Airline Business & Law:

Aircraft Acquisition
Acquisition, Finance & Leasing
Airline Business & Law (ASPL 614)
McGill Institute of Air & Space Law

Mark Lessard
Pillsbury Winthrop Shaw Pittman LLP
Table of Contents

1. Introduction: Aircraft as Investments

2 The Principal Players
2.
a. Aircraft Operators
b. The Metal-Heads
c. Sources of Finance
3. Aircraft Acquisition Process
a. Selecting Equipment
b OEM Aircraft Purchase Agreements
b.
c. Pre-Delivery Payments and Financing
d. Secondary Market
4 The Aircraft Leasing Industry
4.
a. Operating Leasing vs. Finance Leasing
b. Asset Risk Arbitrage vs. Credit Arbitrage
c. Depreciation
p
Table of Contents

5. Aircraft Financing Methods

a. Airline Credit vs. Asset Values
b. Commercial Bank Lending
c. Export Credit Agencies
d. Capital Markets
6 Legal and Contractual Protections
6.
a. Perfecting Security in Aircraft
b. Operation, Maintenance and Return Conditions
c. Insurance
7. Default and Remedies
a. Lease and Loan Defaults
b. Airline Bankruptcies
c. Foreclosure and Repossession
d. Transition and Deficiency
8. Conclusion: Risk and Reward
Introduction: Aircraft as Investments

Q: What is the surest way to become a millionaire?

A: Become a billionaire and start an airline…
- Richard Branson
Introduction: 10 Reasons for Investor Caution

1. Danger and liability = highly regulated industry (SAFETY!)

2. Variable operating costs, mainly driven by fuel and personnel
3. Highly mobile, crossing national borders and subject to expropriation
4 Expensive to maintain even when not in use
4.
5. Value dependent on maintenance status, variant, upgrades, engine
type, operating conditions, line number etc…
6 Highly
6. Hi hl cyclical
li l industry
i d t (GDP growth
th necessary but
b t nott sufficient)
ffi i t)
7. Long-dated asset (30 + years)
q
8. Illiquid market,, with significant
g transition costs
9. Residual value risk and obsolescence
10. Capital-intensive, technology-driven manufacturing process
Introduction: Aircraft as Investments
Source: ACAS, December 2006, Forecast: SH&E
Introduction: Aircraft as Investments
Players: The Airline / Operator

Different Types = Different Needs

ƒ Geographic Markets
Scheduled Charter
ƒ Route Distance
ƒ Price/Quality Ratio
ƒ Distribution Channels
ƒ Competition/Elasticity
Regional Cargo
Players: The Metal-Heads

Primary
ƒ OEMs = Aggregators
Airframers Engine OEMs
ƒ Development costs +
Jobs = Politics
ƒ Back-Stop Loans / RVGs
ƒ After-market Support
((Razor Blade Model))
ƒ Asset Management and MROs Traders/Brokers
Remarketing
Secondary
ƒ Parts and services
ƒ Residual Value
Players: Sources of Finance

Evolution of Banking
ƒ 60s-80s:
60s 80s: North America
ƒ 80s-90s: Japan Bank Debt Capital Markets
ƒ 90s-00s: Europe
ƒ 10s+: Emerging Markets
Evolution of Lessors
ƒ Asset Risk Arbitrage to
Credit Risk Arbitrage
ƒ Capital Consumer/Provider
Evolution of Capital Mkts Lessors Export Credit
ƒ US-based in 1990s
ƒ Islamic bonds and other
global opportunities
Evolution of Export Credit
ƒ “Leveling the field”
ƒ Ch
Changing
i d duopolyl
Acquisition Process: Selecting Equipment

ƒ Technical considerations:
à Range/payload, fuel burn, engine type, training, spares, tech support, BFE
ƒ Economic considerations :
à Demand, price, load factors, financing, residual values, commonality
ƒ Types of fleeting decisions:
1. Purchasing aircraft of a type already in the fleet:
2. Purchasingg aircraft new to fleet, but with other carrier
3. Purchasing a new type of aircraft
ƒ New Aircraft vs. Used Aircraft
ƒ Technological
g advances now incremental,, thoughg efficiency
y counts ((fuel))
ƒ Increased capital cost vs. Increased operating cost (depends on utilization)
ƒ Premium travel (passenger experience) vs. LCC (operating efficiency)
Acquisition Process: OEM Purchase Agreements

