A Legal Solution to a Commercial Problem?
A Legal Solution to a Commercial Problem?This article briefly considers the legal basis for the financier or lessor's concerns when considering the issue of what might be called 'jurisdictional risk' in aircraft financing and leasing. It then goes on to look at a new international legal regime - the product of collaboration between the legal profession and the civil aviation community - aimed at mitigating that risk.
In aircraft financing and leasing, there is one constant: a high value, highly movable asset is involved. The acquiring airline will want flexibility in its use of the aircraft to generate as much revenue from it as possible. The financier or lessor, however, will want as much control as possible so as to preserve the aircraft's value and its accessibility (and the financier's or lessor's ease of recourse) following a default.
As a consequence, there is often negotiation about matters such as the jurisdictions into which an aircraft may be subleased and whether the airline may use the engines from one aircraft on other aircraft within its own fleet and/or submit those engines to interchange agreements with other airlines (known as engine pooling). It would appear that, with the growth in airline alliances, one of the benefits that has been identified is access to each alliance partner's engines and stock of parts. Consequently, it is common for an airline to request that it be permitted to sublease its aircraft to and submit its engines to pooling arrangements with, as a minimum, its alliance partners. This may involve a number of jurisdictions in the case of the larger alliances. Some of these jurisdictions are seen as 'friendlier' than others. From the financier's or lessor's perspective, a jurisdiction's friendliness depends upon the ease or difficulty with which aircraft and/or engines may be repossessed.
The risk to which the financier or lessor will be exposed, if an airline's requests are permitted, is one important factor in the overall risk assessment of a transaction. If recourse to an aircraft is not possible or is troublesome when that aircraft is in a particular jurisdiction, the financier or lessor may see it as taking effectively unsecured credit risk on the airline customer. This might affect the pricing of financing or, in an extreme case, even its availability. Neither outcome is good for an industry looking to expand, the tools for which require high capital investment.
The Historical and Operational Context
Financiers and lessors have long been advised that questions of private
international law, often complex, may be involved in a repossession of an
aircraft. If an airline has been given flexibility in its use of the aircraft
and engines, the number of relevant jurisdictions may be greatly increased and
those questions may become more complex.
A court that is asked to determine who has what interests in an aircraft and its engines may take one of a number of approaches. That court might consider, for example: (a) that the law of the jurisdiction of registration of the aircraft is relevant to the determination of priority of interests; (b) that the law of the jurisdiction in which title was transferred or the mortgage granted is relevant; or (c) that the governing law of the transaction documents is relevant in determining the rights of the parties.
An added layer of complication may arise if the airline has been permitted to use an aircraft's engines throughout its fleet. The reality is that, whatever rights are given to an airline in the transaction documents, it is only able to operate its fleet by swapping engines between airframes from time to time. It may be that, upon repossession, an aircraft is found to be equipped with engines owned by or mortgaged to a third party. This problem may be compounded if the airline has been permitted to interchange engines with another airline.
Whilst various devices have been employed to mitigate this - such as title exchange clauses which provide for title to any replacement engine to vest in the airline or lessor upon installation on a particular airframe - it is clear that there is, nevertheless, potential for conflicting interests to hamper the repossession and, possibly, subsequent sale of an aircraft following a default.
An attempt was made to develop an internationally applicable recognition of rights regime under the 1948 Geneva Convention on International Recognition of Rights in Aircraft. The concept embodied in this convention is that rights (including security interests) duly created by contract and recorded under the laws of the state of aircraft registration will be protected. To gain the benefit of this convention, the state of aircraft registration (and the state in which enforcement is sought) must be party to the convention. As not every country is party to the convention, the protection that it affords is not worldwide in nature. As an aircraft is likely to be used to operate to a number of jurisdictions (and an airline will seek to have the ability to sublease to a number of jurisdictions), the risk of seeking to enforce an interest, whether as owner (in the case of a lessor) or a mortgagee (in the case of a financier), at a time when the aircraft (or even one of its engines) is in a country which is not party to the convention cannot be ignored.
It is against this background of risk assessment and its impact on the availability of finance for aircraft that the International Institute for the Unification of Private Law and the International Civil Aviation Organisation have together promoted the development of a new international legal regime. That new international legal regime is the Cape Town Treaty ('the Treaty'), applied to aircraft by means of an aircraft-specific protocol ('the Protocol').
At this stage, the text of the Treaty and the Protocol has merely been agreed. The regime remains subject to ratification or similar process within the individual contracting states. Commentators currently estimate that the Treaty and Protocol are likely to come into force during the next couple of years. What follows, therefore, is a summary of the main principles of the Treaty as applied by the Protocol and of potential issues that may arise from its implementation.
The Next Step: The Cape Town Treaty and Aircraft Protocol
Fundamental principles
The Treaty is not an aircraft-specific document. Rather, according to the
explanatory report and commentary submitted to the Cape Town Conference, it:
is designed to establish an international legal regime for the creation, enforcement, perfection and priority of security interests and interests held by conditional sellers and lessors in three categories of high-value, uniquely identifiable mobile equipment, namely: (a) airframes, aircraft engines and helicopters ...; (b) railway rolling stock; and (c) space property.
The Treaty sets out the broad conceptual framework; this framework is applied to airframes, aircraft engines and helicopters by the Protocol. The Treaty and Protocol are, however, designed to be read together and are, therefore, collectively referred to in this article as 'the Convention'. The underlying objective of the Convention is to provide financiers, conditional sellers and lessors with prompt recourse to the airframe, aircraft engine or helicopter (referred to in the Convention collectively as 'aircraft objects'). It seeks to achieve this by creating an international interest in aircraft objects that may be easily enforced in all contracting states. If this is achieved, it is hoped that aircraft finance and leasing will become more generally available and less costly. The terminology of the Convention is adopted from this point on. Financiers, conditional sellers and lessors are referred to generically as 'the creditor' and the airline or other obligor as 'the debtor'.
