Category Archives: LLPs

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.

Treatment of Engine LLP Reserves in Lease Agreements

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Last month I wrote about the most (IMO) overlooked important issue in an aircraft purchase agreement–the description of the aircraft. This post is about the least understood and most neglected (again IMO) section of lease agreements–the maintenance reserve provisions as they relate to engine LLPs.

Some lessors do understand the issues related to engine LLP reserves, and the lease agreements from those lessors reflect that understanding, but for purposes of this post let’s assume we are reviewing a lease agreement with an engine LLP reserve provision that reads as follows (paraphrasing):

Lessee will pay on the 10th of each month with respect to the LLPs on each Engine a maintenance reserve amount of US$200 for each cycle of utilization on such Engine during the previous month.

In the event Lessee replaces LLPs on an Engine during the Lease Term Lessor will reimburse Lessee for the cost of the replacement LLPs from the LLP maintenance reserves paid by Lessee for such Engine.

If an Engine was delivered to the Lessee by the Lessor on the Delivery Date other than with zero time on the LLPs, then to the extent the reimbursement from the LLP maintenance reserves is insufficient to fully reimburse Lessee for the cost of the replacement LLPs Lessor will contribute a further amount up to the product of US$200 and the number of cycles of utilization on the LLPs on the Delivery Date.

Ignoring the imprecise drafting (I did say I was paraphrasing!), how many conceptual errors can you find in the above? Here are the ones I see:

1. First and most importantly, note the above drafting treats the LLPs as a pool. LLPs on an engine may have different manufacturer-mandated cycle-lives and an LLP may fail or be removed before its expected cycle-life. In addition, used LLPs are sometimes installed on an engine as replacement parts. So an engine with 15 LLPs may have 15 different LLP cycle-lives remaining.

If all LLPs stayed installed for their expected life and were always replaced with new LLPs, then treating the LLPs as a pool for maintenance reserves purposes should (I think) work out over time. But if an LLP fails early and needs to be replaced or an LLP needs to be replaced early to comply with an engine overhaul build standard, then under the above drafting a lessee could draw the full cost of the replacement LLP from the reserves and lessor contribution, thereby depleting the reserve pool and lessor contribution out of proportion to the part replaced.

For example, a lessee takes delivery of a used aircraft and operates it for six months, paying US$240,000 in LLP reserves on an engine, before an LLP costing US$400,000 fails. Under the above drafting the lessee could draw the entire US$240,000 plus up to $160,000 of the lessor contribution for the replacement of one LLP.

I can hear some of you saying “what’s wrong with that, the LLP reserve balance is then zero and the lessor contribution is reduced and so the next time the lessee needs to draw for an LLP replacement, it may need to come out of pocket for the cost, right?” Yes, but the problem is that lease terms do not go on forever and at some point the aircraft will need to transition to a new lessee, who will likely be smart enough to ask for a lessor contribution based on its calculation of the cycles used on each LLP; and if the reserves and lessor contributions under the current lease have been depleted through the replacement of a few parts the lessor will need to make up the difference.

To put it another way, treating the LLP maintenance reserves as a pool effectively shifts a lot of the risk of early LLP removal to the lessor. So, the first conceptual error is that LLP reserves and lessor contributions are not tracked on a per part basis.

2. Note that the above drafting does not require the replacement LLP to be new. Replacement of failed or (soon to be) expired LLPs with used LLPs is common practice; there are various legitimate reasons for a lessee to install a used replacement LLP instead of a new LLP. But if a Lessee does install on used LLP there should be limits on the lessor’s reimbursement obligation. For example, let’s say a lessee replaces an LLP with a used LLP that had exactly the same number of cycles as the replaced LLP had on the date the aircraft was delivered to the lessee? Should the lessee be entitled to draw on the LLP reserves allocated to such part? Yes, because the LLP has paid for the time used and is returning the LLP to is original (delivery date) condition. Should the lessee be entitled to make a claim against the lessor contribution for such part? No, because the lessee has not improved the condition of the LLP from its original (delivery date) condition.

As you can imagine there are numerous possible fact patterns to address when dealing with both new and used LLPs and both maintenance reserves and lessor contributions–and the drafting in the lease can get complex–but for purposes of this post just realize that if the lease documentation allows the installation of used LLPs then you need to be very careful how the reserve reimbursement and lessor contribution sections are drafted.

3. Note that the above drafting does not say lessor will reimburse lessee only for the lessee’s net cost of the replacement LLP. The cost of the LLP may be reduced in various ways that won’t be obvious from the invoice that the lessee provides the lessor with the lessee’s reimbursement request. For example, the removed part may have salvage value. Also, the engine manufacturer may have a deal with the airline to provide a credit or rebate in connection with the purchase of LLPs, especially if the LLP comes off early. It may be difficult to determine the lessee’s “true net cost” of an LLP, but at a minimum the lease agreement should contain some general language providing for the netting of salvage value, credits and rebates.

4. The above drafting assumes that the cycle-life of an LLP will not change after installation. If cycle-life is reduced (fortunately a rare occurrence) then the lessor should have the option to adjust upwards the per cycle reserve amount. Of course the lessor may have to concede that the reserve amount be adjusted downwards in the event that cycle-life on one or more of the LLPs is extended.

Finally, I have yet had to deal with this issue but I understand that at least one engine manufacturer is looking at assigning LLP cycle-life on an operator by operator basis–with each operator to be assigned into one of two categories–with some operators being allowed a longer cycle-life and some restricted to a shorter cycle life. The issues here for an operating lessor are obvious and scary, both in the calculation and collection of LLP reserves and the drafting of LLP return conditions. After I gain some real life experience on this issue I will revisit it in a post.