Category Archives: Aircraft Maintenance

Initial Reserve Credits When Leasing a Used Aircraft: Some Thoughts

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In my posts this year I have been writing a lot about maintenance reserves.  This focus is not misplaced.  The maintenance reserve section is one of four aircraft lease sections where the lawyers on a deal can make a commercial difference–either positively or negatively.  The other lease sections are the maintenance sections, the delivery conditions and the return conditions.

My work for the last year has been focused on reviewing lease agreements in connection with the purchase of leased aircraft–and an unsurprising pattern has emerged in these reviews.  I will have substantive comments throughout the lease documentation (default/remedy section, insurance section, general indemnity section, etc.), but when I finish the review and prepare a summary highlighting the most serious problems with the lease documentation, the list is heavily weighted with maintenance reserve and return condition issues–mainly because these are the issues that will have a material and inevitable financial impact on the lessor.  If there is a mistake in the general indemnity, insurance or the default/remedies section, it’s highly unlikely such mistake will ever have any impact on the lessor.

As a consequence, when my client discusses my comments with me and then with the seller of the aircraft, my client’s focus is on these maintenance reserve and return condition issues.  And if a purchase falls apart during the due diligence stage, it’s very likely going to be because of either an unsatisfactory aircraft inspection or deficiencies in the maintenance reserve and return condition sections of the lease documentation.  The deal is not going to fail because, for example, the scope of the general indemnity isn’t broad enough.

With the above in mind, here are some thoughts on the maintenance reserve provision dealing with initial credits for reimbursable maintenance (aka “lessor contributions”).

1. Start Date. When a lessor is offering to lease a used aircraft to a lessee the lessor will generally offer to provide the lessee with credits that the lessee may use in connection with the first reserve reimbursable maintenance visit (major airframe check, engine performance restoration, etc.) during the lease term.  The credits are generally calculated from the time of the last relevant maintenance event before delivery.  One of the things that I look for when reviewing this lease provision is whether the lease documentation is clear about the start date for the calculation of the credit.

For the airframe and the landing gear, where the checks/overhauls are generally calendar driven and the workscope well-defined, the start date should be obvious from the aircraft’s maintenance records.  Similarly, for the engine LLPs, assuming the aircraft records and lease documentation accurately reflect cycles since new and have back-to-birth (including thrust usage) traceability, the start date and the credit calculation should be just a matter of math.

But for the engines and APU, the timing of performance restorations is driven by operating condition and not by calendar time, hours or cycles, and the workscope for an engine restoration can be heavy or light.  Consequently it is very common for a lessor and lessee to disagree about the start date for the initial credit on the engines and APU–that is, disagree on the amount of the initial credit.  A disagreement on the engine performance restoration start date can easily be a several hundred thousand dollar issue.

The best practice here is to agree either the start date or the amount of the initial credit during the lease negotiation.  If the start date is not clear from the lease documentation, then I will recommend to the buyer of the aircraft to agree the start date in the lease novation documentation.

2. The Method of Calculation. Once the start date is agreed there are a couple ways to calculate the initial credit–the pro rata method and the rate-times-hours/cycles/months method.

Under the latter method, the calculation of the initial credit is the simply the applicable base year (unescalated) maintenance reserve rate multiplied by the number of hours, cycles or months (as applicable) since the last relevant maintenance event.

Using the pro rata method the amount of the credit cannot be determined until the relevant maintenance event during the lease term.  At that time the full reimbursable cost for the visit is allocated pro rata between the usage before the delivery date and  the usage after the delivery date, with the lessor obligation to provide a credit for the usage before the delivery date.  For example, if an engine performance restoration costs $4M, the “start date” was two years before the delivery date and the performance restoration was started two years after the delivery date, then the initial credit would be $2M.

Lessors generally don’t like the pro rata approach because (1) it shifts the risk early maintenance (especially respect to engines) on to the lessor (because the denominator in the pro rata calculation is smaller for early maintenance) and (2) it shifts part of the risk of the final cost of the maintenance on to the lessor (because the lessor’s credit is not capped at the per hour/cycle/month rate, but instead is calculated using the actual reimbursable cost of the maintenance event).

The use of the pro rata method for engine performance restorations is especially risky for lessors–because an engine can come off wing early for condition reasons and because the cost of performance restorations is notoriously difficult to predict/control.  To take an extreme example, if an engine is driven off wing for a performance restoration on the first day of the lease term, the pro rata approach would result in the lessor bearing 100% of the cost of the performance restoration.

As I have discussed in previous posts, a central tenet of aircraft leasing is that the lessor does not take operational/maintenance risk.  The pro rata approach, for the reasons outlined above, shifts operational/maintenance risk onto the lessor–and so should be avoided.