ƒ OEMs have “war rooms” and conduct “campaigns”

ƒ Negotiating power of airlines varies, as does discount from list price
ƒ Key airline considerations:
à Minimizing unit cost for aircraft
aircraft, engines
engines, spares
spares, ground equipment
equipment, training
à Pre-delivery payments (PDPs), delivery delays, escalation
à Specification changes, configuration, options, warranties, customer support
ƒ Possible OEM Incentives:
à Credit memos, performance guarantees (including fuel burn), AD cost participation,
escalation caps, maintenance cost protection, promotional support

ƒ Sales Financing and Asset Management

à Back-Stop Facilities, Residual Value / Deficiency Guarantees, Remarketing
à Should be dissuasive, yet allow OEM to book sale; must ensure ability to exit
Acquisition Process: PDP Financing

ƒ Credit facility in favor of an aircraft purchaser to finance a portion of

the significant progress payments (e.g. 35%) due on an aircraft order
ƒ PDPs are partially funded by the lender directly to the OEM and loans
mature on or around the delivery date for an aircraft
ƒ Lender secured by lien on “portions” of the aircraft purchase
agreement; has right to step in and purchase if borrower defaults
ƒ Collateral assignment of contract rights,
rights as opposed to a security
interest in the aircraft itself; no special filings (e.g. FAA, Cape Town).
ƒ Borrower, lender and OEM enter into consent and agreement defining
assigned
i d purchase
h agreement terms andd rights
i h off parties
i
ƒ The market for PDP Loans has fallen apart, as the security has limited
value in a falling market
Acquisition Process: Secondary Market

ƒ There is an aircraft “food-chain”:

à Carrier Tiers; Freighter Conversion; Part-Out
ƒ Generally active secondary market, especially for narrow-body
aircraft, but high volatility and dependent on availability of loans
ƒ Passing of title to an aircraft over time as chain of ownership grows
à Risk of title defect, e.g. possessory or tax lien, undischarged interest
ƒ Sale “as
as-is
is”, w/o representation as to condition (vs (vs. OEM warranties)
à Rely on due diligence and seller credit to back-up title representation
à Physical inspection + records; contracts always include rejection rights
ƒ Operational indemnities e
exchanged
changed for period pre
pre- and post-sale
post sale
ƒ Aircraft trading (esp. distressed) = Opportunities + Risks!
Leasing: Finance Leases vs. Operating Leases

ƒ Legal, tax and accounting differences, with large impact on economics

ƒ Finance (Capital) Lease: Really a security device used for a loan
à Lender (Lessor) “owns” aircraft; “Rent” payments benchmarked on LIBOR
à Usually long-term, based on useful life; purchase option (lease balance or bargain)
à Economic ownership rests with Lessee; aircraft goes on its balance sheet
ƒ Operating (True) Lease: Economic ownership rests with Lessor
à Capital
p cost not fully
y amortized over term of lease, so residual/remarketing
g risk
à Shorter term; FMV purchase option is a possibility
à Aircraft goes on balance sheet of Lessor; rentals are an “expense” for lessee
ƒ Operating
p g leasing g has g grown from 5%-35% of fleet in last 25 y years
à Flexibility for airlines in terms of fleet planning; requires less capital
à Lessors require security to protect asset value: deposits, reserves, letters of credit
Leasing: Asset Risk Arbitrage vs. Credit Arbitrage

ƒ “Original Lessors”: Asset-risk arbitrage (Capital Consumers)

à ROI based on knowledge of residual values, asset management, and ability to
monetize (remarket); capital raised on basis of secured debt
à Funding mismatch = trouble; GPA to GECAS; ILFC to AIG

ƒ “L
“Large L
Lessors”” A Assett Ri
Riskk + Credit
C dit arbitrage
bit (Capital
(C it l P Providers)
id )
à Using borrowing capacity of parent (cheap unsecured debt) to fund new deliveries
à Tax structuring allows parents to take depreciation credits
à Hard to compete
compete, but difficulties loom when funding issues arise (AIG
(AIG, RBS
RBS, CIT)

