier (particularly those who may be seen as having ‘deep pockets’) is exposed to the risk of becoming entangled in a claim, even though they may have no real role in the loss. As a result, it is important that any lessor/owner and/or financier understands the risks, including which risks can and cannot be covered by insurance.

INSURANCE-BASED RISK TRANSFER 16.5 As discussed above, insurance is one of the means whereby the parties can manage the asset and liability risks associated with aviation financing transactions.

Lessee insurances 16.6 For a lessor/owner and/or financier, there are four key issues in connection with any insurance policy taken out by the lessee. (1) Aircraft financing documentation will usually require that coverage be placed with insurers of ‘reputable standing in international aviation insurance’. This is a reasonable requirement from the perspective of the airline and insurer, as it should not be difficult to establish if any aviation insurer meets this standard at any particular time. It is common for an operating lease to contain a provision requiring that the insurer/reinsurance chosen by the lessee is acceptable to the lessor/owner and/or financier. (2) Substance of the insurance policy – the lessor/owner and/or financier will want to be satisfied that the policy is in line with other similar policies in the aviation market. The use of standardised clauses, such as the London aviation market clause AVN67B, has provided a level of harmonisation in the market and standardised how lessors/owners/financiers are included in the lessee’s insurance. (3) Quantum of the insurance coverage – the lessor/owner and/or financier will want to be satisfied that the level of insurance coverage is sufficiently high to cover the value of the aircraft and meet any potential liability claims. For the hull insurances, provided there is a rational justification for the sum required to be insured, there should not be any technical reason why 272

Airline insurance – detailed principles and practices  16.8 a lessee cannot insure the required amount. For liability insurances, it is necessary to consider the value of any potential claims (whether resulting from losses in the air or on the ground) in determining the appropriate level of cover. Particular attention should be paid to any high-risk jurisdiction into which the aircraft operates where losses may be more frequent or potential claim pay-outs are higher than average. (4) Monitoring – a lessor/owner and/or financier will require ongoing monitoring of the lessee insurances to ensure that the levels of insurance coverage agreed are maintained and insurance policies are renewed on each renewal date. An operating lease will typically contain covenants from the lessee regarding the maintenance of insurance and annual renewal. A lessor/owner and/or financier will also typically ask for a letter of undertaking from the relevant insurance broker in which the broker undertakes to notify the lessor/owner and/or financier if the insurances are not maintained or there are any significant changes of circumstance that may affect the policies.

Lessor insurances 16.7 Lessor insurance may be either ‘contingent’ or ‘possessed’ and can cover both the asset risk and the liability risk: • contingent insurances: insurances taken out by a lessor/owner in addition to the lessee insurances to ‘backstop’ the lessee insurances. For liability risks, such insurances can operate in excess of the lessee policy; • possessed insurances: insurances taken out by a lessor/owner where there are no lessee insurances (for example, when an aircraft has been repossessed by a lessor and that lessor wishes to operate the aircraft). In terms of liability risk such insurances must, at a minimum, comply with the applicable regulations or laws relating to insurances (for example, Regulation (EC) No 785/2004 on insurance requirements for air carriers and aircraft operators, 21 April 2004).

AIRLINE INSURANCE – DETAILED PRINCIPLES AND PRACTICES The insurance buying environment 16.8 Most airlines will arrange a fleet insurance programme via a broker. The hull insurance will be subject to a ‘maximum agreed value’, the upper limit that insurers will pay for any one aircraft. This will need to include some ‘head room’ over and above the highest-valued aircraft in the fleet to allow for the possibility of one or more third-party engines being fitted. For liability insurance, policy limits of US$1.5 billion any one occurrence are not unusual for international airlines operating wide body aircraft. No single insurer has the financial resources to retain risk of this magnitude or even a substantial proportion of such risk. Such insurances, therefore, have to be effected in one of two ways: (1) direct (co-insurance) placing: a series of insurers take a share of the risk from 10% or more for the lead underwriter down to much smaller shares. 273

16.9  Insurance Considerations In London, this process of placing the risk is accomplished by means of a placing slip prepared by the broker (the Slip). The risk is summarised on the Slip which the brokers show to the potential underwriters who will indicate their percentage participation and sign on. A  major airline risk will typically have 30 or more participants. The totality of available participants represents the ‘capacity’ for a particular risk or class of risks; (2) reinsurance participation: insurances are placed with a single insurer with the risk being spread by way of reinsurance participations among a number of reinsurers. This is common in jurisdictions with controlled insurance systems such as Brazil, India, China, Indonesia, Mexico, Russia, some African states and United Arab Emirate states. The availability and cost of reinsurance will influence the availability and cost of direct insurance. The scale of the fleet insurance programme will dictate how many (and what type) of insurers/reinsurers will be used.

Airline insurance coverage – detailed analysis 16.9 A typical airline insurance programme will provide a range of coverages across the fleet of aircraft that an airline owns or has leased or financed or for which it has insurance responsibility. The following policies are a representation of the coverage obtained.

Hull ‘all-risks’ 16.10 The hull ‘all-risks’ policy wording will usually cover ‘all risks of physical loss or damage to aircraft from any cause except as hereinafter excluded’. The words ‘all-risks’ are usually in parentheses because it is recognised that it is not possible to cover all risks under an insurance policy. The standard exclusions are as follows: • wear, tear and gradual deterioration: these perils are thought to be a trading expense and not a peril to be insured. If any improvement is made to the condition of the aircraft as a result of effecting insured repairs, then a contribution for this ‘betterment’ will normally be required from the insured; • ingestion: caused by stones, grit, dust, sand, ice and so on, and resulting in progressive engine deterioration, this is also regarded as ‘wear and tear and gradual deterioration’ and is, therefore, excluded. Ingestion damage caused by a single recorded incident (such as ingestion of a flock of birds) where the engine or engines concerned have to shut down is not regarded as wear and tear and is covered under hull ‘all-risks’, subject to the applicable policy deduction; • mechanical breakdown: considered to be an operating expense, although subsequent damage outside the unit concerned is usually covered. However, it is possible to obtain insurance covered against mechanical breakdown of engines by way of a separate policy, but this cover has a high degree of exposure and as a result is relatively expensive. The majority of airlines do not purchase it, probably viewing such exposure as part of their engineering budget; • war and allied perils: largely insured separately under a hull ‘war risks’ policy, which is discussed later in this section. 274

Airline insurance – detailed principles and practices  16.11 Hull ‘all-risks’ policies are subject to a standard deductible, applicable in the event of damage to the aircraft that does not result in a total loss. This deductible is dependent on the type and size of the aircraft concerned and ranges from US$500,000 for narrow body aircraft up to US$1 million for wide bodies. Deductibles can be reduced by means of a separately placed deductible insurance policy. ‘All-risks’ cover does not include loss of use, delay, grounding or any other consequential loss. Nor does it offer ‘residual value’ protection. What the policy will cover is the reinstatement (to the extent possible) of the aircraft to its preloss operational condition, if repairable damage is involved, or some other form of settlement in the event that the damage is more substantial. Most airline ‘all-risks’ policies will contain a constructive total loss threshold – the point at which the aircraft will be deemed a total loss for insurance purposes. Typically, this is 75% of the agreed value. Therefore, if the estimated cost of repair is greater than this threshold, the insurers will agree that the aircraft is a total loss and will pay the agreed value without any deductible. An ‘all-risks’ policy is normally subject to 30 days’ notice of cancellation by insurers. Some markets (the US in particular) apply a shorter notice period (as little as ten days) for cancellation due to non-payment of premium.

Hull ‘war risks’ 16.11 The hull ‘all-risks’ policy will contain the exclusion of ‘war and allied perils’. The hull ‘war risks’ policy will provide cover for loss of, or damage to, the aircraft from risks excluded from the hull ‘all-risks’ policy, followed by the listing of the so-called ‘war and allied perils’. Throughout the aviation insurance world, ‘war and allied perils’ generally have a defined meaning. In the London aviation insurance market, there is a standard exclusion clause entitled the ‘War, Hijacking and Other Perils Exclusion Clause’ (known as AVN48B). The US aviation insurance market uses a similar clause entitled the ‘Common North American Airlines War Exclusion Clause’ with substantially similar exclusions, although it does not contain the final paragraph of AVN48B (which excludes any loss or damage occurring while the aircraft is outside the control of the operator by reason of any of the ‘war’ perils) or equivalent language. The majority of the excluded ‘war and allied perils’, other than the detonation of a nuclear weapon and a war between the ‘five great powers’ (identified in the aviation insurance world as the USA, the Russian Federation, China, France and the UK), are covered under a hull ‘war and allied perils’ policy. Such policies will use LSW555D (or similar) as the basis of cover. Introduced in 2006, this policy form introduced a further limitation on cover over its predecessor (LSW555B) for so-called ‘dirty bombs’ (chemical, biological, biochemical, electromagnetic pulse), primarily where these are external to the aircraft. This policy will cover physical loss or damage and, like the ‘all-risks’ policy, does not cover loss of use, delay, grounding or any other consequential loss. No deductibles are normally applicable, although there are specific and more stringent cancellation provisions including automatic termination upon outbreak of war among any of the five great powers and as little as seven days’ notice to review terms and conditions. Most (if not all) airline ‘war risks’ policies are subject to an aggregate limit, a maximum sum payable for any or all losses occurring during the policy period. 275

16.11  Insurance Considerations This limit, set by insurers, and negotiated by the buyer will often be of much debate. Aviation insurers cannot offer unlimited coverage and the potential exposure for a terrorist event to cost way beyond what they could offer is certainly there; sadly the events of 11 September 2001 in New York City proved that. In addition to excluding war between the five great powers and nuclear war, the ‘war risks’ insurers will also usually exclude, inter alia: (1) confiscation by the ‘state of registration’ – although this exclusion can usually be deleted in respect of financial interests; (2) any debt, failure to provide bond or security, or any other financial cause under court order or otherwise; (3) the repossession or attempted repossession of the aircraft either by any title holder or arising out of any contractual agreement to which any assured protected under the policy may be party; and (4) delay and loss of use (although there is often an extension to the policy for a limited amount for extra expenses necessarily incurred following confiscation or hijacking). Otherwise, except as stated above, the ‘war risks’ policy will cover the aircraft on the same basis as the ‘all-risks’ policy, including as regards ‘agreed value’ and noting additional interests. One area of continuing confusion relating to ‘war risks’ is on the subject of ‘confiscation’. This confusion is linked to the existence of another form of insurance – ‘political risk’ or ‘repossession risk’ insurance. The principal difference between the two is that whereas the hull ‘war risks’ policy (which is normally effected by the aircraft operator) insures against physical loss of or damage arising from the perils insured, the political risks insurance (which is usually effected by the aircraft owner/lessor/financier) insures against financial loss arising from the perils covered under that policy. The prime difficulty in the case of the hull ‘war risks’ policy, and particularly the ‘confiscation’ peril, is that of proof of loss. Proof of loss is the procedure under which an insured must demonstrate that they have a valid claim under a policy. If an aircraft is damaged or destroyed in what we might call ‘normal circumstances’, it is relatively easy to obtain and provide proof of loss. If, however, an aircraft is parked at an airport without any obvious sign of either damage or detention, the situation is more difficult. If the aircraft is registered in the state where its operator is based, the task of proving loss is even more difficult, especially if the operator is state-owned. If an aircraft is confiscated or seized, there is usually no predetermined date specified in the ‘war risks’ policy at which the aircraft is deemed to be ‘lost’. The policy is to cover physical loss or damage. In the event of the operator or owner being deprived of the aircraft, it will be necessary to demonstrate that all reasonable steps have been and are being taken to effect recovery of the aircraft and that there is no likelihood of the return of the aircraft within a reasonable timeframe and, therefore, that it is ‘lost’. Contrast that with a non-confiscation situation, such as if the aircraft disappears off the radar. The insurance markets have found solutions to afford comfort that such a loss will be paid within a reasonably foreseeable timeframe. This is either through: (a) a ‘disappearance clause’ which specifies that after a specified number of days (usually 60), the aircraft will be deemed ‘lost’; or (b) the ‘50/50 Clause’ which deals with how the underwriters on the ‘all-risks’ and ‘war risks’ 276

Airline insurance – detailed principles and practices  16.13 slips will respond if it is not clear if the aircraft was lost in circumstances where the ‘all-risks’ or ‘war risks’ coverage applies.

Spares risk 16.12 Under most ‘hull’ policies, the word ‘aircraft’ includes parts removed but not replaced. However, once a part is replaced it is no longer, from an insurance perspective, part of the aircraft. Conversely, once a spare part is attached to an aircraft as a part of that aircraft it is no longer a ‘spare’. Spares can be insured in one of two ways: (1) under a ‘spares’ section of a hull policy; or (2) by a separate spares/property policy. In either case, the scope of coverage will be similar. ‘War risks’ can also be covered in respect of international transits. Spares coverage is usually subject to a small deductible except in respect of ground running of spare engines when the applicable aircraft deductible applies. Spares are normally covered for the replacement cost. However, engines and high-value components can be insured on an agreed value basis, just like aircraft.

Liabilities risk 16.13 An airline operating aircraft is exposed to potential liability claims of significant amounts. The classic scenario often used to illustrate the potential is the collision of two wide bodies over a major city such as New York. The events of 9/11 brought home the true potential of a major incident, albeit that 9/11 was not an accident. However, it is probably the ground accumulation of aircraft (with and without passengers on board) and other property (including buildings) and people who are intending passengers, workers or visitors that can make the major airport location the ultimate in potential exposure. It is this accumulation of risk that has been a focus of attention for insurers, their capital providers and, in the event of insurance market failure, the relevant national and international governmental agencies. Aircraft liability exposures, for insurance purposes, are normally divided into the following: • passengers liability (including baggage); • cargo liability; • mail liability; and • aircraft third-party liability. The last category provides coverage in respect of damage caused by the aircraft to third-party persons and property, whereas the first three refer to persons or goods carried on board the aircraft itself. The remaining liabilities are often referred to as ‘airline general third party’. These are the liabilities arising from the ground operations of the airline. Airlines will often develop substantial support organisation for maintenance and so on which generate services which may be sold on. The risks involved are described as premises, hangar-keepers and products liability. Airline liability risks are usually placed in a single policy on a combined single limit (CSL) basis. This means that bodily injury and property damage arising from each of the exposures is covered within the one policy limit. Personal injury (defined as offences against the person, such as false arrest and malicious prosecution) is also included but this is now subject to a sub-limit of 277

16.14  Insurance Considerations US$25 million, regardless of the size of the CSL. The CSL structure has many advantages (including simplicity of placing and cost). However, it also creates the disadvantage that the policy limit can be exhausted by one aspect of an incident (for example, third-party claims), leaving no funds under the operator policy to deal with potential passenger claims, and vice versa. However, the CSL is a ‘per occurrence’ limit and for all claims other than ‘products’ and ‘personal injury’, the policy limit can be paid for any number of occurrences during the policy period. Airline liability coverage is usually obtained with a combined hull and liability policy. Like the hull ‘all-risks’ referred to earlier, a liability policy is also subject to a number of exclusions including the ‘war risks’ exclusion AVN48B. However, a limited form of ‘write-back’ is available for liabilities under a clause identified as AVN52(E). This reinstates coverage for most of the AVN48B exclusions but coverage for third-party risk is limited. However, additional war third-party liability cover can he purchased under a separate policy.

Ongoing liability or ‘tail liability’ 16.14 Aircraft financiers and lessors should consider the liability implications that may still attach to an aircraft once their direct involvement in the aircraft has finished. If an aircraft was to suffer a loss in the future that could be blamed on an event, faulty maintenance for instance, which occurred in the past is it possible that the financier or lessor who was involved in the aircraft at that point may have some residual liability? Even if the answer is eventually ‘no’ it may take a great deal of expense in defending a claim to get to that point. Who will pay for that? The finance or lease agreement will ask that a liability coverage be in place for two years or until the aircraft goes through a heavy maintenance check. It is thought that any residual risk that may attach should be found within two years of that major check. The aircraft operator will be asked to provide certification to add the financier or lessor to their liability coverages (it may be as specific as to add them purely to the ‘product liability’ section of the coverage) until the two years has passed.

AIRCRAFT FINANCING AND INSURANCE 16.15 Having reviewed the principal types of insurance that an airline is likely to arrange in respect of the aircraft it operates, this section will now discuss the insurance implications involved in the financing of an aircraft.

Aircraft hull insurance 16.16 The type and scope of cover usually arranged either through hull ‘allrisks’ or hull ‘war risks’ insurance has already been discussed. The quantum of that insurance (that is, the value to be insured for the relevant aircraft) may initially be a commercial matter between the lessor and lessee and is likely to be tied to the termination sum payable under the lease or the amount of the loan outstanding at any one time. It will represent the casualty value under the lease 278

Aircraft financing and insurance 16.19 which is payable regardless of insurance. That number will be driven by several factors, including the attributes of the aircraft such as its age and economic cost or value for the owner, lessor or financier. The insurers must agree this valuation for insurance purposes, and they may, on occasion, query that number. However, provided there is some logical ‘auditable’ basis (in the absence of any suggestion of ‘moral hazard’), there should be no technical reason for refusing to accept a value for insurance on an ‘agreed value’ basis. The basic protection to be sought under the hull insurance (’all-risks’ and ‘war risks’) is the inclusion of the owner, lessor or financier as an additional insured for its respective rights and interests. The status of additional insured provides: (a) a direct contractual relationship with the insurers; (b) any claim would have to be negotiated with the lessor as well as the operator; and (c) because the interest of the lessor in the insurance is ‘direct’ (not via the operator), the possibility of the insurance being prejudiced by a third party (such as the operator) is limited.

Loss payable clause 16.17 A  loss payable clause in a lease would normally specify that all payments on a total loss will be made direct to the lessor (or a designee), that all payments above an agreed financial threshold will also be paid to the lessor and that amounts below that threshold can be paid direct to the lessee unless and until the insurers have been notified by the lessor that an event of default has occurred. An assignment of insurances (where available) gives binding legal effect to the loss payee clause by giving notice to the insurers.

Breach of warranty cover 16.18 Airline policies typically contain warranties relating to compliance with airworthiness or other regulations. Failure to comply with these warranties could cause the insurance to be invalidated. In addition, there are other terms and conditions in the policy, a breach of which by the insured could invalidate the cover. Examples would include inaccuracies in the policy declaration or failure to comply with notification requirements or if the airline made a material change to its operations and failed to advise its insurers. A financier can protect itself from the consequences of such actions (or inactions) by the lessee through ‘breach of warranty’ cover which will ensure the financier still gets paid out under the policy even though the airline is not entitled to payment because they have not complied with the policy terms, conditions or warranties.

Contribution rights 16.19 One of the principles of insurance is that insurers are entitled to claim a contribution from any other valid insurance(s) available for the same loss. Leases will prohibit the lessee from taking out other insurance cover (other than that specified in the lease) without their consent. This is because existence of ‘other contributing’ insurance (which has not been approved by the lessor and to which 279

16.20  Insurance Considerations the lessor has not been added) will undermine the totality of insurance available to the lessor. However, leases will typically allow lessees take out insurance against a limited number of risks without lessors’ consent – for example, hull total loss, loss of use and deductible risk.

Waiver of subrogation 16.20 Subrogation is the principle that, having paid for a loss, insurers are entitled to pursue the party who caused the loss. The insurers will be entitled to be subrogated to the rights of the lessor under the lease and in respect of any other security held against the lessee, unless such rights are specifically waived. Such waivers are generally available although insurers will be reluctant to waive their rights of subrogation against the manufacturer, supplier or overhauler of the aircraft.

Notice of cancellation or change 16.21 Because of the risks incurred by a financier as a result of the invalidity of the insurances (for example, if the insurances do not comply with the specified requirements of the transaction), a financier will typically require that any insurances are subject to notification to the additional insureds of intended cancellation or material change. Such notice will be endorsed on the relevant policy and will typically specify that 30 days’ (or seven days’ or such shorter period as may be customarily available in the case of ‘war risks’) notice of cancellation be given to the additional insureds before the cancellation of the policy is effective in respect of their interests. Historically, those notice periods operated from the date the additional insureds received the notice. However, more recent practices specify that the notice periods start from the time that they are given by insurers via brokers. As an additional security (particularly when AVN67B is used), a broker’s undertaking can be included, requiring any such notices to be promptly reported.

Set-off rights 16.22 Insurers would normally have a right to set off unpaid premiums against any claim. On a fleet policy, this could be a significant credit risk and is likely to be of concern to the financier. However, insurers will normally agree to waive any rights of set-off or counterclaim in respect of unpaid premiums for all aircraft other than the aircraft that is the subject of an insured loss. A lease may also require an express statement that the additional insureds have no legal liability to pay premiums, but that they reserve the right to do so, at their option.

Liabilities 16.23 The airline faces liability as the operator of the aircraft, but the financier may face a (separate) liability exposure as owner, lessor or lender depending on the facts and circumstances, applicable laws and so on. As stated earlier, a financier is most likely to become involved in litigation because of the perception (and in some cases, the reality) that the financier has greater financial strength 280

Aircraft financing and insurance 16.26 than any other party involved. However, the financier is not in the business of operating, using or maintaining aircraft, so it has no ‘operational’ interest in any financed aircraft and could only have any real exposure for liability on the basis of some theoretical duty of care (for example, negligent entrustment) or direct interference with the aircraft. Notwithstanding this ‘remote’ relationship to the liability risk, financiers (and all relevant parties) will insist on being (and should be) added as an additional insured to the operator’s liability insurance. Relevant parties should include the legal entities but also their respective directors, officers, employees, agents and so on.

Severability of interests 16.24 A ‘severability of interest’ clause provides expressly that the liability insurance will operate in all respects, except in respect of the limit of liability, as if each party insured was the subject of a separate policy.

Indemnities 16.25 Leases and other financing documents contain detailed indemnity provisions whereby the lessee agrees to indemnify the lessor for any losses incurred by the lessor (and the other indemnitees) arising from the operation of the aircraft. There are qualifications to that indemnity but the expectation is that the lessee insurances will ‘backstop’ the insurable indemnity matters.

Reinsurance 16.26 Where the primary insurance is not effected on a direct basis with insurers of recognised responsibility, leases will normally specify the level of reinsurance and the markets with which such reinsurance is arranged. They will also require that the reinsurers are advised of the finance/lease transaction and confirm that the reinsurance policy will be: (a) on the same basis as the insurance policy; and (b) endorsed in a similar manner to the primary policy. These requirements will necessitate facultative reinsurance (bespoke reinsurance covering just this single risk) rather than treaty reinsurance (a reinsurance programme covering a number of risks that fall within certain criteria). A requirement for a reinsurance ‘cutthrough’ clause may also be included. This clause (currently only applicable to hull insurances) requires that payment will be made by the reinsurers directly to the loss payee nominated in the original policy instead of paying the primary insurer. There will still be a need to provide satisfactory proof of loss and the reinsurers will only make payment under such a cut-through, provided it does not contravene any law, statute or decree of the home state of the primary insurer. Some airlines establish and use ‘captive’ insurance companies as a means of obtaining more cost effective insurance. When captives are used, reinsurance assumes greater significance. It is important that lessors understand the significance of this buying structure and adopt appropriate due diligence and monitoring processes. It is not unusual for financiers to insist on retaining discretion as to the acceptability of the reinsurers. 281

16.27  Insurance Considerations

Practical application of insurance to financing 16.27 While each lease agreement will be different, the insurance requirements are likely to be fundamentally similar. The aviation insurance industry has, therefore, produced a standard market endorsement, the ‘Airline Finance/Lease Contract Endorsement’, the most commonly used version of which is known as AVN67B, for use in aviation financing transactions. AVN67B applies to both aircraft and parts/engines and there are two versions – one for hull ‘all-risks’/ liabilities/spares and another for hull ‘war risks’. AVN67B has provisions for the following principal key areas: • confirms that the equipment is insured; • seeks to define the period of cover provided by the endorsement; • names the interested contract parties for hull and liability insurances; • addresses the loss payee situation; • provides the key ‘breach of warranty’ coverage; and • deals with notification of cancellation and so on given by insurers. Lessors should ensure that the current AVN67B is used properly and that all relevant procedures, including notification to insurers, are carried out by the lessees and/or their brokers.

Certificates of insurance 16.28 In most financings, prior to delivery and on each renewal anniversary, a certificate of insurance (and reinsurance if applicable) is provided, evidencing compliance with the lease and/or finance contract. Certificates issued by the broker authorised by insurers (the ‘approved broker’) are a practical way of obtaining summarised evidence of the insurance required (which, as discussed, may be spread amongst a number of different insurers). The style and layout of certificates of insurance vary from broker to broker, although the introduction of AVN67B has ensured a greater degree of consistency, at least in confirming what has been agreed in respect of the particular finance agreement. However, the approved broker is only authorised to evidence what has been agreed by the insurers. In the absence of having sight of the policies themselves (which may not be practical if a large number of insurers are involved), the financier is wholly dependent on the accuracy of the certificate provided to ensure that the provisions of the financing documents have been complied with. For this reason, insurance advisers are commonly commissioned by the financier to review and report to the financier on the insurance cover arranged.

Letter of undertaking 16.29 A letter of undertaking is issued by the insurance broker in its capacity as broker to the airline in which certain things are undertaken by the broker for the benefit of the financier. Under usual circumstances, it will encompass such things as giving advice of any notices of cancellation or material change given by the insurers, or advice in the event that the airline does not pay premiums due 282

Conclusion 16.30 under the policy. Finally, the broker is often required to undertake to advise in the event that it ceases to be broker to the airline concerned.

CONCLUSION 16.30 As discussed in this chapter, insurances enable a lessor/owner (and any financiers) to mitigate its risk in an aircraft financing transaction. When reviewing the insurance requirements for any aviation financing transaction, the parties should pay particular attention to the following key issues: • Subleasing: a lease may permit subleasing subject to the satisfaction of certain conditions. It is critical in permitting subleasing that the lessor ensures that the underlying substance of the sublessee insurances meet the insurance requirements set for the original lessee. This is particularly important where sub-wetleasing is involved. In a sub-wetlease, responsibility for the legal liability insurance may be split between the wet-lessor and the wet-lessee. Such sub-wetleasing should be supported by contingent liability insurance, arranged by the original lessee, to ‘backstop’ the sub-wetlessee insurance. • Engines: the vast majority of aircraft leases will include language that makes it very clear that the operator’s responsibility to the aircraft lessor/ financier is to replace an engine that suffers a total loss and that the replacement engine must be in the same or better operating condition. If total loss of the engine occurs whilst it is a spare, it is simply a case of sourcing a suitable replacement and insurers will pay the replacement cost (less the applicable spares deductible). If the engine is fitted to another aircraft which has suffered a total loss, the obligation of the operator is still to replace the engine. Experience has shown that this is often achieved by means of a title swap on the engine that was not fitted at the time of loss, thus avoiding any need for insurers to pay for an additional engine. • Airline aviation liability insurance: airline aviation liability insurance typically excludes liability to employees. Depending on the wording of the exclusion, there is a risk that the exclusion will remove all coverage (including in respect of financiers who are added subject to AVN67B) for claims arising from operational losses where the financier is sued by the employees of the airline. This is clearly not acceptable to a financier so the drafting of the exclusion provisions should be reviewed carefully to ensure the financier’s interests are protected. • Lessor contingent insurances: lessor contingent insurance will not cover all risks. There are still some gaps where a positive response from the insurance markets would be helpful. For example, in the case of lessee insurer insolvency, the contingent insurers have been asked to cover the potential liability of the finance parties. Thus far, the insurers have declined on the grounds that this risk is a ‘financial guarantee’ and for most insurers, they are prohibited from providing such products. However, no alternative product has been offered. • Cut-through clauses: cut-through clauses are not available in all jurisdictions (for example, they are illegal in the People’s Republic of China). Lessors need to be aware of the practicality of obtaining cutthrough clauses, the value such clauses provide (for example, such clauses are typically qualified and will only apply to the extent they comply with local law) and the implications of their non-availability. 283

16.30  Insurance Considerations •

•

Changes to the insurances at renewal: it is important that lessors obtain timely confirmation that lessee insurances have been renewed with no material adverse changes. The renewal certificate is typically only received ten days after renewal so simply waiting for the renewal certificate is not a prudent approach. Monitoring by financiers: there is an ongoing debate (initiated by insurers) regarding a financier’s due diligence and reporting obligations (that is, the extent to which the financier should oversee the operational behaviour of the airline and inform the insurers where relevant). This debate arose from the litigation relating to a particular insurance claim involving a major lessor/lender where the circumstances of the loss were complex. One of the insurers’ defences for a refusal to pay included suggestions that the finance parties had not exercised due diligence in a number of areas. The financing industry’s position is (and always has been) that financiers are providers of ‘capital’ to the airline industry (via loans or leases) and are not involved in the policing of the operational activities of airlines. The financier’s position is that the airline industry is already comprehensively regulated and that, in the context of insurable risk, the primary due diligence responsibility rests with the insurers who underwrite the risk.

In conclusion, financing (in one form or another) continues to be a significant feature of the global aviation industry. For the financier and its shareholders, observance of the disciplines of diligence and prudence can mitigate the risks associated with aviation financing transactions and can ensure that their continued participation in the aviation business is sustained and grows in a prudent and reasonable way. Insurance will continue to be a key tool in managing such risks and the expectation in the aviation financing industry is that the insurance markets can continue to respond positively to the needs of the aviation industry.

284

17 Aircraft Repossession – Practical Considerations Phil Seymour

INTRODUCTION 17.1 Repossessing aircraft is not a new subject matter. However, the last year saw the world hit by a once in a century type pandemic and at the time of writing, more than one year on, there is still no clear path back to pre-Covid-19 air traffic levels. There has been considerable forbearance from many lessors and financiers of aircraft and unprecedented government support for many airlines. However, not every airline has received enough support and, in many cases, it is only the airline that is perceived as the ‘flag carrier’ that has received such funding. It is inevitable that there will be ‘unscheduled’ returns of aircraft as part of the process of airline failures and/or restructuring. It has been a truly awful year in aviation. The graphic below shows how many aircraft have been impacted and are likely to be repossessed, either by hopefully ‘friendly’ means, but in some cases with no support from the defaulting airline: EXHIBIT 17.1 AIRLINE FAILURES/RESTRUCTURING

Source: IBA Intelligence and Advisory, accurate as of 1 July 2021

Every repossession case is different in terms of the ease of process. The key factors are the location of, and completeness of, the aircraft and records, the 285

17.2  Aircraft Repossession – Practical Considerations operator/pilot/employee’s goodwill, the cost of return to service with another owner, and ease with which the assets can be moved. The purpose of this chapter is to allow the reader a better understanding of the processes required to successfully exit from a repossession scenario. Much can vary depending on whether major maintenance is required, ie if the engines are on programme/due a shop visit, or the airframe is due a heavy check. An ‘odd ball’ interior configuration can also lead to additional costs to prepare the aircraft for optimal remarketing. In a balanced market, the downtime expectation for remarketing a five-year old A320/B737–800 to a price to within 95% of the expected market value for this category of aircraft is six months. This includes the time required for any maintenance or delivery requirements of the next purchaser/lessee. A review of defaults and repossessions in this market category over a period of ten years gives remarketing timeline extremes from as little as one month to sell through to 12 months. Clearly the downtime is a function of aircraft pricing, aircraft condition and the market condition. The Covid-19 pandemic has meant that the timescales have been severely impacted due to: •

even more limited resources at the airline to complete a ‘reasonable’ process due to redundancies, furlough of staff or, of course, airline enters administration/liquidation;

•

even more reluctance at the owner/lessor to take back an aircraft given the lack of onward placement opportunity;

•

severe lack of mobility for the redelivery teams due to travel restrictions.

In previous deeper downtimes, such as post 9/11 and the global financial crisis, it took around two years for some values to recover. Older aircraft are often the first to be permanently retired. It is expected that this scenario will be played out this time round and it could possibly take longer given IATA’s prediction that pre-COVID-19 traffic recovery is unlikely before 2024/2025. The key issue is that whilst it is easy to talk in general terms, but each case differs from region to region, not just in terms of legal jurisdiction/Cape Town Convention, etc but each airline and the staff engagement can vary. As well as regional differences the aircraft type being repossessed will offer different practical challenges – does size really matter? Well, yes it does. Frankly it is much easier to find alternative storage locations for a regional turbo-prop than a wide body aircraft – the bigger the aircraft the more limited the choice.

OPERATIONAL AND COST CONSIDERATIONS 17.2 Gaining possession of the aircraft and its records following a default situation can be an unpredictable process. As mentioned above, the process can be easily and quickly affected if the operator is cooperative, but for the purpose of the budget one should assume that the process will not always go according to plan and the need to hire local representatives will be crucial given any lack of mobility due to travel restrictions. 286

The legal process 17.6

THE LEGAL PROCESS 17.3 The contingency plan will need to involve and be ratified by the legal team. Often, working closely with the lawyers, aviation authorities, insurers and back-up maintenance providers can occur prior to the immediate need to repossess. Defaults do not normally happen instantly but they develop over time and the specific act of repossession is merely a part of the ‘distress’ cycle. Once the legal clearance and permission to repossess has been given, the physical process can begin. Some believe that the act of repossession takes place under the cover of darkness with a team of camouflaged pilots and technicians; this is rarely the case, although each member of the repossession team has to be well briefed and be prepared for any eventuality. It will be important to place a realistic time line on the recovery process given the potential lack of onsite resource from both the airline team and the lessor/ owners.

Legal costs 17.4 Costs for the legal process will depend on whether a court order is required, or if the legal owner/bank can just serve a termination notice. There is little difference in the cost whether the aircraft is large or small.

Securing the aircraft 17.5 The aircraft will need to be made secure until moved to the storage location. This may require the physical presence of a security team at the airport to ensure the safety and security of the aircraft. Local arrangements will need to be made with the airport and ground handling facilities to establish a towing procedure. To protect the asset, security should ideally be obtained on a 24/7 basis, especially if local companies are owed monies, since history has shown that they may take it upon themselves to take aircraft parts as their own security. Log books and certificates should be removed from the aircraft and a notice of ownership affixed to the cockpit door, with tape masked around the door seals. In the current Covid-19 world many aircraft are parked at remote airfields rather than major airports either due to lack of space and/or lower parking fees.

Pre-ferry flight parking and maintenance 17.6 The local CAA will need to be consulted if the period of downtime from repossession to departure exceeds a defined period. This may be as little as 24 hours and will require proof that the aircraft remains airworthy and that no crucial maintenance is outstanding. In some cases, the CAA may require maintenance to be performed prior to the so-called ferry flight. This is a further reason why the retention of key maintenance documents is useful, since without them it will be impossible to establish the maintenance status to prove to the authorities what should be required in the absence of a ‘going concern’ operator. 287

17.7  Aircraft Repossession – Practical Considerations An increase in ‘remote’ surveys by the CAA has been seen, given the lack of mobility; however, there is often a need for a physical presence – the CAA will want to be absolutely sure that no ‘short cuts’ have been taken, such as relying upon video or delegating to a random inspector.

Suitable parking facility 17.7 Arrangements will be made to move the aircraft to a suitable storage facility. The determination of the storage facility will be made as a result of understanding the situation surrounding the repossession. For example, if the process is supported by the operator, the jurisdiction is flexible and the facilities exist to store aircraft and provide a welcoming environment to remarket the aircraft then the operator’s base could be used. A ‘standby’ facility may need to be sourced since it is often the case that the operator’s base is targeted by the media, creditors and disgruntled employees. Potential sources of ferry flight crews include the current operator since many of their pilots will be looking for work. This is the most efficient source since the crews should be knowledgeable and au fait with the aircraft types operated. Other sources will be various flight crew agencies and operators of similar types. The CAA will need to verify the licensing credentials of crews. The process of validation can be relatively quick so long as the proposed crew’s training and medical records are complete and transmitted in a timely fashion to the authorities. Such validation does not normally occur at weekends! Submission of flight plans, determination of fuel requirements and overfly permissions is normally undertaken by the ferry crews.

ENGINE REPOSSESSION CONSIDERATIONS 17.8 A  repossession of one or more engines may be necessary if the titled engines are not fitted to the aircraft and are either fitted to another aircraft, in storage or undergoing maintenance. This has become one of the most common problems in the Covid-19 world. As described above, the lack of mobility of maintenance crews has restricted the options for ‘engine swapping’ especially if the engines are placed on aircraft in different locations, or in some cases, different continents. In planning an engine repossession, a number of questions and aspects need to be considered: • If the engines are fitted to another aircraft, is this part of a permitted pooling provision in the lease? • Is a recognition of rights agreement in place with that aircraft’s owner? • Are engines undergoing maintenance and, if so, are the rights of owners recognised under the respective maintenance agreements? • Is maintenance complete and, if not, how can this be managed? • If engines are stored, are they serviceable or unserviceable? • What is the maintenance and preservation status? • Are there component shortages? • If stored, what type of stands are the engines fitted to? Are they suitable for transportation and who owns the stands? 288

Inspection of aircraft 17.11 • •

Are maintenance payments and flight hour agreements up to date? Copies of engine records will normally be with the aircraft records but there may be situations where the more recent records will need to be sought from maintenance providers.

POSSIBLE LIENS 17.9 In the course of operations, several debtors may have been able to impose liens against the aircraft. This is one area that would need to be assessed during any pre-default stage to assess the overall indebtedness of the operator. Maintenance facilities such as component overhaulers, airports and aerospace control may require debts to be cleared prior to the release of aircraft. It is possible that titled engines and landing gears could be on another aircraft or in various states of disassembly. Also, the aircraft may contain parts to which other parties hold title. It may be necessary to work closely with other parties to ensure that they do not remove parts that immobilise the aircraft. Aerospace control powers are wide, and the pursuit of debts includes the ability to claim against the aircraft owners and not just the failed operator. Does the bank/owner have the authority to regularly check the outstanding debts of the operator? The debts are specific to the aircraft registration/serial number. Airports may often physically prevent the movement of aircraft that are associated with the operator’s non-payment of airport landing fees and other support fees.

SECURING THE RECORDS 17.10 The location of aircraft records is normally at the operational base of the owner. It will be important to fully understand the whereabouts of the key records. It would not be unusual for the technical records staff to request payment to collate and package the aircraft records prior to their release. Whilst this practice may not be ethical or even legal, experience shows that it is essential to keep the goodwill of records staff (or those that remain) during the phase of repossession. Of course, the diligent upkeep of copies of the aircraft records in the ‘prerepossession phase’ will ensure that, in the worst case scenario, sufficient records will be available in any case. If the aircraft is on a computerised aircraft maintenance programme, critical records will then be available online with access available for a fee.

INSPECTION OF AIRCRAFT 17.11 The aircraft should be thoroughly surveyed before the repossession to provide evidence of the physical condition. This is important for two reasons: (1) if there is any chance that the aircraft may be placed back with the original owner, the evidence of condition will ensure that there is no claim against the ‘repossessor’ for damaging or degrading the aircraft whilst in its possession; 289

17.12  Aircraft Repossession – Practical Considerations (2) further claims against the owner may be made if there is any evidence of misuse.

REGULATORY CONSIDERATIONS 17.12 Close liaison with the applicable authority will be necessary in order to secure an export certificate of airworthiness and/or ferry flight permit. For example, placing an Australian registered aircraft outside the country may lead to a need for avionic modifications or other equipment installation.

MAINTENANCE AND REFURBISHMENT 17.13 There will always be an element of maintenance required and therefore an element of ‘buyer’ consideration has been included in this. There may be changes according to how the overall market is at the time of the sale. When demand exceeds supply an ‘as is, where is’ sale may be an easy option but in ‘softer’ times the buyer will often be required to enhance the condition of the aircraft, such as new paint or an upgrade of the interior. Unfortunately, a default usually means that the airline has neglected some of the maintenance tasks in the same period. Hopefully these will not be important technical areas but the interior of the cabin may well be much more heavily worn if costs have been cut.

INSURANCE 17.14 It is important to establish the insurance status of the aircraft prior to repossession taking place, since insurance may be invalidated in the event of default or repossession under the policy terms. Standby insurance may be needed to cover the exposure to ground risk and ferry flight cover should be arranged prior to the ferry flight taking place. As part of the next phase, discussions with the operator’s insurers should take place to understand the process in the event of a repossession, for example, a grace period may apply.

ONGOING ASSET MANAGEMENT 17.15 The process of repossession and remarketing will be a quicker and more efficient process if the aircraft is monitored prior to repossession and key records and log books copied. The monitoring programme also serves the following purposes: (1) collation of data allows the creation of a useful back-up if any key documents are lost, damaged or stolen. Even without default this can aid the process of selling the aircraft (or the debt) to other parties; (2) regular visits provide useful contact points within the operation and will create a rapport with key owner staff. This can provide useful ‘shop floor’ insights into the operation and to the attitudes held by staff; 290

Post-repossession action items 17.16 (3) the procedure shows the operator that the financier takes a serious view towards its assets and will instil disciplines within the operation. Consideration must also be given to a worst-case scenario where the operator may not cooperate in the process of repossession. If records are found to be missing, the value of the aircraft will be impaired. If such evidence is not available, expensive work tasks may then have to be performed. In some cases, this has meant major airframe, engine, landing gear and component overhauls being required. Not only is direct cost incurred, but the additional non-revenue downtime could be as much as six months, taking into account the maintenance planning phase, sourcing of suitable facility, performance of the tasks and liaison between the manufacturer and the aviation authorities.

POST-REPOSSESSION ACTION ITEMS 17.16 Following the repossession of any aircraft, the client is strongly recommended to undertake the following work to ensure the asset is brought up to a condition where it can be flown and remarketed at the optimal selling price: • arrange for a specialist engineer to visit the owner base and review all hard copy records, maintenance statuses and manuals plus obtain the latest log books; • compile the scope of work and estimated costs for the next three months of storage and essential maintenance; • determine whether the airframe and engines can remain under any manufacturers support programmes (and if so, how long these will remain valid) and whether there are any remaining warranties; • clean the aircraft of all food and toilet matter if this has not already been done; • check with the CAA on the continuing validity of the Certificate of Airworthiness and whether any arrangements need to be made to protect this; • as the aircraft has operated under the approvals, manuals and certificates of the previous operator, obtain an opinion as to the most practical and financially advantageous way it can be maintained and stored if the mortgagor wishes to sell the aircraft; • when the aircraft is in a presentable condition inside and out, prepare specifications, maintenance status and photos for remarketing.

291

18 Global Aircraft Trading System (GATS®) Dominic Pearson

INTRODUCTION 18.1 The Global Aircraft Trading System (GATS®)1 is a system designed to make the trading and financing of aircraft equipment (including leased aircraft in particular) faster, less costly and more efficient, while at the same time protecting the rights of airlines and the other parties in such trade or financing. The GATS electronic platform (the ‘GATS Platform’), which launched on 1 June 2020, is the interface through which lessors, financiers and airlines can use all of the electronic features and functionality of GATS. The GATS Platform may be accessed by navigating to https://e-gats.aero/ and is operated by Fexco on behalf of the Aviation Working Group (AWG). Watson Farley & Williams LLP managed the design and build of the GATS Platform acting, on behalf of AWG, as its ‘single point of contact’ with Fexco. Use of GATS and the GATS Platform is entirely optional. This chapter is not intended to provide a complete or exhaustive guide on how GATS works or how to use the GATS Platform; rather, it is intended to provide an overview of its main features and benefits, and some background information as to how and why it was developed. For more information on how to use GATS, please consult the official guidance materials and other information, available free of charge, on the GATS online help page at https://e-gats.aero/help/. The main features and principal benefits of the GATS may be summarised as follows: • use of trusts established by or migrated into GATS (‘GATS trusts’), allowing existing leases to be left in place and avoiding lease novation’s or lease assignments; • digital signature technology and electronically executed documents through the GATS Platform; • ‘best in class’ standard form documentation for all transactions executed electronically through the GATS Platform (‘designated transactions’); • retention and strengthening of the legal protections and rights available to airlines through the confidential recording and tracking, through the GATS Platform, of conditions or requirements (‘advance requirements’) applicable to the trading of an aircraft effected through the GATS Platform. The GATS Platform will technologically block the trading of an aircraft 1

GATS is a registered trade mark.

293

18.2  Global Aircraft Trading System (GATS®)

• •

unless all advance requirements applicable to the transfer have been satisfied or waived by the airline or other designated beneficiary of such condition or requirement; establishment, using secure technology on the GATS  Platform, of an electronic ledger (the ‘GATS e-Ledger’), recording the holder from time to time of the beneficial interest and any security interest in each GATS trust; proposed additional transfer clauses which, at the option of lessors and airlines, can be adapted and dropped into lease agreements to take full advantage of the benefits of GATS in making aircraft trading and financing faster and more efficient.