3. Engine LLPs. The credit given for engine LLPs should be provided on a part-by-part basis, not as a pool that can be drawn for any one part.  Like the pro rata approach discussed above, allowing the lessee to draw on a pool of credits for the replacement of any one part shifts the risk of early removal to the lessor.  Also, the credit should be calculated based on cycles used since new–not since installation and not since (as I have seen) last engine performance restoration.

4. Other Considerations. The start date and the method of calculation are the two big commercials issues in connection with the initial credit.  Here are some further less controversial recommendations:

(a)  The initial credit provisions should apply only to the first reimbursable maintenance event during the lease term.

(b)  The initial credit should apply only to reimbursable maintenance events and only to the extent the maintenance event is reimbursable.

(c)  The obligation to pay the credit should be conditioned on the same conditions as the reimbursement of reserves (e.g., no continuing lessee default).

(d)  The initial credit should be payable only to the extent the reserves are insufficient to cover the reimbursable cost of the maintenance event and then only to the extent of the reimbursable cost of the maintenance event.

(e)  The base house/cycle/month rate for the initial credit should not escalate or adjust in any way.

I know some you will be saying “no duh, dude” to (a) through (e) above, but it’s common for a lease to be silent on one or more of these issues.

5. Novation. As discussed in a previous post, when acquiring a lease by novation or assignment, the novation/assignment agreement should have a provision in which the lessee confirms which credits have already been satisfied and, unless the lease documentation uses the pro rata method, the amount of the remaining credits.

Engine Thrust at Delivery and Return

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Here’s a common fact pattern in connection with the sale and leaseback of a used aircraft:  An airline and a lessor will agree that the lessor will purchase one or more of the airline’s aircraft and then lease those aircraft back to the lessee for an agreed term and at an agreed rent.  The lessor’s obligation to purchase the aircraft will usually be subject to a pre-purchase inspection of the aircraft and to the aircraft being in the same condition (as at inspection) on the purchase date.  Rarely will there be a full description of the aircraft in the purchase agreement; instead the lessor will rely on its inspection of the aircraft and on detailed return conditions in the leaseback documentation.  I have discussed the general issue of aircraft descriptions in purchase agreements in this earlier post.

As most of you know most (all?) aircraft jet engines may be operated at different thrusts.  Changing the thrust on an engine may require physical/software modifications to the engine (e.g., a derate plug), but a change will also require paperwork from the engine manufacturer; and the paperwork from the manufacturer for an increase in thrust will generally require a large payment to the engine manufacturer (sometimes hundreds of thousands of dollars per engine).  Instead of purchasing additional thrust, airlines may “lease” the thrust for an agreed period of time.

Most of you probably see where I’m going here.  If the lessor in a sale/leaseback transaction sends its inspector to look at, say, a 737-800 and the inspector reports back that the installed engines are CFM56-7B26 engines (per the dataplate on each engine), the lessor knows that that the installed engines are certified to operate at 26,300 lbs. thrust (signified by the “26” in the “7B26”).  But the first question from the lessor’s tech and legal officers should be “is that thrust rating owned and transferable by the airline or is it leased by the airline (and the engines will revert to a lower thrust rating at some point)?”

If the lessor fails to ask that question, it may be surprised to find at return of the aircraft at lease end that the engines are returned as CFM56-7B24 engines (that is, with 24,000 lbs. thrust).  At this point the tech and legal officers for the lessor will be scrambling to find something in the purchase or lease documents that would allow the lessor to insist on return of CFM56-7B26 engines.  For example, the lessor may say “look, the description of the engine in the purchase agreement says ‘CFM56-7B26,'” to which the airline will respond “that’s because they were CFM56-7B26 engines at delivery.”  Then the lessor will say “look, the lease return conditions require the aircraft to be returned in the same configuration and with the same capabilities as delivery,” to which the lessee will say “‘configuration’ refers to the seating configuration and the aircraft is airworthy and so does have the same capabilities.”  Acrimony ensues.

The lessons here are:

  1. The purchase agreement should be clear that the current thrust is owned and transferable by the airline. In addition, the lessor’s tech officers should confirm such with the engine manufacturer directly.
  2. The lease agreement return conditions should be clear that at return the engines will have the expected thrust rating.

The above also applies to new aircraft in sale/leaseback transactions.  For example, an airline may have a deal with the engine manufacturer such that the installed engines will be delivered from the airframe manufacturer at a higher thrust but such thrust will apply only for so long as the airline operates the aircraft, after which a lower thrust rating would apply.

As always, be careful out there.

