Monthly Archives: August 2015

The Description of Aircraft in Purchase Agreements

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Here is my nomination for the “most overlooked important issue in an aircraft purchase agreement”: What exactly is the seller selling and the buyer buying?

I often see purchase agreements that have a definition of “Aircraft” in the definition section that reads as follows (paraphrasing):

“Aircraft” means one Boeing 737-800 aircraft bearing manufacturer’s serial number xxxxx, together with two Engines [defined elsewhere] and all parts, accessories, etc. installed on the aircraft on the Delivery Date.

Sometimes the definition will go into more detail by referring to a schedule to the purchase agreement which will contain APU and landing gear model and serial numbers. Sometimes the definition will also have a reference to “all associated aircraft documents.”

Now, if the aircraft is off lease, parked and available for inspection by the buyer, maybe the above summary description will not lead to any material disagreements later (although I would add to the above definition “in the condition as inspected by buyer on [date]”).

But if the aircraft is on lease and is being sold subject to lease or being sold upon return from lease then I think it is very important for both the buyer and seller (especially the buyer) to insist on a detailed description of the aircraft in the purchase agreement.

Keep in mind that most purchase agreements do not have a delivery condition or delivery inspection section. At most the purchase agreement will have a provision saying the buyer is not obligated to buy the aircraft if the aircraft has suffered damage in excess of an agreed threshold since the buyer’s inspection signoff. So, if an issue arises at closing about what is included with the aircraft, the buyer will have no “out” from its obligation to buy the aircraft.

When the aircraft being purchased is subject to lease, an acceptable shortcut description for the aircraft may be as follows (paraphrasing):

“Aircraft” means one Boeing 737-800 aircraft bearing manufacturer’s serial number xxxxx, together with two Engines [defined elsewhere] and all parts, accessories, etc. installed on the aircraft on the Delivery Date, as more fully described in the Lease Agreement and Lease Acceptance Certificate.

But of course then you need to be satisfied with the description of the aircraft in the lease documents. Hopefully the acceptance certificate in the lease has a LOPA, loose equipment list, document list, etc.

A real life example: I was doing due diligence on an aircraft purchase where the aircraft was subject to a lease and was going to remain on lease after purchase. The aircraft had been purchased by the seller new from the manufacturer as part of a sale-leaseback with the lessee. The lease agreement had the generic return condition requiring the aircraft be in the same configuration at return as at delivery, but otherwise the lease had no description of the aircraft (not really surprising given the aircraft was ordered from the manufacturer by the lessee). The lack of information about the aircraft was making me nervous and then I looked at the lease acceptance certificate and saw that the aircraft was delivered from the manufacturer with no passenger seats. When I kicked this issue back to the commercial people it turned out that neither the buyer nor the seller had realized that the aircraft was going to be returned from the lessee with no seats (and the lessee was well aware of this fact).

If you conclude that a detailed description of the aircraft is needed in your transaction, the next questions are (1) who is going to prepare the description and (2) how detailed does it need to be. I think the description has to be a joint effort between legal and technical and in most cases it can consist of references to existing documents, with the level of detail to be determined on a case by case basis–the goal not being absolute precision, but to avoid surprises later on.

Finally, if the aircraft is being sold subject to lease, you should consider whether you need/want the lessee to confirm (in the novation agreement) the agreed description of the aircraft.

Total Loss Only Cover

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I will admit upfront that some aspects of “total loss only” insurance cover still mystify me.

Some background (as always, from an aircraft lessor’s perspective): from time to time a lessee would approach me and ask whether it could satisfy the lease requirement for hull coverage on the aircraft at a specified agreed value (say US$50M) with a combination of (1) “normal” hull cover with a lower agreed value (say US$45M) and (2) a total loss only policy for the balance (US$5M). As the lessee would explain, the total loss only policy pays out only (of course) in the event of a total loss.

My first question would always be “why do you want to do that?” and the response would always be “because it’s cheaper.” I would then ask whether the underwriters were the same for both the hull and total loss policies and the answer was usually “yes” (or “I don’t know”). And when the lessee said “yes” I would ask “then why is it cheaper if the underwriters are taking the same risks as with a single hull policy with a higher agreed value?” I never got a clear or satisfactory answer to this question but I didn’t doubt that it was in fact cheaper.