The explanatory report and commentary referred to above goes on to state that the Convention is based on five underlying principles:
When does the Convention apply?
The Convention sets out certain conditions that must be satisfied before an
international interest is created. The creditor and the debtor must have entered
into either a security agreement, a conditional sale agreement or a lease (in
each case complying with the formalities set out in the Convention) in respect
of 'uniquely identifiable' equipment. An aircraft or aircraft engine will be
uniquely identifiable by virtue of its being able to be identified by its
manufacturer, manufacturer's serial number and model type. Whilst the location
of the creditor is irrelevant, the debtor must be situated in a contracting
state. The debtor will be considered to be so situated if it is incorporated
under the laws of or has its registered office, centre of administration or
principal place of business in a contracting state. It will also be sufficient
if the aircraft object is registered in a contracting state.
What other action should the creditor take?
If the Convention's conditions are met, the creditor will have an
international interest in the aircraft object. However, the Convention provides
for the creation of an international register. It is envisaged that this will be
highly automated and accessed by computer. There will be a registrar responsible
for the running of this register and all contracting states will be required to
provide an access portal to the register. All international interests will be
registrable against the relevant aircraft object. A search facility will also be
provided and, therefore, it will be possible for the creditor to determine
whether or not any international interests have been registered against a
specific aircraft object. It will become evident that a creditor should ensure
that an international interest is immediately registered against the aircraft
object upon its creation.
What rights and benefits do a registered international interest confer on
the creditor?
The most important benefit is that a registered international interest will
enjoy priority over subsequently registered international interests and (subject
to what follows) unregistered interests. Searches of the register of
international interests should become commonplace as a condition precedent in
financing transactions in the same way that, for example, searches of relevant
national mortgage registers are carried out today.
The beneficiary of an international interest is given various powers on a
default.
A distinction is, however, drawn between the rights of a financier (as mortgagee)
and the rights of a conditional seller or lessor.
If the transaction documentation so provides, a mortgagee may, under the Convention: (a) take possession or control of the aircraft; (b) sell or lease the aircraft; (c) collect or receive income; or (d) apply for a court order authorising or directing any of these. The mortgagee may also take title to the aircraft in satisfaction of the debt but, if any subsequent international interests have been registered, the consent of all interested parties must be obtained before this is possible. The mortgagee is also placed under an obligation to exercise its remedies in a 'commercially reasonable manner'.
The remedies of a conditional seller or lessor are naturally more limited: it may terminate the agreement and take possession or control of the aircraft, or apply for a court order to this effect.
The creditor may, if a contracting state has opted in to the relevant provision of the Convention, de-register and export the aircraft. That contracting state will be bound to honour requests for such action if the formalities prescribed by the Convention have been completed. If any prior-ranking international interests exist, these must be discharged first.
The Convention also contemplates that speedy interim relief should be available, pending final determination of the creditor's claim. The debtor's consent to this should be built into the transaction documents at the outset: it is unlikely to agree, once it has defaulted, to the aircraft object being impounded.
Notwithstanding the rights given to the creditor under the Convention, the exercise of those rights remains subject to national insolvency rules. This might, if unchecked, allow the creditor's rights to be frustrated. Thus, the Convention permits contracting states to adopt a scheme similar to that prescribed by s 1110 of the US Bankruptcy Code. In other words, even if there is an insolvency of the debtor, an aircraft object must be returned to the relevant creditor unless all defaults relating to it have been remedied within a specified period. The corollary of a contracting state adopting such a scheme should be that the availability and pricing of financing for its airlines is improved.
Do contracting states retain any discretion?
Contracting states are able to make declarations concerning certain
provisions of the Convention. These declarations may be made at the time at
which the state ratifies the Convention. Two of these areas have already been
discussed above in relation to insolvency rules and aircraft de-registration.
A contracting state may decide that certain non-consensual interests which currently enjoy priority over even registered security interests - such as liens in respect of unpaid airport charges, navigation services and repairers' unpaid charges - should continue to enjoy such status. Financiers and lessors may, therefore, still see their assets impounded for such unpaid charges. There is no doubt that certain contracting states will make such declarations. For example, it is highly likely that the United Kingdom will make such a declaration in relation to unpaid Eurocontrol charges and airport charges.
Contracting states may make declarations concerning the availability of remedies. Whilst the Convention allows the parties to agree to certain self-help remedies following a default, a contracting state may still refuse to allow such remedies. For example, where a mortgagee's remedy currently lies in a court sale in certain jurisdictions, such an approach might endure beyond the Convention's coming into force.
Conclusion - The Elimination of Jurisdictional Risk?
The Convention shows once again that, where the aviation industry is
concerned, it is the consensus that the industry's international nature demands
a legal regime with true international effect.
Once the Convention comes into force, financiers and lessors can be sure that, where contracting states are concerned, the nature of their respective interest is recognised. However, the Convention's ultimate effectiveness may be compromised by contracting states making declarations in respect of certain aspects of the Convention. It is to be hoped that declarations will be specific and limited but, to the extent they are made, jurisdictional risk cannot be said to have been eliminated. Nonetheless, whilst financiers and lessors will continue to rely on local legal advice as to the actual rights and priority afforded by their interest, this advice should be more certain. That, in turn, should lead to the Convention's objective: lower risk, better priced and more widely available financing for aircraft.
Owain Jones
Denton Wilde Sapte, Hong Kong