THE NEED FOR A ‘GAME CHANGE’ AND THE DEVELOPMENT OF GATS AS A NEW SYSTEM FOR TRADING AIRCRAFT 18.2 Owing to a number of factors, including new sources of capital, new entrants into the aircraft leasing market, an increase in lessor M&A  activity, and an increase in the use of structured finance products, over the past decade there has been a steady increase in the volume of aircraft being traded. While that volume has been temporarily reduced by the Covid-19 pandemic (at least among commercial passenger aircraft), trading volumes are expected to resume to pre-pandemic levels and continue rising. GATS (originally known as the ‘game change initiative’) was developed by the AWG in response to such increasing trading volumes in order to address the frustration experienced by both lessors and airlines at the time, resources and costs required to agree and close a lease novation, a necessary legal step in the way leased aircraft are traditionally traded. The term ‘novation fatigue’ became part of the lexicon of aircraft trading both among airlines and lessors. Airlines, for their part, were becoming frustrated by the amount of resources they needed to divert away from their core business to devote to lease novation requests from lessors. For lessors, the inefficiency of lease novation’s manifested in terms of delays in access to capital and ever increasing administrative and legal costs. The desire was thus to develop a new framework or system to make the trading of aircraft more ‘liquid’, without sacrificing the legal protections available to the airline during a traditional lease novation. GATS emerged by consensus in the aircraft and finance leasing industry as a system which answers that brief, perhaps not as a ‘silver bullet’ in all cases, but as a huge step forward in achieving those aims.

GATS LEGAL FRAMEWORK Trust structure; avoidance of lease novation 18.3 GATS uses trust structures as a legal framework and foundation on which to provide significant legal and technological enhancements to the trading of aircraft. Under a trust structure, bare legal title to the aircraft equipment is held by a trustee, a corporate services provider, for the benefit of the aircraft owner or leasing company. Trustees of GATS trusts are known as ‘GATS trustees’, while owners, leasing companies and financiers using GATS and the GATS Platform, including the beneficiaries of GATS trusts, are known as ‘GATS participants’. 294

GATS legal framework 18.5 Thus, aircraft equipment is traded in GATS not by transfer of legal title but rather by the applicable GATS participant transferring its beneficial or economic interest in the GATS trust holding such aircraft equipment. The transfer is effected pursuant to a standard form transfer instrument digitally signed by one or more individuals on behalf of each transacting entity and executed electronically, in each case through the GATS Platform. The ‘transfer instrument’ is the equivalent of a ‘bill of sale’, transferring economic ownership of the aircraft equipment to the named GATS participant transferee. Because the GATS trustee is the lessor party to any lease agreement, and such party remains the same during any trade of the aircraft equipment, there is no need to novate or assign the lease agreement in favour of the transferee owner or leasing company. Avoiding a lease novation, a document often subject to much negotiation and which the airline-lessee is required to execute, significantly enhances the efficiency of the trade. GATS trusts are ‘established’ (ie  legally formed) by GATS pursuant to a standard form trust instrument which is also digitally signed and executed electronically through the GATS Platform. Additionally, existing owner trusts may be ‘migrated’ into GATS by the digital signing and electronic execution of the same standard form trust instrument which, for the purposes of ‘migration’, preserves the existing trust but in legal terms operates by amending and restating the existing trust instrument in its entirety. The migration of a trust into GATS may result in the name of the trust changing to conform to the GATS trust naming convention (see further section below on UINs). GATS is permissive of ‘empty’ trusts, constituted by a single US dollar (or equivalent). Accordingly, GATS trusts are not required to hold aircraft equipment all of the time; rather, a GATS trust may be established well in advance of title transfer of an aircraft to the GATS trustee of that GATS trust, facilitating the execution by the GATS trustee of a lease agreement in anticipation of the delivery of a new aircraft.

UINs 18.4 The GATS  Platform assigns each GATS trust a ‘UIN’ or ‘unique identification number’. A GATS trust is named according to its UIN, and that name is recorded in the GATS trust instrument constituting that GATS trust.

Trust branches 18.5 GATS is currently organised into three ‘trust branches’: (1) the United States; (2) the Republic of Ireland; and (3) Singapore. Each trust branch signifies the applicable law or laws which are expressed to govern all designated transactions relating to a GATS trust including, principally: •

the selected law of the trust instrument pursuant to which the GATS trust is formed or constituted;

•

the selected law of the transfer of the beneficial interest in the GATS trust (pursuant to which a trade of aircraft equipment is effected using GATS); and 295

18.6  Global Aircraft Trading System (GATS®) •

the grant of a security interest in the GATS participant’s beneficial interest in the GATS trust.

The United States trust branch is further divided into four sub-branches such that GATS participants may select to transact using a GATS trust constituted as: (a) a Utah common law trust; (b) a Utah business trust; (c) a Delaware common law trust; (d) a Delaware statutory trust; (e) an Irish law governed trust; or (f) a Singapore law governed trust. The grant of a security interest in the GATS participant’s beneficial interest in any GATS trust in the United States trust branch, and other designated transactions relating to that security, are expressed to be governed by New York law.

Designated transactions; GATS standard form instruments 18.6 Only ‘designated transactions’, being those transactions of a mechanical nature relating to the constitution of or interests in GATS trusts, may be effected electronically through the GATS  Platform. Designated transactions are each effected pursuant to a standard form instrument which is digitally signed by one or more individuals on behalf of each transacting entity and executed electronically through the GATS Platform. Establishment of a GATS trust, or migration of an existing trust into GATS so that it becomes a GATS trust, is one of the principal designated transactions effected electronically through the GATS Platform. As noted above, the transfer of the beneficial interest in a GATS trust, and the grant of a security interest in the GATS  Participant’s beneficial interest in the GATS trust are two other principal designated transactions. The following list represents all of the designated transactions which currently may be effected through the GATS  Platform using ‘best in class’ standard form instruments, opposite the name of the GATS standard form instrument or instruments which give effect to such transaction. Further designated transactions may come on-stream in future, such as a designated transaction giving effect to the appointment of a successor GATS trustee:

(1) (2)

Designated Transaction Establishment/migration of a GATS trust Transfer of beneficial interest in GATS trust

(3)

Permitted amendment

(4) (5)

Termination of a GATS trust Grant of a security interest in a GATS trust Transfer of benefit of security interest in a GATS trust Discharge and release of a security interest in a GATS trust

(6) (7)

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GATS Standard Form Instrument • Trust instrument (incorporating master terms) • Transfer instrument (full beneficial interest) • Transfer instrument (partial/residual beneficial interest) • Amendment instrument (trust instrument) • Amendment instrument (security instrument) • Termination instrument • Security instrument (incorporating master terms) • Security transfer instrument • Release and discharge • Release and discharge (partial release)

GATS legal framework 18.7 It is worth noting that not every transaction relating to the trading, leasing or financing of aircraft equipment may be effected electronically through the GATS Platform. In particular, it is not (yet) possible to execute, through the GATS Platform, a sale agreement, lease agreement or credit agreement. The standard form instruments were drafted by the firms advising AWG on GATS, including Watson Farley & Williams LLP, and have been comprehensively reviewed by experienced lawyers in many jurisdictions. The standard form instruments are also compatible with rating agency requirements, meaning that GATS trusts may be used for rated structured financings, such as aircraft assetbacked securities. There is a separate set of standard form instruments for each trust branch. The trust instrument and security instrument each incorporate a set of master terms, which keeps the length of each such instrument succinct. Each standard form instrument follows the same format, with transaction specific information contained only on the front page and the schedules. This makes review of GATS instruments in diligence exercises more efficient. Other than: (a) a narrow set of permitted amendments which must be effected pursuant to an amendment instrument through the GATS  Platform; (b) amendments given effect by another designated transaction; or (c) amendments given effect pursuant to a cross-reference in a GATS instrument to another instrument outside of GATS, no amendments to the GATS standard form instruments are permitted. Upon signing up to use the GATS  Platform, each GATS trustee and each GATS participant agrees not to amend any GATS instrument outside of the GATS Platform, without first submitting a notice through the GATS Platform that the affected trust is no longer a GATS trust. Upon submitting such notice, no further transactions relating to such trust may be conducted through the GATS Platform (nor will be recorded on the GATS e-Ledger) unless and until such trust is migrated back into GATS through the GATS Platform.

Favourable FAA/ACC opinion for United States trust branch GATS instruments 18.7 GATS standard form instruments are compatible for use with United States registered aircraft. The Office of the Aeronautical Center, Central Region Counsel at US  Federal Aviation Administration (the ‘FAA’), has issued an opinion concluding that the GATS standard form instruments for all United States trust branches comply with applicable federal law, are in due form for filing, and will support aircraft registration in the name of the relevant GATS trustee or GATS trust, as applicable. In line with the efficiency objectives of GATS, the opinion is a ‘global opinion’, the intent of which being to cover any designated transaction (using the electronic, non-amendable GATS standard form instruments) and the filing of the GATS standard form instruments. The filing of each GATS standard form instrument with the FAA will need to be accompanied by a certificate, as outlined in the opinion, certifying the conformity of such instrument with the corresponding GATS standard form. 297

18.8  Global Aircraft Trading System (GATS®)

Partial beneficial interest transfers 18.8 In order to facilitate a two-step transfer, whereby the transacting parties desire to transfer one item of equipment forming part of an aircraft a short while before or after transferring the remaining items (such as an off-wing engine shortly before or after the transfer or the airframe and other engine(s)), a partial beneficial interest transfer instrument has been developed to facilitate this scenario. Prior to GATS, one of the drawbacks of using owner trusts was that this could not be accommodated.

Limitation on GATS trustees’ resignation rights 18.9 In a change to the ‘standard’ resignation provisions in non-GATS trust instruments, GATS trustees of a GATS trust will not be permitted to resign for business reasons only while any aircraft equipment held by the GATS trust is subject to a lease. Resignation for other reasons, such as non-payment of fees or for regulatory reasons, is permitted.

ADVANCE REQUIREMENTS 18.10 GATS strengthens the protections available to airlines by allowing the airline and leasing company to record and track the conditions or requirements to any trade of the aircraft as ‘advance requirements’ against the relevant GATS trust. Once recorded, GATS applies a ‘technological block’ preventing any transfer of the beneficial interest in the GATS trust unless the airline has indicated, through the GATS Platform, that each of those advance requirements has been satisfied or waived. Advance requirements applicable to lease agreements may be recorded against a GATS trust at any time, including in advance of the delivery of the aircraft equipment held in the GATS trust and subject to the lease agreement, and can be set to apply to any transfer of the beneficial interest in the GATS trust for the duration of the scheduled lease term. Advance requirements may only be removed either with the consent of the airline, or upon the GATS participant of the relevant GATS trust certifying that the leasing of the aircraft equipment under the lease agreement has terminated.

BENEFITS OF GATS TO FINANCIERS 18.11 The use of a GATS trust in an aircraft equipment financing brings notable benefits to financiers, including the following: • the grant of security in the beneficial interest of the GATS trust provides an extra layer of security and therefore an additional enforcement option; • the GATS Platform imposes a technological block on any trading of the beneficial interest in the GATS trust until the security over the GATS trust has been released; • enforcement of the security over the beneficial interest of a GATS trust is arguably more efficient and straight forward than enforcement over share security or over security in a non-GATS trust, as that security can 298

The GATS Platform 18.14

•

be enforced electronically through the GATS Platform (to the extent such action is not prohibited by applicable laws, such as bankruptcy moratoria); the risk of the GATS trust being infected with liabilities is lower than that of a special purpose company, because a trust is a collection of assets and (with the exception of a Delaware statutory trust) is not treated as a separate legal entity.

THE GATS PLATFORM 18.12 As noted above, the GATS  Platform is the interface through which lessors, financiers and airlines can use all of the electronic features and functionality of GATS and may be accessed by navigating to https://e-gats.aero/.

GATS e-Ledger; searches 18.13 The GATS  Platform hosts the GATS e-Ledger, which records each designated transaction effected through the GATS Platform. Except during the short period of time during a partial beneficial transfer (see para 18.8 above), GATS does not permit there to be more than one beneficiary of a GATS trust at any one time. Also, no more than one person may be recorded in the GATS e-Ledger as holding a security interest granted in the beneficial interest in the GATS trust (although GATS does not prevent or prohibit second and other junior priority security interests being granted outside of GATS pursuant to nonGATS documentation). Thus, at any given time, only one person is recorded on the GATS e-Ledger as being the holder of the beneficial interest in the GATS trust or such security interest in it. The GATS e-Ledger is fully searchable, and, for a fee, a search certificate may be obtained in respect of any GATS trust which describes: • •

•

all designated transactions relating to that GATS trust, together with the effective time of each such designated transaction; the current and any prior GATS trustees, the current and any prior GATS participants holding the beneficial interest in that GATS trust, and the current and any prior GATS participants holding any security interest over that GATS trust; and the aircraft equipment noted on the GATS trust instrument as being currently held in that GATS trust.

The GATS e-Ledger may be searched by trust UIN, name of GATS participant, or aircraft equipment serial number. It is not possible to search the GATS e-Ledger by the name of the GATS trustee.

Entity profiles and categorisation 18.14 Entities or businesses wishing to use the GATS Platform are categorised as either: (1) GATS trustees, being corporate service providers wishing to provide corporate trust services and to act as the trustee of GATS trusts; 299

18.15  Global Aircraft Trading System (GATS®) (2) GATS participants, being aircraft owners, leasing companies or financiers wishing to hold a beneficial interest or security interest in a GATS trust; (3) professional advisors, including law firms (‘GATS professional entities’) wishing to take certain actions on behalf of other entities in the GATS Platform (to the extent authorised to do so, including within the GATS Platform); or (4) airlines or other organisations wishing only to benefit from advance requirements (‘non-GATS entities’). In order to use the features and functionality of GATS and the GATS Platform, an entity must, through the GATS Platform: • create its entity profile on the GATS Platform; • except for non-GATS entities, agree to the terms governing its use of GATS and the GATS Platform (the ‘GATS e-Terms’); • nominate two individuals, who have each created an individual user account on the GATS Platform, to act as its initial administrators. Except in respect of a non-GATS entity, each such individual must have ‘digital certificate user’ status on the GATS Platform; • pass a sanctions check (carried out in the background during the application process); • be cleared by the relevant person (see further below) or, in the case of a non-GATS entity, have the creation of its entity profile ‘acknowledged’ by an existing GATS participant. GATS trustees must be cleared by AWG as maintaining ‘KYC’ standards equivalent to that of a bank in the trust branch the applicant entity wishes to act as GATS trustee. GATS participants must be cleared by a GATS trustee as having passed that GATS trustee’s ‘KYC’ procedures. GATS professional entities must be cleared by a GATS trustee or a GATS participant as being a bona fide professional services provider. Non-GATS entities must have their application acknowledged by a GATS participant only for the purpose of preventing ‘bogus’ entity profiles being created, in order to maintain the integrity of the system. Use of the GATS Platform is available only to businesses, and not to consumers.

GATS professional entities 18.15 GATS professional entities may act as escrow coordinator of an escrow facility (the ‘GATS escrow facility’), the environment in the GATS  Platform through which designated transactions for any given GATS trust are populated and given effect. The escrow coordinator is the only person, once all digital signatures have been collected in escrow and all advance requirements have been confirmed as satisfied or waived, who may close the GATS escrow facility and thereby close and determine the effective time of each of the designated transactions contained in it. As of the time of publication, it is intended that further functionality will soon come on-stream which will considerably expand the role of and functionality available to GATS professional entities. If implemented in full, GATS trustees, GATS participants and non-GATS entities will be able to authorise one or more GATS professional entities to perform all actions on their behalf, including (from 300

GATS escrow facility; GATS fees 18.17 a technological standpoint) the digital signing of GATS instruments. Delegated authority granted to GATS professional entities in this way may be limited to one or more GATS trusts and to one or more individual users associated with that GATS professional entity. Additionally, GATS professional entities will also be able to create entity profiles on behalf of GATS participants, and act as administrator of such GATS participant.

User accounts and authentication 18.16 Prior to an individual user being allowed to create an entity profile for a GATS trustee, GATS participant or GATS professional entity, or digitally sign any GATS instrument on the GATS Platform, the individual is required to create a user account and upgrade their status to a ‘digital certificate user’. This means that the user is required to download an identification app on their mobile phone or smart device and pass a sanctions check. Through the identification app, the individual must verify their identity by scanning identification documentation and upload a live photo (the app requires the user to blink to ensure the photo is live). The app compares the live photo against the photo on their identification document. Identity verification helps to ensure that, at the first instance, digital certificate users are who they say they are (ie they are not masquerading as someone else) and that their digital signature, if applied to any GATS instrument, is uniquely linked to them. Additionally, the GATS  Platform uses two-factor authentication every time a user logs in. This means that, each time they wish to log in and in addition to being required to type their password, the individual user must also type a single use confirmation code sent to their mobile phone. The individual is required to give their mobile phone number at the time their identity is verified. This makes it very difficult for a person other than the verified user to log in using their account and use their digital signature. This two-factor authentication helps to ensure that the signatory is the same person that initially set up their user account, and also helps to ensure that their digital signature remains under their sole control.

GATS ESCROW FACILITY; GATS FEES 18.17 A  core feature of the GATS  Platform is the GATS escrow facility, which is the environment through which: • designated transactions are populated; • the GATS instruments related to such designated transactions are digitally signed and executed in escrow; • advance requirements, if any, are confirmed as satisfied or waived; and • digital signatures and executed GATS instruments are released from escrow, and the related the designated transactions are ‘closed’. GATS fees, which are charged on a per designated transaction basis, are charged prior to closing of the GATS escrow facility. The prevailing GATS schedule of fees can be viewed by navigating to https://documents.e-gats.aero/ scheduleOfFees.pdf. 301

18.18  Global Aircraft Trading System (GATS®) Upon closing of a GATS escrow facility, each designated transaction in it is effected in sequence, one immediately after the other, according to the order in which it was organised by the escrow coordinator of that GATS escrow facility. Any entity with a profile on the GATS Platform (other than a non-GATS entity) may create a GATS escrow facility and populate it with one or more proposed designated transactions. The entity that creates the GATS escrow facility becomes the ‘escrow coordinator’ and will typically be a GATS professional entity.

DIGITAL SIGNATURES AND GATS DIGITAL CERTIFICATES 18.18 The GATS  Platform employs the use of secure, ‘digital signature’ technology in order to facilitate the execution of the GATS standard form instruments through the GATS Platform. The term ‘digital signature’ is an encryption process used to logically and securely associate one set of data with another. However, as a matter of ‘legal tech’, it usually denotes a special type of electronic signature that has been applied, using an encryption process, to an electronic record, such as a legal instrument in electronic form. The encryption process utilised by GATS, like many other platforms using digital signatures, is a set of processes, procedures and policies known as ‘public key infrastructure’ (PKI). Many electronic signature laws worldwide, including those of the United States, the Republic of Ireland, the European Union and Singapore recognise digital signatures as fulfilling the requirements of an electronic signature, being a signature capable as having the same legal effect as a ‘wet ink’ signature (but subject to any limitations or qualifications imposed on electronic signatures by such laws). The PKI cryptographic processes used by GATS to manage and generate digital signatures satisfy the additional requirements under the laws of those jurisdictions (including Regulation (EU) No 910/2014 on electronic identification and trust services for electronic transactions, the so-called ‘eIDAS  Regulation’) which recognise what are generally known as ‘advanced’ electronic signatures and which confer on such electronic signatures enhanced legal recognition. Consistent with PKI principles, each individual signing documents using the GATS Platform has their own ‘digital identity’, made up of three components: (1) a digital certificate issued by the GATS  Platform to that individual (a ‘GATS digital certificate’). An individual’s digital certificate contains information about their identity, about the certificate authority who issued it to them, about the digital certificate itself (for example, its expiry date), and their public key (see below); (2) a public cipher or ‘key’ (a ‘public key’). The details of an individual’s public key are described in their GATS digital certificate and can be used to verify any digital signature of that individual and make sure the GATS instrument to which it was applied has not been subsequently edited or tampered with; (3) a private cipher or ‘key’ (a ‘private key’). When an individual digitally signs a GATS instrument, they do so using their private key. Each private key must be securely stored by the certificate authority while remaining 302

Digital signatures and GATS digital certificates 18.20 accessible only to and under the sole control of the individual to whom it belongs. While an individual’s GATS digital certificate is not itself used to digitally sign GATS instruments (that is done using the individual’s private key, which should never be disclosed and should be kept under their sole control), the information contained in their GATS digital certificate, including that individual’s public key, forms part of their digital signature. In so doing this allows each digital signature, and its application to a GATS instrument, to be validated by the GATS Platform at any time.

Visualisation of digital signature on GATS instruments 18.19 On the GATS  Platform, the digital signature of the individual or individuals executing a GATS instrument is visually represented on the ‘signature page’, and contained in an execution block, mirroring the location of a wet ink signature and the form of a paper-based document; however, the visual representation is not the digital signature itself. A  sample of the visual representation of an individual signatory’s digital signature on a GATS instrument is shown below. The whole execution block which, for each party to the instrument, may contain one or more signatories (for compliance with applicable law or corporate governance requirements) is also shown for completeness: EXHIBIT 18.1 DIGITAL SIGNATURE ON A GATS INSTRUMENT

Source: Property of the Aviation Working Group and used with its permission

Both the ‘digital signature code’ and the QR code (when scanned using a QR code reader) can be used to authenticate, through the GATS Platform, the valid application of that digital signature by the signatory to the GATS instrument. A timestamp is also provided identifying when the GATS instrument was signed by the signatory. This is not the date and time of effectiveness of the GATS instrument, but the actual time the digital signature was applied (like the paperbased world, the digital signature is held in escrow until it is released).

Configuration of execution block 18.20 The GATS Platform allows each entity to customise its execution block, by being able to add multiple layers of intermediate corporate authorisations. For example, if a GATS participant, as the beneficiary of a GATS trust, is a single 303

18.21  Global Aircraft Trading System (GATS®) member-managed limited liability company, and its sole member-manager is not an individual, this can be accommodated through such customisation.

Multiple signatories per transacting entity; witnessing of digital signatures 18.21

The GATS Platform allows each transacting entity to:

•

customise the number of signatories required to digitally sign the GATS instrument on its behalf; and

•

toggle the ability to require the digital signature of each signatory to be witnessed and customise how many witnesses per signatory are required.

Where an individual’s digital signature is to be witnessed, the witness must also hold a user account on the GATS Platform and also have ‘digital certificate user’ status, so that they can apply their digital signature to the GATS instrument confirming that they witnessed the signatory digitally sign the document. Where a GATS instrument is required to be witnessed (none are by default, but the requirement may arise pursuant to other applicable law), the visual representation of the witness’s digital signature on a GATS instrument is shown immediately below the signatory’s. It is important to note that, under the electronic signature laws of most jurisdictions, for a witness’s attestation to be legally valid, the witness must still, in person (for example, by looking over their shoulder or through a window), witness the signatory applying their digital signature, even if the witness digitally signs as a witness in a separate location and at a later time.

Validation of GATS instruments 18.22 GATS instruments may be validated as a true copy of the original by scanning the QR code on the front of the document. An individual’s visual representation of their digital signature may be validated by scanning the QR code next to it. Additionally, a PDF of a GATS instrument indicating on its front page that it is a duplicate original may be validated as such through the GATS Platform by navigating to http://e-gats.aero/authenticate/.

WHAT’S NEXT FOR GATS? 18.23 While the Covid-19 pandemic has temporarily depressed aircraft trading volumes, GATS and the GATS Platform represent a huge leap forward in terms of modernising and making much more efficient the way in which aircraft equipment is traded, not least through the innovative use of digital signatures and the electronic execution of documents. As use of GATS steadily increases, its benefits will be fully realised through lower transaction costs and faster ‘closings’. This in turn will facilitate more liquidity in the trading of aircraft. It is conceivable that the digital signature and electronic execution functionality of GATS will in future be expanded to allow, for example, any document or suite of documents to be uploaded, including lease documents and finance documents, and for those documents to be digitally signed and executed electronically in a wholesale fashion. 304

What’s next for GATS? 18.23 More interestingly perhaps and if its success continues, GATS and the technology developed for it could be expanded further to open the door to ‘pick and mix’ investment in aircraft portfolios, with the beneficiaries of GATS trusts issuing fractionalised, equity securities (ie securities representing a specific percentage ownership of the equity in an aircraft), with those securities being issued and traded electronically.

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19 Airline Restructurings William Glaister, Philip Hertz, Jennifer DeMarco, Gabrielle Ruiz and Marisa Chan

INTRODUCTION 19.1 The commercial passenger airline market is an inherently cyclical industry, typified by tight operating margins and a high degree of sensitivity to external influences, including jet fuel prices and US dollar interest rates. Political, economic and trade tensions, financial markets disruption and other major regional or global events, any of which may lead to a noticeable increase in those fuel costs or interest rates and/or to a sudden drop in passenger numbers, are all factors which have a pronounced impact on airlines’ businesses. At the time of writing, the industry has been and continues to be severely affected by the Covid-19 pandemic and the resulting travel restrictions, border controls and public health measures put in place by governments to deal with the virus outbreak. Previous events which have had a significant, negative effect on the sector include the 9/11 terrorist attacks, the global financial crisis and past pandemics or epidemics, such as SARS and MERS. However, none of these has had the equivalent reach, duration or level of severity as that brought about by the Covid-19 global shutdown.

Consensual restructurings 19.2 In any distressed environment, many airlines are seeking rescue. The rescue plan may involve the airline agreeing consensual forbearance or amendments and rescheduling of existing financial debt and other payments with its creditors, as well as taking other measures, such as further borrowings, debtto-equity conversions and broader operational restructuring steps, for example, reducing operations and personnel, depending on negotiations with its employees and other stakeholders and the management’s overall business plan for survival. These consensual agreements may be in accordance with pre-agreed contractual majorities, or based on unanimous consents.

Statutory restructuring processes 19.3 In other scenarios, the rescue may take the form of a statutory restructuring process where, for example, obtaining unanimous creditor consent is not required and a court or other supervising authority sanctions may be called upon to approve the airline’s proposals and to exercise other protective powers, 307

19.4  Airline Restructurings such as a stay on enforcement against the airline’s assets based on certain creditor thresholds being met. If the airline is state-owned or controlled and/ or it is in the national interest to maintain aviation connectivity, then its home government may step in to assist reorganisation. Some airlines may be eligible for state support.

Insolvency procedures 19.4 Sometimes, the airline will have no choice but to enter into a formal corporate insolvency process which may include a rescue process. Depending on the applicable regime, the airline’s creditors may also petition for its insolvency. The process may result in the airline being rehabilitated and it may emerge in a different form, with certain assets and liabilities transferred to a new entity (often referred to as a ‘hive-down’). Matters such as the transfer of pilots, crew and other employees, goodwill, ticket and credit card receivables, airport slots, operating routes and applications for operating licences, safety and other regulatory authorisations will need to be resolved, together with the settlement or discharge of existing debts. If the business is unable to be rescued, it will be wound up and its assets distributed to creditors according to a prescribed order of priority.

Jurisdiction 19.5 In many cases, the restructuring or insolvency will be governed by the laws of the airline’s jurisdiction of incorporation: these are referred to as ‘domestic processes’. However, increasingly, airlines have sought to avail themselves of restructuring laws in two key jurisdictions – the United States of America and, more recently, the United Kingdom. This chapter summarises the corporate reorganisation regime under Chapter 11 of the US Bankruptcy Code and the English statutory restructuring processes available under Part 26 and Part 26A of the Companies Act 2006, with a focus on those issues of relevance where the debtor company is a commercial passenger airline incorporated in another country, that is, respectively, not a US or a UK incorporated airline.1

UNITED STATES 19.6 The powers and protections available to a debtor under Chapter  11 of the US Bankruptcy Code are generally considered to be significantly more extensive than those available under many other countries’ restructuring and insolvency laws. The US  Bankruptcy Court is well-versed in determining 1 This chapter does not address the US bankruptcy regime or any UK corporate insolvency processes (eg  administration, liquidation or company voluntary arrangements) which the debtor airline may consider nor does it cover any separate enforcement mechanisms, such as administrative receivership or receivership, which may be available to creditors in a distressed airline scenario. A  detailed examination of general restructuring and insolvency principles, including jurisdiction and recognition of foreign proceedings, is outside the scope of this chapter. This chapter is not intended to provide legal, structural, commercial or other advice and shall not be relied upon by any party as such. It is not exhaustive or definitive as to the subjects it discusses.

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United States 19.8 complex and high-value reorganisations involving foreign companies and their worldwide assets and the jurisdictional threshold for commencing a proceeding in the US is minimal. A Chapter 11 reorganisation may be commenced by the airline debtor (by filing a petition, together with supporting documents, with the Bankruptcy Court) or, in certain circumstances, by a requisite number of its creditors with a requisite amount of claims. Subject to exceptions, the airline will retain possession of its property and its management will continue its day-to-day operations: Chapter 11 is therefore commonly referred to as a ‘debtor-in-possession’ regime. The court’s approval is required for any transaction outside of the airline’s ‘ordinary course of business’, eg obtaining financing and selling assets (in each case, other than in the ordinary course).

Automatic stay 19.7 Upon the filing of a case under Chapter 11, a stay arises immediately and automatically, which prohibits, amongst other things, any act against the debtor or its property, wherever located. The automatic stay captures, eg  the filing of any proceedings against the company, the service of a default notice against the company or the set-off against a security deposit provided by the company. In an airline context, it prevents a lessor of an aircraft operated by the airline from terminating its lease and a lender with security over the aircraft from enforcing its security, in either case, regardless of the governing law of the agreement and the location or registration of the aircraft at the relevant time, unless the lessor or the lender obtains Bankruptcy Court approval to do so. The automatic stay is worldwide and remains in place for the duration of the Chapter 11 case (unless modified or lifted by the court), subject to limited exceptions: it is considered one of the fundamental debtor protections under the Bankruptcy Code.

Other key Chapter 11 measures Rejection of leases and executory contracts – abandonment of mortgaged property 19.8 Under Section 365 of the Bankruptcy Code, the debtor may assume or reject unexpired leases and executory contracts, subject to the court’s authorisation. In order to assume an unexpired lease, the airline must cure existing defaults (other than bankruptcy defaults) and provide adequate assurance of future performance. A rejection of an unexpired lease or executory contract is treated as a breach as of the commencement of the bankruptcy proceeding and the lessor or other counterparty may submit a claim for damages against the debtor’s estate. Any leased aircraft which are rejected may be returned to the lessor ‘as is, where is’ and not in the condition or at the location specified in the lease. Similarly, the debtor may seek court approval to abandon property that is owned by the estate, including, in an airline context, any aircraft which is mortgaged to another party and typically in which the airline has no residual interest. In such case, the airline may return the aircraft ‘as is, where is’ and not in the condition or at the location specified in the loan or other agreement. 309

19.9  Airline Restructurings

Debtor-in-possession financing – cash collateral 19.9 The Bankruptcy Code allows the debtor to obtain new debtor-in-possession financing. If the airline is unable to obtain unsecured funding, the court may approve it incurring debt by granting the lender: a ‘super-priority’ administrative expense claim; a lien on any unencumbered assets; a junior lien on encumbered assets; or, in special cases, a lien equal or senior to any existing liens (a ‘priming lien’), provided that the existing security-holder is adequately protected. Post-petition, the company may use any unencumbered cash to operate its business or, if it has none, it may use a secured creditor’s ‘cash collateral’, as defined in the Bankruptcy Code, provided that the secured creditor consents to such use or the court authorises such use on the basis that it determines that the secured creditor is adequately protected.

Jurisdiction 19.10 Jurisdiction for a Chapter 11 case may be established by the foreign airline (or other debtor) having US assets, including a US dollar account. At the time of writing, several non-US distressed airlines are in Chapter 11 proceedings, including major Latin American operators severely impacted by the Covid-19 pandemic.

‘Ipso facto’ provisions – Section 365 of the Bankruptcy Code 19.11 Section 365 of the Bankruptcy Code generally renders ‘ipso facto’ provisions unenforceable. These are provisions in a contract which allow termination or modification of the debtor’s rights upon the commencement of bankruptcy (or similar) proceedings or the deterioration of the debtor’s financial condition.

US certificated air carriers – Section 1110 of the Bankruptcy Code 19.12 Section 1110 of the Bankruptcy Code, which applies to certain US certificated air carriers, provides for a modification to the automatic stay if the debtor airline does not agree to cure the non-bankruptcy related defaults and to perform its obligations under a relevant agreement by a specified period (essentially, within 60 days of the Chapter 11 filing, unless the relevant creditor has agreed to extend that period), that permits the applicable lessors or financiers to repossess qualifying aircraft and other equipment. Section 1110 is a crucial protection for airline creditors, however, it applies to debtors who qualify as US certificated air carriers and thus, generally speaking, it is not available in a foreign airline Chapter 11 case.

Alternative A of the Cape Town Convention2 19.13 Alternative A  of Article XI of the Aircraft Protocol to the Cape Town Convention is modelled on Section 1110 of the Bankruptcy Code. The 2

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Please refer to Chapter 21 of this publication for details on the treaty provisions.

United Kingdom 19.14 Alternative A protections are available to the holder of a registered international interest (a ‘Cape Town Creditor’) upon the occurrence of an insolvency-related event (as defined) regarding the relevant debtor; and Article XI applies where the contracting state that is the primary insolvency jurisdiction (PIJ) has made a positive declaration adopting the regime and specifying the relevant waiting period. The PIJ is the contracting state in which the debtor’s ‘centre of main interests’ (COMI) is situated. While the United States has ratified the Cape Town Convention, it has not made the Article XI declaration. If the United States is the PIJ in a Chapter 11 case, then Alternative A will not apply. Alternative A may still be relevant where a foreign airline enters into Chapter 11 and its home jurisdiction (or COMI, if different) is in a contracting state which has adopted Alternative A. In such scenario, that contracting state might be treated as the PIJ for Cape Town Convention purposes. Further, Article XXX(4) of the Aircraft Protocol provides that the courts of a contracting state shall apply Article XI in conformity with the declaration made by the contracting state that is the PIJ. While as yet untested, the Bankruptcy Court might be called upon to afford those Alternative A protections to the creditors of a foreign airline in a Chapter 11 case.3

UNITED KINGDOM Schemes of arrangement 19.14 A creditors’ scheme of arrangement is a compromise or arrangement between a company and its creditors (or any class of them) and/or its members, made pursuant to the Companies Act 2006 (‘CA 2006’), Part 26, ss 895–901 (a ‘scheme’). It is not an insolvency proceeding but can be implemented in conjunction with formal insolvency proceedings, such as administration or liquidation, or on a standalone basis. The scheme becomes legally binding on the company and such creditors, which may include secured creditors (or any class), if: • a majority in number representing 75% in value of creditors (or each class) present and voting at meetings (in person or by proxy) summoned pursuant to a court order, vote in favour; • the scheme is sanctioned by a further court order after the creditors’ meetings; and • an office copy of the order sanctioning the scheme is delivered to the Registrar of Companies for registration. If the requisite majorities are obtained, the scheme will bind all the relevant company’s creditors as at its date (or the relevant class/classes), whether they were notified of the scheme and/or whether they voted in favour or against. This outcome applies, notwithstanding any contractual provisions requiring the consent of a dissenting or absent creditor to any amendments to the relevant debt 3

For further reading, please refer to the Cape Town Convention Academic Project’s published annotation to the 4th Edition of the Official Commentary, dated 13  July 2020 and entitled ‘Aspects of cross-border insolvencies and the Cape Town Convention’: see https://ctcap.org/wpcontent/uploads/2020/07/Annotation-2-to-OC-4th-Ed-Aspects-of-cross-border-insolvenciesand-the-Cape-Town-Convention.pdf.pdf.

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19.15  Airline Restructurings being ‘schemed’. The court must be satisfied that every effort has been made to contact all creditors. A  scheme therefore provides a highly useful mechanism to overcome the impossibility or impracticality of obtaining unanimous creditor consent; and to prevent, in appropriate circumstances, a minority from frustrating what is otherwise in the interests of a company’s creditors generally (where, eg  the alternative is an insolvency process which may destroy value). It is extremely flexible and may be used for implementing almost any compromise or arrangement a company and its creditors and/or members may agree amongst themselves (eg a debt-to-equity swap, moratorium or amendments to existing agreements). Companies regularly use schemes to restructure their arrangements, there is no financial threshold to access the English court’s jurisdiction to approve a scheme, they can be used by solvent and insolvent companies. The scheme does not have to address all the company’s debts and affairs. The company may decide which creditors (or classes) and which debts it wishes to compromise. The court will determine whether particular creditors have been appropriately classified in the same class: the established test is whether their ‘rights are not so dissimilar as to make it impossible for them to consult together with a view to their common interest’. A  scheme does not give rise to a moratorium, although the company may be eligible to seek a limited moratorium under Part A1 of the Insolvency Act 1986, as introduced by the Corporate Insolvency and Governance Act 2020 (CIGA 2020). A company could also file for administration or liquidation in parallel with use of a scheme, both of which involve a statutory moratorium.4 Regulation 37 of the International Interests in Aircraft Equipment (Cape Town Convention) Regulations 2015 (SI  2015/912, the ‘UK  Cape Town Regulations 2015’) provides that, amongst other things, the restrictions on enforcement of security and repossession of hire purchase property, including leased property, under the respective moratoria do not apply after the end of the specified waiting period.

Foreign airline – scheme of arrangement – case study 19.15 In the case of Re MAB  Leasing Ltd5 (February 2021), the English court sanctioned a scheme proposed by MAB Leasing Ltd (‘MABL’). MABL is part of Malaysia Aviation Group Berhad (‘MAB’) which operates Malaysia’s national flag carrier. The scheme restructured the English law governed operating leases of aircraft representing over half the airline’s fleet. The scheme offered various operating lessors a menu of options, including rent revisions to reflect current market rates, with variations depending on aircraft type and vintage, and termination of the leases and repossession of the aircraft. Leases relating to the 4

5

Prior to the restructuring reforms introduced by the CIGA 2020, administration was the main rescue procedure and has been used in a number of high-profile airline insolvencies including by Monarch Airlines in 2017. In the UK, during the administration process it should be noted that the terms for the continued use of an aircraft is simply a matter for negotiation with the administrator and payments for the use of the aircraft are treated as an administration expense (ie  payable before other unsecured claims including the administrator’s own fees and importantly also ahead of creditors with floating charge security). Likewise funding in the UK for the period of any trading administration is a matter for negotiation and any super priority must be agreed by those affected. A bespoke special administration regime for airlines prioritising the repatriation of passengers is also being considered as recommended by the Department of Transport’s Airline Insolvency Review (19 May 2019). [2021] EWHC 152 (Ch) (convening order) and [2021] EWHC 379 (Ch) (sanction order).

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United Kingdom 19.17 remaining fleet aircraft and other agreements were kept out of the scheme and negotiated by the airline on a bilateral basis. The court was satisfied that the grouping of the various operating lessors into a single class for voting purposes was appropriate, applying the classic test. The scheme creditors’ rights in the comparator (that is, if the scheme were not implemented, which the airline argued would be a domestic liquidation) would be materially similar, as each lessor could terminate its lease and claim damages against the airline’s estate, and those claims would result in a substantial loss. The rights conferred by the scheme were also sufficiently similar to satisfy the test as the creditors were offered the same set of options, essentially to terminate their respective leases, recover their aircraft and receive a termination payment slightly above what they would receive in the comparator, or to continue their respective leases on amended terms. Differences in the market rent payable for different aircraft types and vintages, for example, did not fracture the class. The court took a pragmatic view of the scheme, grouping lessors with leases of different maturities in a single class: amongst other things, a term-sensitive approach might result in a proliferation of individual creditor classes. All lessors were offered the same option of immediate termination and their likely recoveries upon a liquidation would be similar.

Jurisdiction 19.16 When determining whether to sanction a scheme proposed by a foreign airline, the English court will ask whether there is a sufficient connection to England and if the scheme will be internationally effective. The court in the MABL scheme (at para 19.15) was satisfied that the choice of English law as the governing law of all the operating leases established sufficient connection. The unanimous consent of all the scheme creditors together with persuasive expert evidence from Malaysian counsel that the scheme was likely to be recognised in Malaysia indicated its international effectiveness.

Restructuring plans 19.17 The CIGA  2020 established a new restructuring plan procedure (an ‘RP’) under Part 26A of the CA 2006. This is modelled on the schemes in that the court may sanction a compromise or arrangement between a company and its creditors (or any class of them), including secured creditors, and/or its members. The expectation is that the developed case law regarding schemes will inform the English court on RPs, including the same test for jurisdiction based on a sufficient connection. However, an RP differs from a scheme in the following key aspects: • the procedure is only available to companies encountering, or likely to encounter, financial difficulties that will or may affect their ability to continue as a going concern; and • the purpose of the RP must be to eliminate, reduce, prevent or mitigate those financial difficulties (the ‘threshold conditions’); and further: • an RP allows creditors (or members) representing 75% in value (in any class) to vote in favour of the plan, ie there is no numerosity test as with schemes, only a value test, and this outcome will bind the others in that class; and 313

19.18  Airline Restructurings •

further, one class can bind the other classes who have voted against the plan, provided that the court is satisfied that the dissenting creditors/ classes are no worse off than they would be in the relevant alternative (eg a liquidation) and that the approving class has a genuine economic interest in that alternative. This measure is often termed ‘cross-class cram-down’.

As with a scheme, an RP does not give rise to a moratorium, although the company may enter a Part A1 moratorium, if applicable, or file for administration or liquidation at the same time.

Domestic airline – restructuring plan – case study 19.18 In the case of Re Virgin Atlantic Airways Ltd6 (September 2020), the English court sanctioned the first ever RP which was proposed by the UK airline, Virgin Atlantic Airways Limited (‘VAA’). The plan included four creditor classes, including a class comprising operating lessors of 24 aircraft leases, and involved the rescheduling of certain debts as part of a broader recapitalisation programme by the airline. The lessors were offered a menu of options, including rent deferrals for a certain period or terminating the leases and recovering their aircraft. All the creditors in three of the classes agreed in advance to the proposals, with the remaining class of trade creditors ultimately voting in favour at the class meeting. Accordingly, the court was not required to determine whether the new cross-class cram-down power was available or, if so, on what basis it should be exercised.7 VAA applied also to the US Bankruptcy Court for recognition of the RP approved by the English court. This was granted pursuant to Chapter 15 of the US Bankruptcy Code.8 Chapter 15 is a well-trodden path for recognition of English proceedings, in particular for schemes.

Alternative A of the Cape Town Convention – UK Cape Town Regulations 2015, reg 37 19.19 The UK has ratified the Cape Town Convention, as implemented by the UK  Cape Town Regulations 2015. The UK did not make the relevant treaty declaration adopting Article XI, Alternative A; however, it amended its domestic insolvency laws to import Alternative A, with a 60-day waiting period, as provided for by the UK Cape Town Regulations 2015, reg 37. Regulation 37(9) provides that upon an insolvency-related event (as defined), ‘no obligations of the debtor under the [relevant] agreement may be modified

6 7

8

[2020] EWHC 2376 (Ch). Some guidance as to how the English court will approach cross-class cram-down can be found in another case in relation to a health club operator: Re Virgin Active Holdings Ltd, Virgin Active Ltd and Virgin Active Health Clubs Ltd [2021]  EWHC  1246 (Ch). The court’s focus in that case was to ensure that the dissenting creditors were no worse off than the relevant alternative. Most notably in that case the court held that if creditors are ‘out of the money’ in the relevant alternative, then they can upon an application being made, be excluded from voting on the plan by the court. If they are not excluded, the court will place no weight upon their disapproval of the plan. Chapter 15 is the US enactment of the UNCITRAL Model Law on Cross Border Insolvency Proceedings. The UK has also enacted the Model Law on Cross Border Insolvency Proceedings which takes the form of the Cross-Border Insolvency Regulations 2006 (SI 2006/1030) and has been regularly used in providing assistance and recognition of foreign proceedings, including Chapter 11.