ƒ Large Portfolio Sales and Future Funding Challenges

à Many lessors rely on capital markets exit strategy
à Increased lessee defa
defaults
lts = cash flo
flow iss
issues
es (less rent
rent, remarketing e
expense)
pense)
à Private equity stepping in to fill the void, but still need leverage for desired returns
à Lessors are once again capital consumers
Leasing: Depreciation

ƒ Depreciation is the decline in useful value of a fixed asset due to wear

and tear from use, the passage of time or obsolescence
à It is an actual cost; we can view it as “spending” the capital balance of an asset]
à Since it is an expense, tax rules allow a deduction against expenses
ƒ Two accounting methods:
à Straight Line: 100M aircraft, 20 year useful life = $5M depreciation / yr.
à Declining Balance: 100M aircraft, 10% / yr. = $10M, $9M, $8.1M, $7.29M, $6.56M
ƒ To encourage investment, tax rules permit accelerated depreciation
à Generally 11 years, sometimes 7 years
à Tax deferral method results in up front value for taxpayer (time value of money)
ƒ Unfortunately, most airlines don’t make money, so had limited use for
the depreciation credit…
Leasing: Leveraged Leasing

ƒ Non-recourse financing allowing for transfer of tax benefits

Equipment Notes Indenture Trustee

Debt Service

Owner Trustee Residual Value

(aircraft title)

RENT EQUITY

Owner Participant
Lessee (Flush Cable Co.)
(Dirt Broke Air Lines, Inc.)
Financing Methods: Credit Risk vs. Asset Risk

ƒ Until 1960s, airlines funded aircraft with equity / unsecured debt

ƒ Arrival of expensive jet aircraft required new sources of capital
ƒ Secured lending, but still very dependent upon airline credit risk
à Credit rating
rating, Risk of Default; based on relationships
relationships, often with flag
flag-carriers
carriers
à Government supported airlines = value of collateral secondary
à Aircraft values always cyclical, difficult to predict
ƒ De
De-regulation
regulation / Legal Protections / Standardization / Liquidity
à Creates opportunities for lenders willing to take asset risk (Lessor’s terrain)
à Non-recourse financings; some banks develop remarketing expertise
à Depends
p on ability
y to recover aircraft in a default situation

ƒ Capital Markets = Longer Term and Asset Drive

Financing Methods: Secured Bank Lending

ƒ Historically, important relationships between national banks/carriers

à Syndicated Deals vs. Club Deals
ƒ Banks have developed significant expertise; can move very quickly
and provide committed funding
ƒ Risky airline credits weigh on risk capital allocations; structuring helps
à Yield protection, withholding taxes, indemnification, security, guarantees
ƒ Liquidity/funding problems have slashed availability
à Higher margins, lower Loan-to-Value ratios
à Market disruption clauses allowing loan for “cost of funds” interest
à Shorter term loans, more rapid amortization
à Financial covenants, including LTV tests
à Flight to quality for borrowers and aircraft
Financing Methods: Export Credit Agencies

ƒ A private or quasi-governmental body that extends export financing

à EDC, Ex-Im Bank, COFACE, Hermes, ECGD, BDNES
ƒ Benefits: better borrowing terms, improved balance of trade
ƒ Polemic: illegal trade subsidy
subsidy, welfare for large corporations
ƒ OECD Aircraft Sector Understanding sets out most favorable terms on
which export credit may be provided
à Minimum
Mi i iinterest
t t rates
t and
d premiums
i b
basedd on risk
i k classification
l ifi ti off a b
borrower
à ‘Cape Town Discount’ applies if operator has ratified the Cape Town Convention
ƒ ‘Base security package’: 12 yrs. / 85% / mortgage style repay
ƒ Home Country Rule: Applies to US and to UK/FR/GER/SPN
ƒ “Category 1” vs. “Category 2”: (Term and Pricing)
 Financing Methods: Export Credit Agencies

