Monthly Archives: October 2015

The “No Increased Obligations” Condition in the Assignment Section

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Absent unusual circumstances it is standard for the Lessee to take “day one” structure risk and “change in law/circumstance” structure risk throughout the lease term. As a practical matter, what this means is that if (1) tax withholding is imposed on rent payments (and the lessee must therefore gross up), (2) foreign exchange controls make payments more difficult or expensive or (3) any other requirement (legal or otherwise) is imposed on the lessee in connection with its performance of the lease agreement or its use of the aircraft, then the risk and burden of that requirement is on the lessee.

Aircraft lessors are fond of using the real estate leasing term “triple net lease.” In real estate a triple net lease is one in which the real estate lessee agrees to pay the following three (hence “triple”) costs (1) real estate taxes, (2) insurance costs and (3) maintenance costs related to the property; but in both real estate and aircraft leasing “triple net lease” is also used generically to mean that, as between the lessor and the lessee, the lessor bears no asset, operational or performance risks under the lease agreement.

Aircraft leases being “triple net leases” is a core concept of the aircraft leasing business and any deviation from that concept should be allowed only for compelling reasons.

That said, one exception to the “triple net lease” concept is often made in connection with the assignment of the lease by the lessor (usually accompanying the sale of the aircraft by the lessor or an affiliate). The assignment section of most lease agreements will contain a provision saying something like (paraphrasing):

“As a condition precedent to the lessor’s assignment of the lease, the lessee’s obligations under the lease will not, as determined at the time of the completion of such transfer, increase as a consequence of such transfer.”

That’s fair. The lessee should not be required to bear increased obligations as the result of a transfer to, say, a lessor based in another jurisdiction.

But now let’s look at a couple ways that lessors screw up this provision.

1. In the paraphrase above, note the clause “as determined at the time of the completion of such transfer.” This clause is key for at least a couple reasons.

First, if it is omitted a large part of the risk of change in law (post transfer) is shifted to the lessor if the new lessor is in a different jurisdiction from the transferring lessor. For example, if, post-transfer, tax withholding is imposed on lessee payments to the new lessor’s jurisdiction (and not to the old lessor’s jurisdiction), then the lessee will not be obligated to gross up. (I suspect some lessees would see not grossing up as the fair result, but it is contrary the concept of an aircraft lease being a triple net lease; that is, change in law is not a risk that aircraft lessors should take–either in a de novo lease or an assigned leases.)

Second, by not tying the “no increased obligation” condition to the time of transfer, the new lessor leaves itself open to spurious and not so spurious defenses for the rest of the lease term.

2. The “no increased obligation” condition should be just that–a condition, not a covenant. Once the lease transfer is accomplished, the condition should fall away and no longer be an operative provision (at least until the next transfer). I’ve seen some lessors fail spectacularly on this issue, not only making the “no increased obligation” provision a covenant but going on to give the lessee an explicit defense to performance, setoff rights, an express indemnity and lease termination rights if the lessee does have increased obligations.

Maybe I shouldn’t be so critical. Aircraft leases are commercial transactions and an outsider will never know about all the tradeoffs involved in a negotiation, but I suspect that a lessor which agrees to an on-going “no increased obligations” covenant in a transferred lease would never agree to take change in law/circumstance risk in a lease it originates.

Contingent Aircraft Insurance: The Exceptions Clause

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As counsel to aircraft lessors I’ve worked with the major brokers in the London insurance markets and have found that the guys (and occasional gal) that work there are on the whole professional, friendly, knowledgeable and very customer oriented, but (you knew the “but” was coming) as a lawyer I frequently am frustrated with the vague drafting of the insurance policies and insurance certificates coming out of London and the equally vague responses to my attempts to understand or clarify the wording.

A prime example of vague drafting are two coverage exceptions that have been in contingent aircraft insurance policies for at least the last 15 years. I’ll discuss those exceptions below, but first some brief background on contingent aircraft insurance.

As you know, each aircraft lessor requires an aircraft lessee to maintain hull/hull war and liability insurance on the lessor’s aircraft during the term of the lease. That insurance is, either directly or ultimately, usually placed through the London insurance market. The London market also sells (or tries to sell) “contingent insurance” directly to the aircraft lessors. Simply stated, contingent insurance covers the risk that the lessee’s insurance doesn’t pay the lessor after a valid claim is made by the lessor. Contingent insurance is generally sold on a fleet basis—that is, the insurance covers the lessor’s entire fleet of aircraft.

I would guess that most aircraft lessors buy contingent insurance. I consider contingent insurance an optional insurance (not a core, required business insurance), but it’s an insurance product that is hard not to buy. If a lessor does buy it and never has to make a claim, the cost is seen as just another cost of doing business—rarely thought about again. If a lessor doesn’t buy it and would have had a claim (or a potential claim), then somebody at the lessor is likely to be fired. I’m not suggesting that the only reason that executives at aircraft lessors buy contingent insurance is for job security, but it is one reason.

With the foregoing as background, let’s get back to the main topic: two coverage exceptions that limit the scope of the contingent insurance. I have seen these exceptions in various policies over the years but the language quoted below is from a policy I found online today through a Google search:

Principal Policy

This Policy does not cover loss or damage which is recoverable as a claim from the Principal Policy.

Insolvency and Financial Default

This Policy does not pay any claim for liability, loss or damage which is not recoverable (in whole or in part) as a claim from the Principal Policy by reason of the insolvency and/or financial default of an Insurer or Insurers and any amount claimed under a self insured retention within the Principal Policy.

Let’s start with second exception first. Contingent insurance does NOT pay if the primary insurance doesn’t pay because the primary insurer is insolvent. I suspect this fact will surprise some of you. London brokers and underwriters will tell you that this exception is required in contingent insurance policies because Lloyd’s underwriters are prohibited from providing “financial guarantees.” Also note that “insolvent” is not defined and so will likely be broadly construed by a contingent insurer facing a claim.

Now note that contingent insurance also does NOT pay if the primary insurance doesn’t pay “by reason of the . . . financial default of” the primary insurer. What does the “financial default” exception cover that isn’t already covered by the insolvency exception? And isn’t every failure to pay money a “financial default”? I have asked those two questions many times, and have yet to receive a satisfactory response.

Regarding the first exception, note that it does NOT say “this Policy does not cover loss or damage which is recovered as a claim from the Principal Policy”–in other words, you don’t get paid twice. What the above language says is the insured under the contingent policy does not get paid for any claim which is “recoverable” under the primary policy–presumably even if not actually recovered. What does “recoverable” mean? Only that the claim is within the scope of the primary policy? That can’t be right–otherwise no claim would be payable under a contingent policy. That the claim can be recovered if the claimant tries hard enough? Again I have repeatedly raised this issue over the years without a satisfactory resolution.

Some of you may be thinking that I just didn’t do a good job negotiating the language. Maybe, but I don’t think so.

When you look at the look at the two exceptions together a fair question to ask a London broker is: What potential claims under a contingent policy would not fall under one or both of those exceptions? In other words, what risks are actually being covered by contingent insurance? Yet another variation of the question: What are the details of actual claims that have been paid out (or denied) over the last several years?

I don’t mean the above to be a criticism of contingent insurance (I really don’t), but I do think the two exceptions discussed above illustrate the problems lawyers often have when dealing with the London insurance market. Lawyers are looking for clear, precise language that will lead to predictable outcomes over various fact patterns. And the London market operates using insurance forms and precedents that have been in place for years (and years) and that brokers and underwriters are loathe to modify.