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United Kingdom 19.20 without the consent of the creditor’. The impact of this creditor protection where an airline or other debtor seeks, under either a scheme or an RP, to compromise its obligations owed to Cape Town creditors (who may be aircraft lessors or lenders with the benefit of qualifying mortgages or other aircraft security), has been a matter of great interest to industry participants in the current distressed airline market, particularly in light of the cross-class cram-down measure available under an RP since its introduction in June 2020. Certain aviation parties, including academics and legal practitioners, consider that the effect of reg 37(9), if applicable, is that a dissenting Cape Town creditor in a scheme or an RP (or a dissenting creditor class in an RP) proposed by an airline cannot be bound by the relevant plan, notwithstanding that the requisite majorities vote in favour. The threshold question is whether an RP or a scheme is an ‘insolvency proceeding’ within the definition of ‘insolvency-related event’ for the purposes of the UK Cape Town Regulations 2015, or, as the case may be, the Cape Town Convention itself (the ‘Cape Town question’9) and which triggers reg 37. In February 2021, the English court in a separate, non-airline related decision (Re Gategroup Guarantee Ltd10), confirmed that RPs are insolvency, rather than civil and commercial, proceedings for the purposes of the Lugano Convention. The UK Cape Town Regulations 2015 were not under discussion; however, in the context of an RP where the threshold conditions set out above are met, such a plan may well be treated as a Cape Town ‘insolvency proceeding’, on the basis that the principles applied by the court in Gategroup to the Lugano analysis are very similar to those applicable to the Cape Town question. The categorisation of the process was key in Gategroup to ensure that the English court had jurisdiction to approve the RP. The RP in that case sought (amongst other things) to compromise Swiss law governed debts with an exclusive jurisdiction clause in favour of courts in Zurich, and was based on the likelihood of its recognition and effect in Switzerland. The Gategroup RP represented the only route for avoiding an insolvency which would have been highly damaging for all stakeholders, including all the creditors of Gategroup. The Gategroup decision did not address the question of whether a scheme is an insolvency proceeding and this remains as yet untested. The conclusion is likely to be fact-specific, eg a company is not required to satisfy the threshold conditions in order to avail itself of a scheme. As all the creditor classes in the VAA RP (see para 19.18) and all the scheme creditors in the MABL scheme (see para 19.15) discussed above voted in favour of the relevant plan, the English court was not required to consider the Cape Town question in either case.

Cape Town Convention compliant arrangements 19.20 Both the VAA RP (see para  19.18) and the MABL scheme (see para 19.15) offered the relevant lessors, including those who qualified as Cape 9 The Cape Town Convention defines ‘insolvency proceedings’ as ‘bankruptcy, liquidation or other collective judicial or administrative proceedings, including interim proceedings, in which the assets and affairs of the debtor are subject to control or supervision by a court for the purposes of reorganisation or liquidation’ (Ch 1, Art 1(l)). 10 Re Gategroup Guarantee Ltd [2021] EWHC 775 (Ch).

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19.21  Airline Restructurings Town creditors, the choice between, amongst other things, exercising their right to terminate their respective leases and repossess their aircraft or agreeing to the proposed amendment of the airline’s lease obligations. There is an argument that, notwithstanding that the UK Cape Town Regulations 2015, reg 37(9) might be triggered by a specific plan (in other words, the Cape Town question has been satisfied), if such plan respects a Cape Town creditor’s right to terminate the lease (or other relevant agreement) and to recover its aircraft object, then such plan may still be treated as complying with the UK Cape Town Regulations 2015. Further, it is generally accepted as a matter of English restructuring and insolvency law that the proprietary interests of a creditor, including the rights of an owner or a lessor, may not be compromised by a scheme or an RP.11 While case law on schemes, RPs and other procedures (eg company voluntary arrangements) has primarily involved landlord and tenant arrangements and the landlord’s reversionary interest, the English court might apply a similar analysis to the ownership or other proprietary right of any lessor of personal property, including a Cape Town creditor.12

‘Ipso facto’ provisions – Insolvency Act 1986, s 233B 19.21 Under the Insolvency Act 1986, s 233B, as amended by the CIGA 2020, a provision in a contract for the supply of goods or services to a company ceases to have effect when the company becomes subject to a relevant insolvency procedure (as defined), if and to the extent that, under that provision, either the contract or the supply would terminate (or any other thing would occur) or the supplier would be entitled to terminate the contract or the supply (or do any other thing). A relevant insolvency procedure includes an RP but not a scheme. Section 233B also applies where the termination right arises prior to the relevant time but has not been exercised, although termination for a subsequent, noninsolvency related event (eg  a payment default) is permitted. A  supplier may seek relief from the court if the continued supply would cause hardship and the debtor company or its insolvency officer may consent to termination of the relevant contract, for example where the insolvent company is not in a position to pay for the continued supply of goods or services. It is assumed that an English law governed operating lease of an aircraft is subject to s 233B. There are prescribed exclusions to this section, including where the contract involves ‘financial leasing’ and other financial services and/or one of the parties is involved in financial services. Further, there is an express provision 11 See Re Virgin Active Holdings Ltd, Virgin Active Ltd and Virgin Active Health Clubs Ltd [2021] EWHC 1246 (Ch). 12 For further reading on the Cape Town question, please refer to: (1) the Cape Town Convention Academic Project’s published annotation to the 4th Edition of the Official Commentary, dated 16 June 2020 and entitled ‘Reorganisation Arrangements’: see https://ctcap.org/wp-content/uploads/2020/06/CTCAP-%E2%80%93-annotation-1to-OC-4th-Ed-%E2%80%93-reorganisation-arrangements.pdf; (2) an expert opinion obtained by the Aviation Working Group: Professors Louise Gullifer and Riz Mokal, ‘CTC restructuring plans and schemes of arrangements in the insolvency context’: see http://awg.aero/wp-content/uploads/2021/04/CTC-status-of-RPs-and-Schemes-ExpertReport-Revised-29-Apr-2021.pdf; and (3) William Glaister, Philip Hertz, Marisa Chan and Gabrielle Ruiz, English schemes and the Cape Town Convention Butterworths Journal of International Banking and Financial Law (May 2021).

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United Kingdom 19.21 that nothing in s 233B affects the UK Cape Town Regulations 2015. This may be helpful to an operating lessor which is the creditor of an international interest over the relevant aircraft object as constituted by the lease and therefore, once the waiting period is over, a lessor’s usual remedies will apply.

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Part IV Regulatory Matters

20 The Regulatory Framework for Airline Operations Alan Ryan

THE INTERNATIONAL FRAMEWORK Introduction 20.1 The regulation of international air transport has a significant influence on aircraft financing. Some countries such as Singapore and Dubai have always had a very open and deregulated approach to civil aviation but, until recently, larger countries have all had a protectionist approach to a greater or lesser extent. However, in recent years, there has been a strong move towards deregulation or liberalisation of the skies, emanating initially from the USA and Europe, which is starting to free airlines from the constraints of the highly regulated environment set down by the Chicago Convention of 1944. Whilst the US domestic market was deregulated in 1978, international routes had remained restricted. The USA had made the conclusion of ‘open skies agreements’ with third countries a policy priority and, in recent years, the European Union (EU) followed suit though it took many years for the cumulative effect of many different open skies agreements to be felt. These deregulation moves were largely achieved by the turn of the century, if not earlier in the USA and Europe, following which airlines have adjusted to the new normal of a deregulated internal market and partially deregulated international market (with some routes being significantly more deregulated than others). Other regions such as Latin America, Association of Southeast Asian Nations (ASEAN), Australia and New Zealand have since followed suit leading to many regions being deregulated for internal travel but travel between the regions is still largely regulated. In any analysis of how the regulatory regime affects an airline’s credit position and financing options, it is important to look at the practical reality as well as the theoretical legal position. Even though many countries in regions such as Africa still technically have highly regulated and restrictive aviation regimes, market forces have led to the emergence of pan-African carriers like Ethiopian Airlines which have affiliates in several countries outside its home country and run a very successful pan-African and indeed global network. As a result, whilst in this changing environment the extent to which an airline will profit or lose from such liberalisation is an important credit issue for financiers, the practical reality of increasingly deregulated markets and market-driven international players is at least as important as the theory behind the regulation. This chapter seeks to explain the background to the liberalisation or open skies developments and the main areas of regulation that will interest financiers and airlines alike. 321

20.2  The Regulatory Framework for Airline Operations

Chicago Convention 19441 20.2 Notwithstanding the deregulation of the US, EU and other countries’ aviation markets, the principles laid down in the Chicago Convention of 1944 still govern international air travel. Even though these date from well before the jet age, it is still instructive to review this convention. Many of the concepts appear outdated and relevant only to the history books; and many are in practice irrelevant to the modern day reality. Nevertheless, the concepts of the Chicago Convention are still essential to understanding the modern day industry. States that are parties to the Chicago Convention agreed that they should have the power to grant each other certain rights to fly over each other’s territories and also the ability to place certain restrictions on the exercise of such rights. The actual rights granted and restrictions imposed are either contained in a multilateral agreement between several states, such as the Five Freedoms Agreement of 1944, or have been individually negotiated in separate bilateral treaties. The Final Act of the Chicago Convention was signed in 1944 by 51 states. The Chicago Convention laid down various obligations concerning the flight and manoeuvre of aircraft, and established the International Civil Aviation Organisation (ICAO) which subsequently became a specialised agency of the United Nations. The ICAO’s functions cover a wide range of as aircraft design, airport design and management, the provision of air navigation services, the maintenance of fair competition between carriers and the general oversight of interstate relationships in civil aviation. The Chicago Convention established the general principle that each state should have the absolute right to control the operation of its scheduled aviation system (sometimes referred to as ‘the Chicago system’) that has developed from the Chicago Convention itself, the Five Freedoms Agreement and a web of bilateral treaties.

Five Freedoms Agreement 20.3 Following signature of the Chicago Convention, approximately 20 states signed the International Air Transport Agreement, otherwise known as the Five Freedoms Agreement, which was intended to establish general and universal ground rules for international air transport. Among other things, the Five Freedoms Agreement defined the five different air navigation rights that have frequently been used in subsequent agreements. These air navigation rights are: (1) the privilege for aircraft of one state to fly across another state’s territory without landing; (2) the privilege for aircraft of one state to land in another state for non-traffic purposes (for example, for refuelling); (3) the privilege for aircraft of one state to bring passengers, mail and cargo from its home state to another state; (4) the privilege to take on board passengers, mail and cargo in another state for carriage to an aircraft’s home state; and (5) the privilege to take on board passengers, mail and cargo in another state for carriage to a third state and to put down passengers, mail and cargo from the third state in the other state. 1

322

Convention on International Civil Aviation, Chicago (7 December 1944).

The international framework 20.4 The sixth, seventh and eighth freedom rights have also been informally recognised. These are: (6) the privilege to take on board passengers, mail and cargo between two countries by an airline of a third on two routes connecting in its home country; (7) the privilege to take on board passengers, mail and cargo between two countries by an airline of a third on a route outside its home country; (8) the privilege to take on board passengers, mail and cargo within a country by an airline of another country on a route with origin/destination in its home country (also known as consecutive cabotage). The privilege to take on board passengers, mail and cargo within a country by an airline of another country (that is, a true domestic service), also known as true cabotage, has also been informally recognised. Under the Chicago Convention, states generally regulate domestic and international flights differently. International flights are normally regulated by bilateral air services agreements which are treaties concluded on a bilateral basis between different states. These bilateral air service agreements are discussed in more detail at para 20.4. Domestic traffic is typically regulated by domestic legislation. This may provide for deregulated traffic rights (ie any national airline can fly any domestic route without restriction or need for prior authorisation with no frequency or fare restrictions as is the case in the USA, within the EU and many other countries) or may subject domestic traffic rights to prior authorisation by the local civil aviation authorities. Typically, most countries restrict domestic traffic rights to airlines licensed by the relevant country and substantially owned and effectively controlled by nationals of that country. For example, US domestic routes are restricted to US carriers and, save to a very limited extent, the same is true within the EU. Other countries such as Australia have a more open approach and will allow non-Australians to own an Australian airline operating Australian domestic routes.

Bilateral treaties 20.4 The Chicago Convention contemplated that parties who had not signed the Five Freedoms Agreement should regulate air services between them as they saw fit with the use of bilateral treaties negotiated between individual states. Generally, bilateral treaties cover: (1) the grant of the first and second freedom rights to each party; (2) the designation of particular carriers for carriage between the contracting states: this can either specify that rights are granted to all carriers of the contracting states (‘multiple designation’) or only to a limited number of them specifically designated for the purposes of the relevant bilateral treaty (‘single/dual and so on, designation’); (3) the designation of specified routes, gateway airports and intermediate airports on which and at which aircraft of designated carriers from the other contracting state can fly and land; (4) the exclusion of rights of cabotage (ie traffic rights for airlines from third countries) except in specified circumstances; (5) the grant of rights to maintain commercial support operations in the other state, such as the provision of ground handling services at specified airports; 323

20.4  The Regulatory Framework for Airline Operations (6) the establishment of a permanent tariff working group and filing requirements for tariff changes; (7) the grant of rights to operate international charter services between the contracting states; and (8) the designation of specific cargo operations. The US domestic market was deregulated in 1978. As regards international traffic, since the 1990s, the USA’s official policy has been to replace its existing bilateral agreements with third countries with open skies agreements which, although still generally restricting traffic rights to airlines licensed by the relevant contracting states and substantially owned and controlled by nationals of such states, otherwise allow for unlimited traffic rights and code-sharing opportunities. Such agreements typically allow airlines to fly between any points in the two countries at the airlines’ choice, with no restrictions on the frequencies or capacity on these services and with no requirements of file tariffs and no restrictions on the fares the airlines may charge. The first open skies agreement was signed with The Netherlands in 1992 and, in November 2010, Colombia became the one hundredth country to sign such an agreement with the USA. In the EU, the situation is more complex given the interplay between the EU and its member states. The EU single market was first deregulated with the advent of the single European market on 1 January 1993 with full liberalisation of domestic routes several years later. The EU single market has been extended by treaty to the EEA states (Norway and Iceland as well as Liechtenstein) and by separate treaty to Switzerland. At the time of writing, Brexit had come into effect (with de facto effect from 1 January 2021 following the EU withdrawal from the EU and the end of the transitional period) and the UK had left the EU and thus the single aviation market and UK carriers had no special privileges within the EU. As a result, Ryanair which is an Irish registered airline (with at the time of writing operating subsidiaries also registered in Poland and Malta) could fly any route between any two EU airports, including domestic routes between say Rome and Milan. However, flights from the EU to non-EU member states remained regulated at least in theory (as the significant number of flights by Ryanair to non-EU countries attests). Historically, all bilateral air services agreements were negotiated at member state level and all typically restricted traffic rights to airlines not only licensed by, but also substantially owned and controlled by, nationals of that member state as opposed to EU nationals as a whole. This was despite the fact that several EU airlines are owned and controlled by nationals of other member states which became a significant impediment to intra-EU crossborder airline consolidation. The European Commission challenged several of these bilateral agreements in the European Court of Justice (ECJ). In 2002, the ECJ ruled that these bilateral agreements were indeed contrary to the EU law on freedom of establishment, in that they prevented airlines from other member states setting up an ‘establishment’ in another member state and benefiting from the same rights as a national airline from that second member state. In addition, the ECJ ruled that certain other provisions (slots, central reservation systems (CRSs)/ global distribution systems (GDSs) and intra-EU fares) fell within exclusive EU competence and could not be decided by member states but could only be agreed internationally by the EU.2 2

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Cases C-466/98, 467/98, 468/98, 469/98, 471/98, 472/98, 475/98 and 476/98 Commission v United Kingdom, Denmark, Sweden, Finland, Belgium, Luxembourg, Austria and Germany.

The EU regulatory framework 20.5 As a result of the ECJ’s rulings, the EU agreed that international air services agreements could be agreed in one of three ways. (1) A multilateral EU-wide agreement with a third country replacing all the bilaterals concluded by the individual member state with one EU-wide agreement. This has been done, for example with the USA with the conclusion of the landmark EU-US open skies agreement in April 2007 with the second round signed in June 2010. The second round did not live up to the original ambitions since it was hoped that ownership and nationality restrictions would be waived but this did not happen for political reasons. Nevertheless it remains a significant achievement compared to the status quo previously. The EU-US open skies agreement effectively allows an EU or US airline to fly from any point in the EU (even from a member state different to its home member state) to any point in the USA with no frequency or fare restriction. Similar agreements have been signed with other countries, including Canada in 2009. (2) A  combined approach involving a ‘horizontal’ agreement between the EU and the third country which sits alongside individual bilaterals concluded by the relevant member states individually. The EU agreement would, typically, provide that all traffic rights can be exercised equally by carriers from across the EU such that traffic rights are not reserved for carriers licensed by and substantially owned and controlled by nationals of one member state. The individual bilateral would then govern which routes may be flown, the number of carriers, and the amount of fares and capacity. However, the member state must introduce a procedure to ensure that if rights traffic are restricted, carriers from other member states can compete for the available opportunities on an equal basis to the carriers from that member state. (3) Individual bilaterals agreed on a per-member state basis with no EU-level agreement. In such a case, the bilaterals must ensure non-discrimination between EU carriers and so achieve the same result in practice as the combined approach. There have also been a number of regional open skies initiatives such as: the Australia-New Zealand agreement; the European Common Aviation Area between the EU, Iceland, Norway, Albania, Bosnia-Herzegovina, Croatia, Kosovo, the Former Yugoslav Republic of Macedonia, Montenegro and Serbia; the EU-Morocco agreement concluded as part of the Euromed Aviation Project; the EU-Switzerland agreement; and others. In June of 2021, ASEAN and the EU announced that they had agreed an open skies agreement on a bloc-to-bloc basis, the first ever such agreement between two trading areas.

THE EU REGULATORY FRAMEWORK EU competition rules and the air transport sector 20.5 How has EU liberalisation been achieved so far? Although the current market situation with a fully deregulated single aviation market and low cost carriers (LCCs) operating across Europe bears no resemblance at all to the earlier regulated situation, a brief recap of history is still useful. Articles 90 to 100 of the Treaty on the Functioning of the European Union (TFEU), the successor to 325

20.5  The Regulatory Framework for Airline Operations the EEC Treaty (also known as the Treaty of Rome), set out the basic objectives of the EU regarding the adoption of a common transport policy. As a result of the Chicago Convention and the nature of the industry that derived from this, for many years, air transport was largely excluded from the normal EU competition rules (see the TFEU, Articles  101 and 102 – EEC Treaty, ex 85 and 86, and see Council Regulation 141/62 and the decision of the ECJ in the Nouvelles Frontières case).3 However, various recent developments have brought the EU air transport sector within the sphere of the regime for competition regulation which, in turn, has led to an uneasy relationship between the different regulatory systems governing air transport within and outside the EU. First, the Single European Act 1986 (SEA) made important amendments to the EEC Treaty, with effect from 1  July 1987. These amendments included a provision for the adoption of measures to create a single internal market by the end of 1992, being ‘an area without frontiers in which the free movement of goods, persons, services and capital is ensured …’. This provided fresh impetus for the inclusion of air transport in the EU competition regime. A  further provision of the SEA (Article  16) amended Article  84(2) of the EEC  Treaty to allow many of the decisions of the EU Council of Ministers on air transport policy to be taken by qualified majority rather than by unanimity. This alteration was considered necessary to enable the EU to extend the scope of its regulatory authority over the air transport sector in the face of anticipated opposition to reforms from certain member states. Second, the application of the EU’s competition rules to the aviation sector proved decisive in ushering forward deregulation. In 1987, the European Commission was given power to enforce Articles 101 and 102 of the TFEU in the field of international air transport services between EU airports (Council Regulation (EEC) No  3975/87). Air transport between the EU and non-EU countries remained outside the direct scope of Articles 101 and 102, but within the ambit of Articles 104 and 105, meaning that either member states (Article 104) or the Commission (Article 105) had certain powers to review transactions and apply the principles of Articles  101 and 102 to them. In effect, this meant that EU carriers are subject to EU competition-based regulation as well as that provided by the system under the Chicago Convention. This was amended in 2004 to bring all routes within the direct scope of Articles 101 and 102, such that now both intra-EU routes from the EU to non-member states are equally subject to the EU competition rules. Third, Council Regulation (EC) No 139/2004 (the ‘Merger Regulation’) gives the Commission jurisdiction to review concentrations between undertakings in two circumstances, providing that the following criteria are satisfied: (1) where aggregate worldwide turnover of the undertakings is more than €5 billion and where at least two undertakings have an aggregate EU-wide turnover exceeding €250 million, unless each party achieves more than two-thirds of its EU turnover within the same member state; (2) a concentration must be notified to the European Commission where: • the combined aggregate worldwide turnover of the undertakings concerned exceeds €2.5 billion in each of at least three member states, the combined aggregate turnover of all of the undertakings concerned exceeds €100 million; 3

326

Judgment of the Court of 30 April 1986 in Joined Cases 209 to 213/84, Criminal proceedings against Lucas Asjes, Andrew Gray, Jacques Maillot and Léo Ludwig [1986] ECR 1425.

The EU regulatory framework 20.7 • • •

in each of those same three member states, the aggregate turnover of at least two of the under- takings concerned exceeds €25 million; the aggregate EU-wide turnover of each of at least two undertakings concerned is more than €100 million; and the undertakings concerned do not achieve more than two thirds of their EU-wide turnover within one and the same member state.

The Merger Regulation has already had an impact on the air transport sector, and will become increasingly significant as carriers forge alliances to meet the demands of a more liberal and competitive EU environment. Each area of EU competition regulation is examined in more detail in the following paragraphs.

TFEU, Article 101 20.6 The TFEU, Article 101(1) sets out the fundamental principles prohibiting anti-competitive behaviour. For this prohibition to apply, there must exist some form of agreement or concerted action between two or more undertakings which has as its object or effect the prevention, restriction or distortion of competition within the EU and which may have some effect on trade between member states. Article 101(3) exempts practices falling within Article 101(1) if they fulfil certain criteria relating to the preservation of competition and the grant of benefits to consumers. Such exemptions may be claimed by companies operating agreements without any requirement to obtain a prior European Commission exemption decision, though the European Commission retains the power to issue individual exemption decisions and there are also ‘block exemptions’ which exempt entire categories of agreements by so-called ‘block exemption regulations’ issued by the European Commission. An early example of an individual exemption was the Commission’s decision in January 1996 to exempt the Lufthansa/SAS alliance and the exemption granted to the Air France/Alitalia alliance, subject to commitments, in 2004. More recently, the Commission has taken individual exemption decisions for the three transatlantic alliances (oneworld, A++/Star and Skyteam4). These exemption decisions provide a template for other alliances to assess whether any other alliance proposed is likely to qualify for exemption or not. It is probable that the Commission will not, however, be inclined to issue further individual exemption decisions, preferring to leave it to the airlines concerned to ‘self-assess’ their proposed alliance.

TFEU, Article 102 20.7 Article 102 prohibits any abuse of a dominant position in the EU or a substantial part of it, insofar as it may affect trade between member states. Article  102, therefore, is primarily concerned with preventing unilateral anticompetitive behaviour by a single carrier, although such behaviour by two or more dominant carriers may also fall within the ambit of the prohibition. It was

4 See Case COMP/39.595 Continental/United/Lufthansa/Air Canada (A++/Star); Case COMP 39.596 British Airways/American Airlines/Iberia; and Case COMP 39.964 Air FranceKLM/Delta/Alitalia.

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20.7  The Regulatory Framework for Airline Operations held in the Ahmed Saeed5 case that Article 102 had direct effect in member states in the air transport sector even before the implementation of Council Regulation (EC) No 3975/87 (as discussed earlier). Article 102 can be a useful instrument for the extension of EU competition policy over existing practices in the air transport sector. For example, Aer Lingus was fined ECU750,000 in 1992 for refusing to provide interlining facilities to British Midland on the London-Dublin route, and was also ordered to cooperate with British Midland on that route for two years so that interlining facilities would be guaranteed, at least until British Midland was firmly established on the route. The application of Article 102 clearly depends heavily on the definition of the relevant geographical or product market on which the carrier may be dominant. The Aer Lingus case illustrates that a single route can, in certain circumstances, constitute a relevant market when determining whether or not a carrier has a dominant position under Article 102. In March 1996, the French independent airline AOM submitted a complaint to the European Commission regarding a contravention of Article  102 by the French government and the Paris airports in favour of Air France. The dispute arose in January 1996 when AOM tried to reverse an agreement of December 1994 to transfer all its activities by the end of March 1996 from Orly’s West terminal to Orly’s South terminal, a move that would allow exclusive use of the West terminal for Air France. The allegations were that, in moving AOM to make room for Air France, the state-owned carrier would hold a monopoly of the West terminal, and this constituted an abuse of a dominant position in breach of Article 102. Notwithstanding the use of Article  102 in a number of cases in the 1990s, the provision has been largely unused this century in airline to airline cases. However, Article 102 is relevant not only to the provision of air transport itself but also to the provision of ancillary services such as CRSs and ground handling. The 1999 Virgin/BA case also reveals that the European Commission will closely review complaints relating to an abuse of a dominant position by an air carrier also in cases where the abuse does not directly concern air transport services but the market for air travel agency services. Further to a complaint lodged by Virgin, the European Commission examined the rebates and other incentives that BA offered to customers and travel agents. Based on the finding that the commission schemes offered by BA were giving incentives to travel agents to maintain or increase the sales of BA tickets which did not depend on the absolute size of these sales, the European Commission concluded that BA’s exclusionary conduct constituted an abuse of its dominance. Although the travel agency business has changed beyond recognition in recent years with the growth of online sales, Article 102 (and 101) is still being alleged in disputes between travel agents (mainly now online travel agents) and airlines. Many online travel agents are seeking to hold airlines to the same set of competition rules relating to distribution as other industries such as luxury goods which have seen a plethora of European Commission decisions and large fines in recent years, but so far the European Commission has not yet taken up a case in the air transport distribution space. It is expected that the European Commission’s revision to the vertical block exemption and related guidelines which is due towards the end of 5

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Judgment of the Court of 11 April 1989 in Case 66/86, Ahmed Saeed Flugreisen and Silver Line Reisebüro GmbH v Zentrale zur Bekämpfung unlauteren Wettbewerbs eV [1989] ECR 803.

The EU regulatory framework 20.8 2021 will provide some clarity to the application of the competition rules and their likely enforcement focus in this area. Similarly, the European Commission has on the basis of Article  102 (in combination with Article  106 in some cases) adopted decisions finding an abuse of dominance by airport authorities. By way of example, in 1999 the Commission had in two instances looked into the landing charges imposed on air carriers by airports. Further to the finding of an abuse of a dominant position, the European Commission requested the Finnish aviation authority and the Portuguese government respectively to bring an end to the system of differentiated landing charges by flight origin imposed in a number of Finnish and Portuguese airports. According to the landing charges schemes applied, domestic flights benefited from a discount of 50% to 60% as compared to intraEU flights, without any objective justification. Again, the use of Article  102 has become rarer in recent years even in the airport and airline services space. Landing charges at large airports are now regulated in many member states by specific regulatory mechanisms and there is an Airports Charges Directive6 which requires member states to set up a mechanism for consultation between the airports and airlines for charges at the airports covered by the directive (basically the larger commercial airports in the member states). This also means that there is less scope for a standalone Article  102 complaint in relation to airport charges at these airports.

Merger Regulation 20.8 Airline mergers are subject to prior notification to, and clearance by, the European Commission, if they meet the turnover thresholds of the Merger Regulation.7 Mergers falling within the Merger Regulation must be notified to the Commission prior to their implementation. Failure to notify can give rise to substantial fines. The merger must be suspended until clearance and the Commission must complete its preliminary review of the proposals within 25 working days of notification. Cases that give rise to serious doubts as to their compatibility with the common market view of the European Commission are subject to a further review by the European Commission of typically four to six months. The European Commission will block transactions that it considers would create or strengthen a dominant position that would significantly impede effective competition in the common market. Two airline transactions have been blocked to date, although many have been investigated in depth and several have required modification in order to obtain clearance, with conditions attached. The first Merger Regulation decision directly involving the air transport sector was the acquisition by Delta of PanAm’s Frankfurt operations in 1991.8 Two significant factors came out of this case. The first was in relation to calculating turnover for the purpose of the Merger Regulation’s thresholds and the second was in relation to the definition of the relevant markets.

6 7 8

Directive 2009/12/EC of the European Parliament and of the Council of 11  March 2009 on airport charges. Council Regulation (EC) No  139/2004 of 20  January 2004 on the control of concentrations between undertakings (the ‘EC Merger Regulation’). Commission Decision of 13 September 1991, in Case No IV/M 130, Delta Air Lines/Pan Am.

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20.8  The Regulatory Framework for Airline Operations Article 5(1) of the Merger Regulation provides that turnover in the EU or in a member state shall comprise products sold or services provided in the EU or in a member state. This, according to the Commission, creates three possibilities in the case of an airline merger: (1) to calculate operating revenues in terms of country of destination; (2) to allocate operating revenues in a 50/50 ratio between the country of origin and the country of destination; (3) or to treat revenues as arising in the member state in which the relevant ticket sale occurred. The European Commission has never yet taken a definitive position on which of the three different methods of calculation is the correct one for the Merger Regulation. As the turnover thresholds for Delta/PanAm were met in all three cases, the Commission decline to offer advice as to the circumstances in which each option should be adopted. In the more recent case of Swissair/Sabena,9 the geographic allocation of turnover was made on the basis of the ‘point of sale’ criterion, although the decision mentions that the 50/50 test is equally met. The choice of methods for calculating turnover also arose in most airline cases ever since. In many of these cases, the European Commission was able to avoid the need to resolve the issue finally. In Air France/Sabena, the 50/50 option was suggested as the preferable option, but this was not followed in British Airways/ TAT. In its draft notice on the calculation of turnover, the European Commission suggested that airlines’ turnover should be calculated by reference to the place of ticket sale. However, this reference was eventually withdrawn from the final version of the notice. It was only in the Ryanair/Aer Lingus case10 that the 50/50 methodology was accepted by the European Commission as the most appropriate method for calculating turnover to determine jurisdiction. One of the points that the European Commission considered to reach this conclusion is the shift in ticket purchase methods, that is, the shift from the physical transaction at a bricks-andmortar airline counter or travel agent to the internet-based search engines and transactions. It appears that as the physical location of customers purchasing airline tickets over the internet is difficult to trace the point of sale methodology is not as appropriate as it was in the past for the allocation or air carriers’ turnover. In the Delta/PanAm decision, the European Commission gave its views on market definition, and these views were further amplified in its decision in the Air France/Sabena decision. This high-level approach has persisted to this day. The European Commission found that the main principles of market definition in the context of schedule air transport were as follows: • the relevant market will be either a particular route or a bundle of routes if they are substitutable from the consumer’s point of view; • substitutability is affected by various factors, including the length of the routes, the distance between the different airports at the end of the routes forming the bundle and the number of frequencies on each route; and • alternative methods of transport (for example, charter flights or trains) generally constitute distinct markets.

9 Commission Decision of 20 July 1995, in Case No IV/M 616, Swissair/Sabena. 10 Commission Decision of 27 June 2007, in Case No COMP/M 4439, Ryanair/Aer Lingus.

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The EU regulatory framework 20.8 In the British Airways/TAT decision, the European Commission adopted a similar approach in finding that the relevant market was for London-Paris and London-Lyon services, because the city pairs were not substitutable by other routes. This approach was subsequently upheld by the General Court.11 In Swissair/Sabena,12 the European Commission distinguished between certain routes that were treated as a market when bundled together (for example, between EU departure points and various destinations in Africa) and other routes that individually constituted separate markets (such as the individual routes between Switzerland and Belgium). In the Air France/KLM,13 Lufthansa/Swiss,14 Lufthansa/BMI15 decisions and all cases since, the European Commission adopted the ‘point of origin/point of destination approach (O and D approach)’ in relation to the market for scheduled passenger air transport services, according to which every combination of a point of origin and a point of destination is considered as a separate market. The rationale of the European Commission is based on the idea that from a demandside perspective, customers would consider all possible alternatives of travelling from one point to another. The European Commission has nevertheless also acknowledged the network competition approach (for instance, in the Air France/ KLM case), which takes into account supply side elements, that is, competition between air carriers on a network basis. However, the European Commission has so far never done more than acknowledge this element and has always defined markets on an individual O and D basis despite airlines urging it to look beyond that and look at the overall network. They justify this by saying that their remit is to protect competition for consumers who look at the individual O and D pair and that has to be the basis for their assessment. When defining the relevant market, the European Commission will also take into account airport substitutability. According to their decision-making practice, flights from or to airports which have overlapping catchment areas can be regarded as substitutes. In the Ryanair/Aer Lingus decision, the European Commission found that secondary airports are likely to be in the catchment area of a city if they are within one hundred km or one hour of travel time of the city centre though there is no hard and fast rule. This applies both for primary and secondary airports (eg Brussels National and Zaventem) and main airports in the same conurbation (like Orly and Charles de Gaulle in Paris and New York JFK and Newark). In some cases (for example, in the Air France/KLM and Lufthansa/Swiss cases), the European Commission has also considered a market segmentation on the basis of the time-sensitivity of passengers. Typically, the European Commission will reach a conclusion that passengers travelling on unrestricted tickets are in a different market from non-time-sensitive passengers. This tends to be the case when the airlines involved, or at least one of them, offers a two class product (usually business and economy) and where passengers buying different class tickets usually respond to different considerations. Despite the fact that the driver for this market segmentation is usually a multi-class product offering, the way the markets are segmented tends to be on the basis of restricted economy 11 12 13 14 15

Commission Decision of 27 November 1992, in Case No IV/M 259, British Airways/TAT. Commission Decision of 20 July 1995, in Case No IV/M 6l6, Swissair/Sabena. Commission Decision of 11 February 2004, in Case No COMP/M 3280, Air France/KLM. Commission Decision of 4 July 2005, in Case No COMP/M 3770, Lufthansa/Swiss. Commission Decision of 14 May 2009, in Case No COMP/M 5403, Lufthansa/BMI.

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20.8  The Regulatory Framework for Airline Operations versus all other tickets, with unrestricted economy, business and first class included in the ‘time-sensitive’ category and restricted economy in the nontime sensitive category. Where airlines offer mainly one-class products (mainly but not exclusively LLCs) then the difference becomes less relevant and the European Commission typically uses an ‘all passengers’ market definition. This can also lead to different airports being included in the relevant market or not. For example, in relation to flights to London, all London airports including Luton and Stansted are included in non-time-sensitive passenger markets or all passenger markets whereas for time-sensitive passengers typically only Heathrow and City and increasingly Gatwick are included. In practice, the European Commission adopts a pragmatic, case-by-case approach to decisions under the Merger Regulation, often securing undertakings from the parties to remedy anti-competitive aspects of mergers. For example, they decided that the Air France/Sabena combination would have a monopoly or a dominant position on various routes and at Brussels airport, but nevertheless cleared the transaction when the airlines and their sponsor governments had given adequate undertakings to promote the interests of new entrants on the routes in question and at Brussels Zaventem airport. Undertakings of a similar nature were given by British Airways to secure clearance of the British Airways/TAT transaction, in particular in relation to route access and slots (discussed later in this chapter). Similar remedies involving a promise to transfer slots in the event a new entrant sought to enter a route and could not obtain adequate slots through the normal slot allocation process were a staple of the European Commission’s merger regulation practice for many years and are often referred to as a ‘traditional’ or ‘standard’ slot remedy. In the Lufthansa/Brussels Airlines and Lufthansa/Austrian Airlines transactions, Lufthansa submitted a remedies package which included commitments to offer slots, grandfather rights over the relevant slots and also foresaw ancillary measures, such as participation in Lufthansa’s Frequent Flyer Programme. It may be seen from these decisions that the European Commission’s chief concern is to eliminate barriers to entry by protecting the access of new entrants to routes dominated by existing carriers and also to slots at congested airports. The remedies offered by Lufthansa in the Lufthansa/Swiss case similarly aim at allowing a new entrant to have a fair chance to establish itself as a credible competitor. These remedies were endorsed by the European General Court in Case T-177/04 easyJet v Commission as appropriate and acceptable to remedy the identified competition concerns. However, more recently the European Commission has declined to accept the ‘standard’ slot remedy in several airline cases under the Merger Regulation. In the Ryanair/Aer Lingus case, the European Commission considered that the remedies offered were insufficient to eliminate their concerns about the anticompetitive effects of the transaction. The merger involved the two main airlines of Ireland, which were operating from the same base airport and whose activities overlapped on a significant number of routes (35 in total). The European Commission was not convinced that the commitments offered would be sufficient to ensure entry of a size necessary to replace the competitive pressure exercised by Aer Lingus on Ryanair. The high market shares that the merged entity would have accounted for on the routes to and from Dublin and to and from Ireland, as well as the fact that entry on these routes was considered unlikely, led to the adoption by the European Commission of a prohibition decision. This decision was challenged before the General Court which dismissed the appeal. In several 332

The EU regulatory framework 20.9 cases since that case the European Commission did accept more traditional ‘standard’ slot remedies eg  in IAG/BMI.16 The main distinguishing feature of the cases seems to be that in those cases where the European Commission did accept the remedy, a number of airlines indicated to the Commission that they would be prepared to enter the relevant route and the European Commission had a high degree of confidence that entry was in fact likely. This seems to be much more likely to be the case if the route is to a highly in-demand airport where slots are scarce and demand significantly exceeds supply, of which London Heathrow is a prime example. Most recently in the Air Canada/Air Transat case, it appears that Air Canada submitted a traditional slot remedy but this was refused by the European Commission. As Air Canada withdrew its notification and terminated the transaction there is no published decision so the full reasons are unknown but the case serves as an important reminder that slot remedies cannot be counted on in all cases to secure clearance for airline mergers. Given that airline alliances are expanding at a galloping pace, the European Commission is increasingly faced with transactions that involve members of the same or of different airline alliances and thus is required to assess the effects of an envisaged merger by taking into account alliance memberships. In this regard, the European Commission examines whether the merging parties may, after the merger, start operating routes on which they currently only market flights operated by the other party (see, for instance, the Lufthansa/BMI decision) and will, in general, assess carefully the competition dynamics created by the participation of the merging parties in a different or the same airline alliance. In the Lufthansa/Swiss case, the European Commission reached the conclusion that the proposed acquisition of Swiss by Lufthansa would eliminate or significantly reduce competition on intra-EU routes also taking into consideration the effect of Lufthansa’s close cooperation with the Star Alliance members. However, in more recent cases, such as the Continental/United case,17 it has not followed this approach.

Ground handling 20.9 In 1996, the EU adopted Council Directive 96/67/EC on access to the ground handling market in the EU. The directive aims to lower costs and raise standards and also to allow airlines to self-handle if they wish. Liberalisation took place in the following main steps (and is subject to certain limited postponement and service restriction rights of member states): (1) from 1 January 1998, airlines had the freedom to self-handle the following services: passenger handling; ground administration and supervision; flight operations and crew administration; aircraft maintenance; catering services; aircraft services (such as cleaning); and surface transport on any airport regardless of volume of traffic; and also the freedom to self-handle baggage handling; ramp handling; fuel and oil handling; and freight and mail handling at airports with an annual traffic of at least one million passengers; (2) from 1 January 1999, airlines had the freedom to contract-in third-party handling services at airports that have annual traffic of at least three million passengers. Member states may limit the number of suppliers with regard to certain services (but not limited to just one supplier); 16 Commission Decision of 30 October 2017, in Case M 6447, IAG/BMI. 17 Commission Decision of 27  July 2010, in Case No COMP/M  5889, United Air Lines/ Continental Airlines.

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20.10  The Regulatory Framework for Airline Operations (3)

from 1 January 2001, airlines had full ground handling freedom at airports with at least two million passengers. Also at least one of the limited number of third-party suppliers authorised with regard to certain services must be independent of the airport operator and airlines having more than 25% of the traffic at that airport.

State aid 20.10 The last area of EU competition law to be considered is that concerning state aid, which is regulated by Articles 107 to 109 of the TFEU. State aid has been one of the most controversial areas of EU aviation policy and will remain controversial, if any of the carriers whose state aid packages have been approved by the European Commission were to require further aid or were to breach conditions regarding existing aid. State aid is the provision of resources or other advantages, in any form whatsoever, by a member state to an undertaking. It is for the European Commission to decide whether particular aid is compatible with the TFEU. If the aid distorts or threatens to distort competition then, pursuant to Article 107(1), it is likely, insofar as it affects trade between member states, to be regarded as incompatible with the TFEU. Member states are required to notify the European Commission before putting into effect any plans to grant or alter aid, so that the European Commission can decide whether the proposed aid is compatible with the TFEU, and if not, can issue proceedings. If aid is not notified until after it is put into effect, then even if it is later found to be compatible, that does not remedy the illegality. If the European Commission finds that the aid is incompatible, then it can declare it incompatible with the common market, and order repayment of any sums already paid, together with interest. Although the Treaty rules have in theory remained constant, the European Commission’s position on state aid has evolved significantly since the 1990s. Prior to that time, most airlines were state-owned and in practice heavily subsidised. Starting with the advent of the single market in 1993, the position was gradually clarified: (1) by the recommendations of the Committee of Wise Men; (2) under a communication from the European Commission dated 15 November 1994; and (3) as a result of various decisions of the European Commission in relation to applications for approval of state aid through state-owned airlines such as Air France, Sabena, Olympic, TAP, Aer Lingus and Iberia. The Committee of Wise Men considered the issue of state aids in its report in 1994.18 The committee recognised that the most effective way to phase out privileged treatment of state-owned carriers would be to privatise all air carriers. It, therefore, exhorted governments to work towards privatisation, but recognised that privatisation normally requires prior restructuring. The Committee of Wise Men concluded that financial support to airlines should be banned if it violated the rules of the EEC Treaty (now the TFEU) by exceeding normal commercial 18 ‘Expanding horizons’, a report by the Comité des Sages for Air Transport to the European Commission (January 1994).

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The EU regulatory framework 20.10 conditions. For a brief transitional period, however, the committee agreed that there would be a need for some state-owned airlines to be given a genuine ‘one time, last time’ opportunity to receive state aid to set them on a sound commercial footing. This was followed by the ‘Communication from the Commission’ of 15  November 199419 which gave guidelines (the ‘1994 Guidelines’) for the application of Article 92 and 93 of the EEC Treaty (now TFEU, Articles 107 and 108) to state aid in the aviation sector. This brought the airline sector more or less in line with most other industries in terms of the application of the state aid rules. Since then most airlines have been privatised and several LLCs have emerged to compete with them on an unsubsidised basis. The number of airlines receiving state aid in the decade leading up to the Covid-19 pandemic dwindled dramatically. However, with the near-shutdown of the airline industry due to the pandemic, governments around the globe moved to fund their airlines to keep them solvent in anticipation of a return to the skies. The state aid rules in Europe made this more difficult, both because the aid would need to be approved by the European Commission because of the state aid rules and because the responsibility of financing the airlines is necessarily that of the member states and different member states had different schemes (and some airlines had no or limited access to subsidies due to their place of incorporation even if they had to compete directly against subsidised airlines). With the onset of the Covid-19 pandemic, the European Commission put in place a ‘Temporary Framework for State Aid Measures to Support the Economy in the Current Covid-19 Outbreak’. This sets out the criteria on which they will approve state aid linked to the pandemic. As at the time of writing, the temporary framework has been amended five times since it was first introduced in March 2020 and applies until December 2021. Several parts of it are relevant to airlines: the provisions on state aid by way of loans and guarantees on the one hand; and state aid by way of (equity) recapitalisation. The former are fairly lenient and allow state aid by way of loans or guarantees for loans to be provided on relatively generous terms to airlines. Importantly, they do not require airlines or member states to take compensating action to benefit airlines which compete against the subsidised carrier yet which are not subsidised themselves. On the other hand, the guidelines for recapitalisation aid are much stricter and importantly require the airline and the member state to put in place compensatory measures for the benefit of unsubsidised competitors. This latter requirement, for example, required the German government and Lufthansa to offer certain slot pairs to competitors at Frankfurt as ‘compensation’ for Lufthansa’s equity recapitalisation by the German government. Many of these pandemic-driven state aid schemes have been challenged in the European General Court by Ryanair and until the court rules on all the challenges it will remain to be seen what their market impact really is. Since, however, the temporary framework is (at the time of writing) scheduled to expire in December 2021, it is hoped that the temporary framework will soon become a thing of the past. That said, many airlines will for years to come continue to be subject to the conditions of their loans, guarantees or recapitalisation state aid decisions and will need to comply with the conditions attached to these decisions such that lenders to airlines should check the up-to-date status of any state aid decision applicable to the intended airline.

19 OJ C 350, 10 December 1994, p 5 (94/C 350/07).

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20.11  The Regulatory Framework for Airline Operations Apart from direct aid to airlines, several airlines benefited from financial support provided by airports and their local regions. For example, Ryanair had agreed a financial package with Charleroi airport in Belgium when it first started flights to that airport and then again later when it significantly expanded. The European Commission adopted a decision finding many elements of that financial package to be state aid because: (a) it was granted by the regional government in its own capacity and as shareholder of the airport; and (b) the elements were unlikely to have been agreed to by a private sector shareholder applying the ‘market economy investor principle’. This is the principle used by the European Commission to distinguish between investment decisions made by a government acting as shareholder which would be normal investment decisions (and thus not state aid), and investments which are state aid and thus require prior approval. If a private sector investor would have made the same investment on the same terms, it is not state aid. Ryanair appealed to the European General Court and won which forced the European Commission to revisit its approach to these airport and route support packages which had also become more widespread. In 2005, the European Commission issued a set of guidelines (the ‘2005 Guidelines’) focusing on aid for the financing of airports and start-up aid to airlines departing from regional airports. These guidelines added to, rather than, replaced the 1994 Guidelines mentioned above. The main aim of the 2005 Guidelines is to clarify to what extent and how public financing of airports and state aid for starting up air routes will be assessed in light of the existing EU legal framework on state aid; they do not deal with the general conditions for granting public financing to airlines. The 2005 Guidelines appear to take into consideration the difficulties that regional airports often face when developing their services and the fact that airlines are not prepared to run the risk of opening routes from new and untested airports, without sufficient incentives. Importantly, the 2005 Guidelines endorse the Aéroports de Paris case,20 pursuant to which airport management and operation activities consisting in the provision of airport services to airlines and to the various service providers within airports are economic activities. The 2005 Guidelines were updated and revised in 2014 and have been amended several times since then. In 2018 they were extended and now apply until 2024. In practice, most state aid covered by these guidelines will be small amounts of support for an airline to set up operations at a secondary airport and certain route support and marketing packages which may be important for the viability of the route but are not significant in the overall context of most airlines.

