Monthly Archives: November 2015

Cross-Operational Indemnities in Aircraft Purchase Agreements

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Despite often referring to themselves as “aircraft suppliers,” aircraft lessors are more accurately described as aircraft financiers who also take residual aircraft value risk. In an aircraft lessor’s perfect world, the lessor would never take possession of an aircraft or become involved in the manufacture, configuration, maintenance, repair or operation of an aircraft–because all of those things open the lessor up to claims from a lessee and possibly from third parties in the case of an accident involving the aircraft. In general, aircraft lessors will go to great lengths to avoid taking any risks associated with the physical (as opposed to financial) aspects of an aircraft.

The Disclaimer and General Indemnity sections of the lease agreement reflect this distancing of the lessor from the aircraft. The Disclaimer and General Indemnity sections of an aircraft lease agreement provide that, respectively, (1) as between the lessor and the lessee, once the aircraft is delivered to the lessee, the lessor has no responsibility or liability with respect to the condition of the aircraft and (2) during the lease term the lessee will bear all risks and costs, and will indemnify the lessor for all claims, arising out of the operation, maintenance, etc. of the aircraft. Lessees understand this allocation of risk and responsibility, and it’s rarely questioned in any meaningful way during the negotiation of the lease documentation. “Lessors don’t take operational risk” is a fundamental tenet of the aircraft leasing business.

And so I’m always surprised when I’m working on an aircraft purchase agreement and the lawyer on the other side (representing another aircraft lessor) says “my client insists on cross-operational indemnities in the purchase agreement.” Cross-operational indemnities in this context mean that (simplifying) the seller indemnifies the buyer for claims arising out of the operation of the aircraft prior to the purchase and the buyer indemnifies the seller for claims arising out of the operation of the aircraft after the purchase.

Here’s the seller half of a cross-indemnity (redacted) from a draft agreement I reviewed (representing the buyer):

Without prejudice to the disclaimers in Clause 7 (Condition of Aircraft), the Seller shall indemnify the Purchaser in full on demand on a net after-Tax basis in respect of all Losses suffered or incurred by the Purchaser or any of its officers, directors, employees, servants, representatives or agents arising out of or connected in any way with . . . the purchase, manufacture, ownership, possession, registration, performance, transportation, management, sale, control, use, operation, design, condition, testing, delivery, leasing, maintenance, repair, service, modification, overhaul, replacement, removal or redelivery of such Aircraft, or any loss of or damage to the Aircraft, or otherwise in connection with the Aircraft or relating to loss or destruction of or damage to any property, or death or injury to any Person caused by, relating to or arising from or out of (in each case whether directly or indirectly) any of the foregoing matters and regardless of when the same arises or occurs, or whether it arises out of or is attributable to any act or omission, negligent or otherwise of the relevant Purchase . . . provided that such indemnities shall not extend to Losses . . . to the extent that such Losses arise out of any occurrence or event which occurs after Delivery in respect of such Aircraft.

There was a mirror indemnity given by the purchaser.

In this particular transaction, the aircraft was being sold subject to lease. So, my first question was “why do we need cross-indemnities given that, pursuant to the lease novation, both the purchaser and the seller will be covered by the lessee’s operational indemnity and by the lessee’s insurance?” I also pointed out that as aircraft lessors we usually strenuously try to avoid ANY operational risk on aircraft, but in the draft we are each expressly taking broad, unlimited operational risk for an aircraft operated by a third party. The actual response I received: cross-indemnities are “standard.”

A better response would have been something like “cross-indemnities just fairly allocate existing risk between the purchaser and the seller, they don’t create any risk that isn’t already there.” Well said, but (1) do the cross-indemnities really allocate the risk fairly and (2) would the parties be better off without the cross-indemnity? The same question another way: Does the before-after split really allocate the risk fairly?

One example: seller and buyer agree to cross-indemnities using the above wording and the sale/purchase of the leased aircraft closes. The aircraft crashes and there are lawsuits for injury/death and property loss. Neither the seller nor the purchaser was at fault (no negligence or other misconduct), but the jurisdiction where the aircraft crashed is a strict liability jurisdiction that imposes liability on the owner of the aircraft regardless of fault (e.g., Sweden last time I checked). The cause of the aircraft crash was faulty maintenance by the operator that occurred prior to the sale of the aircraft. Without the cross-indemnities, the purchaser, as owner at the time of the crash, would bear the full liability for the crash (as between the purchaser and the seller); with the cross-indemnities, the seller bears the full liability. Reasonable people could argue about which is the “fair” result, but for the seller the cross-indemnities definitely created an operational risk that it did not have before (once it sold the aircraft).