Lessor Parent

•
Sh
ar
e
Pl
ed
ge
• Declaration of Trust Ag
re
em
en
(Share Ownership) t

• Guaranteed Loan • Aircraft Mortgage

• Ex-Im Bank Agreement • Deregistration Power
Guarantee
Guaranteed Lessor • Lease Assignment
Security Trustee
Eximbank Lenders SPC
• Promissory
Note ((Aircraft Title))

t
en
• Lease nm
sig
• Purchase Assignment As n
c e tio
• Engine Assignment an tra
r is
su
In reg
• De
•

Lessee
Engine Manufacturer Boeing
g
• Engine
E i Airline • Purchase
P h A
Agreementt
Agreement • Consent to Assignment
• Engine Consent
to Assignment
Financing Methods: Capital Markets

ƒ Late 80’s, U.S. carriers sought access to deep and liquid capital mkts
à Funding source diversification; structure different tranches
à Ability to fund larger deals; Longer maturities (25-30 yrs.)
à Rating agencies play an important role for institutional investors
ƒ Credit/Asset-Based Issuance: ETCs, PTCs, EETCs (Section 1110)
à “Enhancements” put in place to achieve AAA ratings (higher than airline rating)
à Senior tranches, liquidity facilities, cross-collateralization
ƒ Asset-Based Issuance: Portfolio Securitization (ABS)
à Special purpose vehicle issues debt to purchase pool or aircraft on lease
à Used by Lessors to exit certain pools of assets; remain as servicer
à Assumes that assets will be managed and monetized properly, with stress tests
Financing Methods: Capital Markets
1995A-1 BONDHOLDERS 1995A-2 BONDHOLDERS

1995A-11
1995A 1995A-22
1995A
Pass-Through Trustee Pass-Through Trustee

N189UA Equipment N766UA Equipment N766UA Equipment

N189UA Equipment Notes % Notes % Notes %
Notes %

N189UA N766UA
Indenture Trustee Indenture Trustee

Debt Service N777UA

N777UA N777UA Debt Service
Equipment Indenture Trustee Equipment
Notes % Notes %
N189UA Debt Service
N766UA
Owner Trustee Owner Trustee
N777UA Limited Future Rent Limited Future Rent
Limited Future Rent Owner Trustee / Residual Value / Residual Value
/ Residual Value

RENT N766UA
N777UA
Owner Participant
N189UA Owner Participant
RENT RENT (NCC Key Co.)
Owner Participant
p (NCC Key Co.)
(Bell Atl. Credit Co)
Lessee
(United Air Lines, Inc.)
Financing Methods: Islamic Finance

ƒ Islamic funds estimated at over $200 billion

ƒ Shariah forbids the payment and receipt of interest
ƒ Economic similarities (e.g. seeking return), but not simple end run as
there are many specific issues (e
(e.g.
g tradability
tradability, yield protection)
1. Murabaha:
à Trade for mark-up on deferred payment terms (benchmark to LIBOR)
2. Ijara:
à Lease of aircraft with purchase option for financed amount (with mark-up)
3. Sukuk:
à Islamic bond allows many investors; leverage achieved through Ijara
ƒ Shariah Board Approval: structural and documentation review
Protections: Perfecting Security in Aircraft

ƒ The operator needs freedom to monetize assets, whereas the lender

requires that it remain accessible and in good condition
ƒ An aircraft is an item of personal property, can be subject to
mortgage, conditional sale, lease, trust, possessory liens etc.
ƒ Many countries have special registries for title and security interests
à Canada: no central registry for security interests, must make provincial filings
à US: FAA registry, for recording any instrument affecting title to or interest in A/C
à Until recorded with FAA
FAA, the interest is effective only as to parties
parties, their relatives
and heirs and persons with knowledge of the agreement
ƒ Geneva Convention on recognition of rights in aircraft
à Basic qquestions of international law arise – where to file?
à Contracting states recognize interest recorded in state where aircraft registered
ƒ Cape Town Convention: Creates a central international registry of
interests in aircraft (see handout)
Protections: Operation, Maintenance, Return Conditions