From the lessor’s perspective the problem with using a combination of two policies to cover the risk normally covered by one policy is that the lessor may get whipsawed between the two policies when an accident occurs by, for example:

1. The hull underwriters taking the position the aircraft has suffered a total loss and the total loss underwriters disagreeing and saying the aircraft should be repaired, or

2. Both the hull and total loss underwriters taking the position that the aircraft should be repaired, but when the actual repair cost exceeds the agreed value of the hull policy, the lessor is required to cover the excess cost (and the total loss insurers are let off the hook entirely).

My strong inclination (from the lessor’s perspective) is to decline any such request because (1) of the potential for being whipsawed, (2) in insurance, “it’s cheaper” usually equates to “it offers less protection” and (3) in risk mitigation for lessors (whether insurance, security deposits, letters of credit, maintenance reserves, guarantees, etc.) simplicity of structure should be (IMO) a priority.

If a lessor does want to be cooperative and to consider the lessee’s request then in order to protect against being whipsawed the underwriters should confirm to the lessor (e.g., by way of an insurance certificate from the broker) that:

1. A total loss will be automatically declared under the total loss only policy if a total loss is declared under the hull policy, and

2. A total loss will be declared under the hull policy if the estimated cost of repair to the aircraft exceeds 75% (or a lower or higher percentage depending on the lessor’s comfort level) of the agreed value under the hull policy alone.

I have been successful in getting the underwriters to agree to the above and have been told (not sure I believe it) that the above is in fact how the policies are drafted.

As mentioned at the outset, the use of total loss only insurance cover still mystifies me. So, be careful and ask a lot of questions. And I would be especially wary if the total loss only cover is for more than 10% of the required agreed value.

Questions to Ask About a Proposed Engine FHA

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Here is a not uncommon situation:  You are a senior officer at an aircraft operating lessor.  One of your lessees has asked whether you would consider waiving engine performance restoration reserves for the remainder of the lease term (and returning the engine performance restoration reserves you now hold) in connection with the lessee entering into a maintenance agreement with the engine manufacturer (or some other third party, but for this discussion let’s assume it is an engine manufacturer).  The lessee tells you that engine manufacturer will agree to perform all performance restorations during the lease term and at the end of the lease term the engine manufacturer will “put the lessor in the same economic position as if the lessor had continued to collect reserves for the remainder of the lease term.”  The lessee then explains that the engine manufacturer will be charging a per flight hour fee for these services pursuant to a Flight Hour Agreement (or FHA) and the lessee does not want to pay both engine performance restoration reserves under your lease and the engine manufacturer’s per flight hour fee.  In addition, the engine manufacturer will be charging an “entry fee” for each engine on your aircraft to reflect utilization on such engine at the time that it enters the engine manufacturer’s program, hence the need for the return of the engine performance restoration reserves you already hold.  Sound familiar?

Let’s say you’re willing to consider this request.  You’ll be losing the use of the cash reserves in your possession and your finance officers have advised you of the cost of that loss.  In addition your legal and credit officers have reminded you that cash reserves are (much) better than a contract right for the same amount.  But you think there are good commercial reasons for considering the lessee’s request–maybe you want to place additional aircraft with this lessee.

Below are the questions that I think you should be asking the lessee and the engine manufacturer about their proposal.  I have provided some rough answers to the first three questions because they are the most important questions.  I will likely return to this topic later and deal with some of the other questions, but the answers to those questions will vary engine manufacturer to engine manufacturer (more so than the first three questions).

1. What happens at the end of the current lease term? At one time the engine manufacturers were willing (at least in my experience) to re-fund the reserve account at the end of the lease term so that the account held the same cash amount as if reserves had continued be paid (and drawn) during the lease term.  Assuming the engine manufacturer (or its relevant subsidiary) is creditworthy and assuming the lessor is willing to absorb the cost of not holding cash reserves during the lease term, this re-funding mechanism really did “put the lessor in the same economic position as if the lessor had continued to collect reserves for the remainder of the lease term.”  My experience lately however is that the engine manufacturers will offer only a “credit” towards a future performance restoration to be performed by one of the engine manufacturer’s shops;  the manufacturer may also agree to “fix” the price of that shop visit.  The calculation of the credit and the fixed price will be based on the engine manufacturer’s own formulae, not the formulae you have used in your lease.  And so in various senses the lessor will not be “in the same economic position as if the lessor had continued to collect reserves for the remainder of the lease term.”

The mechanisms for providing this credit and, if any, fixed price vary from engine manufacturer to engine manufacturer but in general there will be a written agreement between the relevant engine manufacturer and the lessor of the aircraft in which the credit and, if any, fixed price mechanisms are agreed.  I’ll refer to this as the “engine credit agreement.”