SLOT ALLOCATION Introduction 20.11 Slot allocation procedures are crucial for an airline’s overall business for two reasons. First, certain slots have acquired significant rarity value and so might be viewed as some form of ‘asset or resource of the airline’, albeit one that may not appear on the airline’s balance sheet. Second, the unavailability of slots at congested airports plays a dominant part in shaping the competitive environment in which the airline operates. For airlines with numerous slots at 20 Judgment of the Court of First Instance of 12 December 2000 in Case T-128/98, Aéroports de Paris v Commission of the European Communities [2000] ECR II-3929.

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Slot allocation 20.12 important international hubs, the present system of slot allocation guarantees a significant position in certain markets and affords a degree of protection against competitors. For airlines without such slots, airport capacity restrictions can strangle attempts to develop new route systems and will nullify any attempts by the regulators to open up inter-carrier competition. The importance which regulators now place on slot allocation can be seen by the demand for British Airways to give up slots at London Heathrow as a condition for approval of its alliance with American Airlines. To deal with the problem of excess demand for slots, many airports around the world use guidelines issued by the International Air Transport Association (IATA) to allocate slots. Under the IATA guidelines, slot allocation is overseen by a scheduling committee, which will generally be comprised of representatives of the airlines using the airport. An airline wanting to land or take off at such an airport must apply to the scheduling committee for a slot, which is generally granted for a six-month season (that is, summer or winter). The scheduling committee allocates slots according to the following IATA rules, which must be applied without favouritism: (1) a slot operated by an airline for scheduled services should entitle the airline to the same slot in the following season (‘grandfather rights’); (2) if an airline had a slot in the previous season, but used it less than a specified proportion of time, the slot will be allocated to another airline in the next season (the ‘use it or lose it’ principle); (3) after slots have been allocated in accordance with grandfather rights, 50% of the remaining slots should be given to airlines who qualify as ‘new entrants’; (4) if two airlines compete for the same slot, the schedule that involves the most use of the slot will take priority; (5) if the procedures described above do not resolve competing demands for slots, then the scheduling committee will come to a decision reflecting the following factors: – extending a schedule to operate for consecutive seasons; – accommodating larger aircraft; – taking account of different daylight hours in different time zones; and – arranging a more practical schedule.

Slot Allocation Regulation 20.12 The EU has long been concerned about the restrictions on free and open competition that result from limitations of airport and airspace capacity. While one solution would clearly be to increase capacity by developing bigger airports and more technologically advanced air transport systems, the expense and environmental obstacles to such developments have tended to concentrate efforts on the reallocation of existing resources – that is, slots. In January 1993, the EU Council of Ministers finally adopted the Slot Allocation Regulation governing the allocation of slots, after many months of preparation and negotiation by the European Commission. The Slot Allocation Regulation has been amended several times including, most importantly, by Regulation 337

20.13  The Regulatory Framework for Airline Operations 793/2004 in 2004, but the basic principles remain the same. Some provisions, and particularly the ‘use it or lose it’ or ‘80-20’ rule have been suspended at various times and especially during the Covid-19 pandemic to reflect the reality that many airlines could not viably continue to operate as before. However, these are only suspensions and not amendments and the regulation is expected to come back into full force as the airlines recover from the pandemic. The Slot Allocation Regulation follows many of the principles adopted by the IATA, but with some variations, summarised in the following paragraphs.

Coordinated airports 20.13 The Slot Allocation Regulation requires member states to carry out a capacity analysis at an airport when air carriers representing more than half of the operations at the airport and/or the airport authority consider that capacity is insufficient for actual or planned operations at certain periods or when new entrants encounter serious problems in securing slots or when a member state considers it necessary. If the analysis does not indicate that the problems can be resolved in the short term, the airport must be designated a ‘fully coordinated airport’ for the periods during which capacity problems occur. Slots at fully coordinated airports must be allocated, and their use monitored, by an independent airport coordinator appointed by the relevant member state. The airport coordinator should be assisted by a coordination committee drawn from representatives of the participating airlines, the airport authorities and the air traffic control authorities. Member states may provide for any airport to be designated a ‘coordinated airport’, provided certain principles are adhered to in its management. Most of the provisions described below in respect of fully coordinated airports apply also to coordinated airports.

Grandfather rights 20.14 Where a carrier has operated a slot that has been cleared by the coordinator, it will be entitled operate the same slot in the next equivalent season (although this is subject to certain conditions regarding slot pools, as discussed at para 20.18).

Slot transfers 20.15 Slots may be exchanged between carriers or used by the same carrier for different routes, subject to prescribed safeguards covering the requirements of regional services and the maintenance of undistorted competition between carriers. However, slots allocated to new entrants operating an intra-EU service may not be exchanged for the first two years.

Monetisation of slots 20.16 The availability of slots has a great impact on an airline’s operations and ultimately on its profitability and creditworthiness. From a financier’s perspective, this is not reflected in an airline’s balance sheet. In most jurisdictions, the relevant authorities, at least in the EU, are unwilling to officially recognise any property rights in slots, which means that they are only as secure as the administrative system allocating them. For example, Council 338

Slot allocation 20.16 Regulation (EEC) No  95/93 (the ‘Slot Allocation Regulation’) provides that grandfather rights will not apply to a slot used less than 80% of the time it was available. Furthermore, the pool system under the Slot Allocation Regulation is intended to favour new entrants at the expense of other carriers. Factors such as these make it difficult on a prudent basis to attribute value to an airline in respect of its slots. As noted above, the EU Slot Allocation Regulation allows airlines to exchange slots between airlines. A  practice has grown up in certain member states that an airline will exchange one valuable slot for an unusable slot held by another airline and cash. In this way the airline is paid cash not directly for the slot itself but as compensation for the difference in value between the slots as it has exchanged a valuable slot and received one in return with little or no value. Airport slot coordinators in these member states understand that this market exists and in some cases facilitate it. Other member states take the position that such slot exchanges are not permissible under the regulation which permits only exchanges one for one of slots which both airlines will use. This difference in interpretation has never been resolved definitively but the European Commission has recognised that the ‘grey market’ in slots exists and accepts explicitly that it is not contrary to the language of the slot regulation. It has also been ruled compatible with the slot regulation by the English High Court in several cases starting with R v Airport Coordination Ltd, ex p States of Guernsey Transport Board.21 These court judgments have never been challenged by the European Commission. Although the grey market for slots which developed following these judgments was most prominent in the UK, and particularly at Heathrow airport where the cash payments associated with some slot exchanges are rumoured to exceed £40 million per slot pair, it is widely believed that it exists in some other member states as well. Although the UK has now left the EU, the Slot Allocation Regulation has been transposed directly into UK law and so continues as retained UK legislation. Consequently, the grey market for slots at Heathrow can continue post-Brexit under the same conditions as it did when the UK was an EU member state. However, the UK government now has the power following Brexit to introduce its own legislation on slots and this has been mooted. An air carrier may only hold slots under the Slot Allocation Regulation as long as it retains a valid operating licence. This raises an issue for financiers on the ability of an air carrier in financial difficulties to monetise any valuable slots it may be holding. In particular, once it enters bankruptcy proceedings, any EU air carrier with an operating licence issued under national laws deriving from EU Regulation 1008/2008 (see para 20.21) must have the status of their operating licence reviewed by its licensing authority. The ability of an air carrier to exchange slots whilst in bankruptcy proceedings was considered by the English Court of Appeal in R  v Airport Coordination Ltd, ex p Monarch Airlines (in administration).22 Monarch was in administration and its operating licence was the subject of a proposal by the UK  Civil Aviation Authority to revoke it. Under the applicable UK procedural regulations (the Operation of Air Services in the Community Regulations 2008, SI  2008/41), revocation of an operating licence by the CAA involved the CAA issuing a proposal to revoke and giving the air carrier concerned an opportunity to comment. The 21 [1999] EWHC Admin 264. 22 [2017] EWCA Civ 1892.

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20.17  The Regulatory Framework for Airline Operations CAA then takes a decision which is appealable to the Secretary of State. The regulations provide that revocation is effective only either on the Secretary of State rejecting an appeal against at CAA revocation decision if an appeal is lodged or 14 days after the CAA’s decision if no appeal is lodged (14 days being the applicable appeal deadline). In the Monarch case, the CAA had decided to revoke but the appeal period was still pending at the time of the Court of Appeal judgment. The Court of Appeal held that as the revocation of the operating licence was not yet effective Monarch remained an air carrier for the purposes of the slot regulation and entitled to exchange its slots. This judgment was then applied in the case of Thomas Cook Airlines which went into liquidation. Even though liquidation is final and a one-way street (unlike administration as Monarch had been under), Thomas Cook was able to exchange its valuable slots prior to the operating licence revocation procedure becoming final and effective.

Regional services 20.17 Member states may reserve certain slots for regional services where the route is to a peripheral or development region and is considered vital for the economic development of the region, or in order to meet EU-imposed public service obligations.

Slot pools 20.18 Coordinated airports must set up slot pools for all newly created slots, unused slots and slots relinquished by other carriers. This provision is backed up by the power to withdraw slots from carriers if existing slots are not used. Furthermore, a carrier must demonstrate that it has used a series of slots for at least 80% of the time during the period for which the slots have been allocated in order to claim grandfather rights in the next season, failing which the relevant slots are transferred back to the pool for reallocation. New entrants must be allocated at least 50% of the slots available in slot pools, unless requests by new entrants amount to less than 50%.

New entrants 20.19 New entrants are defined as carriers requesting slots at an airport and holding, or having been allocated, fewer than four slots at that airport on that day, or carriers requesting slots for a non-stop intra-EU service where no more than two other carriers operate a direct service on the same route on the same day and holding, or having been allocated, fewer than four slots at that airport on that day for that service. However, a carrier holding more than 3% of the slots at the airport on a relevant day, or more than 2% of the slots available on that day in the airport system of which that airport forms part, will not qualify as a new entrant. There is no qualification as to the applicant’s size or resources in determining new entrant status.

Reciprocity 20.20 The Slot Allocation Regulation contains provisions enabling the European Commission to withdraw the benefits of the regulation from carriers from non-EU states that discriminate against EU carriers. 340

Slot allocation 20.21

Airline licensing 20.21 Following the Chicago system, most countries operate a nationality qualification for the licensing of airlines. In the EU, however, it was always uncertain whether national systems for granting operating licences contravened fundamental provisions of the EEC  Treaty. Certainly, Article  7 (nondiscrimination on grounds of nationality), Article 52 (freedom of establishment throughout the EU) and Article  221 (equal treatment of nationals of other member states) did not sit comfortably with individual nationality requirements in respect of ownership and control of airlines, particularly after the decision in one of the Factortame cases.23 Nevertheless, until the Third Regulatory Package,24 member states continued to operate licensing systems based, to a greater or lesser extent, on the nationality of the aircraft operator or owner. The Third Regulatory Package provided for common licensing requirements for air transport undertakings and obliged member states to grant operating licences to any undertaking that is majority owned and effectively controlled by nationals of any member state, provided that the undertaking satisfies the common standards. In 2008, the EU adopted Regulation 1008/200825 which refined the Third Regulatory Package by recasting and consolidating into one single text the rules on the operation of air services in the EU. Regulation 1008/2008 preserves the basic policy that licensing of EU air carriers should be done by the national aviation authorities of the member states but subject to the common rules set out at EU level in Regulation 1008/2008. Regulation 1008/2008 also preserves the requirement that all EU air carriers must be majority owned and effectively controlled by EU nationals. The main changes brought by Regulation 1008/2008 are the following: •

Provision of intra-EU air services: essentially, an EU airline is allowed to operate any route within the EU, whether international between member states or domestic within any member state. In order to complete the internal aviation market, existing restrictions between member states, such as restrictions on the code-sharing on routes to third countries were lifted. First, Regulation 1008/2008 provides that member states cannot subject the operation of air services within the EU by an EU carrier to any permit or authorisation. Member states are not allowed to require EU air carriers to provide any documentation which they have already provided to the competent licensing authority that granted them the relevant operating licence, provided that this documentation is accessible. Second, EU air carriers are free to enter into code-share agreements (provided that such agreements are not in breach of the relevant EU competition rules) and any restrictions on the freedom of EU air carriers to provide air services within the EU arising from bilateral agreements between member states are superseded. Regulation 1008/2008 also allows EU air carriers to combine air services and enter into code-share agreements with any

23 Judgment of the Court of 25 July 1991 in Case C-221/89, R v Secretary of State for Transport, ex p Factortame Ltd [1991] ECR I-3905. 24 The Third Regulatory Package comprises Council Regulation (EEC) Nos 2407/92, 2408/92 and 2409/92. 25 Regulation (EC) No 1008/2008 of the European Parliament and of The Council of 24 September 2008 on common rules for the operation of air services in the Community.

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20.22  The Regulatory Framework for Airline Operations

•

•

•

•

air carrier on air services to, from or via any airport in the territory of a member state or to any point in a third country, notwithstanding the provisions of bilateral agreements between member states and subject to the applicable competition rules. Licensing rules: Regulation 1008/2008 follows the common EU operating licence rule which was introduced with the Third Regulatory Package, and reinforces the competences of the licensing authority which can closely monitor whether the conditions for the validity of the operating licence, as specified in Regulation 1008/2008, are met. The competent licensing authority is also responsible for verifying whether the air carrier holds a valid air operator’s certificate (AOC) and whether modifications therein are reflected in the operating licence. Fares: Regulation 1008/2008 extends the pricing freedom of air carriers by providing that EU air carriers and, on the basis of reciprocity, air carriers of third countries are free to set air fares and air rates for intra-EU air services. The new regulatory framework also introduces more transparency in air fare pricing, as it sets specific conditions for the information on air fares that has to be made available to the public, including that the final price must at all times be indicated. PSO routes: Regulation 1008/2008 also contains detailed provisions on public service obligations. These are basically uneconomic lifeline-type routes which may be subsidised by a member state, provided a specific procedure is followed. Whilst the general principles already introduced by the repealed Regulation 2408/92 have not changed, the relevant provisions have become simpler and clearer. The rules on the public tender procedure for public service obligations have also been revised, in order to, inter alia, take into account the Altmark case,26 according to which the parameters for calculating the compensation in consideration for public service obligations must be established in advance and in an objective and transparent manner. Leasing: in order to avoid excessive recourse to lease agreements of aircraft registered in third countries, Regulation 1008/2008 establishes strict rules on the wet leasing of aircraft. It is thus provided that prior approval is required where an EU carrier wet leases aircraft registered in a third country. The competent authority in each member state must provide the specific authorisation, but can do so only if a number of conditions are met, mainly aiming at ensuring that such leasing can be justified on the basis of exceptional needs.

US airline licensing requirements 20.22 Ever since the Air Commerce Act of 1926, US policy has held that strategic reasons, both commercial and military, demand that only airlines owned and controlled by US citizens should be licensed to operate in the US. The relevant ownership restrictions are now set out in the Federal Aviation Act of 1958 (the ‘1958 Act’). Under the 1958 Act, a US airline may only be owned by a ‘citizen of the United States’, who is defined as: 26 Judgment of the Court of 24  July 2003 in Case C-280/00, Altmark Trans GmbH and Regierungspräsidium Magdeburg v Nahverkehrsgesellschaft Altmark GmbH, and Oberbundesanwalt beim Bundesverwaltungsgericht [2003] ECR I-7747.

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Slot allocation 20.23 (1)

an individual who is a citizen of the United States or one of its possessions; or

(2) a partnership of which each member is such an individual; or (3) a corporation or association created or organised under the laws of the United States, of which the president and two-thirds or more of the board of directors and other managing officers thereof are such individuals and in which at least 75% of the voting interest is owned or controlled by persons who are citizens of the United States or of one of its possessions. It should be noted that the requirement is only that 75% of the voting interest should be US-held, with a further requirement that 51% of the economic interest should he held by US citizens. In addition, there is a requirement that US air carriers be under the ‘actual control’ of US citizens. Nevertheless, foreign airlines have over the years successfully acquired stakes in US airlines. For example, Ansett Airlines of Australia acquired 20% of the voting stock in America West Airlines in 1987, and in 1989 KLM was allowed to take a 25% stake in Northwest Airlines, carrying 5% of the votes (although KLM had originally wanted to take a 57% stake). A conspicuous example of the effect of the 1958 Act was the prolonged, and ultimately successful attempt by British Airways to take a stake in US Airways. Under the original scheme announced in July 1992, British Airways would have invested US$750 million for a 44% equity stake carrying 21% of the votes in US Airways. However, the other major US carriers lobbied vigorously against the link-up, and when it became clear to the US government that it was not going to extract from the UK the hoped-for concessions on access to the UK for US carriers, the deal was abandoned. The more modest version of the scheme that was eventually signed provided for British Airways to invest US$300 million for a 24.6% share of the equity of US Airways with 19.9% of the voting stock. British Airways has subsequently sold this holding in the wake of its proposed link-up with American Airlines. More recently, Lufthansa acquired a stake in JetBlue and now holds just under 16% of the airline which appears to have completed without regulatory issues whereas the attempts to set up Virgin America had to be restructured in order to secure the Department of Transportation’s approval by reducing the influence of Richard Branson showing the continuing importance of taking full account of US airline ownership laws when investing in and also financing US airlines.

Aircraft registration – Chicago Convention 20.23 The Chicago Convention lays down the following principles in relation to the nationality of aircraft: (1) that aircraft have the nationality of the state in which they are registered (Article 17); (2)

that an aircraft cannot be validly registered in more than one state, but that its registration may be changed from one state to another (Article 18); and

(3)

that each contracting state is to adopt measures to ensure that every aircraft carrying its nationality mark, wherever such aircraft may be, shall comply with the rules and regulations relating to the manoeuvre of aircraft there in force (Article 12). 343

20.24  The Regulatory Framework for Airline Operations The Chicago Convention does not, however, stipulate that contracting states must adopt a common approach regarding the requirements that must be satisfied before an aircraft is entitled to be entered on their registers, nor does it require that there be any ‘genuine link’ between the ownership of an aircraft and its nationality. Indeed, the Chicago Convention expressly provides that each contracting state is free to regulate the registration and the transfer of registration of aircraft in accordance with its own national laws and regulations (Article 19). Most countries’ laws provide that an air carrier licensed by them can only operate using aircraft entered on their national register. The Third Regulatory Package introduced some exceptions to this general rule.

Nationality requirements 20.24 The varying requirements of the aircraft registries of different states illustrate that there is no common approach to registration. Certain states only permit aircraft that are owned by nationals of that state to be entered on their register, while other states permit the entry on their register of aircraft that are foreign-owned but which are operated under a lease or similar arrangement by an operator who is a national of that state. Other states permit aircraft that are leased to nationals of that state to be entered on their register, even though the aircraft are subleased to operators established outside the state in question. In the case of owners or operators that are corporations, the nationality requirements of certain states will be satisfied if the owner or operator is simply incorporated in the state in question while other states impose additional requirements as to the nationality of the management and or shareholders of the owner or operator. The result of this divergence of approach is that an aircraft may, at first sight, be eligible for registration in more than one state, which means that the parties to an aircraft financing transaction may have a choice of countries in which the aircraft in question may be registered.

REGISTRATION IN THE EU Under Regulation 1008/2008 20.25

Under Regulation 1008/2008:

(1) the basic rule is that aircraft operated by an EU licensed air carrier should be registered, at the option of the member state issuing the licence, in its national register or within the EU. Some member states allow for registration anywhere in the EU, although many require national registration. Member states may not, however, refuse to register aircraft owned by nationals of other member states nor may they refuse transfers from registers of other member states (Article 12); and (2) the first exception to the basic rule is that a member state must allow its air carriers to operate wet leased aircraft registered in other member states ‘except where this would lead to endangering safety’. There are only limited circumstances in which EU airlines may use wet leased aircraft registered outside the EU. These are set out in Article 13(3) of Regulation 1008/2008 and discussed earlier. 344

Conclusion 20.27

Code-sharing 20.26 Airlines have realised that given the scarcity of slots, regulatory constraints and imperfect load factors, it would make sense to ‘share lights’ with other operators. Code-sharing can take several forms. The essence is that two or more carriers, each under its own (or their combined) designator code(s) and/or flight number(s), sell seats on a single flight provided by the operating carrier. Often, the code-shared light connects to a flight operated by the codesharing partner. By attaching its designator code (and same flight number) to both flights, the marketing carrier is able to market and sell both flights as if the connection would be on-line (connecting to a flight of the same air carrier) instead of inter-line (connecting to a flight of another air carrier). Code-sharing is sometimes described as interlining under the airline’s own code and is generally considered to bring advantages to consumers (in terms of check-in procedures, flight connections and extended frequent flier benefits) so long as the details of the airlines involved are clearly published. Code-sharing is also argued to be procompetitive in that it enables carriers to market their services on routes that they are unable to operate themselves, on account of cither capacity or regulatory constraints. As code-sharing has become more common, it has begun to attract attention from competition/anti-trust authorities. The concern has been that the ability to enter new markets by partnership rather than by competition might reinforce the position of incumbent carriers on lucrative routes, permit carriers to divide such routes between them and raise barriers to entry to potential competitors. By and large, most code-sharing which takes the form of simple free flow or free sale agreements (whereby the operating carrier sets the fare and the marketing carrier simply sells the seat at that fare subject to a code-share commission) rarely fall foul of competition law. If the code-sharing goes further and involves cooperation on fares or capacity, then these code-share agreements fall more squarely within the ambit of applicable competition laws and require a more in-depth analysis. Concern has also been voiced that unless fare-paying passengers are kept fully aware of the code-sharing arrangements they may be paying for a service they did not choose. Hence, many countries require disclosure of the operating carrier in published schedules and at the time of booking. Almost every major airline now has a web of code-sharing agreements with other airlines, which range from simple block-seating arrangements to full strategic alliances.

CONCLUSION 20.27 The air transport industry is going through a period of considerable change which, to an extent, has been disguised by the current generally strong financial performance of airlines in almost every sector. Three factors can be seen to be underlying this change: deregulation in the US and the development of a liberalised regime in the EU and other countries; the growth of global carriers; and predicted long-term increases in demand putting pressure on existing capacity worldwide, but particularly in the EU. However, liberalisation in the Asian and other markets is moving at a slower pace. These factors will undoubtedly alter the landscape for operators in the air transport sector, although changes will continue to arise only after they have 345

20.27  The Regulatory Framework for Airline Operations been thoroughly debated and the necessary political will is present. Large carriers will have to be more careful to avoid falling foul of the competition regulators in the way they operate. Delays and uncertainty surrounding the British Airways/American Airlines alliance caused by regulatory issues have already been seen. Nevertheless, the scramble by large carriers to forge alliances with carriers in other lucrative markets will continue and it will be interesting to observe who the winners and losers will be. Medium-sized carriers may be faced with a choice; to grow to compete with the large carriers, or to concentrate on niche markets and risk competition with smaller carriers. For new and niche carriers, there will be opportunities for expansion and development though with the related costs and risks of operation, scaling up and competition. The new wave of LCCs in the EU is adding to the size of the market (that is, creating more passengers) rather than taking business away from existing operators. However, established carriers will act to protect their markets and ironically, this may lead to re-regulation to protect new entrants. All carriers should be keeping a watchful eye on the possibility of a downturn in the aviation market and how liberalisation measures would affect them in the event of a downturn. In the EU, liberalisation measures that have been implemented or proposed will tend to favour more client operators, and a consolidation of air carriers is already under way. However, infrastructure limitations will continue to restrict progress to open competition. Gradual moves towards bringing relations with third countries under the control of the EU are likely to reinforce this trend in the long term. It will be important for all those connected with the air transport sector to keep up with the changes taking place. These will have direct consequences for the businesses of operators and financiers and also for the travelling public.

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21 International Conventions Affecting Aircraft Financing Transactions Laura Cunningham and Domhnall Breathnach

INTRODUCTION 21.1 Aircraft financing is essentially an international activity. The funding can come from a financing institution situated anywhere in the world. The tax structuring of the transaction may straddle several jurisdictions and the asset is constantly on the move. Yet, the legal structures that are available to put together a financing and the legal remedies available to the financier in the event of a default or an insolvency are largely structures and remedies of one or more national legal systems. International conventions have, therefore, been developed over the years to unify or harmonise some of the legal rules and issues affecting aircraft financing transactions. A cohesive international legal framework of rules is particularly important in secured financings where prompt enforcement of a financier’s rights over the aircraft is imperative. If clear and consistent international rules are available, financiers will be able to price their product without a further premium for legal uncertainty. This chapter will begin with a discussion of the Cape Town Convention, arguably the most significant international convention to date in the context of aircraft financing. The Geneva Convention and the Rome Convention on the Precautionary Arrest of Aircraft will also be briefly examined. The Rome Regulations on contractual and non-contractual obligations, the Brussels Recast Regulation on jurisdiction and enforcement of judgments and, in light of Brexit, the Hague Convention on Choice of Court Agreements are also important conventions for multi-jurisdictional transactions (and, therefore, relevant to aircraft financing transactions) and merit a brief discussion. Finally, this chapter will consider conventions in relation to thirdparty liability for terrorism and general accident damage. In this chapter, references to aircraft financing transactions are intended to include aircraft leasing transactions, and financiers to include lessors.

CAPE TOWN CONVENTION AND AIRCRAFT PROTOCOL 21.2 On 16  November 2001, a diplomatic conference was held at Cape Town, South Africa, at which the Convention on International Interests in Mobile Equipment (Cape Town Convention) and an associated Protocol on Matters Specific to Aircraft Equipment (Aircraft Protocol) were adopted. 347

21.2  International Conventions Affecting Aircraft Financing Transactions The Cape Town conference was convened by the International Civil Aviation Organisation (ICAO), a specialised agency of the United Nations set up under the Chicago Convention,1 and the International Institute for the Unification of Private Law (UNIDROIT), in response to a collective demand from the international financing industry for a unified set of legal rules to facilitate the financing, leasing and sale of mobile equipment. The Cape Town Convention creates an international legal framework for the creation, perfection, priority and enforcement of security and certain other interests in aircraft equipment, railway rolling stock and space assets granted by a charger under a security agreement, vested in a conditional seller under a title reservation agreement or vested in a lessor under a lease agreement. The Cape Town Convention also sets out provisions that protect a creditor’s rights in the event of a default by the debtor or if the debtor becomes insolvent. The Cape Town Convention itself is not equipment specific. Separate protocols in respect of aircraft equipment, railway rolling stock, space assets, mining, agricultural and construction equipment supplement the Cape Town Convention. To date, the Aircraft Protocol is the only protocol to have been adopted and to have come into force.2 However, the protocol concerning railway rolling stock is expected to come into force in the near future as it only requires one additional ratification/accession alongside the deposit of a certificate by the relevant secretariat confirming the international registry is fully operational.3 As regards aircraft equipment, the Aircraft Protocol covers ‘aircraft objects’ which are defined as airframes, aircraft engines and helicopters, each with a minimum size and power requirement. The Cape Town Convention and the Aircraft Protocol came into force on 1  March 2006. Over 70  countries (including major economies such the US, China, Russia, the UK and India)4 have ratified or acceded to the Cape Town Convention and the Aircraft Protocol. The European Union (EU) acceded to the Cape Town Convention and the Aircraft Protocol on 28 April 2009 as a Regional Economic Integration Organisation.5 The key features of the Cape Town Convention and the Aircraft Protocol are: (1) a unified set of rules for creating an ‘international interest’ in an aircraft object; (2) a ‘first-to-file’ rule for the perfection and priority of international interests based on an electronic notification system; 1 2

Convention on International Civil Aviation, Chicago (7 December 1944). The Luxembourg Protocol on Matters Specific to Railway Rolling Stock was adopted in 2007 but has not yet come into force. A  Protocol to the Convention on International Interests in Mobile Equipment on Matters Specific to Space Assets was adopted in Berlin on 9 March 2012 but has not yet come into force. More recently, the Protocol to the Convention on International Interests in Mobile Equipment on Matters Specific to Mining, Agricultural and Construction Equipment was adopted in Pretoria in November 2019 but has not yet come into force. 3 Preparatory Commission for the Establishment of the International Registry for Railway Rolling Stock pursuant to the Luxembourg (Rail) Protocol, 9th Session, 8 April 2021. 4 The dates of ratification/accession of these countries are as follows: United States (28 October 2004); China (3 February 2009); Russia (25 May 2011); and India (31 March 2008). Source: UNIDROIT. 5 To date, Denmark, Latvia, Luxembourg, Malta, Norway, Republic of Ireland, Romania, Spain, Sweden and The Netherlands (but only in respect of Aruba and The Netherlands Antilles) have acceded to the Cape Town Convention and the Aircraft Protocol. France, Germany and Italy have signed but not yet ratified the Cape Town Convention and the Aircraft Protocol.

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Cape Town Convention and Aircraft Protocol 21.4 (3) a system of remedies for creditors, including in the contest of insolvency; and (4) a system of declarations for contracting states.

International interests 21.3 The Cape Town Convention created the concept of an ‘international interest’. An international interest is an interest either granted by a chargor under a ‘security agreement’,6 or vested in a conditional seller under a ‘title reservation agreement’,7 or vested in a lessor under a ‘leasing agreement’.8 An international interest must satisfy four formal requirements set out in the Cape Town Convention.9 Although the debtor10 must be situated or the aircraft must be registered in a contracting state for the Cape Town Convention and the Aircraft Protocol to apply, the creditor need not be situated in a contracting state.

Perfection and priority of international interests 21.4 International interests may be registered on the International Registry of Mobile Assets (International Registry). The International Registry is a webbased electronic registry system in which registrations are effected, searches are made and search certificates are issued electronically, obviating the need for physical filing. The International Registry is supervised by the ICAO who contracted Aviareto Limited to manage and operate the International Registry. Registrations are made against and can be searched by reference to aircraftspecific criteria (such as the manufacturer’s name, the aircraft’s serial number and the engines’ serial numbers). An entity search can also be performed against all entity types on the International Registry which include: transacting user entities; professional user entities; and controlled entities.11 Registration ensures that the registered international interest takes priority over subsequently registered interests and over unregistered interests, even if the creditor had actual knowledge of these subsequently registered and unregistered interests. An international interest also takes priority over unsecured creditors in insolvency proceedings against the debtor, provided that it is registered prior 6 ‘Security agreement’ means an agreement by which a chargor grants or agrees to grant to a chargee an interest (including an ownership interest) in or over an object to secure the performance of any existing or future obligation of the chargor or a third person (Article 1(ii) of the Cape Town Convention). 7 ‘Title reservation agreement’ means an agreement for the sale of an object on terms that ownership does not pass until fulfilment of the condition or conditions stated in the agreement (Article 1(ii) of the Cape Town Convention). 8 ‘Leasing agreement’ means an agreement by which one person (the lessor) grants a right to possession or control of an object (with or without an option to purchase) to another person (the lessee) in return for a rental or other payment (Article 1(q) of the Cape Town Convention). 9 The agreement creating or providing for the interest must: (i)  be in writing; (ii)  relate to an aircraft object of which the chargor/conditional seller/lessor has the power to dispose; (iii) enable the object to be identified in conformity with the Aircraft Protocol; and (iv) in the case of a security agreement, must enable the secured obligations to be determined, but without the need to state a sum or maximum sum secured (see Article 7 of the Cape Town Convention). 10 ‘Debtor’ is defined in the Cape Town Convention as a chargor under a security agreement, a conditional buyer under a title reservation agreement, a lessee under a leasing agreement or a person whose interest in an object is burdened by a registrable non-consensual right or interest. 11 See https://www.internationalregistry.aero/ir-web/faq.

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21.5  International Conventions Affecting Aircraft Financing Transactions to the commencement of the insolvency proceedings (or need not be registered under applicable law). However, a registered international interest is subject to any rules of insolvency law relating to the avoidance of a transaction as a preference or any rules of procedure relating to the enforcement of rights to property under the control or supervision of the insolvency officer. Article XI (remedies on insolvency) of the Aircraft Protocol, particularly Alternative A of Article  XI, modifies these restrictions on enforcement. However, Article  XI is not an automatic remedy. A  contracting state must make a declaration for Article XI to apply at the time it ratifies or accedes to the Aircraft Protocol. It is important to note that other interests may also be registered on the International Registry, as if they were international interests. These interests include prospective international interests, assignments or prospective assignments of international interests and national interests.12 When a prospective international interest develops into an international interest, it takes priority as from the time of registration of the prospective international interest. The Cape Town Convention permits contracting states to make a declaration enabling non-consensual rights or interests13 to be registered on the International Registry, as if they were international interests. The Cape Town Convention also permits contracting states to make a declaration14 specifying the categories of non-consensual rights or interests which under national law will take priority over an interest equivalent to that of the holder of an international interest and will take priority over a registered international interest (including any non-consensual right or interest registered as an international interest). This declaration also provides that the Cape Town Convention will not affect the rights of a contracting state, state entity or private provider of public services to arrest or detain an aircraft for payment of money owed to it in relation to that aircraft. As a result, declared liens (and similar rights of detention), if they have priority under national law, will take priority over any rights or interests created under the Cape Town Convention. The majority of contracting states have made this declaration. General contracts of sale are also covered under the Cape Town Convention and the Aircraft Protocol. Therefore, purchasers of aircraft objects have the benefit of certain rights under the Cape Town Convention and the Aircraft Protocol, such as the registration and priority provisions.

Remedies for creditors 21.5 The Cape Town Convention and the Aircraft Protocol set out a system of basic and expedited remedies for the creditor in the event of a default15 by the debtor or if the debtor becomes insolvent. 12 ‘National interest’ means an interest held by a creditor in an object and created by an internal transaction covered by a declaration under Article 50(l) of the Cape Town Convention. 13 ‘Non-consensual right or interest’ means a right or interest conferred under the law of a contracting state which has made a declaration under Article 39 of the Cape Town Convention to secure the performance of an obligation, including an obligation to a state, state entity or an intergovernmental or private organisation. 14 This declaration applies to Article 39(1) of the Cape Town Convention. 15 An event of default may be agreed by the debtor and the creditor or, if not so agreed, means a default ‘which substantially deprives the creditor of that which it is entitled to expect under the agreement’ (Article 11 of the Cape Town Convention).

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Cape Town Convention and Aircraft Protocol 21.6 Basic default remedies vary according to whether the creditor is a chargee under a security agreement, a conditional seller or a lessor. Remedies of a chargee include the right to take possession or control of the aircraft object, sell or grant a lease over the aircraft object or collect or receive any income or profits deriving from the management or use of the aircraft object. A conditional seller or lessor may terminate the agreement and take possession or control of the aircraft or apply for a court order authorising these acts. As an expedited remedy, a creditor who adduces evidence of default by the debtor may obtain interim relief from a court pending final determination of its claim. Interim relief is available to the extent agreed by the debtor and may take the form of, for example, preserving the aircraft object and its value or taking possession, control or custody of the aircraft object. Article X of the Aircraft Protocol, an opt-in provision, adds both a timetable (as declared by a contracting state) and the remedies of sale and application of proceeds. Article XI of the Aircraft Protocol sets out two alternative insolvency remedies for the creditor. Alternative A provides that, upon the occurrence of an insolvencyrelated event, a creditor is entitled to take possession of the aircraft object within a specified time, unless the debtor or the insolvency officer has cured all defaults (other than a default constituted by the opening of insolvency proceedings) and has agreed to perform the debtor’s future obligations under the relevant agreement by that time. Alternative B provides that the debtor or the insolvency officer can either cure all defaults and agree to perform the debtor’s future obligations or give possession of the aircraft object to the creditor. Alternative A is generally considered to be the more favourable option for creditors and has been adopted by most contracting states, including China, Russia and India. The Cape Town Convention and the Aircraft Protocol also provide significant benefits to financiers in the area of aircraft deregistration and export (see Article  IX of the Aircraft Protocol) and, importantly, the introduction of the irrevocable deregistration and export request authorisation (IDERA) (see Article XIII of the Aircraft Protocol).

Declarations 21.6 An essential element in ensuring that the Cape Town Convention and the Aircraft Protocol can work in practice is the system of declarations available to contracting states. Although the objective of the Cape Town Convention was to establish a uniform set of rules which effectively supersede the national laws of a contracting state, it was recognised that certain provisions of the Cape Town Convention and the Aircraft Protocol may raise fundamental policy issues requiring individualised consideration by contracting states. That noted, the actual declarations made to date have been reasonably consistent. With the exception of the mandatory declaration in Article 54(2) of the Cape Town Convention,16 all the declarations under the Cape Town Convention and the Aircraft Protocol are optional. Contracting states may declare to apply or reject certain provisions of the Cape Town Convention and the Aircraft Protocol 16 Article 54(2) provides that a contracting state must at the time of ratification of or accession to the Cape Town Convention declare whether or not any remedy available to a creditor under the Cape Town Convention which is not expressed to require application to the court may be exercised only with leave of the court. This provision is known as the ‘self-help’ provision.

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21.7  International Conventions Affecting Aircraft Financing Transactions as appropriate. For example, declarations exist in relation to the insolvency remedies in Article  XI of the Aircraft Protocol (including the adoption of Alternative A or Alternative B), the ability for parties to choose the choice of law applicable to their contractual obligations under Article VIII of the Aircraft Protocol, and the availability of interim relief under Article 13 of the Cape Town Convention. It is important to note that under the Aircraft Sector Understanding 2011 guidelines for export credit aircraft financings, all borrowers (irrespective of their credit rating) are eligible for a flat rate discount of 10% on their premiums, provided that they are situated in a state that has ratified and properly implemented the Cape Town Convention, and has made certain qualifying declarations. These qualifying declarations include adopting Alternative A of Article XI. A detailed discussion of the economic benefits of the Cape Town Convention and the Aircraft Protocol is beyond the scope of this chapter but suggested material for further reading is set out at the end of this chapter.

GENEVA CONVENTION 21.7 Although the Geneva Convention17 has now been expressly superseded by the Cape Town Convention, it is still useful to provide a brief overview of the key features and limitations of the Geneva Convention, for the purposes of transactions which fall outside the scope of the Cape Town Convention. Before the Geneva Convention came into force, there was no international legal regime relating to property rights in aircraft. An aircraft mortgage created in one jurisdiction was not necessarily recognised as a valid form of security interest in the jurisdiction where the aircraft was located at the time of enforcement. Even if the mortgage was valid in the jurisdiction of enforcement, the priority of the mortgagee was likely to be determined in accordance with the priority rules of the jurisdiction of enforcement, taking account of local creditors and any locally created competing securities. The Geneva Convention attempted to address this problem by displacing existing conflict of laws rules and allowing aircraft to carry with them the legal rights and property interests of their country of registration. Under Article I of the Geneva Convention, each contracting state undertakes to recognise security interests and certain other property rights in aircraft which have been created under the laws of the state of registration of the aircraft (provided that the state of registration is also a contracting state) and which rights are recorded in a public register in that country. The rights so recognised are: (1) rights of property in aircraft; (2) rights to acquire aircraft coupled with possession; (3) rights to possession of aircraft under leases of six months or more; and (4) mortgages and other similar security interests in aircraft.

17 Convention on the International Recognition of Rights in Aircraft, signed at Geneva on 19 June 1948. Over 80  countries have ratified or acceded to the Geneva Convention (though not the UK). However, the majority of these countries have subsequently ratified or acceded to the Cape Town Convention which supersedes the Geneva Convention.

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Rome Convention on Precautionary Arrest 21.8 While any contracting state may recognise rights in aircraft other than those specified in the Geneva Convention, the rights specified in the Geneva Convention should have priority. The priority of the rights specified in the Geneva Convention is determined in accordance with the laws of the state of registration. However, if the contracting state is also a party to the Cape Town Convention, and there is a conflict between interests and rights specified in both conventions, then under Article XXIII of the Aircraft Protocol, the Cape Town Convention will supersede the Geneva Convention where it relates to aircraft and aircraft objects. While the Geneva Convention successfully addresses the rules of priority over property rights in aircraft, it does not provide any valuable enforcement remedies in the case of a default by a debtor or in insolvency proceedings against a debtor. Unlike the Cape Town Convention and the Aircraft Protocol, the only enforcement remedy available under the Geneva Convention is judicial sale. This remedy does not provide much comfort to a creditor in need of prompt enforcement as the Geneva Convention stipulates a mandatory notice period (of at least six weeks) for the date and place of the sale. The actual proceedings of the sale are governed by the laws of the place where the execution sale takes place.

ROME CONVENTION ON PRECAUTIONARY ARREST 21.8 The Rome Convention on Precautionary Arrest18 is of limited practical application. This is attributable to the fact that only 28 countries have ratified or acceded to this Convention19 and the core purpose of this Convention, preventing the arrest of aircraft, is at odds with the principles of modern assetbacked financing which is based on prompt enforcement remedies for the financier. As a result, the Rome Convention on Precautionary Arrest has been expressly superseded by the Cape Town Convention and the Aircraft Protocol. However, to the extent that the Rome Convention on Precautionary Arrest is still applicable to countries which have not ratified the Cape Town Convention, a brief summary of the Rome Convention on Precautionary Arrest is relevant. The Rome Convention on Precautionary Arrest sought to restrict and regulate pre-judgment arrest and detention of aircraft. Aircraft registered in a contracting state may not be arrested in another contracting state where: (a) the aircraft is exclusively appropriated to a state service (including the postal service) commerce excepted; or (b) the aircraft is actually being used for public transport or is an indispensable reserve aircraft for these purposes; or (c) the aircraft is appropriated to public transport (unless the debt being enforced relates to the journey the aircraft is about to make). The Rome Convention on Precautionary Arrest only applies where the arrest is a form of pre-trial or interim relief. It does not apply to post-judgment execution. In addition, the arrest must not relate to insolvency proceedings or the enforcement of customs or criminal laws.

18 Convention for the Unification of Certain Rules Relating to the Precautionary Arrest of Aircraft, signed at Rome on 29 May 1933. 19 Countries which have ratified or acceded to the Rome Convention on Precautionary Arrest include: Germany; Brazil; and Spain. The United States and the United Kingdom have not ratified or acceded to this Convention.

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21.9  International Conventions Affecting Aircraft Financing Transactions Should an aircraft which is immune from arrest under the Rome Convention on Precautionary Arrest be arrested, the person effecting the arrest is liable for any damages incurred by the aircraft operator or the aircraft owner. Where arrest is not forbidden or where, although the aircraft is immune from arrest, immunity is not invoked, arrest can always be avoided by the granting of security equal to the amount of the disputed debt and costs or the value of the aircraft (if this value is smaller than the debt and costs).

ROME I REGULATION ON CONTRACTUAL OBLIGATIONS 21.9 The Rome I Regulation20 has been in force in all EU member states (with the exception of Denmark) since 17 December 2009. The objective of the Rome I Regulation was to harmonise the rules by which the law applicable to contractual obligations were determined across the EU. Prior to the application of the Rome  I  Regulation, the choice of law rules for contractual obligations were set out in the 1980 Rome Convention on the law applicable to contractual obligations (Rome Convention). The rules in the Rome  I  Regulation apply to contracts entered into on or after 17  December 2009. The rules under the Rome Convention continue to apply to any contracts created on or before 16 December 2009. The scope of the Rome I Regulation is similar to that of the Rome Convention. While some of the rules under the Rome  I  Regulation are not significantly different from those set out in the Rome Convention, the Rome  I  Regulation sought to improve the Rome Convention by introducing new rules and revising existing rules. The Rome I Regulation applies to contractual obligations in civil and commercial matters. Revenue, customs and administrative matters (and a number of other specific contracts) are expressly excluded. The general rule under the Rome I Regulation is that the parties to a contract are free to agree on the law applicable to their contractual relationships. The choice must be made expressly or be clearly demonstrated by the terms of the contract or the circumstances of the case. This freedom of choice preserves one of the fundamental tenets of the Rome Convention. It is important to note that the Rome I Regulation (and the Rome Convention) applies whether or not the law chosen is that of an EU member state or a nonEU member state, or whether one of the parties to the contract is domiciled in a non-EU member state. For example, the Rome  I  Regulation will determine the effectiveness of a choice of New York law between a Spanish claimant and a Brazilian defendant as much as it will determine the effectiveness of a choice of English law between a German claimant and a French defendant. Therefore, post-Brexit, the Rome I Regulation continues to apply in EU member states where the law chosen is that of a jurisdiction of the UK. Although the Rome  I  Regulation is no longer directly applicable in the UK, the UK has introduced regulations providing for the continued application in the UK of the Rome I Regulation rules.