ƒ Operation and Possession

à Lawful use, all permits and insurance, restrictions on operations in some countries
à Subleasing; Pooling and exchange: Customary arrangements with solvent carriers
ƒ Approved maintenance program compliant w/ FAA/EASA regulations
à Shop visits: FAA/EASA approved repair stations; workscope and timescale
à “Back to birth” historical records in English on all parts
à Monthly reports of hours and cycles
à Airworthiness
Ai thi Directives
Di ti and
d Mandatory
M d t Service
S i Bulletins
B ll ti (Cost-Sharing)
(C t Sh i )

ƒ Usage Fees/Maintenance Reserves/Other Security

ƒ Return Conditions:
à Physical inspection, engine borescopes, records, test flight, deregistration etc.
à Hard-time conditions: Hours or cycles on airframe, engines, LLPs…
à Financial adjustments: Based on pre-delivery use or agreed threshold
Protections: Insurance

ƒ Creditworthiness is key; main int’l market in London (Lloyd’s)

ƒ Insurance and Re-Insurance (insurer’s spreading risk)
ƒ Hull “all risks”: Physical damage to the a/c (Agreed Value)
à No replacement, deductibles, excludes “war risk”, spares usually separate
ƒ Hull “war risks”: War, hijacking and allied perils / WMD
à Completely unavailable after 9/11; slow to come back and expensive
à US, China, Canada etc. assist airlines; FAA provide full hull/liability cover
ƒ Liability: Passenger, Cargo, Third Party
à Combined single limit for bodily injury and property; $250M-$1B
à Need to make sure all appropriate parties are additional insured (your client!)
ƒ Airline Finance/Lease Contract Endorsement: AVN 67B / AVN 67C
à Financier need not review policy; insurer need not review financing contract
à Breach of warranty cover; severability of interests; notice of cancellation/change
Default and Remedies: Lease and Loan Defaults

ƒ Some Typical Events of Default:

à Failure to pay rent/loan amount within X days of due date
à Failure to comply with covenants remaining uncured for X days
à Inaccuracy of representations or warranties
à Loss of air carrier license
à Voluntary or involuntary insolvency petitions
à Failure to insure
à Loss or invalidity of security
à UCC Remedies and Cape Town Remedies:
à Lender: repossess, foreclose, account to the borrower
à Lessor: default must “substantially impair” value of lease contract (UCC 2A-523)
ƒ Lessee/Borro
Lessee/Borrower er cooperation is critical to achie
achieving
ing main objecti
objectives:
es
ƒ Protecting the value of the asset; and
ƒ Keeping it in revenue-generating service.
ƒ Best
B t way to
t avoid
id a default
d f lt is
i tto see it coming
i and
d work
k around
d it
Default and Remedies: Chapter 11 / CCAA

ƒ Automatic Stay: Creditor “stayed” from remedies

ƒ Adequate Protection: Creditor will encounter difficulty lifting stay on
remedies unless there is a risk of harm to the value of collateral
ƒ Rejection of Executory Contracts: Loans, Loans leases etc etc.
à Come and get it; value of aircraft may be less than debt burden
ƒ Section 1110: Mandates the expiration of the automatic stay for
aircraft after 60 days
days, no matter what
à 1110(a): Airline may elect to assume pre-petition contract
à 1110(b): Airline and creditor may consensually restructure terms
à 1110(c): Creditor takes back the aircraft (not to be taken lightly)
ƒ Restructure employment arrangements, pensions etc.
ƒ Polemic: Chapter 11 is a self-fulfilling prophecy
Default and Remedies: Airline Bankruptcies
2/29/00 Tower Air 11 9/14/05 Northwest Airlines 11
5/1/00 Kitty Hawk 11 9/29/05 TransMeridian Airlines 7
9/19/00 Pro Air 11 10 /13/05 Mesaba Airlines 11
9/27/00 Fine Ai r Services 11 11/7/05 In dependence Air 11
12/3/00 Le gend Airlines 11 12 /28/05 Era Aviation 11
12/6/00 National Airl ine s 11 1/6/06* In dependence Air 7
12/13/00 Alle gia nt Air 11 2/21/06 Florida Coastal Airlines 11
1/10/01 Trans World Airlines 11 10 /15/07 Kitty Hawk Aircargo 11
8/13/01 Midway Airlines 11 12 /24/07 MAXjet Airways 11
1/2/02 Sun Cou ntry Airlines 7 1/7/0 8 Big Sky 7
7/30/02 Vanguard Airl ines 11 3/31/08 Champion Air 11
8/11/02 US Airways 11 3/31/08 Aloha Airlines 7
12/9/02 United Airlines 11 4/2/0 8 ATA Ai rlines 11
3/21/03 Hawaiian Airlines 11 4/7/0 8 Skybus Airlines 11
10/30/03 Midway Airlines 7 4/11/08 Frontier Airlines 11
1/23/04 Great Plains Airlines 11 4/26/08 Eos Airlines 11
1/30/04 Atlas Air/Polar Air Cargo 11 5/14/08 Air Midwest 7
9/12/04 US Airways 11 6/18/08 Gemini Air Cargo 11
10/26/04 ATA Airlines 11 7/18/08 Vin tage Props & Jets 11
12/1/04 Southeast Airlines 7 8/12/08 Gemini Air Cargo 7
12/30/04 Aloha Airlines 11 10/6/08 S un Country 11
9/14/05 Delta Air Lines 11 10 /15/08 Primaris Airlines 11
9/14/05 Comair 11 1/5/1 0 Mesa Air 11
Default and Remedies: Foreclosure and Repossession

