Some Issues with Reinsurance–Part 2

In Part 1 of this post I talked about the use of reinsurance in aircraft lease transactions and the issues raised by an aircraft lessor relying on reinsurance cut-through clauses. In this Part 2, I’ll look at one way to address those issues. Unfortunately the best solution has some traps for the unwary.

Rather than rely on a reinsurance cut-through clause, the best approach for a lessor to get direct recourse to the reinsurance proceeds is by an assignment of the rights to those reinsurance proceeds by the local insurer (viz. the insured under the reinsurance policy). I suspect that most or all or you are familiar with reinsurance assignments and so I’ll note only that a reinsurance assignment (1) is an assignment by the local insurer to the relevant lessor party (lessor, owner or possibly security trustee) of any hull and hull war (usually not liability) proceeds under the reinsurance policy and (2) provides for notice of such assignment to the reinsurers (or their representative), which notice serves to “perfect” the assignment under relevant law. Such a perfected assignment should trump any claims by the local insurer (or its representative) in the reinsurers’ jurisdiction to such proceeds.

OK, now let’s talk about the traps for the unwary:

1. The rationale behind the illegality/unenforceability of cut-through clauses also applies to reinsurance assignments. Like a cut-through clause, a reinsurance assignment effectively (we hope) cuts the local insurer out of the picture; for this reason, it is imperative that the reinsurance assignment be governed by the law of the jurisdiction of the reinsurer and the parties agree to submit to the courts in the jurisdiction of the reinsurer. I have had local insurers insist on their local law/courts, and I strongly suspected they were trying to subvert the assignment–knowing that the local courts would find the assignment invalid.

And as discussed in Part 1 of this post, one of the reasons for a lessor requiring reinsurance is to reduce the lessor’s country exposure to the lessee’s jurisdiction. By a lessor agreeing to use the local insurer’s law/courts, it is exposing itself to additional lessee country risk–and, separately, as noted in the preceding paragraph, possibly undermining the validity of the assignment.

2. Things change. Reinsurance policies generally run for a 12 month period. We all talk of “policy renewals” but as a matter of practice (at least in the London market) policies are replaced, not renewed; that is, when one policy expires, a new one will be put in its place. In addition, in the London market the underwriters/insurers for the policy (the “syndicate”) are very likely to change at each renewal–a few will be added, a few will drop out. And most importantly, the local insurer can change at each renewal (and even between renewals).

So, what does a lessor need to do?

(1) A reinsurance assignment needs to be carefully drafted to give the lessor a valid interest under not only the current reinsurance policy, but also under each replacement policy.

(2) In addition, to satisfy the notice of assignment requirement each year, at a bare minimum, the reinsurance certificate issued at renewal should list the reinsurance assignment in the “Contracts” section; a lessor may also want to actually issue a notice of assignment each year, especially if the reinsurance broker changes.

(3) If the primary insurer changes, then there needs to be a new reinsurance assignment–no way around that requirement. Why? Because the replaced primary insurer is the “Assignor” under the existing reinsurance assignment, but no longer has any interest under the reinsurance policy.

All of these “things change” issues should be discussed with the lessor’s counsel from the reinsurers’ jurisdiction during lease documentation, and the lease agreement and reinsurance assignment drafted accordingly. The above requirements are not something you want to try to impose retroactively after delivery–and without adequate support under the provisions of the lease documentation (and I’m not counting the lease agreement’s “further assurances” clause as adequate support).

A reinsurance assignment is not a document can be forgotten after delivery. At a minimum it should be reviewed at each insurance renewal to make sure it is still relevant and accurate. And the lease documentation should be clear that the lessee has an obligation to arrange the amendment or replacement of the reinsurance assignment during the lease term upon the request of the lessor “in order to effectively carry out the intent and purpose of the Reinsurance Assignment and to establish, perfect and protect the rights and remedies created or intended to be created in favor of Lessor thereunder” (or something like that).

