The outbreak of COVID-19 has caused a very dramatic drop in airline passenger numbers, particularly to areas identified as having many cases. The dramatic reduction in passenger numbers represents a profound threat to the solvency of affected airlines. Airlines have responded in several ways – some are more visible, such as cutting services to affected areas; while others are less visible such as requesting rental holidays or seeking to return equipment to aircraft lessors. The swimmer is not waving: under the surface airlines are in a life and death struggle: so how should the aircraft leasing industry respond?
The COVID-19 situation was not a major talking point at the January Dublin aircraft finance conferences – the scale of the problem was not then apparent. At that point the expectation for the aircraft leasing business was of business as usual for the next twelve months with the likely return to service of the B737 MAX aircraft, an increased focus on environmental issues, possibly a return of sale and leaseback activity with airlines seeking liquidity, continued trading activities and access to the capital markets for funding and as part of the trading cycle. True that there was a greater number of airlines on credit-watch than historically but in general the aircraft leasing world seemed to be relatively stable and, consequently, liquidity continued to be available for further investment into aircraft on-lease or for lease.
Lease Agreements and Risk Allocation
One of the rocks on which this stability was built is the legal instrument that is the operating lease. The operating lease embodies a distinct and deliberate risk allocation that is both logical and consistent with law. Whether as owner or lessee of an Aircraft, an airline is highly regulated in relation to safety, liability and insurance coverage among others. While the Lessor will need capability in these areas to manage its assets, it is not qualified to accept these responsibilities. The Airline leases aircraft with the intention to exploit for profit which, if successfully obtained, it will retain or distribute to its shareholders. There is no desire on either Lessor or Airline’s part for an arrangement whereby the operational burden is shared or the rewards of successfully exploiting the Aircraft are shared (other than by way of a fixed payment for use (the rent) for a fixed period (the term)). Other risk allocations are possible but would require important changes: in the UK rail industry, for instance, there are “damp leases” where the rolling stock is returned to the lessor (ROSCO) each night for maintenance before being redelivered the next day to the train operating company (TOC) but in this scenario the lease contracts are much longer and the ROSCOs are themselves regulated, creating a barrier to entry.
The operating lease risk allocation model has worked well to allow the major expansion of the world fleet of Aircraft that has taken place over the last twenty years. Low barriers to entry have allowed a significant expansion of the population of aircraft lessors and indirectly other investors whether through products such as JOLs or JOLCOs or through capital market vehicles. The world fleet is roughly half leased and half owned and generally this is also considered a desirable breakdown for an individual Airline’s fleet. The access to liquidity through the medium of competing aircraft lessors has allowed Airlines to enjoy very competitive lease rates.
The cornerstone of the risk allocation is that the contract is asymmetrical. The Lessor’s obligations will be limited: to deliver the Aircraft in an agreed condition (but once accepted by the Airline responsibility for its condition transfers), to ensure no interference by the Lessor or those claiming through it in the quiet enjoyment of the Aircraft by the Airline, return of any deposit, possible paying out maintenance reserves for qualifying expenditure and possibly contributing to the costs of implementing a mandatory Airworthiness Directive where the benefit of such compliance will also form part of the residual value after the lease term has ended. In return the Airline has all the extensive operational obligations and must pay the Rent in all circumstances. The obligation to pay the Rent continues through “Hell or High Water”. And this is the legal answer to whether any lessee is entitled to a Rental Holiday or to return an Aircraft asset: if the lease has been drafted properly (and no highly unusual concession given) the obligation to pay rent for the full term is absolute. Absent a specially negotiated termination for convenience, the lease term continues until its scheduled expiry. Force majeure does not apply (under English law - the position may differ under other legal systems – for instance leases between Chinese parties written under Chinese law where the issue of official Force Majeure certificates may have a different legal effect). A suggestion that the doctrine of Frustration could apply is in circulation but well drafted leases specifically exclude its application and, in the context of a lease of equipment, the occurrence of the virus does not affect the availability of the leased equipment or directly prohibit rent payment so the lease contract remains possible to perform and is not frustrated.
If only the commercial world were as simple as reciting the strict legal position. While Lessors may be entitled, legally, simply to decline requests for concessions on lease obligations, it is likely that requests for rental holidays are advance notice that rent will not be paid even though due because the reduction in ticket receipts has created a liquidity crisis at the Airline: “can’t pay, won’t pay”. The commercial reality may well be that Lessors will have to assess whether supporting an Airline in some way is likely to see a return to financial health when the COVID-19 crisis period has passed or whether any help is only delaying the end to a business that was struggling in any case. The choice Lessors face may, in practice, be whether to reach an agreement with an Airline to help it through this period or begin a process of discussion that could end up with repossession of an Aircraft that will be very difficult to place in the present market and an unsecured claim for future unpaid rent against an insolvent or barely solvent airline. It is not a great choice.
What could Lessors offer? The phrase “Rental Holiday” covers a multitude of possibilities. In practice Lessors offering support will want to defer payment only, not forgive. Effectively a standstill for a limited period with an agreed payment schedule to recapture the unpaid rents. It is likely that an Event of Default will have occurred under the Lease and so forbearance at a cost is an appropriate response. For Lessors with good liquidity and ambitions to grow and faith in the business model of the Lessee despite current challenges perhaps the deferral could be linked to commitments in terms of future leasing or sale and leasebacks (with a lease factor that does not start with a 5) of further equipment.
