“Underlying Transaction Doesn’t Violate Law” Exception in a Letter of Credit

As a lawyer representing leasing companies I hate letters of credit. Kinda harsh I know, but read on.

The LC most common in aircraft leasing is the standby LC. It is usually issued in lieu of the lessee paying the security deposit and sometimes in lieu of the lessee paying maintenance reserves, and it is usually drawable by the lessor upon the occurrence of an event of default by the lessee under the lease documentation.

Lessees sometimes prefer to provide LCs rather than a cash deposit or cash reserves because the lessee needs/wants the cash for itself and the LC costs imposed by the bank issuing the LC are (sometimes) low enough for the lessee to justify agreeing to those costs and providing the LC in lieu of cash.

Lessors of course prefer to receive and hold the cash, but the use of an LC by the lessee is often a negotiating point during the lease negotiations, and it is common for the lessor to agree to accept an LC in lieu of a security deposit (much less common is the lessor accepting an LC in lieu of maintenance reserves).

During these negotiations on the LC issue, I will hear from the lessee (and sometimes from the lessor’s own commercial people) “an LC is the equivalent of cash.” That is never true in a strict sense and, depending on the form of the LC and other factors , often not true in a meaningful sense.

An LC gives the beneficiary (the lessor) a right to payment from the issuing bank upon certain conditions and requirements being met. The primary job of counsel for the lessor is to make sure those LC conditions and requirements are minimal and are able to be easily satisfied by the lessor; that is, the primary job of counsel for the lessor is make sure the LC is as close as practical to the “equivalent of cash.”

The reason I hate letters of credit is because at the time the lessor wants to draw a letter of credit neither the issuing bank nor the lessee (as the LC account party) will want the lessor to get paid under the LC–the issuing bank will be worried about not being repaid by the lessee (and/or becoming involved in litigation/bankruptcy proceedings) and the lessee will be worried about the commercial consequences of an LC draw after default. Both will be looking for excuses allowing the issuing bank not to pay the lessor under the LC. On the other side, the commercial officers at the lessor will be expecting prompt payment under the LC–after all, “it is the “equivalent of cash, right Brad?”

With the forgoing as background, I’ll discuss one somewhat common LC provision that should be struck by the lessor’s counsel from any LC draft.

From time to time I will see a broad illegality exception in an LC providing that the issuing bank is not obligated to pay under the LC if the underlying transaction is illegal. When I see this exception it can usually be traced to a current political or regulatory event that is making banks more cautious at that time. For example, I saw the following language in a draft LC last year at the height of the crisis in Ukraine and when the US and EU were imposing sanctions against Russia (even though neither the LC nor the underlying transaction had any connection to Russia or Ukraine):

No party which is sanctioned by the United Nations, United States or the European Union, or United Kingdom, is to be involved in the transaction in any manner. We may not complete a transaction which involves such a party, or any party in the above countries.

Wow. Ignoring the really bad drafting (what countries are being referred to in “or any party in the above countries”?), that provision is way too broad. Let’s give the bank of the benefit of the doubt and assume what it was trying to say was something like:

We will not be obligated to make any payment hereunder if the transaction underlying this letter of credit is illegal.

When first reading that exception, a reasonable lawyer might think “hmm, that sounds right–the bank shouldn’t be obligated to be involved in an illegal transaction.” But the second time the lawyer reads the exception he should think the following:

1. Wait a minute, should the bank be excused for paying under the LC if the underlying transaction is illegal or only if the payment itself by the issuing bank is illegal?

2. Who bears the risk of illegality under the underlying transaction documents, and more importantly why is the LC addressing a risk normally allocated between the parties in the underlying transaction documents?

3. If the LC is supposed to be a cash equivalent, then shouldn’t the LC issuer be obligated to pay regardless of illegality of the underlying transaction–so that the lessor is put in the same position as if it had held cash? Isn’t this especially true if the illegality arose during the performance of the underlying transaction?

4. LCs are supposed to be separate and independent from the underlying transaction. Some LCs state this expressly, and even where they don’t the LC rules incorporated by reference do (see UCC 600 Article 4 (“A credit by its nature is a separate transaction from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such contract, even if any reference whatsoever to it is included in the credit. Consequently, the undertaking of a bank to honour, to negotiate or to fulfil any other obligation under the credit is not subject to claims or defences by the applicant resulting from its relationships with the issuing bank or the beneficiary.”) and ISP98 Section 1.06(a) (“A standby is an irrevocable, independent, documentary, and binding undertaking when issued and need not so state.”)).

In conclusion, be very wary of any exception to the issuing banks obligation to pay under an LC. Your lessor client is going to be anxious during the draw process and very disappointed with a failed draw. As a general rule you should review a draft LC with the same intensity and care as you would read a final LC after your client has called and told you to draw the LC.

Treatment of Engine LLP Reserves in Lease Agreements

Last month I wrote about the most (IMO) overlooked important issue in an aircraft purchase agreement–the description of the aircraft. This post is about the least understood and most neglected (again IMO) section of lease agreements–the maintenance reserve provisions as they relate to engine LLPs.

