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.