Other steps Lessors may wish to consider at this time might include regular updates on the charges which can lead to rights of detention: Eurocontrol and equivalent, air traffic controls, airport charges. If scheduled heavy maintenance is upcoming, greater scrutiny of what work is to be undertaken, where it will be undertaken and the costs. It may be worthwhile considering whether an Event of Default has occurred as part of the overall picture to aid possible solutions that later become necessary. Even if rent is current it is possible that a material adverse change may have occurred as a limb of a MAC is likely to refer to material adverse changes in the airline’s financial or operating condition. It is quite possible that there will also be an Event of Default for commencing negotiations to reschedule debts with a creditor by virtue of any request for a rent holiday.
If aircraft are the subject of financings, Lessors will need to consider what are their obligations under the terms of those financings in related to requests from the airline – are consents needed before a response can be given? At what point does the notice of assignment stop the Lessor dealing with the lessee and substitute the Security Agent? For managed aircraft there will be the need to consult with the aircraft owners and consideration will need to be given to how discussions with the lessee advance to ensure no discrimination between owned and managed leased aircraft.
In situations of impeding distress, it is likely that airlines seeking concessions will be making the same or similar requests of all their Lessors. Lessors will want reassurance that this is the case and that they are not being discriminated against. Negotiations often start with requests of individual creditors or specific groups of creditors but may swiftly escalate and lead to the restructuring of the wider business and its debt obligations, involving all creditors and other stakeholders.
Typically, the airline in distress would first attempt to implement a consensual restructuring with its creditors (outside of a formal insolvency process), involving the rescheduling of the airline’s debts, generally aimed at alleviating the liquidity pressure on the business. As part of such a restructuring, the airline may seek to set up a creditor committee to provide a platform for discussions. Lessors would be represented on such a committee, alongside other stakeholders. Whilst participation in such a financial restructuring is voluntary, the commercial reality may be that the alternative is a formal insolvency, with a potentially much lower recovery for the Lessors.
If the period of reduced travel because of COVID-19 continues, it may be difficult to agree financial restructurings with all creditors and stakeholders. In such instances, there are restructuring and insolvency tools which may be helpful. Under English law there are two: (1) a scheme of arrangement and (2) a company voluntary arrangement (CVA). Both processes may help to “cram down” certain creditors, but they have their limitations and should be viewed in that context.
- A scheme of arrangement involves a court-approved compromise with the company’s creditors (or any class of them), which has to be approved by at least 50% in number constituting 75% in value of each relevant class of creditors, in order to then bind creditors (which may include secured creditors). Schemes are used for the most complex cases only, as they are expensive and time-consuming.
- A CVA is a contractual arrangement between the company and its creditors, which broadly speaking, must be approved by at least 75% by value of creditors who vote and more than 50% by value of shareholders who vote. CVAs may bind all creditors, except that they cannot compromise certain rights of secured and preferential creditors. CVAs have recently been used by retailers to achieve reductions of rent payments to landlords. However, companies which implement CVAs often ultimately enter administration and there has also been a rise in challenges to CVAs.
Depending on the location of the centre of main interests of the affected airline, other local restructuring and insolvency tools may be applicable. Several European jurisdictions have been developing restructuring tools similar to an English scheme of arrangement recently – although some of these remain relatively untested at this stage for cross-border cases.
If COVID-19 impacts air travel for a protracted period, even schemes and CVAs or their local equivalents may only provide temporary assistance: a number of airlines may then face formal insolvencies. Recent UK airline insolvencies (such as Monarch and Thomas Cook) have been terminal, with the operations of the airline ceasing immediately upon it entering an insolvency process, aircraft grounded, and passengers stranded. This has been so that the funds available to the creditors of the airline in an insolvency process are not further depleted by the repatriation of passengers (which then is funded by the ATOL scheme and/ or taxpayers) although the costs of repatriation may be less with the significant reduction in flights and passenger numbers. This is very different from a US Chapter 11 bankruptcy process (that several airlines, such as American, Delta and United have all successfully used to restructure), which allows for operational continuity until the restructuring completes. Following the Monarch collapse, the UK Government has been reviewing airline insolvencies and considering whether a special administration regime for airlines would be appropriate, but no reforms have been implemented to date.
If the Government was minded to support any distressed airlines throughout the COVID-19 crisis, this would very likely be scrutinised, especially in light of the challenges to the rescue package to FlyBe as illegal state aid earlier this year.
Lessors will need to develop their strategy to meet the challenges that their customers face very quickly with the knowledge that refusing assistance might trigger payment defaults. This could quickly spiral into being forced to consider repossession or other action or may lead to airlines developing other alternatives where the freedom to negotiate individually is reduced or removed. The options available to airlines to restructure their business and debt will be jurisdiction specific, but it is likely that any restructurings will have to be agreed and implemented relatively quickly, in order to avoid airline collapses. Knowledge will be valuable in implementing a strategy. Ultimately, however, COVID-19 is going to continue to cause pain and this discussion is a commercial conversation about allocating that pain, and the timing of that pain, as between Lessor and Lessee.