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.

Total Loss Only Cover

I will admit upfront that some aspects of “total loss only” insurance cover still mystify me.

Some background (as always, from an aircraft lessor’s perspective): from time to time a lessee would approach me and ask whether it could satisfy the lease requirement for hull coverage on the aircraft at a specified agreed value (say US$50M) with a combination of (1) “normal” hull cover with a lower agreed value (say US$45M) and (2) a total loss only policy for the balance (US$5M). As the lessee would explain, the total loss only policy pays out only (of course) in the event of a total loss.

My first question would always be “why do you want to do that?” and the response would always be “because it’s cheaper.” I would then ask whether the underwriters were the same for both the hull and total loss policies and the answer was usually “yes” (or “I don’t know”). And when the lessee said “yes” I would ask “then why is it cheaper if the underwriters are taking the same risks as with a single hull policy with a higher agreed value?” I never got a clear or satisfactory answer to this question but I didn’t doubt that it was in fact cheaper.

From the lessor’s perspective the problem with using a combination of two policies to cover the risk normally covered by one policy is that the lessor may get whipsawed between the two policies when an accident occurs by, for example:

1. The hull underwriters taking the position the aircraft has suffered a total loss and the total loss underwriters disagreeing and saying the aircraft should be repaired, or

2. Both the hull and total loss underwriters taking the position that the aircraft should be repaired, but when the actual repair cost exceeds the agreed value of the hull policy, the lessor is required to cover the excess cost (and the total loss insurers are let off the hook entirely).

My strong inclination (from the lessor’s perspective) is to decline any such request because (1) of the potential for being whipsawed, (2) in insurance, “it’s cheaper” usually equates to “it offers less protection” and (3) in risk mitigation for lessors (whether insurance, security deposits, letters of credit, maintenance reserves, guarantees, etc.) simplicity of structure should be (IMO) a priority.

If a lessor does want to be cooperative and to consider the lessee’s request then in order to protect against being whipsawed the underwriters should confirm to the lessor (e.g., by way of an insurance certificate from the broker) that:

1. A total loss will be automatically declared under the total loss only policy if a total loss is declared under the hull policy, and

2. A total loss will be declared under the hull policy if the estimated cost of repair to the aircraft exceeds 75% (or a lower or higher percentage depending on the lessor’s comfort level) of the agreed value under the hull policy alone.

I have been successful in getting the underwriters to agree to the above and have been told (not sure I believe it) that the above is in fact how the policies are drafted.

As mentioned at the outset, the use of total loss only insurance cover still mystifies me. So, be careful and ask a lot of questions. And I would be especially wary if the total loss only cover is for more than 10% of the required agreed value.

The Importance of Transaction Checklists

I’m a big believer is developing and using checklists in connection with legal work in general, not just in connection with transaction closings.  And to that I’m sure a lot of you will say “no duh, Brad.”  But in my experience many lawyers don’t use checklists even in connection with transaction closings and those that do often prepare the checklist just a couple days before the scheduled closing–often too late to effectively manage what needs to get done.  Instead I suspect many lawyers and paralegals rely on memory, email chains, Post It notes, and the conditions precedent sections of the relevant documents.

A well thought out transaction checklist prepared early in a transaction (at the latest when primary transaction documents are agreed) will allow a lawyer to spot logistical, commercial and other issues well in advance of the closing.  It will also provide a central location for keeping track of the status of the checklist items, developments and changes in the transaction and any other ideas and thoughts relevant to the closing of the transaction.  A checklist is also a great way to share information among the lawyers and paralegals on a deal.

When I see a young lawyer or paralegal overwhelmed with the logistics of an upcoming closing my advice is usually something like this:  “After the transaction documents are signed, closing a deal is relatively easy.  Make a detailed list of all the things that need to get done for the deal to close, and then make sure each item gets done.  That’s it.  Look at each item on the list at least once every day and ask yourself ‘what can I do to move this item forward right now?’ and then do it.  Closing a deal involves a finite number of steps; you just need to identify them and make sure they get done.”

Here’s a link to a New Yorker article about checklists.  The article is about the use of checklists in the medical profession, which use is unfortunately not as prevalent as you may expect (and hope).  (The article also has an interesting discussion of the introduction of checklists for pilots.)  Below is an excerpt about a medical checklist:

“In 2001, though, a critical-care specialist at Johns Hopkins Hospital named Peter Pronovost decided to give it a try. He didn’t attempt to make the checklist cover everything; he designed it to tackle just one problem, the one that nearly killed Anthony DeFilippo: line infections. On a sheet of plain paper, he plotted out the steps to take in order to avoid infections when putting a line in. Doctors are supposed to (1) wash their hands with soap, (2) clean the patient’s skin with chlorhexidine antiseptic, (3) put sterile drapes over the entire patient, (4) wear a sterile mask, hat, gown, and gloves, and (5) put a sterile dressing over the catheter site once the line is in. Check, check, check, check, check. These steps are no-brainers; they have been known and taught for years. So it seemed silly to make a checklist just for them. Still, Pronovost asked the nurses in his I.C.U. to observe the doctors for a month as they put lines into patients, and record how often they completed each step. In more than a third of patients, they skipped at least one.

“The next month, he and his team persuaded the hospital administration to authorize nurses to stop doctors if they saw them skipping a step on the checklist; nurses were also to ask them each day whether any lines ought to be removed, so as not to leave them in longer than necessary. This was revolutionary. Nurses have always had their ways of nudging a doctor into doing the right thing, ranging from the gentle reminder (“Um, did you forget to put on your mask, doctor?”) to more forceful methods (I’ve had a nurse bodycheck me when she thought I hadn’t put enough drapes on a patient). But many nurses aren’t sure whether this is their place, or whether a given step is worth a confrontation. (Does it really matter whether a patient’s legs are draped for a line going into the chest?) The new rule made it clear: if doctors didn’t follow every step on the checklist, the nurses would have backup from the administration to intervene.

“Pronovost and his colleagues monitored what happened for a year afterward. The results were so dramatic that they weren’t sure whether to believe them: the ten-day line-infection rate went from eleven per cent to zero. So they followed patients for fifteen more months. Only two line infections occurred during the entire period. They calculated that, in this one hospital, the checklist had prevented forty-three infections and eight deaths, and saved two million dollars in costs.”

I’ll come back to this topic later and discuss checklists for other legal tasks, like document review.