Aircraft leasing

Aircraft leasing is a fairly recent development in legal practice, it having become established in the 1980s thanks in no small part to Steven Udvar-Házy and partners setting up International Lease Finance Corporation (ILFC) in the mid-1970s. The high capital cost of aircraft acquisition for airlines presented an opportunity for a leasing model which not only allowed airlines (as lessees) to control and budget for monthly expenditure on aircraft, it also allowed them to shift depreciating assets from their balance sheets. Today, aviation leasing companies are legion and between them cater for the leasing of all manner of aircraft types, from brand new wide-bodied jet aircraft through to elderly propeller-driven relics, and everything in between.

There are many types of aircraft lease. For the purposes of this overview it is intended only to focus on the “operating” or “dry” lease, where an airline lessee will take possession of the aircraft, register the same in its own name with its civil aviation authority and provide the crew, fuel, maintenance and insurance. This article will take a high-level look at some of the key terms in an aircraft lease coupled with relevant decisions of the courts, where applicable.

A dry lease is in many ways similar to a conventional commercial property lease. The lessor lets the property to the lessee for a set term, in return for a periodic rental. The lessee obtains possession of, but not title to, the property. Throughout the term of the lease the lessee will, for example, be responsible for carrying out certain maintenance to the property and for insuring the property. The lessee will grant both positive and negative covenants to the lessor in respect of its dealings with, and utilisation of, the property. In return, the lessor will grant the lessee a covenant of quiet enjoyment. The lessee may pay reserves into a sinking fund or similar for costly repair works to be carried out on the property. The property will be let to the lessee in a specified condition and, at the end of the term, the lessee will return the property to the lessor in a similar specified condition. If the lessee defaults in its obligations to the lessor, the lessor may recover the property from the lessee and terminate the lease.

Where aircraft leasing differs to real property leasing is that an aircraft is of course a chattel, a moveable asset. The aircraft could be anywhere in the world and subject therefore to the laws, political status, governmental whims and other risks of such territories. Further, aviation is a heavily regulated industry and the lessor will need to be satisfied that the lessee has all relevant licences, approvals and authorisations to register and safely operate the aircraft for the intended purpose.

Preliminaries: It is commonplace for the parties to a proposed lease to first enter into a term sheet or letter of intent (LOI). The principal purpose of the LOI is to set out the main terms of the lease, such as aircraft specification, term, rent and reserve levels, maintenance obligations and the law that shall govern the lease. It is likely that the aircraft will have been marketed for sale or lease by the lessor in the period prior to the LOI being signed and it is therefore common for the lessor to request a deposit or commitment fee from the lessee in return for the lessor removing the aircraft from the market (which will likely become, in whole or in part, a deposit for the purposes of the lease itself). As such, whilst the bulk of the LOI’s terms will be both non-binding and subject to contract, care must be taken to ensure that certain parts of the LOI are specified to be legally binding. The payment by the lessee (and reimbursement by lessor, if applicable) of any commitment fee should be a legally binding term of the LOI together with any provisions as to confidentiality, governing law and jurisdiction.

Aircraft Condition: Much time and effort would have been expended by the lessee in determining its fleet requirements and in sourcing a suitable aircraft. In addition, it is likely that the lessee will have a set date (or at least a set period, e.g. summer holiday period) by which it needs the aircraft to enter into revenue service. Accordingly it is of utmost importance that the aircraft is in a condition satisfactory for the lessee’s purposes. The lessee will not want to accept delivery of the aircraft, and therefore commence payment of rent under the lease, until such time as the aircraft’s condition is acceptable. If the aircraft cannot be made acceptable by a certain date then the lessee will wish to walk away from the deal, recover any deposit or commitment fee paid, and seek an alternative aircraft.

From the lessor’s point of view, it is merely the owner of the aircraft. It did not manufacture, and neither has it operated, maintained or repaired, the aircraft. Accordingly, the onus is squarely upon the lessee and its technical team to inspect the aircraft and ensure that it is, in all respects, satisfactory for the lessee’s purposes. The lease will stipulate, as a condition precedent to the lessee taking delivery, that the aircraft must be in a specific condition, but a lessor will not typically grant any warranties in this respect and will disclaim all liability in relation to the condition of the aircraft. Such limitations, in international aircraft leasing at least, do not fall foul of the Unfair Contract Terms Act 1977 (see Trident Turboprop (Dublin) Ltd v First Flight Couriers Ltd [2009] EWCA Civ 290; [2010] Q.B. 86).