A couple other random thoughts on reinsurance:

1. Let’s say (1) an aircraft suffers a total loss, (2) the local insurer fails to pay the lessor any hull insurance proceeds because the local insurer is insolvent (or is made insolvent by the claim from the lessor) and (3) the reinsurers pay the reinsurance proceeds to the local insurer because the cut-though and/or reinsurance assignment is found to be invalid (and almost needless to say the reinsurance proceeds are not passed on by the local insurer to the lessor). Does the lessor have a claim under its contingent insurance policy? Good question. See my discussion of the “exceptions clause” in contingent insurance policies. Such clause usually contains an exception similar to the following:

“This Policy does not pay any claim for liability, loss or damage which is not recoverable (in whole or in part) as a claim from the Principal Policy by reason of the insolvency and/or financial default of an Insurer or Insurers.”

2. I discussed cut-through clauses and reinsurance assignments. Are there any other options? Occasionally counsel in a lessee’s jurisdiction will suggest using an “irrevocable instruction” where the local insurer “irrevocably” instructs the reinsurers to pay the lessor directly. Workarounds put forth by local counsel should always be considered, but I’ve never seen how an irrevocable instruction differs substantively from a cut-through or how it offers more protection than a properly documented reinsurance assignment.

Some Issues with Reinsurance–Part 1

When negotiating aircraft lease agreements, at some stressful point during the negotiations I will, invariably and usually with some exasperation, make the following statement to the lessee’s commercial people and lawyers: “Look, we’re giving you a [say] US$50M aircraft and in exchange you’re giving us a pile of paper, and so we need to make sure the pile of paper protects our interests.”

If that pile of paper were sorted by the importance of the issues addressed, with the most important issues on top and the least important on the bottom, the lease insurance provisions and insurance documents would be near the top—along with the provisions addressing rent, reserves/return comp and return conditions.

In practice however, the insurance provisions and documents often do not get the attention they deserve from the lessor’s perspective, generally because the review task is spread across a few people—the lessor’s lawyer, the lessor’s internal “insurance person” and usually the lessor’s own broker. In my experience it’s rare that any one of these three people has a good grasp of all the insurance issues—and each tries to shift responsibility to the others. So, if you’re a junior aircraft finance lawyer and looking for a subject-matter to master, I’d put insurance at or near the top of the list. You will soon become an invaluable resource not only to your clients but to other lawyers in your firm/company.

A comprehensive review of aircraft insurance issues from the lessor’s perspective would require a long article or small book, but I’ll tackle one of the more difficult and confusing issues in this post—the use of reinsurance cut-through clauses and/or reinsurance assignments. And I will make an effort to come back to insurance issues on a regular basis over the next few months. (if you have any requests for a specific topic, send me an email.)

A little background: primarily for credit-related reasons, aircraft lessors prefer that the aircraft insurance provided by the lessee is placed by a broker (e.g., Aon) in the London market or with a major U.S. or European insurer experienced in commercial aircraft insurance (e.g., Allianz). It’s very common however for the lessee’s country to have trade protection laws requiring that an airline based in that country place its insurance with an insurance company based in that country. Generally lessors will not be willing to rely on this local insurance because the lessor will not accept the creditworthiness of the local insurer and because relying on a local insurer increases the lessor’s credit exposure to the country; in other words, the lessor will be unwilling to take local insurer credit risk or additional country risk.

The standard workaround is for the airline to place 100% of its insurance with a local insurance company, but then require the insurance company to reinsure 100% (or sometimes less) of the insurance risk with the London market or an acceptable European insurer (I’ve never seen a U.S. insurer act as reinsurer, not sure why). When this happens each of the local insurance company and the reinsurer will issue an insurance certificate to the lessor detaining the scope of aircraft coverage and the lessor’s rights under that coverage; usually the certificates are virtually identical.

Reinsurance is such a standard workaround for the local insurance requirement that the lessor’s lawyer and insurance person may forget for a moment (or more) that (1) the reinsurance policy is a contract between two parties (the local insurance company and the reinsurers) wholly unrelated to the lessor and lessee and not under the control of either, (2) the reinsurance policy is very likely governed by the law of the jurisdiction of the local insurance company, and (3) the loss payee under the reinsurance policy is (forgetting about “cut-throughs” and assignments for a minute) the insured under the reinsurance policy (that is, the local insurance company is the loss payee, not the lessor or the lessee).