20 Regulation (EC) No 593/2008 of the European Parliament and of the Council of 17 June 2008 on the law applicable to contractual obligations.

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Rome II Regulation on non-contractual obligations 21.10 In the absence of a choice of law by the parties, the Rome I Regulation introduces specific rules (not mere presumptions as the Rome Convention provided) that apply to certain types of contract. A contract for a sale of goods (for example, the sale of an aircraft) where no choice of law is agreed by the parties will be governed by the law of the country where the seller has his ‘habitual residence’. Where a contract does not fall within any of the specific types of contract and no choice of law is agreed, the contract will be governed by the law of the country where the party required to effect the characteristic performance of the contract has his habitual residence. However, if the applicable law cannot be determined under any of these rules, the contract will be governed by the law of the country with which it is most closely connected. The Rome I Regulation (as the Rome Convention did) provides that the parties’ choice of law can be displaced in certain circumstances. For example, ‘overriding mandatory provisions’21 of the law of where the dispute is to be heard must not be prejudiced by the parties’ choice of law. The Rome I Regulation refined the provisions of the Rome Convention by defining these overriding mandatory provisions and clarifying their application.

ROME II REGULATION ON NON-CONTRACTUAL OBLIGATIONS 21.10 The Rome II Regulation22 has been in force in all EU member states (with the exception of Denmark) since 11  January 2009.23 Since Brexit, the Rome II Regulation is no longer directly applicable in the UK. However, the UK has introduced regulations providing for the continued application in the UK of the Rome II Regulation rules. Prior to 2009, a set of uniform choice of law rules in relation to non-contractual obligations did not exist in the courts of EU member states. However, the refinement of the choice of law rules concerning contractual obligations under the Rome  I  Regulation precipitated the implementation in the EU of a set of rules to ascertain which governing law should apply to claims relating to noncontractual obligations. The Rome  II  Regulation applies to non-contractual obligations in civil and commercial matters. Revenue, customs or administrative matters (and a number of other specific contracts) are expressly excluded. The general rule under the Rome II Regulation is that the governing law of a non-contractual obligation arising out of a tort will be the law of the country in which the damage occurs, irrespective of the country in which the event giving rise to that damage occurs and irrespective of the country in which the indirect consequences of that event occur. An exception to the general rule applies where the claimant and the defendant have their habitual residence in the same country

21 ‘Mandatory provisions’ arc defined in the Rome I Regulation as provisions the respect tor which is regarded as crucial by a country for safeguarding its public interests. 22 Regulation (EC) No 864/2007 of the European Parliament and of the Council of 11 July 2007 on the law applicable to non-contractual obligations. 23 There is some uncertainty over the date from which the Rome  II  Regulation applies. It either applies to events occurring after 20  August 2007 when proceedings are commenced after 11  January 2009 (an interpretation of Article  31) or it applies to events occurring and proceedings commencing after 11 January 2009.

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21.11  International Conventions Affecting Aircraft Financing Transactions at the time when the damage occurs, in which case the law of that country will apply. In addition, where it is clear from the circumstances of the case that the tort is manifestly more closely connected with a country other than the country where the damage occurs or the country of habitual residence, the law of that country will apply. The general rule will also be superseded in a number of specific cases, including where the non-contractual obligation arises out of damage caused by a product, environmental damage or an infringement of an intellectual property right. In the case of product liability, the governing law will be: (a) the law of the country in which the claimant had his habitual residence when the damage occurred (if the product was marketed in that country); or, failing that, (b) the law of the country in which the product was acquired (if the product was marketed in that country); or, failing that, (c) the law of the country in which the damage occurred (if the product was marketed in that country). Party autonomy is also a significant feature of the Rome II Regulation. Parties can agree on the law that will govern their non-contractual obligations by an agreement entered into either prior to the occurrence of the event giving rise to the damage or, in the case of commercial activities, after the event giving rise to the damage has occurred. Although this freedom of choice does not apply to all non-contractual obligations,24 allowing parties to choose a governing law for their non-contractual obligations as well as their contractual obligations provides contracting parties with greater certainty about the nature and the scope of their legal relations. Aircraft owners, lessors and financiers may wish to resist the inclusion of a Rome  II choice of law provision in the relevant purchase, lease or finance agreements on the basis that third-party claimants (for example, passengers) may seek to rely on governing law clauses in these agreements where the law chosen is particularly favourable to the claimant (for example, where the strict liability principle is applied or where the claimant’s costs may be recovered). However, the advantage of influencing which law will govern their noncontractual obligations and the legal certainty this provides to parties in the event a dispute arises before an EU member state court provides support for the application of the Rome II Regulation.

BRUSSELS REGULATION ON JURISDICTION AND ENFORCEMENT OF JUDGMENTS 21.11 Each country has its own rules as to whether its courts will accept jurisdiction in any particular case or will enforce judgments issued by a court of another country. In aircraft financing transactions, where the parties and their assets are often based in a number of different jurisdictions, an international legal framework which provides rules relating to jurisdiction and enforcement of judgments is particularly important. The claimant will want to enforce its rights under the contract in a jurisdiction in whose courts the claimant has confidence. However, the defendant and its assets 24 Non-contractual obligations arising out of unfair competition or intellectual property rights infringement are excluded from the freedom of choice provisions contained in Article 14 of the Rome II Regulation.

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Brussels Regulation on jurisdiction and enforcement of judgments 21.11 may be located in a different jurisdiction which is either a less favourable forum for the claimant or which will not recognise and enforce a judgment issued by another court. The Recast Brussels Regulation25 governs issues of jurisdiction and enforcement of judgments in civil and commercial matters between all EU member states (including Denmark).26 The Brussels Regulation27 was initially introduced in 2001 and applies to proceedings instituted before 10  January 2015. The Recast Brussels Regulation applies to proceedings instituted after 10  January 2015. Matters relating to, for example, bankruptcy, insolvency proceedings or arbitration fall outside the scope of the Recast Brussels Regulation. The 2007 Lugano Convention28 contains similar provisions to the Recast Brussels Regulation and applies between all EU member states and Iceland, Switzerland and Norway. The basic rule under the Recast Brussels Regulation is that, where a defendant is domiciled in an EU member state, the defendant must be sued in the courts of his domicile, irrespective of the nationality of the defendant or any other party to the case. Certain exceptions to this basic rule exist. In matters relating to contracts, a defendant will be sued in the courts of the jurisdiction where the contractual obligations in dispute were or should have been performed. In the case of contracts for the sale of goods (for example, the sale of an aircraft), the place of performance is the place where the goods were or should have been delivered. The Recast Brussels Regulation also provides that a court can have exclusive jurisdiction in a number of circumstances, for example, if the parties have agreed in writing that a particular court of an EU member state will have jurisdiction to settle any disputes in connection with the contract, provided that at least one of those parties is domiciled in an EU member state. In relation to the recognition and enforcement of judgments, the Recast Brussels Regulation provides that a judgment issued in an EU member state will be recognised in any other EU member state without any special procedure being required. A few qualifications to this basic rule apply. For example, a judgment will not be recognised if it is contrary to public policy of the EU member state in which recognition is sought. A judgment issued in an EU member state will be declared enforceable in any other EU member state on the application of any interested party. The Recast Brussels Regulation, therefore, facilitates the recognition and enforcement of judgments across the EU by dispensing with the need for new proceedings to be brought by the relevant party or for the case to be re-examined. Since Brexit, the Recast Brussels Regulation no longer applies in the UK, or to the enforcement of EU judgments in the UK or UK judgements in the EU (except for judgments delivered in proceedings commenced before Brexit). Where agreements contain exclusive jurisdiction clauses, the Hague Convention on

25 Regulation (EU) No 1215/2012 of the European Parliament and of the Council of 12 December 2012 on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters (recast). 26 The Brussels Regulation was extended to apply to Denmark by means of a separate agreement between the EU and Denmark in 2007. 27 Council Regulation (EC) No 44/2001 of 22 December 2000 on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters. 28 Convention on jurisdiction and the recognition and enforcement of judgments in civil and commercial matters, signed at Lugano on 30 October 2007.

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21.12  International Conventions Affecting Aircraft Financing Transactions Choice of Courts may determine issues relating to jurisdiction and enforcement. Otherwise, the domestic rules of the relevant jurisdictions will apply.

HAGUE CONVENTION ON CHOICE OF COURT AGREEMENTS 21.12 The Hague Convention of 30 June 2005 on Choice of Court Agreements (Hague Convention) sets out rules relating to jurisdiction and enforcement of judgments as between the contracting states. The EU ratified the Hague Convention on behalf of EU member states on 11  June 2015. In the wake of Brexit, the UK initially acceded to the Hague Convention in its own right in 2019, but suspected its accession a number of times, before ultimately acceding to it on 28 September 2020. In addition to all EU member states and the UK, the contracting states to the Hague Convention also include Mexico, Montenegro and Singapore. The Hague Convention applies in ‘international cases’ to exclusive choice of court agreements (also called ‘forum selection’ or ‘jurisdiction’ clauses) concluded in civil or commercial matters. A case is ‘international’ unless the parties are resident in the same contracting state and the relationship of the parties and all other elements relevant to the dispute, regardless of the location of the chosen court, are connected only with that state. For the purposes of enforcement of judgments, a case is international where recognition or enforcement of a foreign judgment is sought. The Hague Convention applies only to ‘exclusive’ choice of court agreements. It does not apply to ‘asymmetric’ (also called ‘unilateral’ or ‘hybrid’) jurisdiction clauses. If a jurisdiction clause designates the courts of one contracting state or one or more specific courts of one contracting state it will be deemed to be exclusive unless the parties have expressly provided otherwise. An exclusive choice of court agreement must be concluded or documented in writing (or by any other means of communication that renders information accessible so as to be usable for subsequent reference). The Hague Convention does not apply to exclusive choice of court agreements in relation to certain matters, including the carriage of passengers and goods, insolvency, anti-trust (competition) matters, or tort or delict claims for damage to tangible property that do not arise from a contractual relationship. When determining jurisdiction, the basic principle under the Hague Convention is that the court or courts of the contracting state designated in an exclusive choice of court agreement will have jurisdiction to decide a dispute to which the agreement applies, unless the agreement is null and void under the law of that state. A court that has jurisdiction cannot decline to exercise jurisdiction on the ground that the dispute should be decided in a court of another state. On the other hand, a court of a contracting state other than that of the chosen court must suspend or dismiss proceedings to which an exclusive choice of court agreement applies unless: (a) the agreement is null and void under the law of the state of the chosen court; (b) a party lacked the capacity to conclude the agreement under the law of the state of the court seised; (c) giving effect to the agreement would lead to a manifest injustice or would be manifestly contrary to the public policy of the state of the court seised; (d) for exceptional reasons beyond the control of the parties, the agreement cannot reasonably be performed; or (e) the chosen court has decided not to hear the case. 358

Third-party liability conventions 21.13 Under the Hague Convention, a judgment given by a court of a contracting state designated in an exclusive choice of court agreement must be recognised and enforced in other contracting states. Recognition or enforcement of a judgment may be refused only on the grounds  specified in the Hague Convention. In addition, there can be no review of the merits of the judgment given by the court of origin (with the exception of any limited review that might be necessary to apply the provisions of the Hague Convention). The court through which enforcement is sought is bound by the findings of fact on which the court of origin based its jurisdiction, unless the judgment was given by default. However, a judgment will be recognised only if it has effect in the state of origin, and will be enforced only if it is enforceable in the state of origin. Recognition or enforcement of a judgment may be postponed or refused under the Hague Convention if the judgment is the subject of review in the state of origin or if the time limit for seeking ordinary review has not expired. A refusal does not prevent a subsequent application for recognition or enforcement of the judgment. Recognition or enforcement may be refused if: (1) the agreement was null and void under the law of the state of the chosen court, unless the chosen court has determined that the agreement is valid; (2) a party lacked the capacity to conclude the agreement under the law of the requested state; (3) the document which instituted the proceedings or an equivalent document, including the essential elements of the claim, was not notified to the defendant in sufficient time and in such a way as to enable the defendant to arrange for their defence, unless the defendant entered an appearance and presented their case without contesting notification in the court of origin, provided that the law of the state of origin permitted notification to be contested, or was notified to the defendant in the requested state in a manner that is incompatible with fundamental principles of the requested state concerning service of documents; (4) the judgment was obtained by fraud in connection with a matter of procedure; (5) recognition or enforcement would be manifestly incompatible with the public policy of the requested state, including situations where the specific proceedings leading to the judgment were incompatible with fundamental principles of procedural fairness of that state; (6) the judgment is inconsistent with a judgment given in the requested state in a dispute between the same parties; or (7) the judgment is inconsistent with an earlier judgment given in another state between the same parties on the same cause of action, provided that the earlier judgment fulfils the conditions necessary for its recognition in the requested state.

THIRD-PARTY LIABILITY CONVENTIONS 21.13 In 2009, two international conventions were adopted at the International Conference on Air Law in Montreal. These were the General Risks Convention29 29 Convention on Compensation for Damage Caused by Aircraft to Third Parties (enacted 2 May 2009, not in force).

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21.13  International Conventions Affecting Aircraft Financing Transactions (which covered damage caused to third parties by aircraft in the ordinary operation of aircraft) and the Terrorism/Unlawful Interference Convention30 (which covered damage caused to third parties as a result of terrorism and other unlawful interference with an aircraft). Precipitated by the events of 9/11, these conventions were adopted in an attempt to modernise the Rome Convention of 195231 which dealt with damage caused by aircraft to persons and property on the ground. The Terrorism/Unlawful Interference Convention provides that any action for compensation for damage to a third party as a result of terrorism can only be made against the aircraft operator. This compensation is subject to the limits of liability set out under the Terrorism/Unlawful Interference Convention. Any claims over and above the capped amount must be made against an international fund which is financed by passenger and cargo-based contributions. Owners, lessors, financiers and manufacturers are excluded from the strict liability provisions applied to operators and are, therefore, protected against direct claims by third parties. Rights of recourse by the operator or the international fund against owners, lessors and financiers retaining title to, or holding a security interest in, the aircraft are also restricted. The Terrorism/Unlawful Interference Convention, therefore, provides a significant amount of protection for lessors and financiers from legal and financial liability following a terrorist (or other unlawful interference) act. The General Risks Convention also benefits owners, lessors and financiers by excluding them from liability for third-party damages under the General Risks Convention or any laws of a contracting state relating to third-party damage. The General Risks Convention provides that only aircraft operators are liable. As in the case of the Terrorism/Unlawful Interference Convention, the General Risks Convention prevents the operator from taking any recourse against owners, lessors and financiers. While the Terrorism/Unlawful Interference Convention and the General Risks Convention are of significant interest to lessors and financiers, the benefits of these conventions have not yet been realised as neither Convention has entered into force. Since 2009, the pace of ratification has been slow with the General Risks Convention only gathering 13 signatures, four ratifications and eight accessions to date. Similarly, the Terrorism/Unlawful Interference Convention has 11 signatures, three ratifications and six accessions to date. This remains problematic for implementation as both conventions require ratifications from 35 states to come into force. In the case of the Terrorism/Unlawful Interference Convention, the ratifying states must cumulatively have had at least 750 million passengers depart from their airports in the previous year. At a practical level this would probably require ratification by the US and the EU who, at the date of writing, have not ratified either Convention. Whilst these conventions have the potential to effect significant change to thirdparty liability in the aviation industry, the lack of ratification especially by states with considerable stakes in the industry, indicates an apparent lack of enthusiasm for either convention.

30 Convention on Compensation for Damage to Third Parties, Resulting from Acts of Unlawful Interference Involving Aircraft (enacted 2 May 2009, not in force). 31 Convention on Damage Caused by Foreign Aircraft to Third Parties on the Surface, Rome (7 October 1952).

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Further reading 21.14

FURTHER READING 21.14 Convention on International Interests in Mobile Equipment, https:// www.unidroit.org/instruments/security-interests/cape-town-convention Protocol to the Convention on International Interests in Mobile Equipment on Matters Specific to Aircraft Equipment, https://www.unidroit.org/instruments/ security-interests/aircraft-protocol Goode, Professor Sir R, Official Commentary on the Convention on International Interests in Mobile Equipment and Protocol Thereto on Matters Specific to Aircraft Equipment (2008) Legal Advisory Panel of the Aviation Working Group, ‘Practitioner’s guide to the Cape Town Convention and the Aircraft Protocol’, http://awg.aero/wpcontent/uploads/2020/12/Practitioners-Guide-December-2020.pdf Linetsky, V, ‘Economic benefits of the Cape Town Treaty’ (2009), http://awg. aero/wp-content/uploads/2019/09/economicbenefitsofCapeTown.pdf Wool, J, ‘Lessor, financier, and manufacturer perspectives on the new thirdparty liability conventions’ (2010) The Air & Space Lawyer 22(4) Wool, J, ‘Treaty Design, Implementation, and Compliance Benchmarking Economic Benefit – A  Framework as Applied to the Cape Town Convention’ (2012) Uniform Law Review Anton Didenko, The Cape Town Convention, a Documentary History (1st edn, 2021), Chapter titled ‘7.2.2. Economic Benefit Studies in the History of the CTC’

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22 Basel III and IV – The Regulatory Framework Brendan Wallace and Ruth Lillis

INTRODUCTION 22.1 Since the Global Financial Crisis in 2007/2008 (GFC), the spotlight has been on regulation of capital resilience within the financial markets. The G20 summit in 2009 approved the process for the introduction of regulations to further tighten banking capital rules and the inter-governmental Basel Committee on Banking Supervision (BCBS) (which is responsible for the global coordination of banking supervision) published its new global regulatory framework in December 2010 (Basel III). The Basel III accord aimed to reform and enhance regulation, supervision and risk management within the banking industry following the GFC. Its regulatory changes included increasing the quantity and quality of capital and liquidity which banks were required to hold, in order to strengthen individual banks’ ability to withstand financial stresses and mitigate system-wide shocks. The majority of the Basel III changes were scheduled to be gradually introduced over a six-year period from January 2013. Meanwhile, the Basel accords continued to develop and in December 2017 the BCBS published its outstanding Basel III post-GFC regulatory reforms (Basel IV), which are due to be implemented from January 2023 onwards. With the objective of reducing what the BCBS saw as excessive variability of risk-weighted assets, the Basel IV reforms include a capital floor. This measure will present a particular challenge for banks that apply an internal-ratings-based approach to object finance exposures and may result in an increase in the amount of capital banks are required to hold against aviation (and other similar longduration) exposures.

BASEL CAPITAL ACCORD AND BASEL II 22.2 In order to give context to Basel III and the Basel IV reforms, it is necessary to understand the broader regulatory framework. In 1988, the Basel Capital Accord (the ‘Accord’) was published by the BCBS and applied only to internationally active banks. The Accord required a minimum amount of capital to be held against the credit risks such a bank was exposed to. Under the Accord, the minimum capital held against each risk was based upon 363

22.3  Basel III and IV – The Regulatory Framework an 8% minimum capital requirement for the majority of risks, with lower capital requirements (implemented through the use of risk weightings below the 100% norm for corporate exposures) being permitted for certain defined lower risk assets, including bank or sovereign credit risks. The 8% capital may be made up of different types (Tiers) of capital with a minimum of 4% of capital being required to be of Tier 1 capital, with half of that (that is, 2% of total capital) being of so-called Common Equity Tier 1 capital, being common equity and retained earnings. The Accord contained a detailed definition of capital and set out the credit risk weightings applied to all asset types. In 1996, an amendment to the Accord to incorporate market risks was published. This amendment gave detailed risk weightings for trading exposures and covered all types of trading exposures including repos, stock loans and derivatives. The BCBS issued a revised set of regulatory guidelines in 2006, known as Basel II. One of the main changes introduced by Basel II was to give more detailed risk weightings for assets based upon the individual risk profile of an asset and calculated either by reference to external credit ratings or by a bank’s own internal estimates. In addition, a further requirement against which capital had to be held was introduced in respect of operational risk. Basel II implemented a three pillar system, with the original capital requirements of the Accord, as amended, making up Pillar 1: (1) Pillar 1 minimum capital requirements: the minimum capital required to cover credit risk, market risk and, for the first time, operational risk; (2) Pillar 2 supervisory review process: the supervisory review process intended to facilitate better supervision of banks’ resources and to encourage better internal management of banks. Pillar 2 enabled regulators to impose additional capital requirements upon banks where the Pillar 1 requirements did not adequately cover the risks a bank was exposed to; and (3) Pillar 3 market discipline: a set of disclosure requirements to provide market participants with access to key information on capital, risk exposures and risk assessment processes.

BASEL III 22.3 Basel III was developed in the aftermath of the GFC in 2007/2008 to counteract the perceived weaknesses of the banking sector. Basel III further developed the foundations set out in Basel II by requiring banks to more closely analyse risk and to hold more robust levels of capital. Basel III operates in two main areas: (a) to strengthen the global capital framework; and (b) to introduce a global liquidity standard for the first time.

Part 1: strengthening the global capital framework 22.4 The Basel III framework did not change the object finance regime set out in Basel II and, therefore, object finance, including aviation financing, continues to benefit from this regime, provided the criteria set out above are met. 364

Basel III 22.6 However, other elements of the Basel III regime impacted on aviation financing and they are summarised as follows.

Capital 22.5 Requirements for both the quantity and quality of capital were strengthened requiring better quality capital to be maintained at higher levels. The percentage of capital required to be held continued to be measured by reference to risk-weighted assets (that is, the value of the asset (exposure) multiplied by the appropriate risk weight): (1) Quantity of capital: the minimum ratio for Common Equity Tier 1 increased to 4.5% and the ratio for Tier 1 capital increased to 6% of riskweighted assets. However, overall the minimum capital ratio remained at 8%. (2) Quality of capital: total regulatory capital is calculated as the sum of Tier 1 capital (going-concern capital including Common Equity Tier 1 and Additional Tier 1) and Tier 2 capital (gone-concern capital including subordinated debt). The use of hybrid capital instruments, previously permitted up to a maximum of 15% of Tier 1 capital, were phased out. The categories of Tier 2 capital were simplified by the removal of subcategories and Tier 3 capital was abolished to ensure that market risks are met with the same quality of capital as credit and operational risks. Detailed criteria for each category of criteria are set out in the Basel III framework.

Capital buffers 22.6 Two new capital buffers were introduced in Basel III. These apply in addition to the increased capital ratios described above and require additional capital to be held over the 8% minimum: (1) Capital conservation buffer: a buffer of 2.5% is required to be held above the Tier 1 capital requirement which can be drawn down in times of market stress. The buffer must be met with Common Equity Tier 1 capital. Restrictions on the proportions of post-tax earnings that can be paid out in distributions to shareholders or discretionary bonus payments to employees apply to banks operating within the buffer zone. (2) Countercyclical capital buffer: the countercyclical capital buffer (CCB) is a buffer which requires a bank to take into account the macro-financial environment in which it is operating. The introduction of the CCB added a new macro-prudential element to financial regulation. The CCB is designed to protect the banking sector from periods of excessive aggregate credit growth. The CCB is calculated by reference to exposure to borrowers in a particular jurisdiction and is set by authorities in that jurisdiction. International banks will be required to calculate the buffer as a weighted average of the buffers that are being applied in relation to jurisdictions in which they have exposure. The buffer can range from 0% to 2.5% and must be met with Common Equity Tier 1 capital. The same restrictions on distributions and discretionary bonuses described above in respect of the capital conservation buffer apply to banks operating within the CCB zone. 365

22.7  Basel III and IV – The Regulatory Framework EXHIBIT 22.1 CALIBRATION OF THE CAPITAL FRAMEWORK – CAPITAL REQUIREMENTS AND BUFFERS (ALL NUMBERS IN PERCENTAGES) Common equity (after deductions) %

Tier 1 Capital %

Total Capital %

Minimum

4.5

6.0

8.0

Conservation buffer

2.5

Minimum plus conservation buffer

7.0

8.5

10.5

Countercyclical buffer range*

0–2.5

* Common equity or other fully loss absorbing capital Source: Annex 1 of ‘Basel Ill: a global regulatory framework for more resilient banks and banking systems’, December 2010, rev June 2011

Leverage ratio 22.7 Prior to the GFC, a build-up of both on- and off-balance sheet leverage was experienced. When banks were forced to reduce their leverage, this created a downward pressure on asset prices, further exacerbating the crisis. The BCBS therefore proposed a simple non-risk based leverage ratio as a supplementary measure to the risk based capital requirements with the aim of constraining leverage in the banking sector and of supplementing the safeguards against model risk and management. A  new solvency ratio based on gross exposures was introduced in Basel III. This is required to be calculated in a comparable manner, once differences in accounting standards have been adjusted for, across jurisdictions. The leverage ratio must not exceed 3% of the aggregate exposures of the bank, including both balance sheet and off-balance sheet exposures, based on Tier 1 capital (rather than Core Tier 1 capital) as calculated under the Basel III rules. Basel Ill Tier 1 capital Total exposure (including off-balance sheet items,less permitted netting)

= Leverage ratio >3%

Items that are deducted from capital do not contribute to leverage and should be deducted from the measure of exposure; that is, required deductions from Tier 1 capital may also be deducted from the exposure measure. Where a financial entity is included in the accounting consolidation, but not the regulatory consolidation, since the capital of that entity is deducted from consolidated Tier 1 capital, the associated assets should also be deducted from the exposure measure. Exposure is to be measured consistently with financial accounts and therefore: •

on-balance sheet, non-derivative items should be net of specific provisions and valuation adjustments;

•

physical or financial collateral, guarantees or purchased credit risk mitigation do not reduce on-balance sheet exposure; and

•

netting of loans and deposits is not permitted.

Securities financing items may be included by applying the accounting measure of exposure and the regulatory netting rules based on the Basel II framework. 366

Basel III 22.8 Derivative exposure is taken as the accounting method of exposure (the ‘onbalance sheet’ present value reflecting the fair value of the contract) plus an add-on for potential future exposure calculated in accordance with the Basel II framework, net of amounts permitted under the Basel II regulatory netting rules. Other off-balance sheet items, which the BCBS recognises as a significant source of leverage, are to be included in the exposure measure at notional value, except for commitments which are unconditionally cancellable by the bank at any time, to which a 90% discount on notional value is applied. The Basel IV package (see para  22.10) includes certain amendments to the leverage ratio requirement to align it with other elements of the Basel IV standard, including alignment with changes to calculation of credit risk and counterparty credit risk exposures under the standardised approach. It also makes amendments to the exposure measure to account with regard to future derivative exposures and securitisations that have been de-recognised for capital purposes, among other changes.

Part 2: liquidity standards 22.8 Basel III introduced a global liquidity standard comprised of required liquidity coverage and stable funding ratios supplemented by monitoring tools: • Liquidity coverage ratio: designed to promote ‘resilience to potential liquidity disruptions over a thirty day horizon’. The specified scenario is built upon the circumstances of the GFC that began in 2007 and assumes: – a significant downgrade of the bank’s external credit rating; – a partial loss of deposits; – a loss of unsecured wholesale funding; – a significant increase in secured funding haircuts; and – increases in derivative collateral calls and substantial calls of contractual and non-contractual off-balance sheet exposures, including committed credit and liquidity facilities. Banks are required to hold a minimum 100% stock of liquid assets that would enable them to survive the 30-day stress scenario. High quality liquid assets Net cash outflows over 1 month

•

= Liquidity coverage ratio >100%

Net stable funding ratio: the net stable funding ratio (NSFR) requires a bank to hold a minimum amount of stable sources of funding relative to the liquidity profiles of the bank’s assets, as well as the potential for contingent liquidity needs arising from off-balance sheet commitments, over a oneyear horizon. The NSFR is made up of two elements: (a) available stable funding (ASF); and (b) required stable financing (RSF). ASF must meet or exceed RSF. The NSFR aims to ‘limit over-reliance on short-term wholesale funding during times of buoyant market liquidity and encourage better assessment of risk across all on- and off-balance sheet items’. Available stable funding (1 year) Required stable funding (1 year)

= Net stable funding ratio >100%

367

22.9  Basel III and IV – The Regulatory Framework

Treatment of object finance under Basel III 22.9 Under Basel III, there are three different methods of calculating the credit risk requirement from which a bank can choose: the standardised approach (SA); and the foundation and advanced internal ratings-based (IRB) approaches. In the case of object finance, sophisticated banks tended to use one of the two IRB approaches, with the standardised approach mainly used as a backstop to internal models, as opposed to other exposure classes where many banks use the standardised approach as their primary approach. Under the SA, different risk weightings are given to assets depending upon their external credit ratings, with unrated exposures usually attracting a 100% risk weighting. Under the IRB approach, banks are required to input certain risk components into a given formula to calculate the risk weight in respect of each exposure. For the foundation IRB approach for corporate, sovereign and bank exposures, banks are required to estimate their own probability of default (PD) for each borrower grade, but must use supervisory estimates for the other risk components: the loss given default (LGD); exposure at default (EAD); and maturity (M). Under the advanced IRB approach, a bank must calculate its own estimates for all of the risk components. Under both IRB approaches, there is a specialised regime for certain types of specialised lending, including ‘object finance’. ‘Object finance’ is defined as a method of financing the acquisition of physical assets, including aircraft, where the repayment of the exposure is dependent upon the cash flows generated by the specific assets (for example, rental or lease contracts with a third party) that have been financed and pledged or assigned to the lender. To fall within the specialised lending regime under Basel III (of which object finance is a sub-class), the following criteria must be met, either in legal form or economic substance: • the exposure is typically to an entity (often a special purpose entity) which was created specifically to finance and/or operate physical assets; • the borrowing entity has little or no material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income it receives from the asset(s) being financed; • the terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates; and • as a result of the preceding factors, the primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of a broader commercial enterprise. The text of Basel IV amends the definition of specialised lending slightly to allow exposures meeting ‘some or all’ of the relevant characteristics to qualify as specialised lending exposures but does not materially amend these conditions. Where a bank does not meet the requirements for the estimation of PD under the foundation approach for their object finance assets, they are required to map their internal risk grades to five supervisory categories, each of which is associated with a particular risk weight (the supervisory slotting criteria approach). The supervisory rating grades vary from a 70% risk weighting for a ‘strong’ exposure (broadly corresponding to a BBB – external credit assessment) to a 250% risk weighting for a ‘weak’ exposure (broadly corresponding to a B to C – external credit assessment). Although the slotting criteria broadly correspond to 368

Basel IV 22.10 external credit assessments, detailed criteria are set out in respect of each grade containing an assessment of financial strength, political and legal environment, transaction characteristics, operating risk, asset characteristics, strength of sponsor and the security package. At national discretion, the weightings for ‘strong’ and ‘good’ exposures may be reduced by 20% to a 50% and 70% risk weighting respectively, provided the exposure has a maturity of less than 2.5 years or the supervisor determines that the bank’s underwriting and other risk characteristics are sufficiently strong. Banks that meet the requirements for the estimation of: (a) PD, are able to use the foundation approach; and (b) PD, LGD, EAD and M, are able to use the advanced IRB approach, to derive risk weights for object finance exposures. The consequence of an organisation being able to calculate its own estimates under either of the IRB approaches is generally that capital consumption of highvalue secured aircraft finance transactions is low, relative to the size of the asset and when compared to the capital required for a traditional corporate loan. This is due to the risk component(s) that the bank is able to calculate being estimated by reference to the specific object being financed and taking into account the cash flows generated by that object, rather than being estimated by reference to the general financial condition and debt-servicing capabilities of a borrower.

BASEL IV 22.10 The key changes under Basel IV are in the following areas: (1) A  revised standardised approach for credit risk: the Basel IV revisions to the standardised approach for credit risk are intended to improve the granularity and risk sensitivity of the SA and reduce mechanistic reliance on credit ratings by banks. The more granular approach includes: – amendments to the risk weights (RW) for rated exposures; – different treatments for covered bonds, specialised lending and SME exposures; – a more risk-sensitive approach for real estate exposures based on a loan-to-value ratio (LTV) rather than a flat RW; – more granular RWs for subordinated debt and equity exposures; and – increases in the risk-sensitivity of credit conversion factors (CCF) for off-balance sheet items. (2) Output floor: – Basel IV will introduce an output floor whereby banks’ risk-weighted assets must be calculated as the higher of: (a) total risk-weighted assets calculated using the approaches that the bank has supervisory approval to use in accordance with the Basel capital framework (including both standardised and internal model-based approaches); and (b) 72.5% of the total risk-weighted assets calculated using only the standardised approaches. (3) Revised internal ratings-based framework for credit risk: the key revisions to the IRB approaches to credit risk in Basel IV are: – removing the use of the advanced IRB approach for certain asset classes. Notably the use of the IRB approach was not removed for specialised lending exposures (of which object finance forms part) so banks have a choice of foundation or advanced IRB, slotting, SA; 369

22.11  Basel III and IV – The Regulatory Framework –

(4)

(5)

(6)

(7)

the revised IRB framework also introduces minimum ‘floor’ values for bank-estimated IRB parameters that are used as inputs to the calculation of RWA; – a standalone treatment for specialised lending to corporates, including object finance. It allows the use of issue-specific rating where available. Revised credit valuation adjustment (CVA) framework: – The revised CVA framework takes into account the exposure component of CVA risk and removes the option of using an internally modelled approach to CVA. Revised operational risk framework: – The advanced measurement approaches for calculating operational risk capital requirements (which are based on banks’ internal models) and the current three standardised approaches will be replaced with a single risk-sensitive standardised approach for use by all banks. Revised market risk framework: – The revised standards for minimum capital requirements for market risk published by the BCBS in January 2016 form part of the Basel IV package. Leverage ratio: – The finalised Basel IV reforms introduce a leverage ratio buffer for G-SIBs (global systematically important banks), set at 50% of a G-SIB’s risk-weighted higher-loss absorbency requirements.

BASEL III AND BASEL IV – IMPACT FOR AVIATION FINANCE 22.11 Although the BCBS was not directly targeting aircraft financing arrangements in developing the Basel Ill framework, two elements inherent in aircraft financing in particular impacted on banks providing aircraft financing facilities under Basel III. First, as the leverage ratio does not recognise the quality of assets since it is not credit-sensitive, it requires a more conservative approach to capital in relation to good quality assets which in turn negatively impacts pricing. As a consequence, where under Basel II a fully secured aviation financing facility attracted a low capital requirement relative to its notional amount, in part due to the low risk weighting generated by the high expected recovery rate, under Basel III, an increased capital requirement was introduced through the non-risk sensitive leverage ratio. Second, the long-term nature of aviation assets makes them more expensive for banks to fund because of the impact of the liquidity standards. The Basel III requirements with respect to liquidity (in particular, the NSFR requirement referred to above) increases the cost of long-term funding and as a consequence increases the cost of aviation financing facilities. The change under Basel IV that appears most likely to impact on banks providing aviation finance is the addition of an input floor for banks using the IRB approach for object finance exposures. Since the introduction of Basel II, many banks use the SA to determine minimum capital requirements arising 370

Basel III and Basel IV – impact for aviation finance  22.11 from their object finance exposures. As the IRB approach allows banks to consider the actual risk situation of an exposure by modelling credit risk based on internal and external customer-specific data, it provides banks with a great deal of leeway to determine and possibly reduce a bank’s minimum capital requirements. However, in Basel IV the BCBS took aim at the variability associate with bank’s use of internal models and introduced changes targeted at increasing both the risk sensitivity of the standardised approaches and constraining the use of internal models. Although the final Basel IV text did not remove the option for banks to use the IRB approach for specialised lending (despite initial proposals to do so) the Basel IV revisions include the gradual introduction of a floor to constrain the extent to which banks can use internal models to drive down their capital requirements for credit and market risk. Consequently, from 2023 onwards, an RWA result calculated according to the IRB approach will be required to be at least 50% of the RWA calculated with SA. Subsequently, the output floor will increase by five percentage points annually until it reaches its final value of 72.5 % in 2028. This creates a potentially significant capital add-on for banks engaged in specialised lending and, although the market impacts of the Basel IV reforms are expected to vary significantly across countries and geographic regions, in general it is anticipated that the greater the share of IRB models used, the bigger the expected impact in capital requirements.

371

23 Accounting Developments in Aircraft Finance Killian Croke

INTRODUCTION 23.1 With so much of the capital requirements for aircraft finance being provided by the public debt and equity capital markets, there are more aircraft finance and leasing companies that are required to make financial information publicly available than at any other time in recent history, as well as more stakeholders seeking to use and rely on that information. Financial reporting is one of the most basic elements of the internal control and governance infrastructure of a corporate entity; it serves a dual purpose of both communicating and controlling. The key output of financial reporting, financial statements or accounts, are used extensively in value adding communication with the capital markets, customers, suppliers and employees and in decision making (for credit and other risk assessment purposes) as well as in monitoring the performance of the entity (for example, by way of financial covenants, and determining the applicability and enforceability of material adverse change clauses). It is, therefore, important to understand this information and what it does and, perhaps more importantly, does not purport to present. One of the many consequences for airlines, lessors and their financiers of the great financial crisis and the Covid-19 pandemic will be an increased focus on the quality and transparency of their financial reporting. The pace of accounting and financial reporting change in recent years has affected all sectors including aircraft finance and leasing. Standard setters want to achieve more consistency of financial reporting, more clarity over accounting policies, and more openness to the drivers of financial performers. However, there continues to be choices available to companies in their selection and application of accounting policies and this is representative of the diverse nature of companies operating within the aircraft finance and leasing sector – both the way in which they operate, the jurisdictions and geographical regions in which they are domiciled, and the type of activities they undertake. This chapter focuses on financial reporting under both International Financial Reporting Standards (IFRS) and US generally accepted accounting standards (US GAAP) while also addressing some of the recent developments in accounting for leases as a result of the novel coronavirus (Covid-19). This chapter is not a detailed comparison of US GAAP and IFRS but rather an overview of the key accounting and financial reporting principles affecting companies engaged in aviation finance and leasing activities. The matters discussed in this chapter reflect the international nature of the operations in the aviation finance and 373

23.2  Accounting Developments in Aircraft Finance leasing sector. No comment is made or suggested with regard to the adequacy or otherwise of policies adopted by any entity operating in the sector.

WHICH FRAMEWORK? 23.2 Historically many, if not all, lessors and aviation-related securitisation vehicles prepared their financial statements under US GAAP. This was driven primarily by the target audience for whom financial statements were prepared (for example, investors or parent entities) and regulatory requirements (as the US Securities and Exchange Commission (SEC) did not accept any accounting frameworks other than US GAAP without a reconciliation thereto, many issuers chose to report under US GAAP to avoid such a requirement). The SEC accepts IFRS as an acceptable accounting framework for non-US issuers and since IFRS is also an acceptable basis for reporting on many non-US stock exchanges and for local statutory reporting by many non-US based lessors and financiers, this has now become the second most common financial reporting framework. There are many differences between US GAAP and IFRS. Differences that affect the aircraft finance and leasing sector primarily relate to accounting for impairment and for maintenance, and this gives rise to difficulties in obtaining clear and comparable information across the sector. The selection of an accounting framework may impact: (a) the timing of reported results of a transaction; and (b) the reported financial position of an entity engaging in such transactions. It is important to be aware of the potential differences under the two frameworks in negotiating covenants and other key performance indicators as metrics that may be perfectly acceptable under one framework may be significantly different under the other and in a worst case scenario may trigger a breach or default under the accounting standards. However, this is only part of the issue. The application of accounting standards across entities can be quite judgemental and may give rise to different interpretations being applied to the same or similar transactions even by entities reporting under the same accounting framework. This desire for transparency is echoed by national accounting bodies (the Financial Reporting Review Panel in the UK has criticised companies for using what it called ‘boiler plate’ disclosures) and regulators (the SEC has focused many of its comments to aircraft finance and leasing entities on a number of key accounting policies applied by all of the entities reviewed). As the amount of financing required by aviation finance and leasing entities continues to grow to meet the demands of airlines and other users, the suppliers of that financing will continue to demand more transparent and robust financial reporting. It is likely that more extensive and robust discussions of judgements taken in applying accounting policies as well as the provision of more ‘nonGAAP’ information, such as Environmental, Social and Governance (ESG) reporting, will be required if stakeholders are to truly understand the value in entities from their reading financial and other reporting.

LEASE ACCOUNTING 23.3 A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. 374

Lease accounting 23.4 If a contract is, or contains a lease, then a lessee/lessor must account for each separate lease component separately from non-lease components. Under IFRS, while a lessee may elect, by class of underlying asset, not to separate lease components from any associated non-lease components and instead account for them as a single lease component, lessors are required to separate both. From a lessee perspective, IFRS and US GAAP align; however, from a lessor perspective, under US GAAP a lessor may elect, by class of underlying asset, not to separate lease components from associated non-lease components and instead account for them as a single component if: (1) the non-lease component would otherwise be accounted for under the revenue Codification Topic; (2) the timing and pattern of transfer for the lease component and non-lease component are the same; and (3)

the lease component, if accounted for separately, would be classified as an operating lease.

IFRS 23.4 A lessee is required to apply a single, on-balance sheet lease accounting model to all of its leases unless the lessee elects the recognition exemptions for short-term leases and/or leases of low-value assets. A lessee recognises a rightof-use asset representing its right to use the underlying asset and a lease liability representing its obligation to make lease payments. After initial recognition, a lessee measures the lease liability at amortised cost using the effective interest method. The lease liability is also re-measured to reflect lease modifications and changes in the lease payments, including changes caused by a change in an index or rate. A lessee measures the right of use asset at cost less accumulated depreciations and impairment losses. A  lessor classifies leases as either operating or finance leases, depending on the substance of the transaction rather than the form of the contract. The classification determines the accounting treatment followed by the lessor. A lease is classified as a finance lease by a lessor if substantially all of the risks and rewards incidental to ownership of an underlying asset are transferred from the lessor to the lessee by the agreement. The following are typical indicators that a lessor assesses to determine whether it has transferred substantially all of the risks and rewards: •

at the inception date, the present value of the lease payments in relation to the fair value of the underlying asset;

•

the lease term in relation to the economic life of the underlying asset; and

•

whether the lessee will obtain ownership of the underlying asset. A lease that is not a finance lease is an operating lease for the lessor.

Under a finance lease, a lessor derecognises the underlying asset and recognises a net investment in the lease. Under an operating lease, the lessor recognises the lease payments as income over the lease term, generally on a straight-line basis and continues to recognise the underlying asset in its statement of financial position/balance sheet. 375

23.5  Accounting Developments in Aircraft Finance

US-GAAP 23.5 Under US-GAAP there is a dual classification on-balance sheet lease accounting model for lessees: finance leases; and operating leases. Classification is determined by pass/fail tests intended to determine whether the lessee obtains control of the use of the underlying asset as a result of the lease. Classification is made at commencement of the lease and is reassessed only if there is a lease modification and that lease is not accounted for as a separate lease. Like IFRS, the lessee can elect not to apply on-balance sheet accounting to short-term leases. A lessee recognises a right-of-use asset representing its right to use the underlying asset and a lease liability representing its obligation to make lease payments. After initial recognition, a lessee measures the lease liability at amortised cost using the effective interest method. The lease liability is also re-measured to reflect lease modifications and changes in the lease payments, but not including changes caused by a change in an index or rate (unless the lease liability is remeasured for another reason). A lessee measures the right-of-use asset at cost less accumulated depreciations and impairment losses. For a finance lease, a lessee measures the right-of-use asset at cost less accumulated amortisation and accumulated impairment loss. For an operating lease, unless the right-ofuse asset has been impaired, a lessee amortises the right-of-use as a balancing amount that together with accretion on the lease liability generally produces straight-line total lease expenses. Lessors classify leases as either finance or operating leases, with finance leases further classified as either sales-type or direct financing leases. As described above classification is determined by pass/fail tests and is made at commencement of the lease and is reassessed only if there is a lease modification and that lease is not accounted for as a separate lease. Under a finance lease, a lessor derecognises the underlying asset and recognises a net investment in the lease. Any selling margin in a direct financing lease is recognised over the lease term. US-GAAP also includes specific guidance on collectability that in certain circumstances may affect timing of recognition of income for sales-type leases and require classification of a lease as operating that would otherwise be classified as direct financing. Under an operating lease, the lessor recognises the lease payments as income over the lease term, generally on a straight-line basis, and continues to recognise the underlying asset in its statement of financial position/balance sheet. There is also guidance on collectability of operating lease rentals that may result in operating lease income being recognised on a cash basis (ie rather than on a straight-line basis).