2. What impact will these arrangements have if you want to sell the aircraft subject to the current lease–that is, before the end of the current lease term? The buyer of the aircraft will need to review, accept and assume the rights and obligations of the seller under the engine credit agreement.  In most cases, the lack of cash reserves and the need to buy-in to the engine credit agreement is going to have a negative impact on the marketability of the aircraft and the purchase price.  The need to engage with the engine manufacturer during the sale of the aircraft will also complicate, and may delay, the closing of the sale.  (And at least one engine manufacturer requires the buyer to negotiate and enter into its own engine credit agreement de novo, and not simply take an assignment of the seller’s engine credit agreement (which the seller is prohibited from showing to the buyer).)

3. What impact will these arrangements have on the re-lease of the aircraft to a new lessee at the end of the current lease term? In a typical lease transition the new lessee will look to the lessor to provide maintenance credits reflecting the utilization of the aircraft on the delivery date to the new lessee–so that when the new lessee performs maintenance on the aircraft it may draw cash from the lessor to pay for such maintenance.  But where you as lessor have agreed to an engine credit agreement in connection with the current lease, all you will be able to offer the next lessee is a credit (or as a former colleague of mine called it, a “gift certificate”) for use in connection with a performance restoration performed by the engine manufacturer.  The new lessee is going to have various concerns here:

(a)  The new lessee will be required to have its engine performance restoration done by the engine manufacturer if it wants to use the credit;  that is, the new lessee cannot “shop around.”

(b)  The new lessee will be required to pay the fixed price agreed by the lessor–or, if there is no agreed fixed price, the new lessee will be subject to whatever the engine manufacturer charges at the time.

(c)  The workscope and other relevant terms of the performance restoration (see 8 below) will likely be agreed in the engine credit agreement and not open for negotiation by the new lessee.

The effect of the above is that a potential next lessee will look elsewhere for its aircraft needs or, more likely, will look to the lessor to fill any gaps with additional maintenance credits and/or rent concessions and/or other commercial concessions.

4. What happens if the current operator defaults in its obligations under the FHA or terminates its obligations under the FHA?

5. What is the workscope for the engine performance restorations to be performed under the FHA? And will the performance restorations under the FHA during the current lease term (a) meet the requirements for performance restorations under your lease agreement, (b) allow the current lessee to meet its return requirements and (c) result in the engines being in the same or better condition at return (than without he FHA)?

6. What is the expected cost of the “fixed cost” engine performance restoration? How does that cost adjust based on utilization and inflation and other factors?  Is there a per annum assumed floor for inflation (that is, even if inflation is zero in any one year does the cost will still increase by a minimum stated percentage)?  What if the market price charged by the engine manufacturer (or other engine overhaul shops) for a performance restoration at the time of your performance restoration is less (maybe way less) than the fixed price?  Are there exceptions (e.g., FOD) to the fixed cost where the new lessee loses the benefit of the fixed cost agreement?

7. What is the workscope for the engine performance restoration to be performed under the engine credit agreement? Does the engine credit agreement allow for the workscope to be modified, and with any fixed price to be as adjusted?

8. What are the other terms for the engine performance restoration? Keep in mind here that you’re essentially contracting for an engine performance restoration possibly 10 to 15 years (or longer) from signing.  All the terms that you would normally negotiate in an engine performance restoration agreement (workscope, performance criteria, warranties, turn time, etc.) should be addressed in the engine credit agreement.

9. What happens if there is an engine total loss (either as part of an aircraft total loss or where only the engine is lost) during the current lease term? Does the accrued credit transfer to the replacement engine or get paid to the lessor in cash?

10. What happens if there is an engine total loss (either as part of an aircraft total loss or where only the engine is lost) after the current lease term but before the performance restoration is performed under the engine credit agreement? Is the credit lost?  Or does the lessor get the equivalent of the credit in cash?

11. What if during the current lease term you want to swap an engine subject to the engine credit agreement to another airframe in your fleet at the same operator–or at a different operator?

12. What if during the current lease term you want to sell an engine subject to the engine credit agreement in connection with an engine swap with the current operator?

13. Do the FHA and engine credit agreement effectively prohibit subleasing of the aircraft by the current lessee?

14. Is the engine manufacturer’s consent or cooperation required in connection with any early termination or extension of the lease term for the aircraft?

My guess is that you have thought of additional questions as you have read the above.  The above list of questions is not exhaustive.  Feel free to send me an email if you think I should add other questions to the above list.