I can hear some of you now saying “wait a minute, Brad, what about the cut-through clause in the reinsurance certificate delivered to the lessor by the reinsurer or its broker; doesn’t that clause require the reinsurers to pay the lessor directly (and the not the local insurance company)?”

Well, there are a few problems with cut-through clauses:

1. Cut-through clauses are very often illegal/unenforceable in the countries of the local insurers (e.g., Colombia). I have heard various explanations of why this is the case but the general consensus is that cut-through clauses evade the local insurance requirement and in effect make the reinsurer a de facto (unlicensed) insurer in the local insurer’s jurisdiction. Regardless of the rationale, when a reinsurance certificate is being provided to a lessor one of the first questions the lessor’s lawyer should have for local counsel is “are cut-throughs enforceable in your country?”

And in this context, keep in mind almost all cut-through clauses have a sentence similar to the following: “It is a condition that the provisions of this clause will not operate in contravention of the laws, statutes or decrees of the country of domicile of the Reinsured.”

2. A cut-through clause is just an endorsement to a reinsurance policy between the reinsurers and the local insurer. In ordinary course there is nothing in the reinsurance certificate that prohibits the removal of the endorsement during the policy (the 30-day notice period in AVN67 very arguably does not apply to any cut-through clause) or the failure to include the cut-through at renewal. Yes, such removal or failure would trigger an event of default under the lease agreement between the lessor and lessee, but the lessor would have no recourse against the insurer or reinsurer.

3. Under English law a cut-through clause will not have a the same legal effect as a perfected assignment of reinsurance proceeds (from the local insurer to the lessor), and will likely fail if challenged by a receiver or liquidator (or similar) of the local insurance company.

Ok, then what is the best way to give the lessor a direct, enforceable right to the reinsurance proceeds? I’ll address issue that in Part 2 of this post.

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.

Cross-Operational Indemnities in Aircraft Purchase Agreements

Despite often referring to themselves as “aircraft suppliers,” aircraft lessors are more accurately described as aircraft financiers who also take residual aircraft value risk. In an aircraft lessor’s perfect world, the lessor would never take possession of an aircraft or become involved in the manufacture, configuration, maintenance, repair or operation of an aircraft–because all of those things open the lessor up to claims from a lessee and possibly from third parties in the case of an accident involving the aircraft. In general, aircraft lessors will go to great lengths to avoid taking any risks associated with the physical (as opposed to financial) aspects of an aircraft.

The Disclaimer and General Indemnity sections of the lease agreement reflect this distancing of the lessor from the aircraft. The Disclaimer and General Indemnity sections of an aircraft lease agreement provide that, respectively, (1) as between the lessor and the lessee, once the aircraft is delivered to the lessee, the lessor has no responsibility or liability with respect to the condition of the aircraft and (2) during the lease term the lessee will bear all risks and costs, and will indemnify the lessor for all claims, arising out of the operation, maintenance, etc. of the aircraft. Lessees understand this allocation of risk and responsibility, and it’s rarely questioned in any meaningful way during the negotiation of the lease documentation. “Lessors don’t take operational risk” is a fundamental tenet of the aircraft leasing business.

And so I’m always surprised when I’m working on an aircraft purchase agreement and the lawyer on the other side (representing another aircraft lessor) says “my client insists on cross-operational indemnities in the purchase agreement.” Cross-operational indemnities in this context mean that (simplifying) the seller indemnifies the buyer for claims arising out of the operation of the aircraft prior to the purchase and the buyer indemnifies the seller for claims arising out of the operation of the aircraft after the purchase.

