I have been reviewing a lot of leases recently, and among the various lessors and forms of leases I am seeing that there is almost always a drafting or conceptual issue with the engine LLP reserve provisions. This post will discuss a few of those issues. Some of the issues below are also touched upon in less detail in a previous post.
Several years ago a very sharp lessor tech officer pointed out that the lease agreement we were negotiating should have an adjustment to the LLP reserve reimbursement amount where the replacement LLP (for which reimbursement is being sought) is a used LLP. The use of used LLPs by airlines and MROs is not uncommon, and the tech officer’s view was that the lessee should not be able to draw, without limit, from reserves or any lessor contributions (for utilization prior to the delivery date) for the cost of a used LLP.
For example, why should a lessee be allowed to draw reserves, without limit, for the cost of a used LLP where the replacement LLP has less cycles remaining than the replaced LLP had at removal (e.g., in a replacement required because of FOD or failure)? Similarly, why should a lessee be allowed to draw lessor contributions, without limit, for the cost of a used LLP where the replacement LLP has less cycles remaining than the replaced LLP had on the delivery date? Underlying these questions is the (correct and accepted) premise that a lessor should at all times have LLP reserves for an LLP that reflect the utilization of that LLP since new.
The tech officer and I came up with some unfortunately complicated drafting adjusting the LLP reserve reimbursement amount in the above scenarios. I say “unfortunately” because I value simplicity in drafting–easier to negotiate, easier to administer, easier to enforce. Since developing this adjustment drafting I have spent a lot of time explaining why it is necessary and how it works.
In the numerous leases I have reviewed recently not one has made a distinction between used LLPs and new LLPs in the reserve reimbursement section, and I so started to wonder whether maybe I was missing something. Why didn’t these other lessors care about the used LLP issue? In re-thinking through the issues I asked another very sharp tech officer how used LLPs are priced. He told me that used LLPs are generally priced pro rata (straight line) to the price of a new part–so an LLP with 75% life remaining would cost 75% of the catalog price of such part.
If we assume that used LLPs are always priced on a straight-line pro rata basis and if the working assumption for drafting is that the reserve balance and any lessor contribution amount for any LLP reflects all prior utilization for such LLP at catalog price, then the use of used parts should not be an issue. In other words, any LLP reserve reimbursement should deplete the reserves and lessor contribution only to the extent of life remaining on the replacement part. For example, if a part with 10% life remaining (and for which lessor holds reserves and lessor contributions equal to 90% of the cost of such part) is replaced by a part with 75% remaining (with a cost of 75% of catalog price), then after lessor’s reimbursement (65% of catalog price after netting any waste expense on the replaced part–see more on waste expense below) the lessor should have the benefit of an LLP with 75% life remaining and 25% in reserves/lessor contributions.
Let’s try a more detailed example. An aircraft is delivered used to the lessee. One of the LLPs on one of the engines has 60% life remaining at delivery to lessee and the lessor has provided to lessee a lessor contribution equal to 40% of the catalog price for such part. Lessee pays reserves on such LLP during the term and at the time of removal of such LLP for replacement, 20% life remains on such part; in other words, lessee has paid 40% of catalog price in reserves. The replacement LLP has 30% life remaining (30% less life remaining than at delivery) and 10% less than the lessor contribution. Lessor’s reimbursement would be 10% of catalog price after netting any waste expense on the replaced part) and the lessor should have the benefit of an LLP with 30% life remaining and 70% in reserves/lessor contributions.
The key to making these examples work is the assumption that the used LLP is priced on a straight line basis. And so the conclusion I am drawing from the above thinking is that I can scrap the complicated drafting language I have been using and replace it with something along the lines of the following: “If the replacement LLP is used then Lessor’s reimbursement obligation will be equal to the lesser of (1) the actual cost of such LLP and (2) the product of (a) the catalog price of such part divided by its cycle life and (b) the number of cycles remaining on such part, in either case, less waste expense.”
Reimbursement on a Part-by-Part Basis vs. from the LLP Reserve Pool
I have discussed this issue in another post and so won’t repeat myself here. In the leases I have reviewed recently I have seen both approaches taken and also saw a hybrid where the pool approach was used for the LLP reserves and a part-by-part approach was used for the LLP lessor contribution (I didn’t understand the reason behind that split). My view is that the part-by-part approach is the logical and correct approach because the pool approach shifts operational risk on the LLPs to the lessor. For a discussion of this issue see this previous post.
Salvage Value, Waste Expense and Stub Life
LLPS are very rarely removed with no life remaining. Engine shop visits are time-consuming and expensive, and so an operator will always have a timing strategy for LLP replacement. For example, if an engine is going into the shop for a performance restoration and after the performance restoration the engine will be expected to run without another shop visit for 7,000 cycles, then the operator will generally replace all LLPs on the engine with life remaining of less than 7,000 cycles. The lease agreement for an aircraft will also usually have an LLP “build standard” for a performance restoration and separately an LLP cycle-remaining return condition, both of which requirements will affect the timing of LLP replacement during a lease term.
The question for the lessor is how to account for the “early removal” of LLPs when collecting and reimbursing reserves.
Some lessors will build the lost cycle life into the reserve rate using a “stub life” assumption–with the effect that the per cycle reserve rate for an LLP is higher than the per cycle catalog price for such LLP. Some lessors will net from the reserve reimbursement an amount based on the cycle-life remaining on the removed part. Some lessors will net from the reserve reimbursement the market salvage value (if any) of the removed part, usually in connection with using the stub life approach.
I think the most direct, transparent and easiest-to-explain approach is to base the reserve rate on catalog prices (without adjustment) and then deduct from the reimbursement an amount equal to the product of (1) the per cycle then catalog price of the replaced LLP and (2) the number of cycles remaining on the replaced LLP. This approach removes the guesswork of stub life and salvage value, with the calculation of LLP reserve rate and reimbursement tied directly to catalog prices.
LLP Replacement–Scope of Reimbursement
LLP reserve reimbursement is for the purchase price of the part, not for repair, installation or any other labor or any other cost. This preceding sentence isn’t debatable, it’s not an “issue”; it’s the commercial basis of the deal. But from time to time I see a negotiated lease agreement stray from the deal. If the lessee wants anything other than LLP price in the reimbursement, then the LLP rate needs to go up.
What Does Life Mean?
I’m just going to touch on this last issue, because it is a big topic. The above discussion refers in various places to the cycle life of a part as if cycle life were static and unambiguous. But this not the case. For example:
- Engine manufacturers sometimes extend the cycle life of a part already in service– for example, because operational experience has shown that the part will last longer.
- Engine manufacturers may assign different LLP cycle lives to different operators based on each operator’s profile (geographic location, routes, etc.).
- Engine manufacturer’s may guarantee a longer life of an LLP than the current cycle life (because the engine manufacturer expects the cycle life will be extended before the current cycle life is used).
- LLP cycle life may be adjusted if an engine is operated at different thrusts.
For the lawyer drafting the LLP reserve provisions in a lease agreement, all of the above should be considered while drafting. I’ll try to come back at a later date for a full discussion of this last issue. In the meantime, caveat advocatus.