Some lessors do understand the issues related to engine LLP reserves, and the lease agreements from those lessors reflect that understanding, but for purposes of this post let’s assume we are reviewing a lease agreement with an engine LLP reserve provision that reads as follows (paraphrasing):

Lessee will pay on the 10th of each month with respect to the LLPs on each Engine a maintenance reserve amount of US$200 for each cycle of utilization on such Engine during the previous month.

In the event Lessee replaces LLPs on an Engine during the Lease Term Lessor will reimburse Lessee for the cost of the replacement LLPs from the LLP maintenance reserves paid by Lessee for such Engine.

If an Engine was delivered to the Lessee by the Lessor on the Delivery Date other than with zero time on the LLPs, then to the extent the reimbursement from the LLP maintenance reserves is insufficient to fully reimburse Lessee for the cost of the replacement LLPs Lessor will contribute a further amount up to the product of US$200 and the number of cycles of utilization on the LLPs on the Delivery Date.

Ignoring the imprecise drafting (I did say I was paraphrasing!), how many conceptual errors can you find in the above? Here are the ones I see:

1. First and most importantly, note the above drafting treats the LLPs as a pool. LLPs on an engine may have different manufacturer-mandated cycle-lives and an LLP may fail or be removed before its expected cycle-life. In addition, used LLPs are sometimes installed on an engine as replacement parts. So an engine with 15 LLPs may have 15 different LLP cycle-lives remaining.

If all LLPs stayed installed for their expected life and were always replaced with new LLPs, then treating the LLPs as a pool for maintenance reserves purposes should (I think) work out over time. But if an LLP fails early and needs to be replaced or an LLP needs to be replaced early to comply with an engine overhaul build standard, then under the above drafting a lessee could draw the full cost of the replacement LLP from the reserves and lessor contribution, thereby depleting the reserve pool and lessor contribution out of proportion to the part replaced.

For example, a lessee takes delivery of a used aircraft and operates it for six months, paying US$240,000 in LLP reserves on an engine, before an LLP costing US$400,000 fails. Under the above drafting the lessee could draw the entire US$240,000 plus up to $160,000 of the lessor contribution for the replacement of one LLP.

I can hear some of you saying “what’s wrong with that, the LLP reserve balance is then zero and the lessor contribution is reduced and so the next time the lessee needs to draw for an LLP replacement, it may need to come out of pocket for the cost, right?” Yes, but the problem is that lease terms do not go on forever and at some point the aircraft will need to transition to a new lessee, who will likely be smart enough to ask for a lessor contribution based on its calculation of the cycles used on each LLP; and if the reserves and lessor contributions under the current lease have been depleted through the replacement of a few parts the lessor will need to make up the difference.

To put it another way, treating the LLP maintenance reserves as a pool effectively shifts a lot of the risk of early LLP removal to the lessor. So, the first conceptual error is that LLP reserves and lessor contributions are not tracked on a per part basis.

2. Note that the above drafting does not require the replacement LLP to be new. Replacement of failed or (soon to be) expired LLPs with used LLPs is common practice; there are various legitimate reasons for a lessee to install a used replacement LLP instead of a new LLP. But if a Lessee does install on used LLP there should be limits on the lessor’s reimbursement obligation. For example, let’s say a lessee replaces an LLP with a used LLP that had exactly the same number of cycles as the replaced LLP had on the date the aircraft was delivered to the lessee? Should the lessee be entitled to draw on the LLP reserves allocated to such part? Yes, because the LLP has paid for the time used and is returning the LLP to is original (delivery date) condition. Should the lessee be entitled to make a claim against the lessor contribution for such part? No, because the lessee has not improved the condition of the LLP from its original (delivery date) condition.

As you can imagine there are numerous possible fact patterns to address when dealing with both new and used LLPs and both maintenance reserves and lessor contributions–and the drafting in the lease can get complex–but for purposes of this post just realize that if the lease documentation allows the installation of used LLPs then you need to be very careful how the reserve reimbursement and lessor contribution sections are drafted.

3. Note that the above drafting does not say lessor will reimburse lessee only for the lessee’s net cost of the replacement LLP. The cost of the LLP may be reduced in various ways that won’t be obvious from the invoice that the lessee provides the lessor with the lessee’s reimbursement request. For example, the removed part may have salvage value. Also, the engine manufacturer may have a deal with the airline to provide a credit or rebate in connection with the purchase of LLPs, especially if the LLP comes off early. It may be difficult to determine the lessee’s “true net cost” of an LLP, but at a minimum the lease agreement should contain some general language providing for the netting of salvage value, credits and rebates.

4. The above drafting assumes that the cycle-life of an LLP will not change after installation. If cycle-life is reduced (fortunately a rare occurrence) then the lessor should have the option to adjust upwards the per cycle reserve amount. Of course the lessor may have to concede that the reserve amount be adjusted downwards in the event that cycle-life on one or more of the LLPs is extended.