ƒ Take legal advice under:

1. Law governing the lease or loan agreement
ƒ Contracts, substantive remedies
2. Law of the lessee’s jurisdiction
ƒ Bankruptcy
3. Law of the location of the engine
ƒ Procedural remedies
ƒ UCC 2A-525: A Lessor may repossess without judicial process if it
can be done without breach of the peace
p
ƒ NOTE: Even if contractually mandated, self-help rights may not be
available in certain jurisdictions where an engine is located
à Some require judicial proceedings for a repossession
à Cape Town Convention allows for Self-Help
ƒ Foreclosure extinguishes interest of debtor; must be conducted in a
commercially reasonable manner
Default and Remedies: Transition and Deficiency

ƒ Remarketing: trying to minimize down time and maximize price, which

is difficult in a “distressed” situation
à In-house capability and forward market view are advantages
ƒ Refurbishment: extremely useful to know where the engine will go
before deciding how much to invest
à Might be a better strategy to part out
ƒ Deficiency
y Claim: this claim can p
properly
p y be liquidated
q once the “end-
game” is played out
(Old Rent NPV + Old Residual) or (Debt)
- (Sale Proceeds) or (New Rent NPV + New Residual)
+ Repossession and Transition Costs
= Damages
Conclusion: Risk and Reward

ASSET RISK CREDIT RISK

ƒResidual Value ƒDefault Risk (i.e .payment)

ƒRepossession Risk ƒFinancial performance/Cash flows
ƒRemarketing Risk ƒBusiness environment
ƒMaintenance and Operation ƒAirline ownership
ƒCollateral Security ƒQuality of Management

ƒ As for the rewards

rewards….
 Running an airline is like having a baby: fun to conceive, but hell
to deliver.
— C. E. Woolman, principal founder Delta Air Lines

I was engaged in what I believe to be the most

thrilling
g industry
y in the world—aviation. Myy heart still If we went into the funeral
leaps when I see a tiny two-seater plane soaring business, people would
gracefully through the sky. Our great airlines awe stop dying.
me. Yet I know they were not produced in a day or a — Martin R. Shugrue,
decade. Vice chairman Pan Am.
Vice-chairman
— William A. "Pat" Patterson, CEO United Airlines

People who invest in This industry attracts

aviation are the biggest
suckers in the world.
— David G. Neeleman, after
raising a record $128 million
to start New Air (the then
working name for what
became JetBlue Airways),
quoted in 'Business Week,'
3 May
ay 1999.
999
more capital than it I m flying high and couldn't
I'm couldn t
deserves. be more confident about the
— Stelios Haji-Ioannou, future.
founder of EasyJet, — Freddy Laker, Laker
reported in Aviation Airways 3 days before the
Airways,
Week & Space collapse of Laker Airways, 3
Technology, 5 October February 1982.
2009.