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.

Dealing with Maintenance Reserves in the Novation Agreement

Buying used commercial aircraft where the aircraft is on lease to an airline is often seen by the transaction participants (buyer, seller and (if any) lender) as a straightforward and simple transaction.  The buyer and seller agree the purchase price for the aircraft and then get the cooperation of the lessee to the transfer of the lease and, voila, the deal is done.  Aircraft finance lawyers know it’s not quite that simple, but compared to other aircraft transactions, aircraft sales are definitely on the lower end of complexity spectrum.

Aircraft sales and lease transfers do however have many traps for the unwary and one of the biggest traps involves the transfer of the aircraft maintenance reserve balances and responsibilities from the seller to the buyer.  Both the buyer and seller of the aircraft are well aware that the reserves balances need to be transferred as part of the aircraft sale, and the commercial and finance officers on both sides will spend time agreeing between themselves the reserve balances at the time of the closing.  The transfer of the reserves at the closing usually is usually accomplished by netting the agreed amount from the purchase price paid by the buyer.

Sometimes overlooked in these transactions are one or more of the following matters between the buyer–as the new lessor–and the lessee. All of these matters should be addressed in the lease novation (or assignment).  A misunderstanding between the new lessor and the lessee on any one of these issues could lead to a very expensive and acrimonious argument.

1. The new lessor and the lessee should agree the per-hour/cycle/month reserves amounts in effect on the date of closing. These amounts are usually stated as base amounts in the lease documentation and are subject to adjustment for escalation/inflation and for variations from assumptions regarding hour-to-cycle ratio, minimum utilization and other similar operational measurements.

2.  The new lessor should also check to make sure these adjustments (often done on annual basis) have been done in accordance with the lease documentation and on a timely basis throughout the current lease term. At a minimum the new lessor should ask the lessee to confirm in the lease novation that the lessee will not, after the purchase, request a retroactive adjustment because the previous lessor had skipped, missed or made a mistake in a prior adjustment.  Keep in mind that the reserve adjustment provisions in some lease agreements provide for retroactive credits to the lessee, and the new lessor does not want to get an unexpected reimbursement request after the purchase closes.

3. The new lessor and lessee should agree the individual reserve balances as of the last day of the month before the closing. It is common for the lessee and lessor to disagree over these amounts, often because one or the other or both have made simple bookkeeping mistakes along the way or used slightly different methodologies.

4. Where the aircraft delivered to the lessee was not new the lessor will usually have agreed in the lease agreement to provide maintenance credits (aka lessor contributions) to the lessee to reflect utilization since new or since last overhaul at the time of delivery. These lease agreement provisions are, unfortunately, often loosely drafted and when that happens these provisions give rise to high-dollar value arguments between the new lessor and the lessee.  In a perfect world the original lease agreement should provide actual dollar amounts for each of the credits, but in many (maybe most) cases the lease agreement will say something like (paraphrasing) “to the extent the reserves are not sufficient to cover the cost of the first relevant maintenance visit lessor will contribute an amount up to the product of (1) the relevant reserve rate and (2) the number of hours/cycles/months (as relevant) at delivery since the last such maintenance visit.”  If so, the issues will be as follows:

(a)  Is the reserve rate the base reserve rate–or is it the rate as escalated and otherwise adjusted through the date of the maintenance?  While the per hour/cycle/month difference in the dollar amounts may be very small, the aggregate amount can easily be hundreds of thousands of dollars.

(b)  When was the last “relevant maintenance visit”?  In other words, what is the starting date for the calculation?  Sometimes this date is hard to determine, especially with engines and APUs and even with airframes where the airframe manufacturer has changed the interval and/or scope of the relevant check during the lease term.

So, unless the lease agreement is crystal clear on these issues, in the lease novation the new lessor should agree with the lessee either the actual dollar amounts of the maintenance credits or at least the relevant per hour/cycle/month credit amounts and the date of the “last relevant maintenance” for each credit.

Also, the new lessor and the lessee should agree in the lease novation which maintenance credits have already been satisfied by the selling lessor.  For the most part this last issue should be non-controversial.  The exception may be for maintenance credits for engine LLPs, for which lessors have lots of different approaches as to how they collect and reimburse reserves and apply maintenance credits.  I’ll write more about engine LLPs at another time.  In the meantime, tread carefully.

(Whether, when and to what extent the seller transfers the remaining maintenance credits to the buyer is a separate topic for discussion later.)

5. The new lessor should have the lessee confirm that, at the time of the purchase closing, the lessee has not performed any reimbursable maintenance for which the lessee has not been reimbursed–or if that is not correct, then the relevant maintenance and (if possible) the reimbursement amount should be specified in the novation. The buyer/new lessor has based its purchase price in part on the maintenance condition of the aircraft and the reserve balances.  It will be a very unpleasant shock to the new lessor to learn that it has to reimburse the lessee for maintenance for which the new lessor had thought the lessee had already been reimbursed.

The above is more than I intended to write, but this is a complex topic and there is more to say.  I’ll come back to this topic at a later date and talk about, inter alia, engine LLPs, the transfer of maintenance credits and the transfer of leases where return compensation (instead of maintenance reserves) is payable.