Here’s the seller half of a cross-indemnity (redacted) from a draft agreement I reviewed (representing the buyer):

Without prejudice to the disclaimers in Clause 7 (Condition of Aircraft), the Seller shall indemnify the Purchaser in full on demand on a net after-Tax basis in respect of all Losses suffered or incurred by the Purchaser or any of its officers, directors, employees, servants, representatives or agents arising out of or connected in any way with . . . the purchase, manufacture, ownership, possession, registration, performance, transportation, management, sale, control, use, operation, design, condition, testing, delivery, leasing, maintenance, repair, service, modification, overhaul, replacement, removal or redelivery of such Aircraft, or any loss of or damage to the Aircraft, or otherwise in connection with the Aircraft or relating to loss or destruction of or damage to any property, or death or injury to any Person caused by, relating to or arising from or out of (in each case whether directly or indirectly) any of the foregoing matters and regardless of when the same arises or occurs, or whether it arises out of or is attributable to any act or omission, negligent or otherwise of the relevant Purchase . . . provided that such indemnities shall not extend to Losses . . . to the extent that such Losses arise out of any occurrence or event which occurs after Delivery in respect of such Aircraft.

There was a mirror indemnity given by the purchaser.

In this particular transaction, the aircraft was being sold subject to lease. So, my first question was “why do we need cross-indemnities given that, pursuant to the lease novation, both the purchaser and the seller will be covered by the lessee’s operational indemnity and by the lessee’s insurance?” I also pointed out that as aircraft lessors we usually strenuously try to avoid ANY operational risk on aircraft, but in the draft we are each expressly taking broad, unlimited operational risk for an aircraft operated by a third party. The actual response I received: cross-indemnities are “standard.”

A better response would have been something like “cross-indemnities just fairly allocate existing risk between the purchaser and the seller, they don’t create any risk that isn’t already there.” Well said, but (1) do the cross-indemnities really allocate the risk fairly and (2) would the parties be better off without the cross-indemnity? The same question another way: Does the before-after split really allocate the risk fairly?

One example: seller and buyer agree to cross-indemnities using the above wording and the sale/purchase of the leased aircraft closes. The aircraft crashes and there are lawsuits for injury/death and property loss. Neither the seller nor the purchaser was at fault (no negligence or other misconduct), but the jurisdiction where the aircraft crashed is a strict liability jurisdiction that imposes liability on the owner of the aircraft regardless of fault (e.g., Sweden last time I checked). The cause of the aircraft crash was faulty maintenance by the operator that occurred prior to the sale of the aircraft. Without the cross-indemnities, the purchaser, as owner at the time of the crash, would bear the full liability for the crash (as between the purchaser and the seller); with the cross-indemnities, the seller bears the full liability. Reasonable people could argue about which is the “fair” result, but for the seller the cross-indemnities definitely created an operational risk that it did not have before (once it sold the aircraft).

Another example: Same as the above except the lessee had a history of sloppy recordkeeping of which the seller was aware, but the seller did not tell the purchaser. The crash–in a non-owner strict liability jurisdiction–was the result of bad recordkeeping that occurred after the sale of the aircraft. The purchaser was wholly unaware of any recordkeeping problem. The seller is sued because it was aware of the sloppy recordkeeping, and the seller makes a claim under the cross-indemnity. The cross-indemnity would put at least some (and possibly all) of the seller’s liability on the purchaser–an unfair result in my opinion.

My preference in purchase agreements is to not include operational cross-indemnities and, by remaining silent, to make each party responsible for managing its own liability with respect to the aircraft–regardless of whether that liability could be characterized as arising before or after the sale.

What about naked aircraft (that is, aircraft not on lease at the time of sale)? I think it is the same answer. Parties should manage their own liability (through insurance, prior and future operator indemnities, due diligence, etc.) without assuming broad, uncapped liability under cross-indemnities in a purchase agreement.

P.S., bonus points to those of you who paused on clause “Without prejudice to the disclaimers in Clause 7 (Condition of Aircraft), . . .” in the quoted language above. Yes, I too wonder how that would undercut the seller’s indemnity. Even without that clause, I think you still have a possible conflict between the seller’s disclaimer and the seller’s cross-indemnity. The above clause would make more sense if it said “Notwithstanding the disclaimers in Clause 7 (Condition of Aircraft), . . . .”

Who Bears the Risk of Loss in Value After an Aircraft is Damaged?

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

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.