Upon acceptance of the aircraft, the lessee will typically be asked to execute and deliver to the lessor, an acceptance certificate which confirms, inter alia, that the aircraft was in the specified delivery condition. The lessee absolutely must ensure that the aircraft is in order before accepting it. In ACG Acquisition XX LLC v Olympic Airlines SA (In Liquidation) [2013] EWCA Civ 369; [2013] 1 Lloyd’s Rep. 658 the lessee, Olympic Airlines, signed a standard form of acceptance certificate confirming that the aircraft was in the delivery condition specified in the lease. The lease also provided (as is typical) that execution and delivery of the acceptance certificate represented confirmation that the lessee had examined and investigated the aircraft, that the aircraft and the aircraft documents were satisfactory to it and that it irrevocably and unconditionally accepted the aircraft for lease without any reservations whatsoever. It later transpired that the aircraft had a fault which, aside from representing a non-compliance with the delivery condition under the lease, actually rendered the aircraft unserviceable. The lessee was ultimately prevented from claiming damages for breach of contract by the lessor on the basis of the lease term set out above and the execution of the acceptance certificate.

Much care must also be taken to ensure that the parties are fully aware as to the condition in which the aircraft must be returned to the lessor. The (unreported) case of NV Sabena SA v European Aviation Ltd demonstrates that whilst the courts will seek to give meaning to a poorly drafted lease, this is no substitute for clear and detailed delivery and redelivery conditions. Late redelivery of the aircraft will commonly attract a “hold over” rent of perhaps 150% of the usual rent in order to incentivise the lessee to return the aircraft in the correct condition. Due care should be taken with the rates of hold over rent, else it be determined to amount to a penalty.

Deposit: The lessee will almost always pay a security deposit to the lessor (generally one to three months of rent), and only where a lessor is dealing with a very strong airline customer might it waive this requirement. Other security less commonly provided may take the form of a letter of credit from the lessee’s bank, subject always to the standing and nationality of the granting bank. The level and type of security required will largely depend on the financial status and geographical location of the lessee.

The deposit is almost universally described as belonging to the lessor once paid and the lessor will be entitled to co-mingle the deposit with its own funds. Only when the aircraft is redelivered in the correct condition by the lessee will the deposit be refunded. The lessor will retain the right to apply the deposit to any rental areas or in curing any other default by the lessee, and generally such application shall be at the lessor’s discretion. The lessee will be required to reinstate the deposit to its full level if the lessor has cause to utilise it; however, by this stage, it may be that the lessor is concerned more with the recovery of its asset – a lessee that has not been in a position to pay rent will correspondingly be unlikely to be in a position to reinstate the security deposit.

Rent: Rent is usually paid monthly and in advance. The rent is to be paid by the lessee come what may and free of any withholdings or set-off. This is commonly referred to as a “hell and high water clause” and serves to deprive the lessee of its right to refuse to pay rent on the ground of any actual or alleged breach of contract by the lessor (again, the Unfair Contract Terms Act 1977 will not apply where the lease is determined to be an international supply contract). Rents are almost always payable in US dollars and the lessee will be required to make up any shortfalls (and indemnify the lessor in respect of any other costs or charges incurred) if the rent is paid in any other currency than that specified in the lease. Non-payment of rent by the lessee is always an event of default.

Maintenance Reserves: Aircraft maintenance can broadly be split into two categories for the purposes of this article. The first, line maintenance and repair, is the routine day-to-day operational maintenance carried out by the lessee whilst operating the aircraft. This can be repairs carried out on the tarmac between flights but, in some cases, may require the aircraft to be out of service for a short period. These are likely to be, relatively speaking, low-cost events, carried out and paid for by the airline on an “as and when” basis.

Periodically, aircraft will require a “heavy check”, the second type of maintenance event. A lessee will usually pay maintenance reserves to the lessor, in arrears, based upon the number of “flight hours” and “cycles” (definitions may vary) that the aircraft performs each month. These reserves are split between the airframe, landing gears, engines and auxiliary power unit (the small engine below the tail of the aircraft that powers some aircraft whilst on the ground). These reserves will be calculated so as to cover the cost of heavy maintenance when it is required (a “C” check can take a week or longer and will be performed every 18 months or so; a “D” check may take place every five years or so and take perhaps six to eight weeks). The aim of the reserves is therefore to ensure that a pot of cash is available to pay for heavy maintenance on the aircraft rather than the work being carried out and the lessee not then having available funds to pay for it (a D check can cost c.$2m). The lessor will, having agreed the scope of work to be undertaken on the aircraft with the lessee and maintenance performer, reimburse reserves paid by the lessee to pay the maintenance performer. In the event of any shortfall, the lessee will make up the difference. Reserves are commonly adjusted (upwards) on an annual basis to take into account the increase in pricing of parts and labour. Levels of reserves and the responsibilities of lessor and lessee with regard to certain maintenance events are heavily negotiated.

Default: Events of default will give the lessor the right (but not obligation) to bring the leasing of the aircraft to an end and to recover the aircraft. Events of default will include typical insolvency, change control and other commonly seen default provisions in addition to events such as a failure on the lessee’s part to pay any sums due under the lease, a failure to insure and/or maintain the aircraft and the lessee ceasing to hold the requisite licences and approvals to operate the aircraft.

