Monthly Archives: February 2016

Subject and Subordinate Clauses in Subleasing Provisions

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This post will start with a quiz.  The below excerpt is verbatim from the permitted sublease section of a lease agreement I reviewed a couple weeks ago.  The language, which is very common to lease agreements, reflects confused thinking–or more accurately, reflects the use of boilerplate without thinking.  What’s wrong with the below wording?

Any proposed sub-lease shall satisfy each of the following conditions:

(a) the sub-lease shall be expressly stated to be, and shall remain, subject to, and subordinate to this Agreement and the term of any such sublease (including renewal rights) shall not extend beyond the end of the Lease Period and shall terminate immediately upon the occurrence of an Event of Default or upon the date upon which the leasing of the Aircraft hereunder terminates or expires, whichever is the earlier;

. . .

(c) Lessee shall absolutely assign, by way of security, all its rights and interests in the sub-lease to Lessor (in substance and form acceptable to Lessor (acting reasonably)) and procure that the Permitted Sub-Lessee acknowledges the notice to such assignment;

When a lease agreement is in default and the lessor has decided to exercise remedies, the primary concern for a leasing company is the recovery of possession of the aircraft.  Any possible damage claims against the lessee are a distant second to the first priority of protecting the aircraft by getting possession.  Consequently, when structuring a lease transaction and drafting the lease documentation, the lessor’s attorney should ensure that if an event of default does occur the lessor has a clear and unambiguous right to possession of the aircraft.

That all sounds obvious, but it is not uncommon for there to be parties other than the lessee that have a right to possession of or claims against the aircraft (or parts thereof)–for example, sublessees, wetlessees, MROs and parts suppliers.  One or more of these parties may attempt to block a Lessor’s attempted repossession of an aircraft.

In the case of a sublessee, most aircraft lease agreements provide that any sublease is subject and subordinate to the lease agreement between the lessor and lessee, with the lease agreement usually using language similar to that in clause (a) quoted above.

Ok, but then what is the purpose of clause (c) quoted above and doesn’t it undercut the subject-and-subordinate clause?  In other words, why would the lessor want an assignment of a sublease agreement when that agreement terminates automatically before the lessor has ability to step in as sublessor?  In yet more words, doesn’t the language in clause (c) conflict with clause (a) by indicating that the parties expect the sublease to continue after remedies have been exercised against the lessee by the lessor?

Could a sublessee use the ambiguity caused by this conflicting language to try to block a repossession by the lessor?  Absolutely.  Would the sublessee be able to retain the aircraft under the sublease?  I don’t know, it depends on the language of the lease agreement and the sublease assignment, but at the very least the ambiguity gives the lessee and/or the sublessee some leverage over the lessor and buys both of them some time.

Let me argue the other side for a minute:  “Brad, you dolt, the language you quoted is just badly drafted.  The intent is that the sublease is subject and subordinate but that the lessor *at its option* can elect to step into the sublessor’s position under the sublease.”  Or maybe “The intent is that the subleasing is terminated but that the lessor still has the ability to step into the sublessor’s position to force the return of the aircraft by the sublessee.”

Well, ok, maybe, but in my experience those subtleties are not often reflected in real-world lease agreements (e.g., see the language above); usually the subject-and-subordinate language is not (at all) coordinated with the sublease assignment requirement.

That said, I have drafted and negotiated subject-and-subordinate agreements with sublessees that do contain an option by the lessor to continue on with the sublease, with the lessor taking the sublessor’s place (or that require, again at the lessor’s option, a new lease agreement be entered into between the lessor and sublessee on the same terms as the sublease).

But as a lessor’s counsel who has been through many repossessions, my strong preference when approving a sublease is to require a crystal clear and unequivocal subject-and-subordinate agreement under which the sublessee has no arguable claim to continue to possess the aircraft–that is, a subject-and-subordinate agreement that does not contain a sublease assignment.  What limited, speculative upside a lessor gets by requiring a sublease assignment is outweighed, in my opinion, by the sublease assignment muddying the water during a repossession.

 

A couple random but related thoughts:

1. It’s going to be rare case when the sublease will be acceptable “as is” to a lessor. The lessee/sublessor as an operator may have agreed covenants that the lessor cannot perform.  The tax provisions may not work for a direct lease between the lessor and the sublessee.  The return conditions may not be acceptable to the lessor.  The rent and term may be unacceptable to the Lessor.  And so forth.  My point here is the lessor should balance the benefits of simplicity (by not requiring an assignment) against the limited, possible benefit of getting an assignment of the sublease.

2. Here are the general provisions I like to see in the “subject and subordinate agreement” among the lessor, the lessee and the sublessee (these provisions will of course need to be tailored to the specific deal):

(a)  The sublessee should acknowledge that it has received a copy of the lease between the lessor and the lessee (with dollar amounts redacted), and to the extent that the sublease conflicts with the lease, the lease will govern; in addition, the sublessee will ensure the compliance with the maintenance, repair, operation and insurance provisions of the lease.  This approach saves the tedious (for all the parties} exercise of marking up the sublease to conform to the lease.