The “No Increased Obligations” Condition in the Assignment Section

Absent unusual circumstances it is standard for the Lessee to take “day one” structure risk and “change in law/circumstance” structure risk throughout the lease term. As a practical matter, what this means is that if (1) tax withholding is imposed on rent payments (and the lessee must therefore gross up), (2) foreign exchange controls make payments more difficult or expensive or (3) any other requirement (legal or otherwise) is imposed on the lessee in connection with its performance of the lease agreement or its use of the aircraft, then the risk and burden of that requirement is on the lessee.

Aircraft lessors are fond of using the real estate leasing term “triple net lease.” In real estate a triple net lease is one in which the real estate lessee agrees to pay the following three (hence “triple”) costs (1) real estate taxes, (2) insurance costs and (3) maintenance costs related to the property; but in both real estate and aircraft leasing “triple net lease” is also used generically to mean that, as between the lessor and the lessee, the lessor bears no asset, operational or performance risks under the lease agreement.

Aircraft leases being “triple net leases” is a core concept of the aircraft leasing business and any deviation from that concept should be allowed only for compelling reasons.

That said, one exception to the “triple net lease” concept is often made in connection with the assignment of the lease by the lessor (usually accompanying the sale of the aircraft by the lessor or an affiliate). The assignment section of most lease agreements will contain a provision saying something like (paraphrasing):

“As a condition precedent to the lessor’s assignment of the lease, the lessee’s obligations under the lease will not, as determined at the time of the completion of such transfer, increase as a consequence of such transfer.”

That’s fair. The lessee should not be required to bear increased obligations as the result of a transfer to, say, a lessor based in another jurisdiction.

But now let’s look at a couple ways that lessors screw up this provision.

1. In the paraphrase above, note the clause “as determined at the time of the completion of such transfer.” This clause is key for at least a couple reasons.

First, if it is omitted a large part of the risk of change in law (post transfer) is shifted to the lessor if the new lessor is in a different jurisdiction from the transferring lessor. For example, if, post-transfer, tax withholding is imposed on lessee payments to the new lessor’s jurisdiction (and not to the old lessor’s jurisdiction), then the lessee will not be obligated to gross up. (I suspect some lessees would see not grossing up as the fair result, but it is contrary the concept of an aircraft lease being a triple net lease; that is, change in law is not a risk that aircraft lessors should take–either in a de novo lease or an assigned leases.)

Second, by not tying the “no increased obligation” condition to the time of transfer, the new lessor leaves itself open to spurious and not so spurious defenses for the rest of the lease term.

2. The “no increased obligation” condition should be just that–a condition, not a covenant. Once the lease transfer is accomplished, the condition should fall away and no longer be an operative provision (at least until the next transfer). I’ve seen some lessors fail spectacularly on this issue, not only making the “no increased obligation” provision a covenant but going on to give the lessee an explicit defense to performance, setoff rights, an express indemnity and lease termination rights if the lessee does have increased obligations.

Maybe I shouldn’t be so critical. Aircraft leases are commercial transactions and an outsider will never know about all the tradeoffs involved in a negotiation, but I suspect that a lessor which agrees to an on-going “no increased obligations” covenant in a transferred lease would never agree to take change in law/circumstance risk in a lease it originates.

Contingent Aircraft Insurance: The Exceptions Clause

As counsel to aircraft lessors I’ve worked with the major brokers in the London insurance markets and have found that the guys (and occasional gal) that work there are on the whole professional, friendly, knowledgeable and very customer oriented, but (you knew the “but” was coming) as a lawyer I frequently am frustrated with the vague drafting of the insurance policies and insurance certificates coming out of London and the equally vague responses to my attempts to understand or clarify the wording.

A prime example of vague drafting are two coverage exceptions that have been in contingent aircraft insurance policies for at least the last 15 years. I’ll discuss those exceptions below, but first some brief background on contingent aircraft insurance.

As you know, each aircraft lessor requires an aircraft lessee to maintain hull/hull war and liability insurance on the lessor’s aircraft during the term of the lease. That insurance is, either directly or ultimately, usually placed through the London insurance market. The London market also sells (or tries to sell) “contingent insurance” directly to the aircraft lessors. Simply stated, contingent insurance covers the risk that the lessee’s insurance doesn’t pay the lessor after a valid claim is made by the lessor. Contingent insurance is generally sold on a fleet basis—that is, the insurance covers the lessor’s entire fleet of aircraft.

