Category Archives: Aircraft Return

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.

Maintenance Reserves for LLPs: Some Random Thoughts

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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.

Used LLPs

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:

  1. 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.
  2. Engine manufacturers may assign different LLP cycle lives to different operators based on each operator’s profile (geographic location, routes, etc.).
  3. 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).
  4. 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.

 

Some Drafting Tips for Lease Agreement Engine Return Conditions

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Engine maintenance provisions, engine reserve/return comp provisions and engine return condition provisions are “where the money is” in aircraft lease agreements–and this is especially true for older aircraft where the value of the aircraft as a whole can be mostly in the engines.

Here are some drafting tips for the engine performance restoration (not LLP) return conditions in a lease agreement.

1. The Holy Trinity. Each engine should be (1) serviceable, (2) not on watch and (3) have no reduced interval inspections. Yes, there is some overlap in those requirements, but each should be stated to avoid the argument from the returning lessee that, for example, “yes, it has reduced inspection periods, but it is not ‘on watch’.”

As a practical matter, if you try to deliver an engine to the next lessee that fails any of these three conditions, you’re going to have problems–regardless of what the delivery conditions say.

2. Time Remaining. Each engine should have a minimum number of engine flight hours remaining until the next expected performance restoration. There are a lot of drafting traps in this requirement. Here are some of them:

(1) Don’t leave out the word “expected” and make sure that you describe who will determine whether the standard is met and the parameters for that determination (e.g., mutual agreement of the lessor and lessee with a fallback to the determination of the engine manufacturer, and based on an engine borescope, EGT and trend monitoring).

I once had to manage a return from a major US airline where the lease simply said “3,500 engine flights hours remaining to the next overhaul.” The airline took the position that given that engine maintenance is “on condition” and not scheduled, the return condition was nonsensical and the airline was going to ignore it. And we lost that argument–primarily for unrelated commercial reasons.

(2) Make sure the “performance restoration” standard is not too stringent. When a lessor defines “performance restoration” for reserve reimbursement or return compensation purposes, the definition is usually detailed and with extensive requirements. That sort of definition works against the lessor’s interest in the return conditions–and is IMO inappropriate for an engine return condition, the main point of which is to make sure the next lessee has an expected minimum on-wing time after delivery.

(3) Avoid the “hours since” standard as the sole standard. It is a meaningless standard for engines, where maintenance requirements are based on condition, not on a schedule. Sometimes it’s a good standard to have in addition to the hours-remaining standard.

(4) Beware of the following (not uncommon) quoted wording: Each engine should have at least 6,000 engine flight hours remaining until the next expected performance restoration “based on the manufacturer’s expected meantime between overhauls.” This language is very arguably a disguised “hours since” standard. The engine could be a melted mass of metal, but if it has only 5,000 hours consumed out of a 12,000 hours of expected meantime, it’ll meet this return condition (or so the lessee will argue).

(5) Avoid using a cycles-remaining standard unless you specify an assumed hour-to-cycle ratio. Using cycles alone will lead to an argument at redelivery about the assumed hour-to-cycle ratio and will likely lead to a mismatch with the delivery conditions for the next operator (which operator in all likelihood will operate at a different hour-to-cycle ratio than the returning lessee).

3. Engine Borescope. The engine borescope inspection provisions should (1) describe the scope of the inspection (make sure the lessor’s technical team are happy with the scope description), (2) be recorded and either uploaded or put on DVD and provided to the lessor, (3) performed by lessor (or at least in presence of the lessor by a company/individual acceptable to the lessor) and (4) provide for the correction by the lessee prior to the return of any findings outside of manufacturer-approved limits.

Hope that’s helpful.

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.