(b)  The sublessee agrees that the termination of the lessee’s leasing of the aircraft or the termination of the lease agreement automatically results in the termination of sublessee’s leasing of the aircraft under the sublease.

(c)  Upon such termination the lessee will return the aircraft to Lessor as a specified location and in compliance with the return conditions required under the sublease.

The Definition of “Engine Basic Shop Visit”

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I used to joke with a friend that “I’ll be 70 years old and still negotiating the definition of ‘Engine Basic Shop Visit’ on a daily basis.”

That was at least 15 years ago and while “on a daily basis” was an exaggeration, that term (some lessors use “Engine Performance Restoration” or similar terms) is still the most important defined term in most aircraft lease agreements and it is (no doubt about it) the defined term that the lessor’s lawyers and tech officers will look at most often after delivery (and usually while under stress–“oh, please let it say what I need it to say”).

The term should be used sparingly in a lease agreement.  In a previous post I have noted that the term should not be used in return conditions–because the definition usually sets a high standard for the restoration workscope and the main point of the relevant return condition should be on-wing time remaining to the next performance restoration (of any sort)–not on-wing time remaining until the next full performance restoration.  The same logic applies to the delivery conditions, though using the defined term in the delivery conditions would benefit the lessor–unless the delivery conditions uses a “time since” standard for the engine delivery condition.

In lease agreements that I draft the term will usually appear only in the provisions related to maintenance reserves and/or return compensation.  In the maintenance reserve provisions the defined term will be the trigger for when the lessor reimburses reserves.  In the return compensation provisions it will be the trigger for when the hourly return compensation payment from the lessee starts to accrue.  In both cases the lessor will benefit from a high standard.

The definition of ” Engine Basic Shop Visit'” that I use has four components:

1. Workscope. The threshold question in drafting the definition is whether the maintenance reserve/return compensation trigger will be the overhaul of any listed engine module or an overhaul of a set (or all) of modules required.  This issue is usually addressed by the tech and financial officers of the lessor and the resolution will be driven by the expected condition of the engine at delivery and the performance restoration reserve balance for the engine.  (If the “modular approach” is used, then the reserve/return compensation/lessor contribution provisions will need to be drafted to allocate the relevant amounts (usually on a percentage basis) among the modules.)

2. Engine Manufacturer Manuals and Guidelines. The performance restoration should be performed in accordance with the relevant engine manufacturer manuals and guidelines.  The lessor’s tech officers should provide (or at least review) the description of the relevant engine manufacturer manuals and guidelines.

3. Performance Standard. Here is a requirement that I often do not see in lessor’s lease agreements.  The workscope has been agreed with the lessor and the performance restoration has been carried out in accordance with the agreed engine manufacturer manuals and guidelines, but the EGT margin from the test cell after the performance restoration is the same as before the performance restoration.  Should the completion of the performance restoration be a sufficient trigger for purposes of a maintenance reserve reimbursement or return compensation reset?  No, it shouldn’t.

So, I suggest adding a performance standard that requires the performance restoration :

fully restores [the Engine’s/such module’s] performance and service life using the workscope defined in the Engine Manufacturer’s [Engine Management Program and the Engine Manufacturer’s Engine Manual] and so that the EGT margin is (a) at least the average EGT margin that is expected in the industry for an engine of the same model as the Engine fresh from performance restoration (determined on the basis of the Engine Manufacturer prescribed test cell conditions and procedures prevailing at the time of such shop visit) and (b) such that such Engine can reasonably be expected (as determined by the Engine Manufacturer if Lessor and Lessee fail to agree) to run for the average meantime between performance restorations (based on Engine Manufacturer data) for engines of the same model as the Engine

4. LLP Build Standard. The definition should require a minimum LLP build standard, the minimum to be based on the expected run-time between overhauls.  In other words, you don’t want the run-time requirements discussed in 3 above to be undercut by the engine being driven off-wing for an LLP replacement before the next anticipated performance restoration.

Some lessors may argue that 3 and 4 above are unnecessary so long as the lessor has a consent right over the planned workscope.  I don’t think that is right.  A consent right give you no protection over a failed performance restoration and a consent right will likely lead to a negotiation where the lessee will ask for additional (outside of the contract) contributions for what the lessee’s will describe as enhancements to the workscope not required by the lease agreement.  (Nonetheless, somewhere in the lease agreement the lessor should be given consent rights over each performance restoration workscope.)

Random notes:

1. For references to performance restoration where a high standard is not required, I suggest just using “performance restoration” (not defined) or using “Performance Restoration” as a defined term and defining it as follows: “means the off-wing maintenance of an Engine where, as a result of an overhaul or performance restoration, useable life is restored to the engine.”  As always, when using defined terms the drafter and reviewer each needs to be cognizant of both the definition and how it is used–when in doubt, search for the defined term throughout the document and make sure it is being used consistently–and, in each case, to your client’s advantage.

2. In two-way return compensation provisions, you will also need to provide for the “time since” calculation at delivery. As mentioned in a previous post, my preference is (where possible) to specify the date of the last relevant maintenance visit–rather than rely on a definition or description of the prior visit.