Lease modifications 23.6 Aircraft finance is a dynamic business that requires active and often proactive management of arrangements entered into in order to preserve and maximise the economic return to the owner/lessor and maintain commercial relationships with the lessees. Compromises and concessions will often be granted as part of negotiations and, in particular, during periods of economic turmoil and/or recession when airlines and lessees may come under additional operational and financial pressure (see para  23.7 below). The accounting and reporting consequences of these changes need to be considered carefully. 376

Leases – responding to the Covid-19 pandemic 23.7 A lease modification is a change in the scope of a lease, or the consideration for a lease, that was not part of the original terms and conditions of the lease, for example, adding or terminating the right to use one or more underlying assets. An existing lease is generally considered a new agreement when it is renewed or extended beyond the original lease term. The exercise of a renewal option included as part of the original lease term is not a renewal or extension of a lease. Leases are classified at their inception, that is, the date from which the lessee is entitled to exercise its right to use the leased asset(s). If the conditions of a lease are then changed in such a way that a different classification would have resulted at inception of the lease (had the revised or modified terms been in place at that time), then the revised lease agreement is treated as a new lease over its new/revised term. Changes in estimates, of variable discount rates or estimated economic life or circumstances (for example, a default by the lessee) do not give rise to reclassifications. However, sometimes it can be quite difficult to differentiate between changes in estimates and modifications of a lease and significant judgement may need to be applied. The requirement to reconsider the classification of leases and whether the exceptions referred to in the preceding paragraph apply are important considerations in managing portfolios of dynamic lease relationships. The impact on income and/or expenditure because of the reclassification of leases and potentially on balance sheet ratios may be significant and may result in materially different reported financial results and financial positions for both lessors and lessees. Therefore, careful consideration of amendments or changes to any lease arrangements is required.

LEASES – RESPONDING TO THE COVID-19 PANDEMIC 23.7 In May 2020, as a consequence of the impact of the Covid-19 pandemic on economic operations and business conditions, the International Accounting Standards Board (IASB) issued ‘Covid-19 – Related Rent Concessions’ (the 2020 amendments) which amended IFRS  16 to offer an optional practical expedient that simplified how a lessee accounted for rent concessions that were a direct consequence of Covid-19. The practical expedient was time-sensitive, applying only to rent concessions for which any reduction in lease payments affects only payment originally due on or before June 2021. The unprecedented economic challenges, and the length at which they have persisted, has proved longer than originally anticipated. As a result, the IASB issued further amendments ‘Covid-19 – Related Rent Concessions beyond 30 June 2021’ which provides a one-year extension on the practical expedients for lessees relating to payments originally due on or before 30 June 2022. While the 2020 amendments are optional, the 2021 amendments are not. The practical expedients can be adopted if the following criteria are met: (1) the change in the lease payments results in revised consideration for the lease that is substantially the same as, or less than, the consideration for the lease immediately preceding the change; (2) any reduction in lease payments affects only payments originally due on or before 30 June 2022; and (3) there is no substantive change to the other terms and conditions of the lease. 377

23.8  Accounting Developments in Aircraft Finance The practical expedient does not apply to lessors. Lessors are required to assess whether rent concessions result in a lease modification, the following high-level guidelines being appropriate for consideration: (a) change in lease consideration; (b) change in lease tenor; (c) change in asset return condition; or (d) consideration deferral with full repayment later in the lease, all that were not part of the original terms and conditions of the lease.

AIRCRAFT AND RELATED COMPONENTS, DEPRECIATION AND AMORTISATION 23.8 Most aircraft and related assets are held on their respective owner’s (lessor) balance sheet at depreciated historical cost. The objective in reporting and measuring assets in this way is not to recognise decreases in the value of aircraft; rather, the purpose is to allocate the cost amount over its useful life. Therefore, depreciation is recognised even if the value of the asset is being maintained by regular repairs and maintenance or trends in the secondary market. Accounting ‘net book value’ is not intended to be, and is not, a reflection of the current market value of aircraft. Residual value (RV) together with useful economic life (UEL) determines the depreciation charge each year. Estimating RVs and UELs are some of the most difficult judgements in accounting and financial reporting for aviation finance and leasing companies. Furthermore, as IFRS requires an annual re-assessment of these key estimates (which is not required by US GAAP but which many participants undertake as a matter of best practice), owners of aircraft need to have a robust process for deciding and refining these estimates. RVs and UELs are difficult to estimate for aircraft for a number of reasons. These reasons include the long economic lives of aircraft, uncertainty over the future market conditions in which the aircraft will operate, repairs and maintenance policies, fleet deployment and operating cycles, future technological changes (including the impact of regulatory matters such as environmental constraints) and prevailing market prices and trends in secondary markets. Generally, owners/ lessors have determined the useful economic life of commercial passenger aircraft to be between 20 and 25 years from date of manufacture, and up to 35 years for some cargo/converted aircraft. RVs have tended to be estimated on purchase as a percentage of the cost (generally in and around 15%) with RVs subject to ongoing verification, usually against appraiser’s future base values or internal models and estimates. Most owner/lessors depreciate on a straight-line basis over the aircraft’s UEL, that is, the same deprecation charge is applied evenly over the 25- to 30-year life of the aircraft. While this is an accepted methodology under both IFRS and US GAAP and meets the accounting objective and requirement of allocating the cost of the aircraft over its UEL, it may not necessarily provide for an allocation of that cost on a basis that is representative of either: (a) the usage of the aircraft; or (b) the future cash generating potential. There continues to be increased discussion and commentary within the aviation finance and leasing sector and the associated speciality media as to the appropriateness of continuing with these accepted norms (of RV and UEL) which have proven to be robust and representative of the reality of the world in which the sector has operated for the past 20 to 30 years. Some of the arguments put forward for reducing the length of UELs include: the increasing competition between manufacturers to stay ahead in terms of technology and to 378

Aircraft and related components, depreciation and amortisation 23.8 introduce new technology; legal restrictions on older aircraft operating in certain jurisdictions; airline business models (driven to some extent by passenger demand) requiring new aircraft in order to meet their economic and commercial needs; the availability of financing for new aircraft (from export credit agency and other sources); all of which indicated a trend favouring newer aircraft and consequently challenging current estimates of UELs and RVs. A  further evolution in accounting for aircraft may be the consideration of alternative methods of depreciation such as the reducing balance method which provides for a declining depreciation charge with larger amounts taken in earlier years. This method is considered appropriate when an item of property, plant and equipment (such as an aircraft) provides greater benefits to the owner in its earlier years. If it can be proven that this is the case for aircraft, the reducing balancing method may in the future prove to be a more appropriate and acceptable method for depreciating aircraft. However, any change to the accepted norms of RV and UEL is a delicate and sensitive issue which is likely to require significant and increased public and private debate. This issue comes back to the point discussed earlier in this chapter that the objective of accounting depreciation is to allocate the cost amount of an aircraft over its useful life and not to report either its current value or future cash generating potential for its owners. Aircraft are usually leased subject to triple-net leases pursuant to which the lessee is responsible for maintenance, which is accomplished through one of two types of provisions in its leases: (a) end-of-lease return conditions (EOL leases); or (b) periodic maintenance payments (MTX paying leases). Under EOL leases, the lessee is obligated to comply with certain return conditions which require the lessee to perform lease end maintenance work or make cash compensation payments at the end of the lease to bring the aircraft or aircraft equipment into a specified maintenance condition. Under MTX paying leases, the lessee is required to make periodic maintenance payments to the company based upon usage of the aircraft or aircraft equipment. When qualified major maintenance is performed during the lease term, the aircraft owner/lessor is required to reimburse the lessee for the costs associated with such maintenance. At the end of lease, the aircraft owner/lessor is entitled to retain any cash receipts in excess of the required reimbursements to the lessee. As a consequence of these maintenance arrangements, in addition to the recognition of the aircraft (or ‘metal’) component, many aircraft finance entities identify, measure and account for maintenance right assets and liabilities associated with the acquisition of aircraft and related assets with in-place leases. A maintenance right asset represents the value of the contractual right under a lease to receive an aircraft or related asset in a better maintenance condition at lease expiry as compared to the maintenance condition at acquisition. A  maintenance right liability represents the acquirer’s obligation to pay the lessee for the difference between the contractual maintenance condition of the aircraft or related asset at lease expiry and the actual maintenance condition at acquisition. Maintenance right assets in EOL leases represent the difference in value between the contractual right to receive an aircraft in an improved maintenance condition at lease expiry as compared to the maintenance condition on the acquisition date. Maintenance right liabilities exist in EOL leases if, at acquisition date, the maintenance condition of the aircraft or aircraft equipment is greater than the contractual return condition in the lease at lease expiry and the acquirer is required to pay the lessee in cash for the improved maintenance condition. 379

23.9  Accounting Developments in Aircraft Finance Maintenance right assets in MTX paying leases represent the right to receive an aircraft in an improved condition relative to the actual condition on the acquisition date. The aircraft is improved by the performance of qualified major maintenance paid for by the lessee who is reimbursed by the aircraft owner/ lessor from the periodic maintenance payments that it receives. Maintenance right assets are generally recorded as either a separate asset/ liability or as a component of aircraft in the aircraft/owner lessor balance sheet. Maintenance right assets are realised either through the return of the aircraft in a better maintenance condition than when acquired, or through cash payments by the lessee throughout or at the end of the lease, which are retained by the aircraft owner/lessor in the event that the aircraft is not returned in the required maintenance condition.

IMPAIRMENT OF AIRCRAFT AND RELATED ASSETS 23.9 All accounting frameworks require entities to review for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. The aircraft finance and leasing sector is capital intensive and at the same time vulnerable to economic recession, external demand and price shocks (in particular, oil) which, to the extent these give rise to impairment charges, can lead to earnings volatility. Generally, owner/lessors tend to assess aircraft individually for impairment. Recoverability of aircraft is assessed by comparing (under IFRS) its carrying amount to the higher of its value in use and fair value less costs to sell. Value in use is, generally, the future discounted cash flows that the aircraft is expected to generate over its remaining UEL, including RV or proceeds from its sale. In order to assess impairment, estimates and assumptions are made regarding expected cash flows which requires considerable judgement and consideration of current market values for aircraft, operating rentals achievable for the leasing of the aircraft, as well as the UEL of the aircraft. Each of these assumptions requires reference to and consideration of existing contracts and forecasts of macro- and micro-economic conditions. US GAAP uses undiscounted future cash flows to assess whether there has been a trigger for impairment. If the undiscounted cash flows are less than the aircraft’s carrying value, then an impairment is charged to record the aircraft at its fair value. This is one of the key differences between IFRS and US GAAP for the aviation finance and leasing sector and results in IFRS reporters being more likely to suffer impairments before their US GAAP contemporaries.

MAINTENANCE ACCOUNTING 23.10 Most aircraft operating lessors’ business objective is to ensure that the costs of maintenance (MTX) are borne by their lessees. Most aircraft operating lease contracts are triple-net leases under which the lessee takes responsibility for, among others, the maintenance costs associated with the aircraft during the term of the lease. Airline lessees are usually unable to avoid the cost of maintenance activities during the term of the lease. These costs will either be: 380

Use of special purpose entities/companies 23.11 (1) paid for by the airlines, with a contracted refund being made by the lessor up to the amount of maintenance reserves already paid (to the extent contracted) by the lessee; (2) paid over in the form MTX security deposits that are not refunded at the end of the lease (assuming checks are not done before the lease-end date); or (3) paid over in the form of end-of-lease payments (‘upsy/downsy’ payments). The accounting for maintenance is inherently difficult due to the differing contractual arrangements between lessors and lessees, and further complicated since major maintenance events are not always required and/or completed during the life of a lease. Under IFRS, a lessor is not permitted to establish maintenance reserves for uncontracted future maintenance events. Where an item of property, plant and equipment has individual components for which different depreciation methods or rates are appropriate, the lessor is required to depreciate each component separately (component accounting). Maintenance reserves are recorded as maintenance deposits in the balance sheet of the lessor and upon termination of the lease arrangement, any remaining maintenance deposits held are recognised as income (or as a realisation/recovery of the maintenance component asset). Payments/receipts in respect of ‘upsy/ downsy’ leases are generally recorded as expense/income when paid/received. Lessor contributions to the subsequent lessee to ‘compensate’ them for the maintenance condition of the aircraft when delivered are usually treated as lease incentives and recognised as a charge against lease revenue over the term of that lease arrangement. Under US GAAP, most companies have tended to recognise that out of the maintenance reserves received that are expected to be contributed to maintenance costs incurred by the lessee as deposits on the balance sheet, the amount that is not expected to be repaid is recognised as income. There are many variations on this approach which are determined by each company’s specific facts and circumstances, contractual arrangements and interpretation of the requirements of US GAAP. The area of accounting for maintenance reserves and lease and maintenance components has been one of the most complex and diverse accounting issues arising in the aviation finance and leasing industry. It has attracted significant attention from regulators in understanding the basis for the differences between reporters using the same accounting framework. These differences are justified because of different business models, contractual arrangements with lessees, and varying treatments permitted under the accounting frameworks. However, any analysis of a lease transaction or of a leasing entity requires a careful and detailed analysis of the accounting treatment adopted in respect of maintenance if a full and clear understanding of the transaction or entity is to be achieved.

USE OF SPECIAL PURPOSE ENTITIES/COMPANIES 23.11 Many cross-border aviation finance and leasing transactions are undertaken using special purpose entities/companies (SPCs). SPCs are generally considered to be entities that are created to fulfil narrow, specific or temporary objectives. SPCs are typically used to isolate or ring-fence financial 381

23.11  Accounting Developments in Aircraft Finance and/or operating risks. A  company will generally transfer assets to the SPC for management or use the SPC to finance a large project or assets, thereby achieving a narrow set of goals without putting the entire company at risk. SPCs are often used in complex financings and are commonly used to own a single asset, such as an aircraft, to allow for easier transfer of that asset. An SPC may be owned by one or more other entities and certain jurisdictions may require ownership by certain parties in specific percentages. It may also be important that the SPC is not owned by the entity on whose behalf the SPC is being set up (the sponsor). Many SPCs are set up as ‘orphan’ companies with their shares settled on a charitable trust and with professional directors independent of the parties transacting with or through the SPC. Under IFRS, when an entity is a party to a transaction with a SPC it must consider whether or not in substance it controls the SPC. Often, the sponsor retains a significant beneficial interest in the SPC, even if it owns little or no equity in it. Where an entity in substance controls the SPC, even where control arises through the predetermination of the SPC’s activities, the entity must consolidate that SPC. The following circumstances, in addition to the ‘traditional’ indicators (such as ownership of 50%+ of equity and appointment of majority of directors), show that an entity controls and should consolidate the SPC if, in substance: (1) the activities of the SPC are being conducted on behalf of the entity according to its specific business needs; (2) the entity has the decision-making power over the SPC or has delegated these powers through an autopilot mechanism; (3) the entity has the right to the majority of the benefits of the SPC and is, therefore, exposed to the risk incidental to its activities; or (4) the entity retains the majority of the residual or ownership risks related to the SPC in order to obtain benefits. US GAAP has similar provisions for SPCs which are also known as variable interest entities (VIEs). An entity is a VIE when any or the following conditions exists: (1) the total equity at risk is insufficient to permit the entity to finance its activities without additional subordinated financial support; or (2) the holders of equity lack any one of the following characteristics: (a) the ability to make decisions about the entity; (b) the obligation to absorb expected losses of the entity; and (c) the right to receive residual returns of the entity. Companies transacting with a VIE must determine under US GAAP whether it has both: (a) the power to direct the activities that most significantly impact the VIE’s economics; and (b) the right to receive benefits or the obligation to absorb losses that could potentially be significant to the VIE. If this is the case, then the entity must consolidate. The consequences of applying the guidance under IFRS and/or US GAAP to SPCs involved in cross-border transactions in the aviation finance and leasing sector can be significant. Failure to correctly structure a transaction could result in an entity being required to consolidate a SPC (or VIE) and take back onto its balance sheet assets (that is, aircraft) and debt that it had thought would be derecognised, thereby reducing for many entities one of the perceived benefits of undertaking the transaction. Careful consideration will be needed to determine 382

Conclusion 23.12 on which party’s behalf (the airline lessee, the financier/lender, or the owner/ lessor) the SPC is conducting its business, who controls the SPC, whether the governance documents mean the SPC is on ‘autopilot’ and who predetermines this, as well as who is really exposed to the residual risks (and benefits) in the SPC.

CONCLUSION 23.12 As this chapter has discussed, there are already significant accounting and financial reporting issues affecting aviation finance and leasing entities that engage in cross-border aircraft leasing transactions. These matters need to be carefully considered when structuring and documenting these transactions in order to ensure that the reported results and financial positions of entities entering into these arrangements reflect the intended actual commercial and economic consequences of the transactions.

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24 Aircraft Financing – The Compliance Universe Rob Murphy and Fintan Kerins

INTRODUCTION 24.1 Lessors, banks and lessees involved in the aviation industry operate in an area that has become increasingly regulated in recent years. Such players are traversing a ‘compliance universe’, engaged in an industry which is the subject of ever-expanding oversight of regulators worldwide. Failure to comply with regulatory requirements can have hugely detrimental consequences for organisations, with recent high-profile prosecutions showing the level of financial penalties that can be imposed, not to mention reputational and relationships damage. Some of these regulations are aviation industry specific – for example, regulations that relate to sanctions, export/re-export controls and the like that can affect airline operations and jurisdictions, or entities into which or to whom aircraft may be leased. Others have generic application but can place more pressure and complexity in terms of monitoring and compliance on businesses that operate globally. Aircraft lessors and financiers, by the very nature of the business, need to be aware of and compliant with a wide range of regulations in many jurisdictions including, for example: the countries in which they are located/have a place of business; the jurisdictions into which aircraft are leased; as well as the US and EU which have a regulatory reach from various perspectives – not least as the location of the two leading aircraft manufacturers – Airbus and Boeing. Although many organisations operating in the industry have dedicated regulatory personnel with responsibility for ensuring compliance with the requirements applicable to that organisation, firms will be aware that all employees must have an understanding of the relevant obligations, in effect acting as a ‘first line of defence’ in identifying suspicious activity or other potential compliance issues. While an in-depth review of all regulatory obligations facing actors in the sector is beyond the scope of this work, this chapter is intended to highlight some of the main themes in the compliance sphere and provide a high-level and nonexhaustive overview of certain key responsibilities.

ANTI-MONEY LAUNDERING AND COUNTERING THE FINANCING OF TERRORISM 24.2 Given the multi-jurisdictional nature of the aviation industry and the large sums of money involved in the leasing and financing of aircraft, the sector 385

24.2  Aircraft Financing – The Compliance Universe is seen as an area which is a potential target of bad actors looking to use highvalue industries to launder money and fund terrorism. It is not surprising then that organisations involved in the sector will often find themselves subject to substantial duties with regard to anti-money laundering and countering the financing of terrorism (AML/CFT). Applicable AML/CFT obligations will vary depending on the nature of the leasing or financing activities and the jurisdictions involved. In a European context, the fight against money laundering/terrorist financing has been a key part of the EU’s legislative agenda since the EU adopted the first anti-money laundering directive in 1990. In this regard, the EU has set out its legislative goals most recently in the Fourth Anti-Money Laundering Directive,1 as amended by the Fifth Anti-Money Laundering Directive.2 Member states have individual responsibility for implementing the principles of the EU AML/CFT framework into national law and, therefore, standards of application and enforcement of rules can vary quite significantly across member states. The EU regime applies to certain ‘obliged entities’ including entities that engage in lending (which includes the financing of commercial transactions), financial leasing and guarantees and commitments.3 Many leasing companies and financiers of aircraft operating within the EU will be involved in such activities and will therefore fall within the scope of the EU’s AML/CFT regime. Performing client due diligence (CDD) is a key aspect of the EU AML/CFT framework. Organisations should perform checks on all counterparties including lessees, buyers, investors and suppliers, and must take additional safeguards such as enhanced CDD when dealing with non-EU firms and in particular, those located in designated ‘high-risk’ countries.4 Those subject to the directive must report suspicions of money laundering or terrorist financing to the relevant authorities and take supporting measures, such as ensuring the proper training of personnel and establishing appropriate internal preventive policies and procedures. Similar obligations exist in other jurisdictions, including the United States.5 Under the European framework, entities must make informed, risk-based and proportionate decisions of the effective management of individual business relationships and occasional transactions for AML/CFT purposes. Organisations can then adjust the extent of their CDD measures in a way that is commensurate to the AML/CFT risk they have identified. Examples of risk factors to be considered include the nature, scale and complexity of operations, types of customers, distribution channels and the products and services being provided.6

1

Directive (EU) 2015/849 of the European Parliament and of the Council of 20 May 2015 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing. 2 Directive (EU) 2018/843 of the European Parliament and of the Council of 30  May 2018 amending Directive (EU) 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing. 3 Directive (EU) 2015/849, Article 2. 4 Annex to the Commission Delegated Regulation supplementing Directive (EU) 2015/849 by identifying high-risk third countries with strategic deficiencies. 5 Including in particular the US Bank Secrecy Act 1970 and the US Patriot Act. 6 See Joint Guidelines under Articles  17 and 18(4) of Directive (EU) 2015/849 on simplified and enhanced customer due diligence and the factors credit and financial institutions should consider when assessing the money laundering and terrorist financing risk associated with individual business relationships and occasional transactions.

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Anti-money laundering and countering the financing of terrorism 24.2 In this way, entities should have AML/CFT policies and procedures in place which are tailored to their particular operations and risk profile and should undergo regular review and updates of the same. It is also important to note that while CDD will most often be performed at the outset of dealings with a particular party, AML/CFT compliance is very much an ongoing process involving continued monitoring and supervision. An organisation’s AML/CFT policy will typically cover: • a risk-based approach in assessing and managing money laundering and terrorist financing risks; • details of applicable law and offences; • provision for training and education for staff to ensure awareness of the procedures and personal responsibilities; • client on-boarding process and details of documentation required; • monitoring obligations and ongoing due diligence; • procedure for enhanced due diligence for high-risk client relationships; • record keeping; • reliance on third parties for due diligence; • details of the money laundering reporting officer; • how to recognise suspicious activity; • reporting mechanisms where any reasonable grounds to suspect that money laundering offences have been committed. Although organisations may appoint a dedicated money laundering reporting officer (MLRO) or choose to outsource the performance of AML/CFT functions including its CDD processes, to related companies or third-party specialist providers, ultimate responsibility for compliance will remain with the obliged entity itself.7 Companies should have a detailed customer on-boarding system in place which both complies which applicable laws and also meets best practice and standards. This will involve, for example, developing a CDD checklist, having a system in place or access to a system that can screen names and entity screening for sanctions or similar issues. Organisations will often avail of online databases such as World-Check to assist with CDD processes. Such resources allow firms to identify politically exposed persons (PEPs) and sanctioned individuals and organisations. Firms can use such databases during their screening process to mitigate risk and ensure that they meet their AML/CFT obligations. AML/CFT has become an increased area of attention for authorities in many jurisdictions in recent years. For example, AML/CFT is now stated as a key focus for the Central Bank of Ireland (the CBI), carrying out supervisory undertakings, which include: issuing risk evaluation questionnaires (REQs); holding review meetings for AML/CFT and financial sanctions (FS); conducting inspections; and having ad hoc meetings with firms where necessary. In 2020, following supervisory engagements undertaken in respect of firms registered with the CBI to assess compliance with their AML/CFT obligations, the CBI issued a ‘Dear CEO’ letter. This outlined the Central Bank’s expectations of firms in relation to AML/CFT and FS requirements and detailed follow-up 7

Directive (EU) 2015/849, Article 25.

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24.3  Aircraft Financing – The Compliance Universe actions to be taken by CEOs and Boards in response to the findings outlined. The examination undertaken by the CBI, which comprised of both inspections and review meetings, found an overall lack of compliance across all areas of the AML/ CFT control framework, as well as poor understanding of the requirements from Board and senior management levels, including at those firms who outsourced their AML/CFT and FS activities to third parties.

ANTI-BRIBERY AND CORRUPTION 24.3 While anti-bribery and corruption (ABC) has been a hot topic in the US for over 40 years, it has historically received much less consideration in Europe. This has changed in recent years as the EU has more closely focused its attention on preventing bribery and corruption, recognising that such malfeasance costs the European economy around €120 billion annually.8 Corruption also constitutes a threat to security, as an enabler for crime and terrorism, and acts as a drag on economic growth by creating business uncertainty, slowing processes and imposing additional costs.9 Corruption can take many forms, such as bribery, trading in influence or abuse of functions. There are heightened sensitivities in the aviation industry around the issue of bribery and corruption given the fact that many airlines are state-owned or quasi state-owned, and therefore transactions will often involve dealings with public officials or various brokers or intermediaries who can shoehorn themselves into transactions. There is a track record in the aviation industry of large corporates being held responsible for breaches of ABC laws. In one of the most high profile instances, Rolls Royce ended up paying fines of over £671 million across the UK, the US and Brazil after it emerged that it had been using bribes to win foreign contracts over the course of several decades. These related to the sale of aero engines, energy systems and related services and took place across seven jurisdictions, including Indonesia, Thailand and Russia.10 In what amounted to the largest settlement in a corporate bribery case on record, Airbus SE agreed to pay over US$3.9 billion for having used a department with a US$300 million annual budget to illegally sway government officials and other decision makers on airplane sales, boosting profit by more than US$1 billion in a long-running bribery campaign.11 As part of the campaign, Airbus engaged the wife of a SriLankan Airlines executive agent although she had no aerospace expertise and arranged for US$2 million to be paid to her company to influence the airline’s purchase of ten aircraft; in China, the company used ‘consultants’ to pay bribes to government officials and executives at Chinese state-owned airlines.12

8

See https://ec.europa.eu/home-affairs/what-we-do/policies/organized-crime-and-humantrafficking/corruption/anti-corruption-report_en. 9 See https://ec.europa.eu/home-affairs/what-we-do/policies/organized-crime-and-humantrafficking/corruption_en. 10 See https://www.sfo.gov.uk/2017/01/17/sfo-completes-497-25m-deferred-prosecutionagreement-rolls-royce-plc/. 11 See https://www.justice.gov/opa/pr/airbus-agrees-pay-over-39-billion-global-penaltiesresolve-foreign-bribery-and-itar-case. 12 See https://www.justice.gov/opa/press-release/file/1241466/download.

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Sanctions and export controls 24.4 Organisations should tread carefully when it comes to corporate hospitality and gifts and similar activities. While what is acceptable in this regard will vary across jurisdictions, in general, the provision of corporate hospitality that is offered simply to maintain good business relations may be acceptable. Relevant factors include the motivation, value, whether the recipient is a public official, the jurisdictions involved and other elements. For example, an offer of gifts, hospitality or services should not be accepted by an office holder or public servant where it would, or might appear to, place the recipient under an obligation. Generally, small token gifts such as calendars, diaries or pens of small value may be acceptable, provided that there is no intent to influence an official. Many organisations will have a detailed policy on the subject covering topics such as the types of gifts and hospitality that is and is not acceptable as well as a reporting, tracking and approval systems. Considering the global reach of certain ABC laws and the liability that companies can face for acts committed by their employees, organisations should put in place clear ABC policies that are proportionate to the bribery and corruption risks they face. Such policies should outline the organisation’s approach to corporate hospitality and gift-giving, as well as to issues such as facilitation payments and dealing with public officials. Organisations should make sure that ABC policies should be periodically reviewed at board level and are promulgated to all relevant employees. While having ABC policies in place is by no means a guarantee of immunity from prosecution for ABC breaches, proper implementation of such policies and procedures, including regular training and an effective ABC leadership structure, will help entities in any defence to show they have taken reasonable steps to ensure compliance. A typical ABC policy will cover: • policy statement and purpose of policy; • what constitutes bribery and corruption; • applicable law and penalties; • dealing with public officials and who is considered a public official; • requirements for giving or receipt of a gift or hospitality (including acceptable quantum); • conduct in engaging the services of business partners and intermediaries; • examples of unacceptable practices; • record keeping in relation to hospitality or gifts given or received; • how to raise a concern; • procedure for periodically reviewing and updating the policy. In building its ABC policy a company will need to take into the account the requirements and expectations of its home jurisdiction as well as other relevant jurisdictions – for example, the jurisdictions in which it is operating/transaction business and most likely the USA and the EU – in brief the policy should be robust and flexible enough to meet what is a very extensive regulatory reach.

SANCTIONS AND EXPORT CONTROLS 24.4 Sanctions are another key piece of the ‘compliance universe’ for lessors, financiers of aircraft and airlines to consider. These are a modern tool for 389

24.4  Aircraft Financing – The Compliance Universe governments to use, ie the blocking of assets and trade restrictions to accomplish foreign policy and national security goals. Sanctions may target governments of countries, as well as companies, groups or individuals through a wide range of measures including arms embargoes, restriction on admission (travel bans), asset freezes or other economic measures such as restrictions on imports and exports. European entities and individuals must abide by the EU’s sanctions regime, regardless of where they are operating. The EU has over 40 different sanctions regimes in place, some of which are mandated by the United Nations Security Council, whereas others are adopted autonomously by the EU.13 The task of conducting investigations into potential non-compliance cases falls to the member states and their national competent authorities. Member states must have in place effective, proportionate and dissuasive penalties, and enforce them when EU sanctions are breached. The EU sanctions map indicates those sanctions that are adopted by the European Council (including those imposed by the UN Security Council and adopted by the European Council).14 In the US, the Office of Foreign Assets Control (OFAC) of the US Department of the Treasury administers a wide-ranging sanctions framework. Sanctioned individuals or entities are placed on OFAC’s Specifically Designated Nationals and Blocked Persons (SDN) List. Generally speaking, OFAC prohibits all transactions between those on the SDN list and US individuals and companies that have a sufficient US nexus. Further, all property and interests of the SDNlisted entity or individual which fall under US jurisdiction are blocked, including companies which are majority owned by the SDN-listed entity or individual. If a non-sanctioned entity is found to be transacting with an SDN-listed individual or company in breach of the terms of the sanctions, there is a risk that the nonsanctioned entity will itself be subsequently subject to sanctions and added to the SDN list. US sanctions apply not only to transactions or entities which have a nexus to US jurisdiction (for example, entities organised in the US, US citizens, etc) (‘primary sanctions’), but also involve ‘secondary sanctions’. These do not require a US connection and are imposed on non-US persons directly or indirectly engaged in certain significant transactions relating to certain specified countries including Iran, Russia, North Korea and Syria, aimed at deterring non-US persons from engaging in dealings deemed to be contrary to US interests, by restricting their access to US markets. From a practical perspective, aircraft lessors, financiers and operators should ensure they implement a robust sanctions programme which is regularly reviewed given that the countries, individuals and entities subject to sanctions frequently change. Transaction parties should also carefully review control of use, illegality, force majeure, default and change of law clauses in documentation. Nevertheless, recent high-profile cases demonstrate that it is not sufficient to merely structure transactions and related documentation in a manner compliant with sanctions – ongoing monitoring of assets and counterparties is required to ensure no breach of sanctions in substance, and failure to do so could expose parties to significant financial and reputational consequences. 13 See https://ec.europa.eu/info/business-economy-euro/banking-and-finance/internationalrelations/restrictive-measures-sanctions_en. 14 See https://www.sanctionsmap.eu/.

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Cyber resilience and data protection 24.5 Perhaps the most stark recent example of this is OFAC’s US$210,600 settlement in 2019 with Apollo Aviation (now Carlyle Aviation). Apollo was cited for 12 apparent violations of sanctions against Sudan, when it leased three aircraft engines to an entity incorporated in the United Arab Emirates, which then subleased the engines to a Ukrainian airline, which then installed the engines on an aircraft wet leased to Sudan Airways. At the time of the transactions, Sudan Airways was identified on OFAC’s List of Specially Designated Nationals and Blocked Persons as meeting the definition of ‘Government of Sudan.’15 The Apollo enforcement action was the third aviation-related release from OFAC in a seven-month period and emphasises OFAC’s focus on the broader international aviation industry. In its briefing published in respect of the Apollo case, OFAC: • highlighted the importance of companies operating in high-risk industries to implement effective, thorough and ongoing, risk-based compliance measures, especially when engaging in transactions concerning the aviation industry; • warned of deceptive practices employed by Iran and other actors with respect to aviation matters; • emphasised the need for companies operating internationally to implement ‘Know Your Customer’ (KYC) screening procedures and implement compliance measures that extend beyond the point-of-sale and function throughout the entire business or lease period; and • advised that companies can mitigate sanctions risk by conducting risk assessments and exercising caution when doing business with entities that are affiliated with, or known to transact with, OFAC sanctioned persons or jurisdictions, or that otherwise pose high risks due to their joint ventures, affiliates, subsidiaries, customers, suppliers, geographic location, or the products and services they offer.16 The Apollo example is also illustrative of the onus on non-US participants in aviation deals to be aware of any links with the US (subsidiaries, personnel or US origin goods or software): OFAC will expect high compliance where nonUS parties are knowingly working with sanctioned jurisdictions. The case also highlights that it is not adequate in itself to have prohibitions in the contract on the use of leased equipment by sanctioned jurisdictions – there is a duty on these parties to have an effective monitoring programme to ensure that there is no breach in OFAC rules.

CYBER RESILIENCE AND DATA PROTECTION 24.5 While lessors or financiers of aircraft may not deal directly with consumers, all organisations acting in the industry should be aware that they could nonetheless hold data in respect of individuals sufficient to bring them within the scope of data protection laws, most notably, the EU’s General Data Protection Regulation (GDPR) – regarded as the toughest privacy and security law in the world, imposing obligations on organisations worldwide, so long as they target or collect data related to people in the EU.17 15 See https://home.treasury.gov/policy-issues/financial-sanctions/recent-actions/20191107_33. 16 See https://home.treasury.gov/system/files/126/20191107_apollo.pdf. 17 See https://gdpr.eu/what-is-gdpr/.

391

24.6  Aircraft Financing – The Compliance Universe The GDPR applies to organisations holding or using personal data – broadly defined to include any information that relates to an individual who can be directly or indirectly identified. Personal data would therefore include names, addresses and contact details, as well as location information, web cookies and CCTV footage. Those processing data (again broadly defined, to include collecting, recording, organising, structuring, storing, using or erasing data) must do so according to seven protection and accountability principles outlined in Article 5.1–5.2 of the GDPR, for example, that the processing must be lawful, fair, and transparent to the data subject, and that the data processed must be for the legitimate purposes specified explicitly to the data subject when collected. A standard data protection policy should cover: • explanation of data protection principles; • appropriate security measures against the accidental loss of, or damage to, personal data; • commitment to adequate, relevant and non-excessive processing of data; • retention of data – for how long and for what purpose; • updating, verifying and deleting personal data; • disclosure of information to third parties, including service providers or authorities; • conditions under which data can be transferred outside the state. The GDPR levies harsh fines against those who violate its privacy and security standards. There are two tiers of penalties, with a maximum levy of €20 million or 4% of global revenue (whichever is higher). In addition, data subjects have the right to seek compensation for damages. As well as putting in place data privacy policies and performing GDPR audits, organisations should also have comprehensive IT policies in place and ensure regular staff training and system resilience monitoring to guard against potential cyber attacks and data breaches. IT/cyber security policies will typically include: • security awareness such as phishing campaigns and security awareness training; • acceptable use; • email security policy; • mobile device policy; • password management; • remote working policy and particular vulnerabilities associated with same; • data leak prevention policy and incident management procedures relating to data breaches; • penetration testing policy; • encryption policy; • data back-up and disaster recovery procedures.

PRICE FIXING, MARKET ABUSE 24.6 Price fixing involves agreeing prices with competitors. In an aviation context, this could include agreement on fares among airlines, lease rates among 392

Other regulatory filings/procedures 24.8 lessors, interest rates and other terms for banks or surcharges for cargo airlines. It is not necessary to actually make an agreement with competitors as in many cases, merely sharing prices with competitors is enough to fall foul of price fixing rules. Furthermore, passive participation can be sufficient to establish liability. Hence, in any interaction with competitors where sharing prices is discussed, it must be opposed actively in order to avoid liability. Market abuse can also encompass ‘market sharing’ – meaning an agreement among competitors not to compete, for example, for certain customers, countries or routes. Again, no formal agreement between the competitors is required in order for liability to be established. A detailed examination of these elements is beyond the scope of this chapter, but the headings/themes are clear and need to be given focus in policy, training, review and audit.

INSIDER DEALING 24.7 Another compliance topic which organisations in the sector should be wary of is insider dealing – that is, using price-sensitive information not generally available to the market to buy or sell securities in a company (or to procure others to do so). For this reason, organisations should have share dealing policies in place and provide staff training to address this risk. A usual insider dealing/share policy will cover: • details of what constitutes insider trading or market abuse; • examples of insider trading or market abuse; • details of permissible dealing activities and personnel responsibilities; • notification/approval procedure in respect of shares owned; • consequences of failure to comply; • procedure for raising queries or concerns.

OTHER REGULATORY FILINGS/PROCEDURES 24.8 In addition to the requirements flagged above, there will generally be a whole host of regulatory filings and procedures applicable in the jurisdiction where a particular business is located. For example, in the Republic of Ireland, the following filings could be relevant, depending on the nature of the business: • Companies Office filings (required for example, in respect of granting or releasing security, changes in officers, company name, address etc, share issuances, amending share capital and a wide range of other scenarios); • EMIR (European Market Infrastructure Regulation) reporting in respect of derivatives; • ultimate beneficial ownership registrations; • competition law/merger-control notifications; • director compliance statements in respect of compliance with company law obligations; • CBI reporting such as FVC (financial vehicle reporting) and special purpose vehicle (SPV) reporting and ‘Schedule 2’ registration; 393

24.9  Aircraft Financing – The Compliance Universe • • •

Foreign Account Tax Compliance Act (FATCA) reporting in respect of information on accounts held by US persons and certain US-controlled foreign entities; common reporting standard (CRS) reporting on information on accounts held by tax residents of reportable jurisdictions and entities controlled by such residents; tax returns and reporting – including DAC 6 filings.

SUMMARY 24.9 As flagged in the introduction, this is not intended to be an exhaustive summary of the issues that businesses need to confront in navigating the compliance universe – rather an indication of some key elements. As a base line, businesses will need to have appropriate policies and procedures in place covering: • customer due diligence/on-boarding/KYC; • anti-money laundering; • anti-bribery and corruption; • gifts and hospitality; • share/securities dealings; • sanctions/export controls; • market abuse risks/required behaviours; • regulatory filings, reporting, notification, approval and legal/compliance requirements in relevant jurisdictions – including in relation to transactional activities; • tax filings and compliance; • data protection including GDPR compliance; • IT systems/equipment access levels and required behaviours; • staff training on all elements; • compliance plan and compliance officer/MLRO roles; • review and audit.

CONCLUSION 24.10 The aviation industry is perhaps the quintessential global business, taking place in virtually every country in the world and with transactions routinely crossing borders. As explained above, this has become a highly regulated environment, in terms of both industry specific and non-industry specific requirements. For these reasons, compliance has come into sharp focus in recent times and is increasingly important for lessors, financiers and airlines alike. Regulatory compliance is not about bureaucracy or box-ticking, nor should it be seen as a roadblock to transactions or conducting business. Rather, it is about having a robust compliance plan in place that encompasses policies, systems and training which are effectively implemented, continuously monitored and regularly updated. It is about organisations taking ownership and responsibility 394

Conclusion 24.10 to ensure they are not complicit in money laundering or terrorism financing, corruption or breach of sanctions or data protection laws. Organisations and individuals need to be aware of the risk of criminal and civil sanctions that flow from all these elements. It is also about protecting brand value and safeguarding against reputational harm in addition to the risks of potentially the imposition of significant financial punishments.