Replacement of Parts and Part Pooling

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In a perfect world for an aircraft lessor the following rules would apply to each part on a leased aircraft:

Rule 1.  No part should be removed from the aircraft except as required for maintenance of the aircraft and/or the part.

Rule 2.  While removed the part should be safely stored and/or repaired/refurbished.

Rule 3.  No part on the aircraft should be replaced other than because of damage, failure, loss or expiry of that part.

Rule 4.  If a part is to be replaced because of damage, failure, loss or expiry, the part should be promptly replaced with a part of the same manufacturer and model (or a more advanced and compatible model), and upon installation title to the replacement part should vest in lessor free and clear of any liens.

I can hear a number of you saying “uh huh, yeah, that’s right, what’s your point?”

My point is that very few aircraft lease agreements actually contain the first three rules.  Don’t believe me?  Pick up any random lease and check.

Right now I am picking up a lease at random (I really am) and I see the following standard Replacement of Parts clause:

LESSEE, at its own cost and expense, will promptly replace all Parts which may from time to time become worn out, lost, stolen, destroyed, seized, confiscated, damaged beyond repair or rendered unfit or beyond economical repair for use for any reason. In the ordinary course of maintenance, service, repair, Overhaul or testing, LESSEE may remove any Part provided that LESSEE replaces such Part as promptly as practicable.

The wording in this lease agreement goes on to specify the requirements for the replacement part (Rule 4 above) and to address title transfer issues (also Rule 4 above) and the required timing for replacement (again, Rule 4 above).

But what about the first three rules?  They are not contained in the above quoted language (read it again).  Note especially that in the second sentence it does not say “Only in ordinary course of maintenance . . . ” or “maintenance, service, repair, Overhaul or testing of the Aircraft.”

You may be able to find the first three rules partly covered in other parts of the lease agreement.  For example, the lease agreement Possession section may have a provision prohibiting delivering possession of any part to a third party (though the prohibition in that section is often limited to the aircraft and engines).  The Maintenance section will likely have a clause on repair.  But I bet you didn’t find the first three rules in the Replacement of Parts section.

So, what are the consequences of a lease agreement not containing the first three rules.  Well, the most material and (highly) likely consequence is that parts will be removed from the lessor’s aircraft for use on other aircraft in the lessee’s fleet, with the only requirement usually being that the removed part be replaced with a compliant part “as soon as practical but in any case prior to the last day of the Lease Term”–and that the lessor will not be able to prohibit the use of its parts on other aircraft.  Another possible consequence, theoretically at least, is that good parts can also be swapped out for inferior parts–though most leases have a requirement that the replacement part have a value and utility at least equal to the replaced part.

Let me jump to another issue here and then I’ll come back the issues raised above.

Often during lease negotiations the lessee will say “we need the right to do part pooling,” and when I’m reviewing leases I sometimes run across a “Part Pooling” section in which the lessor gives the lessee broad rights to pool “Parts” from the aircraft with other airlines pursuant to an inter-airline pooling arrangement.  When I see such a part pooling section I wonder how can the lessee engage in inter-airline part pooling and still comply with its separate obligation to replace removed parts “as soon as practical,” vesting title to the replacement part in the lessor.  The two provisions are in conflict.

When pooling comes up in my lease negotiations, my first response is to ask the lessee’s representative what he/she means by “parts pooling.”  Invariably the response is something like “if we need a part from your aircraft to keep another aircraft in our fleet in operation then we will want the right to remove the part from your aircraft.”  Anyone who has been in the aircraft leasing business for more than a few deals knows that this sort of part sharing among aircraft is common.  Lessors don’t like it, but it’s going to happen and it’s unlikely the lessor will ever find out.

I don’t think I have ever heard the following response from a lessee:  “we want the ability to share your aircraft’s parts with other airlines as part of an inter-airline pooling arrangement without any obligation on our part to replace them before return of the aircraft to you.”  I can see a very creditworthy airline taking that position, but unfortunately (for me) those are the kind of airlines I don’t usually deal with.  My experience is that a request to “pool parts” is a pretty narrow request to use parts from a lessor’s aircraft in an “emergency.”  And if that is the case and the lessor is willing accommodate the lessee on this request, then the “part pooling” provision should be narrowly drafted.

I sometimes wonder whether the loose drafting around the removal and replacement of parts (as discussed above) is the result of lessees trying to leave open the possibility of removing parts from the leased aircraft for use on other aircraft in its fleet.  If so, I guess that is OK, but as a lessor’s counsel I would strongly prefer that the four rules above are clearly stated and that any exception for “emergency” use of parts on other aircraft is clearly and narrowly drafted.