Engine Thrust at Delivery and Return

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.

Some Drafting Tips for Lease Agreement Engine Return Conditions

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.

Default Grace Period for the Return of an Aircraft

A well drafted lease (or at least the first lessor draft) will have as a separate event of default the failure of the lessee to return the aircraft at the termination of the lease term, with either no or a very short default grace period for the lessee. In other words, the lessor does not want the general covenant grace period (sometimes as much as 30 days (or, ugh, longer)) to apply to the return of the aircraft. In a good and just world the lessor will have another lessee lined up to take delivery of the aircraft upon return from the current lessee, and the lessor does not want to annoy the next lessee with a delivery delay (even if the current lessee continues to pay rent until the actual return). So usually a lessor will require a timely and compliant return, with the right to call an immediate event of default if the lessee fails to return the aircraft in the required return condition on the last day of the scheduled lease term.

Lessees often push back on this immediate event of default, using a couple different arguments:

1. A late return may be caused by a number of factors outside the lessee’s complete control, including problems with the return MRO (e.g., lack of manpower), problems discovered during the return maintenance and inspections (e.g., engine defects discovered during borescopes) and unreasonable lessor inspectors; therefore the lessee argues it should be given a grace period to avoid the problems it may have (usually triggered cross defaults under other leases and financings) if an “Event of Default“ under a lease were to be triggered immediately by a late return.

2. Somewhat more persuasively, the lessor has in all likelihood given itself a grace period on its obligation to deliver the aircraft to the lessee; so, as the lessee will argue, it is fair for the lessee to have a grace period at the end of the lease term. The counter-argument by the lessor is that in most cases the lessor is relying on the returning lessee (or the manufacturer) to meet its obligations and the lessor therefore cannot guarantee (and does not control) the actual delivery date of the aircraft. This counter-argument, in my experience, almost always fails to win the day.

I’ve seen some lessees carry this issue to the extreme by saying that the lessee should have a lengthy return grace period (more than a couple months) and ultimately be obligated only to use reasonable efforts to place the aircraft in return condition by the required date; if the lessee fails to put the aircraft in the required return condition after reasonable efforts then the lessee, in its view, should be able to simply return the aircraft in its then “as is” state. This position effectively shifts aircraft return condition/maintenance risk from the lessee to the lessor–and an aircraft lessor’s Prime Directive should be “don’t take aircraft condition/maintenance risk.” EVER.

What can the lessor offer to the lessee that addresses the lessee’s concerns without losing money, losing the next lessee or shifting aircraft condition/maintenance risk from the lessee to the lessor? Here are my thoughts:

1. The simplest and most reasonable approach is to agree a grace period in the aircraft return event of default, the shorter the better, but any grace period should be conditioned upon (a) the aircraft having been removed from commercial service a reasonable time before the scheduled return date to allow for all return inspections and maintenance, (b) the aircraft not being placed back in commercial service or otherwise flown except in connection with the return inspections and maintenance, (c) the problem or problems causing the delay not having been reasonably foreseeable and avoided and (d) the lessee using all responsible efforts to complete the return as soon as practical.

The lessor should make sure that any grace period is well within the grace period the lessor will likely obtain in its commitment to deliver the aircraft to the next lessee.

2. A lessor should also provide for increased rent during any grace period or maybe a per diem “delay fee.” A return delay, especially one that drags on day-to-day, will result in significant costs to the lessor (primarily the costs of the onsite employees and consultants) and the lessor should be compensated for those costs.

Be very careful about increased rent or fees after the grace period because the lessee may argue that the increased rent is liquidated damages (or an election of remedies) precluding a claim for actual damages for a late return.

3. If a lengthy grace period is agreed, the lease should provide for a lease extension at an agreed rent at the lessor’s option if the aircraft has not been returned by the end of the grace period. The lessor should make sure that it has a complimentary delivery “out” with the next lessee–otherwise this option is useless.

4. Most leases will contain a provision allowing the lessor, at its option, after an a return event of default to take the aircraft back “as is” and complete the return maintenance itself. The lease agreement should be clear that any costs incurred by the lessor in performing the remaining return maintenance are to be reimbursed by the lessee and that the lessor taking over the return maintenance does not relieve lessee of its other obligations under the lease or waive any remedies available to the lessor arising out of the return event of default (such as retaining any security deposit).

In sum, a lessor can address the lessee’s concerns with missing the scheduled return date without substantial hardship, but the general point to make to lessees on this issue is that any solution needs to reflect the basic commercial agreement between the lessor and the lessee that the lessee is fully responsible for the condition and maintenance of the aircraft.