Tag Archives: Aircraft Return

Engine Thrust at Delivery and Return

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Here’s a common fact pattern in connection with the sale and leaseback of a used aircraft:  An airline and a lessor will agree that the lessor will purchase one or more of the airline’s aircraft and then lease those aircraft back to the lessee for an agreed term and at an agreed rent.  The lessor’s obligation to purchase the aircraft will usually be subject to a pre-purchase inspection of the aircraft and to the aircraft being in the same condition (as at inspection) on the purchase date.  Rarely will there be a full description of the aircraft in the purchase agreement; instead the lessor will rely on its inspection of the aircraft and on detailed return conditions in the leaseback documentation.  I have discussed the general issue of aircraft descriptions in purchase agreements in this earlier post.

As most of you know most (all?) aircraft jet engines may be operated at different thrusts.  Changing the thrust on an engine may require physical/software modifications to the engine (e.g., a derate plug), but a change will also require paperwork from the engine manufacturer; and the paperwork from the manufacturer for an increase in thrust will generally require a large payment to the engine manufacturer (sometimes hundreds of thousands of dollars per engine).  Instead of purchasing additional thrust, airlines may “lease” the thrust for an agreed period of time.

Most of you probably see where I’m going here.  If the lessor in a sale/leaseback transaction sends its inspector to look at, say, a 737-800 and the inspector reports back that the installed engines are CFM56-7B26 engines (per the dataplate on each engine), the lessor knows that that the installed engines are certified to operate at 26,300 lbs. thrust (signified by the “26” in the “7B26”).  But the first question from the lessor’s tech and legal officers should be “is that thrust rating owned and transferable by the airline or is it leased by the airline (and the engines will revert to a lower thrust rating at some point)?”

If the lessor fails to ask that question, it may be surprised to find at return of the aircraft at lease end that the engines are returned as CFM56-7B24 engines (that is, with 24,000 lbs. thrust).  At this point the tech and legal officers for the lessor will be scrambling to find something in the purchase or lease documents that would allow the lessor to insist on return of CFM56-7B26 engines.  For example, the lessor may say “look, the description of the engine in the purchase agreement says ‘CFM56-7B26,'” to which the airline will respond “that’s because they were CFM56-7B26 engines at delivery.”  Then the lessor will say “look, the lease return conditions require the aircraft to be returned in the same configuration and with the same capabilities as delivery,” to which the lessee will say “‘configuration’ refers to the seating configuration and the aircraft is airworthy and so does have the same capabilities.”  Acrimony ensues.

The lessons here are:

  1. The purchase agreement should be clear that the current thrust is owned and transferable by the airline. In addition, the lessor’s tech officers should confirm such with the engine manufacturer directly.
  2. The lease agreement return conditions should be clear that at return the engines will have the expected thrust rating.

The above also applies to new aircraft in sale/leaseback transactions.  For example, an airline may have a deal with the engine manufacturer such that the installed engines will be delivered from the airframe manufacturer at a higher thrust but such thrust will apply only for so long as the airline operates the aircraft, after which a lower thrust rating would apply.

As always, be careful out there.

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

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Every lessor has horrifying examples of heavy damage to one or more of its aircraft—the tail strike on takeoff, the hard landing, the landing with the landing gear retracted, the exploding grenade perforating the fuselage, the aircraft leaving the runway and sinking in the mud, etc. Whether the damage constitutes a “total loss” of the aircraft for insurance purposes is often clear, and where not clear the lessor, the operator and the underwriters will negotiate to determine whether to attempt repair or declare a total loss. In these negotiations, the underwriters will generally favor repair (because it is cheaper than paying out the aircraft agreed value) and the lessor will favor declaring total loss (because it wants to receive the agreed value, which is usually in excess of the lessor’s book value). The oft quoted full of thumb is that if the expected cost of repair will exceed 75% of agreed value, then the underwriters will declare a total loss.

In those cases where the aircraft is repaired after heavy damage the airframe manufacturer will be involved in the repair planning and often will perform or manage the repair, and the airframe manufacturer will, at least as a practical matter, be the final arbiter of whether the repair was successful—that is, that the aircraft is airworthy and can be returned to service. But even after a successful repair, the aircraft re-sale value and re-lease value will be less than if the aircraft had not suffered the damage in the first place. Whether the values should be less will depend on the damage and the repair, but in the real world aircraft market an aircraft that has had substantial damage will always suffer a loss in re-sale and re-lease values.

Who should bear this loss in value?

The insurers will, correctly, point out that their only obligation is to pay for the repair.

The lessee will, maybe correctly, point out that its only obligations are to repair the aircraft in accordance with the terms of the lease (which usually provide that all repairs will be performed in accordance with the structural repair manual or otherwise as approved by the airframe manufacturer) and return the aircraft in the required return condition.

It’s at this point that the lessor’s lawyers will be closely reviewing the lease documents for a provision putting the burden of the loss in value on the lessee–which in all fairness is where it belongs. The first stops will be the damage repair provisions and return conditions. Maybe the lawyers will find something–it’ll vary lease to lease.