395

Index

All references are to paragraph numbers

A accounting policy/basis boiler plate disclosures, 23.2 common reporting standards, 24.8 compliance, generally, 24.8 credit risk analysis, 8.8, 8.9, 8.10, 8.16 cross-border transactions, 23.11–23.12 depreciation charge, 23.8 end of lease return conditions (EOL), 23.8 finance leases, 23.5–23.6 financial reporting, generally, 23.1 foreign exchange risk, 8.16 fuel hedging, 8.16 generally, 23.1 IFRS, 8.10, 8.21, 23.1–23.4, 23.8, 23.9, 23.10, 23.11 impairment of assets, 23.9 interest rate hedging, 8.16 key performance indicators (KPIs), 23.2 lease accounting, 8.8, 8.9, 8.10, 8.16, 23.3–23.8, 23.10 maintenance right assets and liabilities, 23.8, 23.10 net book value, 23.8 operating leases, 8.10, 8.21, 23.3, 23.5–23.6 periodic maintenance payments (MTX), 23.8, 23.10 residual value (RV), 23.8, 23.9 special purpose entities/companies (SPCs), 23.11 Statement of other Comprehensive Income (SCI), 8.16 transparency, 23.1 US-GAAP, 8.8, 12.2, 23.1–23.3, 23.5, 23.8, 23.9, 23.10, 23.11 useful economic life (UEL), 23.8, 23.9 variable interest entities (VIEs), 23.11 acid test ratio credit risk analysis, 8.18; Appendix 8 I activity ratio quantitative analysis, 8.19; Appendix 8 I

aircraft carbon neutral goal, 9.2 carbon neutral growth, 9.1 depreciation, accounting, 8.10, 23.8 depreciation policy, risk analysis, 8.9 downside protection, 2.10 economic life, 2.10, 4.7 engine ingestion, 16.10 investment in See investment, aircraft as mechanical breakdown, 16.10 new build, 4.8–4.9 sale by lessors, 1.7 technological obsolescence, 2.12 value/valuation See aircraft value/ valuation wear and tear, 16.10 Aircraft Finance Insurance Consortium (AFIC) generally, 12.2 aircraft financing market aircraft as investments See investment, aircraft as airline bankruptcies, 2.1 asset-backed securities (ABSs), 2.8 asset quality, 2.10 background to, 2.1 capital markets See capital markets Chinese yuan, 2.9 covered bond market, 2.16 Covid-19 pandemic, effect, 1.1, 2.1, 2.4, 2.10, 8.41, 12.1 credit worthiness of obligor, 2.10 debt capital markets, 2.16, 3.7 debt and tax lease market, 2.11 due diligence and reporting obligations, 16.30, 23.1, 24.8–24.9 EETCs, 1.10–1.11, 2.16, 3.4, 3.7, 4.5 environmental considerations and, 2.12 euro currencies, 2.9 export credit See export credit financing financiers’ perspective, 2.10–2.18 global financial crisis and, 2.3, 10.7, 11.3, 12.2, 23.1 global liquidity, 2.6 global perspective, 2.1 growing need for finance, 2.7

397

Index aircraft financing market – contd hedge funds, 2.16, 2.17 high yield secured bonds, 2.16 Islamic bond market (sukuk), 2.16 Islamic leases, 2.14 lease portfolio securitisations, 2.16 leasing, generally, 2.15 liquidity pyramid, 2.6 private equity, 2.16, 2.17, 2.18 public equity, 2.18 regulatory frameworks, 2.8 sustainable financing, 9.11 tax leasing, 2.13 transaction structure, 2.10 trends in, 2.7–2.9 US dollar, 2.9, 8.14, 12.2 World Trade Center attacks, effect, 2.1, 2.2 aircraft on ground time E-notes/equity certificates, 1.9 Aircraft Protocol generally, 21.2–21.6 Aircraft Sector Understanding (ASU) 2007, 10.5–10.7 2011, 2.11, 10.7, 12.2 A risk mitigants, 10.7 asset backed transactions, 10.7 B risk mitigants, 10.7 common lines, 10.2, 10.10 environmental factors, incentives linked to, 10.10 home market rule (HMR), 10.6, 10.7 minimum premium rate (MPR), 10.5, 10.7 non-asset backed transactions, 10.7 risk category (RC) scale, 10.7 aircraft value/valuation aircraft specification, 7.8 appraisers (external valuers), 4.7, 7.1, 7.3, 7.5 asset value guarantees, 5.43 average (mean) value, 4.7 base value (BV), 4.7, 7.4 cashflow structure and, 7.6, 7.10 commercial considerations, 7.10 components of valuation and risk, 7.7–7.8 confidence in, generating, 7.12–7.13 contract, impact of, 7.8 current market value (CMV), 7.4 data evaluation, 7.11, 7.12 debt structure and assumptions, 7.6, 7.8, 7.10 depreciation See depreciation documentation, 7.12 downtime, anticipated, 7.8 economic life and, 4.7

398

aircraft value/valuation – contd engine performance restoration (EPR), 7.8 feedback loop, 7.12 flexible process, 7.12 forecasted sales value, 1.9 future sale value as percentage of original, 4.7 highest and best use, 4.7 in-house team coordination, 7.10 in-house valuation, 7.1–7.2, 7.4, 7.6–7.13 intrinsic value, 2.10 investment horizon, 7.8 key terms, 7.4 lease-encumbered value (LEV), 4.7, 7.4, 7.8 lease end, prospects for aircraft at, 7.7 legal terms affecting, 7.10 lessee, consideration of, 7.7 loan to value rates (LTVs), 1.1, 1.6 maintenance compensation and, 7.8 maintenance condition and, 5.38, 7.4, 7.10 market to base value ratio, 4.7 market value (current market value), 4.7 market volatility, 11.3 modification costs, 7.8, 7.10 near term, 7.4 operator, consideration of, 7.7 optional items, 4.9 ownership structure and, 7.6 parts value, 11.25 performance metrics, 7.6 proficiency in, developing, 7.9 projected supply and demand, 7.9, 7.10 rent, 7.8 repossessed aircraft, 17.2 residual value, 1.3, 1.5, 7.7, 11.18, 12.2 risk/credit considerations, 7.10 sale following repossession, 5.28 securitised value, 4.7 security structure, 7.8 storage costs, 7.8 technical asset management, 4.9 technical overhauls, factoring in, 7.8, 7.10 transition costs, 7.8, 7.10 validity of collateral, 5.25–5.27 value growth/retention, 4.6, 4.7 airline accounting, credit risk analysis, 8.8, 8.9, 8.10, 8.16 bankruptcies, financing markets and, 2.1, 2.4 competitive landscape, 4.3, 8.15, 8.37 depreciation policy, 8.9

Index airline – contd fuel hedging strategy, 8.15, 8.16, 8.25 investments in aircraft, 4.2–4.3 jurisdiction of incorporation, 5.11 licensing, 20.21 restructuring See restructuring returns on investment in, 4.3 start-ups, 4.3 visibility to revenue streams, 2.3 vulnerability to exogenous events, 2.3 airport charges unpaid, 5.22, 5.50 airspace navigation See navigation charges; navigation rights Altman’s Z score model, 8.26; Appendix 8 IV appraiser methodologies, 7.5 valuation by, 4.7, 7.2–7.3 arrest of aircraft precautionary, Rome Convention, 21.1, 21.8 ‘as is’ disclaimers lease agreements, 5.48 asset backed securitisation (ABS) aircraft, investors in, 4.5 capital structure/liability structure, 1.8 Cayman-incorporated Irish tax-resident vehicles, 3.7 collateral profile, 1.8 Covid-19 pandemic, 1.6 credit support, 1.8 deferred tax, 8.11 equity sales, 3.5 finance leases, 3.5 generally, 3.5 growth of sector, 3.7 impairment of assets, 23.9 lessors utilising, 1.8, 3.5 metal investors, 4.10 passive investor participation, 4.5 post-Covid-19 investor demand, 1.1 reserve accounts, 1.8 trends for aircraft financing, 2.8 asset risk aircraft-secured debt, 4.1 analysis, 8.2–8.3 liquid current assets, 8.18 assignable price PDP financing, 13.4 assignment by way of security PDP financing, 13.3 available seat kilometres (ASK), Appendix 8 II available seat miles (ASM), Appendix 8 II

aviation finance See also aircraft financing market; compliance; export credit financing; finance lease; legal issues; loan; mortgage 2020/2021 overview, 1.2–1.3 accounting developments See accounting developments Basel accords See Basel accords Cape Town Convention and, 5.8 cyclical nature, 7.9 hybrid structures, 5.2 lease arrangements, 5.2 risk in See risk secured loans, generally, 5.2, 5.9 transaction documents, filing, 5.11 validity of collateral, 5.25–5.27 aviation industry sector growth China, 14.58 cyclical nature, 2.7, 3.1, 4.1, 4.6, 4.7, 7.9, 11.3 leasing sector, 1.5, 2.4, 2.15, 3.8, 4.10, 10.8, 11.2, 12.1 operating leases, 11.1, 11.2, 11.15– 11.20, 11.34 predicted, 1.4, 1.12, 3.1, 11.2, 20.27 revenue passenger kilometres (RPK), 1.4, 11.2 stress testing analysis, 8.27–8.32 ‘supercycle’, 10.8, 10.9, 12.2 Aviation Working Group (AWG) assessment of regulations by, 9.6 carbon emissions calculator, 2.12, 9.6, 9.11 Global Aircraft Trading System (GATS), 6.5, 18.1 navigation charges, 5.23 statement of principles on environmental regulation, 9.6 template novation agreement, 12.4 B bai bithaman ajil Islamic finance, 15.4 Balthazar, 12.2 bankruptcy/insolvency Altman’s Z score model, 8.26; Appendix 8 IV bankruptcy-remote entity, ownership by, 5.2, 5.3, 5.9 Brazil, 14.15 Cape Town Convention, 5.27, 19.14, 19.20, 21.2, 21.5 Chinese airline, of, 14.60 domestic processes, 19.5 financing markets and, 2.1, 2.4 Germany, 14.71, 14.73 India, 14.54 Japan, 14.77, 14.81–14.83

399

Index bankruptcy/insolvency – contd Japanese Operating Lease with Call Option (JOLCO), 14.77 jurisdiction of incorporation, 19.5 lease, provisions, 12.7 non-petition clauses, 5.3 PDP borrowers, 13.7 predicting, 8.26 receiver, misconduct by, 5.28 restructuring following, 5.27, 19.4–19.22 Russia, priority of claims, 14.31 sale arrangements following, 5.28 special purpose companies, ownership by, 5.3 UK Insolvency Act, 5.25–5.27, 19.5, 19.15–19.22 US Bankruptcy Code, 5.27, 19.5–19.14 validity of collateral and, 5.25 banks See also commercial banks banking supervision See Basel accords investment in aircraft, 4.5 investment banks, 1.7 Middle Eastern, 2.3 side business to global offers, 2.10 base value (BV) external appraisers, 7.5 meaning, 7.4 valuation, 4.7 Basel accords Additional Tier 1 capital, 22.5 available stable funding (ASF), 22.8 banking supervision, generally, 22.1, 22.03 Basel Capital Accord, 22.2 Basel Committee on Banking Supervision (BCBS), 22.1 Basel II, 22.2, 22.11 Basel III, 22.1, 22.3–22.9, 22.11 Basel IV, 22.1, 22.7, 22.9, 22.10–22.11 capital buffers, 22.6 Common Equity Tier 1 capital, 22.2, 22.5, 22.6 countercyclical capital buffer (CCB), 22.6 credit conversion factors (CCF), 22.10 credit valuation adjustment (CVA), 22.10 derivative exposure, 22.7 disclosure requirements, 22.2 exposure at default (EAD), 22.9 external credit assessment, 22.9 global capital framework, strengthening, 22.4–22.7 global financial crisis, response to, 22.1, 22.3, 22.7, 22.8 impact, generally, 2.8, 22.11 internal-ratings based (IRB) approach, 22.9–22.11

400

Basel accords – contd leverage ratio, 22.7, 22.10, 22.11 liquidity standards, 22.8, 22.11 loss given default (LGD), 22.9 market discipline provisions, 22.2 maturity (M), 22.9 minimum capital requirements, 22.2, 22.5 net stable funding ratio (NSFR), 22.8, 22.11 netting rules, 22.7 object finance regime, 22.1–22.2, 22.9 off-balance sheet items, 22.7, 22.8, 22.10 output floor, 22.10 probability of default (PD), estimating, 22.9 repos, 22.2 required stable funding (RSF), 22.8 risk assessment process, 22.2, 22.9– 22.10 risk management within the banking sector, 22.1 risk-weightings, 22.1, 22.2, 22.9–22.11 solvency ratio, 22.7 standardised approach (SA), 22.9, 22.11 supervisory review process, 22.2 Tier 2 capital, 22.5 Bermuda aircraft registration, 5.24 blind pool warehousing Covid-19 pandemic, 1.6 boiler plate disclosures accounting, 23.2 Brazil Aircraft Sector Understanding (ASU), 2.11, 10.5, 10.6 Brazilian manufactured aircraft, 14.18 Cape Town Convention, 14.15 capital gains taxes, 14.8 commercial lease (arrendamento mercantil), 14.2, 14.6, 14.11, 14.15 cross-border leases, 14.1, 14.4, 14.6, 14.13 currency exchange transactions, 14.12 double tax treaties, 14.7 export credit financing, 14.1, 14.18 finance lease (arrendamento mercantil), 14.2, 14.6, 14.11, 14.15 financial transactions, 14.12 foreign exchange controls, 14.13 import taxes, 14.9 insolvency legislation, 14.15 insurance, 14.16, 16.8 Irrevocable Deregistration and Export Request Authorisation (IDERA), 14.15

Index Brazil – contd operating lease (arrendamento simples), 14.3, 14.5, 14.6, 14.8, 14.11, 14.15 outbound leasing, 14.18 PIS/COFINS, 14.10 security interests, registration, 14.17 services, tax on, 14.11 taxation, 14.5–14.12 ultimate beneficial owner, disclosure, 14.14 war/terrorism, insurance against, 14.16 withholding tax, 14.6, 14.7 breakeven load factor (BLF), Appendix 8 II bribery anti-bribery and corruption regulations, 24.3 Brussels Convention generally, 5.33, 21.1, 21.11 ‘build out’ PDP financing, 13.2 business plan credit risk analysis, 8.38 C cabotage air navigation rights, 20.3, 20.4 Canada Aircraft Sector Understanding (ASU), 2.11, 10.5, 10.6 capacity managing, 1.5 Cape Town Convention aircraft mortgages, 5.6, 5.8, 5.12 Aircraft Protocol, 21.2–21.6 Alternative A provisions, 5.27, 19.14, 19.20 Brazil, 14.15 China, 14.61 choice of financing structure and, 5.8 conflict of laws, 5.12 declarations system, 21.2, 21.4, 21.6 export credit financing discount, 10.5, 10.7, 10.10 financial market regulation, 2.8, 3.1 ‘first-to-file’ rule, 21.2 generally, 21.1, 21.2 Germany, 14.69 India, 14.41, 14.54, 14.57 insolvency, contesting, 5.27, 19.14, 19.20, 21.2, 21.5 ‘international interests’, 21.2, 21.3– 21.4 Irrevocable Deregistration and Export Request Authorisation (IDERA), 11.12 jurisdictional risk analysis, 8.6

Cape Town Convention – contd leasing structures, 5.8 operating lease lessors, 11.12 quiet enjoyment rights, 5.35 registration of aircraft, 5.8 remedies for creditors, 21.2, 21.5 repossessions, 5.13 sovereign immunity, 5.14 United Kingdom, 19.20–19.21 United States, 19.14 capital lease US GAAP, 12.2 capital management advantages of leasing, 1.5 liquidity, 1.5 capital markets 144A offerings, 1.7, 3.3, 3.7 asset-backed securities transactions (ABSs), 3.5, 3.7 Covid-19 pandemic and, 3.7, 3.8 debt capital markets, 2.16, 3.7, 7.10 enhanced equipment trust certificates (EETCs), 3.4 export credit financing, 10.13 external factors, 3.1 green bonds, 3.6, 9.8 growth, 3.1, 3.7 primary, 3.1 private placements, 3.3 return on investment in aircraft, 3.1 secondary, 3.1 structure, 3.2–3.6 support for aviation lending and finance, 1.7, 2.16 trends, 3.7, 3.8 capital requirements Basel accords, 22.4–22.7 carbon emissions aircraft financing markets and, 2.12 aircraft obsolescence, 2.12 aviation industry’s impact, 9.1 AWG calculator, 2.12, 9.6, 9.11 CORSIA, 1.6, 9.3, 9.4, 9.5, 9.11 current global aim, 9.1–9.2 emissions trading scheme (ETS), 9.3, 9.4, 9.5 environmental, social and governance (ESG) risk, 2.12, 9.1, 9.10 green bonds, 3.6, 9.8 IATA strategy, 9.2 ICAO Environmental Protection Standards, 1.6 offsetting See carbon offsetting and reduction reduction methods, 9.5 sequestration, 9.2, 9.11 technological and operational innovation, 9.1, 9.2, 9.10, 9.11

401

Index carbon offsetting and reduction See also carbon emissions generally, 9.5, 9.10, 9.11 ICAO Environmental Protection Standards, 1.6 Scheme for International Aviation (CORSIA), 1.6, 9.3, 9.4, 9.5, 9.11 technological and operational innovation, 9.1, 9.10, 9.11 transparency, 9.10 verifiability, 9.10 cargo aircraft See freighter cargo yields during Covid-19 pandemic, 1.4 carrier legacy, 8.15, 8.24 liability, 5.18 low cost, 8.24, 8.25 cash flow statement cash flow adequacy, 8.25; Appendix 8 III cash interest coverage ratio, 8.24; Appendix 8 III cash to capital expenditure ratio, 8.25; Appendix 8 III cash to current debt coverage ratio, 8.24; Appendix 8 III cash to total debt ratio, 8.25; Appendix 8 III free cash flow, 8.25; Appendix 8 III funds flow coverage ratio, 8.24; Appendix 8 III generally, 8.23; Appendix 8 III going concern position, analysis, 8.25; Appendix 8 III liquidity/solvency analysis, 8.24 operating cash flow ratio, 8.24; Appendix 8 III cash flow structure aircraft valuation and, 7.6, 7.10 cash interest coverage ratio credit risk analysis, 8.24; Appendix 8 III liquidity/solvency analysis, 8.24; Appendix 8 III cash to current debt coverage ratio credit risk analysis, 8.24; Appendix 8 III liquidity/solvency analysis, 8.24; Appendix 8 III chattel leasing agreement United Kingdom, 5.27 Chicago Convention aircraft registration, 5.24, 20.23 domestic flights, 20.3 European Union, 20.5 generally, 20.1, 20.2 international flights, 20.3

402

China aircraft financing markets, 2.3 Aircraft Rights Registry, 14.61 bankruptcy of Chinese airline, 14.60 Cape Town Convention, 14.61 customs duty, 14.63 deregistration of civil aircraft, 14.61 foreign exchange controls, 14.65 foreign loans, 14.63 foreign-owned aircraft, 14.60 growth of civil aviation, 14.58 insurance, 16.8, 16.30 Irrevocable Deregistration and Export Request Authorisation (IDERA), 14.61 leases, 14.59, 14.60, 14.61, 14.62, 14.64 mortgages, 14.59, 14.63 registration of aircraft, 14.59 renminbi internationalisation, 14.65 special purpose vehicles (SPVs) in bonded area, 14.64 subleasing, 14.64 taxation, 5.3, 14.62 Tianjin Dongjiang free trade port zone, 14.65 value-added tax, 14.62, 14.63, 14.64 choice of law cross-border financing, 5.32, 14.38 Hague Convention, 5.33, 21.1, 21.12 Rome I and II Regulations, 5.32, 21.9–21.10 climate change See carbon emissions; carbon offsetting and reduction; emissions; environmental issues collateral asset value guarantees, 5.43 chain of title, 5.25 confidentiality considerations, 5.25 cross-collateralisation, 5.42 enforcement, 5.27 priority of, 5.26 registration of security interest, 5.25 validity, 5.25–5.27 commercial banks asset risk of aircraft-secured debt, 4.1 blind pool warehousing, 1.6 competitive landscape, 1.6 Covid-19 pandemic, 1.1, 1.6 ESG standards, 1.6 loan to value rates (LTVs), 1.1, 1.6 underwriting due diligence, 1.6 warehouse financings, 1.6 commercial lease Brazil, 14.2, 14.6, 14.11, 14.15

Index competition rules compliance, 24.8 European Union, 20.5–20.10 compliance, regulatory accounts, common reporting standards, 24.8 anti-bribery and corruption, 24.3, 24.8 anti-money-laundering, 24.2, 24.8 client due diligence (CDD), 24.2, 24.9 companies office filings, 24.8, 24.9 competition law, 24.8 countering the financing of terrorism, 24.2 cybersecurity, 24.5 data protection, 24.5, 24.8 derivatives reporting, 24.8 EMIR reporting, 24.8 equipment access levels, 24.9 export/re-export controls, 24.1, 24.4 generally, 24.1, 24.8–24.9 gifts and hospitality, 24.9 import controls, 24.4 insider dealing, 24.7 IT systems, 24.9 leasing regulations, 24.1–24.4 market abuse, 24.6–24.7 market sharing, 24.6 merger controls, 24.8 penalties for non-compliance, 5.29, 24.1, 24.10 price fixing, 24.6 reporting obligations, 16.30, 24.8, 24.9 sanctions obligations, 24.1, 24.2, 24.4, 24.9 share/securities dealings, 24.7, 24.9 staff training on, 24.9 taxation, 24.8, 24.9 technical, operating leases, 11.29 trade restrictions, 24.4 ultimate beneficial ownership registration, 24.8 condition precedent documents generally, 5.55 conditional sale agreement generally, 5.4 United Kingdom, 5.18, 5.27 Convention on International Civil Aviation aircraft emissions, 1.6 aircraft noise, 1.6 carbon offsetting, 1.6 CO2 emissions, 1.6 ICAO Environmental Protection Standards, 1.6 corporate jet sector India, 14.55 corporate social responsibility (CSR) sustainability linked loan principles (SLLPs) and, 9.9

corruption anti-bribery and corruption regulations, 24.3 CORSIA environmental issues, 1.6, 9.3, 9.4, 9.5, 9.11 exemptions, 9.3 goal, 9.3 implementation, 9.3 offsetting obligations, calculation, 9.3 voluntary participation, 9.3 counterparty Cape Town Convention signatories, 8.6 letters of credit, 8.5 risk analysis, 8.2, 8.4 security deposit, 8.5 Covered Tax Agreements (CTAs) cross-border leasing, 6.5 Covid-19 pandemic accounting developments resulting from, 23.1 airline debt, 2.4, 12.1 aviation funding and, 1.1, 1.2–1.3, 2.1, 2.4, 2.5, 2.10, 11.3 bank loans during, 1.6 capital markets during, 3.7, 3.8 cargo yields during, 1.4 credit risk analysis and, 8.41 decline in operating costs during, 1.4 expected industry losses, 2.4, 17.2 export credit financing and, 10.9 generally, 19.1 hell or high water clauses, 5.36 leasing arrangements and, 1.1, 1.3, 1.4, 1.5, 3.8, 12.1, 12.7, 23.7 planning for future pandemics, 1.12, 8.41 post-crisis aviation demand, 1.1, 1.4, 1.12, 11.2, 17.2 rent concessions/deferrals, 1.1, 1.3, 1.4, 1.5, 2.4 repossessions, 17.1–17.2 slot allocation regulation and, 20.12 state aid, 1.4, 1.12, 2.4, 2.5, 8.41, 12.1, 17.2, 20.10 vaccination rollout forecasts, 11.2 credit default swaps (CDS) availability, 2.6 credit derivatives instrument availability, 2.6 credit memoranda PDP financing, 13.4 credit risk analysis accounting policies/basis, 8.8, 8.9, 8.10, 8.16 acid test ratio, 8.18; Appendix 8 I activity ratios, 8.19; Appendix 8 I airlines, of, 8.7–8.33

403

Index credit risk analysis – contd Altman’s Z score model, 8.26; Appendix 8 IV business plan, operator’s, 8.38 Cape Town Convention signatories, 8.6 cash flow statements, 8.23; Appendix 8 III cash interest coverage ratio, 8.24; Appendix 8 III cash to current debt coverage ratio, 8.24; Appendix 8 III competitiveness, 8.37 Covid-19 pandemic and, 8.41 cross currency interest rate swaps, 8.14 debt to equity (gearing) ratio, 7.6, 8.21; Appendix 8 I deferred tax, 8.11 depreciation, 8.9, 8.10 earnings per share ratio (EPS), 8.22; Appendix 8 I economic growth, 8.27–8.32 foreign exchange risk, 8.12, 8.13, 8.16 fuel costs, 8.27–8.32 fuel hedging, 8.12, 8.15, 8.16 funds flow coverage ratio, 8.24; Appendix 8 III generally, 8.42–8.43 interest rate risk, 8.12, 8.14, 8.16, 8.27–8.32, 12.4 jurisdictional risk, 8.2, 8.6 labour costs, 8.27–8.32 leasing contracts, 12.2 lessors, of, 8.7–8.33 letters of credit, 8.5 leverage ratios, 8.21; Appendix 8 I liquidity ratios, 8.18, 8.24 management expertise, 8.36 operating cash flow ratio, 8.24; Appendix 8 III operating profit margin ratio, 8.20; Appendix 8 I ownership structure, 8.35 portfolio risk management, 8.2–8.6 post-balance sheet events, 8.41 profitability ratios, 8.20; Appendix 8 I quantitative analysis, 8.17–8.22 quantitative factors, 8.34–8.40 regulatory environment, 8.39 security, 8.2, 8.5 solvency, 8.24 solvency ratio, 8.21 stock market ratios, 8.22; Appendix 8 I stress testing, 8.27–8.32 tax strategy, 8.33 technical and maintenance issues, 8.5, 8.40 times interest earned ratio, 8.21; Appendix 8 I

404

credit risk analysis – contd transactional risks, 8.2, 8.5 zero weighted risk, 12.2 credit sale agreement liability under UK law, 5.18 cross-border financing accounting policy and, 23.11–23.12 choice of law, 5.32, 14.38 conflict of laws, 5.12 exchange control, 5.30 judgment currency, 5.31 legal issues, generally, 5.10 cross-border lease accounting policy and, 23.11–23.12 beneficial ownership, meaning, 6.5 Brazil, 14.1, 14.4, 14.6, 14.13 conflict of laws, 5.12 contract, drafting, 4.9, 6.13 Covered Tax Agreements (CTAs), 6.5 definition, 12.2 double depreciation (double dip transaction), 12.2 double taxation agreements, 6.5, 6.14 European Union, 6.3, 6.6, 6.14 finance leases, 6.5, 12.2 French tax lease (FTL), 2.1, 12.2 GATS, 6.5 generally, 5.10 import taxes, 6.3 income tax on aircraft sales, 6.6, 6.9, 6.11 Japanese operating lease (JOL), 2.1, 4.5, 14.75, 14.79 Japanese Operating Lease with Call Option (JOLCO), 4.5, 12.2, 14.75, 14.76–14.80 legal title, ownership, 12.2 maintenance reserves, 6.8 OECD Multi-Lateral Instrument (MLI), 6.5 operation leases, 6.5 principal purpose test (PPT), 6.5 registration taxes, 6.4, 6.12 sales taxes, 6.6, 6.9, 6.11 security deposits, 6.8 special purpose vehicle (SPV), 12.2, 12.4, 23.11 stamp duties, 6.2, 6.7, 6.10 tax considerations, generally, 6.1 taxes during, 6.5–6.8 taxes on origination of leases, 6.2–6.4 taxes on transfers of aircraft, 6.9–6.14 withholding tax, 6.5 cross-collateralisation legal considerations, 5.42 cross currency interest rate swap credit risk analysis, 8.13

Index cross-default legal considerations, 5.42 currency exchange transactions Brazil, 14.12 exchange control, 5.30 judgment currency, 5.31 current market value (CMV) external appraisers, 7.5 meaning, 7.4 cybersecurity regulations compliance, 24.5 D daily utilisation predicted improvements, 1.4 damages breach of contract, 5.29, 5.31 debt cash to current debt coverage ratio, 8.24; Appendix 8 III credit risk analysis, 8.24 debt structure, aircraft valuation and, 7.6, 7.8, 7.10 debt to equity (gearing) ratio, 7.6, 8.21; Appendix 8 I financial leverage, 8.21; Appendix 8 I net total debt, 8.21 times interest earned ratio, 8.21; Appendix 8 I debt capital markets aircraft financing markets, 2.16 aircraft valuation, 7.10 generally, 2.16 growth of sector, 3.7 debt and tax lease market, 2.11 debtor-in-possession proceedings Germany, 14.73 United States, 19.9 default repossession on See repossession Delaware statutory trusts Global Aircraft Trading System (GATS), 6.5 demand managing, 1.5 passenger, predicted growth, 1.4, 1.12, 3.1, 11.2 post-Covid-19 investor demand, 1.1 projected, 7.9, 7.10 depreciation accounting for, 23.8 double (double dip transaction), 12.2 end of lease return conditions (EOL), 23.8 IFRS accounting, 8.10, 23.8 JOLCO tax deferral leases, 14.76– 14.80 net book value, 23.8

depreciation – contd operating leases, 8.10, 14.76 periodic maintenance payments (MTX), 23.8, 23.10 policy, credit risk analysis, 8.9 residual value (RV), 23.8 tax leasing and, 2.13, 14.76–14.80 useful economic life (UEL), 23.8 deregistration IDERA, 11.12 derivatives reporting compliance, 24.8 disappearance clause insurance cover, 16.11 domestic processes insolvency, 19.5 double dip transaction cross-border leasing, 12.2 double taxation agreements Brazil, 14.7 cross-border leasing, 6.5 India, 14.47 downtime anticipated, 7.8 Dubai regulatory framework, 20.1 E E-notes anchor investor, 1.9 asset manager, 1.9 forecasted sales rates, 1.9 forecasted sales value, 1.9 issue, 1.7, 3.4, 3.7 market/marketing process, 1.9 modelling, 1.9 sale timing, 1.9 earnings before interest, tax, depreciation, and amortisation (EBITDA) cash flow analysis, 8.24 credit risk analysis, 8.20 earnings before interest and taxes (EBIT) credit risk analysis, 8.20, 8.21 economic growth stress testing analysis, 8.27–8.32 emissions See also carbon emissions; carbon offsetting and reduction; environmental issues aircraft financing markets and, 2.12 aircraft obsolescence, 2.12 aviation industry’s impact, 9.1 AWG calculator, 2.12, 9.6, 9.11 cap and trade systems, 9.4 CORSIA, 1.6, 9.3, 9.4, 9.5, 9.11 current global aim, 9.1–9.2 emissions trading scheme (ETS), 9.3, 9.4

405

Index emissions – contd environmental, social and governance (ESG) risk, 2.12, 9.1, 9.10 green bonds, 3.6, 9.8 growth, 9.4 IATA strategy, 9.2 ICAO Environmental Protection Standards, 1.6 reduction methods, 9.5 employees airline aviation liability insurance, 16.30 compliance training, 24.9 enforcement Brussels Convention, 5.33, 21.1, 21.11 collateral, 5.27 Germany, 14.72 Russian Federation, 14.29–14.30 UK judgments, 5.33, 21.21 United Kingdom insolvency/ restructuring process, 5.27 engine ingestion, 16.10 insurance, 16.27, 16.30 mechanical breakdown, 16.10 OEM agreements, 5.38, 11.6 performance restoration (EPR), 7.8 pooling, 5.41, 12.5, 17.9 replacement, 16.30 repossession, 17.9 title tracking, 5.41 enhanced equipment trust certificate (EETC) alternatives to, 2.16 availability, 2.16 Covid-19 pandemic, 2.5, 2.6 equipment notes, 3.4 generally, 3.3 investors in aircraft, 4.5 lessor, 1.10–1.11, 3.4 multiple airlines, 1.11 rated securities, 3.4 single airline transactions, 3.4 environmental, social and corporate governance (ESG) factors commercial bank lending, 1.6 emissions reduction and, 9.10 financing and, generally, 9.1, 10.11 environmental issues See also carbon emissions; emissions aircraft financing markets and, 2.12 alternative fuels, 9.1 ASU environmentally-linked incentives, 10.10 aviation industry’s impact, 9.1 carbon offsetting See carbon offsetting and reduction CORSIA, 1.6, 9.3, 9.4, 9.11

406

environmental issues – contd current global aim, 9.1–9.2 emissions reduction methods, 9.5 ESG performance, 9.1 EU Green Deal, 9.2 IATA strategy, 9.2 market-based measures, 9.1 operational improvements, 9.1, 9.2 Paris Agreement, 1.6, 9.2 single-use plastics, 9.5 sustainable financing, 9.1, 9.11 sustainable fuels, 9.1, 9.2, 9.5 equity certificates See E-notes equity funds Japan, 14.75 escrow facility Global Aircraft Trading System (GATS), 18.14 Eurocontrol navigation charges, 5.23, 5.50 European Union air fares, 20.21 aircraft registration, 20.23, 20.25–20.26 airline licensing, 20.21 airport capacity analysis, 20.13 anti-money-laundering regulations, 24.2 bilateral agreements, 20.4 Brussels Convention, 5.33, 21.1, 21.11 client due diligence (CDD), 24.2 code share agreements, 20.21, 20.26 competition rules, 20.5–20.10, 20.27 countering the financing of terrorism regulations, 24.2 cross-border leasing, 6.3, 6.6, 6.14 data protection, 24.5 domestic routes, 20.3 EMIR reporting, 24.8 emissions trading scheme (ETS), 9.3, 9.4 Germany, 14.70, 14.71 Green Deal, 9.2 greenwashing, protecting investors from, 9.7 ground handling, 20.9 growth of air travel market, 20.27 intra-EU air services, 20.21 leasing, regulation, 20.21 legislation, generally, 14.70, 14.71 Merger Regulation, 20.5, 20.8 product liability regime, 5.18 public service obligation (PSO) routes, 20.21 regulatory framework, 20.1, 20.4 Slot Allocation Regulation, 20.12– 20.20 state aid rules, 20.10 taxonomy, 9.6, 9.7, 9.11

Index European Union – contd Third Regulatory Package, 20.21, 20.23 VAT concessions, 6.3, 6.6, 6.14 wet-leasing, 20.21 export credit agencies (ECAs) PDP financing not offered by, 13.1 export credit financing A risk mitigants, 10.7 Aircraft Finance Insurance Consortium (AFIC), 12.2 Aircraft Sector Understanding (ASU), 2.11, 10.5–10.7, 12.2 asset backed transactions, 10.7 B risk mitigants, 10.7 Balthazar, 12.2 Brazil, 14.1, 14.18 Cape Town Convention discount, 10.5, 10.7, 10.10 capital markets structure, 10.13 common lines, 10.2, 10.10 Covid-19 pandemic and, 10.9 debt and tax lease market, 2.11 direct credit, 10.5 environmental factors, incentives linked to, 10.10 ESG criteria, 10.11 export credit agencies (ECAs), 10.2, 10.12–10.13, 12.2 finance lease structure, 10.12 future developments, 10.10–10.11 GATS system, transition into, 10.10 global financial crisis and, 10.7, 12.2 home market rule (HMR), 10.6 interest rate support, 10.5 market based pricing, 10.6, 10.7 market reflective surcharge (MRS), 10.7 minimum premium rate (MPR), 10.5, 10.7 non-asset backed transactions, 10.7 OECD Arrangement, 10.2, 10.4 OECD Large Aircraft Sector Understanding (LASU), 10.3, 10.4, 10.7 political risk insurance, 10.2 pure cover, 10.3, 10.5 purpose, 10.1, 10.2 refinancing, 10.5 regulatory framework, generally, 10.2 risk based rate (RBR), 10.7 risk category (RC) scale, 10.7 ‘supercycle’, 10.8, 10.9 transaction structures, 10.12–10.13 WTO litigation, 10.4, 10.5 export/re-export controls compliance with, 24.1, 24.4 F finance lease accounting policy/basis, 23.5–23.6

finance lease – contd amortisation, 12.2 asset backed securitisation (ABS), 3.5 Brazil, 14.2, 14.6, 14.11, 14.15 cross-border See cross-border lease definition, 12.2 double depreciation (double dip transaction), 12.2 economic ownership of aircraft, 12.2 export credit financing, 10.12 flexibility provided by, 12.5 general indemnities, 5.44 generally, 5.2, 11.4, 12.2 Germany, 14.67 hell or high water clause, 5.36–5.37 hire purchase agreement compared, 12.2 hybrid loan/mortgage structures, 5.2 ijarah wa iqtina, 15.4, 15.7 India, 14.40, 14.44, 14.56 insurance, 12.2 lease agreement, 5.55, 12.4, 12.7 leasing arrangement, 12.4 legal title, ownership, 12.2 LIBOR rate, 12.2 maintenance conditions, 5.38, 12.5 operating lease distinguished, 5.4, 11.4, 12.2, 12.3 part and engine pooling or interchange, 5.41, 12.5, 17.9 residual value risk, 12.2, 12.5 return conditions, 5.38, 5.41, 5.51, 12.5, 23.8 risk assumed by lessee, 12.2 risk free rates (RFRs), 12.2 Russia, 14.32 sale agreement, 12.4 sale and novation agreements, 5.47, 12.4 Secured Overnight Financing Rate (SOFR), 12.2 subleasing, 5.35, 12.5, 16.30 term, 12.5 transfer of title to lessee, 12.2, 12.4 financial reporting See accounting policy/basis financier due diligence and reporting obligations, 16.30 generally, 2.10–2.18 insurance considerations, 5.15–5.20, 5.40, 16.23 liability, 5.15–5.20, 16.23 Five Freedoms Agreement generally, 20.2, 20.3 fleet planning emissions reduction, 9.5 operating leases, 11.16

407

Index flight hour agreement (FHA) lease agreements, 5.38, 8.5 force majeure leasing, 12.7 foreign exchange controls Brazil, 14.13 China, 14.65 India, 14.44 France Aircraft Sector Understanding (ASU), 2.11 financiers, generally, 2.1 French tax lease (FTL), 2.1, 2.13, 12.2 société de credit foncier, 2.8 tax leasing, 2.13 freighter conversion to, 7.7 economic life, 1.4, 2.10 fuel carbon-neutral, 9.10 costs See fuel costs fuel efficiency, 9.5 sustainable, 9.1, 9.2, 9.5 fuel costs accounting treatment, 8.16 competitive nature of air travel industry, 8.15 cyclical nature, 8.15, 8.16 forecasting fuel usage, 8.16 hedging strategy, credit risk analysis, 8.12, 8.15, 8.16 percentage of operating costs, 8.15 stress testing analysis, 8.27–8.32 funds flow coverage ratio credit risk analysis, 8.24 liquidity/solvency analysis, 8.24; Appendix 8 III G GAAP US-GAAP, 8.8, 12.2, 23.1–23.3, 23.5, 23.8, 23.9, 23.10, 23.11 General Risks Convention third party liability, 21.13 Geneva Convention generally, 21.1, 21.7 Germany, 14.69 Germany Aircraft Sector Understanding (ASU), 2.11 aviation finance industry, 14.66, 14.67 aviation sector, generally, 14.66, 14.74 Cape Town Convention, 14.69 debtor-in-possession proceedings, 14.73 enforcement of mortgage agreements, 14.72 EU legislation, 14.70

408

Germany – contd finance leases, 14.67 German financiers, 2.1 insolvency of lessee, 14.69 insolvency and restructuring procedure, 14.71, 14.73 international treaties, 14.68–14.69 Kommandigesellschaft (KG) funds, 2.15, 4.5 leases, 14.67, 14.71 legal environment, 14.68–14.71 mortgages, 14.71–14.72 non-consensual lien over aircraft, 14.71 öffentliche Pfandbriefe, 14.67 operating leases, 2.15, 14.67 parts and engines, 14.71 Pfandbrief, 2.8 registration of aircraft, 14.71 repossessions, 14.72 salvage rights, 14.71 Schuldschein, 14.67 transfer of title, 14.71 Global Aircraft Trading System (GATS®) advance requirements, recoding and tracking, 18.1, 18.10, 18.17 beneficial interest transfers, partial, 18.8, 18.13 benefits of use, 18.1, 18.11 cross-border leasing, 6.5 designated transactions, 18.1, 18.6, 18.12, 18.17 digital certificates, 18.1, 18.12, 18.16, 18.18–18.22 digital signatures, 18.1, 18.15, 18.16, 18.17, 18.18–18.22 e-Ledger, 18.1, 18.13 e-terms, 18.14 empty trusts, 18.3 entity profiles, 18.14 escrow facility, 18.15, 18.17 execution block, 18.20 export credit structures, 10.10 fees, 18.17 future developments, 18.1, 18.23 GATS Platform, 18.1, 18.11, 18.12– 18.16 generally, 5.75 lease novations, 18.2, 18.3 leased aircraft, 18.1, 18.2 operating leases, 11.14, 18.1 participants, 18.3, 18.14 professional entities, 18.14, 18.15 purpose, 18.1–18.2 standard form instruments, 18.1, 18.6–18.7 trust branches, 18.5 trustees, 18.3, 18.9, 18.14

Index Global Aircraft Trading System (GATS) – contd trusts, 18.1, 18.3 unique identification number (UIN), 18.4 US registered aircraft, 18.7 user accounts, authentication, 18.16 validation of GATS instruments, 18.22 global financial crisis (GFC) accounting developments resulting from, 23.1 aircraft financing markets, 2.3, 10.7, 11.3, 12.2 Basel accords, 22.1, 22.3, 22.7, 22.8 global warming See carbon emissions; emissions; environmental issues green bonds green bond principles (GBPs), 9.8 growth of sector, 3.6 purpose, 3.6, 9.8 tax exemptions and credits, 3.6 green loan principles (GLPs), 9.8 greenhouse gas emissions See carbon emissions; emissions; environmental issues greenwashing protecting investors from, 9.7 H Hague Convention choice of courts, 5.33, 21.1, 21.12 hedge funds aircraft financing markets, 2.16, 2.17 hedging agreement, generally, 5.55 delivery costs, 1.12 fuel hedging, 8.15, 8.16, 8.25 interest rate hedging, 8.12, 8.13, 8.16 hell or high water clause lease agreements, 5.36–5.37, 11.10, 12.4, 12.7 hire purchase agreement finance lease compared, 12.2 generally, 5.4 liability under UK law, 5.18 repossession, 5.27 humanitarian operations CORSIA exemption, 9.3 hypothecation India, 14.42 Japan, 14.85 I ijarah Islamic operating lease, 15.4, 15.6, 15.7 ijarah wa iqtina Islamic finance lease, 15.4, 15.7

import restrictions compliance, 24.4 imported aircraft Brazil, 14.9 cross-border leasing, 6.3 import taxes, 6.3 India, 14.41, 14.44, 14.46 registration taxes, 6.4 India aircraft acquisition, 14.40 aircraft registration, 14.41–14.42, 14.54 airport charges, non-payment, 14.43 airport operation, maintenance and management, 14.43, 14.57 all-in cost ceilings on external borrowing, 14.44 ‘automatic route’ external borrowing, 14.44 aviation industry, generally, 14.39, 14.57 borrowing restrictions, 14.40, 14.44 Cape Town Convention, 14.41, 14.54, 14.57 corporate jet sector, 14.55 deregistration of aircraft, 14.41, 14.54 double taxation agreements, 14.47 finance leases, 14.40, 14.44, 14.47, 14.56 foreign direct investment, 14.45 foreign exchange requirements, 14.44 foreign-owned aircraft, 14.41 General Anti-Avoidance Rule (GAAR), 14.47 hypothecation over aircraft, 14.42 importing aircraft into, 14.41, 14.44, 14.46 insolvency laws, 14.54 insurance, 16.8 inter-state goods and services tax (GST), 14.46, 14.48, 14.50, 14.52 International Financial Services Centres (IFSCs), 14.56 lease rentals, 14.46, 14.47 leasing, 14.40, 14.44–14.49, 14.56 mortgage over aircraft, 14.42 mortgagee’s rights, 14.42 national aviation policy, 14.39 operating leases, 14.40, 14.56 operator’s licence, 14.45 pre-delivery payments, 14.44 regulatory regime, 14.41–14.42 stamp duty, 14.53, 14.56 tax gross up clauses, 14.49 taxation, 14.46–14.53, 14.56 transfer of aircraft ownership, 14.51 insider dealing regulations compliance, 24.7 insolvency See bankruptcy/insolvency

409

Index insurance agreed value, 5.40, 16.2, 16.8, 16.12, 16.16 aircraft financing implications, 16.15– 16.29 airline aviation liability insurance, 16.30 asset risk, 16.2–16.3, 16.5, 16.6, 16.7 AVN48B, 16.11 AVN67B, 16.27 baggage liability, 16.13 Brazil, 14.16, 16.8 breach of warranty cover, 16.18 buying environment, 16.8 cancellation, 16.21 cargo liability, 16.13 certificate of, 16.28 changes to, 16.21, 16.30 China, 16.8, 16.30 combined single limit (CSL), 16.13 contingent, 16.7 contribution rights, 16.19 cut-through clauses, 16.30 deep pocket claims, 5.40 direct (co-insurance) placing, 16.8 disappearance clause, 16.11 disclosure, insured’s duty of, 5.40, 16.1 employees, liability to, 16.30 endorsement, standard, 16.27 engines, 16.27, 16.30 finance leases, 12.2 financiers, due diligence and reporting obligations, 16.30 financiers’ perspective, 5.15–5.20, 5.40, 16.23 general considerations, 5.40 hull, 5.40, 12.6, 16.2, 16.8, 16.10– 16.13, 16.16, 16.27 hull all-risks, 5.40, 16.10, 16.13, 16.16, 16.27 hull war-risks, 5.40, 16.11, 16.16, 16.27 ijarah leases, 15.7 indemnities, 5.44, 16.25 India, 16.8 Japan, 14.87 lessees, 16.6, 16.19 lessors, 5.40, 16.7, 16.30 letter of undertaking, 16.29 liabilities risk, 16.2, 16.4, 16.5, 16.6, 16.13 liability of financier, 5.15–5.20, 16.23 loss payable clause, 16.17 LSW555D, 16.11 mail liability, 16.13 monitoring, 16.6 moral hazards, 16.16 ongoing liability, 16.14 operating expenses, exclusion, 16.10

410

insurance – contd operating leases, 11.10, 11.11, 16.4, 16.6 parts, generally, 16.12, 16.27, 16.30 parts, product liability, 6.4 passenger/third party claims, 5.15– 5.17, 5.40, 16.4, 16.6, 16.13 political risk, against, 5.13, 10.2, 16.11 possessed, 16.7 product liability, 6.4 reinsurance, 16.8, 16.26 renewal, 16.30 repossessed aircraft, 16.7, 17.15 repossession risk, against, 16.11 risk assessment, 16.1 risk transfer, 16.5 Russia, 16.8 set-off rights, 16.22 severability of interest clause, 16.24 slip, 16.8 spares risk, 16.12, 16.30 standard exclusions, 16.10–16.11, 16.30 standard form endorsement (AVN67), 5.40 subleasing and, 16.30 subrogation, 16.20 sub-wetleasing, 16.30 tail liability, 16.14 third party liability, 6.4, 16.6, 16.13, 21.13 total loss, 5.40 uberrima fides contracts, 16.1 war/terrorism, insurance against, 14.16, 16.10, 16.11, 16.12, 16.13, 16.16 warranty cover, 16.18 interest Sharia’h prohibition, 15.1, 15.3, 15.7 interest rate accounting treatment, 8.16 credit risk analysis, 8.12, 8.14, 8.16, 8.27–8.32 cross currency swaps, 8.14 hedging, 8.13, 8.16 stress testing analysis, 8.27–8.32 International Civil Aviation Organisation (ICAO) CORSIA, 1.6, 9.3, 9.4, 9.5, 9.11 Environmental Protection Standards, 1.6 establishment, 20.2 functions, 20.2 international conventions Brussels Convention, 5.33, 21.1, 21.11 Cape Town See Cape Town Convention Chicago See Chicago Convention Convention on International Civil Aviation, 1.6