The lessor may not always wish to recover the aircraft immediately where the lessee has failed to pay rent. The airline industry can be unpredictable and affected by season, oil prices, terrorist events and the like. Lessors may in certain circumstances allow the lessee some time to pay (with of course adequate “no waiver” provisions in place in the lease). From the lessor’s point of view, if it recovers the aircraft it will need to store and insure the aircraft until a new lessee can be found. A lease will usually have provisions which require the lessee to indemnify the lessor for any losses suffered as a result of the lessee’s breach and the associated recovery (and, if necessary, repair) of the aircraft. This will be in addition to general remedies available at law for breach of contract. Some leases may provide for a sum to be paid by the lessee on termination for default, comprising the rent that would have been paid for the remainder of the lease, but for the default. Such amount should be discounted for the lessor’s early receipt. From a lessee’s perspective, care should be taken in reviewing the remedies that the lessor will have on termination and the extent to which these will augment the sums the lessor could normally claim over and above those for a simple breach of contract.

It is unlikely, in the sphere of operating leases, that a lessee would be granted relief from forfeiture on default (see Celestial Aviation Trading 71 Ltd v Paramount Airways Private Ltd [2010] EWHC 185 (Comm); [2011] 1 All E.R. (Comm) 259).

Lessor’s Rights in Aircraft: A final, albeit brief, mention should be given to securing the lessor’s rights in the aircraft, but this topic could form the basis of an entire text in itself.

Firstly, the lessee will grant the lessor a number of positive and negative covenants regarding protection of the lessor’s right in, and title to, the aircraft (and its engines and parts) and will be required to take all necessary action and file such documents as are necessary or desirable to protect the lessor’s rights in the aircraft. Typically, the lessee will also provide a form of power of attorney to the lessor granting the lessor the right to de-register and export the aircraft from the relevant jurisdiction in the event of default. This should be supplemented, where applicable, by an Irrevocable De-registration and Export Request Authorisation (IDERA) pursuant to the Cape Town Convention, to which see further below.

It will often be the case that the aircraft will be leased into a different jurisdiction to that of the lessor or indeed the governing law of the lease. Operation of foreign law and, particularly foreign insolvency regimes, can serve to deny or hinder the lessor in asserting its rights over the aircraft in the event of a default by the lessee. As such, advice on enforcement should be sought by local counsel, in the jurisdiction where the lessee is incorporated and, if different, the jurisdiction where the aircraft is to be registered. Leases will commonly provide that the lessee’s counsel provide suitable transaction and lex situs legal opinions. Where possible and advisable, the lessor’s (and any financier’s) interest in the aircraft should be registered with the local civil aviation authority and/or with any corporate or fiscal registers equivalent to Companies House.

The Convention on International Interests in Mobile Equipment, signed at Cape Town on 16 November 2001 (the Cape Town Convention), and its associated aircraft equipment protocol gave rise to the International Registry of Mobile Assets (IR). In a nutshell, the IR provides for the electronic registration and the protection of “international interests” which will be recognised by all states that have ratified the Cape Town Convention, with priority being determined on a “first-to-file” basis. Registration of interest in an aircraft asset serves as a notification and is considered to be best practice for owners, creditors, debtors, lessors, lessees, agents and others in protecting their financial interest in such an asset. As such, a lessor can register the lease of an aircraft on the IR as an “international interest” and be named as a “creditor” thereon, which shall give notice to those searching the register and/or seeking to obtain or enforce any action or interest against the asset. Where an IR filing is to be made, the lessor should ensure that both it and the lessee are set up as “transacting user entities” with the IR, else filings cannot be made. Many professional service firms can act as an agent for airlines and lessors and take care of such filings for them. As far as the UK is concerned, the European Union, on behalf of its member states, acceded to the convention in 2009 but made certain declarations where the convention was incompatible with extant EU legislation, including but not limited to Regulation 44/2001 and the wider Brussels and Rome I regimes. The Convention and associated Protocol enters into force in the UK on 1 November 2015 and implementing regulations (International Interests in Aircraft Equipment (Cape Town Convention) Regulations 2015/912) will come into force at the same time. The implications of the Convention are perhaps going to be more useful with respect to the financing of aircraft and the granting and perfection of security. For the purposes of operational leasing, a lessor will be able to register its interest in the aircraft leased to a UK entity. Such interest will have priority over unregistered interests, save in respect of (i) mechanics’, possessory, liens and (ii) the express or implied authority of entities which are entitled to lawful rights of possession or detention of the aircraft (such as airport parking charges in the UK and Eurocontrol debts). Of note, but beyond the scope of this overview, is the adoption of protocol “Alternative A” which will have a real impact on English insolvency law, especially the administration regime. Insolvency practitioners appointed by Lessees should take advice on the additional liabilities imposed as a result of the Alternative A procedures.