Finally, I have yet had to deal with this issue but I understand that at least one engine manufacturer is looking at assigning LLP cycle-life on an operator by operator basis–with each operator to be assigned into one of two categories–with some operators being allowed a longer cycle-life and some restricted to a shorter cycle life. The issues here for an operating lessor are obvious and scary, both in the calculation and collection of LLP reserves and the drafting of LLP return conditions. After I gain some real life experience on this issue I will revisit it in a post.

Default Grace Period for the Return of an Aircraft

A well drafted lease (or at least the first lessor draft) will have as a separate event of default the failure of the lessee to return the aircraft at the termination of the lease term, with either no or a very short default grace period for the lessee. In other words, the lessor does not want the general covenant grace period (sometimes as much as 30 days (or, ugh, longer)) to apply to the return of the aircraft. In a good and just world the lessor will have another lessee lined up to take delivery of the aircraft upon return from the current lessee, and the lessor does not want to annoy the next lessee with a delivery delay (even if the current lessee continues to pay rent until the actual return). So usually a lessor will require a timely and compliant return, with the right to call an immediate event of default if the lessee fails to return the aircraft in the required return condition on the last day of the scheduled lease term.

Lessees often push back on this immediate event of default, using a couple different arguments:

1. A late return may be caused by a number of factors outside the lessee’s complete control, including problems with the return MRO (e.g., lack of manpower), problems discovered during the return maintenance and inspections (e.g., engine defects discovered during borescopes) and unreasonable lessor inspectors; therefore the lessee argues it should be given a grace period to avoid the problems it may have (usually triggered cross defaults under other leases and financings) if an “Event of Default“ under a lease were to be triggered immediately by a late return.

2. Somewhat more persuasively, the lessor has in all likelihood given itself a grace period on its obligation to deliver the aircraft to the lessee; so, as the lessee will argue, it is fair for the lessee to have a grace period at the end of the lease term. The counter-argument by the lessor is that in most cases the lessor is relying on the returning lessee (or the manufacturer) to meet its obligations and the lessor therefore cannot guarantee (and does not control) the actual delivery date of the aircraft. This counter-argument, in my experience, almost always fails to win the day.

I’ve seen some lessees carry this issue to the extreme by saying that the lessee should have a lengthy return grace period (more than a couple months) and ultimately be obligated only to use reasonable efforts to place the aircraft in return condition by the required date; if the lessee fails to put the aircraft in the required return condition after reasonable efforts then the lessee, in its view, should be able to simply return the aircraft in its then “as is” state. This position effectively shifts aircraft return condition/maintenance risk from the lessee to the lessor–and an aircraft lessor’s Prime Directive should be “don’t take aircraft condition/maintenance risk.” EVER.

What can the lessor offer to the lessee that addresses the lessee’s concerns without losing money, losing the next lessee or shifting aircraft condition/maintenance risk from the lessee to the lessor? Here are my thoughts:

1. The simplest and most reasonable approach is to agree a grace period in the aircraft return event of default, the shorter the better, but any grace period should be conditioned upon (a) the aircraft having been removed from commercial service a reasonable time before the scheduled return date to allow for all return inspections and maintenance, (b) the aircraft not being placed back in commercial service or otherwise flown except in connection with the return inspections and maintenance, (c) the problem or problems causing the delay not having been reasonably foreseeable and avoided and (d) the lessee using all responsible efforts to complete the return as soon as practical.

The lessor should make sure that any grace period is well within the grace period the lessor will likely obtain in its commitment to deliver the aircraft to the next lessee.

2. A lessor should also provide for increased rent during any grace period or maybe a per diem “delay fee.” A return delay, especially one that drags on day-to-day, will result in significant costs to the lessor (primarily the costs of the onsite employees and consultants) and the lessor should be compensated for those costs.

Be very careful about increased rent or fees after the grace period because the lessee may argue that the increased rent is liquidated damages (or an election of remedies) precluding a claim for actual damages for a late return.

3. If a lengthy grace period is agreed, the lease should provide for a lease extension at an agreed rent at the lessor’s option if the aircraft has not been returned by the end of the grace period. The lessor should make sure that it has a complimentary delivery “out” with the next lessee–otherwise this option is useless.

4. Most leases will contain a provision allowing the lessor, at its option, after an a return event of default to take the aircraft back “as is” and complete the return maintenance itself. The lease agreement should be clear that any costs incurred by the lessor in performing the remaining return maintenance are to be reimbursed by the lessee and that the lessor taking over the return maintenance does not relieve lessee of its other obligations under the lease or waive any remedies available to the lessor arising out of the return event of default (such as retaining any security deposit).

In sum, a lessor can address the lessee’s concerns with missing the scheduled return date without substantial hardship, but the general point to make to lessees on this issue is that any solution needs to reflect the basic commercial agreement between the lessor and the lessee that the lessee is fully responsible for the condition and maintenance of the aircraft.