Another example: Same as the above except the lessee had a history of sloppy recordkeeping of which the seller was aware, but the seller did not tell the purchaser. The crash–in a non-owner strict liability jurisdiction–was the result of bad recordkeeping that occurred after the sale of the aircraft. The purchaser was wholly unaware of any recordkeeping problem. The seller is sued because it was aware of the sloppy recordkeeping, and the seller makes a claim under the cross-indemnity. The cross-indemnity would put at least some (and possibly all) of the seller’s liability on the purchaser–an unfair result in my opinion.

My preference in purchase agreements is to not include operational cross-indemnities and, by remaining silent, to make each party responsible for managing its own liability with respect to the aircraft–regardless of whether that liability could be characterized as arising before or after the sale.

What about naked aircraft (that is, aircraft not on lease at the time of sale)? I think it is the same answer. Parties should manage their own liability (through insurance, prior and future operator indemnities, due diligence, etc.) without assuming broad, uncapped liability under cross-indemnities in a purchase agreement.

P.S., bonus points to those of you who paused on clause “Without prejudice to the disclaimers in Clause 7 (Condition of Aircraft), . . .” in the quoted language above. Yes, I too wonder how that would undercut the seller’s indemnity. Even without that clause, I think you still have a possible conflict between the seller’s disclaimer and the seller’s cross-indemnity. The above clause would make more sense if it said “Notwithstanding the disclaimers in Clause 7 (Condition of Aircraft), . . . .”

Who Bears the Risk of Loss in Value After an Aircraft is Damaged?

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Every lessor has horrifying examples of heavy damage to one or more of its aircraft—the tail strike on takeoff, the hard landing, the landing with the landing gear retracted, the exploding grenade perforating the fuselage, the aircraft leaving the runway and sinking in the mud, etc. Whether the damage constitutes a “total loss” of the aircraft for insurance purposes is often clear, and where not clear the lessor, the operator and the underwriters will negotiate to determine whether to attempt repair or declare a total loss. In these negotiations, the underwriters will generally favor repair (because it is cheaper than paying out the aircraft agreed value) and the lessor will favor declaring total loss (because it wants to receive the agreed value, which is usually in excess of the lessor’s book value). The oft quoted full of thumb is that if the expected cost of repair will exceed 75% of agreed value, then the underwriters will declare a total loss.

In those cases where the aircraft is repaired after heavy damage the airframe manufacturer will be involved in the repair planning and often will perform or manage the repair, and the airframe manufacturer will, at least as a practical matter, be the final arbiter of whether the repair was successful—that is, that the aircraft is airworthy and can be returned to service. But even after a successful repair, the aircraft re-sale value and re-lease value will be less than if the aircraft had not suffered the damage in the first place. Whether the values should be less will depend on the damage and the repair, but in the real world aircraft market an aircraft that has had substantial damage will always suffer a loss in re-sale and re-lease values.

Who should bear this loss in value?

The insurers will, correctly, point out that their only obligation is to pay for the repair.

The lessee will, maybe correctly, point out that its only obligations are to repair the aircraft in accordance with the terms of the lease (which usually provide that all repairs will be performed in accordance with the structural repair manual or otherwise as approved by the airframe manufacturer) and return the aircraft in the required return condition.

It’s at this point that the lessor’s lawyers will be closely reviewing the lease documents for a provision putting the burden of the loss in value on the lessee–which in all fairness is where it belongs. The first stops will be the damage repair provisions and return conditions. Maybe the lawyers will find something–it’ll vary lease to lease.

The next stop will be the general indemnity, which in almost all leases will provide that the lessee will indemnify the lessor for “losses” incurred in connection with the “operation” of the aircraft. The lawyers should also carefully review the exceptions to the general indemnity–an exception for “loss in market value” is a not uncommon exception. Even if the general indemnity looks like it applies, the lessee is certain to argue that its only obligation is to repair the damage in accordance with the lease documents’ damage and repair provisions, and these provisions trump the general indemnity–in other words, the lessor shouldn’t be able to make a claim under the general indemnity where the lessee has fully performed under the specific provisions of the lease documents.