The next stop will be the general indemnity, which in almost all leases will provide that the lessee will indemnify the lessor for “losses” incurred in connection with the “operation” of the aircraft. The lawyers should also carefully review the exceptions to the general indemnity–an exception for “loss in market value” is a not uncommon exception. Even if the general indemnity looks like it applies, the lessee is certain to argue that its only obligation is to repair the damage in accordance with the lease documents’ damage and repair provisions, and these provisions trump the general indemnity–in other words, the lessor shouldn’t be able to make a claim under the general indemnity where the lessee has fully performed under the specific provisions of the lease documents.

The safest approach is to deal with the issue clearly and expressly in the damage and repair provisions, but you can expect some push back from the lessee during the lease negotiations.

Four Biggest Mistakes Lessors Make in the Return Compensation Section

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Return compensation provisions in lease agreements are often poorly drafted. Given that these provisions generally require a multi-million dollar payment from the lessee to the lessor (or sometimes vice versa) you would think the drafting would be clear, precise and complete. Maybe it is the fact that the provisions don’t come into play for a long time. I don’t know.

In any case here are the four biggest (and surprisingly common) mistakes lessors make when drafting and negotiating the return compensation provisions in the lease agreement:

1. Starting with the most costly mistake, the parties will often fail to adequately describe the maintenance event that triggers the start of the return compensation calculation. For example, I have seen the following in a one-way return compensation provision: “Lessee will pay Lessor US$[__] for each hour of utilization of each Engine since such Engine’s last engine shop visit.” And “engine shop visit” is nowhere defined in the lease agreement. Sometimes the drafting is a little better and “engine shop visit” will be defined as, say, a performance restoration whereby useable life has been restored–a pretty low standard. The risk for the lessor in both of these examples is obvious; a shop visit with a minimal work scope will restart the return compensation clock and the return compensation payable to the lessor will not reflect the actual maintenance status of the engine and will fall short of the maintenance credit expected by the next lessee.

The problem is the same for airframe checks and landing gear and APU overhauls, though the range of possible workscopes is smaller and the dollar amounts for the APU and landing gear are smaller. But each should be well defined, including by a reference to the manufacturer’s requirements.

When return compensation is two-way (or “upsy-downsy”) equal care needs to be taken in describing the predelivery maintenance events, and my preference is (where possible) to specify by date each of the last relevant maintenance visits.

2. I really can’t understand this one: return comp provisions often lack any adjustment to the agreed dollar amounts for escalation, hour:cycle ratio changes (for engines), derate (for engines), minimum utilization (usually for airframes), etc. Whereas these adjustment will be dealt with in detail in maintenance reserve provisions, I will frequently see no such adjustments in return compensation provisions. Without escalation that US$150 per hour for engine performance restorations is going to look really puny at the end of a 12-year lease term.

(And remember to make sure the escalation formula provides for annual compounding.)

3. Maybe out of laziness, maybe to avoid conflict, maybe because there is a concern that maintenance costs may be much more expensive or cheaper than current costs, lessors and lessees often agree to the “two quotations” or “three quotations” method to determine the return compensation rates. In a common formulation each of the lessor and the lessee get quotations for the relevant maintenance events (heavy check, engine performance restoration, etc.) and use those quotations as a basis agreeing the per hour/cycle/month return compensation rate and in the absence of such agreement the quotations are averaged (or a third quotation obtained).

There are numerous problems with this approach for a lessor, including:

(a) Lessors always lose these type of negotiations. The lessee has possession of the aircraft and the lessee is likely to be the payer of the return compensation. In addition the lessor will likely be trying to lease other aircraft to the lessee. All the negotiating leverage is on the lessee’s side. In the end, if there is a disagreement the lessee will simply pay the lessor the amount the lessee thinks it owes, and put the burden on the lessor to either pursue the matter or give up.

(b) MROs are not in the business of providing accurate quotations for work they will not be performing (especially if the workscope is not precisely defined–see 1 above–and especially to lessors who as general matter don’t give much work to MROs)–and so such quotations will be difficult to get, may differ wildly and may be biased to the operator.

(c) As a drafting matter, the parties will generally forget to provide for adjustments to the amounts. No adjustment is necessary for escalation because the quotations method is in return date dollars, but hour:cycle and derate adjustments should still be provided.

(d) The quotations method will guarantee an acrimonious aircraft return. Most returns are already adversarial–the quotations method will take the acrimony to the next level.

4. Return compensation payments due from the lessee should be required to be made prior to return and, when due from the lessee, as a condition to return–that is, as a condition to the lessor’s obligation to accept return. I see most often the phrase “upon return,” which to me means either simultaneously with return or promptly thereafter. The lessee, when it is obligated to pay, will interpret “upon return” as promptly after return–and “prompt” to the lessee may not comply with your view of “prompt.” If you want to get paid promptly and in the correct amount then return compensation payments due from the lessee should be required to be made prior to return and, when due from the lessee, as a condition to return.