Four Biggest Mistakes Lessors Make in the Return Compensation Section

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.