I would guess that most aircraft lessors buy contingent insurance. I consider contingent insurance an optional insurance (not a core, required business insurance), but it’s an insurance product that is hard not to buy. If a lessor does buy it and never has to make a claim, the cost is seen as just another cost of doing business—rarely thought about again. If a lessor doesn’t buy it and would have had a claim (or a potential claim), then somebody at the lessor is likely to be fired. I’m not suggesting that the only reason that executives at aircraft lessors buy contingent insurance is for job security, but it is one reason.

With the foregoing as background, let’s get back to the main topic: two coverage exceptions that limit the scope of the contingent insurance. I have seen these exceptions in various policies over the years but the language quoted below is from a policy I found online today through a Google search:

Principal Policy

This Policy does not cover loss or damage which is recoverable as a claim from the Principal Policy.

Insolvency and Financial Default

This Policy does not pay any claim for liability, loss or damage which is not recoverable (in whole or in part) as a claim from the Principal Policy by reason of the insolvency and/or financial default of an Insurer or Insurers and any amount claimed under a self insured retention within the Principal Policy.

Let’s start with second exception first. Contingent insurance does NOT pay if the primary insurance doesn’t pay because the primary insurer is insolvent. I suspect this fact will surprise some of you. London brokers and underwriters will tell you that this exception is required in contingent insurance policies because Lloyd’s underwriters are prohibited from providing “financial guarantees.” Also note that “insolvent” is not defined and so will likely be broadly construed by a contingent insurer facing a claim.

Now note that contingent insurance also does NOT pay if the primary insurance doesn’t pay “by reason of the . . . financial default of” the primary insurer. What does the “financial default” exception cover that isn’t already covered by the insolvency exception? And isn’t every failure to pay money a “financial default”? I have asked those two questions many times, and have yet to receive a satisfactory response.

Regarding the first exception, note that it does NOT say “this Policy does not cover loss or damage which is recovered as a claim from the Principal Policy”–in other words, you don’t get paid twice. What the above language says is the insured under the contingent policy does not get paid for any claim which is “recoverable” under the primary policy–presumably even if not actually recovered. What does “recoverable” mean? Only that the claim is within the scope of the primary policy? That can’t be right–otherwise no claim would be payable under a contingent policy. That the claim can be recovered if the claimant tries hard enough? Again I have repeatedly raised this issue over the years without a satisfactory resolution.

Some of you may be thinking that I just didn’t do a good job negotiating the language. Maybe, but I don’t think so.

When you look at the look at the two exceptions together a fair question to ask a London broker is: What potential claims under a contingent policy would not fall under one or both of those exceptions? In other words, what risks are actually being covered by contingent insurance? Yet another variation of the question: What are the details of actual claims that have been paid out (or denied) over the last several years?

I don’t mean the above to be a criticism of contingent insurance (I really don’t), but I do think the two exceptions discussed above illustrate the problems lawyers often have when dealing with the London insurance market. Lawyers are looking for clear, precise language that will lead to predictable outcomes over various fact patterns. And the London market operates using insurance forms and precedents that have been in place for years (and years) and that brokers and underwriters are loathe to modify.

“Underlying Transaction Doesn’t Violate Law” Exception in a Letter of Credit

As a lawyer representing leasing companies I hate letters of credit. Kinda harsh I know, but read on.

The LC most common in aircraft leasing is the standby LC. It is usually issued in lieu of the lessee paying the security deposit and sometimes in lieu of the lessee paying maintenance reserves, and it is usually drawable by the lessor upon the occurrence of an event of default by the lessee under the lease documentation.

Lessees sometimes prefer to provide LCs rather than a cash deposit or cash reserves because the lessee needs/wants the cash for itself and the LC costs imposed by the bank issuing the LC are (sometimes) low enough for the lessee to justify agreeing to those costs and providing the LC in lieu of cash.