Index international conventions – contd General Risks Convention, 21.13 generally, 21.1 Geneva Convention, 14.69, 21.1, 21.7 Hague Convention, 5.33, 21.1, 21.12 Lugano Convention, 5.33, 21.11 Minsk Convention, 14.38 Montreal Convention, 5.18 Rome Convention, 14.69, 21.1, 21.8, 21.13 Terrorism/Unlawful Interference Convention, 21.13 third party liability, 21.13 International Financial Reporting Standards (IFRS) accounting basis, 8.10, 8.21, 12.2, 23.1–23.4, 23.8, 23.9, 23.10, 23.11 international regulations See also Basel accords Rome I and II, 5.32, 21.9–21.10 investment, aircraft as acquiring the assets, 4.8 airline and lessor earnings trends, 4.1 airlines as investors, 4.2–4.3 asset management during hold period, 4.1, 4.4, 4.9 asset sales, 4.10 asset selection, 4.6 base value (BV), 4.7, 7.4 capital markets, 3.1 credit risk management, 4.9 current market value (CMV), 7.4 cyclical nature of aviation industry, 4.1, 4.6, 4.7, 4.8, 4.10, 11.3 direct orders from manufacturer, 4.8 economic life of aircraft, 2.10, 4.7 exit strategy, determining, 4.10 financial investors, 4.5 generally, 2.10, 4.1, 9.11 investment equation, 4.1 investment horizon, 7.8 key investment drivers, 4.1 lease-encumbered value (LEV), 4.7, 7.4 lessors as investors, 4.2, 4.4 market value (current market value), 4.7 metal investors, 4.5, 4.10 optional items, 4.9 portfolio acquisitions, 4.8 purchase and leaseback schemes, 4.8 relative liquidity ratings, 4.6 return criteria, 4.8, 4.9 securitised value, 4.7 through-the-cycle trading strategy, 4.1 transaction economics, 4.1 valuation See aircraft value/valuation value growth/retention, 4.6, 4.7 vulnerability to exogenous events, 4.3

investment banks support for aviation lending and finance, 1.7 investor Asset Backed Securities (ABS), 1.1, 4.5 EU taxonomy and investments, 9.6, 9.7, 9.11 financial investors, 4.5 institutional, 4.5 joint venture, 4.5, 4.10 metal investors, 4.5, 4.10 passive participation, 4.5 primary, 4.5 risk management, 4.5, 4.9 secondary, 4.5, 8.4 sidecar partnerships, 4.5, 4.10 ipso facto provisions UK Insolvency Act, 19.22 US Bankruptcy Code, 19.12 Ireland aircraft registration, 5.24 anti-money-laundering/countering the financing of terrorism, 24.2 GATS trust branch, 18.5 Irrevocable Deregistration and Export Request Authorisation (IDERA) Brazil, 14.15 Cape Town Convention, 11.12, 14.15, 14.61 China, 14.61 operating lease lessors, 11.12 Islamic finance asset-backed nature, 15.3 bai bithaman ajil, 15.4 bond market (sukuk), 2.16 canonical contracts, 15.3, 15.4 debt-based sale arrangements, 15.4 equity-based profit and loss sharing, 15.4 fatwa, 15.2, 15.4 forum shopping, 15.2 gambling, prohibition, 15.3 generally, 15.1 gharar and maisir, prohibition, 15.3, 15.7 governing law and Sharia’h, 15.5 ijarah (operating lease), 15.4, 15.6, 15.7 ijarah wa iqtina (finance lease), 15.4, 15.7 interest, prohibition, 15.1, 15.3, 15.7 istisna’a, 15.4 leasing, 2.14, 15.4, 15.7 mudaraba, 15.4, 15.6 mudarib, 15.6 murabaha, 15.4 musawama, 15.4

411

Index Islamic finance – contd musharaka, 15.4, 15.6 rab-al-mal, 15.6 risk-sharing, 15.3, 15.7 salam, 15.4 Sharia’h law, generally, 15.1–15.3 special purpose vehicle, use, 15.6 sukuk, 15.6 tawarruq, 15.4 uncertainty, prohibited and permitted, 15.3, 15.7 istisna’a Islamic finance, 15.4

jurisdiction – contd cross-border financing and, 5.11 incorporation, restructuring or insolvency, 19.5 jurisdictional risk analysis, 8.2, 8.6 jurisdictional questionnaires taking, 5.11

J Japan Aircraft Sector Understanding (ASU), 2.11 at-risk rule, 14.76 equity funds, 14.75 equity regulation, 14.78 foreign registered aircraft, 14.84 hypothecation, 14.85 insolvency and restructuring procedure, 14.77–14.83 insurance, 14.87 international debt financing, 14.75 international leasing industry, 14.75 Japan Aviation Insurance Pool (JAIP), 14.87 Japanese financiers, generally, 2.1 Japanese operating lease (JOL), 2.1, 4.5, 14.75, 14.79 Japanese Operating Lease with Call Option (JOLCO), 4.5, 12.2, 14.75, 14.76–14.80 lending not involving Japanese elements, 14.86 mezzanine funds, 14.75 mortgages, 14.85 nationality requirements, 14.84 nin-i kumiai (NK) structure, 14.76 parallel debt structure, 14.86 registration of aircraft, 14.84 registration of mortgages, 14.85 security trustees, 14.86 tax investors, 14.75, 14.76–14.80 tax leasing, 2.13, 14.76–14.80 tax-leveraged financings, 5.45 taxation, 14.80 titleholder structure, 14.84 tokumei kumiai (TK) agreements, 14.76–14.80 yield investors, 14.75 joint venture leasing platforms, 4.5, 4.10 jurisdiction Brussels Convention, 5.33, 21.1, 21.11

L labour rates stress testing analysis, 8.27–8.32 landing Five Freedoms Agreement, 20.3 Large Aircraft Sector Understanding (LASU) export credit financing, 10.3, 10.4, 10.7 lease-encumbered value (LEV) external appraisers, 7.5 meaning, 7.4 valuation, 4.7, 7.4, 7.8 leasing See also lessee; lessor accounting policies, 8.8, 8.9, 8.10, 8.16, 23.3–23.8, 23.10 advantages of, 1.5 aircraft habitually based in another jurisdiction, 5.4, 5.10 aircraft trading, 5.47 airline and lessor earnings trends, 4.1 ‘as is’ disclaimers, 5.48 asset backed securitisation (ABS), 1.8 asset management during hold period, 4.1, 4.4, 4.9 assignment, 5.47, 12.4, 12.6 Brazil, 14.1, 14.2–14.18 breach of contract, 5.29 Cape Town Convention, 5.8 capital leases, 12.2 capital management and, 1.5 cashflows, 7.8, 7.10 China, 14.59, 14.60, 14.61, 14.62, 14.64 compliance, generally, 24.1–24.4 contract, drafting, 4.9, 5.29, 6.13 contract, generally, 23.3 corporate investors, 4.5 corporate risk rating, 12.2 covenants, 12.7 Covid-19 pandemic and, 1.1, 1.3, 1.4, 1.5, 2.5, 3.8, 12.1, 12.7, 23.7 cross-border See cross-border lease cross-border financing, 5.4, 5.10, 23.11–23.12

412

K key performance indicators (KPIs) accounting, 23.2 Kommandigesellschaft (KG) funds, 2.15, 4.5

Index leasing – contd cyclical nature of industry, 11.3 debt and tax lease market, 2.11 default by lessee, 11.12, 11.30–11.32, 12.6, 12.7, 14.37 definition of lease, 23.3 Delaware statutory trusts, 6.5 deregistration, 11.12, 12.6 double depreciation (double dip transaction), 12.2 double taxation agreements, 14.47 dry leases, 5.15 E-notes, 1.7, 1.9 early returns, 1.3 economic ownership of aircraft, 12.2, 12.3 engine pooling, 5.41, 12.5, 17.9 enhanced equipment trust certificates (EETCs), 1.10–1.11 equity build-up risk, 5.4 EU regulation, 20.21 export credit financing, 10.12 finance leases See finance lease flexibility provided by, 11.16, 12.3, 12.5 flight hour agreements (FHA), 8.5 force majeure events, 12.7 French tax leases (FTLs), 2.1 GATS See Global Aircraft Trading System general indemnities, 5.44 generally, 5.2, 5.4 Germany, 14.67, 14.71 growth of sector, 1.5, 2.4, 2.15, 3.8, 4.10, 10.8, 11.2, 11.34, 12.1 hell or high water clause, 5.36–5.37, 11.10, 12.4, 12.7 highest and best use, 4.7 hire purchase agreement compared, 12.2 hybrid, 5.4, 5.10 hybrid loan/mortgage structures, 5.2 India, 14.40, 14.46–14.49, 14.56 insolvency provisions, 12.7 insurance cover, 16.4, 16.6–16.7, 16.19, 16.30 interest rate risk, 8.14 investment horizon, 7.8 Islamic finance, 15.4, 15.7 Islamic ijarah, 15.4, 15.6, 15.7 Islamic ijarah wa iqtina, 15.4, 15.7 Islamic leases, generally, 2.14, 15.3 Japanese international leasing industry, 14.75 Japanese operating lease (JOL), 2.1, 4.5, 14.75, 14.79 Japanese Operating Lease with Call Option (JOLCO), 4.5, 12.2, 14.75, 14.76–14.80

leasing – contd joint venture investments, 4.5, 4.10 jurisdiction in which aircraft based, 5.4 lease agreement, 12.4, 12.7 lease-encumbered value (LEV), 4.7, 7.4, 7.8 lease portfolio securitisations, 2.16 lease rates, volatility, 11.3 leasing arrangements, 12.4 legal considerations, 5.4 lessee perspectives, 12.1–12.7 lessor perspectives, 11.1–11.34 liability, 5.15–5.20 liability, servicing coverage, 11.33 maintenance compensation, 7.4, 7.8, 12.4, 12.5 maintenance conditions, 5.38, 12.5 maintenance expenses, 7.8 maintenance payments (MTX), 23.8, 23.10 maintenance reserves, 6.8, 8.5, 11.6, 11.10, 11.26, 11.29, 12.4, 23.10 management fees, 11.33 manufacturer’s warranties, 5.39 mergers and acquisitions (M&A) activity, 4.10 ‘net lease’ provisions, 12.7 new aircraft, 12.2 non-resident lessors, 14.48 novation fatigue, 18.2 novation of lease, 5.47, 12.4, 18.2, 18.3 off-balance sheet treatment, 1.5 onward sales, 5.51 operating leases See operating lease part and engine pooling or interchange, 5.41, 12.5, 17.9 penalties for breach of contract, 5.29 percentage of leased fleets, 1.3, 1.5 periodic maintenance payments (MTX), 23.8, 23.10 perspectives, 11.1–11.34 power by the hour (PBH), 8.5 pre-delivery payment transactions, 13.4 pricing advantages, 1.5 profitability, 4.4 prospects for aircraft at lease end, 7.7 purchase and leaseback schemes, 4.8 quiet enjoyment arrangements, 5.35, 5.36, 11.9, 12.4, 12.6 reconfiguration costs, 11.31 registration taxes, 6.4 rent concessions/deferrals, 1.1, 1.3, 1.4, 1.5 repossessed aircraft, insurance, 16.7 repossession by lessor See repossession residual value risk, 1.3, 1.5, 11.4, 11.18, 12.2, 12.3, 12.5

413

Index leasing – contd return conditions, 5.38, 5.41, 5.51, 12.5, 23.8 Russia, 14.20, 14.32–14.37 sale of aircraft at mid-life, 1.7 sale of aircraft with lease attached, 12.4 sale and leaseback See sale and leaseback sale and novation agreements, 5.47, 12.4 sales taxes, 6.6, 6.9, 6.11 secondhand aircraft, 12.2 security, generally, 5.9 security deposits, 6.8, 11.7, 12.4 security documentation, 12.4 servicing coverage, 11.33 special purpose companies (SPCs), 5.2 special purpose vehicles (SPVs), 12.2, 12.4, 23.11 standard of care, servicing agreement, 11.33 state of registration, 5.4 subleasing, 5.35, 12.5, 16.30 sub-wetleasing, 16.30 tax gross up clauses, 6.5, 6.13, 14.49 tax indemnity clauses, 5.44, 6.5, 6.13 tax leasing, 2.1, 2.13, 12.2, 14.76– 14.80 term, 12.5 termination, penalties on, 5.29 termination of agreement, 5.29, 5.39, 12.7 time ‘of the essence’, 5.29 total loss events, 5.40, 12.7 trading between lessors and investors, 4.10 triple-net, 23.8 unpaid airport charges, 5.22, 5.50 upsy/downsy clause/payments, 5.38, 23.10 US Bankruptcy Code, 19.8 US dollar-denominated industry, 2.9, 4.4, 8.14, 12.2 validity of collateral, 5.25–5.27 variable interest entities (VIEs), 23.11 warranties, 12.7 wet leases, 5.18, 16.30, 20.21 withholding tax and lease payments, 6.5 zero weighted risk, 12.2 legacy carriers operating cash flow ratio, 8.24 operating costs, 8.15 legal issues aircraft mortgages, 5.2, 5.6, 5.11 aircraft registration, generally, 5.11

414

legal issues – contd aircraft trading, 5.47 airport charges, 5.22, 5.50 ‘as is’ disclaimers, 5.48 asset value guarantees, 5.43 aviation insurance, 5.40 Cape Town Convention, 5.8 checklist of key documents, 5.55 choice of law, 5.32 compliance, generally, 24.1–24.10 confidentiality considerations, 5.25 conflict of laws, 5.12, 14.22, 14.28 contractual, 5.34–5.40 cross-border transactions, 5.10 cross-collateralisation, 5.42 cross-default, 5.42 deposit, refund, 5.52 deregistration rights, 5.11 detention, rights of, 5.20–5.23 engine pooling, 5.41 exchange control, 5.30 finance documentation, 5.11 flight hour agreement (FHA), 5.38 general indemnities, 5.44 generally, 5.1, 5.10 hedging agreements, 5.55 hell or high water clause, 5.36–5.37, 11.10, 12.4, 12.7 hybrid leasing, 5.10 judgment currency, 5.31 jurisdiction of incorporation, 5.10 jurisdiction of registration, 5.10 jurisdictional questionnaires, 5.11 leases, 5.2, 5.4 legal opinions, seeking, 5.11 letter of intent, 5.52, 5.54, 5.55 liability of financier and lessor, 5.15– 5.20 liens against aircraft, 5.7, 5.20 manufacturer’s warranties, 5.39 memorandum of understanding, 5.55 mortgagee’s power of sale, 5.28, 5.53 navigation charges, 5.23 onward sales, negotiation, 5.51 penalties, 5.29, 24.1, 24.10 political risks, 5.13, 10.2, 16.11 priority of collateral, 5.26 product liability, 5.18 quiet enjoyment arrangements, 5.35, 5.36, 11.9, 12.4, 12.6 registration of aircraft, 5.24 repossession, risk of, 5.13 return condition and maintenance obligations, 5.38, 5.41, 5.51, 12.5 Rome I and II Regulations, 5.32 sale arrangements, 5.28, 5.53 servicing agreements, 5.55 share security, 5.5

Index legal issues – contd sovereign immunity, 5.14 special purpose companies, 5.2, 5.3, 5.5, 5.11 stamp duties, 5.11, 5.44 structural issues, 5.2–5.9 tax indemnities, 5.44, 6.5, 6.13 tax-leveraged financings, 5.45 terms-sheet, 5.55 UK judgments, enforceability, 5.33, 21.21 upsy/downsy clause, 5.38, 23.10 withholding tax, 5.46 lessee cross-border lease See cross-border leasing default by, 11.12, 11.30–11.32, 12.6, 12.7, 14.37 finance leases See finance lease hell or high water clause, 5.36–5.37, 11.10, 12.4, 12.7 insurance cover, 16.6, 16.19 insurance obligations, 12.5 leasing arrangement, 12.4 liability, 5.15 obligations, 12.5–12.6 operating leases See operating lease perspectives, generally, 12.1–12.7 quiet enjoyment, letter of, 5.35, 5.36, 11.9, 12.4, 12.6 sale and novation agreements, 5.47, 12.4 subleasing by, 5.35, 12.5, 16.30 termination of right to possession, 5.29 lessor accounting, credit risk analysis, 8.8, 8.9, 8.10, 8.16 aircraft trading, 5.47 asset backed securitisation (ABS), 1.8, 3.5 closely held, 7.6 credit risk analysis of, 8.7–8.33, 12.4 cross-border lease See cross-border lease differentiation of aircraft operating lessors, 11.27 E-notes, 1.9 earnings trends, 4.1 enhanced equipment trust certificates (EETCs), 1.10–1.11, 3.4 equity certificates, 1.9 finance lease See finance lease import taxes, 6.3 insolvency, 12.4 insurance, 5.40, 16.7, 16.30 interest rate risk, 8.14, 8.16 investment in, 4.5 investment-grade credit rating, 4.4

lessor – contd investments in aircraft, 4.2, 4.4 investors and, 4.10 lease management capability, 11.28 liability, 5.15–5.20 operating leases See operating lease optimal ratings, achieving, 1.8 perspectives, generally, 11.1–11.34 publicly traded, 4.5, 7.6 registration taxes, 6.4 repossession by See repossession sale and novation agreements, 5.47, 12.4 sales taxes, 6.6, 6.9 special purpose vehicle (SPV), 12.2, 12.4 spreading credit risk, 3.5 stamp duties, 6.2, 6.7 technical compliance, 11.29 termination of agreement, 5.29, 5.39, 12.7 terms broken by, 11.10 trading with investors, 4.10 withholding tax and lease payments, 6.5 letter of credit maintenance letters of credit, 11.6, 12.4 transactional quality analysis, 8.5 letter of intent legal considerations, 5.52, 5.54, 5.55 letter of undertaking insurance brokers, 16.29 leverage ratio Basel accords, 22.7, 22.10, 22.11 credit risk analysis, 8.21; Appendix 8 I liability carriers, 5.18 effective supplier, 5.18 financiers, 5.15–5.20, 16.23 health and safety, UK law, 5.19 lessors, 5.15–5.20 maintenance liabilities, accounting policy, 23.8 Montreal Convention, 5.18 ostensible supplier, 5.18 product liability, 5.18, 6.4 receiver, misconduct by, 5.28 risk of, consideration, 5.15–5.20 third party, 6.4, 16.6, 16.13, 21.13 in tort, 5.17 United Kingdom law, 5.15–5.20 United States law, 5.15 LIBOR rate finance leases, 12.2 lien against aircraft cross-border financing, 5.10 legal considerations, 5.7, 5.10 priming lien, 19.9

415

Index lien against aircraft – contd repairer’s lien, 5.20 repossession and, 17.10 UK law, 5.7, 5.20 US Bankruptcy Code, 19.9 life limited parts (LLP) factoring into valuation, 7.8 liquidity acid test ratio, 8.18; Appendix 8 I aircraft financing markets, 2.6 capital management, 1.5 cash flow statement analysis, 8.24 current ratio, 8.18; Appendix 8 I leasing, advantages, 1.5 legacy carriers, 8.25 low cost carriers, 8.25 quantitative analysis, 8.18, 8.24 securitisation, created by, 2.6 load factor, Appendix 8 II improving, 1.4, 9.5 loan See also aircraft financing market; export credit financing; finance lease asset-backed security (ABS) markets, 1.6 commercial banks See commercial banks confidentiality considerations, 5.25 ESG standards, 1.6 export credit financing See export credit financing green loan principles (GLPs), 9.8 hybrid lease structures, 5.2 loan agreement/loan facility agreement, 5.55 mortgages See mortgage risk See risk secured, generally, 5.2 sustainability linked loan principles (SLLPs), 9.9 sustainable, 9.1, 9.11 loan to value rates (LTVs) commercial banks, 1.1, 1.6 Covid-19 pandemic, 1.1, 1.6 level, generally, 1.7 low cost carriers operating cash flow ratio, 8.24 operating costs, 8.15 Lugano Convention generally, 21.11 UK post-Brexit, 5.33 M maintenance accounting for, 23.8, 23.10 adjustment payments, 5.38 compensation, 7.4, 7.8, 12.4 costs, 7.8, 7.9, 7.10

416

maintenance – contd credit risk analysis, 8.5, 8.40 cross-border leasing, 6.8 depreciation charge and, 23.8 finance lease conditions, 12.5 flight hour agreement (FHA), 5.38 ijarah leases, 15.7 letter of credit, 11.6, 12.4 maintenance reserves, 5.38, 6.8, 8.5, 11.6, 12.4, 23.10 OEM agreements, 5.38, 11.6 operating leases, 11.6, 11.10, 11.26, 11.29, 12.5, 23.8, 23.10 periodic maintenance payments (MTX), 23.8, 23.10 repairer’s possessory lien, 5.18 repossession and, 17.2, 17.7, 17.9, 17.17 return condition obligations, 5.38, 5.41, 5.51, 12.5, 23.8 risk analysis and, 8.5, 8.40 security deposits, 23.10 triple-net leases, 23.8 valuation and maintenance condition, 7.4, 7.10 manufacturer manufacturer’s warranties, 5.39 original equipment manufacturer (OEM), 1.1, 1.12, 5.38, 8.1, 11.6 product liability, 5.18 market abuse regulations compliance, 24.6–24.7 market reflective surcharge (MRS) export credit financing, 10.7 memorandum of understanding generally, 5.55 merger EU Merger Regulation, 20.5, 20.8 leasing platforms, 4.10 regulatory compliance, 24.8 metal investor aircraft, investment in, 4.5, 4.10 asset backed securitisation (ABS), 4.10 asset sales, 4.10 cyclical nature of aviation industry, 4.10 exit strategy, determining, 4.10 monetising the investment, 4.10 mezzanine funds Japan, 14.75 minimum premium rate (MPR) export credit financing, 10.5, 10.7 Minsk Convention signatories, 14.38 modification costs aircraft valuation, 7.8, 7.10 money-laundering anti-money-laundering compliance, 24.2

Index Montreal Convention carrier liability, 5.18 mortgage Cape Town Convention, 5.6, 5.8, 5.12 China, 14.59, 14.63 conflict of laws, 5.12 consensual, 19.2 generally, 5.2, 5.6 Germany, 14.71–14.72 hybrid lease structures, 5.2 India, 14.42 Japan, 14.85 jurisdiction in which aircraft registered, 5.6 legal considerations, 5.6, 5.12 liens against aircraft and, 5.7 local procedural rules, 5.6 manufacturer’s warranties, 5.39 mortgagee’s power of sale, 5.28, 5.53 priority of claims, 5.6, 5.7 Russia, 14.20, 14.24–14.31 security, generally, 5.9 security documents, 5.55 UK mortgages, conflict of laws, 5.12 UK Register of Aircraft Mortgages, 5.6 US Bankruptcy Code, 19.8 validity, 5.25 mudaraba Islamic finance, 15.4, 15.6 murabaha Islamic finance, 15.4 musawama Islamic finance, 15.4 musharaka Islamic finance, 15.4, 15.6 N narrow-body aircraft growing demand for, 1.5 navigation charges unpaid, 5.23, 5.50 navigation rights bilateral treaties, 20.4 cabotage, 20.3, 20.4 Five Freedoms Agreement, 20.3 new build aircraft investments, bought as, 4.8 optional items, 4.9 new technologies/services aircraft financing and, 2.10 aircraft obsolescence, 2.12 noise ICAO Environmental Protection Standards, 1.6 novation agreement leasing and, 5.47, 12.4

O object finance regime Basel accords, 22.1–22.11 operating cash flow ratio credit risk analysis, 8.24; Appendix 8 III liquidity/solvency analysis, 8.24; Appendix 8 III operating costs during Covid-19 pandemic, 1.4 fuel costs, generally, 8.15 fuel hedging, 8.15, 8.16, 8.25 legacy carriers, 8.15 low costs carriers, 8.15 mechanical breakdown, 16.10 operating lease accounting policies/basis, 8.10, 8.21, 12.2, 23.3, 23.5–23.6, 23.10 advantages, 11.15–11.20 Brazil, 14.3, 14.5, 14.6, 14.8, 14.11, 14.15 business models, 11.21–11.26 credit risk analysis, 8.10 cross-border leasing, 6.5 cyclical nature of industry, 11.3 default by lessee, 11.12, 11.30–11.32, 12.6, 12.7, 14.37 definition, 11.1, 12.3 depreciation, 8.10, 14.76 deregistration, 11.12, 12.6 differentiation of lessors, 11.27–11.33 economic ownership of aircraft, 12.3 efficiency of financing, 11.16 efficiency of scale, 11.19–11.20, 11.21 features of, 11.4–11.14 finance lease distinguished, 5.4, 11.4, 12.2, 12.3 flexibility provided by, 11.16, 12.3, 12.5 funding sources, diversification, 11.23 general indemnities, 5.44 generally, 5.2, 11.4–11.14 Germany, 2.15, 14.67 Global Aircraft Trading System (GATS), 11.14, 18.1 hell or high water clause, 5.36–5.37, 11.10, 12.4, 12.7 hybrid loan/mortgage structures, 5.2 IFRS, 12.2 ijarah, 15.4, 15.6, 15.7 India, 14.40, 14.56 insurance, 11.10, 11.11, 15.7, 16.4, 16.6–16.7 Japanese international leasing industry, 14.75 Japanese operating lease (JOL), 2.1, 4.5, 14.75, 14.79 Japanese Operating Lease with Call Option (JOLCO), 4.5, 12.2, 14.75, 14.76–14.80

417

Index operating lease – contd lease agreement, 5.55, 12.4, 12.7 lease end adjustments, 11.6 leasing arrangement, 12.4 lessee perspectives, 12.1–12.7 lessor perspectives, 11.1–11.34 liability, servicing coverage, 11.33 maintenance conditions, 5.38, 12.5, 23.10 maintenance in ijarah, 15.7 maintenance/maintenance reserves, 11.6, 11.10, 11.26, 11.29, 12.4 management, 11.28 management fees, 11.33 net lease, 11.10 part and engine pooling or interchange, 5.41, 12.5, 17.9 payment obligations of lessee, 11.10 pre-delivery payment transactions, 13.4 profitability, 11.1 quiet enjoyment, 5.35, 5.36, 11.9, 12.4, 12.6 reconfiguration costs, 11.31 rental payments, 11.5 repossession on lessee default, 11.30– 11.32, 14.37 residual value risk, 11.4, 11.18, 12.3, 12.5 return conditions, 5.38, 5.41, 5.51, 11.13, 12.5, 23.8 risk assumed by lessor, 11.4, 11.18 risk mitigation, 11.13–11.14, 11.24 Russia, 14.32 sale of aircraft during, 11.14, 11.25, 12.6 sale and novation agreements, 5.47, 12.4 sector growth, 11.1, 11.2, 11.3, 11.15– 11.20, 11.34, 12.1 security deposit, 11.7, 11.16, 12.4 security over aircraft, 11.14 servicing coverage, 11.33 special purpose companies (SPCs), 5.2 staggered terms, 12.3 standard of care, servicing agreement, 11.33 start-up airlines, 11.16 subleasing, 5.35, 12.5, 16.30 supplemental maintenance rent, 11.6, 11.26 tax deferral, 14.76 technical compliance, 11.29 term, 11.8, 12.5 terms broken by lessor, 11.10 title retained by lessor, 11.4, 11.13– 11.14, 12.3 transfer of lease, 11.14 US GAAP, 12.2, 23.3, 23.10

418

operating profit margin ratio credit risk analysis, 8.20; Appendix 8 I operating revenue per available seat mile (Operating RASM), Appendix 8 II Organisation for Economic Cooperation and Development (OECD) Aircraft Sector Understanding (ASU), 2.11, 10.5–10.7 Arrangement for Officially Supported Export Credits, 10.2, 10.4 BEPS initiative, 6.5 Covered Tax Agreements (CTAs), 6.5 Large Aircraft Sector Understanding (LASU), 10.3, 10.4, 10.7 Multi-Lateral Instrument (MLI), 6.5 original equipment manufacturer (OEM) generally, 1.1 hedging delivery costs, 1.12 loans to, 8.1 maintenance agreements, 5.38, 11.6 ‘orphan’ ownership structure special purpose companies, 5.3, 23.11 ownership notice of, 17.6 ultimate beneficial ownership registration, 24.8 ownership structure aircraft valuation and, 7.6 credit risk analysis, 8.35 ‘orphan’ ownership structure, 5.3, 23.11 share-quoted, 8.35 special purpose companies, 5.3 state-owned operators, 5.14, 8.35 P Paris Climate Agreement goal, 9.2 ICAO Environmental Protection Standards, 1.6 parts leasing, part and engine pooling or interchange, 5.41, 12.5, 17.9 parts value, 11.25 product liability insurance, 6.4 spares risk insurance, 16.12, 16.27, 16.30 passenger aircraft air navigation rights, 20.3 liability insurance, 5.15–5.17, 5.40, 16.4, 16.6, 16.13 useful economic life, 1.4 passenger demand predicted growth, 1.4, 1.12, 3.1, 11.2

Index passenger revenue per available seat mile (PRASM), Appendix 8 II plastics, single use, 9.5 political risk insurance export credit financing, 10.2 generally, 5.13, 16.11 portfolio risk management asset risk analysis, 8.2, 8.3 counterparty risk analysis, 8.2, 8.4 generally, 7.10, 8.2–8.6 jurisdictional risk analysis, 8.2, 8.6 maintenance reserves, 8.5 security, 8.2, 8.5 transaction risk analysis, 8.2, 8.5 power-by-the-hour (PBH) generally, 2.10 lease agreements, 8.5 pre-delivery payment (PDP) financing assignable price, 13.4 assignment by way of security, 13.3 assignment of purchase agreement, 13.2 borrower default, 13.2, 13.7 ‘build out’, 13.2 buy-back options, 13.10 credit memoranda, 13.4 delayed delivery, where, 13.1 engine general terms agreements, 13.2 escalation in purchase price, 13.5 generally, 13.1 India, 14.44 insolvency of borrower, 13.7 interest, 13.1 legal nature of PDP, 13.3 ‘long-stop’ date, 13.1 ‘manufacturer’s option’, 13.2 purchase agreement amendment, 13.6 purchase agreement disclosure, 13.11 purchase agreement as security, 13.1, 13.2 security package, 13.2, 13.3 security realisation, 13.9 standstill period, 13.8 step-in price, 13.4 third party purchaser, sale of rights to, 13.2 price fixing regulations compliance, 24.6 principal purpose test (PPT) cross-border lease, 6.5 private equity aircraft, investment in, 4.5 aircraft financing markets, 2.16, 2.17, 2.18 profitability credit risk analysis, 8.20; Appendix 8 I public equity aircraft financing markets, 2.18

purchase agreement amendments, 13.6 assignment, 13.2 ‘build out’, 13.2 default, 13.2 deposit, refund, 5.52 escalation in purchase price, 13.5 good faith, 5.52 letter of intent, 5.52, 5.54, 5.55 ‘manufacturer’s option’, 13.2 manufacturer’s warranties, 5.39 PDPs See pre-delivery payment (PDP) financing security over, 13.2, 13.3 Q quiet enjoyment contractual arrangements, 5.35, 5.36, 11.9, 12.4, 12.6 R recognition of foreign judgments Russia, 14.38 record keeping anti-money-laundering obligations, 24.2 countering the financing of terrorism obligations, 24.2 refuelling Five Freedoms Agreement, 20.3 registration of aircraft Bermuda, 5.24 Cape Town Convention and, 5.8 Chicago Convention, 5.24, 20.23 China, 14.59 cross-border leasing, 6.4, 6.12 deregistration rights, 5.11 deregistration risks, 5.24 economic owner, by, 5.24 European Union, 20.23, 20.25–20.26 generally, 5.9, 5.24, 20.23–20.24 Germany, 14.71 India, 14.41–14.42, 14.54 International Registry, 5.8, 5.9 Ireland, 5.24 Japan, 14.84 jurisdiction of, 5.9, 5.10, 5.11, 5.24 legal considerations, 5.10, 5.11, 5.24 mortgage over aircraft and, 5.6, 5.9 Russia, 14.19, 14.20–14.23, 14.32 sales taxes and, 6.9 United Kingdom, 5.24 United States, 5.24 regulatory framework air navigation rights, 20.3–20.4 aircraft registration, 20.23–20.26 airline licensing, 20.21–20.22 bilateral treaties, 20.2, 20.4

419

Index regulatory framework – contd cabotage, 20.3, 20.4 Chicago Convention, 20.1, 20.2, 20.5, 20.23 code share agreements, 20.21, 20.26 competition rules, 20.5–20.10 credit risk analysis, 8.39 domestic flights, 20.3 Dubai, 20.1 European Union, 20.1, 20.4, 20.5– 20.10, 20.12–20.21, 20.25, 20.26 Five Freedoms Agreement, 20.2, 20.3 ground handling market in EU, 20.9 International Civil Aviation Organisation (ICAO), 20.2 international flights, 20.3 international framework, 20.1–20.4 open skies agreements, 20.1, 20.4 refuelling, 20.3 Singapore, 20.1 slot allocation See slot allocation United States, 20.4, 20.22 repairer possessory lien, 5.20 repossession aircraft records, securing, 17.11, 17.16, 17.17 Cape Town Convention, 5.13 cost of, 17.3, 17.5 engines, 17.9 generally, 17.1–17.2 Germany, 14.72 hire purchase agreements, 5.27 inspection of aircraft, 17.12 insurance against, 16.11 insurance considerations, generally, 16.7, 17.15 legal process, 17.4–17.8 lessee default, on, 11.30–11.32, 14.37 liens against aircraft, 17.10 maintenance condition and, 17.2, 17.7, 17.9, 17.12, 17.14, 17.17 maintenance documents, 17.7, 17.17 notice of ownership, 17.6 ongoing asset management, 17.16– 17.17 operational considerations, 17.3 refurbishment following, 17.14 regulatory considerations, 17.13 remarketing following, 17.2, 17.14, 17.17 risk of, consideration, 5.13 Russia, 14.37 sale arrangements following, 5.28 securing/storing the aircraft, 17.6–17.8, 17.17 repurchase agreement Basel accords, 22.2

420

residual value risk avoiding, 1.5 finance leases, 12.2, 12.5 Japanese operating lease (JOL), 14.79 operating leases, 11.4, 11.18, 12.3, 12.5 restructuring consensual, 19.2 Covid-19 pandemic and, 19.2 domestic processes, 19.5 Germany, 14.71, 14.73 insolvency procedures, 19.4 Japan, 14.77–14.83 jurisdiction of incorporation, 19.5 state aid, 19.3 statutory, 19.3 UK process, 5.27, 19.5, 19.15–19.22 US Bankruptcy Code, 19.5–19.14 return on asset (RoA) credit risk analysis, 8.20; Appendix 8 I return on equity (RoE) credit risk analysis, 8.20; Appendix 8 I revenue expense, matching with, 1.5 revenue passenger kilometres (RPK), Appendix 8 II predicted improvements, 1.4, 11.2 revenue passenger miles (RPM), Appendix 8 II revenue per revenue passenger mile (RRPM), Appendix 8 II revolving credit facility loan agreement, 5.55 risk analysis, generally, 8.2–8.6 asset allocation, 8.3 asset risk analysis, 8.2, 8.3 banking supervision See Basel accords bankruptcy, predicting, 8.26 Cape Town Convention signatories, 8.6 cash flow statement analysis, 8.23– 8.25; Appendix 8 III components of valuation and risk, 7.7–7.8 counterparty risk analysis, 8.2, 8.4 credit risk analysis See credit risk analysis credit techniques, 8.1 depreciation, 8.10 deregistration risk, 5.24 differentiation of aircraft operating lessors, 11.27–11.33 foreign exchange risk, 8.12, 8.13, 8.16 fuel hedging, 8.12, 8.15, 8.16, 8.25 generally, 7.10, 8.1 global risks, mitigation, 8.41 going concern position, analysis, 8.25; Appendix 8 III hedging agreements, 5.55

Index risk – contd insurance risk assessment, 16.1 interest rate, 8.12, 8.14, 8.16 jurisdictional risk analysis, 8.2, 8.6 lease agreements, 8.5 letters of credit, 8.5, 12.4 liability, risk of, 5.15–5.20, 5.40 loans, generally, 8.1 maintenance reserves, 8.5 objectives, matching investments to, 8.3 pandemics, planning for, 1.12, 8.41 political risk insurance, 5.13, 10.2, 16.11 political risks, generally, 5.13 portfolio risk management, 8.2–8.6 quantitative analysis, 8.17–8.22 repossession risk, 5.13 secondary operators, consideration of, 8.3 security, 8.2, 8.5 stress testing, 8.27–8.32 tax strategy, 8.33 transaction risk analysis, 8.2, 8.5 risk based rate (RBR) export credit financing, 10.7 risk free rates (RFRs) finance leases, 12.2 Rome Convention on Precautionary Arrest of Aircraft generally, 21.1, 21.8, 21.13 Germany, 14.69 Rome I and II Regulations choice of law, 5.32, 21.9–21.10 contractual and non-contractual obligations, 21.1, 21.9–21.10 routes predicted growth, 1.4, 1.12 shortest feasible, 9.5 Russian Federation aircraft retirement/withdrawal, 14.23 arbitration clauses, 14.38 bankruptcy of Russian party, 14.29 bilateral treaties, 14.38 choice of court clauses, 14.38 civil aircraft, 14.20, 14.24 conflict of laws rules, 14.22, 14.28 deregistration of aircraft, 14.22, 14.23 deregistration of mortgage, 14.27 enforcement of mortgage agreements, 14.29–14.30 export of aircraft from, 14.22, 14.23 finance leases, 14.32 foreign law contracts, enforcement, 14.29 foreign lessors, 14.32 generally, 14.19 insurance, 16.8

Russian Federation – contd jurisdiction over aircraft and mortgages, 14.22, 14.28, 14.29– 14.30 jurisdiction over leases, 14.22–14.23 leasing, 14.20, 14.32–14.37 Minsk Convention, 14.38 operating leases, 14.32 priority of claims, 14.31 recognition of foreign judgments, 14.38 Register of Rights, 14.20, 14.24–14.27, 14.34–14.36 registration of aircraft, 14.19, 14.20– 14.23, 14.32 registration of leases, 14.34–14.36 registration of mortgages, 14.20, 14.24–14.29 repossessions, 14.37 Russian nationality, aircraft acquiring, 14.22 spare parts, 14.28, 14.33 state aircraft, 14.20 unmanned aircraft, 14.20, 14.21 S salam Islamic finance, 15.4 sale of aircraft cross-border leasing and, 6.6, 6.9, 6.11 E-notes, 1.9 forecasted sales value, 1.9 future sale value as percentage of original, 4.7 generally, 4.10 lessor, by, 1.7 registration taxes, 6.12 sale and leaseback See sale and leaseback sale and leaseback Covid-19 pandemic, 1.1, 2.5, 11.3, 12.1 sanctions compliance with, 24.1, 24.2, 24.4 secondary aircraft sale market alternative to, 1.9 risk in aviation finance and, 8.3 Secured Overnight Financing Rate (SOFR) finance leases, 12.2 securitisation liquidity created by, 2.6 special purpose companies, share security, 5.5 servicing agreement generally, 5.55 Sharia’h See Islamic finance sidecar partnership leasing platforms, 4.5, 4.10

421

Index Singapore GATS trust branch, 18.5 regulatory framework, 20.1 single purpose company ownership by, 5.2 slot allocation assets, slots as, 20.11, 20.16 competition for, 20.11 EU Slot Allocation Regulation, 20.12– 20.20 EU slot pools, 20.18 exchanging slots, 20.15 grandfather rights, 20.11, 20.14 IATA guidelines, 20.11 new entrants, 20.11, 20.19 scheduling committees, 20.11 use it or lose it (80-20) principle, 20.11, 20.12 solvency cash flow statement analysis, 8.23; Appendix 8 III credit risk analysis, 8.24 sovereign immunity Cape Town Convention, 5.14 state-owned operators, 5.14 sovereign wealth fund investment in aircraft, 4.5 Spain Aircraft Sector Understanding (ASU), 2.11 operating leases, 2.13 special purpose entity/company (SPC) accounting policy, 23.11 bankruptcy remoteness, 5.3, 5.9 control, 23.11 cross-border financing, 5.11, 23.11 IRFS accounting, 23.11 lease agreements, generally, 5.2, 5.3, 23.11 legal considerations, 5.2, 5.3, 5.5, 5.11 legal title held by, 5.3 location, 5.3 negative pledge covenants, 5.3, 5.5 ‘orphan’ ownership structure, 5.3, 23.11 role, 5.3, 23.11 sale transactions and, 5.47, 23.11 security, generally, 5.9 share security, 5.5 SPC-related covenants, 5.3 sponsor, 23.11 US-GAAP accounting, 23.11 stamp duties cross-border leasing, 6.2, 6.7, 6.10 India, 14.53, 14.56 legal considerations, 5.11, 5.44 standstill period PDP financing, 13.8

422

start-up airline operating leases, 11.16 state aid Covid-19 pandemic, 1.4, 1.12, 2.4, 2.5, 20.10 EU competition rules, 20.10 state-owned operators generally, 8.35 sovereign immunity, 5.14 step-in price PDP financing, 13.4 stock market ratios credit risk analysis, 8.22; Appendix 8 I storage costs aircraft valuation, 7.8 stress testing credit risk analysis, 8.27–8.32 sukuk Islamic finance, 15.6 sustainability See also environmental, social and corporate governance (ESG) factors; environmental issues sustainability linked loan principles (SLLPs), 9.9 sustainability performance targets (SPTs), 9.9 T tawarruq Islamic finance, 15.4 taxation Brazil, 14.5–14.12 China, 14.62 compliance, generally, 24.8 deferred liability, credit risk analysis, 8.11 deferred liability, JOLCOs, 14.76– 14.80 double tax treaties, 14.7, 14.47 indemnity clauses, 5.44, 6.5, 6.13 India, 14.46–14.53, 14.56 Japan, 14.80 rates, 2.13 special purpose companies, location, 5.3 tax-leveraged financings, 5.45 tax strategy, credit risk analysis, 8.33 withholding taxes, 5.46, 6.5, 14.6, 14.7 technical overhauls factoring into valuation, 7.8, 7.10 terms-sheet legal considerations, 5.55 terrorism countering financing of obligations, 24.2 insurance against, 14.16, 16.10, 16.11, 16.12, 16.13, 16.16

Index Terrorism/Unlawful Interference Convention third party liability, 21.13 title chain of, 5.25 validity of collateral, 5.25–5.27 tort, liability in UK law, 5.17 total cost per available seat mile (CASM), Appendix 8 II trade restrictions compliance, 24.4 trading, aircraft See also Global Aircraft Trading System legal issues, 5.47 transaction at undervalue UK insolvency law, 5.25 transition costs aircraft valuation, 7.8, 7.10 trust GATS See Global Aircraft Trading System U United Kingdom See also United Kingdom insolvency/restructuring process Airbus fraud investigation, 10.8 aircraft registration, 5.24 Aircraft Sector Understanding (ASU), 2.11 airport charges, 5.22, 5.50 banks, 2.1 breach of contract, 5.29, 5.31 Brexit and enforceability of UK judgments, 5.33, 21.21 chattel leasing agreements, 5.27 conditional sale agreements, 5.18, 5.27 conflict of laws, 5.12 damages, judgment currency, 5.31 detention, rights of, 5.20–5.23 Hague Convention, 5.33, 21.1, 21.12 health and safety rules, 5.19 hell or high water clauses, 5.36–5.37 hire purchase agreements, 5.18, 5.27 Immunity Act, 5.14 liabilities of financier and lessor, 5.15–5.20 liens against aircraft, 5.7, 5.20 liquidated damages, 5.29 navigation charges, 5.23 product liability, 5.18 Register of Aircraft Mortgages, 5.6 registration of security interest, 5.25 transactions at undervalue, 5.25 UK mortgages, conflict of laws, 5.12

United Kingdom insolvency/ restructuring process Cape Town Convention, 19.20–19.21 enforcement of collateral, 5.27 foreign airlines, 19.16 generally, 5.27, 19.5, 19.15 ipso facto provisions, 19.22 jurisdiction, 19.17 priority of collateral, 5.26 restructuring plans, 19.18–19.19 schemes of arrangement, 19.15–19.17 transactions at undervalue, 5.25 validity of collateral, 5.25–5.27 United States See also United States insolvency/restructuring process Aircraft Sector Understanding (ASU), 2.11 airline licensing, 20.22 anti-money-laundering regulations, 24.2 capital leases, 12.2 countering the financing of terrorism regulations, 24.2 debt capital markets, 3.7 domestic market deregulation, 20.1, 20.4 domestic routes, 20.3 emissions trading scheme prohibition, 9.4 Ex-Im Bank, 2.1 GATS trust branch, 18.5, 18.7 Immunity Act, 5.14 international traffic, 20.4 liabilities of financier and lessor, 5.15 private placement exemption, 3.3 registration of aircraft, 5.24 regulatory framework, 20.1, 20.4 Rule 144A offerings, 3.3, 3.7 Securities Act 1933 registration, 3.3 Securities and Exchange Commission (SEC), 23.2 US-GAAP, 8.8, 12.2, 23.1–23.3, 23.5, 23.8, 23.9, 23.10 United States insolvency/restructuring process automatic stay, 19.7 Bankruptcy Code, 5.27, 19.5–19.14 Cape Town Convention, Alternative A, 19.14 Chapter 11 reorganisation, 19.05, 19.06 debtor-in-possession regime, 19.06, 19.09 executory contracts, 19.8 generally, 19.5, 19.06 ipso facto provisions, 19.12 jurisdiction, 19.10 mortgaged property, 19.8 priming lien, 19.9 unexpired leases, 19.8 US certificated air carriers, 19.13

423

Index upsy/downsy clause/payments return condition and maintenance obligations, 5.38, 23.10 V valuation See aircraft value/valuation variable interest entity (VIE) US-GAAP accounting, 23.11 W war risk insurance against, 5.40, 14.16, 16.10, 16.11, 16.12, 16.13, 16.16, 16.27 warehouse facility loan agreement, 5.55

424

warehouse financing commercial banks, 1.6 widebody aircraft demand for, 1.5 withholding taxes Brazil, 14.6, 14.7 cross-border leasing, 6.5 legal considerations, 5.46 Word Trade Center attacks impact on aircraft financing markets, 2.1, 2.2, 5.40, 21.13 World Trade Organization (WTO) export credit financing and, 10.4, 10.5