Dealing with Maintenance Reserves in the Novation Agreement

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Buying used commercial aircraft where the aircraft is on lease to an airline is often seen by the transaction participants (buyer, seller and (if any) lender) as a straightforward and simple transaction.  The buyer and seller agree the purchase price for the aircraft and then get the cooperation of the lessee to the transfer of the lease and, voila, the deal is done.  Aircraft finance lawyers know it’s not quite that simple, but compared to other aircraft transactions, aircraft sales are definitely on the lower end of complexity spectrum.

Aircraft sales and lease transfers do however have many traps for the unwary and one of the biggest traps involves the transfer of the aircraft maintenance reserve balances and responsibilities from the seller to the buyer.  Both the buyer and seller of the aircraft are well aware that the reserves balances need to be transferred as part of the aircraft sale, and the commercial and finance officers on both sides will spend time agreeing between themselves the reserve balances at the time of the closing.  The transfer of the reserves at the closing usually is usually accomplished by netting the agreed amount from the purchase price paid by the buyer.

Sometimes overlooked in these transactions are one or more of the following matters between the buyer–as the new lessor–and the lessee. All of these matters should be addressed in the lease novation (or assignment).  A misunderstanding between the new lessor and the lessee on any one of these issues could lead to a very expensive and acrimonious argument.

1. The new lessor and the lessee should agree the per-hour/cycle/month reserves amounts in effect on the date of closing. These amounts are usually stated as base amounts in the lease documentation and are subject to adjustment for escalation/inflation and for variations from assumptions regarding hour-to-cycle ratio, minimum utilization and other similar operational measurements.

2.  The new lessor should also check to make sure these adjustments (often done on annual basis) have been done in accordance with the lease documentation and on a timely basis throughout the current lease term. At a minimum the new lessor should ask the lessee to confirm in the lease novation that the lessee will not, after the purchase, request a retroactive adjustment because the previous lessor had skipped, missed or made a mistake in a prior adjustment.  Keep in mind that the reserve adjustment provisions in some lease agreements provide for retroactive credits to the lessee, and the new lessor does not want to get an unexpected reimbursement request after the purchase closes.

3. The new lessor and lessee should agree the individual reserve balances as of the last day of the month before the closing. It is common for the lessee and lessor to disagree over these amounts, often because one or the other or both have made simple bookkeeping mistakes along the way or used slightly different methodologies.

4. Where the aircraft delivered to the lessee was not new the lessor will usually have agreed in the lease agreement to provide maintenance credits (aka lessor contributions) to the lessee to reflect utilization since new or since last overhaul at the time of delivery. These lease agreement provisions are, unfortunately, often loosely drafted and when that happens these provisions give rise to high-dollar value arguments between the new lessor and the lessee.  In a perfect world the original lease agreement should provide actual dollar amounts for each of the credits, but in many (maybe most) cases the lease agreement will say something like (paraphrasing) “to the extent the reserves are not sufficient to cover the cost of the first relevant maintenance visit lessor will contribute an amount up to the product of (1) the relevant reserve rate and (2) the number of hours/cycles/months (as relevant) at delivery since the last such maintenance visit.”  If so, the issues will be as follows:

(a)  Is the reserve rate the base reserve rate–or is it the rate as escalated and otherwise adjusted through the date of the maintenance?  While the per hour/cycle/month difference in the dollar amounts may be very small, the aggregate amount can easily be hundreds of thousands of dollars.

(b)  When was the last “relevant maintenance visit”?  In other words, what is the starting date for the calculation?  Sometimes this date is hard to determine, especially with engines and APUs and even with airframes where the airframe manufacturer has changed the interval and/or scope of the relevant check during the lease term.

So, unless the lease agreement is crystal clear on these issues, in the lease novation the new lessor should agree with the lessee either the actual dollar amounts of the maintenance credits or at least the relevant per hour/cycle/month credit amounts and the date of the “last relevant maintenance” for each credit.

Also, the new lessor and the lessee should agree in the lease novation which maintenance credits have already been satisfied by the selling lessor.  For the most part this last issue should be non-controversial.  The exception may be for maintenance credits for engine LLPs, for which lessors have lots of different approaches as to how they collect and reimburse reserves and apply maintenance credits.  I’ll write more about engine LLPs at another time.  In the meantime, tread carefully.

(Whether, when and to what extent the seller transfers the remaining maintenance credits to the buyer is a separate topic for discussion later.)