Lessors of course prefer to receive and hold the cash, but the use of an LC by the lessee is often a negotiating point during the lease negotiations, and it is common for the lessor to agree to accept an LC in lieu of a security deposit (much less common is the lessor accepting an LC in lieu of maintenance reserves).

During these negotiations on the LC issue, I will hear from the lessee (and sometimes from the lessor’s own commercial people) “an LC is the equivalent of cash.” That is never true in a strict sense and, depending on the form of the LC and other factors , often not true in a meaningful sense.

An LC gives the beneficiary (the lessor) a right to payment from the issuing bank upon certain conditions and requirements being met. The primary job of counsel for the lessor is to make sure those LC conditions and requirements are minimal and are able to be easily satisfied by the lessor; that is, the primary job of counsel for the lessor is make sure the LC is as close as practical to the “equivalent of cash.”

The reason I hate letters of credit is because at the time the lessor wants to draw a letter of credit neither the issuing bank nor the lessee (as the LC account party) will want the lessor to get paid under the LC–the issuing bank will be worried about not being repaid by the lessee (and/or becoming involved in litigation/bankruptcy proceedings) and the lessee will be worried about the commercial consequences of an LC draw after default. Both will be looking for excuses allowing the issuing bank not to pay the lessor under the LC. On the other side, the commercial officers at the lessor will be expecting prompt payment under the LC–after all, “it is the “equivalent of cash, right Brad?”

With the forgoing as background, I’ll discuss one somewhat common LC provision that should be struck by the lessor’s counsel from any LC draft.

From time to time I will see a broad illegality exception in an LC providing that the issuing bank is not obligated to pay under the LC if the underlying transaction is illegal. When I see this exception it can usually be traced to a current political or regulatory event that is making banks more cautious at that time. For example, I saw the following language in a draft LC last year at the height of the crisis in Ukraine and when the US and EU were imposing sanctions against Russia (even though neither the LC nor the underlying transaction had any connection to Russia or Ukraine):

No party which is sanctioned by the United Nations, United States or the European Union, or United Kingdom, is to be involved in the transaction in any manner. We may not complete a transaction which involves such a party, or any party in the above countries.

Wow. Ignoring the really bad drafting (what countries are being referred to in “or any party in the above countries”?), that provision is way too broad. Let’s give the bank of the benefit of the doubt and assume what it was trying to say was something like:

We will not be obligated to make any payment hereunder if the transaction underlying this letter of credit is illegal.

When first reading that exception, a reasonable lawyer might think “hmm, that sounds right–the bank shouldn’t be obligated to be involved in an illegal transaction.” But the second time the lawyer reads the exception he should think the following:

1. Wait a minute, should the bank be excused for paying under the LC if the underlying transaction is illegal or only if the payment itself by the issuing bank is illegal?

2. Who bears the risk of illegality under the underlying transaction documents, and more importantly why is the LC addressing a risk normally allocated between the parties in the underlying transaction documents?

3. If the LC is supposed to be a cash equivalent, then shouldn’t the LC issuer be obligated to pay regardless of illegality of the underlying transaction–so that the lessor is put in the same position as if it had held cash? Isn’t this especially true if the illegality arose during the performance of the underlying transaction?

4. LCs are supposed to be separate and independent from the underlying transaction. Some LCs state this expressly, and even where they don’t the LC rules incorporated by reference do (see UCC 600 Article 4 (“A credit by its nature is a separate transaction from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such contract, even if any reference whatsoever to it is included in the credit. Consequently, the undertaking of a bank to honour, to negotiate or to fulfil any other obligation under the credit is not subject to claims or defences by the applicant resulting from its relationships with the issuing bank or the beneficiary.”) and ISP98 Section 1.06(a) (“A standby is an irrevocable, independent, documentary, and binding undertaking when issued and need not so state.”)).

In conclusion, be very wary of any exception to the issuing banks obligation to pay under an LC. Your lessor client is going to be anxious during the draw process and very disappointed with a failed draw. As a general rule you should review a draft LC with the same intensity and care as you would read a final LC after your client has called and told you to draw the LC.

Treatment of Engine LLP Reserves in Lease Agreements

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.