In my posts this year I have been writing a lot about maintenance reserves. This focus is not misplaced. The maintenance reserve section is one of four aircraft lease sections where the lawyers on a deal can make a commercial difference–either positively or negatively. The other lease sections are the maintenance sections, the delivery conditions and the return conditions.
My work for the last year has been focused on reviewing lease agreements in connection with the purchase of leased aircraft–and an unsurprising pattern has emerged in these reviews. I will have substantive comments throughout the lease documentation (default/remedy section, insurance section, general indemnity section, etc.), but when I finish the review and prepare a summary highlighting the most serious problems with the lease documentation, the list is heavily weighted with maintenance reserve and return condition issues–mainly because these are the issues that will have a material and inevitable financial impact on the lessor. If there is a mistake in the general indemnity, insurance or the default/remedies section, it’s highly unlikely such mistake will ever have any impact on the lessor.
As a consequence, when my client discusses my comments with me and then with the seller of the aircraft, my client’s focus is on these maintenance reserve and return condition issues. And if a purchase falls apart during the due diligence stage, it’s very likely going to be because of either an unsatisfactory aircraft inspection or deficiencies in the maintenance reserve and return condition sections of the lease documentation. The deal is not going to fail because, for example, the scope of the general indemnity isn’t broad enough.
With the above in mind, here are some thoughts on the maintenance reserve provision dealing with initial credits for reimbursable maintenance (aka “lessor contributions”).
1. Start Date. When a lessor is offering to lease a used aircraft to a lessee the lessor will generally offer to provide the lessee with credits that the lessee may use in connection with the first reserve reimbursable maintenance visit (major airframe check, engine performance restoration, etc.) during the lease term. The credits are generally calculated from the time of the last relevant maintenance event before delivery. One of the things that I look for when reviewing this lease provision is whether the lease documentation is clear about the start date for the calculation of the credit.
For the airframe and the landing gear, where the checks/overhauls are generally calendar driven and the workscope well-defined, the start date should be obvious from the aircraft’s maintenance records. Similarly, for the engine LLPs, assuming the aircraft records and lease documentation accurately reflect cycles since new and have back-to-birth (including thrust usage) traceability, the start date and the credit calculation should be just a matter of math.
But for the engines and APU, the timing of performance restorations is driven by operating condition and not by calendar time, hours or cycles, and the workscope for an engine restoration can be heavy or light. Consequently it is very common for a lessor and lessee to disagree about the start date for the initial credit on the engines and APU–that is, disagree on the amount of the initial credit. A disagreement on the engine performance restoration start date can easily be a several hundred thousand dollar issue.
The best practice here is to agree either the start date or the amount of the initial credit during the lease negotiation. If the start date is not clear from the lease documentation, then I will recommend to the buyer of the aircraft to agree the start date in the lease novation documentation.
2. The Method of Calculation. Once the start date is agreed there are a couple ways to calculate the initial credit–the pro rata method and the rate-times-hours/cycles/months method.
Under the latter method, the calculation of the initial credit is the simply the applicable base year (unescalated) maintenance reserve rate multiplied by the number of hours, cycles or months (as applicable) since the last relevant maintenance event.
Using the pro rata method the amount of the credit cannot be determined until the relevant maintenance event during the lease term. At that time the full reimbursable cost for the visit is allocated pro rata between the usage before the delivery date and the usage after the delivery date, with the lessor obligation to provide a credit for the usage before the delivery date. For example, if an engine performance restoration costs $4M, the “start date” was two years before the delivery date and the performance restoration was started two years after the delivery date, then the initial credit would be $2M.
Lessors generally don’t like the pro rata approach because (1) it shifts the risk early maintenance (especially respect to engines) on to the lessor (because the denominator in the pro rata calculation is smaller for early maintenance) and (2) it shifts part of the risk of the final cost of the maintenance on to the lessor (because the lessor’s credit is not capped at the per hour/cycle/month rate, but instead is calculated using the actual reimbursable cost of the maintenance event).
The use of the pro rata method for engine performance restorations is especially risky for lessors–because an engine can come off wing early for condition reasons and because the cost of performance restorations is notoriously difficult to predict/control. To take an extreme example, if an engine is driven off wing for a performance restoration on the first day of the lease term, the pro rata approach would result in the lessor bearing 100% of the cost of the performance restoration.
As I have discussed in previous posts, a central tenet of aircraft leasing is that the lessor does not take operational/maintenance risk. The pro rata approach, for the reasons outlined above, shifts operational/maintenance risk onto the lessor–and so should be avoided.
3. Engine LLPs. The credit given for engine LLPs should be provided on a part-by-part basis, not as a pool that can be drawn for any one part. Like the pro rata approach discussed above, allowing the lessee to draw on a pool of credits for the replacement of any one part shifts the risk of early removal to the lessor. Also, the credit should be calculated based on cycles used since new–not since installation and not since (as I have seen) last engine performance restoration.
4. Other Considerations. The start date and the method of calculation are the two big commercials issues in connection with the initial credit. Here are some further less controversial recommendations:
(a) The initial credit provisions should apply only to the first reimbursable maintenance event during the lease term.
(b) The initial credit should apply only to reimbursable maintenance events and only to the extent the maintenance event is reimbursable.
(c) The obligation to pay the credit should be conditioned on the same conditions as the reimbursement of reserves (e.g., no continuing lessee default).
(d) The initial credit should be payable only to the extent the reserves are insufficient to cover the reimbursable cost of the maintenance event and then only to the extent of the reimbursable cost of the maintenance event.
(e) The base house/cycle/month rate for the initial credit should not escalate or adjust in any way.
I know some you will be saying “no duh, dude” to (a) through (e) above, but it’s common for a lease to be silent on one or more of these issues.
5. Novation. As discussed in a previous post, when acquiring a lease by novation or assignment, the novation/assignment agreement should have a provision in which the lessee confirms which credits have already been satisfied and, unless the lease documentation uses the pro rata method, the amount of the remaining credits.