The safest approach is to deal with the issue clearly and expressly in the damage and repair provisions, but you can expect some push back from the lessee during the lease negotiations.

Four Biggest Mistakes Lessors Make in the Return Compensation Section

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Return compensation provisions in lease agreements are often poorly drafted. Given that these provisions generally require a multi-million dollar payment from the lessee to the lessor (or sometimes vice versa) you would think the drafting would be clear, precise and complete. Maybe it is the fact that the provisions don’t come into play for a long time. I don’t know.

In any case here are the four biggest (and surprisingly common) mistakes lessors make when drafting and negotiating the return compensation provisions in the lease agreement:

1. Starting with the most costly mistake, the parties will often fail to adequately describe the maintenance event that triggers the start of the return compensation calculation. For example, I have seen the following in a one-way return compensation provision: “Lessee will pay Lessor US$[__] for each hour of utilization of each Engine since such Engine’s last engine shop visit.” And “engine shop visit” is nowhere defined in the lease agreement. Sometimes the drafting is a little better and “engine shop visit” will be defined as, say, a performance restoration whereby useable life has been restored–a pretty low standard. The risk for the lessor in both of these examples is obvious; a shop visit with a minimal work scope will restart the return compensation clock and the return compensation payable to the lessor will not reflect the actual maintenance status of the engine and will fall short of the maintenance credit expected by the next lessee.

The problem is the same for airframe checks and landing gear and APU overhauls, though the range of possible workscopes is smaller and the dollar amounts for the APU and landing gear are smaller. But each should be well defined, including by a reference to the manufacturer’s requirements.

When return compensation is two-way (or “upsy-downsy”) equal care needs to be taken in describing the predelivery maintenance events, and my preference is (where possible) to specify by date each of the last relevant maintenance visits.

2. I really can’t understand this one: return comp provisions often lack any adjustment to the agreed dollar amounts for escalation, hour:cycle ratio changes (for engines), derate (for engines), minimum utilization (usually for airframes), etc. Whereas these adjustment will be dealt with in detail in maintenance reserve provisions, I will frequently see no such adjustments in return compensation provisions. Without escalation that US$150 per hour for engine performance restorations is going to look really puny at the end of a 12-year lease term.

(And remember to make sure the escalation formula provides for annual compounding.)

3. Maybe out of laziness, maybe to avoid conflict, maybe because there is a concern that maintenance costs may be much more expensive or cheaper than current costs, lessors and lessees often agree to the “two quotations” or “three quotations” method to determine the return compensation rates. In a common formulation each of the lessor and the lessee get quotations for the relevant maintenance events (heavy check, engine performance restoration, etc.) and use those quotations as a basis agreeing the per hour/cycle/month return compensation rate and in the absence of such agreement the quotations are averaged (or a third quotation obtained).

There are numerous problems with this approach for a lessor, including:

(a) Lessors always lose these type of negotiations. The lessee has possession of the aircraft and the lessee is likely to be the payer of the return compensation. In addition the lessor will likely be trying to lease other aircraft to the lessee. All the negotiating leverage is on the lessee’s side. In the end, if there is a disagreement the lessee will simply pay the lessor the amount the lessee thinks it owes, and put the burden on the lessor to either pursue the matter or give up.

(b) MROs are not in the business of providing accurate quotations for work they will not be performing (especially if the workscope is not precisely defined–see 1 above–and especially to lessors who as general matter don’t give much work to MROs)–and so such quotations will be difficult to get, may differ wildly and may be biased to the operator.

(c) As a drafting matter, the parties will generally forget to provide for adjustments to the amounts. No adjustment is necessary for escalation because the quotations method is in return date dollars, but hour:cycle and derate adjustments should still be provided.

(d) The quotations method will guarantee an acrimonious aircraft return. Most returns are already adversarial–the quotations method will take the acrimony to the next level.

4. Return compensation payments due from the lessee should be required to be made prior to return and, when due from the lessee, as a condition to return–that is, as a condition to the lessor’s obligation to accept return. I see most often the phrase “upon return,” which to me means either simultaneously with return or promptly thereafter. The lessee, when it is obligated to pay, will interpret “upon return” as promptly after return–and “prompt” to the lessee may not comply with your view of “prompt.” If you want to get paid promptly and in the correct amount then return compensation payments due from the lessee should be required to be made prior to return and, when due from the lessee, as a condition to return.