5. The new lessor should have the lessee confirm that, at the time of the purchase closing, the lessee has not performed any reimbursable maintenance for which the lessee has not been reimbursed–or if that is not correct, then the relevant maintenance and (if possible) the reimbursement amount should be specified in the novation. The buyer/new lessor has based its purchase price in part on the maintenance condition of the aircraft and the reserve balances.  It will be a very unpleasant shock to the new lessor to learn that it has to reimburse the lessee for maintenance for which the new lessor had thought the lessee had already been reimbursed.

The above is more than I intended to write, but this is a complex topic and there is more to say.  I’ll come back to this topic at a later date and talk about, inter alia, engine LLPs, the transfer of maintenance credits and the transfer of leases where return compensation (instead of maintenance reserves) is payable.

The Importance of Transaction Checklists

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I’m a big believer is developing and using checklists in connection with legal work in general, not just in connection with transaction closings.  And to that I’m sure a lot of you will say “no duh, Brad.”  But in my experience many lawyers don’t use checklists even in connection with transaction closings and those that do often prepare the checklist just a couple days before the scheduled closing–often too late to effectively manage what needs to get done.  Instead I suspect many lawyers and paralegals rely on memory, email chains, Post It notes, and the conditions precedent sections of the relevant documents.

A well thought out transaction checklist prepared early in a transaction (at the latest when primary transaction documents are agreed) will allow a lawyer to spot logistical, commercial and other issues well in advance of the closing.  It will also provide a central location for keeping track of the status of the checklist items, developments and changes in the transaction and any other ideas and thoughts relevant to the closing of the transaction.  A checklist is also a great way to share information among the lawyers and paralegals on a deal.

When I see a young lawyer or paralegal overwhelmed with the logistics of an upcoming closing my advice is usually something like this:  “After the transaction documents are signed, closing a deal is relatively easy.  Make a detailed list of all the things that need to get done for the deal to close, and then make sure each item gets done.  That’s it.  Look at each item on the list at least once every day and ask yourself ‘what can I do to move this item forward right now?’ and then do it.  Closing a deal involves a finite number of steps; you just need to identify them and make sure they get done.”

Here’s a link to a New Yorker article about checklists.  The article is about the use of checklists in the medical profession, which use is unfortunately not as prevalent as you may expect (and hope).  (The article also has an interesting discussion of the introduction of checklists for pilots.)  Below is an excerpt about a medical checklist:

“In 2001, though, a critical-care specialist at Johns Hopkins Hospital named Peter Pronovost decided to give it a try. He didn’t attempt to make the checklist cover everything; he designed it to tackle just one problem, the one that nearly killed Anthony DeFilippo: line infections. On a sheet of plain paper, he plotted out the steps to take in order to avoid infections when putting a line in. Doctors are supposed to (1) wash their hands with soap, (2) clean the patient’s skin with chlorhexidine antiseptic, (3) put sterile drapes over the entire patient, (4) wear a sterile mask, hat, gown, and gloves, and (5) put a sterile dressing over the catheter site once the line is in. Check, check, check, check, check. These steps are no-brainers; they have been known and taught for years. So it seemed silly to make a checklist just for them. Still, Pronovost asked the nurses in his I.C.U. to observe the doctors for a month as they put lines into patients, and record how often they completed each step. In more than a third of patients, they skipped at least one.

“The next month, he and his team persuaded the hospital administration to authorize nurses to stop doctors if they saw them skipping a step on the checklist; nurses were also to ask them each day whether any lines ought to be removed, so as not to leave them in longer than necessary. This was revolutionary. Nurses have always had their ways of nudging a doctor into doing the right thing, ranging from the gentle reminder (“Um, did you forget to put on your mask, doctor?”) to more forceful methods (I’ve had a nurse bodycheck me when she thought I hadn’t put enough drapes on a patient). But many nurses aren’t sure whether this is their place, or whether a given step is worth a confrontation. (Does it really matter whether a patient’s legs are draped for a line going into the chest?) The new rule made it clear: if doctors didn’t follow every step on the checklist, the nurses would have backup from the administration to intervene.

“Pronovost and his colleagues monitored what happened for a year afterward. The results were so dramatic that they weren’t sure whether to believe them: the ten-day line-infection rate went from eleven per cent to zero. So they followed patients for fifteen more months. Only two line infections occurred during the entire period. They calculated that, in this one hospital, the checklist had prevented forty-three infections and eight deaths, and saved two million dollars in costs.”

I’ll come back to this topic later and discuss checklists for other legal tasks, like document review.